Thursday, January 31, 2013

Fiat Currency Scenarios

Change will occur.

What is clear from the current amount of questioning of fiat currency is that the current system will change.  How it will change is, to some extent, dependent upon developments that will occur as the pressure on fiat currencies increases.  So, it would be inaccurate to say that exactly what will occur can be outlined at this point.  Nevertheless, it is possible to determine some of the changes that will occur.  That is the subject of this posting.
Those changes can be broken down and looked at in a number of ways.  The overall analysis has to address the many roles of fiat money.  That includes international exchanges among sovereigns (i.e., the medium of exchange on transactions between governments).  It also includes how governments’ choose to hold their assets (i.e., the store-of-wealth role of money as it relates to sovereigns).  These are closely related to how international trade is carried out.  Within any individual sovereign, one needs to consider the role of fiat currency as a medium of exchange, store of wealth, measure of value, and method of paying taxes.  All the while, one should be aware that it is highly unlikely that changes will be the same in relationship to all the different roles fiat currency plays.
Some of those changes have already begun.  For example, the role of the US dollar as an international reserve currency is decreasing.  Governments around the world are already diversifying their reserves away from the US dollar.  That should not be too surprising.  The form in which countries choose to hold their reserves has changed periodically throughout the 20th century.  Some of those changes have involved violent dislocations of international trade, but others are best described as merely tinkering with the international exchange system.
The US dollar is losing its position as the central reserve currency among sovereigns.  The key issue for economic stability is how quickly that transition occurs.  It is easy to overlook how big a change it is when there is a transition in the major reserve currency.  Such transitions only occur every 30 or 40 years.  Often they are accompanied by major disruptions of international trade and widespread declines in prosperity.
There is, however, no reason why the transition cannot be orderly except that it involves numerous sovereigns with conflicting interests and an excess of confidence on the part of those sovereigns.  Each believes it can gain from the transition.  Unfortunately, they are not playing a zero-sum game where one sovereign’s gain is another's loss.  International trade facilitated by orderly exchanges of currencies is a win-win situation, unless non-market participants such as sovereigns decide that someone has to lose.  Then it becomes a lose-lose situation.
The risk that governments will turn it into a lose-lose situation is extremely high.  For individuals, especially those in the US, that poses a number of unusual risks.   There are limits to the extent to which the Federal Reserve System can suppress the interest rate pressure created by the shift.  As foreigners move out of the US Treasuries in order to diversify their reserves, the selling pressure could force up interest rates.  If the Federal Reserve continues to buy the Treasuries in order to suppress interest rates the eventual result will be inflation.
That, however, is only the impact of the shift in sovereigns’ choices of reserves.  At the same time there is a risk that large amounts of US currency held by individuals overseas will be repatriated.  Currently, the US dollar is a store of wealth for individuals in foreign countries who have lost faith in their own fiat currency.  If the dollar loses its status as a store of wealth relative to the local currency, those dollars could flow back to the US.  This action of individuals would tend to create the exact same pressures as a shift by sovereigns to an alternative reserve currency.
The pressure on the Fed created by these flows is manageable if the transition occurs slowly over time and sovereigns do not take their competitive devaluations to unreasonable levels.  Thus, those who see a marked period of chaotic activity may be wrong.  An equally likely alternative is a prolonged period of decline in the value of the dollar as a store of wealth.  An alternative way of saying the same thing is the US could experience a long period of inflation, a declining dollar, and eventually rising interest rates.
Since gold is often advanced as an alternative international reserve, the first step is to look at the role of gold as a reserve currency.  During the period when gold was a major reserve, countries left and entered the gold block.  Countries changed the rate at which they would exchange their currency for gold.  Some countries used other precious metals, most frequently silver, as an alternative.  Even among countries that claimed to be on the gold standard, the amount of gold held as reserves against their currency varied between countries.  Within individual countries, the amount of gold held as reserve against the currency was also changed over time.  In addition, it was not at all unusual for one country that did not have gold reserves to peg its currency to another country that did have gold reserves.  Governments knew how to offset the supposed automatic functioning of the gold standard.  The term of art was to “sterilize” gold flows.
The gold standard’s durability was the result of the flexibility in how was applied. Yet, for all the flexibility gold standard afforded, in the end it proved to be too rigid to survive.  That should not be surprising.  Both the supply and demand for gold fluctuate based on a multitude of factors other than just the amount of currency.  The interesting thing is that the demand is often driven by fictions surrounding gold.  Some of the factors that influence the price of gold were discussed in previous postings entitled “Gold, Be Sure You Know What You've Hedged,” and “Gold Again.” 
The period since gold prices have been allowed to float illustrates just how much the value gold fluctuates relative to other goods and services.  That is apparent even within the US, which experiences those fluctuations filtered through the lens of the practice of quoting the price of gold and many other assets in dollars.  In some countries where the price of gold and their currency’s exchange rate fluctuate in a synchronized fashion, the instability of the price of gold is even greater.
It does not take a rocket scientist to see that gold will never be central to international reserves.  The rate at which it is exchanged for other goods is not stable enough.  But most importantly, it will never be the central reserve because governments do not want it to be.  They may welcome the fiction that their currency is backed by something other than their promise and the coercive power implied by their ability to tax, but they do not want the limitations that strict backing by anything would imply.  Specifically, when it comes to sovereigns, no government is willing to accept the limitations their gold holdings would place on their freedom to set policies.  That was true during the period when the international system was supposedly on the gold standard.  It is even truer now.
At the same time, commodities have a certain appeal as reserve if the commodities are durable and their usefulness in the future is reasonably certain.  In the US and many other countries, a strategic petroleum reserve is a good example.  Recently, China's stockpiling of various raw materials has been in the news.  But even in biblical tales the Pharaoh stockpiled grain based on Joseph's economic forecast. 
Gold will probably play a high profile role among those commodity reserves.  But gold will not be alone as a reserve.  What is fairly certain is that the portion of international reserves held as gold will be small enough that it does not inhibit the flexibility of the government.  If gold constitutes 5% of a country’s international reserves, fluctuations in the amount of gold hardly justify changing government policies.  By contrast, if gold is 95% of international reserves, a change in the amount of gold may be considered indicative of a need to adjust policy. 
Once a country moves to holding only part of its reserves as gold, gold becomes a tool that it can use to manage its foreign exchange rate.  That adds exchange rate policies to the fiscal and monetary policy tools available to the government.  Ultimately, it is the ability to manage foreign exchange rates that governments seek.  The ability to manage foreign exchange rates is best served by holding not commodities, but foreign currencies or IOUs.  Thus, what is clear is that governments’ foreign currency reserves will include a variety of foreign currencies and foreign currency-denominated assets. 
The system will be a system of fiat currencies.  It will just be a system where the relative values of the currencies fluctuate substantially.  Such a system will retain the medium of exchange role of fiat currencies, but, clearly, an alternative store of value will be developed by sovereigns.  However, governments are more inclined to spend then to store wealth.  So, the store-of-wealth role of money among sovereigns is of minimal importance.
But, as noted in the introductory paragraph, there are alternative scenarios, but they almost all support the general observation that foreign currency reserves will be diversified.  The main difference in the scenarios results from the fact that it is not clear how governments will manage those reserves.  One alternate is the issue raised by those who talk about competitive devaluations (often referred to as “beggar thy neighbor” devaluations).  It is also quite possible that foreign currency reserves will be used as a method of intimidating foreign countries.  It is easy to overlook the fact that gold reserves, when the world was supposedly on the gold standard, were often used to damage or to intimidate other sovereigns.
As an international system, competitive devaluations will necessitate either a reduction in international trade because of the higher barter costs, or a method, probably privately developed, of laying off the risk associated with currency fluctuations.  Any privately-developed technique would probably first develop the capability to handle the risk for the private sector.  That would leave sovereigns to develop their own methods. 
At least initially, the asset category that will suffer most from this diversification is sovereign debt, especially the sovereign debt of the US.  What is not clear at this point is whether that transition will be accomplished in an orderly fashion.  The effect on the prices of stocks and physical assets will depend upon whether those moving out of US Treasuries use the proceeds to acquire assets in the US. 
As a shorthand conceptual explanation, envision the Chinese or Japanese governments choosing to liquidate their Treasuries in order to buy US companies.  Clearly, it will not be that simple, but conceptually the equivalent could easily be executed.  In many respects, it would be the most profitable approach for the Japanese and Chinese government.  They could avoid crushing the value of the dollar (a major asset in their current portfolio) and end up with a set of assets almost as liquid as, and certainly more productive than, their current inventory of Treasuries.  If it is accomplished in an orderly fashion, other dollar-denominated asset categories might not suffer along with US Treasuries. 
The macroeconomic risk is that there will be a spike in the cost of international trade associated with the increased risk inherent in fluctuating exchange rates.  That scenario would have a negative impact on almost every asset class in any country that is currently integrated into the international financial system.  Unfortunately, the possibility of this scenario is more likely than one would like.
To summarize, between sovereigns the likely scenario is that, at least initially, the substitute for the dollar as a reserve currency will be multiple foreign currencies. That process has already begun.  The issue actually is far less one of what will be the reserve than of how the transition will be executed.
Economics and economists have, to an unfortunate extent, become the handmaiden of sovereigns.  Thus, many economists see the issue of how sovereigns facilitate exchanges as the only real issue.  It is not.  It is curious that much of the public, especially among gold bugs, has been duped into thinking that how sovereigns facilitate exchange has to be linked to how the private sector facilitates exchange.  That also is not the case.  One would be inclined to think that eventually sovereigns would be forced to acknowledge how the private sector is facilitating exchange.  However, sovereigns have a phenomenal ability to live in a fantasy world of their own making.  So, it seems appropriate to look beyond just how sovereigns handle the issue.
Interestingly, among US corporations that process of diversifying reserves has already proceeded a long way.  The Obama administration chooses to call the process “tax avoidance by keeping the reserves overseas.”  Yet, it is a very logical step given the direction in which the global economy will evolve.   Further, it is very beneficial from a US perspective: US shareholders are acquiring foreign currency denominated assets through their ownership of corporations that trade on US markets.  Having those corporations own income-producing assets certainly implies a brighter future than liquidating the assets in order to pay taxes.
Similarly, there is also a raft of financial advisors who advocate a globally-diversified portfolio.  The issue of how one's assets should be distributed across fiat currency denominations is important.  However, first, we should address the alternative asset most frequently raised when fiat currencies are called into question.  That, of course, is gold again.
Each country’s transition from gold-convertible currencies proceeded at its own pace and within a timeframe unique to that country.  Nevertheless, the general model was fairly uniform.  Most countries first eliminated the need for gold convertibility internally (i.e., they eliminate the desire or even the ability of their citizens to cash in their banknotes for gold).  US citizens tend to associate that change with Roosevelt's banning of private gold holdings.  They overlook the less coercive approach used in many other countries.  Probably, the most common way of eliminating gold backing for banknotes is to simply continue to offer convertibility, but to set the price at levels that discourage conversion.  Combine that with taxation based on the paper currency, and the transition can occur quickly. 
The approach taken in many countries allows individuals to keep gold as a store of wealth.  It was the perceived superiority of the gold as a store of wealth that led to its abandonment as a medium of exchange.  It was a classic application of Gresham's law (i.e., bad currencies drive good out of circulation). There are people who view that transition as defining the beginning of fiat money.  Yet, often (e.g., in the US) that change was made in order to increase the reserves of gold available for backing of the fiat currency in international trade. 
Once the relationship between the currency and gold has been severed, the logical follow-on step is to allow the price of gold to fluctuate freely.  When that point is reached, citizens are free to convert their currency to gold.  The primary change from the gold standard is that an open, free market in gold does away with the fiction that the price of gold will not or should not fluctuate.  It is far more logical to assume that it will and that it should. 
Since governments use gold as a tool in the management of their foreign exchange rate, the price of gold will continue to be a function of government whims.  Because the price of gold is now so subject to unpredictable government whims, its role as a store of value is highly questionable.  Thus, gold will continue to be an interesting speculation.  It will continue to provide a hedge against distrust and chaos. 
However, the very instability in international relations that gold is often seen as hedging will produce increasingly large moves in the price of gold.  They will be the consequences of governments using gold to manipulate their exchange rate.  That will be especially true for those investing with US dollars.  As is currently the case, the magnitude of the price fluctuations in other currencies will depend upon the interaction of their exchange rate against the dollar and the dollar's exchange rate against gold.
There is a distinct possibility that gold will appear to be a store of value for US citizens.  As foreign sovereigns use their dollar holdings to diversify their reserve holdings to include a larger portion of gold, they will tend to raise the price of gold in dollars.  Keep in mind that at the same time, they will be using their dollars to purchase other fiat currencies to hold as reserves.  Thus, the price of gold will rise in dollar terms more than in other local currencies that are being purchased as a reserve.
However, as governments become more adept at managing reserve portfolios of multiple foreign fiat currencies, their need for gold will stop increasing.  Consequently, how smoothly we transition to a multiple currency reserve system will have an impact on gold prices in US dollars.  Nevertheless, in the long run there is no reason to assume that the rate at which gold can be exchanged for other assets and commodities should be stable.
As discussed in “Gold, Be Sure You Know What You'veHedged,” gold provides a valuable hedge.  But, there is no reason to believe that the price a rational individual will pay for that hedge should be stable over time.  The hedge is sometimes far more viable than at other times.  Consequently, as the title of that posting implies, it is very important to carefully analyze what gold can hedge and what it does not hedge. Since governments are using their gold reserves to manipulate their exchange rate, for individuals gold does not serve well as a method of hedging exchange rate fluctuations.
That failure to hedge exchange rate fluctuations is aggravated by the fact that most individuals are not in a position to trade with the sovereigns who are exchanging gold.  One should keep in mind that for long periods of time governments have agreed to exchange gold between sovereigns but excluded individuals from participating in that market.  At a minimum, for an individual, there is a three-step process: first, they have to convert the gold to their native currency.  Then, they can convert their native currency to the foreign currency.  It is only at that point that they are in a position to acquire whatever it was they wanted the foreign currency for in the first place.
Just as the most efficient way for the sovereign to manage foreign currency exchange rates is by holding reserves of foreign currencies and assets, individuals who want to hedge foreign currency risk are best served by having reserves of foreign currency-denominated assets.  Viewing foreign currency assets as a hedge against foreign currency risk implies a portfolio allocation that is very different from the standard financial advice of holding foreign currency assets on a cap-weighted basis. 
Thus, to summarize, when individuals view gold, they have to view it from the perspective of its relationship to their native currency.  Further, it is important to keep in mind that one of the reasons that gold is not a good store of wealth is that the price of gold is being made unstable by its use as a reserve currency by sovereigns.
For individuals, foreign currency-denominated assets are the best hedge against instability in the value of their native fiat currency.  Investors can determine the desired allocation across currency exposures by their personal exposure to that currency.  Each individual has to determine how he or she wants to measure that exposure. 
For investors whose sole focus is the return on their investments, the allocation is best if it is based on their best guess at relative returns when converted back to their native currency.  Capitalization-weighted asset allocations are a variation on this general approach recommended by those who choose not to try to guess which currencies and financial markets will appreciate the most. 
An alternative is for individuals to base it on their country’s exposure to foreign economies through trade.  This has the advantage of providing a hedge against the economic impact of currency fluctuations on the local economy.  The logical allocation under this approach would be the trade weighting appropriate to one’s native currency. 
Yet another alternative is to base it on one’s personal exposure through one’s need to acquire goods that are denominated in various foreign currencies.  This is in many respects the hardest approach to apply.  Since individuals are investors as well as consumers, it retains an element of the first approach listed above.  Further, since every individual is exposed to the economy, it retains an element of the second alternative listed above.  However, since every individual has a different personal exposure to foreign currencies, it is the most logical. 
Applying that logic is less than straightforward.  But one can get a general feel by considering such factors as one’s relative need for, say, pharmaceuticals produced in Europe versus, say, toys or electronics produced in China.  Thus, while the third approach does not provide the nice, simple rules that the first two approaches imply, it should yield superior results for individuals.  There is no denying that there is an element of judgment, perhaps subjectivity, required to apply this third approach; it is a fiction to pretend that the same is not true of the alternatives.
The questioning of fiat currencies discussed in the previous posting should not be dismissed without addressing an underlying cause.  To a large extent, that cause is a questioning of the ability to maintain a system of fiat currencies without producing destructive inflation. 
It is highly likely that the most pronounced transition associated with the questioning of fiat currencies will be the development of separate ways to address the store-of-wealth and medium-of-exchange roles currently played by the single item, fiat currency.  Whether economists will ever be able to recognize the separation of the two roles is an interesting question.  The separation that has already occurred in many peoples’ minds does not seem to have affected “economist’s think.”
There is, however, another alternative.  It is the development of ways to address the medium-of-exchange role of money and the store-of-wealth role of money that are unrelated to how taxes are paid.  This is far more likely than most people believe.
One of the impacts of the debasement of fiat currency that is often overlooked is its impact on the sovereign.  As mentioned in the discussion above, one of the consequences of the shift currently taking place will be an increase in sovereigns’ cost of borrowing.  That will be a global phenomenon that will be particularly acute in the US.  Since governments are not particularly good at reducing their expenditures, they will have no alternative but to raise taxes in order to compensate for the increased cost they would incur if they just borrowed the money.  The fiction that their central bank can offset that eventual consequence by printing money only aggravates the phenomena because it encourages further abandonment of the fiat currency.
Many countries that have ruined their fiat currency experienced a rapid escalation in the amount of barter taking place.  That barter reflects two phenomena.  One is that it avoids the taxation that usually accompanies a government failure to manage its fiat currency.  The second, and, in many respects, the more important, is that barter eliminates the need to receive a depreciating fiat currency in exchange for goods.
Sometimes such failures result in the use of a foreign currency as a substitute for the failed fiat currency.  That substitute foreign currency may substitute for either the store-of-wealth or the medium-of-exchange role of the failed fiat currency.  Many of the US dollars currently circulating in the world are being used in this way.  Unfortunately, the abandonment of currency as a store of wealth is often accompanied by a shift of assets into unproductive forms.  There are numerous examples of the phenomena historically.  Land has often been one of those assets that benefited from the phenomena, but livestock, metals, and just about any other commodity has at one time or another benefited from the phenomena.
What is particularly interesting about the current mismanagement of fiat currencies is that it is not restricted to just a few countries.  Consequently, it is quite likely that the debasement of many fiat currencies will stimulate the development of multiple currency blocs.  The interesting question is whether the currency blocs recognized or encouraged by the sovereigns are the same as the currency blocs that developed informally between trading partners and individuals.  A country may peg its currency to the US dollar, the Euro, or the Yuan.  Individuals in those same countries may choose to trade in, or hold, a third currency.
Many people assume that if one has a forecast, it automatically implies a course of action that is appropriate.  That is not the case.  Every forecast involves uncertainty.  The appropriate action is as dependent upon the uncertainty as the forecast.  Some of the changes in fiat currency are apparent:
1) The diversification of reserves to include more of currencies other than the US dollar
2) The abandonment of fiat currencies as a store of wealth
3) Eventual increased cost of borrowing for the US government and probably in many developed economies
4) A shift to higher taxes as a way to fund government in the US, and the increased use of alternatives to fiat currency as a way to facilitate exchange of goods
5) Most importantly, nothing is more apparent than that there is a new scope to the uncertainty surrounding future developments.
One implication is that the risk associated with sovereign debt is greater than it has ever been in the past.  That is true of many sovereigns, and particularly true of the US sovereign debt.  The irony of that development is that sovereign debt is often used as a proxy for the risk-free rate of return.  In many countries right now that supposedly risk-free rate of return is in fact a risk-free rate of loss. 
Most people do not realize that the instability of the risk-free rate of return has implications for almost all bond trading strategies.  Basically, it means that there is a new dimension of risk in any bond portfolio.  That is particularly true of managed bond funds that depend upon a trading strategy that uses any analysis of spreads.  In simple language, bonds are the high risk investment.  Since they do not offer high returns, holding bonds in the current environment makes little sense unless each bond is specifically intended to meet a liquidity needs upon maturity.
No implication is as clear as the overwhelming evidence that tax management of assets is going to increase in importance.  One unfortunate consequence is that the most tax efficient investments are not always the most productive.  That loss of productivity is the hidden consequence of the failure of many sovereigns to manage their fiat currency. 
Generally, investing in things that will produce in the future is the best way to provide for the future.  The more a portfolio is designed to avoid taxes, which is becoming of increasing importance in the current environment, the more it will have to sacrifice productivity in the future in order to avoid tax consequences.  That can be seen in some of the additional implications discussed below.
In a serious twist of the historical experience of most people, the US currency probably embodies the greatest risk.  For non-US-based individuals, that represents less of a problem since it implies that a very common alternative to their own currency can be removed from consideration.  For US-based individuals, it introduces some serious complexities.  One implication is clear.  US-based individuals should have some non-US-currency-denominated assets. 
Those assets should be productive resources whose earnings are not dependent upon exports to the US.  The major focus is not on the currency in which the asset’s price is quoted, rather the important thing is to have assets that produce returns in a foreign currency.  Mutual funds that invest outside the US and ADR’s are good examples, but actually holding the assets in the non-US-currency has benefits that may be more appealing to some individuals.
Another implication of the increased uncertainty and a broader range of potential outcomes is that the value of the hedge provided by gold has increased.  Consequently, regardless of the future price of gold, its value to individual investors right now is greater than it has been in the past.  Thus, one implication is that the portion of an individual's portfolio allocated to gold should be allowed to increase.  If that portion has declined, additional purchases may be required.  As discussed in previous postings, the gold exposure is a hedge similar to insurance.  It lays off certain risks that one hopes will never surface.  In that respect, the increased gold exposure is not the end in-and-of itself.
An investor is presented with numerous options for how to hold that gold exposure.  Some, such as ETFs, make it quite simple for investors to switch between exposure to the metal and exposure to the miners.  In the long run, exposure to the miners stocks should provide a better return than exposure to the metal itself.  Miners are, after all, producing future consumable output while the metal itself produces nothing.
Ownership interest in real estate, and especially real estate that produces income, is a highly effective hedge against a failing fiat currency.  For individual investors, the easiest way to acquire income-producing real estate is through REITs (unless the investor is in a position to acquire the real estate out right).  REITs, however, have experienced considerable price appreciation over the last few years.  Nevertheless, they should be included in an investor’s portfolio.  However, because of the run the REITs have had, careful selection is extremely important.  Another form of owned real estate is one's own residence.  Despite low interest rates, increasing one's equity in one's own home makes sense.
The inverse of the desirability of income producing real estate is the undesirability of mortgages on such assets.  Commercial mortgages are risky in the current environment, but residential mortgages and residential mortgage bonds are downright foolhardy investments.  Without the Federal Reserve Bank’s monthly purchases the price of mortgage backed securities would fall substantially.
An indirect implication of the concentration of risk in mortgage debt is implied by our regulatory environment.  Under current bank regulations, banks are encouraged to hold mortgages and mortgage-backed securities by lower capital requirements.  Thus, investing in banks should be done with considerable care.  Very few have appealing risk reward profiles.  Bank stocks appreciated significantly last year and may do the same this year, but once the Federal Reserve abandons monetary easing, bank earnings will be dependent upon interest rate spreads.  Once they make the transition, they will be good investments.  However, the transition will be very difficult for some of them.
It should be obvious that every investor should be carefully watching the development of alternatives to fiat currencies.  For him or her it is not yet time to abandon currency as one's method of holding a reserve for a rainy day.  But that day is closer than it has ever been and vigilance is warranted.  Even now it is possible that some investors will prefer to diversify that rainy day fund into multiple currencies or combination of currencies and commodities.  After all, that is what foreign governments are doing.
One final point that needs to be noted is the fallacy in the notion that all asset prices will collapse if a fiat currency fails.  Income-producing assets, assets that actually produce, will retain their value.  However, that value in the original fiat currency becomes irrelevant.  They will continue to have value, but that value will be measured in a totally different way. 
Bonds by contract are denominated in fiat currency terms.  Equities on the other hand, are quoted in fiat currency terms, but actually represent percentage ownership of the underlying asset.  If nothing else during a period of uncertainty regarding the currency, that consideration alone would argue in favor of equity over debt, or, put differently, stocks over bonds.




Wednesday, January 30, 2013

Currency in Question

Fiat money is being questioned

All of the uses of fiat money are currently being called into question in one way or another.  For example, economists long since discarded the notion of currency as a reliable measuring stick for a great many purposes.  They have developed alternatives such as constant dollar value, trade adjusted value of the currency, and, of course, the ECONOMIST’s “big Mac index.”
The contradiction between enumerating “store of wealth” as a function of the currency, while using deflated or constant dollar values when measuring across time, does not seem to bother economists.  But it is not just the store of wealth role of money that is being questioned.  The alternative measures listed above imply that its role as a medium of exchange between countries is in question.

The ability to retain conflicting views on the same subject is not unusual.  Interestingly enough, it often surfaces in connection with efforts to defend a fiat money.    For example, an article in the WALL STREET JOURNAL entitled “A Golden Solution forEurope's Sovereign-Debt Crisis,” pointed out that many sovereigns in southern Europe could reduce their borrowing costs by securing the loans with their gold reserves.  The whole issue arises as a part of the effort to defend a fiat currency, the euro. 
So, essentially, the article points out, the euro could be defended by having it abandoned for some purposes of a currency: for borrowing costs to be lower for gold-backed debt versus debt backed by the sovereign government, buyers of the bonds have to believe the wealth preserving value of the gold is better than the wealth-preserving value of the sovereign backed fiat currency.  Part of this is a questioning of the trustworthiness of the sovereign, but there is undoubtedly also an element of distrust of fiat currency.
The issue was raised in connection with southern European countries with large amounts of debt and large gold reserves.  So, undoubtedly the focus was on the trustworthiness of the countries.  But it would be naïve to assume that the distrust does not reflect upon the currency.  Basically, it reflects a belief that there is some probability that no entity will step in and honor the value of the currency implied by the debt.  In that respect, it is the currency that is in question.  Further, while the article focuses on southern European countries, the same issue has been raised in connection with other countries not in the Euro Zone.  At its extreme, entities are forced to issue bonds in a foreign country’s currency. The issue has receded in the background now that the European Central Bank seems to be indicating that it will step in to honor the debt.
In the example of the southern European countries, the proposal would result in one currency being used to pay taxes within the sovereigns, and a second currency, gold, being used to secure debt.  Further, since a substantial portion of that debt is held by other sovereigns or their proxies, the banks, it would move the medium of exchange between sovereigns toward gold rather than the fiat currency.  Put differently, barter between sovereigns would be carried out in gold if it involves a transfer across time.
Europe is not alone in experiencing a questioning of the role of fiat currency.  The WALL STREET JOURNAL on August 29, 2012 had an opinion piece entitled “The Gold Standard Goes Mainstream.  It pointed out that the major political party in the US was calling for a Gold Commission.  Now, as we all know, government commissions often are nothing more than a showcase for politicians who like to hear themselves talk.  But it is worth noting that the topic they are talking about is the abandonment of fiat currency.
The opinion piece tries to make some sense of this.  Those readers interested in their interpretation of this should review the opinion piece.  However, an obvious interpretation of the very existence of the opinion piece is that a substantial number of people in the US are fed up with the failings of fiat currencies and looking for alternatives.
More direct and broad-brush questioning of the medium of exchange currently in use was advanced by Stephanie Pomboy, founder of MacroMavens, in an interview in BARONS (July 21, 2012).  The article was entitled “Coming: The End of Fiat Money” which leaves little doubt about the major focus of her comments.
She also makes it quite explicit by stating: “I don't see it in the next 12 months. I think a five-year time horizon is very, very realistic. I envision a gold-backed currency system. We are going back to hard money, rather than a fiat system where debtors can silently default by inflating their debts away.”
One does not need to go so far as to depend on a forecast.  The first time the statement was made by Pomboy, gold was trading in the 1570's.  Subsequently, the price in terms of fiat money has gone up.  Since gold has very little value other than as a medium of exchange and store of wealth, that price change reflects a decrease in the role of fiat money as a medium of exchange and store of wealth.  Of those functions, Pomboy’s focus is on investing as is reflected in her statement, “I would own gold [and] companies tied to mining.”
Further, one doesn't have to adopt Pomboy’s conclusion that gold will become the substitute for fiat money.  She could be totally wrong regarding gold.  Her comments reflect the growing trend toward questioning fiat currencies regardless of whether gold is a viable substitute.
Pomboy could well turn out to be partially right.  Fiat money may cease to function as a store of wealth and be replaced by gold or some other mechanism.  However, as discussed in a previous posting, “When a Currency Is Working, It Isn't Questioned,” the “store of wealth” role of a currency may be the least important of the three functions that economists often cited.  Further, it should be clear that the Hedged Economist believes that the only true store of wealth is the acquisition of something that produces wealth in the future.  No money in existence or ever conceived fills that role.
The examples above harken back to a past time when gold served as a currency.  One doesn't have to be a gold bug to question fiat currencies.  In fact, one can just question how fiat currencies are being managed without advocating an alternative to fiat currencies.  That is exactly what was reported in the WALL STREET JOURNAL on December 23, 2012.  The article was entitled “Global CurrencyTensions Rise: Japan's Abe Calls on Central Bank to Resist Easing Moves by U.S.and Europe.”

Although the title makes reference to Japan’s complaint about how fiat currencies are being managed, it references a number of other similar complaints and actions.  In fact, the general theme of the article is best summarized by a quote. It is from a presentation by Mr. King, a UK official.  He commented:  “I do think 2013 could be a challenging year in which we will, in fact, see a number of countries trying to push down their exchange rates. That does lead to concerns.”  He went on to say: “The policies pursued by countries for domestic purposes are leading to tension collectively.”
Such complaints are not new to international relations.  However, what does seem to be new is that a significant number of countries are acting upon their concern.  Further, their actions sometimes involve the use of a non-fiat asset as an alternative to fiat money for reserves.  US citizens, because it became a political issue, are well aware that China manages its exchange rate.  It has been an object of global criticism for its efforts to hold down the value of its currency.  China's purchases of reserves of commodities have become an important determinant of world prices and are closely followed by commodity investors.
But now a number of countries long committed to allowing the value of their currency to be determined by the market feel it is necessary to intervene.  They include Switzerland, Israel and South Korea, along with others like Brazil that do not have as long history of commitment to fiat money for actual trade. Policy makers in Australia also are under increasing pressure to fight the rise of the Australian dollar.  An article published on January 8, 2013 highlighted how unusual the current situation is by the very title of the article: “Button-Down Central Bank Bets It All.”  It went to some lengths to describe how unusual the behavior of the Central Bank of Switzerland has been. 
One should also note that governments’ use of gold as a part of its reserves has been rising.  In fact, there are observers who attribute a substantial portion of the rise in the price of gold to the efforts of governments to expand their gold reserves.  In a curious twist, if that is true, the governments' efforts are probably contributing to the demise of fiat currency.  It is highly likely that the rise in the price of gold calls attention to the failures of fiat currencies.
These currency disputes are currently within the bounds of just being tension.  One is free to attach their own level of significance to the fact that the tension is surfacing in the form of disputes about fiat money.  But it is hard not to believe that if enough countries are dissatisfied with the existing fiat currency system, an alternative will be found.  That alternative may be another fiat money, but that is not guaranteed.
On a totally different front, Barron's cover on December 31, 2012 highlighted an article entitled “The End of Cash?” In this article, it is the use of fiat currency as a medium of exchange that is questioned.  The article points out that “fewer and fewer Americans use cash to make purchases large and small…” The article explains that “while cash in circulation is growing, it is becoming increasingly marginalized for retail transactions. This year, greenbacks will account for an estimated 29% of U.S. retail payments, according to McKinsey & Co., down from 36% a decade ago.”
As the article explains.  “Having already vanquished checks, the two big payment networks, Visa (V) and MasterCard (MA), are even more focused on displacing cash.”  The article also points out that there are: “A wave of relative upstarts … beginning to garner attention, particularly as so-called digital wallets take hold. The eBay (EBAY) unit PayPal, Google (GOOG) Wallet, and Square are all plays on the digital wallet, essentially a locker of personal-payment data stored either in the cloud or on smartphones. The wireless carriers are also fighting to get into the game by controlling the secure chips that are becoming common in smartphones.”  Discover and American Express also compete to replace currency as the medium of exchange.
However, all of these competitors use currency as the measure of value.  The Hedged Economist would contend that as long as the fiat currency is used to measure value, these substitutes do not constitute a challenge to the fiat currency.  Thus, since the role of currency as a measure of value is not questioned, the article’s implications are indirect. 
A logical question is: How this differs from checks as a substitute for dollar bills, or for that matter, how is it different from the decision to issue a dollar coin rather than a paper dollar?  If one wants to understand how this relates to currency, it is necessary to go beyond just the methods being used to pay for transactions.  One has to look at the ways the transactions are being financed.
Keep in mind that many brokerage firms, including Fidelity and Schwab, offer credit cards linked to brokerage accounts.  In essence, the transaction is financed, not off of future income, but off of capital in the form of income-earning assets.  While still denominated in dollars, the transaction is secured not by gold or the government's guarantee, but by an income-producing capital investment.  Further, remember that the accounts the credit cards are linked to may allow margin borrowing.  This certainly represents something very close to the equivalent of the banking system’s fractional reserves.
Granted, the relationship between currency and these new forms of paying for transactions is indirect, but, basically, people are issuing their own currencies through the use of their brokerage account linked credit cards.  It bears a striking resemblance to the development of fractional reserves currency by individuals.  Fractional reserve banking was the original source for fiat currencies.  One should never forget that the first dollar bills, pound sterling, etc. were issued not by governments but by individual banks. 
A more direct challenge to fiat currency is appearing on the Internet.  The Hedged Economist recently received an inquiry about a clear effort to develop a new fiat currency.  The inquiry related to Coinbase.  Coinbase issues Bitcoin which is a new digital currency that is being used all over the world. 
It is interesting, although it has some of the markings of an affinity-based Ponzi scheme.  Despite that, it is worth close observation because it makes for very easy barter. As the ECONOMIST article referenced in the previous postings points out, "The origin of money is a response to barter costs, in which the best money is that which minimizes the costs of trade."  The person who forwarded the inquiry was told that about $25M USD is traded a day, and personally knows of several business that accept it.  So, to the tune of $25M USD, Bitcoin is serving as money.
Interestingly, Bitcoin's challenge to currency also includes an element focused on the role of currency as a store of wealth.  That challenge as a store of wealth is introduced by the fact that they have pre-announced how much additional currency will be issued.  To those familiar with the relationship between the value of money and the supply of money, that represents a definite challenge.  Coinbase will be issuing a pre-announced dollar value of the Bitcoins.  If their rate of issuance is less than the Central Bank’s rate of issuance, the dollar value of each Bitcoin could increase.  If that is done without impeding its role as a medium of exchange, it could become a very appealing currency.
Nothing in this posting or the previous two (“When a Currency Is Working, It Isn't Questioned” and “Currency and the Role of Government”) represent an endorsement of the positions noted.  Regarding gold, The Hedged Economist’s perspective has been the subject of a number of postings.  Hopefully, this posting is clear regarding other substitutes for fiat currency that it references.
Any discussion of the future role of fiat currency contains a forecast.  As has been discussed in The Hedged Economist, forecasts are always scenario-based.  What is significant about the questioning of fiat currency discussed in this posting is that it reflects the fact that a large number of people can see a variety of scenarios under which fiat currency will lose its luster.  The sheer fact that so many observers can see so many different scenarios under which fiat currency is called into question is in-and-of itself significant.  Thus, even without a full scenario it is possible to determine some characteristics of how our fiat currency system will change.  That will be the subject of the next posting.



Tuesday, January 29, 2013

Currency and the Role of Government

An irrelevant issue.

It is interesting, but totally irrelevant, that the ECONOMIST magazine (“On the Origin of Specie,” Aug 18th 2012) delves into a long-standing debate in economics.  That debate is the issue raised in the title of this blog: what is the role of government in the process of establishing a currency?  The government's role regarding currency has an impact upon whether the different roles of money can be retained by one commodity regardless of whether that commodity is a slip of paper or a physical good.
The ECONOMIST discussion is made irrelevant by the application of totally circular reasoning.  The article states: “The evidence suggests that only “informal” monies can spring up purely privately.” But, the article's definition of informal money seems to be that it is not endorsed by the government.  The net effect is that the article says nothing relevant to the discussion of the role of government in creating a viable currency.

In fact, the author goes on to point out that “informal money can exist on the grandest scale.”  It uses the example of the dollar’s position as the world’s reserve currency as an example of a currency being adopted informally.  By using that particular example, the article illustrates the irrelevance of their definition of formal money.  A government endorsement does nothing but meet their criteria for formal money.  That endorsement is totally irrelevant to whether something functions as a currency.  All of the functions of currency are totally unrelated to whether it is “formal” currency.  Such circular logic in order to reach the conclusion that government has a role in defining the currency is unfortunate.
Many of those who argue that currency requires, or is dependent upon, government will at the same time point out the advantages to the government of having a central role.  One of the advantages is the ability to capture seigniorage (the difference between the value of the currency and the cost of the inputs).  That, however, represents the introduction of inefficiency, a cost to using currency.  Further, there is no particular reason why only government could capture that seigniorage.

The historical evidence is that government is no more reliable as the benefactor of that seigniorage than private entities.  In fact, a number of the examples that are often used to illustrate the role of government in establishing a currency could equally well be used to illustrate governments’ tendency to abuse seigniorage.
The argument often also recognizes why governments get involved in the development of a currency.  It allows governments considerable efficiency in taxing economic activity confiscating resources produced by the private sector.  If those who argue that government has an essential role in defining the currency would look closely at history, they would realize that often the definition of the currency is dependent upon the definition of how one can pay taxes.  So, the argument that government has an essential role in establishing a currency is reduced to an argument that governments can define how they will take resources from the private economy.  That is true, but proves nothing.

Viewed from that perspective, it isn't surprising that often those who favor a major role for government in the regulation of society also believe that government has an inherent role in defining currency.  By contrast, those who would see the government's role reduced are inclined toward allowing the market to define the medium of exchange.  One of the great dangers to strong central government is that a substantial portion of the population will facilitate trade by barter and start holding their wealth in a form that is hard to tax.  That makes it much harder for the government to confiscate a portion of the increased value generated by trade.
The ECONOMIST article is interesting in that it points out that a currency can end up functioning both as an informal, some would say freely chosen, medium of exchange, while also existing as a formal, government-endorsed, medium of exchange.  The example often given is that a country's currency can also become a freely chosen international reserve currency.  That has been true throughout history and was true of gold, silver, the British pound and now the US dollar. 

What is dependent upon government involvement is how quickly a currency can cease to be a viable medium of exchange and store of wealth.  Governments change their method of taking resources much slower than the private sector can shift to a new currency.  That follows automatically from the fact that governments are always responding to the medium of exchange.  It also can leave the government collecting money that is less and less useful as a method of commandeering resources. 
One only needs to recognize that economists developed a number of “laws” to explain how currencies function when more than one medium of exchange was in existence.  If there was a formal mechanism for stating that this is the currency, the issue of how multiple mediums of exchange function would never have existed.

The issue of the government's role would be irrelevant.  There is, however, no reason to believe that “bad money drives good money out of circulation” could not equally apply to where money circulates.  One currency could be of no use other than to pay taxes, while another is used primarily for trade.  That separation in the roles of currency is exactly what happens and is described in connection with international reserve currencies.  In most countries the native currency will be a medium for paying taxes, while that function is totally missing in the international reserve currency function. 
More generally, alternative methods of facilitating barter can coexist quite comfortably alongside of formal money without the tax-paying role of money being undermined.  There have always been methods of exchange other than formal monetary transactions.   Similarly, it is not the money itself that produces in the future.  Money is just a method by which current resources are channeled into something that produces in the future. 

Economists often brush over the third role of money: “it must be a unit of account, a useful measuring-stick.”  They just assume that it follows from the first two.  Yet, in some respects it is the most telling.  If people start calculating their wealth using something other than the currency or start thinking of prices in terms other than the currency, the role of money is clearly in question.  That questioning will be the topic of the next posting.

Monday, January 28, 2013

When a Currency Is Working, It Isn't Questioned.

Definitions matter

Economists are fond of defining money by enumerating its uses.  The ECONOMIST Magazine had an article on the topic.  It first reviewed the standard definition:
“Money fulfills three main functions. First, it must be a medium of exchange, easily traded for goods and services. Second, it must be a store of value, so that it can be saved and used for consumption in the future. Third, it must be a unit of account, a useful measuring-stick. Lots of things can do these jobs. Tea, salt and cattle have all been used as money.”

Economists do a substantial disservice to the public's understanding of the role of money by enumerating its potential uses as if they were all equally important.  As is discussed below, there are important caveats to the notion that money is a store of wealth.  If money is not channeled into something that produces in the future, there is no wealth in the future. 
ECONOMIST magazine goes on to describe the function of money as reducing the cost of barter (“On the Origin of Specie,” Aug 18th 2012).  The emphasis on reduced cost of barter has the advantage of automatically explaining the benefit of having a well-functioning currency.  There is tremendous benefit to society from making barter (trade) less costly.  It introduces tremendous efficiencies into the economy.  Reduced costs of exchange allow the same resources to produce more benefits to society.

Considerable controversy about monetary policy and the government's role can arise from placing different emphasis on “store of wealth” verses “media of exchange.” That can be seen immediately from the fact that inflation is inherently an issue "across time."  So, it relates only to the role of money as a store of wealth.  If one places a high value on the role of money as a medium of exchange and a low value on the role as a store of wealth, one’s policy conclusions will be different from those of somebody who inverts those priorities.
The focus on making barter efficient can lend perspective to this often contentious debate.  The role of money as a store of wealth can be viewed as making barter more efficient.  However, in the case of "store of wealth" the barter is across time.  Essentially, the store of wealth function of money relates to only a subset of the broader category of medium of exchange. 

Monetary theorists do not seem to realize that the issue of whether the different roles of money can be separated is more important than the emphasis on specific aspects of the role of money.  Clearly, they can be separated for prolonged periods of time.  Further, there is a distinct possibility that too much emphasis upon the role for money as a store of wealth is counterproductive.  Wealth can never be produced by money.  It is always produced by the effective deployment of resources to produce in the future. 
If a substantial portion of the population does not know how to use current resources to produce in the future, money may have a default role as a store of wealth.  When money fills that default role as a store of wealth, it becomes a mechanism by which society can transfer current productive effort into the future, but for that to happen the money must be entrusted to someone who can effectively use it to produce in the future.  In that respect, the size of the financial service industry, or at least its importance, is inversely related to the portion of the population who know how to productively employ resources.  If few people know what to do with money other than spend it, they need a large financial service sector to channel resources into future production.

Differences in the emphasis placed on the various functions of money are often assumed to relate primarily to one's balance sheet.  Specifically, the role as a store of wealth is far more important to those with wealth.  Those with debt, on the other hand, do not want money to function well as a store of wealth.  They benefit from a depreciating currency. But they will care whether it is an effective means of exchange. 
A strong argument can be made for the position that the wealth is not the cause for the attitude about the importance of money as a store of wealth.  Both the wealth and the belief that money should serve as a store of wealth reflect an individual's preference for income in the future rather than immediate consumption.  The inverse is also true.  Those who think the exchange value of money (i.e., the ability to spend it) is most important probably are those most anxious to spend it now.

It never seems to occur to people that what applies to the individual may also apply to the entire society.  A society that is wealthy and producing wealth may lean toward a stable currency, while a society in decline where wealth and income are falling favors a currency that is declining in value along with their income and wealth.  What is not clear is the direction of causality.  Does a society with growing income and wealth want a stable currency?  Or, does a stable currency produce rising income and wealth within a society?