The USD and bond market made simple

Many have leveled the accusation that my previous posts were too long or convoluted, and I guess that's kind of fair. It's taken me a lot of concerted effort to come to the place I'm at with my albeit limited knowledge of the monetary system. Which is kind of the point. It's so insanely complicated that you have to put in huge effort to understand its basic operation, and thus few people ever do. And most who try give up before they really find out how it works, which almost always leads to the "fed go brrr" mentality, when the really scary harry monster to anyone who actually understands it is deflation.

It's a little bit akin to the myth of overpopulation, insofar as a limited understanding of that leads one to fear immiment overpopulation, whereas a more complete understanding leads one to fear an imminent population collapse.

So with that in mind, here's my TLDR version of how the monetary system works.

For all intents and purposes, the USD monetary system is nothing more than a highly complex system of ledgers keeping track of who owes what to whom. There's very little actual money in this system, which consists mostly of the physical currency you have in your pocket (which is negligible and therefore we can ignore it for this discussion).

That said, dollars, T bills, T notes, and T bonds can all be considered the same thing. They are all debt obligations, which is just a fancy way of saying IOUs.

The only fundamental difference between them is the rate at which they mature. Dollars have instant maturation. You can exchange them for goods and services at any time. T bills' terms are measured in weeks, notes in months to a few years, and bonds in decades.

The fundamental problem with this entire system is that there is more debt than can be paid back, which is why the can keeps getting kicked. The burden of repaying the debt would in and of itself destroy the debtor's ability to repay, and they would default. We have long since passed the point where austerity can fix the debt problem, so now it's slowly starting to dawn on everyone that the debt isn't going to be repaid.

Essentially, the total debt obligation far exceeds the total ability to repay. Let's say a barber went around town trading free haircuts for goods and services. He goes down to the general store and explains he's short on cash, but he'll give the storekeeper a 15 dollar haircut for a 10 dollar bag of groceries. And he does that everywhere. Pretty soon, he's booked solid giving haircuts to people he owes. And of course they've prepaid, at a lower rate, so he's working harder than ever for less money than ever. Pretty soon, he's having to give even steeper discounts to get the goods and services he needs. For example, he says to the general storekeeper that he's too busy to cut his hair this week, but he can do it next week, and since the storekeeper has to now wait to redeem his haircut, he's going to say okay but this time he's only going to give him eight dollars' worth of groceries for that same 15 dollar haircut. In other words, the barber's interest rate just went up.

Now pretty soon, the barber is booking haircuts years into the future. And people are thinking, why not? Pay a small fee now and not have to worry about paying for a haircut ever again! Sounds great, right? But of course things don't always go according to plan. Maybe the general storekeeper dies suddenly, leaving his wife all the IOUs he collected over the years for haircuts, which she has no use for. So she trades them for other stuff she does need, like hair stylings. By now, the barber is so booked solid with owed haircuts you can hardly get a haircut in this town to save your life. Meaning you have to find someone who got in on this scheme in the early days when he was writing IOUs that were for short term haircuts. The first ones were redeemable upon request, immediately, and then subsequently got longer and longer out. So if you need a haircut right away, you have to find someone with an immediately redeemable one from the early days. Or maybe you plan ahead and buy one that matures two weeks from now, when you know you have an important date and want to look your best. So now there's a whole bond market for these things!

But the whole thing comes crashing down when it starts to dawn on people that the barber has traded more haircuts than he can possibly give in the remaining years of his life. If he gave haircuts all day every day, every waking hour for the rest of his life, he still wouldn't be able to give a haircut to everyone he owed one to. So now it becomes a guessing game. How long will he live? How many people will redeem their haircut, vs simply let it roll over? One thing is for sure, though. At some point, the demand of his bondholders will someday exceed his ability to supply haircuts. At some point, more people will show up with legally redeemable IOUs than he can service at one time.

It's an imperfect analogy, but I hope you get it. The very limited physical currency in the system is kind of like those original, immediately redeemable haircuts. It lets you skip ahead to the front of the line, and there aren't very many of them. When the whole thing comes crashing down, and people with 30 year haircut bonds realize they're not getting those haircuts, the only barber bonds that will be worth anything will be the immediately redeemable and very soon to be redeemable ones. Let's say someone has a barber bond redeemable in two weeks. Well, the barber is 50 and looking good. Chances are, he's going to alive and well that long. The ones redeemable in 30 years? Maybe not so much. Is an 80 year old barber going to be giving many haircuts? Probably not. So the longer the term, the more likely you won't be able to redeem your haircut before that day when demand finally exceeds supply.

Eventually, people stop taking his IOUs, so he has to keep paying higher and higher interest. And finally, at some point, nobody wants them at all, no matter how deep the discount. The long term holders will have to restructure. Instead of getting two haircuts a month, maybe they have to go down to one. They've just taken an unrealized loss on their barber bonds.

Now imagine this same scenario, but magnified across the entire town. Imagine every single person is trading their own IOUs, and getting themselves in the same situation as the barber. Imagine the entire town has issued far more credit than can ever be repaid, all denominated in this universal, immediately redeemable contract known as the dollar. If you have this magical debt obligation called the dollar you are contractually entitled to redeem it for any good or service of your choosing, and they can't say no (because they desperately need the use of that contract to service their own debt).

So the moral of the story is that in a system where there's no actual money and only IOUs, you want the highest quality ones you can get. And FYI, money in a bank isn't money. It's the lowest quality form of debt there is, which is unsecured credit. You don't have dollars in a bank, you have a bank's IOUs. So cash is king, followed by T bills. T bills mature in only a few weeks. If the government looks like it's going to be around in four weeks, a four week T bill is almost as good as cash. But the longer the term, the less likely it is that anyone will want it.

People think there's inflation because they don't understand the difference between the dollar and dollar denominated debt (which most often seem like the same thing, until they don't). They can operate interchangeably up until people realize there's not enough hypothetical dollar supply to ever fulfill the debt obligations. And when people become unwilling to exchange dollar denominated debt obligations in place of real dollars, that's when people will find out that the two are intrinsically very different animals.

But at its core, this is all very, very simple. What's worth more to you? A haircut today or a haircut 30 years from now? When the barber is young and spry, and supply exceeds demand, those two can seem not far removed from one another, and be appraised to be of virtually the same value. But when the barber is long in the tooth and demand has begun exceeding supply, all the sudden the vast differences in tangible value become realized.