How do we value value?
On the 19th of July 1844, faced with rampant (and unstable) inflation, the British government of Queen Victoria under Prime Minister Sir Robert Peel passed The Bank Charter Act, establishing what ultimately became to be known as the “Gold Standard”.
It was a radical shock to the system, for prior to 1844, any bank anywhere in the country had the authority to issue their own bank notes, presumably against deposits held in their accounts, although in reality, no one could really tell. The Act put in place a requirement for all subsequent bank notes to be issued with backing from an equivalent amount of gold, with a limit of £14m of bank notes issued without gold backing.
The text of the Act is itself a fascinating read, particularly given the shortage of full stops and its highly proficient use of semicolons. More importantly, it embodied the idea that value had to be based on something tangible – not necessarily useful, but at least tangible and in limited supply, like Gold or Silver bullion.
100 years after the Bank Charter Act was enacted, at the end of World War 2, the Bretton Woods Agreements were initially signed in 1944 by the US, Canada, Western European economies, Australia and Japan, establishing a negotiated system of exchange rate management with the initial aim of supplying capital across multiple economies for the purposes of postwar reconstruction and rehabilitation. The anchors of the system were Gold and the US Dollar, valued against each of the participating countries’ domestic currencies.
On the 15th of August 1971, faced with a growing balance of payments deficit, the US unilaterally walked out on the Bretton Woods agreement, terminating the convertibility of the US dollar to Gold, rendering the US dollar a fully fiat currency, backed by nothing but confidence in the currency itself.
Almost 50 years later, we’re starting to see the real impact of a global anchor currency that is quite simply the best of a bad bunch. Every central bank in the world is zealously printing new currency. Quantitative Easing is back (in truth it didn’t really disappear for long), but this time everyone’s in on the game, not just the majors – from the UK, to Canada, to New Zealand, even South Africa and Turkey. Yes you read correctly, remember the Fragile Five?
History has a curious way of repeating itself, so much so that one could almost say we’ve found ourselves in a global version of pre-1844 England.
Choked Plumbing?
A couple of months ago, we took a snapshot of the Fed’s balance sheet, remarking at the end of 2019 that all the effort to reverse and normalise QE had been reversed as repurchase operations, meant to provide liquidity to banks to keep lending going, were put in place.
If that was a “reversal”, then we need a new term for this:
Note: this newsletter was written before Thursday’s additional US$2.3 trillion bazooka announced by the Fed
The Fed’s balance sheet is now the largest it’s ever been, and with a full-blown Covid-19 pandemic in progress, it is unlikely to reverse anytime soon. If ever.
To be clear, we are not casting judgement on the appropriateness of the Fed’s reaction to the crisis: in this case, they are doing exactly what any Central Bank feels it should do in principle, serving as the lender of last resort.
The point we are examining, however, is this: at US$5.8tn of assets currently in issue, that’s the equivalent of the Fed providing a credit line of roughly US$17k per US resident. About a third of the average US salary of c. US$48k (according to 2019 BLS numbers). Yet, it is evident that the distribution of this liquidity isn’t uniform. One wouldn’t expect it to be uniform, but one would certainly not expect the largest US bank, JP Morgan, to be the one claiming to be short on liquidity for lending.
Something has gone wrong with the plumbing in the system.
A one-trick plumber
The risk here is that policymakers have played the QE game for so long that they’ve forgotten what it’s like to make policy, leaving them with only one trick left in the book: print more cash. They know it’s not going to end well, but they have no other option anymore.
The above is data from the OECD showing government fiscal deficits as a percentage of total GDP over the past 20 years. With the exception of Norway, Iceland and Ireland (which are the three obvious outliers), it is amazing how tightly all of these governments have held on to their fiscal discipline. Yet, what they demonstrate in fiscal restraint they more than offset with monetary hedonism.
Perhaps governments have lost their creativity in problem solving, to the extent that every problem is a problem to be solved by chucking more cash at it?
Perhaps they simply got lazy, and prefer the “set it and forget it” approach of top down monetary sprinkling.
Or perhaps it is also a case of governments themselves being in on the money-printing game? With 10 out of 35 of the OECD member countries running government debt balances of more than 100% of GDP, and 25 out of 35 running debt/GDP of more than 50%, any threat to sovereign credit ratings from increased fiscal spend would create an interest load that is too heavy to bear.
After all, while the deficits are running at pretty stable levels over time, they’re still in the red on a yearly basis. Call it “not getting worse at a worsening rate”.
Whatever the reasons may be for policymakers going down the route of unending monetisation, whether they simply don’t know any alternatives, or they cannot enact any alternative policy, or because they outright don’t want (or don’t dare) to – the way things stand point to one increasingly likely endgame.
A one-trick plumber that only knows how to clear a choke by flushing more water down the pipes will do just that. But what if the choke doesn’t clear?
Overflow
The beauty of a fiat currency is that the issuer can print as much of it as desired. The problem comes when you keep printing and no one else really cares about what it’s all worth anymore - not even Dr. Evil:
Jokes aside, an overflow of liquidity on a global scale, especially with an anchor currency that is being printed with gusto, is problematic, especially in terms of inflationary risks.
But what inflation? The same time series data from the OECD would seem, at first glance, to support the idea that the past 10 years of QE and monetary easing has done nothing in terms of causing inflation for the large proportion of OECD economies, with a few exceptions (e.g. Argentina and Turkey, each with idiosyncratic issues).
The riposte to that snarky comment could well be “well, not yet.” To find inflation, look no further than this chart put together by Yardeni Research, the textbook definition of “too much money chasing too few assets”, that we first referenced in “Where did all the money go?”:
What inflation? That depends on where you look. And who you ask.
How to value value
Every measurement, including that of value, needs to be measured relative to a reference point. Currency allows goods to have a common point of reference with respect to their intrinsic value, since 4 rides in the London Tube could hardly be compared to the value of a Sashimi Bento Box at our local Japanese restaurant (of which we’ve been sadly deprived for the past few weeks). Put a price on them and suddenly it is the case that 4 rides in the tube at £2.60 each is worth slightly more than lunch, as much as we’d beg to differ.
The beauty of money is that it provides a common medium of exchange. That works well in a domestic economy. But those days of autarky are long gone. As the fallout from Covid-19 has demonstrated, supply chains are so globally intertwined that even in lockdown, no man is an island.
But when the value of money, both domestically and internationally, starts getting debased as a result of varying extents of monetary supply expansion, how does one know what value truly is? In 1986, The Economist magazine proposed the “Big Mac Index”, as a way of benchmarking the different levels of purchasing power i.e. real consumption ability and value of money across different countries. It’s useful as an approximation of value, but we certainly aren’t settling global trade transactions with Big Macs.
So what is the Ideal Standard?
By default, we have the US Dollar. But while we can measure the value of everything from Apple shares to the GDP of Tajikistan in US Dollars (US$8.15bn in 2019, if anyone’s wondering), it’s no longer clear what that value truly means when US Dollar M2 supply has just about doubled since Dec 2008, and continues to grow at an exponential pace.
Here’s a simple example: imagine Apple was worth X as a company in 2008, denominated in “true value” (“vals”, for the sake of argument), and the exchange rate between US Dollars to vals was US$1 = 1 val in 2008. Assume that today Apple is still worth X vals (it obviously isn’t, but we’d like to just illustrate the point) but the dollar is half as valuable, at say US$2 per val, then the value of Apple has doubled in dollars, even as its true value (X vals) remains the same!
We’ve seen this game before in the emerging world as local companies don’t really rise in value in dollars, but they can double and triple in local currency terms, creating illusory value and bewildering short sellers who argue (rightly) that true value is being destroyed.
Take note stock market bears. We think the game has changed. The only difference now, as we approach the endgame, is that the dollar is no longer the anchor against which value is measured. Its time has come – it is itself at risk of being put upon the scales, just not as the weights, but as the subject of measurement.
The question is, measured against what?
We could go back to Gold which is benefiting, as it should be, from these developments, but the same issues that plagued the Gold Standard back in the day apply now.
And then there’s Bitcoin: that stubborn little thing that started out with a bunch of programmers, still anonymous and unknown, and a couple of lines of code, but which 12 years on, not only refuses to die, but is durable (effectively indestructible), portable, fungible, divisible to 8 decimal places, uniform, increasingly acceptable as currency and limited in supply (21m BTC). These all happen to be, in the words of the Fed itself, the key characteristics of money.
In previous musings, we have written that the one thing bitcoin had never experienced since its creation was a fully fledged global bear market. We did not know how it would react in a significant risk off environment. Would it trade as just another risk asset; an inflated beneficiary of a decade of easy money in a never-ending bull market? Or would it rise as a safe haven to take its destined place alongside gold? Well, we are in the midst of a major global bear market and Bitcoin is still hovering around $7000 dollars just weeks before the much anticipated halving of its mining block reward. It is of course still early and a lot will unfold in the coming months, but it could certainly be argued that in our multiple path investment approach, Bitcoin is in the process of entrenching itself along the path less travelled, one that leads to a place we haven’t seen before – a possible escape valve from the current choice of infected global fiat currencies.
Our thoughts on bitcoin adoption are that it could happen far sooner in the developing world than in the developed. With QE now started in places like South Africa and Turkey (again, seriously?) these currencies risk becoming unhinged. And with Binance in particular, scaling up its fiat onramps in these and many other developing countries it’s becoming easier and easier to invest in Bitcoin – far easier than investing in US dollars (and certainly gold) in many places. To many in the west, Bitcoin is still mysterious and volatile but to those in the emerging world, nothing accelerated adoption more than necessity and the train has left the station.
For now the dollar is very much king by virtue of its incumbent reserve status but as we know from history, kingdoms come and go.
We can’t (and don’t) claim to know how things will pan out. But when we think about the multiple paths the future can take, the probabilities have shifted materially as a result of this crisis and, dare we say, adversely against “more of the same”. Perhaps the status quo remains for a while longer. Or perhaps something finally gives.
Like it did on the 19th of July, 1844.