Sunday, June 12, 2022

Why Bitcoin is Valuable

One of the most difficult questions is "Why is Bitcoin valuable?". In many ways it looks like a "greater fool" mania. People who own Bitcoin are not paid dividends, so it is not like a profitable company. With a company you can figure out how big a loan those earnings could pay off and have some estimate of the value of the company. We don't have anything like this with Bitcoin. Given no way to estimate an intrinsic value for Bitcoin, many experienced investors think Bitcoin does not have value.

To make matters worse there are around 20,000 other crypto coins and many are clearly jokes or scams. Some jokes and scams are worth billions of dollars, so some cautions people group the whole category as jokes, ponzis, or scams.

All of the above is clear and easy to understand. It is harder to explain why Bitcoin has value but since this is a really important and common question, I am going to try. Will list some arguments below.

Faith in money

The dollar used to have value because it was backed by gold. However, since 1971 it is not backed by gold. Now the Federal reserve assets are mostly Treasuries. Treasuries are just future dollars. So the dollar is backed by future dollars. This is really just faith in dollars. If the faith goes away, there is no gold or anything to prop up the value. The dollar does not have any intrinsic value. During the revolution America had "The Continental Dollar" (stressing that a big continent should not be ruled by the little island of England) but after they printed too many, the value went to zero.

If enough people have faith in Bitcoin as money that may be all it really takes. Over the last 13 years Bitcoin has been growing in converts fast. Projecting the trend seems reasonable.

There have been many strange things used as money in the past. At some point in the future using pieces of paper where governments could print as many as they wanted will seem stranger than Bitcoin with a fixed limit of 21,000,000 Bitcoin. Also, you can not counterfeit Bitcoin but paper money has a problem. So in some ways it is easier to have faith in Bitcoin.

There are people who would buy more Bitcoin if the price got below some certain price. There are people who would sell some Bitcoin and buy a beach house if it got above some price. Large numbers of such people gives Bitcoin a bit of stability and over time I would expect the stability to get better.

The root problem with conventional currency is all the trust that's required to make it work. The central bank must be trusted not to debase the currency, but the history of fiat currencies is full of breaches of that trust.

– Satoshi Nakamoto

Secure Accounts

Having an account that no government can easily grab is valuable. In the normal financial system governments can grab money in accounts. It used to be you could get a numbered Swiss bank account that no government could bother, but those days are gone.

With Bitoin you can make as many different accounts as you want on your own. Nobody else gets to know what accounts are yours. This is kind of nice.

The Bitcoin miners updating the blockchain with new transactions is the most secure accounting system ever developed. Nobody can modify or forge this record of transactions. There is value in having a secure set of books. It is an important service. Particularly when regular Fiat money may be running into high inflation trouble.

Untaxed Income and Investment

If someone pays you for a job in Bitcoin, and neither of you report it, there is no bank involved to report it. So the government need not know about this transaction. If you just keep the Bitcoin you might have saved 30% on your taxes. Years later a normal investment would be taxed when you sell it. The value years later might have mostly gone up due to inflation (dollar going down) but you are taxed on the whole "profit". This can make it where investors have a very hard time to get ahead. If you are invested in Bitcoin you could go to a tropical island, like Anguilla, walk up to an ATM and cash in some of your Bitcoin. No government collects any taxes at that moment, or for the years that you held the Bitcoin.

Given how bad the tax on fake profits normal situation is, this Bitcoin savings/investment is far better.

Moving money is cheaper/faster

Compared to credit cards, wire transfers, western union, etc. Bitcoin is a cheaper and faster way to move money. There is also no waiting in line and paperwork. The old system sucks life out of commerce at a high rate. Businesses that keep using that will have a disadvantage compared to those that use Bitcoin.

Fair money

With US dollars the government and large banks can borrow money from the central bank at crazy low interest rates compared to what normal people have to pay. Also the money the regular people have ends up going down in value (inflation). This is unfair and gives extra advantage to those already big and rich companies and hurts the common man. This is so unfair that many people want to "opt out" and use some other money. Bitcoin has worked better for people most of the time since it came out.

To get an idea of the scale of this, the USA has printed trillions of dollars. This really steals value from all existing dollars, all around the world, and gives value to the government that printed the new dollars. It is best to think of this as an "inflation tax". The USA collects an inflation tax on most of the world, without most of the world understanding that. Diabolical.

The cost that Bitcoin miners spend on electricity to run their equipment is trivial compared to the scale of theft in legacy money.

Simple Secure and Scalable

Bitcoin has a simple blockchain that can fit on an ordinary computer. It is something that people have checked over very carefully. The computation that goes into stamping each block makes it incredibly secure. Still the fees for on chain transactions are only around $2 most of the time recently.

With Lightning Bitcoin scales to any number of transactions and with really low fees (like a penny) that finish in a second or two. It is sort of like having armored trucks that move money around and electronic wire transfers that move money between accounts.

These two together have solved the online payment problem. It is such a good solution that it is possible nothing will be enough better to get people to switch for decades. Payments in 1 second and for a penny are just hard to beat by enough to matter to anyone.

Note that to use Lightning you have to setup a channel using some Bitcoin on-chain. So using Lightning sort of provides a demand for Bitcoin.

When fiat fails

I run some Bitcoin ATMs in Anguilla (see bitcoin.ai). There are people here who send Bitcoin to family in Venezuala. The fiat currency there is failing. The government is taking a cut on money wired in by using a fake exchange rate. They don't get a cut on Bitcoin sent into Venezuala. The government also has price controls on things sold in the local currency at stores and shelves are usually very empty. But you can call a guy and order groceries and pay in Bitcoin and they deliver what you want. So Bitcoin is helping people get by when their local fiat money is failing.

If the US dollar fails, nobody is going to trust other fiat money either. The only real alternative will be Bitcoin. Even if you think there is only a small chance of the dollar failing (I think it is a large chance) having some Bitcoin can be a form of insurance. If more and more people are buying Bitcoin as insurance against a failing dollar, then the price of Bitcoin will go up.

Simple Supply and Demand

The supply of Bitcoin is currently only growing by 6.25 every 10 minutes and this rate is cut in half every 4 years. Currently this comes out to about 1.7% per year (6*24*6.25*365/19000000). It will keep cutting in half every 4 years though. The number of people using Bitcoin is growing at a much faster rate. If demand is growing faster than supply, then we should expect the value to trend upward.

Tax Evasion is a crime

Mish points out on twitter that some of the above can get you in trouble for tax evasion. So lets be clear that I am not giving out any tax advise. In Anguilla there is no income tax or capital gains tax.

Let me also point out that in hyperinflation it can be impossible to both follow the laws and survive. The population ends up having to use a "black market" to trade without deadly amounts of inflation tax or other taxes. Note that black market really means free market, but breaking laws. So maybe just think back on this post if/when your survival depends on buying stuff on the black market.

To be clear on the eventual problem. Imagine you buy potatoes for $1000/bag and the next day sell them for $2000/bag. The government will claim you owe them tax on a $1000 profit. Then you go and try to buy more potatoes and your supplier is now charging $3,000/bag. So really you did not make any profit. If you follow all the laws you will be broke very soon. So the people who live through hyperinflation are the people willing to break the laws.

So if the world gets hyperinflation the fact that Bitcoin can help black markets operate without government approval is an advantage and will increase demand for Bitcoin.

Sanctions Evasion

People inside Russia can no longer use their Visa and Master Cards to pay for things online. They could use Bitcoin to pay for things. Countries (say India and China) want to buy gas and oil from Russia but SWIFT payments are blocked. Both these oil buyers and the consumers inside Russia could get around the sanctions by using Bitcoin. There has already been much talk of using Bitcoin and I would not be surprised if it has already started. I would also expect it to grow really fast as people explain to their friends how they were able to order stuff.

The fact that no company or country can stop this makes Bitcoin valuable. If Russia were to announce that they are selling oil in Rubles or Bitcoin it could make Bitcoin go up in value more than it made the Ruble go up.

Properties of Money - Best Money So Far

A good money needs to be:

1) store of value

2) medium of exchange

3) unit of account

To store value it should not be something that governments can print unlimited amounts of or that is easy to counterfeit. Bitcoin can not be counterfeit

An ideal medium of exchange could be sent electronically anywhere in the world without needing help or permission. Bitcoin is far better than anything else. You don't need banks wire transfer, or western union, or express mail, to send Bitcoin. It can not get lost or stolen in transit. Nobody can censor/block Bitcoin transactions, while normal money can need government approval for movement. It is trivial to check that you got paid with good Bitcoin. In contrast you really need to spend effort to check paper money or gold to be sure it is real and still run a risk of accepting a fake.

While Bitcoin has gone up in value for people who hold it for years, it can be very bad at storing value over short periods. So currently Bitcoin does not do so well on this. There is reason to hope that as it gets more and more users it will become less volatile. Fiat money looks like it is becoming such a bad store of value that the world may be looking for a replacement.

Unit of account. Bitcoin is more Fungible than any previous money. Can divide it down to 1/100,000,000th trivially. All parts are identical. Difficult to get gold below a gram.

In the coming years Bitcoin may be viewed more and more as the best money. The best money should win in the long run.

Bitcoin Age VS US Dollar Age

It is sometimes argued that Bitcoin is too new to trust and that the dollar has been around far longer. The original dollar was backed by gold but since 1971 it has not been backed by gold. So the current form of the dollar is only 51 years old. Bitcoin started in 2009, so only 13 years ago. However, it is open source so people can inspect every line of code. There are no secrets in how Bitcoin works. Computers check digital signatures and add transactions to the blockchain every 10 minutes.

The Fed has humans making decisions and they are clearly flawed. They said "sub prime is contained" and "inflation is transitory" and were wrong. No human choices with unknown motives or reasons, like with the Fed. Also, the Fed has not allowed any audit of their gold holdings, so we can not be really sure how much gold they have. It was really the gold they had in 1980 and the fact that it got to 800/oz that saved the dollar then. So you could even say that it is only 42 years that it has been unbacked.

Things on the Internet with open source mature faster. It is sort of like 1 Internet year is equivalent to 4 regular years in finance. If there was some problem with Bitcoin software it really should have been exposed by now.

The problem with the humans running the Fed is they can let inflation get out of control. The history of unbacked Fiat money shows this time and time again. It really seems like the risk of failure for the dollar is higher than for Bitcoin.

You don't need a bank so no risk from bank failure

Before the global financial crisis Anguilla had 4 banks; however, 2 of them went bankrupt due to GFC. This is half the banks in my country going bankrupt.

With Bitcoin, you don't need to use a bank. You can accept payments or send payments anywhere in the world just using your Bitcoin Wallet software and the Internet.

With Bitcoin you are not at risk from a bank failure. In my experience, this is about a 50% risk over the last 30 years. So Bitcoin seems much safer to me. You may have different statistics in your country.

Migrant Money

If you are leaving a country because of high taxes, corrupt government, or unsafe environment, Bitcoin can be the best way to get your money out. You can easily send Bitcoin to a friend at your final destination. The government, banks, or criminals along the way can not grab this Bitcoin. It may be nearly impossible to get money out any other way. The friend could send you some Bitcoin as you needed it which you could convert to local currency at Bitcoin ATMs along the way.

Option on next world currency

If Bitcoin becomes the next world currency it will be far more valuable. If you buy some today you might make many times your money. If you were to estimate a 3% chance of Bitcoin getting to $1 million, and ignored interest, you might estimate it is worth $30,000 even with a 97% chance of going to $0. If you think it has a much higher chance, and the price was lower, you might decide it was a reasonable gamble.

Tuesday, May 17, 2022

Fed Has A Recursion Problem

Terra made two coins, Luna and UST, that depended on each other. They both crashed recently. I made the following graphic:

The Fed has a similar design problem. The Treasuries are measured in US Dollars but the Fed backing for the US Dollar is mostly Treasuries. In this kind of setup both parts can go to zero in terms of real world things.

The Real Bills Doctrine says that if a bank loans out short term against real things that it can be safe. But if a bank loans out long term in its own currency it can get into trouble. This is very old wisdom. Young folks today did not learn this stuff in school. I think the Fed will be giving the world a demo on how this fails.

In computer science we would call this a recursion problem. In computer science you can have a function that is defined in terms of itself but there needs to be a base case that does not need further recursion. With Luna/UST or Treasuries/USD there is no base case. So the results are "not well defined". So it did not and will not end well.

Originally by law the dollar base case was gold. The Fed originally had 40% gold backing and anyone could turn in $20.67 in dollars and get 1 oz of gold. Then in 1933 only other countries could redeem dollars and only 1 oz gold for $35. Then after 1971 no one could turn in dollars for gold. In 1980 gold got up to around $850 per oz and the Fed still had enough that at that price their gold helped stabilize the dollar.

Friday, May 6, 2022

The Fed's Can Opener

The Fed talks as if "the neutral rate" is 2.5% and they just need to get the Fed Funds rate up to that and all will be fine. As Larry Summers points out this is a logical error very much like the joke about economist assume we have a can opener.

Joke from Wikipedia: President Ronald Reagan told the joke to students and faculty at Purdue University on April 9, 1987 saying: "It seems an economist, a chemist, and an engineer were stranded on a desert island. And between them they had only a single can of beans, but no can opener. The engineer suggested that he climb a palm tree to a precise height, then throw the beans at a precise distance, at a precise angle. 'And when the can hits,' he said, 'it will split open.' 'No,' said the chemist. 'We'll leave the can in the sun until the heat causes the beans to expand so much the can will explode.' 'Nonsense,' said the economist. 'Using either method we'd lose too many beans. According to my plan, there will be no mess or fuss and not a single bean will be lost.' Well, the engineer and the chemist said, 'We're certainly willing to consider it. What's your plan?' And the economist answered, 'Well, first assume we have a can opener.'"

From transcript of Powell's May 4, 2022 press conference and video:

"And the current estimates on the Committee are sort of two to three percent. And also, that's a longer-run estimate. That's an estimate for an economy that's at full employment and two percent inflation. So really the way, really what we're doing is we are -- we're raising rates expeditiously to the -- what we see as the broad range of plausible levels of neutral."

They are assuming there is no inflation in their target estimate of the "neutral rate", even though in the real world we have high inflation. This is wrong. It is like the joke, "first assume we have no inflation, then we just need to get rates to 2.5%".

They have not given us an estimate of the neutral rate for the real inflation conditions we are in, let along a rate that would tame inflation.

Their mandate is to maintain stable prices and in their plan they are just assuming we have stable prices. This is crazy bad. They are not doing their job. They are not taking the tough steps needed to get from where we are to stable prices. To lower inflation you need to get interest rates above the inflation rate. In the real world we have high inflation and even 2.5% will still be a very negative real rate and so stimulative, not neutral. Many months inflation has gone up 0.5% or more and the Fed has ruled out raising rates faster than that. They are far behind and it is not clear they will ever catch up. Runaway inflation is a real possibility.

Thursday, April 28, 2022

Scaling Bitcoin With Lightning

There are many people who understand that Bitcoin can only do a certain number of on-chain transactions every 10 minutes and so think it can not scale. The Bitcoin scaling solution is off-chain transactions with Lightning. I am going to try to give you a way to think about this that might help people understand.

Think of on-chain Bitcoin transactions as being like an armored truck carrying money from one place to another. With a certain number of armored trucks you can only do so many visit per day. If a transaction is on the blockchain then it is like the funds have been physically moved to the other place.

However, this does not limit the number of financial transactions. Banks have a huge optimization. It is not necessary to send money for every transaction between two banks, at worse you just need to send the net different between money going one way and money going the other. In the SWIFT wire transfer system it is really just a bunch of banks that have accounts with each other so they can "move money" mostly by doing debits and credits on accounts and not physically moving the money around. A wire transfer might pass through several different banks along the way to its destination.

You can think of Lighting as similar to the SWIFT wire transfer network. There are links between nodes that can effectively move funds between them just by updating an account balance between them. However, instead of taking a couple days and costing on the order of $100 (humans are slow and costly) it takes about a second and costs on the order of $0.01 (computers are fast and cheap). So around 10,000 times cheaper and 100,000 times faster than a bank wire transfer. This is a very compelling improvement.

People complain about how much energy blockchain transactions take. This is like worrying about how much gas the armored truck is going to burn to clear your wire transfer. The vast majority of the financial transactions do not require any gas for any armored truck. The same is true, or will be true, for Bitcoin. There might be more off-chain Lightning transactions than on-chain Bitcoin transactions already but as the lightning transactions are confidential I don't think we can really tell.

It is easy to imagine banks working together to net-out payments and so minimize the number of armored truck trips and so lower their costs. Bitcoin/Lightning works like this. If the on-chain transactions get too expensive, then people work a bit harder to use Lightning or use it for larger amounts. It is a nice feedback for keeping Bitcoin on-chain fees in check. So while Ethereum still gets crazy high "gas fees" the Bitcoin on-chain fees are steady and low.

Since Lightning transactions are not stored on the blockchain, the Bitcoin blockchain does not grow too fast and can still fit on an ordinary computer with ordinary Internet service. Other cryptos that have more data to store get too large for normal computers and Internet feeds. So others, unlike Bitcoin, can end up not being true Peer-2-Peer, and so easier for a government or other adversary to attack.

It really seems like the Bitcoin/Lightning scaling system will be the winning payment system. With lightning it has the lowest fees and fastest execution. It is the most true P2P system. It is the oldest and has the largest market share. Like Google or Facebook, it has the dominant network effects. It is hard to imagine something else coming that is enough better to really threaten Bitcoin/Lightning at this point.

Update May 13, 2022

The recent stablecoin trouble and this video made me think. Bitcoin/lightning use a blockchain to really solve the P2P Internet payment problem. The 10,000 alt-coins that have come after really can be viewed as scams. Most of them don't have any reasonable claim to doing anything better. Some are centralized things just using a blockchain to trick investors. When markets go down the scams become clear. We will see many scams in the crypto area. As Buffet says, “You don’t find out who’s been swimming naked until the tide goes out”.

Update June 5, 2022

I was watching a video where Elon say that a level 2 layer like Lightning you can scale Bitcoin to handle huge amounts of financial traffic but he would like to see if the base layer could scale further. This is sort of like saying, sure by clearing transactions electronically between banks we can handle huge numbers of transactions, but I would like to see if we can get bigger armored trucks and drive them faster. Why? What is the point? It does not improve things. With lightning there is some incentive to run your own full node, it is nice that a full node can fit on a regular PC with a regular Internet connection.

Update July 17, 2022

This tweet shows how many times channels were reused as of last year for one company. For the cost of an on-chain transaction to open a channel you can do hundreds or thousands of off-chain transactions. These numbers should get better and better over time. These off-chain lightning transactions are very cheap and fast. More and more traffic will move to lightning, in particular if on-chain fees are high.

Update Oct 5, 2022

After scaling, the other vector other coins might have been better than Bitcoin on was "privacy". However, with lightning and "submarine swaps" or using "coinjoin" you can get good privacy just using Bitcoin. So it really does not seem any other coin could be enough better in any way users care about to get them to switch. Seems Bitcoin will be it forever.

Thursday, March 17, 2022

The Fed and Goodhart's Law

Goodhart's law is: When a measure becomes a target, it ceases to be a good measure.

The most common measure of when a recession is coming is the inverted yield curve. I believe the Fed is now targeting this measure.

In the past when inflation got too high and the Fed needed to tighten monetary policy it would raise the Fed Funds rate. This increases short term interest rates. If short term rates were higher than long term (the dreaded "inverted yield curve"), it meant the Fed was tightening monetary policy and a recession would soon come.

So the Fed thinks that "inverted yield curve" is the cause of recessions. So the plan now is to tighten monetary policy without inverting the yield curve, which they think will avoid the recession that usually comes from tightening. The way they will do this is by leaving short term rates low and selling off bonds they bought during Quantitative Easing (QE). This is being called Quantitative Tightening (QT). When they sell bonds they will raise longer term interest rates. If the Fed Funds and short term rates stay low, then the yield curve will not invert.

Again, they think as long as they don't invert the yield curve they can get the mythical "soft landing" and avoid a recession. They are wrong. It is the monetary tightening that causes the recession, not the "inverted yield curve".

When rates are lowered it makes monthly payments on loans smaller so people and companies can buy things sooner. We say "it brings demand forward". Imagine someone can buy the $40,000 car of their dreams sooner if the Fed drops rates from 10% to 2% and so reduces the monthly payments. The problem is that eventually this makes too much inflation and they have to let rates go back up. This pushes demand backward. Someone who was about to buy their dream car with a 2% loan now has to wait much longer when loans are at 10%. The demand being pushed backward is the recession. It is the rates going up that causes demand to be pushed backward, not the inverted yield curve.

Of course, if they don't tighten monetary policy they will get "run away inflation" and then hyperinflation. So the Fed does need to tighten. But doing it in a way that avoids the inverted yield curve will not avoid the pain of the tightening or result in a "soft landing".

There is also a real risk that once people understand that bond prices will be falling as the Fed tries to dump bonds that everyone will "not fight the Fed" or "front run the Fed" and try to sell bonds before the Fed does. For the last 40 years bond prices have generally gone up as interest rates went down. Now with rates going up and bond prices going down we could see a rush to sell and indeed panic selling. The saying is "the market takes the stairs up and the elevator down". This is probably true for the bond market as well. One should not expect bond holders to keep holding as bonds go down for years and years. A bond crash makes more sense.

So far the Fed has just recently stopped buying bonds and only raised Fed Funds by 0.25%. But the markets anticipate the future and so have gone up significantly already. The 30 year mortgage rate has gone from a low last year of 2.65% to 4.16%.

The 0.25% fed funds hike makes it seem like the Fed is not serious about fighting inflation. But really it is probably just that they don't want to make the dreaded inverted yield curve. We will see how serious they are when they start selling bonds. If they let bond interest rates go way up, they are serious. There is still some chance.

We will soon get the first recession without an inverted yield curve, because the Fed targeted this measure. So the measure will cease to be a good measure.

Sunday, January 23, 2022

Crashing Without a Net

"It ain’t what you don’t know that gets you into trouble, it’s what you know for sure that just ain’t so."

The Big Short

Today people "know for sure" that the more money the Fed prints the more the stock market goes up. Using Fred Graph we can make the following:

With this view people may think that the Fed can always print money and always make the stock market go up, but this just ain't so and will get them in trouble.

A more accurate way to think about it is that stocks are correlated to long term bonds but a bit more volatile (here we use 1.5 factor). This Fred Graph shows this:

The Fed can often manipulate the bond market by buying/selling bonds and adjusting the Fed Funds rate. As the Fed buys bonds they are printing money and driving up the price of bonds (and lowering interest rates). The stocks go up as the bonds go up. So often the Fed printing money does make the stock market go up, but again that is too simple a way of thinking about it and will get you in trouble.

The trouble comes when inflation comes, as it has now. By law the Fed has to fight inflation. The way to fight inflation is by not printing so much money. If they are not printing so much money then they are not buying so many bonds, so bond prices will come down. As bond prices come down, stock prices will also come down.

The famous Fed Put is where the Fed steps in and stabilizes markets. This does not work when there is high inflation and interest rates are already at 0%. In previous market crashes the Fed could lower interest rates and so make bond prices and stock prices go up. However, with interest rates already at 0%, the Fed can not lower them any more. Bonds are already at historic highs, so they can not be driven up any higher. High inflation tends to push bond interest rates up and so make bond prices go down. In previous market crashes inflation was low so the Fed was cleared to print money. Today we have high inflation, so the Fed's hands are tied. The Fed Put has expired.

In previous crashes the Fed was able to step in and halt a crash, making for a quick bounce back. Current investors believe the "Fed has their back", but this just ain't so. Today we are crashing without a net. This crash will probably be worse than anything in recent memory.

PS. Powell understood the danger of low interest rates making the current bubble and yet did it anyway. Here is Powell from 2016:

"... it’s plausible to me that rates will have to remain very low for a very long time to achieve stable prices and full employment, but that such low rates will drive excessive credit growth and create irresistible upward pressure on asset prices, including real estate prices. I’m thinking of a situation in which a broad range of asset prices are moving up well beyond what fundamentals would justify; where the other tools we have don’t seem to be addressing the problem or have failed to do so; and where low interest rates are pushing up asset prices and driving credit to excessive levels, probably over many years, and thus are a principal cause of the threat. Recalling that we have had two major real estate blowups in the past 25 years, ..."

Sunday, January 16, 2022

Deep Reasons for Current Trouble

There are a few deep reasons for the trouble coming to the USA which I will go over here.

At Best a Necessary Evil

There is some minimal government with police, courts, and defense that is sort of a necessary evil. While such a government is a cost to the economy, it is better to pay this much cost than to suffer anarchy. After this, the more government the less real economic growth. The USA devotes too much of the economy to government and so not enough to real growth. At this point, the size of the US government is far beyond optimal.

Dutch Disease and Resource Curse

There are the related concepts of Dutch Disease and Resource Curse. Countries that have some valuable natural resource tend to suffer worse governance and to suffer in other areas of their economy. Back in 1711 the Spectator wrote, "It is generally observed, that in countries of the greatest plenty there is the poorest living." It is easier for a bad government to get control of some natural resource and then stay in power. If they have to tax the general economy there will be some resistance to government excess. So when there is a valuable natural resource, the odds of having a bad government go up.

The US ability to print the world reserve currency is like having a valuable natural resource.

Triffin Dilemma

The Triffin Dilemma is the problem of a country with a world reserve currency. For the country's own benefit (say when there is a Pandemic) there is a huge advantage to printing lots of money. But if done too much this harms the rest of the world and makes them not want to keep using that currency as the world reserve currency. You can view inflation as a tax. The country with the world reserve currency can impose an inflation tax on the whole world. However, if the inflation tax gets too high, the world can rebel and stop using that currency. Taxes always cause modifications in behavior.

The current inflation is reported as a CPI of 7%, but really the inflation is over 10% (the owners equivalent rent component of the CPI is a cheat) and going up fast. This is an intolerably high inflation rate for a world reserve currency.

Alternatives to the Dollar

If countries don't want to keep paying the inflation tax to the US they have to reduce their usage of dollars. Many people can not conceive of any alternative to the US dollar but there are some.

Central banks in other countries could use gold as reserves instead of dollars. Before Bretton Woods central banks each kept their own gold reserves. Imagine that country X has 75% dollar reserves and 25% gold reserves. In this case, if the dollar were to get hyperinflation and go to near zero, their currency would drop by a factor of 4 and then stabilize. They would have suddenly moved to a gold standard. So countries may end up moving to a gold standard without planning to do so. At this point, it would be wise for central banks to have some gold just in case. It seems central banks around the world are increasing their gold holdings. If central banks only have dollars then if the dollar gets hyperinflation their currency will also get hyperinflation.

If people live in a country where the central bank is still only using dollars as reserves, they could save in Bitcoin instead of the local currency.

Spain and New World Gold

Spain took huge amounts of gold and silver from the New World. Since gold was the world reserve currency then, getting all this gold was a bit similar to the US ability to print the world reserve currency. This did cause prices, measured in gold, to go up by about a factor of 6 in 150 years, but this is only 1–1.5% per year. While Spain was bringing in the gold and silver they had significant power but after the flow stopped they were a shadow of their former selves. Similar to the resource curse, the rest of their economy was sort of hollowed out.

Dollar Losing World Reserve Status

It is in the interest of other countries to move away from the dollar, and so not pay the dollar inflation tax. As countries do this the dollar will be less and less used. China and Russia have worked to de-dollarize their economies. The same amount of dollar creation will create more inflation when there are fewer countries using it. But more inflation will push countries to flee the dollar even faster. So there will be a positive feedback loop and leaving the dollar could happen very fast.

USA Just Another Banana Republic

If the dollar is not the world reserve currency, then the USA becomes just another Banana Republic that is printing way too much money. Half their spending power comes from printing money. The US will effectively lose a huge amount of its power, similar to when Spain could no longer bring gold from the New World. The USA will be a much weaker country.

The US manufacturing in 2021 was $2.3 trillion. The Fed's balance sheet has on average increased by more than this per year in the last 2 years. I think it is fair to say that money printing contributes more to the US economy than all of manufacturing.

Without reserve currency status, it is nearly impossible to keep spending twice what comes in as taxes without getting high inflation. However, it is probably not possible for the USA to cut spending back to the level of taxes they will be collecting once things go bad. Also, much of their spending is indexed to inflation and some of the bond payments as well. Sadly, the USA is probably headed for hyperinflation.

Sunday, December 12, 2021

Another Fine Mess The Fed Has Gotten Us Into

Laurel and Hardy had a catch phrase with variations on "well here is another fine mess you have gotten me into". The Fed has blown many bubbles since it was created over 100 years ago but this is the first "everything bubble" and a really fine mess.

The core problem is that the bubble economy and government are now dependent on interest rates that are near zero but these low interest rates are causing inflation. The Fed's duel mandate of high employment and stable prices requires that they raise interest rates to fight inflation. But this is likely to pop the everything bubble.

The Fed is targeting 2% inflation. The latest CPI reading was 6.8%. It has been going up very quickly. The current CPI uses owners equivalent rent, where they go around asking non-renters what they think their house could rent for. This is just just aggregating made up numbers and not collecting real housing price data. People experience real inflation and not the made up numbers. If you use real housing data, like they used to, the CPI comes out to 11%. There are other tricks in the CPI that cause it to understate inflation. Really inflation is at least 9% above the Fed's target.

There is a Taylor Rule for figuring out what interest rate the Fed should use to get inflation back to its target rate. It is easy to try out the Atlanta Fed Taylor Rule Calculator to see what rate should be used. But really you should have 2 or 3% more than the current inflation rate. The only way Paul Volker could control inflation was by raising interest rates above the inflation rate. We really need something like 13% interest rates to control this inflation. Staying near 0% will encourage more inflation.

Some people ask, "how could increasing interest rates fix supply chain problems?". The wrong idea here is that the current inflation is just caused by supply chain issues and these are not things the Fed can fix. Let me try to explain. Imagine each businessman is seeing various costs for his input supplies going up at numbers like 10%, 15%, 25%, 50%. Also imagine that banks pays him 0% if he leaves the money in the bank and charges him only 2% if he borrows money. The rational thing for him to do is order extra of his input supplies, either with cash on hand or by borrowing. In these conditions he is better off using these input supplies as a store of value. With 0% interest and these inflation rates, the dollar is not a "good store of value". The dollar has lost one of the key attributes of good money. But the supply chains were designed for normal monthly supply quantities and not for businesses also using supplies as a store of value. This additional usage is too much. If interest rates were at 13% many more businessmen would use money as a store of value instead of input supplies. If the Fed raised rates to 13% the supply chain would be fixed right away. Really.

When the local money fails as a store of value, you always see laws against "hoarding" as if that was the core problem. Hoarding is a symptom of bad money, not a core problem.

It is also not clear to many people how the Fed has caused the labor shortage, so let me try to explain that as well. By dropping interest rates to zero the Fed has about doubled the stock market since the 2020 low. This has made many people feel rich enough that they think they don't need to work, so they quit. If the Fed were to increase interest rates, probably the stock market would crash, and many of these people would be looking for work again.

The US Federal Government has over $29 trillion in debt. These days much of it is short term T-bills and not long term Treasuries. If interest rates went to 13% the interest could be more than the total taxes collected. Many companies and individuals have also taken on lots of debt to take advantage of the low interest rates. If rates go up they will have a very hard time.

The market is only expecting two rate hikes of 0.25% each in 2022. The market is thinking we will be at 0.5% interest 12 months from now. This is nowhere near high enough rate to fight inflation. Inflation has been going up 0.5% per month many times recently. Without some serious effort to fight inflation soon, we will see far higher inflation by the end of 2022. On the other hand, even 2% rates now would no doubt crash the stock market and slow the economy way down. It is another fine mess the Fed has gotten us into.

Monday, December 6, 2021

Inflation Going Higher

The Nov 2021 CPI report comes out Dec 10th. The Oct CPI was 6.2%. Here are three different estimates for Friday's number:

Cleveland Fed estimates 6.6%
Lyn Alden says economists are estimating 6.7%
Trading Economics forecasts 6.9%

As Edward Garbarino commented in response to Lyn's tweet, "If Powell did not have information indicating significant worsening inflationary pressure on the horizon, he would not have jettisoned the "transitory inflation" narrative, IMHO."

This year the real CPI numbers have surprised to the upside many times. We may be at 7% or more on Friday.

People are expecting that about a 0.5% increase in the Fed Funds rate in 2022 will tame inflation. This is naive. Given how fast inflation has been going up (frequently 0.5% per month) that is far too slow a pace of increasing interest rates to ever get ahead of the inflation rate. If interest rates stay far below the inflation rate, inflation will continue to go up. Interest rates need to be well above the inflation rate to be "fighting inflation".

Historically when inflation starts going up the Fed tightens and the market goes down. It really seems that this is likely soon.

However, if we have 7% inflation then it would take something like 10% interest rates to get control of it. If we had such rates the economy would be dead and the government bankrupt. But if interest rates stay low, inflation can get out of control. It really could go to hyperinflation. Either choice the Fed makes has a really bad result. There does not seem to be any nice way out at this point.

Thursday, September 2, 2021

Private Economy is the Real Economy

Government economists define GNP to include government spending. This way the more government spending, the higher the GNP. So if they need to "grow the economy" all they have to do is increase government spending. The more the government is spending, the more power they have.

The reality is that government is a leach on the real productive economy. They are taking resources from the productive parts by taxation and money creation (inflation). Government does not add to the economy, it sucks life out of the economy.

If we subtract government spending from the official GNP and scale for inflation, we get the following graph which gives a better idea of the Real Economy.

First, looking at this graph it is crazy for the stock market to be up by about a factor of 7 in the last 12 years. The real economy is not doing anything close to that kind of growth.

Next, the idea that government spending fixed the recession last year so it was only 2 months is silly. Sure they got the "official GNP" back up, but the real economy is still way down.