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. 

Video: Keynes on Britain's Departure from the Gold Standard

As Predicted U.S.-China Economic War Heating Up

Another prediction which is coming in right on schedule: this Presidential political season the one thing Republicans and Democrats can agree upon (the generally conservative Senate voted 79-19) is that China is manipulating the value of its currency to make its exports more price competitive.

We're still in the early rounds of the latest Congressional flare-up over China's currency policy, so stay tuned.

SNB Gift-Wraps $2,000/oz. Gold

Perhaps not since World Bank President Robert Zoellick publicly advocated a return to the gold standard last year has the barbarous relic received such a sure-fire price boost.

Today the Swiss National Bank declared that it will print an "unlimited" number of Swiss francs (because fiat central banks can do that) to prevent further appreciation of the franc.

The Swiss franc had been considered perhaps the ultimate safe haven currency, alongside perhaps to a lesser extent the Japanese yen. Both have been appreciating steadily over the past year+ in the face of periodic interventions by their respective central banks. Both countries have trade surpluses, which creates a built-in demand for their currencies as domestic firms repatriate funds. The Japanese and Swiss banking systems are also considered relatively strong. However with the SNB's decision to crank up the printing press and peg the franc to the euro at 1.20 francs will undoubtedly increase pressure on the Bank of Japan to do something similar.

Strangely, the price of gold dropped dramatically on the SNB news before rationality returned and pushed gold back up to an all-time record high of $1,923/oz. (although it did finish the day below $1,900).

Bottom line: today's news is very bullish for gold, and my prediction, made just under a month ago when gold reached $1,700/oz., that the yellow metal would push forward to $2,000/oz. should now materialize sooner than anticipated.

Book Review: 'Sustainable Wealth' By Axel Merk

Axel Merk’s Sustainable Wealth is very readable personal finance guide to today’s increasingly complex investment world. The book contains a wealth of practical information, and it can be particularly useful for novice investors who are interested in learning more about the role of macro forces and currencies, and how they influence markets.

About the Author

Axel was born in Munich, Germany and grew up in a family of investors. It was during college that he first began investing on behalf of clients. His academic training is in finance and computer science, and he has lived in many parts of Europe before relocating to the U.S. He is the founder and CIO of Merk Investments, a Palo Alto, California based mutual fund focused on currencies. In his personal life he is a distance runner and pilot, and he is married with children. Axel Merk also gives regular media interviews and periodically writes for SeekingAlpha.

Sustainable Wealth

With his book, written following the financial crisis in 2008, Merk aimed to reach an audience that is intelligent and interested but not necessarily educated in economics or currencies. While Merk runs a currency mutual fund, the book is not aimed at currency traders. Rather the book primarily targets the man in the street who is concerned with the actions of today’s policymakers. In the book Merk describes the pressures between where the market would like to go and the interference run by policymakers. Understanding this pull-push dynamic is at the heart of Sustainable Wealth.

One of the key themes of the book is the idea that “there is no such thing as a safe asset” and that investors may want to take a diversified approach to something as “mundane as cash”. The book contains a number of helpful, easy to understand explanations about the fundamental nature of the world’s current debt problem, and ways to address it on a personal level.

During an interview, Merk emphasized his independent opinion. That certainly can bee seen with his often seemingly minority view on the euro versus the U.S. dollar over the past 12+ months. Other than the temporary slide in the euro last summer to $1.18, Merk’s view on the euro has more or less proven correct. However, it is worth keeping in mind that Merk runs a currency mutual fund inside the United States, and that one of the ways in which more American investors would take an interest in his fund is if they are concerned about the fate of the U.S. dollar.

Continue reading the full review at SeekingAlpha here.

Keynes on Printing Money, and Do Loss-Suffering Central Banks (i.e., ECB, SNB) Need Capital?

Weimar Germany during the early-1920s hyperinflation

A 1924 quote from John Maynard Keynes reflecting on events in Weimar Germany and Lenin's Russia:

"A government can live for a long time, even the German Government or the Russian Government, by printing paper money." 

However, "In the last phase, when the use of the legal tender money has been discarded for all purposes except trifling out-of-pocket expenditure, inflationary taxation has at last defeated itself."

The above quote was excerpted from a 1997 paper by the IMF's Peter Stella titled 'Do Central Banks Need Capital?'

Can Central Banks Go Bust?

Technically speaking, the answer according to Stella is no, central banks do not require a capital buffer to absorb losses in the same sense that a commercial bank does. However, Stella states:

"Weak central bank balance sheets invariably lead to chronic losses, the abandonment of price stability as a primary policy goal, a decline in central bank operational independence, and the imposition of inefficient restrictions on the financial system to suppress inflation. 

...if society values an operationally independent central bank capable of attaining price stability without resorting to financial repression, the transfer of real resources to recapitalize the central bank becomes necessary when chronic losses are sizeable."

In other words, the overarching reason for central banks to hold sufficient capital is that it helps maintain confidence in the soundness of the central bank and the value of the currency it issues.

Has the ECB Become Europe's 'Bad' Bank?

As the European debt crisis has spread and intensified, central banks in Europe have been suffering heavy losses for over a year now.

The Swiss National Bank has reported losses in the tens of billions of swiss francs on its euro purchases over the past 12+ months. Whether or not the Swiss government will move to recapitalize the bank is unclear. So far as I know the Swiss central bank is unique among major world central banks in that it is publicly-traded with both government and private shareholders.

There has also recently been speculation that the relatively thinly-capitalized European Central Bank will need to be recapitalized again if it were to continue to suffer heavy losses on its purchase of European sovereign debt. The ECB recently began purchasing tens of billions in Italian and Spanish debt, which comes on top of the tens of billions in Greek, Irish and Portuguese debt it already holds. The prospect of the ECB needing additional funding is not sitting well with Germany and other rich European nations which will have to foot the bulk of the bill.

Interesting times in the world of central banking.

Will Central Bankers Have the Same Courage On the Way Out?

Exit interview here with outgoing Fed Governor Kevin Warsh, who openly discusses his skepticism of QE2, how inflation is the cruelest tax of all, and other topics.

On the Fed's long talked about but still distant plan to 'exit', or unwind, its unprecedented monetary stimulus, he states "Central bankers must have the same courage on the way out that they had going in".

But just how likely is that? Given the current unemployment situation, and the Fed's dual mandate of stable prices and low unemployment, the Fed seems destined to remain in neutral or biased towards putting it's foot back on the money printing pedal.

The Fed has now surpassed China as the largest holder of government debt and has made it abundantly clear that its weak U.S. dollar policy, hashed in the interest of kickstarting exports, is not really open to negotiation.

Bottom line: don't expect the Fed to have the same courage when (or if) it belatedly decides to exit its massive monetary stimulus.

Rogoff: 'Sovereignty and currency co-habitation do not mix'

Reflecting on the latest twists and turns in the Eurozone debt crisis here are some other choice quotes from Professor Rogoff's FT editorial:

• the euro is looking very much like a system that amplifies shocks rather than absorbs them
• even if the euro system was not at the heart of the crisis, it needs to be able to withstand two standard deviation shocks
• markets are more worried about the US’s lack of a plan A than Europe’s lack of plan B
• It is sometimes said that the euro is a creature of politics that would never be justified by economics. The present episode could well turn this statement on its head.

Full editorial here, and here is a recent Charlie Rose panel discussion he participated in with Paul Krugman and others.

Podcast: Joseph Nye on the Future of Power

Link to audio here.

Joseph Nye is a long-time analyst of power and a hands-on practitioner in government. His concept of "soft power" has been adopted by leaders from Britain to China and "smart power" has been adopted as the bumper-sticker for the Obama Administration's foreign policy. In this lecture, drawn from his new book The Future of Power, Nye outlines the major shifts of this century: new transnational challenges such as the financial crisis, global epidemics, and climate change facing an increasingly interconnected world; a changing global political and economic landscape, including the rise of China and India; and the increasing influence of non-state actors. Nye explores what resources now confer power, and argues that, in the information age, it might be the state (or non-state) with the best story. Joseph S. Nye, Jr. is University Distinguished Service Professor and former Dean of Harvard's Kennedy School of Government. He has served as Assistant Secretary of Defense for International Security Affairs, Chair of the National Intelligence Council, and a Deputy Under Secretary of State. The author of many books, he is a fellow of the American Academy of Arts and Sciences, the British Academy, and the American Academy of Diplomacy.

Fed President Hoenig Opens-up on Why He (in Fedspeak) 'Went Off the Reservation'

Kansas City Fed President & FOMC Member Tom Hoenig

FOMC-member Thomas Hoenig explains why he has been the lone dissenting vote against the Fed's zero interest rate policy (ZIRP), which is coming up on an extraordinary three years.

Link to audio recording include Q&A here, and below is a brief bio:

Thomas M Hoenig is president and chief executive officer of the Federal Reserve Bank of Kansas City. He assumed the role of president on October 1, 1991, making him the longest serving of the 12 current regional Federal Reserve Bank presidents. He is senior member of the Federal Reserve System's Federal Open Market Committee, the key body with authority over national monetary policy in the United States.

Video: Barry Eichengreen at Bretton Woods on the Past and Future International Monetary Order

And the accompanying Q&A for Barry's panel, which included Keynes biographer Lord Robert Skidelsky.

Video: Exporting Propaganda - China's New Charm Offensive

Spin, manufactured in China

A friendly, gentle depiction of the People's Republic may soon be coming to Americans and Europeans via their television screen and newspapers (see today's International Herald Tribune and its cleverly disguised paid-for-but-looks-like-news insert) .

Yes, this bought and paid-for China is the same country which has banned its citizens from using Facebook, Twitter, YouTube, and most recently Skype. As noted by the NY Times, China's rulers are "obsessed with the threat posed by the Internet".

From the article:

Li Changchun, a member of China’s top ruling body, the Politburo Standing Committee, and the country’s senior propaganda official, was taken aback to discover that he could conduct Chinese-language searches on Google’s main international Web site. When Mr. Li typed his name into the search engine at google.com, he found “results critical of him."

A Chinese person with family connections to the elite (said) that Mr. Li himself directed an attack on Google’s servers in the United States 

In the wake of the overthrow of Tunisia's government, other dictatorships (e.g., Mubarak's monarchy in Egypt) are now following China's lead.

I can only imagine how the Politburo Standing Committee's discussion over China's international image problem went down: "China is the world's greatest exporter, and propaganda works pretty well here, so why not package the two together?"

U.S.-China Currency War: Should America Fight Back by Defaulting?

A little less handshaking, a little more action?

China-U.S. relations have dominated this week's headlines with Hu Jintao's official state visit to America. And there is much to talk about with respect to what is arguably the world's most important bilateral relationship.

'Bleeding-hearts' types will no doubt want to focus on human rights issues, such as China's not so secret effort to wipeout Tibetan civilization and the ongoing imprisonment of China's recent Nobel Peace Prize winner, Liu Xiaobo.

As the NY Times opinion page put it, "how can one Nobel Peace Prize laureate be silent when meeting the man who imprisons the next?"

And those concerned with the military balance of power can point to concerns about Chinese espionage, secret development of sophisticated weaponry like a Chinese stealth fighter, and China's navy contesting free navigation in the South Sea.

The Renminbi Runaround

There is also the matter of U.S.-China economic relations. As far as the U.S. is concerned, the big one is the exchange rate of China's currency, the renminbi (yuan). It is widely agreed that China's currency is undervalued by as much as 20-40%, providing China with an unfair trade advantage. Much has been written about this issue previously here.

Former Secretary of State and and National Security Advisor, Henry Kissinger, appeared on Charlie Rose this week to discuss relations with China. Not surprisingly, Kissinger argued for a diplomatic solution to the renminbi. While acknowledging that he is not economist, Kissinger believes there should be some way to bring the Chinese around on revaluing the renminbi by offering something in return. My question is hasn't the U.S. already tried that ad nauseam?

Throughout modern history the world's trade and currency order has always followed a set of explicit and implicit 'rules of the game', so to speak. Over the last two decades China has benefitted significantly from first having access to the world's markets and later gaining entrance into the World Trade Organization. While WTO rules do not cover exchange rate manipulation, one of the hallmarks of our current semi-free trade system is floating exchange rates. China exercises heavy control over its exchange rates in a manner completely unlike other major trading powers, such as the U.S.

The key question, put simply, can be expressed as follows: why is there one set of currency rules for China, and another set for everyone else?

Continue reading the full article published on SeekingAlpha here.

Ken Rogoff Forecasts "Currency Chaos" in 2011

Continuing the 'chaos' theme, thoughts on how various currencies will fare in 2011 can be found here from Ferguson's Harvard colleague Professor Ken Rogoff, author of This Time is Different.

Note to U.S. dollar bears: Rogoff points out that the U.S. dollar's "purchasing power is already scraping along at a fairly low level globally – indeed, near an all-time low, according to the Fed’s broad dollar exchange-rate index. Thus, normal re-equilibration to “purchasing power parity” should give the dollar slight upward momentum."

Timing the Inevitable Decline of the U.S. Dollar

One of the most heavily debated macro topics is the future of the world's reserve currency, the seemingly almighty U.S. Dollar.

Neither the fact that scores of prognosticators have been predicting its demise for decades, nor that when the financial going gets tough (as it did during the 2008-2009 financial crisis) everyone wants it, has dissuaded today's dollar bears from taking a dim view of the greenback's future.

America's Exorbitant Privilege

Barry Eichengreen

Berkeley Professor Barry Eichengreen’s new book, Exorbitant Privilege, explains the U.S. Dollar's historic rise from international monetary obscurity prior to World War I, to surpassing British pound sterling in importance by 1924-25, to its dominant post-World War II position which it continues to occupy today.

Professor Eichengreen opens with the point that while we now live in a multi-polar economic world the financial system and monetary order still revolve around a single currency (the U.S. Dollar).

Some might be surprised to learn that approximately 75% of all $100 bills circulate outside the United States. The reserve currency holdings of the world's central banks are largely in U.S. Dollars or U.S. Dollar denominated assets (e.g., U.S. Treasuries).

What precisely is the 'Exorbitant Privilege' conferred on the United States by the special role its currency plays in the global financial system?

Professor Eichengreen calculates that the U.S. dollar’s status as the world's reserve currency is worth 3% in U.S. national income per year. In other words, having the world’s dominant reserve currency allows the U.S. to run an annual $500 billion current account deficit.

Some may remember Vice President Cheney's quip that "deficits don't matter", or Nixon Treasury Secretary Connally's response to foreign governments, critical of the U.S.’s profligate Vietnam and Great Society spending, on how the U.S. Dollar was "our currency, your problem". It is this 'Exorbitant Privilege', a term coined by French leaders in the 1960s who railed against the fact that American paper currency could be exchanged for "real stuff", which Professor Eichengreen views as unsustainable.

Are Reserve Currencies Analogous to Computer Operating Systems?

Economists explain the U.S. Dollar's rise and dominance through a principle called 'network externalities' (or 'network effect'). Similar to how significant interoperability advantages in computing can be achieved through the adoption of a single operating system (e.g., Microsoft Windows), the widespread use of a single currency (the U.S. Dollar, and previously British pound sterling) can lead to mutually beneficial economic efficiencies.

However, in a world where 'Currency Converter' is one of the Top 10 most downloaded smartphone apps, determining exchange rates and making currency conversions can now be performed quickly and simply by a vast number of people. Just as the computing world is moving towards multiple operating systems (i.e., Windows, Mac, Linux, Google, iOS, etc.), Eichengreen believes the world will transition to three principal reserve currencies: the U.S. Dollar, the Euro, and the Chinese Renminbi (Yuan).

The Euro and the Renminbi: Assessing the U.S. Dollar Bridesmaids

On the currency topic du jour, Eichengreen believes that "euro gloom and doom is overdone". Just as a default by Los Angeles County won't spell the end of the U.S. Dollar, a default by Greece and/or Ireland won't bring about an end to the euro.

Germany is the one country, in Eichengreen's view, which could afford to abandon the euro without suffering catastrophic economic consequences. However, Eichengreen sees this as unlikely. Germany's next generation of leaders, while not having been around for the birth of the EU, are nevertheless heavily wedded to the European Project. Further, Germany benefits from a weaker euro via more competitive exports. If Germany were to leave the euro then the reintroduced Deutsche Mark would shoot up in value and risk choking off the German export led economic renaissance currently underway.

When it comes to the Chinese renminbi becoming a reserve currency, Eichengreen acknowledges that China needs to make significant changes. For starters, the renminbi will need to become freely convertible. China will also need to develop deep, liquid capital markets and make fundamental changes to its overall development model.

However, these and other changes may come quicker than many expect. A short time ago there were basically zero Chinese companies settling international transactions in renminbi; now 70,000 do so. Two U.S. multinational companies, McDonald's and Caterpillar, have issued renminbi-based bonds. Currently most of these changes are occurring in "China's financial petri dish" (Hong Kong), but China has set a target of making Shanghai a preeminent world financial center by 2020.

Timing the Decline of the U.S. Dollar?

Eichengreen assigns a very low probability to a sudden collapse of the U.S. Dollar. But could it happen? In short, the answer is yes.

A spat over Taiwan or rising tensions in the Asia Pacific over China building its first world class navy in 600 years could cause China to suddenly stop funding U.S. deficits. A more confident and assertive China is likely to continue to flex its newfound muscles, a subject I previously covered in more detail here.

However, what Harvard’s Larry Summers termed "The Financial Balance of Terror" is likely to prevent a catastrophic scenario from unfolding. Similar to how President Eisenhower threatened to dump the U.S.'s vast British bond holdings during the 1956 Suez crisis if British forces didn't leave the peninsula immediately (which they did), Eichengreen believes that China and U.S. officials will attempt to work out their differences through diplomatic back channels as opposed to openly fighting it out in financial markets.

A more likely scenario would be a sudden loss in investor confidence, like the one experienced by Greece last spring, in the U.S.'s ability to get a handle on government spending. Eichengreen notes how the ratio of U.S. federal debt (a relatively high 75% of GDP) vis-à-vis tax revenues (a relatively low 19% of GDP) is rapidly approaching the danger zone.

From an investment perspective, investors should continue to expect currency volatility under the current U.S. dollar dominated international monetary system. Further, the U.S. Dollar will continue to be the world's safe haven currency in times of crisis for the foreseeable future. However, according to Eichengreen a change in the international monetary order is all but inevitable within a decade.

Chimerica Rap Video: U.S.-Sino Currency Rap Battle

World Bank President Zoellick Gift Wraps Gold $1400+

'Tis soon to be the season of giving, and the monetary gifts to gold owners are getting off to an early start.

Not to be outdone by Federal Reserve Chairman Ben Bernanke's recent 'QE2' goody bag, World Bank President Robert Zoellick has penned an editorial in the Financial Times calling for a global monetary debate on returning to a gold standard of sorts.

Zoellick's proposal is for a basket of the world's leading currencies - the dollar, euro, yen, pound, and renminbi - to be paired with gold (which he describes as "an international reference point of market expectations") in a new Bretton Woods styled monetary order.

Gold really didn't need much of a reason to finally poke its head above $1400/oz, but Zoellick's op-ed and the gold chatter that's sure to follow will almost certainly provide the nudge.

Meantime gold owners can sit back, grab a bag of popcorn, and enjoy what's about to happen to the price of your Au.