The most valuable currency is trust

Written by Jeffrey Wernick

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I have no plans to either sell or spend my bitcoin. My intention is to accumulate more.

When bitcoin first emerged. It was in the depths of a global financial and economic crisis where payment systems, national currencies and financial institutions were all extremely fragile. The interbank market, where banks borrow and lend to each other became dysfunctional. Banks did not trust each other’s balance sheet. Investors did not trust the banks balance sheets.

Global trade contracted. Economies contracted. Unemployment grew.

Hayek has asserted that busts are a consequence of bubbles. An assertion I agree with. And I believe it is a consequence of how Central Bank interventions pervert the time preference for money.

In a free market, without any manipulation of monetary policy nor change in fiscal policy. Where both are constant and predictable. The interest rate adjusts to reflect our preferences for consumption today and saving to consume tomorrow or at some later date.

Previously in the USA, as an example, before the Fed was created. The government did not spend much as a percentage of GDP. And the private saving rate was high. So people consumed what they valued for today. And they saved so they could spend more tomorrow. To create more wealth for themselves. They bought real estate. They bought stocks. They bought bonds. And they saved by making deposits in banks. For most, they accumulated wealth through the power of compound interest. Albert Einstein once described compound interest as “the eighth wonder of the world”. “He who understands it, earns it; he who doesn’t, pays it”.

For the most part, real interest rates were positive. And there was no inflation. During the 19th Century, in the USA, prices actually deflated except during wartime. It is a myth that deflation is bad. Deflation should be the norm. If a society is productive and productivity is increasing through time. And we innovate. That means we keep making more for less. We allocate resources more efficiently. Or we produce better things. Deflation is natural. We have been tainted by the deflation which occurred during the Depression of the 1930s and lost a broader, deeper and more historical perspective.

An economist forgotten today, Jean Baptist’s Say wrote:

It is worthwhile to remark that a product is no sooner created than it, from that instant, affords a market for other products to the full extent of its own value. When the producer has put the finishing hand to his product, he is most anxious to sell it immediately, lest its value should diminish in his hands. Nor is he less anxious to dispose of the money he may get for it; for the value of money is also perishable. But the only way of getting rid of money is in the purchase of some product or other. Thus the mere circumstance of creation of one product immediately opens a vent for other products.

And further stated that:

Money performs but a momentary function in this double exchange; and when the transaction is finally closed, it will always be found, that one kind of commodity has been exchanged for another.

The interest rate, without manipulation of either the money supply or the interest rate itself, equilibrated saving and investment.

Since 1971, we abandoned any sense of market discipline and substituted Central Bank discretion. And fiscal policy, no longer encumbered by honest money but dishonest discretionary money, became significantly more interventionist, activist and and expanded is presence with respect to how economic activity is organized. Governments borrowed more. Companies borrowed more. People borrowed more.

John Exter, a NY Fed Vice President, wrote, as a consequence of our abandonment of gold and Bretton Woods in 1971:

Today no money in the world fully performs all three services. National currencies are being used as means-of-payment and standard-of-value money, but none in this inflationary age is an assured store-of-value money.

In fact, a foremost concern to voters and politicians everywhere is that so many currencies are so rapidly losing their value in terms of commodities and services. Commodities like gold and silver, which are being used as store-of-value money, are not being used as either means-of-payment or standard-of-value money.

Thus the world we have so long known, in which most currencies were redeemable at a fixed price in a store-of-value money like gold, is in disarray. People are confused and wondering what money they can trust.

So today all currencies in the world are saying, ‘I do not owe anybody anything.’ Each one says, in effect, ‘IOU nothing’ in the way of any commodity that is a store-of-value money.

Governments will always try to shore up IOU-nothing money with laws making it legal tender, or even laws prohibiting the holding of store-of-value money like gold, but such laws cannot for very long add value to something that is losing value in the marketplace. Gresham’s Law, which is really a special form of the law of supply and demand, will override man-made laws. In fact, there would be no Gresham’s Law if governments did not persistently try by man-made laws to over-value their IOU-nothing money in terms of store-of-value money.

So it is a ‘Who owes you nothing?’, and ‘When?’, and it does not even pay a market rate of interest, only l½%. If central banks ever monetize them in significant amounts, they will have moved from days when they issued their IOUs principally to buy enduring store-of-value money like gold, to these days when they issue their IOU-nothings principally to buy government IOU-nothings, to days when they would issue their IOU-nothings to buy who-owes-you-nothings.

In days to come, international monetary reformers will have to consider whether these new kinds of money will produce a stable monetary world. In the world’s marketplaces will they hold their value against goods and services in general?”

I quote John Exter at length. An article he published in 1972 to point out how prescient he was. You would think that someone who so accurately predicted the consequence of our abandonment of gold would be more prominent to those studying economics and finance. Unfortunately the academic curriculums have practically erased any history that questions the Central Bank monopoly control over money. Fiat paper money.

What replaced Bretton Woods? The petrodollar and dollar hegemony. We substituted a system that required the USA to practice both monetary and fiscal discipline. So everyone would be indifferent to whether they had gold or dollars or where gold was as good as dollars and dollars as good as gold. The global economy was predicated upon that assumption. That the dollar would be trusted if its purchasing power with respect to gold was maintained and preserved. The USA breached that trust. And replaced it with dollar hegemony. The Petrodollar.

The Petrodollar meant that all oil produced would be invoices exclusively in dollars. So all oil-importing nations would need to hold dollars to purchase oil. Wherever oil traveled, the US dollar was attached. John Connally, then Treasury Secretary under Nixon as we exited and abandoned Bretton Woods famously told the Europeans and Japanese that “The dollar is our currency, but it’s your problem”.

Then fiscal policy got expansionary in the USA. Government debt grew. Money supply grew. Inflation emerged. And the world implicitly acknowledged what Exter said, fiat paper money is equivalent to IOU Nothings. The gold price went from the Bretton Woods fix of $35 in 1971 to $600 in 1980. Oil rose, during the same period of time, from about $4/barrel to $40/barrel. Oil rose less as a result of OPEC but more of a result to the USA debasement of the dollar versus gold due to inflationary policies now that the USA was no longer encumbered by a fix to gold. And as Connally correctly bragged, it became everyone else’s problem.

The Japanese referred to him as “Typhoon” Connally. He was Governor of Texas when JFK was assassinated in Texas. He was Treasury Secretary when Nixon assassinated Bretton Woods.

Inflation had many bad effects on the economy. I think the best way to illustrate that impact is a measurement called Tobin’s Q. It is the ratio of a physical asset’s market value and it’s replacement value. At the establishment of Bretton Woods, Tobin’s Q was approximately 0.40 and rose to about 1 during the 1960s. Once both monetary and fiscal policies threatened the credibility of the gold dollar fix, Tobin’s Q started going down. And by 1980, is was under 0.40. A huge drop in a short period of time. There are many flaws in the use of Tobin’s Q as a proxy for firm value. But the general point is still valid, the 1970s, when the world lost faith in the dollar. As Americans did as well. There was a significant decline in the marginal productivity of capital and a reduced incentive to invest. The 1970s also witnessed an aggressive use of Keynesian policies. Maybe, in some respects, a misapplication.

As a side note, when many say the USA interferes in the Mideast because it is about oil. I believe it is not about oil but about the Petrodollar and the preservation of dollar hegemony.

The decade of the 1980s ushered in a paradigm shift away from Keynesian and embracing economic freedom. The Reagan-Thatcher partnership. Reagan, advised by Milton Friedman. Thatcher, advised by Hayek. In less than 2 years, gold went from over $650 to under $350. Oil went during a similar period of time from about $40/barrel to about $10/barrel. And Tobin’s Q rose from approximately 0.30 to 1.00.

The severe recession that occurred during the beginning of the Reagan Administration in the USA was deep but short. There was no Keynesian remedy applied but a return to the wisdom prevailing before Keynes and articulated by Jean Baptiste Say. Supply side economics. Not demand side economics. Anchored by a strong dollar.

Real economic growth in 1983, 1984 and 1985 were, respectively 7.90%, 5.58% and 4.18%. To put that in perspective, since the end of the Reagan Administration the USA has never had annual growth of 5.00%. During the 8 years of the Reagan Administration, annual economic growth exceeded 4% four times. Since then, now 31 years later, real economic growth has exceeded 4% only seven times, five of which occurred during the Clinton Administration during his second term when gold prices went from about $400 to $250. Again, low tax rates, fiscal discipline, the government budget went from deficit to surplus and anchored by a strong dollar. Clinton acknowledged that the era of big government was over and scholars have argued that Clinton extended the economic policies of Reagan. With low inflation and a government surplus, Greenspan became concerned about the consequences of a dearth of risk-free assets (USA Government bonds) and deflation. Greenspan added significant liquidity into the financial system. In 2000, gold averaged $280. In 2012, gold averaged $1669.

During this period of time, the global economy has created a huge increase in debt on all levels; governments, corporations, consumers. Wage stagnation. Poor productivity growth. We are borrowing significantly more to stay even or progress incrementally. We have experienced government debt defaults, bank bailouts, bank bail-ins. Central Banks have expanded their balance sheets in a way without precedent. Not only in the size of its balance sheet, but the capital market instruments being bought. We are significantly more leveraged today than we were in 2007.

Government institutions have failed us. Financial institutions have failed us. The enormous fines they have paid as a result of the various ways they have cheated. Rating agencies have failed us. Regulators have failed us. Accounting firms have failed us. Law firms have failed us.

We had a system designed for checks and balances and empowered third parties as trusted intermediaries.

All these institutions and centralized, third party intermediaries have violated our trust. Have lost our trust. Establishment candidates are being defeated everywhere. Nationalism grows. Populism grows. The pre-existing paradigm is no longer accepted.

The most valuable currency is trust. It is the foundation of all exchange, however denominated. It is the foundation for all relationships. A system of third parties intermediating that trust was established and failed. It’s failure, in my opinion, is unequivocal!

A white paper written by Satoshi Nakamoto in 2008 proposed a trust revolution. Money would now be issued without nationality and travel anywhere and everywhere. Its monetary policy well defined and immutable. Predictable. Not subject to discretion. It’s proof of work consensus mechanism works if enough believe in the value of bitcoin. Otherwise no one would make the required capital investment and put the effort into mining or being a node in the system. People contribute work. The work is performed to validate the ledger, a trustless ledger as trust is embedded in the protocol. What is required of the ledger. To confirm each transaction as real. That no counterfeit currency exists. The trust issue is solved through incentives. Analogous to the invisible hand described by Adam Smith.

We fill our wants and needs only by fulfilling the needs and wants of others. When exchange is purely voluntary, it meets the test of coincident wants and needs. Otherwise, exchange would not occur. No force. No violence. No coercion. No asymmetry of power. No cronyism. No political influence. No border. No gender. No religion. No nationality. No ethnicity. Identity is irrelevant.

Martin Luther King talked about a world where freedom and liberty only existed if we are judged not by the color of our skin but by the content of our character. To me, that means we are not judged by by any innate quality that is inherited or circumstantial but we are judged by our deeds, actions, attributes the derive from the choices we make. Individual choices. No other aspect of our identity is irrelevant. I think MLK might have been dreaming about bitcoin.

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