I think the Federal Reserve is one of the most interesting things of all time, but I sometimes forget that most people don’t care.
Between its history, structure, public reception, and its enigmatic impact on the economy, the Fed is one of those topics that is endlessly fascinating to me. It’s also a topic that can feel like a constantly growing mountain of knowledge, complete with intimidatingly technical jargon and stooping gatekeepers, that is impossible to conquer.
I want to avoid becoming another obstacle preventing people from learning about the Fed and monetary policy just as much as I want to write about it. Which draws a fine line that I must walk along to pull off a quality blog post.
Of course, I wouldn’t find myself in this position if the American education system guaranteed students a sound economics education.
My younger brother is in middle school, which provides a steady inflow of opportunities for sobering reflection about my growth and education during my childhood. When I’m not imposing my interests on my brother against his will so that I can live vicariously through him, I’m thinking about how he and his middle school peers could be educated differently so that they can grow to become loyal and engaging subscribers to my blog.
If I’m not skilled enough as a writer to simplify certain concepts that some readers may not have my same affinity for, then maybe I should instead invest in ensuring that the next generation of readers builds the knowledge base necessary for understanding me.
In other words, it’s not that I need to do a better job of making myself more understandable. It’s that they need to do a better job of understanding me.
To develop children into the optimal subscribers, their learning path should probably mirror my own. My infatuation with economics and the Federal Reserve began with learning about financial crises in the 1930s and 2008. Learning about financial crises is a good stepping stone to understanding financial markets, macroeconomics, and economic policy, more broadly.
But because it would be unreasonable to assume that kids these days were as smart as I was, I figure that we would have to develop a more dumbed-down method of instruction than the one I was exposed to.
I’ve always thought that mock simulations such as student government elections are among the better techniques that schools use to teach students.
Earlier this year, when my brother mentioned he was running for his school’s election, I saw the perfect opportunity to enlighten him about the dangers of populism and the importance of building a big-tented coalition of voters. I dismissed the website he created from scratch for his own campaign with detailed policy proposals, imploring him to instead spend more time delineating who the median voter at his school was and devising ways to engage in patronage with them.
For some reason, what I said didn’t seem to resonate with him, which is definitely why he didn’t win. But the experience inspired me to think of comparable mock simulations that would facilitate more opportunities for me to indoctrinate him about topics that I know and enjoy — like a mock shadow banking system.
Bearing the Fruits of Lending
The shadow banking system is composed of parties that intermediate financial transactions between investment banks, corporations, hedge funds, asset managers, and anyone else who wants access to short-term credit or debt that traditionally lies outside of the oversight of central banks and banking law.
It’s a system that is appropriate to simulate because it teaches valuable lessons about how so many financial crises have happened and where financial interventions must occur to promote recovery.
Imagine a class of 30 students, who represent the financial sector, taught by a teacher named Janet, who represents the “real economy.” Students start each day of the simulation with different amounts of cash that are determined by how much Janet likes them as students. With the cash, students can lend to Janet and earn back interest. Students are told that interest is the main way to earn income, along with smaller random allotments of cash that represent sources of income other than interest transferred to the financial sector from the “real economy.”
But students can’t just generate endless amounts of interest income from lending endlessly to Janet. There must be demand from Janet, which will be revealed daily through what will be called an ETF auction. During ETF auctions, Janet will demand whatever amount of cash she wants and students, who represent financial institutions, will give it to her at an interest rate that the class collectively negotiates.
ETF, not to be confused with exchange-traded funds, is an acronym for exchange-traded fruit. I realize that realistically, a change to the curriculum whose goal is to develop the next generation of subscribers to my blog would likely fail to entice notoriously tiresome school boards. This is why students who lend to Janet will receive fruits, instead of some expendable item such as paper or a coin, in return.
Obesity is an important public health crisis that affects 14.7 million children and adolescents in the US. My simulation is important not only because it educates the youth about subjects I intend to write about in the future, but also, and more importantly, because it contributes to the fight against childhood obesity.
The exchange-traded fruits students receive are tradable, like treasury or mortgage-backed securities, and to be eaten when the underlying loan matures. In other words, when Janet pays back a student who possesses the fruit that corresponds to the loan she initially received, that student must eat it. Without holding the loan until its maturity and eating the fruit, students won’t earn any interest income.
My plan for children’s health succeeds where former First Lady Michelle Obama’s plan failed because it incorporates an important lesson from economics: that people respond to incentives. In my simulation, students are driven by a financial incentive to eat fruits.
An important component of how I intend to make eating fruit teach students about financial crises is the fruit’s exchangeability.
Something is exchangeable if there are rules that facilitate trade and there is demand. Demand for exchange-traded fruit partially derives from students’ preferences for certain kinds of fruit, which will encourage securities-like trading frequencies of the fruits.
If Lloyd is a student who likes apples, he may want to trade for an apple so that he gets to eat it when its underlying loan matures. Conversely, if his friend Warren has an apple but doesn’t want to eat it, he can trade it away for a fruit he prefers more.
If Lloyd is interested in Warren’s apple, Lloyd may study the risk conditions of the loan that the apple represents and deliberate about how confident he is that the loan will be paid back. The perceived risk and confidence in the apple, which translates to how easily the apple can be swapped for cash, indicates how liquid the apple is. Apples, along with the rest of the fruits that Janet issues, are very liquid assets mostly because of students’ high approval and trust of Janet.
Liquidity is an incredibly important concept for Janet’s class to understand. In the “real economy,” liquidity is less important because of the tendency for liquid assets to provide less return.
As an average consumer, it might not be smart to keep your savings in cash, letting its value erode as time passes by. It might make more sense to invest the savings in assets that can appreciate over time. But because of the volatility of assets like stocks or real estate that a consumer may invest in, these assets are less liquid, or not as easily swappable for cash.
Meanwhile, in the financial sector, a scarcity of liquid assets guarantees there will be a financial crisis.
A Man is Only as Good as the Liquidity of His Collateral
The quasi-financial sector we have created in Janet’s class isn’t very regulated except for one rule: that every student must have at least 8 dollars in cash available at the end of every day (not unlike a reserve requirement).
Let’s say that students started with between 8 and 20 dollars of cash and that on the first day of holding ETF auctions, Janet asked for a lump sum of 300 dollars, which every student contributed the same 10 dollar amount towards. Accordingly, all fruits issued are equivalent to 10 dollars.
After the ETF auction, Janet initiates a round of small random allotments of cash transfers to everyone. After the auction and the cash transfer, Lloyd is left with 5 dollars in cash and a kumquat worth 10 dollars that yields 10 percent interest, while Jamie is much luckier, accumulating 16 dollars of cash and a tangerine worth 10 dollars that also yields 10 percent interest.
Bruce is another student who really loves fruit and has a sharp financial mind, likely due to his father who runs a money market mutual fund (wink wink).
Because of Bruce’s unrequited love for eating fruit, he wants to collect as many fruits as possible and hold them until their underlying loans mature so that he can eat them – but he knows that doing so would mean accomplishing the unfeasible feat of hogging all the interest income for himself.
So Bruce begins telling his classmates who have surplus cash like Jamie, that they can give him cash, which he can use to buy fruits that he holds until their maturity. In return for depositing money in Bruce’s “fund” and financing Bruce’s fruit addiction, the interest payments that Bruce receives are distributed amongst the depositors. Giving cash to Bruce is like parking money in a high interest-yielding checking account, especially because depositors such as Jamie have the right to withdraw their cash from Bruce at any time.
Lloyd, who doesn’t have enough cash to meet the 8-dollar-quota, has two options:
1. He could go to Jamie for a repo loan, which would comprise an overnight loan of 3 dollars helping Lloyd fulfill the daily quota but also requiring Lloyd to give up a kumquat as collateral. When Lloyd pays the loan back, Jamie makes some quick interest income, and the ownership rights of the kumquat are returned to Lloyd. But if Lloyd fails to pay the loan back, Jamie gets the kumquat, which is much more valuable than the initial 3 dollars that were loaned. The over-collateralization of the repo loan is what helps make it so safe.
2. He could also go to Bruce who is ready to purchase the kumquat from Lloyd with depositors’ cash, giving him enough cash to meet the 8-dollar quota:
Days pass by, in which students in situations such as Lloyd make transactions with students like Jamie and Bruce to meet Janet’s daily quota. Students in Janet’s class continue receiving random allotments of cash and the exchange-traded fruits whose underlying loans are paid off are replaced by new ones that Janet issues in the next round of auctions.
One day, Michael, a student in Janet’s class, looks over at Lloyd’s desk and notices fungus on Lloyd’s apricot. Drawing from Science class, Michael remembers that fungus spreads. If Lloyd’s apricot has fungus, then it is possible that the rest of the batch of apricots that Janet issued, including his own, might have fungus. Even worse, the fungus may have spread to the rest of the fruits that he kept in his inventory.
Worried, Michael begins quietly selling all the fruits in his inventory. But not quietly enough.
Kenneth and Vikram take note and inspect their own inventories, shocked to discover the same fungus that freaked Michael out. Dick and Jimmy don’t know exactly what is going on, but they see Kenneth and Vikram panic and immediately follow suit.
As horror and paranoia spreads throughout the classroom, no one wants to hold apricots or any other fruit, under the suspicion that the items might have fungus and lose all their value or because of general fear.
With demand for fruits rapidly declining, students are having trouble meeting the daily quota. Both repo loans, which aren’t occurring because fruit no longer qualifies as good collateral, and money market mutual funds such as Bruce are no longer viable options. Students are also becoming more tentative about buying more fruits from Janet the next day and anticipating lower performance for days, possibly weeks to come.
Exchange-traded fruits, which used to be highly liquid securities that everyone was willing to swap for cash, have now become the least desired item to hold in Janet’s class. Everyone wants to exchange their fruit for cash, but no one will give up cash for possibly fungus-infected fruits.
Perhaps no one is hurt more by the rising illiquidity of fruits than Bruce.
On one hand, Bruce’s fruits are no longer edible. On the other hand, Bruce promised depositors such as Jamie that they could withdraw their cash at any point in time, predicting that the fruits he was buying with the cash deposits could always be exchanged for cash if needed. But now he can’t sell the fruits to pay his classmates back, nor does he have enough cash on hand to pay them back.
The financial markets are a place where confidence and peer effects are of ultimate importance. As soon as one depositor realizes Bruce’s dire position, the panic will spread like wildfire, not just among Bruce’s depositors who will likely stage a bank run on Bruce, but across the entire financial system.
Similar to a wildfire, the crisis began because of excessive dryness and can only be mitigated by hosing down the entire forest with lots of liquidity. Maybe there is a student in the class with so much excess cash that can act as the figurative hose that stabilizes the financial system. Or maybe the students will want to come together to establish an independent institution that can lend infinite cash instruments to hose the financial system down when wildfires are imminent.
Discovering Unknown Unknowns
The framework created for the simulation may be oversimplified and lack nuance, but it builds the foundation for understanding why financial crises happen. A foundation that anyone can build upon to understand events such as the Great Depression or the 2008 Financial Crisis or even the Terra/Luna Stablecoin fiasco that took place one month ago.
The financial system shouldn’t be as esoteric as it is. Yes, it can sometimes be extremely unpredictable and frustratingly susceptible to breaking for no apparent reasons. But people should be educated to the point that they can acknowledge these flaws in our expertise in a subject that is central to the functioning of our society.
While I was on the brink of giving up on this ridiculous, seemingly half-baked idea for a blog post, I explained my idea for the simulation to my younger brother. Unlike my sermon about political strategy, he seemed to be captivated by the idea of implementing a similar activity in his classroom. Soon, he was asking me about how repo loan markets work in the real world and why money market mutual funds exist, until we got to a point where I couldn’t answer his questions.
It was at this point that he remarked about how humbled he was by the complexity of something he thought would be so simple. At the granular level, the financial system is a simple transaction between a lender and a borrower. The multiplicity of these transactions, however, creates an intricate ecosystem of interactions between different effects that are impossible to discern.
I believe that everyone should aspire to experience the humility that my brother expressed in as many subjects as possible — or at the very least, in whichever subject you choose to specialize in learning. If everyone was more humble about how much they didn’t understand, it would be a positive sign of the strength of our education, the levels of critical thinking occurring, and the state of discourse going forward.
The primary goal of my blog has always been to indulge myself, but where I get more fulfillment is when I become aware of some impact I have made on even just one person. I never intend to teach people anything, as that would communicate a level of credibility and intelligence that I don’t have. I instead try to instill a sense of curiosity and bewilderment in readers that comes from seeing the nuance behind something.
On the surface, the purpose of a mock shadow banking simulation is to show how financial crises happen (while fighting childhood obesity). Beneath the surface, my simulation, like the best learning experiences I have had in school, is an invitation to explore the unknowns of a subject further. Because the optimal subscriber of mine wouldn’t be someone who knows a lot. It would be someone who is constantly humbled by learning.