Tuesday, May 17, 2022

Fed Has A Recursion Problem

Terra made two coins, Luna and UST, that depended on each other.  They both crashed recently.   I made the following graphic:

The Fed has a similar design problem.  The Treasuries are measured in US Dollars but the Fed backing for the US Dollar is mostly Treasuries.   In this kind of setup both parts can go to zero in terms of real world things.

The Real Bills Doctrine says that if a bank loans out short term against real things that it can be safe.  But if a bank loans out long term in its own currency it can get into trouble.   This is very old wisdom.   Young folks today did not learn this stuff in school.  I think the Fed will be giving the world a demo on how this fails.

In computer science we would call this a recursion problem.  In computer science you can have a function that is defined in terms of itself but there needs to be a base case that does not need further recursion.  With Luna/UST or Treasuries/USD there is no base case.   So the results are "not well defined".   So it did not and will not end well.

Originally by law the dollar base case was gold.   The Fed originally had 40% gold backing and anyone could turn in \$20.67 in dollars and get  1 oz of gold.   Then in 1933 only other countries could redeem dollars and only 1 oz gold for \$35.  Then after 1971 no one could turn in dollars for gold.   In 1980 gold got up to around \$850 per oz and the Fed still had enough that at that price their gold helped stabilize the dollar.