Layers of Money: Thoughts on Crypto, US Dollar, and Inflation
Layers of Money:
The notion of layered money isn’t something new, Nik Bhatia does a fantastic job of summarizing his ideas on the subject in his book “Layered Money”. In an essence our monetary system is built upon layers of money, our Central Banks have reserves that guarantee government liabilities to the public. In other words our central bank’s issues currency on the premise that we could redeem our deposits when needed, and we believe in our central banks’ ability to store the value of our currency, to maintain its fungibility and use across the world, and to back it with reserves (which is most likely not true in practice, as money is essentially created out of thin air). The ability of governments to create money is what tends to get us in trouble; this is known as currency debasement. When we issue more money, it becomes increasingly less valuable per additional issuance. More printing, less valuable currency, prices rise to keep up, more currency is printed to counteract yielding a vicious spiral.
The Dollar & Bretton Woods
Being the world’s reserve currency comes with its’ fair share of burdens. It is perhaps the primary reason the US has a deficit, our currency is always in demand, and its’ stability through time has positioned it at the heart of any deal, transaction, and reserve currency status. How did it get this way and why hasn’t this changed?
The short answer is world war two and the monetary system which emerged afterward. A bit of a longer explanation comes from examining how humans have transacted through history. To spare long summations of past coins, gems, and seashells, while super interesting, may take up much space, we can pick up after the abolishment of the gold standard. For many reasons after WWII nations’ currencies were pegged to a standardized weight in gold, but with a twist. The US Dollar would maintain a value of $35 per ounce, and all other global currencies would be pegged to the US Dollar. After the US abandoned the gold standard, as did other nations, it was a bit too late. Too much time had passed, the world demanded dollars, but the Fed only printed enough for domestic use. This led to, what Bhatia describes as “off-shore” dollars — or US dollar creation outside of the Feds’ jurisdiction. This can take the form of private credit lines issued in USD, or in times of emergency Repo facilities and other similar instruments. In short, the dollar’s status as the reserve currency is not going away for a long time. The global financial system always demands dollars.
Repos and Lending Facilities
A quick liquidity detour; when other nations need dollars they can enter into repos or other lending facilities to accommodate the demand. A repo is when one bank that holds US Treasuries, posts it as collateral to another bank, which in turn provides liquidity (cash) to the first bank. The bank then returns the money plus a nominal interest rate (here is where the Feds Fund Rate and LIBOR become relevant) and receives their collateral back. Other forms of lending facilities can be unsecured (i.e. no collateral necessary). Lastly, there is a Money Market Fund (MMF) which is a bouquet or portfolio of highly liquid securities with a Net-Asset Value (NAV, which means the face value of the assets) of $1 per share. These all exist because the dollar has done something incredible through time, it’s maintained its reserve status. And the dollar perpetuates this status by acting as the liquidity king.
Due to the pandemic-related shock, the Fed implemented what is known as QE. In this case, the Fed purchased treasuries to provide liquidity to banks in need-this increased the money supply. At the moment we are entering “tightening” where once the cash is returned to the Fed, the Fed destroys the cash instead of using it to purchase more treasuries.
Inflation, Shocks & Counterparty Risk
Increasingly at the top of everyone’s mind is the pervasive and ongoing inflation. How did we get here? Modern monetary policy seems to be limited in its’ ability to control the effect of inflation; to truly control it the Fed would need to hike rates, implement austerity measures that would hurt everyone. And because our policymakers worry about elections more than what happens 10 years from now, it is easier to expand the money supply than to contract it. When US Treasury yields are significantly lower than inflation, is the dollar a store of value? If Treasuries sit atop the money pyramid alongside gold, guarantying the value of a US note, then the combination of dollar debasement, rising inflation, and low yields relative to that inflation all but guarantee deteriorating value, at least in theory.
An important instrument the Fed has relied on to smooth conditions during turbulent times is QE. In QE the Fed purchases treasuries from banks, leaving them with cash in hand. This cash is used to finance or bridge any pressing expenditures. So when people say that QE is basically like printing money, that is what they mean, the Fed just pumps the system with cash, and with already extremely low rates, the supply continues to expand.
Lastly, a few thoughts on counterparty risk. Our financial system is deeply interwoven, from CLOs, CDOs, CBOs, to basic forms of loans, and swaps — the system engages in a lot of entanglement. This very simple reality is why our system is so fragile, it takes but one giant to sink the whole system.
What’s worse, it seems that we don’t allow for the natural end of things; too big to fail only showed the private sector that worse comes to worst the taxpayer will help!
Enter Bitcoin & Bhatia’s Prediction
Bhatia’s wonderful book very elegantly outlined money’s hierarchy; gold and US Treasuries atop the pyramid. He goes further, arguing that Bitcoin (which was intentionally designed as gold) could supplant the role of gold or event the US treasury atop this pyramid, that banks would be able to issue new forms of currencies backed by Bitcoin itself.
Bitcoin shares a few characteristics with gold, which Bhatia and other authors have aptly pointed out. The amount of Bitcoin in circulation now is larger than any potential future “minting or mining” — this means that inflation, debasement is out of the question. Similar to how most of the world’s supply of gold is higher than any future supply will be. Scholars term this “hard money” money that is hard to issue or create. Lastly, and central to the crypto world: there is no one central issuer of gold. Bitcoin too has no one central issuer of Bitcoins, it is decentralized, anyone can mine it. This means that Bitcoin can be inflation-proof, leaving any debasement worries aside.
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