Adventures in Alternative Currencies: Bitcoin Goes Mainstream

Continuing on with our series covering adventures in alternative currencies, many were quick to proclaim the death of Bitcoin, particularly following the June 2011 bursting of the Bitcoin bubble. For example, here is some doomsaying from the normally reliable Tyler Cowen; and for a pessimistic economic historian's take see here.

But following an undeniably rocky road the little digital currency that could appears to be having the last laugh. A good read can be found here on how Bitcoin is beginning to go mainstream.

At this stage the obvious first question is why has the decentralized, 100% digital currency proven so resilient? Scientific American provides one good answer:

When they (a merchant) finalize a deal in Bitcoin, they do so knowing that the transaction can never be reversed. The Bitcoin network doesn't edit its ledger. As such, merchants no longer have to worry whether they are charging a stolen credit card. 

"'The fraud mitigation is big for Internet merchants, because they are all handling card-not-present transactions. And the business has to eat the loss if the payment is reversed later on,"' Gallippi says. "'Using Bitcoin, a business can receive a payment from any country on the planet, instantly, with no risk of fraud."'

In addition to helping cut down on fraud costs for merchants, Bitcoin is chic. Using Bitcoins to transact business is a mark of digital savvy for both tecno hipsters and the merchants who cater to them.

What the future ultimately holds for Bitcoin is less interesting to me than a more general issue, which is the apparent growing trend in alternative currencies coming into existence.

We have already seen some Congressional saber rattling about Bitcoin prior to its flash crash. Will governments continue to tolerate it, Bristol's new pound note, etc., while they remain small? Or will we see a more formal move in the not too distant future to stamp out these fledgling alternatives to government fiat money? As the article points out, government's might have a hard time shutting down Bitcoin:

But perhaps most consequential for the future of Bitcoin—in order to shut down a peer-to-peer currency exchange, one would have to terminate every node on the network. The few lawyers who have studied Bitcoin all agree that the currency inhabits a legal gray area. No one really knows how governments would react if it gains traction, but many consider the exchanges to be the easiest target for people who want to regulate Bitcoin. Decentralizing the exchanges would make that job nearly impossible. Bitcoin developers are quickly proving that they can design decentralized alternatives to even the most sophisticated financial institutions. 

What is Money? (or How is Money Created?)

I just did a Google search on 'what is money?' and 'how is money created?', and many of the top results are probably confusing for someone looking for a simple explanation of the broader concept of money.

(Note: this post is not about physical cash or coin, which I trust most people correctly understand to be minted by the government. It is instead about a more complete measure of money in all its physical and non-physical forms: cash, coin, demand deposits, savings, etc.)

Courtesy of Dan Hind here's a simply explanation of how money is created:

Banks create money through the act of lending it. They don't have to limit themselves to lending out the money deposited with them. In fact, they can end up lending huge multiples of the money they hold in reserve. 

When they authorise a loan or extend credit in the form of an overdraft, the money is conjured out of nowhere.

So there you have it. Banks create the vast majority of the money supply out of thin air (electronic bits these days) when they make loans. Simple, right? Here's Dan again:

The economist and ironist JK Galbraith once wrote that "the process by which banks create money is so simple that the mind is repelled. When something so important is involved, a deeper mystery seems only decent". Offered the unadorned truth, stripped of any technocratic flim-flam, we can scarcely believe it. It seems preposterous that money should have such humble origins, as though it is beneath money's dignity that it should begin life at a banker's keystroke.  

The truth about money creation is a bit like the end of The Wonderful Wizard of Oz, when it turns out that there is no all-knowing wizard, only an old man behind a curtain, making things up as he goes along.

A perhaps more interesting question is why the subject of how money is created is not taught in secondary school? The reason can't be that it's too complicated. But as one of the commenters on Dan's article notes:

 "it is truly preposterous how little the public knows about arguably the single most influential conception humanity has ever created."

Education Site: Educate yourself on various aspects of the financial industry with classes from accredited online colleges.

Video: Pimco's El-Erian Explains Financial Repression

Investment Implications of Prolonged Financial Repression

Interesting read from Joe Roseman, former head of Moore Capital PM and Head of Macro Research, on the investment implications of 'prolonged financial repression'. Some highlights:

One of the issues that appears to have really confused economists is why corporates have steadfastly refused to participate in a new capital investment cycle? Why has new hiring been virtually non-existent? 

Standard econometric equations get this wrong because equations can’t think. Econometrics will look for the last time that interest rates were this low, looking at what worked before. 

I would argue that such equations do not have the requisite history built into them to recognise a period when three out of four cylinders in the engine of growth have been impaired. Econometric equations can’t think, but Sir Martin Sorrell of WPP certainly can. 

To quote Sorrell; “Most importantly, post-Lehman and the several corporate crises, we have seen a concern, or even fear, amongst Chairmen and CEOs and in the boardroom about making mistakes and a consequent emphasis on cost containment and unwillingness to add to fixed expenses and capacity.” 

Sorrell goes on to say that “Western-based multi-nationals are said to have over $2tr in cash on their balance sheets, but unemployment remains at stubbornly high levels, with only increases in temporary employment and limited expansion in fixed capacity in Western markets. Hence, a willingness to invest in the brand and maintaining or increasing market share, rather than increasing capacity and fixed expenses.” 

Governments don’t have the cash so print it. Households don’t have the cash so borrow it when they can. Banks don’t have the cash so skim it from savers. Corporates have the cash and just hoard it.

And the possible investment implications?

Not everywhere in the world has the same macro-impairment as the major Western economies, thereby allowing many corporates to develop growth strategies based outside of the G7. Having a cheap(er) currency certainly helps those companies. 

The market seemingly does not value cash sitting on the balance sheet highly. I wonder if that is a mistake. Cash, it is argued, offers optionality to the holder to take advantage of falling (asset) prices should they occur. On the same basis it may also be being undervalued on balance sheets.

I wonder if standard tests of “value” are missing the true value of the cash sitting on balance sheets? In a world where black swans are as common as starlings, having high net cash balances is a major plus. I also wonder whether that same optionality to use cash to buy cheap assets should also be valued higher.

In closing, he wondering whether the M&A department of foreign corporates would view weak currencies, like the pound or U.S. dollar, as an opportunity to acquire cash-rich businesses in the UK or U.S., respectively.

Full writeup here.

Video: Jeff Gundlach On What's Better Than Gold if Financial Armageddon Strikes