Dear Thoughtful Investor,
In my last several letters I have attempted to articulate a simplified version of Kindleberger’s Monetarist View: “a mania (or ‘bubble’ in today’s parlance) would not occur if the rate of growth of the money supply were stabilized or constant.” Further, “Surges in the prices of real estate cannot occur without the rapid growth of credit either in the aggregate or to particular groups of borrowers.” The antidote? “Those who believe that the market is rational often prefer the hands-off approach; it is healthy for the economy to go through the purgative fires of deflation and bankruptcy to get rid of the mistakes and excesses of the boom.” (from Mania, Panics, Crashes)
When the supply of money can be expanded or tightened at will by a human it begins to outweigh every other factor of fundamental financial analysis. Markets switch to being based on Game Theory instead of fundamental financial analysis. In Game Theory, each player in the game is trying to anticipate what the other players are going to do and position themselves to benefit or win. Success in the game is based on how good at guessing/predicting you are, not how good you are at sound investment analysis.
Imagine a game of Monopoly where one of the players was the bank with an unlimited supply of $500 bills for themselves and the power to change how much the other players go when they passed Go. This turn is was $200, next turn it was a $1000, the following turn it was $5. The value of the real estate properties that were being traded would fluctuate drastically based on how much cash was flowing into and out of the system based on this round’s income from passing Go. Similarly, if you were going to sell a property to the bank you would change them an extremely high price because you know they have a huge stack of $500 bills and they can afford to overpay. The bank’s participation as a player would drastically skew the prices of the underlying real estate and therefore success of the other players would be based on their ability to anticipate and predict what the bank-player was going to decree next rather than making a cost/income analysis on the underlying property.
Game Theory encourages speculation in financial markets because by its very nature the biggest profits go to those the ‘speculate’ on what the banker-player is going to do next and get it right. In November 2008 the Fed entered the game as a player - just as if the banker in the game monopoly entered as a player and stated buying properties. They bought $600 billion in mortgage backed securities. These were mortgage-backed-securities (MBS) that no one else wanted, they should have been written off as losses on the balance sheets of the original owners. Instead the Fed entered the market and overpaid for them in a price devoid of any fundamental value (that MBS’s ability to interest and principal payments). Once the Fed had used up all its credibility in buying securities, it started relying on Game Theory and began issuing “Forward Guidance”; Forward Guidance is where the central bank tells everyone what they plan to do so the other players can more accurately anticipate it. This is just like a banker in our Monopoly Game example telling the other players what the income would be for passing Go on the next several rounds. The reason this situation shifts the market to Game Theory is because now the other players must decide if the banker is lying or telling the truth, or if the banker is going to switch policies and not follow through on the Forward Guidance. It is market manipulation pure and simple - trying to buoy asset prices by saying “don’t worry there’ll be lots of money flowing into the system for a long time.” It ought to be clear that this greatly exacerbates booms & busts in prices.
The solution is a money supply that maintains a very stable growth rate. History has proven that humans, when provided with the opportunity, will intervene to manipulate money supply and therefore the markets. The Monopoly Game *works* because the growth of the money supply grows at an even $200 per player per trip around the board. It is the rules of the game and no one has the power to change the rules. In the real world we must rely on either nature or technology to provide the discipline of rules - history shows that it is extraordinarily rare for a human to maintain self-discipline when the temptation to money manipulation is offered to them with the profits, wealth, and power that goes along with it and (what appears to be) little personal negative consequence.
This is the reason that from eons past gold has been money. To get more gold, it has to be dug out of the ground and that takes work and time. Gold as money forces discipline because to expand the money-supply of gold it requires work.
Similarly, cryptocurrencies use technology to force the same discipline that nature forces with gold. The underlying technology behind cryptocurrencies like Bitcoin is called “blockchain”. Blockchain technology (I’ll expand on later) forces monetary discipline because to create more money it requires work in the form of computing power and electricity.
The history of money is gold, and gold will again play a critical role as money when the brief chapter in human history titled ‘fiat currencies and explosive debt’ has run its course. The future of money is blockchain technology and cryptocurrencies. This is going to be THE monumental historical shift. One hundred years from now financial history will take for granted the failure of fiat currency and the shift to monetary discipline through technology.
A Thoughtful Investor