Note: I am long on Bitcoin. I am not a registered Security analyst. Views in this post should NOT be taken as an Investment advice. Before you proceed further, please see Disclaimer at the bottom of this post.

This is second post of two part series on my understanding of Bitcoin as an Asset. You can find the first part here.

In the previous post, I laid out my understanding of Money, Gold and Bitcoin from economic standpoint. In this post, I will trying list out my understanding of why Bitcoin is worthy of being an asset.

Price to What?

In traditional markets, assets (primarily stocks) are valued based on several ways like Price to Earnings, Discounted Cash Flow etc. But all these measures assume that underlying asset has earnings. But bitcoin doesn’t have any earnings. This is reason why I feel any method to measure Bitcoin is somewhat speculative in nature. Now, speculation by itself does not need to be wrong. But it means the measure has associated risks with it.

In the next sections, I try to understand the case for Bitcoin through lens of individual investor’s actions and also how the Corporate strategy seems to evolving around Bitcoin.

Case Through Lens of Individual Investor

Stock to Flow

Stock to flow (S2F) is a measure of scarcity of any commodity.

Stock to flow = Stock/Flow

Stock = Total amount of commodity available in the world
Flow = New amount of commodity produced every year.

Historically, there is a relationship between price of a given commodity to its S2F value. For example, here is S2F for Gold and Silver (two of the most precious commodities).

Gold S2F = ~58
Silver S2F = ~33.3

Another way to understand S2F is by inverting its value. The inverse of S2F is supply growth (or can be loosely termed inflation). If you notice, Gold’s inflation is ~2%. That is, if you gold 1 ton of Gold in a reserve. Next year, % of your reserve in relation to total amount of Gold available will reduce by 2%.
This is also happens to be reason why Central banks historically tried to keep inflation to 2%. Because in past Currencies were pegged to Gold, banks needed to make sure inflation is under 2% to make sure currencies dont lose their value with respect to gold.

Since price of commodity tends to be related to S2F, one of the popular techniques to measure Bitcoin is using S2F model popularized by an anonymous blogger Plan B . This method takes Bitcoin’s supply growth (which is not constant unlike Gold), model’s its price as factor of this.

Historically, Bitcoin’s pice followed this model. But history does not guarantee future. There are certain caveats in this approach of comparing Bitcoin to gold.

Gold has centuries of history. Also, as we discussed in previous post current financial system evolved from Gold Standard. So, gold was not the first entrant. Gold is a physical material. Some of the Gold’s value comes from industrial usage (thought not a huge percentage), jewelry (virtue signaling). Rest of it is a hedge against inflation. How much of this value will Bitcoin capture is yet to be known.

A Digital Scarce Asset

Bitcoin has been around for 10 yrs and during its time it proved to be secure, durable, scarce, transferrable. It has been widely considered as digital commodity which is scarce with all properties of sound money.

Even though there were other digital cryptocurrencies that popped up during this time, Bitcoin seems to have clearly distinguished from them. It is truly decentralized (trustless), scarce (fixed supply cadence), secure. Also technologies like Lightening Network are bringing Bitcoin mainstream increasing its utility. Network affect is very critical for cryptocurrencies especially for security and evolution of ecosystem. Because of huge head start is hard to catch up for new entrants.

Along with this, Bitcoin’s scarcity achieving through halving cycle makes it a good inflation hedge. Over 88% of all available bitcoin is already mined. More and more of existing bitcoin is coming out of exchanges into private wallets (which are usually long term holders). This means as adoption of bitcoin increase, new demand will chase after smaller supply of bitcoins which automatically increases price of bitcoin. Last two halving cycles have proven this to be right. Here is a tweet that explains this phenomena.

This increases selling to remain solvent and puts a drag on the price. Here's a chart I built earlier in the year that attempts to capture this interesting and unique dynamic. pic.twitter.com/O8ZSWQw5sv

— Preston Pysh (@PrestonPysh) November 13, 2020

Inflationary Policies

In the post: Inflation, QE – Lemonade Economy, Government & Central Bank I detailed how current monetary policies have adopted inflation. Current US treasury yields are <2%. The rates have got so low and central banks are talking about negative interest yield. Most investment portfolios recommend bonds as a safe haven for money. But with such lower interest rates will force people to look for alternative forms of investment as hedge against inflation.

Apart from that, these inflationary measures have increased the asset prices disproportionately. For a new graduate, even with high paying salary owning a home in places like San Fransisco, New York in increasingly hard. Only way to upward mobility is to invest in assets which have higher risk/reward. So we can expect more and more people turn away from saving cash (at low/negative rates). I have touched on this in a previous post about inflation

It is hard to guess how much of that demand will look for bitcoin. But it is clear, that whoever turns to Bitcoin has to compete for limited supply of Bitcoin available.

Case Through Lens of Corporate Strategy

Corporations using money in BTC as hedge

Just like individual investors, even corporations have to save their treasury somewhere. In a negative interest rate environment these corporations have to put their cash in an inflation hedge because of shareholder pressure.

We are already seeing early signs of that. Microstrategy, an enterprise software company has already moved about $400 Million worth of its reserve to bitcoin. Square, followed up by allocating about 1.8% of its cash ($50M) in to bitcoin as long term investment vehicle. Such movements can cause spike in Bitcoin’s price and also bring Bitcoin more in to mainstream narrative.

Fintech Disrupters using BTC as Orthogonal Vector

Fintech is one of the most crowded place with lot of giant corporations like Banks, Payment processors etc. In such a market best place for  The best way to for some new entrant to compete is by picking a very small part of a market that goes relatively unnoticed by these big corporations. If that small market happens to be complete new technology then these big companies might not be initially interested in competing there. Bitcoin can very well be that orthogonal niche place for small fintech companies to compete.

In fact this already happened. Cash app (from Square which is not a small company) took this bet on Bitcoin recently. Cash now lets its customer buy and send bitcoin. This makes huge sense for Cash app. It is a great way to compete against existing companies like PayPal while also reducing transaction costs by letting customers store bitcoin in Cash and transact from there. PayPal immediately followed up and started supporting bitcoin.

This creates a network affect for Bitcoin ecosystem. More non-tech people have on-ramp to Bitcoin without having to go through effort of setting up hardware wallet. It means more fintech companies might have to follow suite (especially ones in peer-to-peer money market).

Institutional Adoption

As this adoption on bitcoin grows, Bitcoin will become more viable investment vehicle for investors. This might force, institutions to start supporting it. For example, a relatively new company – Choice IRA offers saving bitcoin in IRA (retirement) accounts. If Bitcoin price keeps going up, other larger institutions will have no choice to follow. We are already seeing some Hedge funds (more) investing in Bitcoin. This further spins the fly wheel of Bitcoin adoption.

Risks for Bitcoin

While last few sections listed out bull case for bitcoin (largely speculative), it doesn’t mean that it is without risks. Here are few I can think of.

Regulatory Risk

As bitcoin’s march towards form of money continues, it is unlikely that Governments will let their currencies be replaced. It is very likely that they will put more restrictions on exchanges and other on ramps to Bitcoin. But whether this will trigger Game theory mechanics and make other countries adopt Bitcoin as a competition will be interesting to watch.

Protocol Risk

As we saw earlier, one of the factors in Bitcoin’s superiority compared to another cryptocurrencies is its security. If Bitcoin was ever hacked or proven to be hacked, it could completely derail its narrative. Arguably such risks are more likely early in the lifecycle, with more years it gets harder and harder for hacking as network grows. But with technology we should be always be wary of security risks (quantum computing ?).

Adoption

Lot of current value in Bitcoin is derived from its potential as Digital Gold. But Gold is a real physical commodity with long history. It has proven resilient to inflation for centuries. If Bitcoin and efforts like Lightening network dont pan out, then Digital gold will be only narrative for Bitcoin. Will people really adopt Bitcoin as digital gold is a question hard to answer right now.

See this post from Peter Schiff for counter point to Digital Gold narrative.

Gold is an inflation hedge because it’s also a commodity. When inflation reduces the purchasing power of fiat currencies, it takes more units of the inflated currency to buy a given commodity. Since #gold is also a commodity, it maintains its value relative to other commodities.

Since gold retains 100% of its properties over time, and is easy to store, it’s an ideal asset for consumers to hold during periods of high inflation. While more units of currency are need to buy commodities, the same quantity of gold can still be exchanged for other commodities.

Unlike gold, #Bitcoin is not a commodity so it has no historic price relationship to any other commodity. As such it has no measurable purchasing power that can be stored for use as a medium of exchange. Its price exists in a vacuum. It’s only worth what the market will bear.

Originally tweeted by Peter Schiff (@PeterSchiff) on December 19, 2020.

Even if Bitcoin technology can eventually scale (through efforts like Lightening Network), it is hard to imagine how Bitcoin can became a default money without integrating into existing financial system. Because ultimately societies are controlled and served by governments. Financial system is one of the core pillars of a society with its own sets of rules and regulations. Some of these regulations (like Knew your customers) go against the ethos and one of the founding principles of Bitcoin.

If Bitcoin integrates into financial system; if so, how will its network react to this ? and will it be continued to be viewed as a hedge against currencies?

If Bitcoin does not, then will run the risk of being a “hard to adopt” technology?

These are some interesting questions that will surface in near future.

Here is an excellent write up by Tyler Cowan on why Crypto assets can be either useful hedges or useful forms of payment — but not both.

Conclusion

At this point, best case for Bitcoin seems to be a reserve asset (Digital Gold). It has strong security and scarcity along with being truly decentralized. There is a lot of momentum in the ecosystem (Lightening Network) which could potentially increase the use of Bitcoin beyond store of value but it is yet to be realized. In the meanwhile, we are seeing adoption of Bitcoin by both Institutional investors and corporations.

However, there is lot of uncertainty Bitcoin as an asset. My choice of work – “uncertainty” as opposed to “risk” in above sentence is intentional. Risk is measurable (you can attribute a probability of winning) but uncertainty is not measurable hence every more dangerous and could cause permanent loss of capital.

Disclaimer

I am long on Bitcoin. I might sell Bitcoin in future anytime. This post is NOT a recommendation to buy, sell, or hold Bitcoin. I wrote this post to organize my thoughts about Bitcoin and shared it so that you might find it useful. I am not a registered Security analyst. Views in this post should NOT be taken as an Investment advice.

References

1. Inflation-QE-Lemonade-Economy-Government-Central-bank
2. The Bitcoin Standard – By Saifedean Ammous
3. Macro Impact On Bitcoin :: Pantera Blockchain Letter, April 2020
4. Bitcoin as Reserve Asset
5. Bull case for Bitcoin – Vijay Boyapati
6. Podcast: BITCOIN & MICHAEL SAYLOR – A MASTERCLASS IN ECONOMIC CALCULATION
7. Podcast: Once BITten – People-Know-Something-Is-Wrong
8. The Greatest Game – Jeff Booth
9. The Price of Tomorrow – Jeff Booth
10. Youtube: Chamath Palihapitiya: Why Bitcoin Will Be ‘the Category Winner’

Note: I am long on Bitcoin. I am not a registered Security analyst. Views in this post should NOT be taken as an Investment advice. Before you proceed further, please see Disclaimer at the bottom of this post.

This is first of my two part series on my understanding Bitcoin as an Asset. You can find the second part here.

What is Money?

Money has to be one of the greatest human inventions. It unlocked human potential to cooperate leading to acceleration of further innovations and thus leapfrogging humans ahead of all other species on this planet.

Human needs have evolved from food & shelter to innumerable conveniences that are part of our lifestyle today. This is possible because we as humans figured out how to exchange one valuable goods to another (barter system). Because of cooperation, different person can specialize and pursue different skill and still have their needs met by exchanging the goods they produced with ones they need. This has led to continuous innovation by humans as species taking us from hunter-gatherer days to species capable of exploring outer space.

But this system works only if any two people involved in trade have coincidence of wants. Let’s take an example, of person A who has chicken farm and person B who has a cow. Person A can exchange with B some (agreed upon) number of eggs in return for some milk. This trade will only work if B needs eggs. However, if B only needs (values) wheat, then A has to find a third person (C) who has wheat and values eggs, and then exchange wheat for milk with B.

This model of trade is not scalable once number of involved parties increase. It becomes too complex to find a counter party to your trade. This is because not every one values same good. Which brings to first property of medium of exchange:

1. It must be valued/desired by all parties in a trade

Another important criteria for this trade to happen is, coincidence of wants at same time. My hypothetical trade above only works if C is in need of eggs right now. If they need it a month later, this trade is not valuable to them, because eggs will be rot by then. Which brings to second required property of money or any medium of exchange:

2. Must retain value over time

It doesnt stop with this. It is quite possible that A might think 2 eggs is too much for a pound of wheat. While C might think 1 egg is too little for the trade. So A and C need to figure out a way to divide the egg. But your cant really break a raw egg into two. Even if you think we can cut it after boiling, what if the trade involves a chicken instead of egg. How can you cut chicken into 2 pieces. This leads to third property need for medium of exchange:

3. Must be divisible

It doesn’t stop with this either. What A and C and far away from each other? It must be possible for A and C to carry their goods to agreed place of exchange. Which is why a house as a medium of exchange is not a feasible. This leads to fourth property for a medium of exchange:

4. Must be carryable across space

There are many other ways (and many properties) to define money but for me these four are main ones.

Gold as Money (and then store of value)

If we study human history from early days of our evolution, we can find long list of experiments with different forms of money. There were attempts to use commodities like cattle, wheat and even coca as money. But these experiments kept failing because these commodities did not have some (or all) of the properties above.

As human skills advanced, we got good at producing metals from ground. These metals proved to be good choice for money over commodities because they are easier to carry over larger distances (property #4), divide into smaller pieces (humans figured out how to weigh metals. property #3), and their durability over time (property #2). While many metals were experimented with, ultimately Gold won because it was much rarer than most metals at same time more durable. This naturally made Gold a more desirable metal (property #1).

Because of this perceived value, gold became even a signal virtue (ornaments) which further propelled gold’s value. Through innovation humans figured out how to mint raw gold into coins, where each coin representing certain quantity of gold (humans figured how to weigh things). Many empires and governments through history standardized on government minted coins as agreed “money”.

But over a period of time, these empires misused their power as sole authority to mint these coins. In the quest to propel their economy, these governments started minting more coins (with reduced amount of gold per coin). While this increased money supply created a vibrant economy for a while, without proper control, this inflation soon became uncontrollable because of the greed of the empires. Soon, these empires became unstable because of loss of trust in currency and thus led to their eventual decline.

But the perceived value of gold never changed. It continued to be rare material which was treasured by humans, leading to continue to be a store of value.

Paper Currency (Fiat Money)

Paper currency was adopted my multiple governments and empires as better form of money. This paper money was durable over time (to an extent), was easier to carry over longer distances and also it was easy to print money in different denominations (divisibility). However, it lacked the fundamental property of perceived value (it is neither rare nor as durable as metals). And also, early incarnations of paper money had trouble with adoption, because people did not trust government printed money.

Governments were able to get around this value problem by pegging the paper money to Gold. Meaning, it was possible for anyone to bring their money to government and exchange for gold. This increased adoption of paper money. This is called “Gold Standard”. This standard continued for hundreds of years. Over a period of time, confidence in paper money increased. People no longer really redeemed gold from their currency making government printed paper as the de-facto money.

As is often case in human history, power leads to abuse. In early 1900s countries like Germany, started abusing this power and started printing more currency (than amount of gold they had). While this circulation of money improved commerce and propped up the economy, it eventually led to inflation (much like Gold era above) and eventual crash leading to 1929 great depression (history may not repeat but it rhymes).

In 1944 after the World War II, all of the allied nations met to solve the problem of currency inflations. This meeting took place in Bretton Woods, New Hampshire and hence the name – “Bretton woods agreement”. Under the agreement, all central banks would maintain fixed exchange rates between their currencies and USD (which was pegged to gold. US had control of lot of gold reserves at Fort Knox). This would mean, any inflation would essentially devalue the currency in relation to USD (and Gold). A side affect of this agreement is that USD became a de-facto global currency.

This eventually failed in 1971. In 1971, United states started seeing slowing economic growth and recession. To prop up the economy, USA had to increase money supply. This led eventual drop in value of USD with respect to Gold. This meant people started redeeming their USD for gold. To avoid this, President Nixon made a historic choice to unpeg USD to gold. This pretty much ended Bretton woods agreement (and Gold Standard).

Without this peg to Gold, governments were able to print more money into system leading to inflation in currency. So Gold’s perceived value continued to rise. To this day, gold is traded in most stock markets. See below chart from which shows increase in Gold value related to USD over last 5 decades.

Bitcoin – Digital Currency and Store of Value

In early 1990s, with explosion of internet it soon became evident that commerce will move over to internet. Many people started seeing the need for a digital currency which can power commerce on internet. But creating a digital currency met with multiple challenges.

• Who would authorize this digital currency? Physical money had centralized trusted authority (Central banks) to validate its authenticity. A digital currency is arguably global because of unique power of internet but there is no clear answer on which centralized entity can validate & control this currency.
• How do avoid double spending? Without central authority how can we ensure that individuals are not double spending they money? Who maintains the ledger for the available balance of each individual?
• How to maintain Security of the ledger? In traditional money, banks are responsible for securing your assets. Without centralized entity to hold your money, securing the ledger becomes a unique challenge .
• How to create digital scarcity? Digital items are by very nature easier to copy. Look no further than music, movies and all the piracy on internet. This exposes any digital asset to massive re-production and duplication leading to inflation.

While these problems remained unanswered for a while, e-commerce continued to prosper. Banks started supported wire transfers; Visa, Mastercard etc built out massive payment networks acting as centralized authority to validate purchasing power (whether individual has money) of individuals. This was all backed under the hood by same physical currency. These payment networks and banks enabled these micro transactions between individuals and behind the doors doing a large settlements between the banks (once a day etc).

But the answer to a true digital global currency was left answered until 2009, when an anonymous hacker Satoshi Nakamoto published a seminal paper on a decentralized digital currency based on purely peer-to-peer technology which he coined as Bitcoin.

Satoshi used a combination of game theory, cryptography and peer-2-peer networks to solve the problem of creating digital scarcity, authorization, a decentralized ledger. While technical details of beyond the scope for this post, let us briefly look at how these problems are solved.

Authorization

Bitcoin leverages public key cryptography to solve the authorization issue. Using this technology each individual has two digital keys – private and public. As name indicates private key is a secret which is only known to the individual, while public key is available for everyone to see. Uniqueness of this technology is that a key which is signed & encrypted with private key can only be unlocked with public key. This helps ensure that money was spent by the rightful owner of the money.

Decentralized Network to Maintain Ledger and avoid double spending

Bitcoin leverages peer-2-peer network in which multiple volunteers maintain a copy of the ledger (balances and transactions). These volunteers are called miners (a term copied from Gold miners). To verify balance and whether a person initiating payment has right balance, majority of the volunteers needs to agree on the balance.

Through this unique insight and reliance on decentralized peer-2-peer network Bitcoin removes the need for a centralized trusted party. It is these centralized trusted parties that repeatedly through the course of history caused downfall of various forms of money.

Incentives as way to issuance and establish security

In bitcoin, the security of network is proportional to number of miners. So, in order to incentivize more minters to participate, the algorithm will issue certain amount of Bitcoin to miner who authorizes transactions. This is how new money is generated in the system and at same miners are incentivized to participate. Miners are also eligible to receive certain % of transaction amount as fee (much like visa or mastercard does today). The side affect of this incentive structure is increased security of the network. For any one to attack the network (and create unauthorized transactions), they need to own 51% of nodes in the network. Bitcoin’s unique incentive structure meant this is virtually impossible given the number of miners competing to validate the transactions in the network.

Difficulty Adjustment as a way to Scarcity

Any currency should have scarcity in order for its value to retain or appreciate. Bitcoin has a fixed number of bitcoins – 21 million. Its algorithm has fixed schedule in which new bitcoins are issued. Every 4 years, the reward given to the miners to validate transaction reduces by 50%.

The way this schedule is maintained is through Difficulty Adjustment algorithm. Every miner has to solve a cryptographic puzzle along with validating transactions to win the bounty. This puzzle is a cryptographic problem which is very difficult to solve requiring lot of computational resources. If more miners are attempting to solve the puzzle (to increase the supply of bitcoins), the difficulty automatically goes up to make sure schedule is maintained. This ensures only once every 10 mins a puzzle can be solved in the entire network maintaining the supply of bitcoin.

All the above 4 properties of the Bitcoin protocol makes it one of the most sound money ever invented. A money which is decentralized & trustless, a money that is secure through its network affect, and money whose supply is controlled.

Over the last 11 years, these properties helped increase bitcoin adoption both in developer community and usage as a digital cash. All this while it has proven to be censorship resistant, secure and reliable. As I write this blog bitcoin has a market cap of ~350 billions.

But it is not without any limitations

Current LImitations

Scale Issue

Bitcoin’s protocol dictates steady creation of supply. As we saw earlier this is achieved through the cryptographic puzzle which needs to be solved to validate transactions. Multiple transactions are grouped together into 1 block. Currently, each block creation takes 10 mins and blocks have a size limit of 1 megabyte. This means bitcoin’s rate of transaction is at best 6-7 transactions per sec.

This limits bitcoin’s usage as basic medium of exchange. Today Visa can process close to 4000 transactions per second. Its multiple orders of magnitude higher than what bitcoin’s protocol can potentially every achieve.

Today, majority of Bitcoin transactions are carried out off‐chain, and settled on‐chain on infrequent schedule (once a day). For example Coinbase (a crypto currency exchange platform), processes all transactions in a local network within their data centers. Coinbase eventually settles these on main bitcoin network at a later time.

There are really interesting initiatives like Lightening network which hope to increase the scale of bitcoin by running several orders of magnitude. The fundamental insight is to create several dedicated networks (block chains) where people can transact bitcoin for specific purpose. These chains will settle the money eventually on the main bitcoin network once a day. This is a very interesting space to watch.

Transaction Costs

Due to the current scale limitations, several transactions need to compete with each other to be included in a block. Due to the nature of free market’s this gives power for miners to charge higher transaction fees. This is much higher than transaction fees associated with traditional money.

These high costs make bitcoin prohibitively expensive for mainstream usage today.

Regulation

Bitcoin as an asset is still not regulated by SEC and other commissions. Because of this there is isnt yet adoption of Bitcoin in mainstream like fidelity, vanguard etc.

Steep On Ramp for Mainstream Adoption

Owning a Bitcoin is not straightforward today. In order to own a Bitcoin a individual needs to maintain hardware wallet which needs to be securely stored. Not many people have these technical abilities. While exchanges like Coinbase, Robinhood etc have made it easier to create account and buy and own bitcoin, there is still a lot left to be done to educate mainstream people on concepts of bitcoin and why it needs to be bought.

All these factors have for now limited Bitcoin to a digital cash or store of value. Because of its scarcity and potential of usage in future, bitcoin is largely viewed as digital gold. Bitcoin has become a prominent reserve asset and hedge against inflation.

In the next post in this series, I will lay out my understanding of Bitcoin as an Asset.

Disclaimer

I am long on Bitcoin. I might sell Bitcoin in future anytime. This post is NOT a recommendation to buy, sell, or hold Bitcoin. I wrote this post to organize my thoughts about Bitcoin and shared it so that you might find it useful. I am not a registered Security analyst. Views in this post should NOT be taken as an Investment advice.

References

1. Inflation-QE-Lemonade-Economy-Government-Central-bank
2. The Bitcoin Standard – By Saifedean Ammous
3. How Currency Works – howstuffworks.com
4. Macro Impact On Bitcoin :: Pantera Blockchain Letter, April 2020
5. Bitcoin as Reserve Asset
6. Blockchain Basics – Coursera
7. Bullish case for Bitcoin – Vijay Boyapati
8. Bitcoin Paper – Satoshi Nakamoto

One of the prominent themes in fintwit these days is inflation and QE (quantitate easing). In this blog, I am capturing my understanding on the topic in (hopefully) simpler terms.

Lemonade Economy

Before we get to inflation, let us try to understand economy through a simple thought experiment.

Lets say, one fine day I get an idea to sell Lemonade in the evenings at a public park new my home. I put in my own money to buy a stand, lemons and equipment needed to make lemonade. This business proves profitable because there are lot of kids who play in this park and they pester their parents for lemonade. It wont be long before I decide to expand this business to two other parks in my neighborhood.

As good as this idea is, it has some limitations. One, I need more capital and two, I cannot be in multiple parks at same time. So I approach a bank and show them my business plan and take a loan. With this money, I buy equipment and supplies needed for additional parks. But, I still did not solve the second problem. How can I be in multiple places at same time? For this I start employing people to run this business in other parks. My business takes off with very good cash flows.

Watching this success, a new entrepreneur decides to put a competing business by selling sugar cane juice in same parks. They go through same process of borrowing from bank, employing people and setting up juice stands. This soon becomes a small economy with money primarily powered by spending.

1. Parents (buyers) of kids spend their excess cash for refreshments passing money to entrepreneurs.
2. Entrepreneurs expand their business through leverage (fancy word for borrowed money), receive money from buyers.
3. Bank lends money to entrepreneurs and collects interest payments.
4. Employees receive money from employers.
5. Suppliers of equipment (lemons, sugar cane, stands) get more revenue for their business.

Important piece to notice here is the total money in this economy has not changed. It just moved from one entity to another. One entity’s spending becomes another one’s income. If the total money in the economy is represented by a pie, the percentage share of each entity has changed.

One of the differences between this hypothetical economy and real world is absence of two critical entities – Government & Central Banks. Let us go through their roles next.

Government

In any society in today’s world, government plays a fundamental pillar which keeps the society intact. Its responsibilities are wide ranging like judicial system for basic safety or well being of society, infrastructure – like roads, parks etc, retirement benefits, military expenses etc.

One side affect of these roles is that it also creates employment to people and hence helps economy engine flowing through deployment of money. Government gets this money primarily through taxes (both on income, trade and other forms). In a happy equilibrium government has enough income to fund its expenditures. But sometimes government need more money than it needs. Let’s say to fund a huger rail system construction which needs capital upfront. Or a far less desirable reason – wars.

Just like entrepreneurs in our example government has to resort to borrowing money. This borrowing can be done in multiple ways. Two popular ways are:

1. Issuing bonds (which is a promise to payback later)
2. Using Quantitate Easing

Issuing Bonds

In this method, government can simply issue a contract – which requests for some amount money with a promise to payback in some number of years with a certain interest rate. Government can they shop this around to lenders. In United states these are referred to as Treasury securities. Lenders could be anyone – an investor looking for a safe way to invest this money or a foreign government who has excess income and wanting to invest. It is important for government to use both forms.

Borrowing always from lenders in country is not feasible. Also, it doesn’t get new capital in the country. Rather, it just moves total money in the country around. On the other hand, borrowing from other nations and foreign investors creates additional influx of money. This could help power the economy, increase productivity, generate more goods and potentially export them, thus generating more money inflow.

If governments are not careful in their spending, soon this could lead to irrecoverable spiral. For ex unexpected costs like wars or change in tax policies or pandemic will lead to more borrowing. Over a period of time, government’s balance sheet becomes lop sided and with it its ability to repay accrued debt soon vanishes. This can lead to lack of enough lenders to fund additional debt to run the government. At this point, governments have to resort to another mode of funding – Quantitive Easing.

Quantitave EASING

Before discussing this, we need to introduce another entity economic system – Central Banks. Central banks (Federal Reserve in USA) is the sole authority that manages monetary policy in a country. Among other things, one major responsibility that it fulfills is managing production of money in the country. In other words, it prints the money.

One form of quantitative easing occurs when government issues more bonds but instead of selling to investors, it sells it to Central bank. Where does central bank get this money? It just prints it. This transaction doesn’t occur in such straightforward way. It is done through intermediaries. But what matters is, at the end these bonds appear in balance sheet of Central bank and government gets the money it needs. So government can get to spend more money without extracting it from investors or foreign lending. This in itself should cause a drop in value of each individual unit of money.

For example, before printing new money if there are total 100 notes in circulation and total value of those 100 notes is 100000. Then each note is worth 1000. But if you suddenly have 110 notes in circulation but total value of goods and services in country hasn’t changed. Then each note is worth 100000/110 = 909.90.

Astute reader may point out that this is not a problem, if those additional 10 units are distributed evenly to everyone. It is true, but in realty that does not happen. In practice not all of those additional money printed gets sent to people. Instead of some of them is used to cover additional expenses of government (isn’t it why it borrowed in first place?), or to power unemployment benefits during time of recession etc. This means that some people have to take a hit in terms of value lost on the cash they hold.

Apart from this form of QE, there are other times in which Central Bank prints money. For example, Central banks in past have printed money to not just buy Treasuries but to also buy bonds issued by other Corporations. This happened during 2009 financial recession and in the current Covid-19 powered recession.

So, in these cases newly minted money is not sent to common person through government. But rather it is sent into financial markets. This causes asset (stocks) prices to rise which benefits people who have luxury to invest in financial markets. These people will see their net worth raise. These people have more money to spend than they would have had otherwise.

This leads us to our next topic – Inflation.

Inflation

All this new money flooding into the system means there are more dollars chasing same number of goods and services. In a free market this causes rise in the prices. This is referred to as inflation – the reduction in purchasing power of each unit of money.

Government has a mechanism to track this rate of price increase. The official term for this is Consumer Price Index. They take a basket of goods that are usually purchased by households and track the price of this basket over a period of time. This is generally what people mean when they say inflation is 2% or 3%.

But there are some flaws in judging outcome of monetary policies purely through lens of CPI. One of them is that it is managed by government and often items (or their proportions) considered in these basket change.

The other is, prices of goods are affected by forces other than money printing. For example in his book – The Price of Tomorrow, Jeff Booth explains how deflationary force of technology causes the prices to go down. Technology and innovation helps us produce goods and services at cheaper price and faster pace. These savings are passed on to consumers causing reduction in prices (deflationary). So, the real downsides from money printing are hidden by these deflationary forces.

Also CPI doesn’t really capture other expenses that are incurred by households. Take College eduction for example. This article by CNBC, cites that college education increased by 25% over last 10yrs. Or this article by Forbes, which says college education rate is growing at faster pace than wages. You will find similar stories for Health care. So while wages increasing at a very marginal rate, these expenses are accelerating.

This puts a massive pressure on majority of population. Education and financial markets are essential ways of upward mobility. Over time it is increasingly difficult for masses to get access to these opportunities, essentially leading to a two class system. No wonder despite a historical bull run in economy over last 10yrs, more and more people feel left out. The system is failing them.

This is very well articulated in this following twitter thread by @PrestonPysh.

Now, the opposite is true for good and services that are absolute essentials to life. I.e. Healthcare, Food, Education. Look at this chart – it graphically explains everything. pic.twitter.com/yxUwJX2FMP

— Preston Pysh (@PrestonPysh) June 3, 2020

Conclusion

No matter where in political spectrum between Capitalism and Socialism one lies, there seems to be enough evidence that current monetary policies and particularly QE seems to have unintended affects. It is driving higher inequality, more polarization, emergence of two class systems and increasing loss of confidence in the fiat monetary system. It is an extremely complex subject which I hope to continue learning about.

References

1. The Price of Tomorrow – Jeff Booth
2. Big Debt Crises – Ray Dalio
3. How The Economic Machine Works by Ray Dalio
4. Preston Pysh’s Explanation of Inflation
5. How currency works – howstuffworks.com