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 BIG PICTURE

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.

A RED HERRING

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.

BEYOND SOVEREIGNS’ RESERVES

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.

TRANSITIONS

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.

THE IMPLICATIONS OF UNCERTAINTY

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.