What is wrong with our financial system, and how to fix it

Many people realize that the US financial system is rigged, but a few understand how.

The Fed controls the amount of dollars in the economy. Its main goal is economic growth, so it makes sure that businesses can borrow enough money, and prices are steadily inflating to encourage buyers to spend.

Therefore, the Fed prints and lends new money. There are two major ways of lending: 1) to other banks under the Fed funds rate, 2) to the Government and its affiliates by buying their bonds.

Typically more loans than returns. Also, not all loans are returned: the borrowers may become bankrupt. As a result, the amount of money constantly grows. Since 1973, when the US dollar was unlinked from gold, until the beginning of pandemic in 2020 the average annual M2 growth was 6.5% (source).

However, there was an important change after GFC in 2008: the M2 grew largely — on 43% — due to the Fed purchasing bonds (source), 57% of those were bought directly from the U.S. Government (source)

The pandemic has made the situation even more extreme: since January 2020 M2 grew on astonishing 39% or 18% annual, and 76% of this growth was generated by the Fed purchasing programs, mostly (72.5%) from the Government (see links above).

What is wrong here? Well, the Fed printed money are not really free for everyone. With every new dollar in the economy the value of existing dollars decrease. But it should mostly hurt rich people with savings, right? No, it is exactly the opposite. Here is the first trick.

In fact there are two types of inflation. First is for consumer products and services, which can be easily replicated — this is what everyone is talking about. There is also a second one: for difficult-to-replicate cash-generating assets: good companies, land, special real estate.

The Fed is monitoring Consumer Price Index — the first type of inflation. Compared to M2 growth, It remains modest (3.8% from 1973 to 2020, source) due to scalable production and technological advancements. Average salaries did grow much faster either.

However, rich people keep their savings in assets with the second type of inflation: stock market and real estate where it is not produced at scale, such as the Californian market.

During the same period from 1973 to 2020 the S&P 500 index grew faster than M2, and almost twice as fast as CPI: 7.3% (source). Californian single family homes exactly matched the M2 growth: 6.5% (source, source)

Currencies like gold or bitcoin also can’t be produced at scale, but they don’t generate cash flows to support their value, so their usage as a store of savings is limited.

The second trick is to convince everyone that growing stock market and real estate is good. When dollar emission was limited by the amount of available gold, growing stock market meant higher confidence in economic growth. Now it can be simply achieved by printing more money.

What are the consequences of such policies? Actually, the majority of people won’t immediately notice the difference. In fact, their life will gradually get better because they will be buying better products with lower cost price.

However, we are heading to extreme inequality. The asset owners will be way more richer than others. It will be more and more difficult to become one of them, but once you are, you don’t need to do much to support your status and pass it to your children.

De facto we are splitting on modern feudal lords and peasants, without officially naming the classes. History tells us what happens with low social mobility societies.

How can it be fixed?

Surprisingly, this is not too difficult. The dollar needs an anchor, and we can use cash flows to be such an anchor, because their value does not change if each dollar is proportionally scaled.

Fortunately, there is already a tool to evaluate the price of the largest variable cash flows: stock market. We can use the S&P 500 index as aggregate for all of them. We can also evaluate the price of fixed cash flow assets: real estate and land — they are used for tax purposes.

To link the dollar to such anchor, the Fed needs to set its funds rate relative to the joint weighed stock market/property index. For example, if the rate is set to 1%, and the index grows 2% in 9 days, the effective rate would be (1.02 * (1+0.01*9/360)) — 1 = 2.0255%.

Additionally, it should be allowed for Fed to buy the assets only with a nominal and coupon values proportional to such index.

These rules will cause the chain indexation of the economy, so in the end all prices and salaries will be proportional to the index. Investing in the index won’t be profitable anymore — it will just preserve the money value. As a result, there will be no way to earn money by investing without a risk — the main driver of wealth inequality.

Indexation of the economy also helps to solve the problem of unrealized capital gain taxation: the governments may start to collect taxes in shares to sell them on the ongoing basis. Since they collect shares from all companies, they will essentially assemble the stock market index — the risk-free and premium-free asset in these conditions.

This thread is a recap of my one year old article Shares as Money, where I describe the details of how such a monetary system. If you like this article, you may also like the others below:

• The problem of unrealized capital gains. Solution: collects taxes as newly issued equity, so the shareholders pay share inflation tax.
• The problem of social inequality. Solution: granting shares not only to employees, but also to the local communities.
• The problem of inefficient governments. Solution: decentralization of decision making process for social projects and laws.

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