With heavy travel over the last week and looming over the next couple of weeks, I figured that I really ought to get an article out before everyone forgets that I write a blog.
It isn’t that there is a dearth of topics. I have so much to talk about that I am brimming over; however, between the usual press of our Quarterly Inflation Outlook (which comes out after the CPI number this month) and the press of business-seeking activity, it has been difficult to put virtual pen to virtual paper.
Here is a great example. The New York Fed blog routinely gives me great material, both positive and negative. They’ve just published an article entitled “Inflation in the Great Recession and New Keynesian Models” with a followup article called “Why Didn’t Inflation Collapse in the Great Recession?” The pair of articles could just as easily be entitled, “When Your Model Doesn’t Work, Add a Parameter.”
I have said on a number of occasions that the credit crisis was a great test of the fundamental Keynesian hypothesis that inflation is caused by growth relative to potential output. And, in the event, that hypothesis was shown to be as bankrupt as Countrywide. I have always liked the way I summed up the state of the argument in 2012:
“The upshot is that we’ve just come off the biggest recession in 80 years, and inflation barely slowed. In fact, if you remove the effects of the bubble unwind in housing, it didn’t slow at all. If growth causes inflation, and if recessions are by definition deflationary, then we should have seen a decline in core prices.”
Here is the chart that accompanies that assertion:
Now, this doesn’t mean that the monetarists are right, but it assuredly means that the Keynesians are wrong. It is far too much, though, to ask for the peaceful surrender of this view. Instead, the Keynesians (or “New Keynesians” if you prefer) first recalibrated their models, like Goldman did in 2012. (Note, incidentally, that their re-calibrated model called for sharply declining core inflation starting from the moment they published that prediction, converging on 1.4% or so in 2013. In actuality, Median CPI basically went sideways from 2011 until recently. Core inflation declined, but only because of the one-off effect of the sequester, which I don’t imagine is what Goldman was forecasting).
What the NY Fed authors have done is to postulate that the real problem with New Keynesian models is that slack isn’t measured right, but rather that “the present value of expected future marginal costs is the more meaningful way of measuring slack.” It is a wonderful thing to be able to live in a world of models populated with unobservable variables that just happen to take on the right values to make the theory work. Even if, from time to time, one needs to re-calibrate when the model’s predictions don’t work out.
For the rest of us, the fact that monetarist models predicted that inflation would not plunge in the crisis, and have consistently given predictions wholly consistent with subsequent outcomes – without requiring re-parameterization – is a pretty strong argument that it’s likely to be closer to the right way to look at the world…even if it doesn’t give us as much to do.
So, the Fed’s tightening is almost done.
Chairman Yellen informed Congress that a “high degree” of easing is needed given the slack in the labor market. This is in keeping with the Fed’s ongoing thematic presentation of “tapering is not tightening,” but of course tapering is indeed tightening. Call it “easing less” if you like, but going from “providing lots of liquidity” to “providing less liquidity” to “providing no added liquidity” is tightening.
I would argue that providing no added liquidity – which is where the Fed is headed, with the taper due to be completed in the autumn – is neutral policy, not an easy policy. But the Fed, like many observers, confuses the level of interest rates with the degree of accommodation. That is confusing a price (the interest rate) with a flow, but it seems not to bother them very much. (I explain the distinction, which is crucial to monetary policymaking, in this article.)
Now, whatever the Chairman thinks she’s saying, what she means is that the Fed isn’t going to be raising interest rates soon. This is partly because the main tool they had been planning to use, the reverse repo facility, isn’t as simple a solution as they believed at first. This isn’t terribly surprising; as I (and others) have been pointing out in presentations and articles for a while it isn’t trivially easy to drain $2 trillion in reverse repo transactions, even if you can do $2 billion with ease. The pattern is familiar, and should be mildly discomfiting:
- At first, the Fed thought to unwind the massive purchases of Treasuries by simply selling them. The original argument was that the Fed pushed rates lower by buying Treasuries, but selling them wouldn’t raise interest rates. This sort of perpetual motion machine never made much sense, and at some point it became clear that if the Treasury started to unwind the SOMA portfolio securities and rates rose, it would likely not be sufficient to drain all of the excess reserves, since the average selling price would most likely be lower than the average purchase price.
- The Fed then thought to just let the securities in the SOMA roll off. Then someone noticed that because of the TWIST program, the Fed doesn’t own many short-dated Treasuries, so that letting QE gradually drain itself would take more than a decade.
- No problem; we’ll just conduct massive reverse repo operations to drain a couple trillion dollars from the system. The link above shows that the Fed’s newly discovered skepticism on that matter; the website Sober Look recently had a good article on the topic as well.
None of this is surprising to people who actually have market experience; unfortunately, over the last decade or so the level of actual market expertise at the Federal Reserve has dropped significantly so they are re-discovering these things the hard way. Now, the focus is on interest on excess reserves (IOER) as the main tool for raising rates eventually.
All of this confusion is one reason that the Fed will move only slowly to ‘normalize’ interest rates. They’re simply not sure how they’ll do it. The problem with IOER is that we have no idea how sensitive the level of reserves it to the amount of interest paid on reserves…since we have never done this before. But to the Fed, that’s no problem because they don’t seem to care about reserves – they only care about the level of interest rates, which at the end of the day don’t matter nearly as much as the growth rate of the money supply.
And so US and UK money supply growth rates are both in the 6-7% range, and interestingly median inflation in the US recently accelerated to 2.3% while core inflation in the UK surprised everyone today by rising to 1.9% (as of April). Commercial bank credit growth in the US over the last 13 weeks has risen at a 10.4% pace, the highest rate since early 2008 (see chart, source Federal Reserve).
Slowing QE has not, evidently, slowed money supply growth, and this is one reason the Fed insists that tapering is not tightening. Unfortunately, this doesn’t mean that the Fed is right, but that they are wrong twice: first, tapering is tightening. Second, changing the pace of addition to reserves does not matter for growth in the money supply (and, hence, inflation) when there are enormous piles of inert reserves already. Picture a huge urn filled with coffee. The spigot at the bottom controls the pace at which coffee leaves the urn, and adding more coffee to the top of the urn has essentially no effect.
So money supply growth, and corporate loan growth, is currently not under control of the Fed in any way. Interest rates are under their control, but interest rates don’t cause changes in the money supply but rather the other way around. Here is another analogy: a robust harvest of corn pushes corn prices lower, but if the government officially sets the price of corn very low it does not cause a robust harvest of corn. This is exactly what the Fed is trying to do if they attempt to control the money supply by changing interest rates.
It actually is worse than this. Raising interest rates will tend to increase money velocity, a relationship which has held very well for the last two decades. I have written about this quite a bit in the past (see for one example this article from last September), but I – like many monetary economists – have often struggled with the fact that there was a regime shift in the early 1990s which messes up the beauty of this fit (see chart, source Enduring Investments).
We have recently resolved much of this problem in our own modeling. The following chart uses three (unstated here, but included in our quarterly inflation outlook to clients) inputs to model M2 velocity, and the regime shift is largely absent. Suffice to say that with a model that makes sense and fits a much wider range of history, we are even more confident now that any Fed move to hike interest rates, rather than to drain reserves, would be a mistake.
The bottom line is that it is good news that Yellen is not planning to hike interest rates soon. It is bad news that she is not planning to drain reserves any time soon. But the Fed is perilously close to making its big policy error of this cycle. Stay tuned.
A very common refrain among stock market bulls these days – and an objection some made to my remarks yesterday that markets are still not making sense – is that the low level of interest rates warrants a high multiple, since future earnings are being discounted at a lower interest rate.
My usual response, and the response from far more educated people than me, like Cliff Asness who published “Fight the Fed Model” back in 2003, is that low interest rates explain high multiples, but they do not justify high multiples. High multiples have always historically been followed – whether explained by low interest rates or not – by poor returns, so it does no good to say “multiples are high because rates are low.” Either way, when multiples are high you are supposed to disinvest.
But I thought it would also be useful, for people who are not as familiar with the argument and only familiar with the sound bite, to see the actual data behind the proposition. So, below, I have a chart of year-end Shiller P/E ratios, since 1900, plotted against year-end 10-year nominal interest rates.
Note that it is generally true that lower nominal interest rates are associated with higher multiples, although it is far more clear that higher nominal interest rates are associated with lower multiples, whether we are talking about the long tail to the right (obviously from the early 1980s) or the smaller tail in the middle that dates from around 1920 (when 5% was thought to be a pretty high interest rate). But, either way, the current multiples represent high valuations whether you compare them to high-rate periods or low-rate periods. The exception is clearly from the late 1990s, when the long downtrend in interest rates helped spark a bubble, and incidentally spurred the first widespread discussion/excuse of the so-called “Fed model.” If you take out that bubble, and you take out the 1980s high-rates tail, then there is left just a cloud of points although there does seem to be some mild slope to it from lower-right to upper-left.
But in short, the data is hardly crystal clear in suggesting that low interest rates can explain these multiples, never mind justify them.
More interesting is what you get if you compare P/E ratios to real rates. Because equities are real assets, you should technically use a real discount rate. Since real economic growth in earnings should be reflected in higher real interest rates generally, only the incremental real growth in earnings should be discounted into higher values today. This eliminates, in other words, some of the ‘money illusion’ aspect of the behavior of equity multiples.
I haven’t seen a chart like this before, probably because the history of real interest rates in the U.S. only dates to 1997. However, using a model developed by Enduring Investments (and used as part of one of our investment strategies), we can translate those historical nominal rates into the real rates we would have expected to see, and that allows us to produce this chart of year-end Shiller P/E ratios, since 1900, plotted against year-end 10-year real interest rates – using Enduring’s model until 1997, and actual 10-year real interest rates thereafter.
I find this picture much more interesting, because there seems to be almost no directionality to it at all. The ‘tail’ at upper right comes from the late 1990s, when again we had the equity bubble but we also had real rates that were higher than at equilibrium since the Treasury’s TIPS program was still new and TIPS were very cheap. But other than that tail, there is simply no trend. The r-squared is 0.02 and the slope of the regression line is not statistically different from zero.
And, in that context, we can again see more clearly that the current point is simply at the high end of the cloud of historical points. The low level of real interest rates – actually quite a bit higher than they were last year – is of no help whatsoever.
None of that should be particularly surprising, except for the buy-and-hope crowd. But I thought it constructive to show the charts for your amusement and/or edification.
As we wait to see whether the Fed slants its statement ever-so-slightly to the hawkish side or ever-so-slightly to the dovish side (not to mention whether Chairman Yellen repeats her blunt performance in the presser), it is probably worth a few moments to think about what the Fed ought to do.
Yesterday’s inflation figures, viewed in isolation, might be perceived as a one-off bad figure. I pointed out yesterday some reasons that this would be an unfortunate error. Keep in mind that anything the Fed does to address monetary policy will take some time to impact an economic process with momentum. That is to say that even if the Fed tightened today, core inflation over 3% is probably still going to happen. The real question is how high inflation goes, and how long it stays there. There is no longer any question about whether inflation is rising. (This has actually been true for a while, but people who were focused on core rather than median and didn’t look at the particulars of inflation, as well as those who focus on the “output gap” as preventing any possibility of inflation, have been able to ignore the signs for a while).
As an aside, the “output gap” crowd – who expected deflation in 2009-10, and didn’t get it, and now expect disinflation, but aren’t getting it – aren’t defeated yet. They’ll simply re-define the gap to fit the data, I am sure. When you get to choose your own observations and change the model to fit the observations, science is easy.
What concerns me about the Fed’s next steps here, and the state of the debate, is that the Federal Reserve seems overly focused on the level of interest rates, and how to adjust them, and not on the level of reserves or controlling the transactional money supply. For example, recently the IMF published a paper arguing that central banks should raise the long-term inflation target from 2% to 4% because with a 2% target it is too easy to get deflation and have interest rates pinned at zero, leaving the central bank powerless to stop deflation. It seems not to matter to the author that Japan only recently proved that it is money, and not interest rates, that matter when they were able to get out of deflation with an aggressive QE. And, after all, “Helicopter” Ben made the point years ago that deflation is easy to prevent if only the Fed prints money.
So the cult of interest rate manipulation concerns me. Another, and more influential, example (because after all, no one really believes the central bank will start targeting 4% inflation) is in the publication recently of “Monetary Policy with Abundant Liquidity: A New Operating Framework for the Federal Reserve,” co-authored by Brian Sack and Joseph Gagnon. Dr. Sack used to be head of the Fed’s Open Markets Desk, so his opinions have some weight in the institution. In this policy brief, he and his co-author suggest ways that the Fed could raise rates even without reducing the amount of excess reserves in the system. Their approach would, indeed, succeed in moving interest rates. But the proposal, in the authors’ words, “appropriately ignores the quantity of money.”
Considering that it is the quantity of money, not its price, that impacts inflation – as hundreds of years of monetary history have proven beyond any educated doubt – this is a frightening view. We are always looking for where the next policy error will come from; this is certainly a strong candidate.
There is a crucial misunderstanding here, and it is unfortunately a fundamental tenet of the interest rate cult. Interest rates are not the cause of money supply changes, but the result of them. The way the Fed operates tends to cause this confusion, because the Fed seems to adjust interest rates. But that is not in fact what happens. The Desk actually adjusts the level of reserves in the system, and reads the interest rate as an indication of whether reserves are at the right level (or at least, this was the way it used to be done, before the “environment of abundant liquidity”). The confusion has gradually developed, and the institution has contributed to the confusion by gradually altering its policy statements to obfuscate what is actually going on. The domestic policy directive of February 1989 said in part:
“In the implementation of policy for the immediate future, the Committee seeks to maintain the existing degree of pressure on reserve positions…somewhat greater reserve restraint would, or slightly lesser reserve restraint might, be acceptable in the intermeeting period. The contemplated reserve conditions are expected to be consistent with growth of M2 and M3 over the period from December through March at annual rates of about 2 and 3½ percent, respectively.”
Notice that the main focus here is how pressure on reserves leads to money supply growth. By 1994, the Fed was drawing the line to interest rates more explicitly. The press release following the February 4th, 1994 meeting said in part:
“Chairman Alan Greenspan announced today that the Federal Open Market Committee decided to increase slightly the degree of pressure on reserve positions. The action is expected to be associated with a small increase in short-term money market interest rates.”
The Federal Reserve eventually stopped talking about “reserve positions,” although that continued to be how interest rates were managed in fact. Here is what the Fed was saying in January 2007:
“The Federal Open Market Committee decided today to keep its target for the federal funds rate at 5-1/4 percent.”
Now, of course, the Fed not only sets the current level of interest rates but also gives us an expected path.
But again, even when the Fed was talking about the interest rate target, the Fed actually managed interest rates by managing reserves. By doing large system repos or matched sales, the supply of reserves was managed with respect to what the Fed thought the demand for reserves (which is unobservable in real time) was. If the resulting interest rate was too low or too high, then they added or subtracted to the supply reserves. And thus we get to the point that is crucial for understanding how monetary policy is conducted: the interest rate is a measurement of the pressure on reserves.
Interest rates, in other words, are like a thermometer that measures the temperature in the body. The doctor plies his trade on a feverish patient with an eye on the thermometer. He can’t see the microbes and antibodies, but the thermometer tells him (her) if he (she) is winning. In exactly the same way, the level of short-term interest rates tells the Fed if they have too many reserves or too few. But suppose the doctor lost sight of the real purpose of treatment? Suppose the doctor said “wow, this would be so much easier if I just put a little dial on the thermometer so that I could control the reading directly! Then I could just set it to the right temperature and I would be done.” We would all recognize that doctor as a quack, and the patient would probably die.
This approach, though, is what the Sack/Gagnon paper proposes. We want to control the temperature, so let’s introduce a thermometer that allows us to control the temperature! But this is wrong, because it is the reserve position that is critical to control; it is that which is out of control at the moment due to the presence of copious excess reserves; and the fact that the Fed can simply set the interest rate is irrelevant. (Why do we need a Fed? Why not have Congress set the legal interest rate at the “appropriate level” so that the Fed doesn’t even need to do open market operations?)
The Sack/Gagnon plan will clearly permit the movement of interest rates to wherever the Fed wants them to be. But it will not solve the root problem, which is that the level of required reserves is essentially out of the Fed’s control – which means the size of the money supply is out of its control as well. Excess reserves will continue to leak into transactional money, and inflation will continue to rise. Here is your error. The Fed is about to score an “own goal.”
I am generally reluctant to call anything a “game changer,” because in a complex global economy with intricately interdependent markets it takes something truly special to change everything. However, I am tempted to attach that appellation to the ECB’s historic action this morning. It probably does not “change the game” per se, but it is very significant.
Feeble money growth in the Eurozone has been a big concern of mine for a while (and I mentioned it as recently as Monday). In our Quarterly Inflation Outlook back in February, we wrote:
“The new best candidate for having a lost decade, now, becomes Europe, as it sports the lowest M2 growth among major economic blocs… It frankly is shocking to us that money supply growth has been so weak and the central bank so lethargic towards this fact even with Draghi at the controls. It was generally thought that Draghi’s election posed a great risk to price stability in Europe… but in the other direction from what the Eurozone is now confronting. There have been murmurings about the possibility of the ECB instituting negative deposit rates and other aggressive stimulations of the money supply, but in the meantime money growth is slipping to well below where it needs to be to stabilize prices. Europe, in our view, is the biggest counterweight to global inflationary dynamics, which is good for the world but bad for Europe.”
All of that changed, in one fell swoop, today. The ECB’s actions were unprecedented, and largely unexpected. First, and somewhat expected, was the body’s decision to implement a negative deposit rate for bank reserves held at the ECB. This is akin to the Fed incorporating a negative rate for Interest on Excess Reserves (IOER). What it does is to actually penalize banks for holding excess reserves.
There are two ways for a bank to shed excess reserves. The first way is to sell the reserves to another bank in the interbank market. This doesn’t change anything about the aggregate amount of excess reserves; it just moves those reserves around. In the process, it will push market interest rates negative (since a bank should be willing to take any interest rate that is less negative than what the ECB is charging) and probably increase retail banking fees at the margin (since there is otherwise no way to charge depositors a negative rate). This will weaken banks, but doesn’t increase money growth. The second way a bank can shed excess reserves is to lend money, which increases the reserves it is required to hold and therefore changes the reserves from excess to required. A bank is incentivized to make marginally riskier loans (which lowers its margins due to increased credit losses) because there is a small advantage to using up “expensive” reserves. This also will weaken banks. But, more importantly, it will stimulate money growth and that is what the ECB is aiming for.
If that was all the ECB had done, though, it would not be terribly significant. The utilization of the ECB’s deposit facility is only about €29bln at this writing, which is already near the lowest level since the crisis began (see chart, source Bloomberg).
But the ECB did not stop there. At the press conference after the formal announcement, Draghi unveiled a package of €400bln in “targeted” LTRO, which means that if banks lend the money they acquire through the LTRO then the term of the loan is four years; otherwise it must be paid back in two years. Even more important, the central bank suspended the sterilization of LTRO. “Sterilization” is when the bank soaks up the reserves created by the LTRO. As long as the ECB was sterilizing its quantitative easing, it could not have any impact. It is similar, but more extreme, to what the Fed did in instituting IOER to restrain banks from actually using the reserves created by QE. It never made much sense, but in the ECB’s case there was evidently some concern that doing QE without sterilization was not permitted under the institution’s charter.
Apparently, those concerns have been resolved. But QE without sterilization is meaningful. The ECB is thus not only doing quantitative easing, but is actively taking steps to make sure that the liquidity being added to the system is flushed, rather than leaked, into the transactional money supply.
If the ECB actually follows through on these pledges, then we can expect a rapid turn-around in the region’s money growth, and before long a turn higher in the region’s inflation readings. And, perhaps, not merely for the region: the chart below (source: Bloomberg, Enduring Investments) shows the correlation between core CPI in the US and the average increase in US and Eurozone M2. Currently US M2 is growing at better than 7% over the last year, while Eurozone M2 is 1.9%. Increasing the pace of M2 growth in Europe might well help push US inflation higher – not that it needed any help, as it is already swinging higher.
The renewed determination of the ECB to push prices higher should as a result be good not only for European inflation swaps (10-year inflation swaps were up 2-3bps today, but have a long way to go before they are back to normal levels – see chart, source Bloomberg), but also for US inflation swaps (which were up 1-2bps today).
Finally, if it is true that central bank generosity is what has been underpinning global asset markets, an aggressive ECB might give a bit more life to global equities. Perhaps one more leg. But then again, perhaps not – and when the piper’s tune is over, it could be brutal. It is currently quite dangerous to be dancing to that piper. For my money, I’d rather be long breakevens.
 This is interesting for lots of reasons, but one of them is that the ECB will measure (if I understand correctly) the net lending of the institution, so if that contracts then the loan will be called. But there are lots of reasons for an institution to decrease lending. Some of them, such as a generally weak economic environment or a weak balance sheet of the bank, would be exacerbated by an unwelcome “call” of the loan by the ECB. In the former case it would exacerbate a weak economic situation; in the latter it could accelerate a bank collapse. I may not understand the conditions for the call, but if my understanding is correct then this is a curious wrinkle.
On Tuesday, the Bureau of Labor Statistics will report the CPI index (along with endless other data) for March. Currently, the consensus estimate calls for +0.1%, and +0.1% ex-food-and-energy. This release will generate the usual irritation among conspiracy theorists who believe the government is monkeying with the inflation numbers for their own nefarious ends. I have previously explained why it is that inflation tends to feel faster than it actually is, and I have regularly debunked the claim by certain conspiracy-minded individuals that inflation has been running about 5% faster than the “official” mark since the early 1980s. However, today I want to point out another reason that right now we will have a tendency to recognize that inflation is not rising at 0.1% per month, and that involves the issue of seasonal adjustment.
The point of seasonal adjustment is to remove regular, cyclical influences so that we can see if the underlying trend is doing anything interesting. Consider temperature. Is it particularly helpful for you as a meteorologist to know that the average temperature in April has been higher than the average temperature in January? Of course not, because we know that April is always warmer than January. Hence, with temperature we ask whether April was warmer than a typical April.
Closer to the point, consider gasoline. The national average gasoline price has risen in 61 of the last 66 days, as the chart below (Source: Bloomberg) illustrates.
Yes, if you’re noticing that gasoline prices have been rising you are not alone, and it is not an illusion! But should we worry about this rapid acceleration in gasoline? Does this necessarily presage spiraling inflation? Bloomberg offers an easy way to look at the seasonality question (we formerly had to do this by hand). The following chart shows the change in gasoline prices (in cents) since December 31st for each of the last four years, for the 5-year average (the heavy, yellow line) and for this year (the white line).
You can see that the rise from late January into April is not only normal, but the scale of the increase is just about the same this year as for the prior four years – what was unusual was that prices didn’t start rising until February.
Now, this particular seasonal pattern is important to inflation-watchers and TIPS traders because the volatility of gasoline prices is an important part of volatility in the overall price dynamic. In fact, it is important enough that if I take the average line from the gasoline chart above and overlay it with the official CPI seasonal adjustment factors from the BLS, you can see the ghost of the former in the latter (see chart, source Enduring Investments).
Now, the seasonal adjustment factors for the CPI as a whole are less dramatic (closer to 1, in the chart above, if you look at the right-hand scale compared to the left-hand scale) than are the factors for gasoline, but that makes sense since gasoline is only a small part – albeit a really important part – of the consumption basket of the average consumer. And the BLS methodology is a lot more sophisticated than the simple average-of-the-last-x-years approach I have taken here. But this should be good enough for you to grasp the intuition.
What this means is that when the BLS reports tomorrow that gasoline prices didn’t add anything to overall inflation in March, you should recognize that that does not mean that gasoline prices didn’t rise in March. It means that they didn’t rise significantly more or less than the average factor the BLS is assuming. Most of all, it doesn’t mean that the BLS is monkeying with the data to make it seem lower. The product of the seasonal adjustment factors is (approximately) 1.0, which means that what the BLS takes away in the springtime, to report inflation numbers lower than would be anticipated given a raw sampling of store prices, they will give back in the late fall and winter, and report inflation numbers higher than would be anticipated given a cursory glance of store shelves. What is left, hopefully, is a more-unbiased view of what is happening with the price level generally.
Where you can see this effect most clearly is in the difference between the seasonally-adjusted number that is reported and the rise in the NSA figure that is used to adjust inflation-indexed bonds like TIPS. While the consensus calls for a +0.1% rise in headline CPI, the forecasts expect the NSA CPI (the price level) to rise from 234.781 to 236.017, which is a rise of +0.5%. So yes – if it feels like inflation is suddenly rising at a 6% annualized pace, that is because it is. But fear not, because that will slow down later in the year. Probably.
 The summary of that argument: we know that wages have increased roughly 142% since the early 1980s – average hourly earnings was $8.45 in April 1984 and is $20.47 now, and this “feels about right” to most people. Against this, the CPI has risen 128%, meaning that our standard of living “should” have improved a little bit since then, but not much (although any individual may be doing somewhat better or worse). But if prices instead of rising at 2.8%/year had risen at 7.8%/year, prices in aggregate would have risen 851% versus a 142% increase in wages, and we would all be living in absolute squalor compared to our parents. This is offensively and obviously wrong.
Whether the evaporation of popular Bitcoin marketplace Mt. Gox (which may have nothing to do with the Gox in Dr. Seuss’s beloved One Fish, Two Fish, Red Fish, Blue Fish) is due to fraud, hacking, incompetence, or some combination of all three – it appears it may have been hacked three years ago, and have been insolvent since then before vanishing from the Internet last night – doesn’t really matter. Either way, investors/speculators with money at Mt. Gox got MFGlobaled. The money wasn’t segregated (if it was money at all, and if it can be segregated at all), there was no audit (if there can be an audit trail for something that doesn’t have a known origin or destination), and the firm was not overseen in any fashion (if it is even possible to oversee something that exists mainly because it is difficult to oversee).
Like Schrödinger’s cat, it was kinda there, until someone actually looked and discovered it was dead.
I have carefully eschewed writing about Bitcoin in the past, though people have asked me to do so. I chose not to write about it because I had no wish to be filleted by one side or the other in the argument. But what I would have said would have been a series of simple observations that have nothing to do with how Bitcoin is mined, managed, or mishandled:
- This is hardly the first currency that has been outside of government control. Currencies existed outside of government control before they existed under government fiat.
- Historically speaking, there is a reason that government-sponsored currencies won, and it wasn’t because they were backed with gold. It was because people trusted the government when it said the currency was backed with gold.
- Trusted banks were issuers of currency for a long time. The coin of the realm has always been trust – and even if a currency is limited, or backed by limited metal, or whatever, you still need trusted institutions through which the coin flows, or it doesn’t work. Where is the trusted institution in Bitcoin’s case?
- So what’s the big deal?
This isn’t schadenfreude. I don’t care if Bitcoin succeeds or not; I don’t think its success or failure has anything to do with whether fiat currencies succeed or blow up. I don’t think Bitcoin is a “safe haven” any more than gold is a safe haven.
But at least I can touch gold. At least I know that gold will have some value in exchange, whereas I don’t know that Bitcoin will, tomorrow. And now, indeed it may not. Surely no institutional investor can now invest in Bitcoin deposits without answering the following question to the satisfaction of its board: “How can we be sure that our money won’t go the way of Mt. Gox?” And institutional acceptance is a huge hurdle for the future success of this substitute currency. Ditto firms using Bitcoin for transactions – a daylight overdraft that can go to zero overnight is a big risk for a bank.
And so, what I think was always the not-so-subtle problem for Bitcoin or any crypto-currency remains: for it to succeed, a trusted institution needs to be involved. Trust can’t be distributed across a network. And if an institution is involved, then the idea of a “people’s currency” loses weight. Bitcoin wasn’t the first of these attempts, and it won’t be the last, but in my mind that is the challenge. You can’t make money that only is used by the credulous and the gullible. It must be used by the incredulous and the suspicious. It is adoption by those people which defines the success or failure of a currency.
(Unfortunately, this puts certain elements at my alma mater in the former category. In our January 2014 alumni magazine was an article on Bitcoin. In the information bar “Bitcoin Dos and Don’ts”, the first point was “Do your research first! More information is available on Bitcoin.it, a wiki maintained by the bitcoin community. For Americans, the most popular and trustworthy place to buy and sell Bitcoins has historically been mtgox.com.” Whoops! Do your research first – popular does not imply trustworthy unless the thing is popular with people whose trust is hard to win!)
 “I like to box. How I like to box! So, every day, I box a Gox. In yellow socks I box my Gox. I box in yellow Gox box socks.”