Calculating a fair value for Bitcoin or USD

 

It is common to complain that there is no good way to calculated or even estimate any sort of correct value for Bitcoin.   It is then followed with something like if they can't tell when it is undervalued or overvalued how can they do any sort of value investing?   When should they buy or sell?

Of course, there is much truth to the above argument.   But I would like to explain here why the same argument works for the US dollar.

When the Federal Reserve was created it was supposed to always be able to redeem $20 in paper they had given out for 1 ounce of gold.   In fact, the paper money said "payable on demand".  This means they had to give you gold if you wanted.     So at that time you could think that $20 USD was the same value as 1 ounce of gold.   Now really they printed more money and over time this broke down, eventually dropping any particular exchange rate in 1971.

Today the assets that the Federal Reserve has are mostly bonds in USD.   This means that value of the assets backing the dollar are determined by the future value of the dollar.   So the current value of the dollar is based on the future value of the dollar.   This is recursive and so there is no good calculation for what the value should be.   For example, if we were to get 10% interest rates then the 30 year bonds the Federal Reserve holds are worth far less.   So the assets backing the dollar would be far less, so the value of the dollar would be far less, so the future value of the dollar would be far less, so the current value of the dollar would be far less, etc.   There is no end to the calculation, except that the dollar will eventually go to 0 value.   

There are many different ways to explain possible hyperinflation of the dollar.  In fact, it is normal for fiat/paper money to go to zero.

So there is no good way to calculate the correct value of the dollar.   So people who only feel safe investing when they can calculate the correct value for an asset should not invest in the dollar.   

So far people can say that the dollar is more stable than Bitcoin and they feel safer with a more stable asset.   But the faster it goes down and the faster Bitcoin goes up, the less compelling this argument is.   So as the dollar moves into hyperinflation, I would expect these "I like stability" types to flee the dollar for gold or Bitcoin.   When they finally switch, I expect they will wish they had switched long before.

For Bitcoin to go to zero value you essentially need something enough better than Bitcoin that people switch to it and stop using Bitcoin. 

With Bitcoin/Lightning transactions can be completed in a couple seconds and a penny.   It is hard to imaging how any other coin gets enough better than this to make it worth people's trouble to switch.   If ATMs and Websites are setup to handle Bitcoin/Lightning they probably don't save enough by switching to justify the cost of switching.

I think of money as a sort of game score keeping system.   Bitcoin is a fair score keeping system.  Nobody gets to cheat and make up as many points as they want in the game.   In the US dollar game the Federal-Reserve/US-Government can make up as many points as they want.   It is a "rigged game".   Players all around the world are not getting a fair deal.   It seems for everyone else, other than the US government, you can get a better deal playing the Bitcoin game than the USD game.   Over time I expect people and companies to switch from USD to Bitcoin.

If the users of Bitcoin are increasing then we can say the demand for Bitcoin is increasing.   If the supply is well constrained, then we can expect the price to go up.   We can't calculate what it should be, but in general over time we can say it should, on average, go up, as long as the number of users keeps increasing.

 It seems far more likely that the dollar will go to zero value than that Bitcoin will go to zero value. 

 

Time to get worried about Hyperinflation

 

Michael Burry warned about Hyperinflation.   Then the SEC made Burry shut up.  You should never believe anything until it is officially denied.

 QED

 

Fed Bubble Trouble

 I have tried to explain to friends and family why I think there is a real risk of the stock market dropping by a factor of 4 or more.   It is hard to explain in conversation and it is easy for them to dismiss me.   I decided to put down my thoughts here and see if I can make a more plausible case in writing.  

First I will explain a very simplified model to evaluate a reasonable price of major asset classes.  Then show how interest rates and inflation impact these prices.  Then explain how the Fed can blow bubbles and why they eventually pop.   Then how far down things can go after a pop.

The 3 main investment categories,  bonds, real-estate, and stocks can all be viewed as a future stream of income that you are trying to put a current price on.  The bonds pay interest, the real-estate pays rent, and the stocks will eventually pay dividends (or buy back shares, but lets simplify that out for this).   The bonds state what the payments should be, so the question is just will the issuer of the bonds really pay or will they default.  With real-estate you have to have some idea of what future rents will be, what operating costs will be,  and what percentage of the time it will be rented.  With stocks to have to figure out what the profits for the company will be in the future (and the odds of it surviving) and what that comes to per share.  Fundamentally in each case you are putting a price on a stream of payments.  

There is a "net present value" calculation for what a future stream of payments is worth today.  This depends on the interest rate.   So changes in interest rates change the "net present value" of all 3 of the main investment types.  

By changing the interest rate, the Fed can change the present value of things.  If the Fed lowers the interest rate, the current price of these investments goes up.   This makes people feel richer and they also pay more taxes on profits and such, so it is good for the government too.   

The problem is that by making the interest rates artificially low, the Fed is making the prices of investments artificially high.   The right way to think about this is, "The Fed can blow bubbles".

 The reader may be thinking that they don't do a "net present value" calculation, and that is fine.  But even if you are just using your intuition to decide where to put your money, the interest rates change how good the yields, rents, company earnings of your potential investment seem to be.  For simplification, lets pretend that the neural network in your head does some sort of "net present value" evaluation and interest rates are really important.  This fits with what we see experimentally.  

Many investors will think that these artificially low interest rates can last for the next 30 years, but they can't really.   So the "net present value" calculations are all in error.   They assume some low interest rate for the next 30 years to get the high current price of the investment.   But that was a wrong assumption,  the interest rate won't be low for the next 30 years.  There is a saying, garbage in, garbage out.   The calculation is only as good as the input.   At some point investors realize they need to use a different interest rate and reevaluate what the "net present value" is.   When they calculate with a higher interest rate, the current price calculates lower.  If the interest rate is assumed to go up by a lot, the resulting current price can be far lower.   This is when "the bubble pops".

The Fed was created in 1914 and made lots of new money in the 1920s and kept interest rates down and caused the Roaring 20s where stock prices went up.  Then we got the 1929 stock market crash.  Eventually stocks were down by something like a factor of 8.

In the 1970s when interest rates were high the P/E on stocks was low, like 5.  Today the P/E on stocks is high, like 43 because interest rates are really low.   If people realized that interest rates were going back up to 1970s levels then stocks could go down by a factor of 8.

Because the reader was not investing in stocks in the 1920s and 1930s, and probably not even in the 1970s, this seems too far fetched to be a real concern.   But I think the reader should be concerned. 

You may think, why can't the Fed just keep interest rates artificially low forever?  The reason is inflation.   If they are loaning money at 2% and you can buy copper (or anything) and watch it go up at 6% then so many people would do it that it would go up at 20%.   If they keep printing money once the inflation starts, they can get hyperinflation.  

Recently the inflation index graph is curving up.   The last CPI report was 4.2% for the last 12 months.    People will say there are "base effects" because of the dip in the previous graph.  But that dip means that the next report will be even higher.   It does not imply that future reports are lower though.   If the last few months the CPI index was steady, then after we got past the dip we would have lower inflation (12 month change in index).  But the last few months the CPI index has been going up as fast as it was coming out of the dip.  So the "base effects" argument does not really work. 

It seems we are getting the start of inflation.  If we do get inflation, the stock market could come down by a factor of 4 or more.   There huge trouble is a real possibility.

In The Great Crash 1929 by Galbraith on page 108 it has:

"A common feature of all these earlier troubles [previous panics] was that having happened they were over. The worst was reasonably recognizable as such. The singular feature of the great crash of 1929 was that the worst continued to worsen. What looked one day like the end proved on the next day to have been only the beginning. Nothing could have been more ingeniously designed to maximize the suffering, and also to insure that as few as possible escaped the common misfortune." 

I fear this crash will be like the 1929 one and would like to warn my friends that although every previous crash in their investing experience was over after a 30% or 50% drop, this one really may not be.   Do not be eager to jump in.   The bottom can be far further down than you think.

The following graph comes from an interesting paper with many other graphs.  The yield is the Earnings divided by price for the stock market (inverse of P/E ratio).   So if you subtract the CPI and plot it you are showing how much above inflation the stock yields should be.  On average it is 4.9% above inflation.   When it gets too low you get the shaded areas that are bear markets.   The inflation rate has gone up since the end of this graph so the current plot would be even lower.   It really seems a bear market should follow.  Just understanding this graph means that as inflation goes up the P/E for stocks will go down.

Must be serious

Jean-Claude Juncker said, 'When it becomes serious, you have to lie'.  When the Fed says, "this is not QE",  they are lying.   The current situation must be serious.   QED

 

Simulating the Difficulty of Putting the Inflation Genie Back in the Bottle

I have updated my Hyperinflation Simulation so it will pause after some level of inflation and you can adjust the sliders to try to stop the inflation.  So if the first pause is at 10% inflation you might increase taxes and set the second pause to be at 20% inflation and then continue.   This makes it an interactive learning experience, almost a game.  It really is very hard to put the inflation genie back in the bottle.   The above link is the ongoing latest version, here is a link to version as of 11/22/19.   Here is a link to my 2013 post about my simulation.

Most people think that if inflation gets too high the government can just increase taxes or reduce spending to stop it.  In particular the MMT types believe this (increasingly popular among Democrats).  If you believe this you don't see any big problem with printing money.   In fact, some people think there is no need for taxes until the inflation starts.   For more on MMT please see this post.

This simulation shows the error in the MMT way of thinking.  Once inflation gets to where people are fleeing bonds the money supply can increase so fast that taxes can not keep it in check.  If the government is running a deficit the central bank has to be willing to buy bonds when nobody else is, or the government shuts down.   In all cases so far the central banks rather print money and buy bonds than see their government shut down and their jobs and paycheck go away.   Sometimes laws were changed or the head of the bank was changed, but in the end they always seem to buy the government bonds.  The new money from debt monetization can be many times the flow of taxes, so taxes can not compensate for it.  

Another problem is that taxes take awhile to collect.  If we imagine that on average there is a 30 day delay between a taxable event and when the citizen pays the government, then it is as if taxes are on the GNP of 30 days ago.  Normally this does not matter, but in hyperinflation it means the government is collecting far too little taxes and so has to keep printing.

The core of this simulation is using the equation of exchange to calculate price.   It also uses Hussman to estimate the velocity of money.   There is a good explanation for the math of hyperinflation.   I believe this is the most reasonable and educational simulation of hyperinflation on the Internet (also the only one :-)) but that it could be improved.  I wish I had data for debt, quantity of money, inflation rate, interest rate, monetization, price level, etc for a bunch of different hyperinflations. I don't have any real world data to get  delays/anticipations to plug into the model.    How fast things happen in the model probably does not show how fast they happen in the real world.


I would love to have people play with the simulation and suggest better formulas or defaults.  Report any funny behavior.    You can also clone this simulation and adjust all the formulas.  Please comment with a link if you do.

Historically people have noticed the difficulty of "putting the inflation genie back in the bottle".  This hyperinflation simulation shows why it is so hard.  Hyperinflation is best seen as a "debt monetization death spiral".  Once you enter a death spiral it is hard to get out.   I think if people really understood the difficulty they would be far more concerned about preventing inflation from starting.

Keynesian Leaches

There was a time when doctors would prescribe leaches for certain health problems.  When it did not work they often just increased the dose, with more leaches.   Often the leaches would kill the patient.  The Keynesian economists today do a similar thing.  They prescribe money creation.  When that does not work, they prescribe an increased dosage of money creation.   Eventually the patient, the economy, dies.

James Rickards on Japan

"Jim is increasingly convinced that Japan is ground zero for some very serious problems coming in the global economy. "     I think so too.

Shape of graph for BOJ holdings of JGBs

In an article on the BOJ holdings of JGBs they have the above graph.  Note that BOJ is Bank of Japan and JGB is Japanese Government Bonds.  The red curve above is actual data and the blue part is a projection.   I think the projection is wrong.  The red part looks like it is curving up while the blue projection is linear.  If the curve is really an exponential growth curve, and the projection is linear, then after a few years the projection will be way off.  Even with this linear projection they get to owning about 50% of the JGBs within about 2 years.  I don't believe there is any historical case of any country monetizing such a large fraction of such a large debt without very high inflation.  If inflation picks up you can be sure everyone will want to dump their JGBs, since fixed rate bonds lose value fast as inflation picks up.  This will make the BOJ buy even faster.  So I expect the real graph will keep curving up.

All you need to know

People think central banks have "lots of different tools to work with" but really they have one trick, they can make more money.   The details on on how they do the trick, the words, and the smoke, can change, but at the end of the day their only "secret weapon" is making more money.  If the only tool you have is a hammer, you treat every problem as if it were a nail.  If you try to fix your car, or the economy, with a hammer, it probably won't be a happy ending.

Studies of Failed Currencies

Somehow I have been credited with a study of 599 failed currencies, though I have not done such a study.   There have been studies of the history of failed currencies and it seems good to have a post where we can collect such studies into one place.   If anyone knows of other interesting studies  please post them in the comments and I will add them to this list.

1) History of Fiat and Paper Money Failures by Mike Hewitt.

Has a list of 177 current currencies and when they were started. I count only 16 of these as existing prior to 1900.

It has a list of 609 currencies that no longer circulate and says 153 of these died of hyperinflation.

2) Inflation and the Fall of the Roman Empire by Arto Bendiken

Detailed history of Roman inflation.

3) Fiat Currency: Using the Past to See into the Future by Nick Jones at Daily Reckoning.

Looks at Rome, China, France, and Germany. Says China's paper money was called "flying money" was because "because it could just fly from your hands.". To clarify, people would spend hyperinflating paper money as fast as they got it and hold onto silver coins.

4) Fiat Money Inflation in France by Andrew Dickson White

Fantastic book (free online) with detailed history of a French hyperinflation.

5)  5 Failed Currencies And Why They Crashed by Investopedia

Looks at Germany, Argentina, Zimbabwe, Peru, and Chile.

Referenced but not located studies.

1)  " 775 fiat currencies by DollarDaze.org" but the domain dollardaze.org does not work.  Wonder if someone has a copy.