#124 - Fiat Currency vs. Hard Currency Regimes

QUOTE OF THE WEEK

"I don’t believe we shall ever have a good money again before we take the thing out of the hands of government, that is, we can’t take it violently out of the hands of government, all we can do is by some sly roundabout way introduce something that they can’t stop." – F.A. Hayek 1984

FOOD FOR THOUGHT

Fiat vs. hard currency regimes

I recently stumbled onto the site wtfhappenedin1971.com and let me just say...

This site's set of graphs absolutely wrecked my mind.

I've studied a lot of economic and financial history, but never really realized how important - and unfortunate for the working class and the poor - the transition from a hard currency regime (gold standard) to a pure fiat currency in 1971 was.

Until I found this site.

In 1971, President Nixon effectively began the transition of the world financial system from the Bretton Woods system (which linked paper currencies with gold through fixed exchange rates) to a freely floating currency system (one that is not backed by anything except for the full faith and credit of the government issuing each currency). The resulting changes in underlying economic fundamentals over the following 50 years was nothing short of breathtaking. On the day to day level, not much really changed, but compounded over decades?

Just see for yourself. Over the 50 years from 1971 to 2020:

- Productivity grew 246% while (middle class) hourly wages only grew 115%

- Real median weekly earnings of full time workers remained virtually unchanged

- The share of labor's percentage of economic income fell from 50% to less than 40%

- Share of income to the top 1% rose to levels not seen since 1929 (25%+)

- Real GDP per capita continued to rise unabated while real wages stagnated

- Cumulative inflation rose tenfold

- Housing prices soared by 2-300%

- Required working hours to buy a house increased by over 3X (60,000+)

- Required working hours to buy the S&P 500 increased from 30 hours to over 120 (4X increase)

- US federal deficit as a % of GDP decreased from ~0% to -15% of GDP

- Incarceration rate per 100,000 increased from a stable 100/100k to 400/100k - a 4X increase (!)

- Share of 25-29 year olds living with parents increased from 15% to 35%

Presumably, the switch from 'sound' money to fiat currency which could be printed ad infinitum by the Federal Reserve allowed for easy currency manipulation. Increasing the money supply had the effect of devaluing fixed dollar denominated debts. So, on the one hand, it created a very stimulative effect for those who owned financial assets (which tended to compound at an exponential rate over time).

But for the poor and working middle class who relied on their hourly labor to make a living (which scales linearly), this regime switch was a long, drawn out highway robbery.

(This is the point at which people on both sides of the political aisle will yell at me something that fits their political narrative around the labor vs. capital story which has repeated constantly throughout history).

This switch also laid the ground work for the United States' disastrous current fiscal and monetary situation. In chapter 6 of Ray Dalio's latest book on US-China relations, he illustrates a few interesting nuggets regarding cycles in China's history where they shifted between hard currency regimes and fiat currency regimes. Each transition is more or less the same. Civilizations tend to like having hard currency regimes until they borrow too much and the debts cannot be paid back by hard currencies, and the currency must be devalued (debts must be deflated away).

So where does this leave us today?

Cash is trash. The combination of fiscal and monetary stimulus over the past 6 months is absolutely unprecedented (~33%+ of GDP). If you think this won't have an inflationary impact on both goods and services as well as asset prices, well, good luck.

Productive, real assets are everything. And sound money may be making a come-back if fiat currency 'stimulus' continues unabated.

It speaks volumes that $6.7B is held in bitcoin on publicly traded corporate balance sheets - cash is trash.

I'll admit, I've never been a huge cryptocurrency advocate, but I try to keep an open mind on everything. I've always known that saving in cash is a fool's errand over the long run, but the fiscal and monetary stimulus response to the covid-19 crisis fundamentally altered my view of our nation's currency. The site I mentioned above sealed the deal.

I wrote the following back in September 2018 regarding bitcoin:

"From what I have read and listened to over the last year, it seems that the best case for cryptos is as a permanent store of value that allows 'the people' to control their own currency via a truly open and free market pricing mechanism. In contrast to fiat currencies which are backed by nothing more than the full faith and credit of whichever government issues them, cryptocurrencies are driven by underlying demand for ownership and transaction. Cryptos simply shift the value of currency to a demand dynamic rather than simply supply driven (fiat currencies are controlled by each respective central bank by increasing or decreasing money supply and base discount rates in an economy). Ultimately, cryptos are about giving the power of exchanging value and valuing that medium of exchange (currency) back to the people."

To wrap up this whole thread, I tend to think about things from an investor's mindset - i.e. how can I maximize my return on capital given my opportunity set? Everyone makes different salaries, everyone has different skillsets, and everyone has different opportunity sets.

But everyone has the ability to choose where to allocate their savings and capital.

Personally, my recommendation is a combination of productive businesses (40-50% in equities with the potential to compound earnings above inflation rates), moderately leveraged real assets (such as residential real estate, industrial real estate, farm and timberland, oil & gas royalties, etc.), and a basket of hard currencies (10-15% in cryptocurrencies, gold, silver, etc.) as a diversified store of value over the long run.

What are you allocating to and why?

LINKS

Investing

Parker Lewis & Will Cole on Bitcoin As A Reserve Asset (The Pomp Podcast)

Why we need a 'good' depression (Chris Leithner)

Q3 2020 fund letters and reports (r/SecurityAnalysis)

Can we predict financial crises? (Bank Underground)

Can you predict the next downturn? (Morningstar)

Technology

State of AI 2020 report (Nathan Benaich, Ian Hogarth)

Hyperloop projects are now eligible for federal funding in the US (Engadget)

We are in a speculative tech market like we haven't seen since 1999 (Bill Gurley)

If California wants cars to run on electricity, it needs a bigger grid (Wall Street Journal)

Why we're still years away from having self-driving cars (Vox)

Real Estate

The scarcity of industrial land (Chris Mayer)

Is it time to short commercial real estate? (Jim Chanos)

The Coming Psychological Revolution in the Housing Market (Ben Carlson)

Economics & Geopolitics

Central banks don't dispense 'stimulus' - they dispense poison (Chris Leithner)

Cities That Were Poised to Absorb Climate Migrants Face a New Challenge (Bloomberg)

Misc.

Build a personal moat (Erik Torenberg)