Governments are unable to resist the temptation to create free money for themselves.

Money serves several critical roles in an economy. It is a unit of account, a medium of exchange, and a store of value.

Currency is a tangible form of money commonly used as a medium of exchange. The challenge, as Nik Bhatia explains in his book Layered Money, is that most currencies ultimately fail because governments are unable to resist the temptation to create free money for themselves.

Nik cites the Roman empire as an early example. The denarius coin weighed 3.4 grams of 80% silver in the second century under Marcus Aurelius, down from 98% three centuries earlier under Augustus Caesar. By reducing the silver content but leaving its name and value unchanged, the government had created money for itself. By the end of the third century, the denarius was devalued so frequently that its purity had dropped to 5% silver.

Fiat Money

Fiat money is government-issued currency that is not backed by a physical commodity. Bankers can create fiat money using a balance sheet instead of minting a coin. This means a government can issue bonds to pay for something, such as a war or a pandemic relief program, and then a central bank can create money on its balance sheet to purchase the bonds.

In Lombard Street: A Description of the Money Market, Walter Bagehot describes the central bank’s essential role as a “lender of last resort” within a financial system trusted to inject liquidity into the market to satisfy sudden surges in the demand for cash. The Bank of England created in 1694 and the US Federal Reserve in 1916 are two examples of nations following this playbook by creating reserves on a central bank balance sheet to purchase bonds in order to finance a war.

Purchasing bonds from a central bank balance sheet is just one of several ways to increase the money supply. The Treasury Repo (banks borrowing dollars against treasury bonds) and Eurodollar markets (US dollars in time deposit accounts in banks outside the US) are two other money-types the Fed has committed to protect in order to counter instability. For example, its Term Auction Facility (TAF) lent a total of $3.8 trillion to 416 banks during the Great Financial Crisis to save the Eurodollar and $1.5 trillion in March 2020 to backstop the Treasury Repo market as part of a broader $6.4 trillion increase in the M2 money supply during the COVID pandemic.

The point here is not to debate the merits of expansionary monetary policy. It doesn’t matter if you live in the United States or Nigeria, currency debasement and its consequences are facts of life.

Inflation

When a currency is debased, sooner or later people demand more money for goods and services.

Inflation rates doubled in 37 of 44 advanced economies in the past two years. While not the only cause, an increase in money supply is among the primary causes of inflation. If you live in the US or one of the other 100 countries with inflation over 8%, the purchasing power of your savings halves every nine years. Or worse, if you live in Turkey or Argentina purchasing power halves every year and every three months in Venezuela and Lebanon.

Strategic investors respond to currency debasement and inflation in different ways.

Horizon Kinetics launched an inflation beneficiaries ETF which attracted $1B+ in its first year. It’s stated objective is to invest “primarily in domestic and foreign equity securities of companies that are expected to benefit, either directly or indirectly, from rising prices of real assets (i.e., assets whose value is mainly derived from physical properties such as commodities) such as those whose revenues are expected to increase with inflation without corresponding increases in expenses.”

Paul Tudor Jones, the founder and CEO of Tudor Investment Group, bought Bitcoin for reasons explained in his memo The Great Monetary Inflation. Among them, “the most compelling argument for owning Bitcoin is the coming digitization of currency everywhere, accelerated by Covid-19.”

Since 2021, BTC has been a high beta (3-5x more volatile) proxy for USD liquidity. Even on longer time horizons there is an undeniable relationship between BTC and the global money supply.

The Separation of Money and State

If we can’t trust governments not to create free money for themselves by debasing currency, and debasement is just one of several ways governments can misbehave with money…

• Canada used emergency powers to freeze protestor assets

• Russian leaders cut off political opposition from their banking relationships

• Nigeria’s central bank freezes bank accounts of police brutality protestors

• Chinese capital and currency controls

• Afghanistan prohibits most women from owning bank accounts

…then it might be time to seriously consider separating money and state.

Until then, accumulating Bitcoin is a proven way to hedge against long term currency debasement and inflation. However, as Arthur Hayes explained last spring, “after rising from $4.5k in March 2020 to $70k in November 2021, Bitcoin has behaved in a more risk-on / risk-off fashion rather than an asset that always appreciates if real rates are negative.”

TLDR; Don’t fight the fed. Be careful when USD liquidity decreases or crabs sideways, as it is now. And be sure to have some BTC in your portfolio when the government starts creating free money for itself again.

nfa.

References

Books | Nik Bhatia, Layered Money | Walter Bagehot, Lombard Street: A Description of the Money Market

Blogs | Lyn Alden, What is Money? | Paul Jones, The Great Monetary Inflation | Arthur Hayes, Teach Me Daddy | Arthur Hayes, Annihilation | BM Pro, Long Live Macro

Data | US M2 Money Supply | Nigeria M2 Money Supply | Inflation by Country | USD Liquidity

Other | Fed Lending Programs for Depository Institutions | Treasury Reserve Management Purchases and Repurchase Operations | World Economic Forum on Inflation | WSJ on Rising Inflation in Emerging Markets | HK Inflation Beneficiaries ETF | Paul Tudor Jones buys BTC

Cover Image | DALL·E “money printer on top of the white house”