Digital central banks

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Initiative, savvy, luck, circumstance, and convolution have taken over currencies – or at least digital creations purported to be currencies (but in reality don’t, and never will, quite fit the bill). Those entities that create and support real currencies are taking notice. In other words, welcome to government in action. Here come central bank digital coins. Now imagine these “developed” governments (of whom France is probably not the worst offender) trying to deal with a global currency, currency exchanges, and the transfer of funds internationally. We don’t have to look too far to find the convoluted rules behind Bretton Woods, the WTO, and other international absurdities to recognize that this problem is not easily solved, or even understood. Bureaucrats are generally better at devising rules, charging fees, and collecting taxes and information than making anything that is useful or even comprehensible.

Luck rather than leadership, circumstance rather than foresight or political skill, seem to have been more helpful in triggering these developments. Digital coins (while loosely described as “currency” are more like a digital asset easily transferred and accounted for in a digital ledger) represent a handful of rather clever people taking on central government’s mighty bureaucrats. Armed with simplicity, clarity, and algorithms, they are defeating all administrations’ fondness for complexity, confusion, and rules.

In general, bureaucrats are masters of the art of convolution. Essentially, governments work overtime to create farce in the spirit of precision. An example of bureaucratic absurdity can be found in France (admittedly, a country that has taken bureaucracy to an art form – perhaps more so than art itself). When the government started a new lockdown because of the pandemic, they devised a two-page permission form to leave home, with 15 different justifications, before, thankfully, shelving it in the face of ridicule. The French can buy alcohol, for instance, but not underwear. These rules were simply to be able to walk out the front door, and the government imagined that this kind of detailed process was somehow useful, and not the bewildering reality it represented.

Inequality and Wealth Creation

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Inequality is not an appropriate measure of economic performance or wealth creation.

Inequality is a relative and comparative statistic. It shows how wealth is distributed, which is not that meaningful, and certainly should not be the basis of economic policy. Essentially, inequality is a comparative metric and not an absolute one. That is, if everyone does better but a few people do much better, inequality increases, and this is seen as something bad even though everyone is better off. It is used to create misleading policies that focus on redistributing wealth that is created versus policy that should be focused on enabling greater and more distributed wealth creation – not wealth capture. Policy should focus on how to best create wealth for more people. The absolute degree of wealth creation is beside the point relative to other people. Creating opportunity for the most people is what matters.

As an example, overall wealth has increased over the last 30 years for every population group, but for the highest group, it has increased more substantially. But, why is that a problem? Instead, it is a natural and unavoidable outcome of the free market.

Here’s the analogy: if you want to hold a lottery, the prize has to be disproportionately large to have the most participants to raise the most capital. The simple goal is that net outflows (prizes) are smaller than the net inflows (contributions or purchased tickets). This is very similar to business opportunities and wealth creation.

As an economy, we want as many contributors to wealth creation – entrepreneurs and new businesses driving economic growth – as possible. The only way to do this is to enable market participants to have the greatest possible reward without restrictions. Most businesses will fail (much like most lottery tickets lose). But, because we have increased the number of willing participants, we also increase the opportunity to create the most wealth – the most businesses, jobs, and economic growth, as well as increasing the tax base from both businesses and individuals. So wealth creation, even if it is concentrated mostly in a handful of people, benefits the overall economy and society much more effectively than any attempt to limit that upside or redistribute it through politically popular but inefficient and demotivating policy.

Investment Principles

Stimulus and silliness

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The world economy is struggling to escape the Covid-19 economic shock. During the worst of this pandemic, the world’s developed economies provided an enormous fiscal stimulus on a scale not seen since the second world war.

Now, however, the US is proposing to more than double its already generous fiscal stimulus. Is this a good idea or excessively risky?

Go Big, But Where?

For its proponents, the idea of “going big” is designed to be a transformative political moment. But too much appears allocated inefficiently, and it may simply be irresponsible.

An easy money era produced only anemic growth. But the scale and direction of additional stimulus look more like irresponsible fiscal policy leading to significant overheating and the waste of resources. While there is a strong case for a more aggressive approach to fiscal policy, that policy still needs to be grounded in economic realities and reasonable priorities. These are not.

Inflation, Profits, and Bitcoin

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“I believe that the present, accurately seized, foretells the future.” V.S. Naipaul There is a lot of uncertainty today in the markets, but there has always been uncertainty in the markets. We have never had certainty regarding the economy or the future. The most reasonable exercise, as V.S. Naipaul reminds us, is simply to understand the present. So what’s going on? The economy is accelerating. Inflation isn’t a problem. The Fed is going to keep interest rates as close to zero as possible for the foreseeable. These components are driving valuations higher, and in some cases, approaching stratospheric levels. Some concern is warranted in certain sectors, but overall, things seem to be relatively steady and not too overblown. Earnings appear likely to grow, and in many cases, quite rapidly, for the next couple of years – assuming something unforeseeable does not occur (but this probability is not zero). Bitcoin has a few interesting characteristics worth understanding. It is a decentralized, permissionless, peer-to-peer network of computers that’s permanent and unhackable .An investment in Bitcoin is, in reality, a part of the peer-to-peer computer network (essentially, a slot on the database), and almost all of those slots have been allocated. Only 21 million Bitcoins will be produced and 18.5 million have already been mined and circulated. Price is a function of supply and demand (see Economics 101).Arguments about “inherent value” are, and always will be, meaningless. Is there really some kind of “inherent value” in gold? We just decided it was valuable to us. The same is happening with Bitcoin. Bitcoin supply grew 2.5% in 2020; it will grow 2.0% in 2021.The question for Bitcoin valuation is simple: Is demand growing faster or slower than 2.0% annually?

Predictability and Panic

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Prepare for more frequent and extreme volatility. New and powerful influences, ranging from social media and financial technology to algorithmic trading and esoteric valuation models, will increasingly upset market stability and bring unprecedented rewards and unpredictable disaster.

Predictable market conditions will be upset by sudden unpredictable movements.

Financial markets can be predicted reliably only when the world does not change.

Even during periods of stability, judgment based on expectations and assumptions as much as hard facts and economic analysis, form the basis for buying and selling decisions. Market crashes and financial crises are a continuing and breathtaking reminder that markets are irrational and uncertain. Taken to an extreme, the combustible combination disrupts global markets and societies.

Coinbase, Bitcoin, Ethereum, and Dogecoin

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Coinbase, Bitcoin, Ethereum, and Dogecoin

Everything you don’t understand about money combined with everything you don’t understand about computers.

Bitcoin and other digital currencies are going mainstream, and along with that, increased volatility. Last week, cryptocurrencies jumped in value as Coinbase, a cryptocurrency exchange, became a publicly traded company worth approximately $100 billion. In other words, trading in digital currencies, with all the expected volatility and unpredictable nature such securities bring, is here to stay.

Uncertainty and Irrationality

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Clear and coherent markets, free from political agenda, bad compromises, and ineffective regulation is almost nonexistent. The consequences are usually pyrotechnic. It is not as if the world hadn’t provided ample warnings about the risks associated with irresponsible finance. History has centuries worth of such examples, but even looking at recent events over the last 25 years is illuminating.

In spite of Alan Greenspan acknowledging the “irrational exuberance” of the markets in 1996, stock market valuations continued to rise. The warning signs of unstable economies were believed to be localized and the broader markets decoupled from this turbulence. This was naïve thinking then and outright irresponsible now.

The idea that markets are uncertain, and consistent prediction is essentially impossible, is not new. John Maynard Keynes published a book on probability and uncertainty in 1921, with this concept of uncertain and irrational markets forming the basis of his general theory of financial markets. So, years before the stock market crash of 1929, and almost every 10 to 15 years afterward, the cycle of financial crashes and panics was predicted by a well-publicized thinker, and then, as is typical, ignored. The lesson is simple, and Keynes laid it out 100 years ago: markets seem rational but only during periods of stability. Markets are uncertain. Predictive models work most of the time, and that is their fundamental flaw. They will fail. Investment models that account for uncertainty and failure succeed in the long term.

Abundant Cash Is Not Cash Available Abundantly

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The pandemic, Fed interest rate policy and bond purchases, restrictive banking regulations, and banks’ swelling cash balances will have a lingering impact on liquidity and produce some mind-bending policies to deal with this uncharted territory.

As the pandemic emerged in March 2020, strange things happened:

o Bond markets seized up and investors panicked.

o Bond yields spiked causing severe price declines.

o Credit default swap prices (debt protection derivatives) rose 100x in less than a month.

o The dollar rose and liquidity dropped for U.S. Treasuries, usually the world’s most liquid security.

o There was substantially lower demand at U.S. Treasury auctions.

The Federal Reserve responded with an almost never-ending pile of cash, buying vast quantities of bonds with newly created cash. It has continued its purchases, at a pace of at least $120 billion a month.

But this has not resulted in “happy days are here again.” This mountain of dollars is limiting liquidity and constraining markets. That’s right, read that again if you must – too much cash can constrain the economy.

More volatility. Less predictability

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S&P 500 stock market values are experiencing the same volatility as the first half of 2020, the start of the Covid-19 pandemic (based on the 50 largest value movements as a percentage of the index’s total market value). These dramatic movements show that market volatility leads to big price movements in stocks, both up and down. There are a couple of factors combining to enhance this turbulence: The popularity of the momentum trade (buying stocks that are rising quickly and dump the relative losers quickly). Decreasing liquidity (fewer buyers and sellers for the other side of trades). Both factors magnify the market’s moves in either direction.

Lessons from a Financial Blowup

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The Archegos implosion teaches the same lessons that apparently need to be taught over and over again.

1. High leverage eventually brings margin calls.
2. Margin calls equal disaster.
3. Margin calls come when too much leverage is attached to securities linked to market volatility.
4. All securities are linked to market volatility.
There is no such thing as uncorrelated assets anymore. Investment strategies founded on the belief that the securities held are somehow immune from previously “uncorrelated” volatility are anachronistic. Combine these investments with substantial leverage intended to enhance returns, and this strategy ends in disaster.

If it’s zero eventually, great quarterly performance is meaningless.

It’s risk-adjusted return, idiot.