Friday, November 29, 2013

Bitcoin: The Future Of An Illusion

“John Law's pioneering note-issuing bank thrived until the French government was forced to admit that the number of paper notes being issued by the Banque Royale were not equal to the amount of metal coinage it held. The bubble burst at the end of 1720, when opponents of the financier attempted to convert their notes into specie en masse, forcing the bank to stop payment on its paper notes.”--Wiki

Now that the price of a Bitcoin has been bid above $1000, I cant ignore it any longer. It begs for comment from financial bloggers*.  Just this month, Bitcoin has gone from $200 to $1200, reportedly due to Chinese demand. Bitcoin has achieved price parity with gold and Google.** 

Bitcoin's literature has grown apace with its price. There is no end to how much you can read on the subject. I will not be devoting my life to reading the Bitcoin oeuvre. But I've read enough to have an opinion, which hasn't changed since I first heard of the phenomenon.

Bitcoin promotes itself as a superior currency to the fiat dollar. Its adherents believe it to be a “disruptive technology” that will ultimately supplant obsolete and discredited fiat currencies. It has been called “the internet of money”***. Bitcoin is the platonic ideal of a currency, free of the encumbrances of antique financial folkways. It comes with its own anti-statist ideology. It is, to use the latest cool word, “transgressive.” It appeals to rebels, those who think outside the box. The FT says that believers see Bitcoin as “purposefully designed to disrupt and destabilise the current economic status quo.” Like gold, Bitcoin has religious overtones.

Should you doubt me about the religious element, read the invective from the metallic and Bitcoin communities when someone dares to cast doubt on their belief system. The response is hostile and ad-hominem. There is no room for rational discussion.

I have seen enough of similar investment vehicles in my lifetime to be able to say with confidence that Bitcoin is another speculative bubble. There is a old story about canned sardines in China, which were being traded up to ever-higher prices. A skeptic opened one of the cans and found nothing but maggots. When confronted, the dealer explained “these sardines are for trading, not for eating”.

Dutch tulips, French bank notes “backed” by gold, Mississippi Company stock, South Sea Company stock, canned sardines, Ponzi, RCA, conglomerates, pyramid schemes, internet stocks, Beanie Babies, mortgage securities, precious metals--you name it, the instruments of speculation will always be handy for the greedy and the ignorant.

Bitcoin believers say that that because Bitcoin has gone up in price, that proves it’s not a bubble. Of course, it would not be a bubble unless it went up in price. The fact that a speculative instrument has risen in price is not indicative as to whether it is a bubble or not.

How can we distinguish between, say, a Google stock and a Ponzi scheme? After all, GOOG is an internet investment that has also gone up to $1000. The answer is fundamental analysis. GOOG may have speculative elements, but it is also a highly profitable and rapidly growing monopoly, which distinguishes it from many other internet stocks. GOOG may decline in value, but it isn’t likely to go to zero, like Beanie Babies or Global Crossing or Enron. (Gold is also unlikely to go to zero.)

The theory behind Bitcoin is that the ultimate supply is finite, at 21 million. As it grows in acceptance as a medium of exchange, it will rise in dollar value, much as gold has in the last 80 years. As one believer says:
“The true value will come when the technology and acceptance become pervasive, and Bitcoin evolves into a primary technology that a world of application, payment and otherwise, is built upon. People with knowledge and insight (the list of renowned technologists and economists is growing) are supporting it due to the real possibility it could become a dominant technology.”

If indeed a meaningful volume of retail trade were to be conducted in Bitcoin, demand for liquidity balances would likely drive up the dollar price to a level much higher than where it is today. Is in fact Bitcoin’s share of retail trade growing? Possibly, but I still say it’s a speculative bubble. Liquidity demand is not driving up the price; Chinese speculators are.

The important thing to remember is that, according to a recent UCSD study, most of the demand for Bitcoin is speculative, and not for use as a medium of exchange. Growth as a medium of exchange would create real persistent demand; speculative demand, by contrast, fluctuates.

Bitcoin is an unofficial currency; it is not regulated, nor are its “banks” regulated. When it blows up, there will be no one to blame or to sue. It is based entirely on anonymous trust. And therein lies its central fallacy: fiat currencies are bad because you can’t trust national central banks, but cyber currencies are good because you can certainly trust unnamed strangers with no fiduciary duty, no regulation, no balance sheet or street address.

Permit me to list some of the rather useful attributes of the dollar, and the less useful attributes of the Bitcoin:

The Dollar
1. Its supply is a known quantity disclosed at regular intervals by the Fed.
2. It is legal tender and it can be used to buy anything and to settle all financial transactions.
3. Dollar purchasing power stability is a Fed mandate.
4. Dollar bank deposits are federally guaranteed.
5. Bank robbery is a federal crime.
6. As a medium of exchange, it can take the form of cash, a debit card, or a credit card.
7. Consumer credit card fraud losses are limited by law.
8. The dollar’s value in dollars is stable.
9. Counterfeiting dollars is a federal crime.
10. Dollars can be readily obtained and exchanged for other currencies.
11. The dollar is highly liquid and fungible. Its price never changes, and virtually every good and service in the US can be bought with it.

The Bitcoin
1. Its supply is based on a promise; there is no official data.
2. It is not legal tender, and no one is obligated to accept it.
3. The minters of Bitcoin make no promises with respect to stable value.It fluctuates in nominal and real value.
4. Deposit balances are held by unregulated private entities with unknown addresses or financial strength.
5. Cyber-theft of Bitcoins is not a top priority at the FBI.
6. As a medium of exchange, it can only take the form of unregulated cyber credits and debits.
7. Fraud losses are to the account of the holder alone.
8. The Bitcoin’s value in dollars fluctuates.
9. Counterfeiting Bitcoins is not a federal crime, although it might someday come under wire fraud.
10. Bitcoins are quite hard to acquire and difficult to exchange for other currencies.
11. Bitcoins are illiquid; the price-discovery process is highly inefficient; there is no central clearinghouse; only a limited variety of goods and services can be bought with them.

To conclude: As a store of value, the Bitcoin is purely speculative. As a medium of exchange, it is inferior to the dollar and its modern derivatives. As a unit of account, it belongs with Beanie Babies and unlisted stocks. There is no saying how high Bitcoin's price will go; its future price is a random walk, ending at zero. All we know is that, at some point, it will crash.

Tidbits from the media:
>A British man says he threw out a hard drive that had 7,500 bitcoins on it, worth over $7.5 million as of Wednesday.
>The ECB has looked into the “threat” from Bitcoin and concluded: “It is mostly the holders of the currency that face risks, including the risk of a complete loss of the monetary value."
>The general consensus is that Bitcoin mining will have approached a point where only those with access to free or cheap electricity will continue operations, and even they will produce a relatively marginal return on investment, rather than the huge multiples possible even earlier this year.
>Every participant in the system must keep a copy of the block chain, which now exceeds 11 gigabytes in size and continues to grow steadily. This alone deters casual use.
>Even the largest Bitcoin Exchanges have been subject to operational interruption by hackers and/or malware, limiting the liquidity of Bitcoins on the Bitcoin Exchange Market and resulting in volatile prices and a reduction in confidence in the Bitcoin Network and the Bitcoin Exchange Market.
>The Winklevoss twins are screaming bulls on bitcoin. Cameron and Tyler Winklevoss—big investors in the digital currency—said Tuesday that Bitcoin should be worth at least 100 times more than it's valued today. "The small bull case scenario is a $400 billion market cap. So the market cap is around $4 billion right now," Tyler Winklevoss said in an interview.
>If a malicious actor or botnet obtains control in excess of 50% of the processing power active on the Bitcoin network, such actor or botnet could manipulate the source code of the Bitcoin network or the blockchain in a manner that adversely affects an investment in the shares or the ability of the trust to operate.
*If you want to read about Bitcoin, I recommend the Bitcoinmania Series written by Izabella Kaminska at FT Alphaville; she is on the case and has decidedly not drunk the Kool-Aid.
***  “Bitcoin is a fixed supply, a first-of-its-kind, global-in-scale, voluntary, decentralized open-source digital currency and payment network that enables direct, peer-to-peer, borderless, pseudo-anonymous, nearly-instantaneous, nearly-free and irreversible cash-like transfers of value. The first currency and money system in the world which has no counter-party risk to hold and to transfer. Instant transactions, no waiting for checks to clear, no chargebacks (merchants will like this), no account freezes (look out Paypal), no international wire transfer fee, no fees of any kind, no minimum balance, no maximum balance, worldwide access, always open, no waiting for business hours to make transactions, no waiting for an account to be approved before transacting, open an account in a few seconds, as easy as email, no bank account needed, extremely poor people can use it, extremely wealthy people can use it, no printing press, no hyper-inflation, no debt limit votes, no bank bailouts, completely voluntary. This sounds like the best payment system in the world!”
--Bitcoin believer at Reddit/bitcoin.

Tuesday, November 26, 2013

Scotland as a Sovereign Credit: A Preliminary Glance

A year from now, Scotland will vote on independence. The Scottish National Party has published its 667-page blueprint for “Scotland’s Future”. I have looked at the document and have read some critiques of it. It is a bit daunting to try to read the whole thing at one sitting. It’s not a light read.

The SNP’s white paper raises many interesting questions, such as:
1. The legal status of UK nationals residing in Scotland, and vice-versa.
2. The formula for dividing up the national debt.
3. Relationship with the EU.
4. Currency arrangements.
5. Security arrangements: neutrality, or alliance with the UK and NATO?
6. Immigration policy.
7. Form of government: kingdom or republic?
8. If a kingdom, which royal house?
9. A written constitution?

The white paper purports to answer these questions, but the UK government has agreed to nothing whatsoever. The document represents a Scottish wishlist, nothing more. Scotland cannot propose a Confederate-style secession on unilateral terms. Rather, she will have to secede as the result of a mutually negotiated settlement with the UK. In such a negotiation, she holds very few cards. The UK government can say nyet to to everything, if it wants.

What I would like to do is to look at an independent Scotland as a sovereign credit. Unfortunately, the white paper does not resemble a rating package or even an offering circular. It is a political manifesto with the occasional nugget of useful information.

There is already quite a bit of literature about the fiscal outlook for an independent Scotland. This is a contentious subject in which my expertise is limited. I would prefer to look, today, at Scotland’s external position.

The SNP’s plan provides for the Bank of England to act as Scotland’s central bank. Instead of adopting the euro or a new currency, Scotland would keep the British pound.

I will dispense with the problematic question of British consent to such an arrangement. After all, any country can adopt any foreign currency as its domestic currency, just as a number of countries use the dollar without permission. I will also ignore the question as to how Brussels would feel about a candidate member opting out of the common currency.

My question, as a credit analyst, is: How would Scotland’s external position look?  Independence does not mean escaping the UK debt-free, given that the parting would be by mutually negotiated agreement. Scotland would have to accept a pro-rata share of the UK national debt. Thus, Scotland would sail forth burdened with a substantial debt load (perhaps ~75% of GDP) denominated in foreign currency, and would perforce continue to borrow in foreign currency. I say foreign, because I cannot see a Tory-led government agreeing to cede any degree of political control over the BofE to a socialist foreign country. (I say Tory-led since Labour would be the loser without Scotland.) Countries such as the Bahamas, El Salvador, Panama and Ecuador can adopt the dollar if they choose, but that only allows their central bankers to gaze at the Eccles Building from Constitution Avenue. It doesn’t give them a seat on the FOMC.

Should Scotland adopt sterling as its currency, it would be committing mortal sin at birth: owing a lot of debt in a currency it can’t print, just like the PIIGS on the continent. The Scottish financial system will be 100% “sterlingized”. Needless to say, this would be a very interesting country and banking system to analyze and rate. I can predict this much without having seen any official numbers: Scotland is not AAA. The Scots will point to Norway, but Norway has no debt, a great track record, and a large sovereign wealth fund. I would point to Ireland.

Because Scotland must command continuing access to the international debt market, she would have to be quite self-disciplined in her fiscal policies. No Troika rescue for her (unless she joined the eurozone). The UK has been allowed by the market to run big fiscal and current account deficits because she prints her own currency. Had the UK joined the eurozone, her rating would be lower today, and she might very well have become a PIIG herself: the UK has had some very bad numbers since the Crash. An SNP-ruled Scotland, with its leftist social-welfare agenda, would not be permitted to run a large fiscal deficit, because she will have to continually roll her debt, just like Ireland and the other PIIGS.

What kind of an economy is Scotland? I would say volatile, due to dependence on oil exports and related economic activity. What kind of a credit would Scotland be with Brent crude at $50? One would like to know the oil price below which the government runs a deficit, and then run  oil-price simulations to suss out the probabilities. Given that we’re talking about expensive North Sea oil, my guess is that the breakeven is a pretty high price: far above the Gulf states’ breakeven. In other words, a somewhat fragile credit given its debt load. Not Norway.

Another potential roadblock: How do you separate one sovereign obligor into two, without the original obligor guaranteeing the other? There is no provision in the UK’s bonds for credit substitution, and there is implicit protection against such an event.  Is the UK is going to call its debt and replace it with a securities package, as in a distressed exchange, or would the swap be voluntary? Is any of this legal under English law? What recourse would gilt-holders have? You can bet that the hedge funds would bring suit, since Scottish bonds are likely to trade below par. Will the UK have to guarantee the bonds that are assumed by Scotland? That would work, but would be politically unpopular down south, because the UK can’t force Scotland to honor its debts.

And what are we to make of the bonds that the UK is selling today? Do they have the risk of an involuntary conversion into the debt of an inferior credit? If there is no such risk, then how will the national debt be divided? You may recall that Russia solved this problem by keeping all of the Soviet Union’s debt (and then defaulting on some of it). The UK will never agree to this, and if it did, it wouldn’t be AAA given its recalculated debt ratios.

Saturday, November 23, 2013

Chinese Monetary Propaganda

“The People’s Bank of China said the country does not benefit any more from increases in its foreign-currency holdings, adding to signs policy makers will rein in dollar purchases that limit the yuan’s appreciation. ‘It’s no longer in China’s favor to accumulate foreign-exchange reserves,’ a deputy governor at the central bank said in a speech yesterday. The monetary authority will end normal intervention in the currency market and broaden the yuan’s daily trading range, Governor Zhou Xiaochuan wrote in an article.
--Bloomberg, Nov. 20, 2013

Bloomberg quotes PBoC officials (above) saying that the PBoC will stop mopping up FX inflows, and will let the yuan appreciate. This already has the metallic community atwitter over the coming Fall of the Dollar and the Bursting of the Treasury Bubble.

This kind of thinking fits into the larger theory that the dollar and the Treasury bond are supported by a Ponzi scheme funded by witting and unwitting central bankers at home and abroad. China buys Treasuries so that she can “control” us, while the Fed buys Treasuries to “finance Obama’s deficits” with hyperinflation. Sooner or later, the music will stop and the Ponzi will collapse, enriching the metallic community and other doubters of America’s benighted currency.

Personally, I am very uncomfortable with China’s mercantilism, and I would like to see the yuan appreciate enough to bring our trade with China into better balance. I don’t like the idea of hollowing out our manufacturing base in exchange for cheap consumer goods. A stronger yuan would reduce unemployment among the young and unskilled, and help us to revive manufacturing.  I think that threatening China with punishment for “currency manipulation” is an excellent idea, especially if there is real policy follow-through, which has never occurred. Romney was pushing for that during the election, and was accused of “China bashing”. It's unsporting to bash one’s enemy!

The Ministry of Propaganda can say whatever it chooses about ending FX intervention, all of which is purely for foreign consumption, and meant to head off Congressional action such as the Schumer-Graham punitive tariff bill. But the hard fact is that China needs to add millions of new jobs every year as its peasants migrate eastward, and that requires a cheap yuan.

China needs to keep the yuan cheap enough that Americans will buy more flatscreens and laptops, not less. Pretty soon it will be cars and airplanes. There is no chance that the yuan will ever float. China cannot build enough dams, bridges and power plants to create adequate internal demand; she must export in exchange for our paper money. Hence her writhing around on the subject of the exchange rate, a topic about which she cannot afford to be frank. Instead she pretends that she is unpegging, which we are supposed to believe.

The metallic community is wrong, as usual. The dollar, bonds and stocks are safe. Gold and silver will continue their downward drift.

Thursday, November 21, 2013

The Fed’s October Minutes: Embracing Defeat

[Note to readers: I have been a bit preoccupied with healthcare policy lately, such that I took my eye off of the economy for the past two months. I may write something about the ACA, although there has already been a tidal wave of ink on the subject. And having said that, I return to my regular beat.]
“Although the incoming data suggested that growth in the second half  might prove somewhat weaker than many of them had previously anticipated, participants broadly continued to project the pace of economic activity to pick up.
“Participants generally expected that the data would prove consistent with the Committee's outlook for ongoing improvement in labor market conditions and would thus warrant trimming the pace of purchases in coming months.
--FOMC minutes from 10/29-30/13 meeting

The Fed has concluded that, despite the fact that it has failed to achieve either of its dual mandates, conditions will nonetheless improve and it can begin to reduce monetary stimulus. Although none of the Fed’s prior forecasts with respect to unemployment and inflation have proved remotely accurate, its current optimistic forecast is sufficient reason to take away the punch bowl with 7.2% unemployment, a low labor-force participation rate, and inflation running at 50% below target.

The Fed has congratulated itself on the success of its policies, despite the fact that the zero funds rate and massive growth in the Fed’s balance sheet have had no  impact on money growth, inflation or unemployment.

In my view slowing QE is an economically meaningless event, since QE itself proved economically meaningless. Instead of using the proceeds of the Fed’s purchases to make loans, banks have instead left it on deposit at the Fed as an interest-bearing, zero-risk asset, doing nobody any good. Money growth has remained sluggish despite “massive monetary stimulus”.

The economy’s #1 problem today is not the sequester, the deficit or Obamacare. It is the abysmal nominal growth rate, now hovering just above 3%. Historically, 3% nominal growth has been recessionary; luckily for us it is only near-recessionary. If the Holy Grail is 4% real growth, we will never achieve it with 3% nominal growth: there isn’t room.  We will need 6-7% nominal growth if we ever hope to see pre-crash unemployment levels.

It has not entirely escaped the Fed’s notice that the rate of inflation has been steadily falling since 2011, and is now at 1%,  50% below a target that was already too low. The failure of QE to influence money growth has resulted in  disinflation that threatens to become deflation.

Monetary policy can be challenging in the context of “stagflation”, when inflation is high and real growth is low.  That challenge, however, is completely absent today. Today, both inflation and growth are very low. If some version of the Phillip’s Curve still operates, the Fed has plenty of room for both higher inflation and higher growth. Expressed differently, money growth today is below NAIRU, the lowest achievable rate of unemployment that does not cause inflation to accelerate. Instead, we have high unemployment and falling inflation, also known as a pre-recessionary condition.

It is ironic that the hawks (on and off the FOMC) criticize the Fed when it experiments with new ways to achieve its mandates. They say that by changing policy instruments or guideposts, the Fed will “lose credibility” because any change is inconsistent with prior guidance. They desire a foolish consistency, and fail to understand that the best way for the Fed to lose credibility is to consistently miss its mandates, as it has been doing for the past five years.

The Fed’s employment and inflation targets have no credibility because they seem to have no influence on policy. When inflation expectations are “firmly anchored” at a rate below your target, you should know that your policy has no credibility. Instead of committing to “do what it takes” to achieve its mandates, the Fed instead commits to continue doing what it has been doing: policy continuity for the sake of policy continuity. And now, to further reinforce its credibility, it will do a bit less of what it has been doing.

The key question going forward is whether the FOMC’s dynamics will be affected by the change in leadership. Will Yellen’s dovish views be given greater deference than Bernanke’s were, or will the War of the Angry Birds continue unabated? Let us pray that, once Janet is seated in the driver’s seat, things will change. The mention in the minutes of possibly reducing interest on reserves provides a glimmer of hope.