A stock portfolio is a bad hedge against inflation

Once in a while I veer out of the realm of abstraction into the land of usefulness. This post is meant to be helpful for anyone currently invested in stocks. Contrary to what you might think, your stock portfolio is not a hedge against inflation. This won't be a big deal if you're not concerned about inflation. If you are, read on.

In an ideal world, stocks would be great inflation hedges. Take a business with revenues of $100, costs of $50, and earnings of $50. After inflation doubles all prices, the business's revenues now amount to $200, its costs $100, and earnings $100. Adjusting for inflation, the firm's earnings power has stayed constant. In this ideal world, a stock is a 100% inflation hedge.

In our not-so-perfect world, companies must pay taxes. This alone isn't sufficient to turn stocks into poor inflation hedges, but when we mix taxes with historical cost accounting, the distortions can be dramatic. The actual accounting details behind this may seem achingly boring, but they're worth running through at least once in your life. I'll try to make the process as hassle free as possible. If accounting just doesn't do it for you, then skip to some of the solutions I give at the bottom of this post.

The Problem

A company's tax bill is calculated based on what remains after costs of goods sold (COGS) and depreciation have been subtracted from revenues.

Lets start with COGS. When an electronics distributor sells a TV from inventory for $250, it has to match the sale of that TV with a corresponding cost. While it would make sense to take today's wholesale market price as a measure of true cost, accountants prefer backwards-looking measures and will try to match the sale of a good against its historical, or book value. Book value refers to the original price paid by the wholesaler for the TV. If the historical cost was $200, then the $250 sale is matched against that $200 cost, for a gross margin of $50.

Here's how historical cost accounting of COGS introduces major discrepancies during inflation. Say that a year has passed, prices have doubled, and our distributor is now selling the same TV today for $500. Since the distributor booked that TV into inventory at $200, the firm reports $300 in operating income ($500-$200). Quite the profit! But historical cost accounting disguises the fact that inflation will have also increased the wholesaler's true costs of replenishing inventory. After all, the wholesaler now has to pay $400 to their supplier to replace the same TV, not $200. Using replacement value rather than historical costs, the sale of a TV for $500 will only earn our distributor a $100 margin at current market prices.

During inflation, historical cost accounting of COGS provides a deceivingly rosy picture of our distributor's financial position. A healthy $300 margin is reported whereas the true margin is only $100. In accounting-land appearances can be deceiving.

This deception wouldn't be a problem, except for the fact that the firm's tax bill is calculated based on the unrealistically healthy snapshot provided by historical cost accounting, not the more accurate snapshot provided by market based costing. Remember that prior to inflation, our distributor was earning a $50 margin. Assuming that its tax bracket is 50%, that means that it was sending a $25 cheque to the government. After inflation hits, our distributor is now earning a $300 margin on the same TV. Its tax bill now amounts to a whopping $150 ($300 x 50%), an increase of 500%! This bloated tax bill is simply not merited: if we were to value COGS at market prices, it would be evident that our distributor was earning only $100 per TV, and that its tax bill should be $50, not $150. Thanks to historical cost accounting, the real value of its tax bill has tripled, even though the company's true fortunes have neither improved nor deteriorated.

The upshot is that during inflation, historical cost accounting of COGS has the effect of sucking wealth out of a company by forcing it to pay excess taxes on fake accounting profits. Inflation always makes firms and their shareholders worse off.

The same dynamic that governs COGS applies to depreciation. Depreciation represents the cost of using up capital equipment like machinery. Under historical cost accounting, depreciation is calculated as a percentage of the original cost of acquiring that machine.

Say that our distributor has a forklift that it paid $1000 for last year, and it depreciates this forklift at a rate of $100 a year. Inflation hits and all prices double. The replacement value of the forklift is now $2000 and the true economic rate at which the forklift is used up has increased to $200. Yet historical cost accounting requires that our distributor continue to use the historic $1000 cost of the forklift and depreciates it at a measly $100.

Much like COGS, this has the effect that our distributor's depreciation expense will remain unrealistically low during inflation, resulting in excess accounting profits on which taxes must be paid. Were depreciation allowances and COGS to increase with inflation rather than stay fixed at historical levels, they would simultaneously offset the rise in revenues and our distributor would not report phantom profits, nor incur unnecessary tax outflows.

Got it? In a nutshell, the combination of historical cost accounting and inflation are bad for stocks. Inflation acts as a tax increase on anyone who uses historical cost accounting. If we were to experience a series of inflation surprises to the upside over the next few years, all else staying the same it's very likely that the real value of your stock portfolio will fall. This is pretty much what happened in the 1970s, the last period of high and rising inflation. As the chart below demonstrates, the Dow failed miserably in keeping up with CPI.

It wasn't until the late 1980s, that stocks finally caught up to the consumer price index, long after Volcker had succeeded in reigning in inflation. Volcker was one of the best things that ever happened for the stock market, since by reducing inflation, he effectively reduced taxes on anyone forced to use historical cost accounting, which amounted to most of corporate America.


Solutions

What should you do if you're worried about inflation but want to stay invested in stocks? Easy. Choose companies that are less likely to suffer from historical cost corruption.

Here's an idea for dealing with the COGS problem. Accountants can choose either of two ways of measuring historical inventory costs: first-in-first-out (FIFO) or last-in-last-out (LIFO). Say that our distributor sells a TV to a customer. FIFO accounting matches that sale against the book value of the first, or oldest, TV in inventory. LIFO, on the other hand, matches that sale against the cost of the most recent TV brought into inventory. During an inflation, the most recent TVs brought into inventory will have the highest costs, which means that LIFO permits COGS to accelerate far more quickly than FIFO. This means that a firm that uses LIFO during inflation has a far lower likelihood of reporting unnatural profits and paying unmerited tax than a firm using FIFO.

Just to illustrate how important these effects can be, I'm posting a table that is taken from an early Larry Summers paper on the effects of inflation on stocks.* For each company listed in the Dow Jones Industrial Index in 1978, Summers calculated the implied percent decrease in stock value caused by the interaction  of inflation and historical cost accounting. The losses due to COGS and depreciation are listed respectively. Note that the majority of Dow companies were protected from the inventory effect because they used LIFO, not FIFO. Chrysler, which used FIFO, faced an implied 49% decrease in stock price in 1978 due to +10% inflation!

So if you're worried about inflation, invest in companies that use LIFO. This won't always be easy. IFRS currently prohibits LIFO, which means it'll be tough to find the right companies. The only jurisdictions in which you will typically get firms using LIFO is the US.** Caterpillar Inc, for instance, used LIFO for 60% of its inventories in 2012. Rumour has it that the US could be putting an end to LIFO soon, so this useful investment tool may be forever dismantled. Even if LIFO does disappear, there are a few other tricks that investors can use to avoid COGS-related historical cost corruption.

How to get around the depreciation problem? You tell me in the comments. I've got a few tricks up my sleeve, but I ain't going to give them all away.
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*Larry Summers cut his teeth on the topic of inflation and corporate equities. His first few published papers deal with the issue, including Inflation and the Valuation of Corporate Equities (1978). Some are written with Martin Feldstein, including Inflation, Tax Rules, and the Long Term Interest Rate (1981). Feldstein also wrote a solo paper on the topic: Inflation and the Stock Market (1978). Note the dates on these papers. A broad literature on the topic developed in the 1970s, but now you hear nothing about the effects of inflation and historical cost inflation on profits and taxes.

**I've heard that Japan allows it too.

IMF SDRs: the world's largest LETS

IMF board room, 1977

I like to think of the International Monetary Fund's special drawing rights (SDR) program as the world's largest Local Exchange Trading System, or LETS. A truly unique part of the monetary landscape, what follows is a short visual essay on SDRs.

What is an SDR?

An SDR has two aspects. First, an SDR is a unit of account, or, put differently, a measure of value. As a unit-of-account, the SDR is defined by the IMF in terms of a reference good, or a medium of account. When the SDR was first introduced in 1969, an SDR was defined as 0.888671 an ounce of gold, so the yellow metal was the SDR's first medium of account. The IMF later redefined the SDR as a certain quantity of central bank currencies. As of 2012, an SDR is comprised of a basket of 0.423 euros, 12.1 yen, 0.111 pounds, and 0.66 US dollars. Thus the modern day SDR is defined in terms of multiple media of account.

The Suez Canal Authorities currently uses the SDR to calculate the Suez Canal Tariff, while the the Universal Postal Union, which coordinates international postal duties, uses the SDR as a unit of account. Apart from these and a few other rare examples, the SDR is not a popular unit of account.

In addition to existing as a unit of account, SDRs also function as media of exchange. This is the aspect of SDRs I'll focus on from here on in.

SDRs as LETS

In many ways, the SDR system represents a souped-up Local Exchange Trading System, or LETS. In a LETS, each member of a local community gets an initial line of credit. These credits, which are accepted by all members of the LETS, are liabilities, or claims, of all LETS members on each other. A LETS member can spend down their line of credit by purchasing stuff from other members, and replenish their line of credit when others spend at their own shop. No one can spend more than their line of credit.*

All LETS need an administrator. The administrator takes on no risk, nor are they liable for credits issued. They simply maintains the books of the LETS and ensure that the system operates efficiently.

Much like a LETS administrator maintains a LETS, the IMF "SDR Department" maintains the SDR system. SDRs are not issued by the IMF, nor are they claims on the IMF. Rather, the community of nations jointly issues SDRs. In the SDR system, each country's respective line of credit is referred to as its "allocation" of SDRs. In general, the larger a nation's GDP, the greater its allocation. The US's current allocation is around SDR 35 billion, whereas Canada's is SDR 6 billion. Cyprus's allocation amounts to a meager SDR 132 million. (One SDR is worth about US$1.50, so Canada's stash of SDRs comes out to around $9 billion)

SDR holdings vary over time as SDRs are spent from nation to nation and as new credits are created. The chart below shows total SDRs in existence. It gives a sense of how SDRs are distributed between some of the program's largest members and blocks.

Individual members can't simply create new SDRs willy nilly. All members must jointly agree to create them. In 1971, 1972, 1979, 1980, and 1981 the total amount of SDRs was increased, but after that a long freeze set in. In 2009, in the midst of the credit crisis, members agreed to an increase in SDR credits from $21 billion to $204 billion. You'll notice in the chart that the BRICs received a far larger shot of SDRs than they did during previous allocation top-ups because their relative position in world GDP has increased so much.

It's particularly interesting to break down the distribution of SDRs. Over time, members will either spend away their SDR credits so that they are holding less SDRs than originally allocated, or they will acquire SDRs so that they are holding more than they were originally allocated. Surplus nations receive interest payments from deficit nations.** We can see the distribution of surplus and deficit countries in the histogram below. In general, far more countries are in an SDR deficit position than a surplus position. Put differently, most counties hold less SDRs than they were initially allocated.

...which doesn't make much sense. If countries spend away SDRs, someone must be left holding the bag. SDRs cannot be uncreated. This is where the IMF once again re-enters our story. While only states can enjoy SDR allocations, certain supranational organizations like the IMF are allowed to purchase SDRs from states after SDRs have been created.*** As my first chart shows, the IMF is a large holder of SDRs and possesses a portfolio that shows much more volatility in scope than the other nations and blocks.

Let's explore this more. The chart below ranks all countries by the excess of holdings over allocations. Deficit countries lie below 0, surplus ones are above. I've added the IMF too which, as the chart shows, is by far the system's largest accumulator of SDRs. The IMF currently holds around SDR 12.7b. The only reason that most countries on the chart are able to be in deficit positions is because the IMF serves as an SDR sop.

Try playing with the slider above by pulling the top tab from 12,691 down to 0 or so. This filters out the IMF and the surplus nations, thereby providing more resolution on the system's greatest deficit countries, which includes the Ukraine, India, Romania, and Hungary. The Ukraine, for instance, has sold of SDR 1.3 billion of its initial allocation (more on this later).

It's also useful to rank countries by their percent surplus/deficit rather than their absolute surplus/deficit. In the chart below, those countries distributed close to the 100% level have about the same number of holdings that they were initially allocated. Anyone over the 100% line holds more SDRs than they were allocated, and those below 100% have been sellers.

Use the slider above to zoom in on the biggest surplus countries. Oddly, you'll see that Libya leads the pack, holding 150% of its initial allocation. One reason for this may be the fact that the Libyan dinar is pegged to the SDR, a link that has been in place since 1986. A buffer of SDRs would be necessary for the Libyan monetary authority to protect the peg. According to the Sadeq Institute, the choice of the SDR was made by the Gadaffi regime in "symbolic retaliation" to the US. Prior to 1986, Libyan dinar's had been pegged to USD. Botswana also has an outsized SDR portfolio. The Botswanan Pula has been pegged to a mix of the South African rand and the SDR since 1980, a policy that would presumably require a large stock of SDRs.

Zooming in on the deficit side of the chart, you'll see that the Ukraine is the third largest deficit nation, having sold all but 0.45% of its initial allocation. Ukraine was hit hard by the 2008 credit cirsis. It also imports terrific amounts of natural gas, much of which gets exported on to Western Europe. In order to pay its natural gas bill late in 2009, it used almost its entire SDR allocation.

Is a nation's per capita GDP related to its status as SDR debtor or SDR creditor? The chart below charts per capita GDP along the x-axis and SDR position along the y-axis.

Most rich nations, those in the two right quadrants with per capita GDP in excess of $10,000, tend to cling closely to 1.0. They are neither in large surplus nor deficit positions relative to the system. Iceland and Hungary, which hover near the bottom of the bottom-right quadrant, are outliers. Both have per capita GDP's above $10,000 but have largely drawn down their SDR balances. Hungary, which only received its first allocation of SDRs in 2009, was hit hard by the financial crisis and  forced to liquidate many of its new SDRs in order to meet bills.

What all these charts illustrate is that except for the IMF (and a few countries that fix to the SDR), only a minority of countries have been net purchasers of SDRs. Most have been sellers. Put differently, members of the SDR LETS have been quite content to be short SDRs, not long. Why? Many poorer countries are no doubt forced by circumstances to sell off a large part of their allocation. But even then, a large proportion of wealthy countries including almost every European nation, the UK, Australia, India, Brazil, and Canada are in deficit.

I'm speculating here, but the general aversion among states to holding SDRs may be due to a weak point that the SDR system shares with any other LETS system. Consider this: what happens to a LETS when a member in deficit splits town only to never be seen again? If the departing member fails to rebalance their account prior to leaving, then the amount by which they are in deficit will never be recouped by remaining members. All members must collectively absorb the loss. The same goes for SDRs. If Iran wishes to leave the system, what guarantees that prior to departure they'll honour their obligation to the system by purchasing enough SDRs to return them to an even level?

Taking this even further, imagine if a large block of deficit nations left the SDR system. What guarantees that SDRs will continue to be valued at their stipulated value of 0.423 euros, 12.1 yen, 0.111 pounds, and 0.66 US dollars? Remaining nations may start to bid SDR prices down until SDRs trade at a wide deficit to their ideal value in terms of media of account. At some point, the IMF might be required to announce a lower value for the SDR in order to catch up to its declining market value.

Alternatively the IMF could prop the system up by purchasing all SDRs at their ideal value of 0.423 euros, 12.1 yen, 0.111 pounds, and 0.66 US dollars. If it did so, the IMF would be left holding a large chunk of the system's SDRs.

But hold on a sec... isn't that already the case? Most countries have been net sellers, leaving the IMF (and other supranationals) currently holding some 6.2% of the total SDR float. This might be a sign that member nations have from time to time valued the SDR at somewhat less than 0.423 euros, 12.1 yen, 0.111 pounds, and 0.66 US dollars and, given the opportunity to sell at an overvalued rate to the IMF, they have seized that opportunity. The asymmetric distribution of SDRs does not give one much confidence in SDRs as assets.

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*Many LETS do not limit member lines of credit. They leave it up to members to self-monitor the system.
**The SDR system defers markedly from a LETS in this respect. Most LETS frown on interest payments.
*** Other parastatals currenlty holding SDRs inclue the Arab Monetary Fund, Bank for International Settlements, Bank of Central African States, Central Bank of West Africa, European Central Bank, and the Islamic Development Bank. Total holdings of these instituitions comes out to about 1/12th that of the IMF's SDR holdings.

Long chains of monetary barter

'...the peculiar feature of a money economy is that some commodities are denied a role as potential or actual means of payment. To state the same idea as an aphorism: Money buys goods and goods buy money but in a monetary economy goods do not buy goods. This restriction is - or ought to be - the central theme of the theory of a money economy.' -Robert Clower [A Reconsideration of the Microfoundations of Monetary Theory, 1967]

I started to sell some of my XRP yesterday, and the process of doing so brought to mind Robert Clower's famous quote. Clower's aphorism describes an idealized pure-money economy that exists only in theory. Were we to apply it to the real world, we'd be missing a lot. To begin with, Clower omits "money" for "money" transactions like the XRP trade I'm about to describe.

XRP is the cryptocurrency used to pay transaction fees in the Ripple system. In order to arrive at my end goal of holding Canadian paper, I have to enter into a surprisingly long line of transactions. Which underlines a point I've made before: we don't live in a monetary world characterized by one universal "money". Rather, we target a final state of liquidity appropriate to our goals, and then engage in a series of barter swaps across items with differing liquidity profiles in order to reach our target. Our final resting state may be XRP or bitcoin, it may be a bank deposit, it may be cash, or it might be an item in inventory destined for final sale. To get there requires a long monetary bartering process.

Here is the rather circuitous route I am currently taking in order to convert XRP into Canadian loonies.

Trades:
1. Sell XRP for bitcoin-denominated IOUs issued by Bitstamp. This is a floating exchange rate.
2. Sell bitcoin-denominated Bitstamp IOUs for actual bitcoin. This is at a fixed rate.
3. Sell bitcoin for bitcoin-denominated VirtEx IOUs. Fixed rate. VirtEx is Canada's largest bitcoin exchange.
4. Sell bitcoin-denominated Virtex IOUs for Canadian dollar-denominated Virtex IOUs. Floating rate.
5. Sell Canadian dollar-denominated Virtex IOUs for Canadian dollar-denominated Royal Bank of Canada IOUs. Fixed rate.
6. Sell Royal Bank IOU for loonies & Canadian currency. Fixed rate.

So after six transactions, I'll finally hold Canadian paper money in my wallet. It'll take at least 5 days to execute this chain of transactions, mainly because step 5 takes f.o.r.e.v.e.r. This is the fault of our legacy banking system. The cryptocurrency world, steps 1-4, is blazingfast.

Alternatively I could cut a few steps out:

1. Sell XRP for bitcoin-denominated IOU issued by Bitstamp.com. This is a floating rate.
2. Sell bitcoin-denominated Bitstamp IOU for bitcoin. This is a fixed rate.
3. Go to a local cafe where someone makes a market in bitcoin. Sell my bitcoins directly for cash at a floating rate.

We experience these long barter chains in the non-crypto world as well. When I am paid with a US dollar check (say for $50), I go to my bank and sell the check at par for $50 worth of USD deposits. Then I sell the bank my new USD deposits in return for $55 or so worth of Canadian deposits, depending on what the exchange rate at that moment.

My next monetary barter transaction depends on what I want to do after. If I want to get a haircut, I'll sell the $55 worth of deposits back to the bank for $55 worth of Canadian paper money. After all, my barber only takes cash. If I want to buy stock, say Blackberry, I'll sell my bank deposits for an equivalent amount of deposits at my broker, and then I'll be able to purchase Blackberry.

Behind the scenes, the bank's transaction chain continues. After buying the check from me, it sells it back to the issuing US bank in return for a deposit at the issuer. It then sells the issuer's deposit for central bank reserves/clearing balances. Long chains of monetary barter.

The other problem with Clower's simplification is that goods often do buy goods.

The word for this in a retail setting is barter. In a corporate setting it is countertrade. One example of countertrade are "soft dollar" practices in the financial industry. Fund managers or investment advisers promise to provide brokers with order flow. In return, managers and advisors enjoy various services such as the broker's internal research, third-party research, data, or exclusive access to new deals. Brokers will sometimes pay for the fund manager's rent, computers, electricity bills, or even vacation in return for trade flow. If the brokerage industry had to rely purely on hard dollar rather than soft dollar transactions, the whole industry would collapse (or so some people say).*

In sum, there is no rule that money must buy goods only, or goods money. The world is far more complex than this. Goods are more moneylike than we suppose, and so-called money is isn't a monolithic entity but a heterogeneous set of goods that get bartered for each other along long monetary chains.

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*Just as barter is often used to avoid leaving a paper trail, so are soft dollar trades used in the financial industry. Soft dollar expenses are not included in your mutual fund's management expense ratio (MER). You may think that the fund you own has low expenses, but until you back out soft dollar barter its engaged in you can't be sure. The more a fund manager can stuff into soft dollar, the cheaper his/her MER appears. Read the fine print. 

Bitcoin's hyperdeflationary recession?

The Telegraph's Willard Foxton writes that Silk Road, a venue where people exchange drugs for bitcoin, is in a recession of sorts. He blames this on higher bitcoin prices:

Following the recent surges in the value of Bitcoin, people have been selling less and less, initially because the value of the Bitcoins was going up so fast people were unwilling to part with them; then, once the Bitcoin price started crashing, dealers were unwilling to part with valuable drugs for Bitcoins worth who-knows-what.

I find Foxton's claim unlikely. Yes, in a regular economy, soaring demand for dollars may cause recessions because certain prices are sticky. But the bitcoin universe isn't a sticky price universe. Silk Road sellers will quickly reprice their product in order to convince buyers to part with their bitcoin. Buyers will modify their bids in order to convince sellers to part with their drugs. As bitcoin prices rise or fall, the real value of transactions in the Bitcoin universe should be constant.

What are my assumptions? I think that people who participate in the bitcoin universe are incredibly savvy about exchange rates and real values. They have to be. Fluctuations in BTC prices are so extreme that anyone suffering from money illusion, or a failure to adequately adjust prices, will quickly die off. In the dollar/euro universe, on the other hand, money illusion is common. Being fooled by nominal prices changes isn't life-threatening, so sufferers aren't weeded out. They never learn because they don't have to.

That's the theory, but what do the numbers say? Foxton provides no evidence for his hoarding claim. Silk Road sales data would suffice. Neither do Izabella Kaminska and Joe Weisenthal who quote Foxton as an authority on the perverse hyperdeflationary effects. [I could digress on the echo chamber effect here, but I'll resist].

Here's my attempt to pin down a few datapoints showing the real value of transactions in the bitcoin universe. SatoshiDice, a bitcoin gambling website, is one of the bitcoin universe's largest companies. Unlike Silk Road, it is public. So we can get good information on its operations. Around 50-60% of all bitcoin transactions involve SatoshiDICE, so it surely serves as an appropriate bellwether for spending activity in the bitcoin universe.

The chart below shows the daily real, or US dollar, value of all SatoshiDICE bets over time.

A number of "whales" (large bettors) placed bets in December and January (see discussion here and here) which may explain the large spikes in bet value around that time. We should ignore these spikes. Looking at the base level of transactions, we can see a gradual increase in real betting value over time, despite the rising bitcoin price. No evidence of a recession here.

Another way to verify the claims of a bitcoin recession would be to look at the value of bitcoin-denominated stock prices over time, specifically the stocks of those companies whose revenues are in bitcoin, not fiat. A decline in stock prices as bitcoin rises would validate the recession hypothesis. What do the numbers tell us? Shares of Vircurex, a cryptocurrency exchange, are up since its February IPO. SatoshiDice is unchanged since January 1. Havelock, a bitcoin miner, has traded between $1.20-2.00 for months. Lastly, MPOE, a bitcoin stock and options exchange, keeps tearing it up.

If people were hoarding such that bitcoin velocity was declining, the prices of all these stocks should have fallen dramatically. That they haven't would seem to indicate that changes in bitcoin price are largely neutral. Those claiming that bitcoin's skyrocketing price is decreasing bitcoin velocity and causing aggregate demand shortfalls, or recessions, need to show more evidence for their claims.

Play with the interactive ECB balance sheet tool

For the full version, go here. The chart below only includes Eurosystem assets, not liabilities. It goes back just a few years. The full version goes back to 2000 and includes liabilities.

To remove a data series, either click on its legend label or the line on the chart. Remove as many series as you want to get a better understanding for how balance sheet items interact. This is in beta, so it may be a bit buggy. Expect redraw delays.

(May take a second or two)

What equity markets can learn from bitcoin and ripple

Stock trading on the New York Curb Association market, 1916

This isn't a bitcoin post. But it cribs some ideas from bitcoin and applies them to equity markets. Specifically, I'm going to play around with the idea that if equity markets were to adopt a bitcoin-style distributed ledger system, then some of the destabilizing effects of the so-called latency wars might be mitigated.

Historically, most databases and ledgers have been maintained at a central hub. In order to get access to this information, users have had to walk into the building that houses the records, or sign into a server that stores them. Bitcoin, litecoin, Ripple, and other cryptocurrencies all demonstrate the possibility of distributing a database away from its center. Rather than a hub doing all the work, networks of independent nodes can store, maintain, and update the database. Bitcoin's ledger, the blockchain, is probably one of the best examples of a real living distributed database.

A few weeks ago I had some fun speculating that one of the worlds most important centralized ledgers, the Federal Reserve's Fedwire system housed in East Rutherford, New Jersey, might one day be converted into a bitcoin-style distributed ledger. The advantage would be redundancy. Take out a hub and the entire database disappears. Take out a node, and the database lives for another day. Here's some more speculative financial fiction: taking inspiration from cryptocurrencies like Ripple and Bitcoin, might all equity trading one day move from a central order book to a distributed order book?

A market's order book is made up of a list of buyers and sellers, the amounts that each are willing to transact in, and their desired price. It amounts to a supply and demand curve for a given equity.

When early financiers congregated on a curb or under a buttonwood tree to buy and sell stock, the demand and supply curves were visible to anyone who was close enough to see the action. Get too far from the buttonwood tree and the order book was no longer visible. Later on, trading migrated into cafés and special rooms. Only those directly on the floor could "see" the current demand and supply curves. Anyone on the edge of the action could get an indication of the order book by communicating with their floor trader via an odd array of hand gestures and signals. An investor outside the building, say Jesse Livermore, had to phone his floor broker for a quote, who in turn had to quickly sign to his trader and then relay the response back to Jesse Livermore. By the time Livermore had the data, the quote on the floor would already be different.

This is one of the defining features of a centralized order book. Access to the information contained therein is tiered. Those closest to the geographical centre have the most current information. Quality steadily deteriorates as one moves away from the hub. Having faster lines of connection into the hub—say a broker and trader who can gesture incredibly quick—can give one trader an informational edge over another.

The order books of modern electronic markets are centralized on powerful computers in suburban data centres. The NYSE's order book, for instance, no longer exists in New York. It can be found in a datacentre in Mahwah, New Jersey, about 30 kilometres from Wall Street. (See map below) One wonders if we shouldn't rename the exchange the NJSE.


View Larger Map

In fact, most of the US's major equity exchanges are run out of datacentres in New Jersey, including the Nasdaq in Carteret, BATS in Weehawken, and Direct Edge out of Secaucus. [See Google Map]

As in times past, it's still very important to be close to the geographic center of a centralized database. Evidence of this is that a large part of the NYSE's Mahwah datacentre is currently rented out to trading firms keen to install their hardware as close as possible to the exchange's own computers. When a new quote is added to the NYSE's order book for a given stock, say JPM, the first tier to receive this information will be those who are co-located next to NYSE's machines. The information will ripple outward from there through T1 fibre optic cables to successive tiers, beginning with those who have set up shop just across the street from the Mahwah datacenter and ending with those who are furthest away, typically retail clients and small institutions.

By the time retail clients and small institutions get to see the order book for JPM, the true order book back at Mahwah will have already been updated with new quotes. Despite not knowing the true book, those on the informational periphery will nevertheless base their trading on the stale quotes they see in their version of the order book. Colocated traders, already apprised of the changes to Mahwah's order book, can take advantage of their superior knowledge and put themselves in a position to profit from relatively uninformed trades flowing back to Mahwah. By virtue of being right next to the central ledger, colocated traders get to "see" the market a few milliseconds ahead of everyone else. Latency wars — the modern competition to decrease time delay over a digital network  — is only the most recent chapter in a centuries' long battle to get as close to the central order book as possible.

A centralized order book is hardly democratic since those closest to the hub can consistently use their informational advantage to game those who are furthest away. But no one ever said markets were fair. Nevertheless, too much unfairness in a stock market can be destabilizing. Unlike say a grocery market, a stock market is only as good as its liquidity. If too many investors feel they are being pickpocketed they'll walk away from the market and liquidity will dry up. This hurts all actors in the market, including those at the center. It also hurts equity issuers, since reduced liquidity inhibits their ability to raise capital.

Which brings us back to bitcoin and the idea of a distributed ledger. Here we have a solution to the tiered nature of information reception from a central hub. Why not have a network of independent nodes store a stock's order book, listen for new quotes and trades, verify the identities of traders, and update the distributed order book? The neat thing about storing data in a distributed fashion as opposed to a hub is that information is freed from geography. Rather than sitting on a computer in Mahwah, New Jersey, the order book is everywhere. This would help to mitigate the unfairness issue that plagues central order book markets.

Exchanges like NYSE Euronext, NASDAQ, and BATS would suffer. These businesses make plenty of money by charging people to get as close to the order book as possible. Think fees for membership, seats, data access, and colacation.  Put a stock's order book in a distributed database and the premium people are willing to pay for access no longer exists.

Distributed order books are not science fiction. If you do want to see one in action, head over to Ripple. The ripple client lets anyone see a distributed order book for claims denominated in multiple currencies including bitcoin, USD, and euros.

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On inequalities caused by latency, read Latency Arbitrage: The Real Power Behind Predatory High Frequency Trading by Arnuk and Saluzzi and Latency Arbitrage, Market Fragmentation, and Efficiency by Wah and Wellman.

Here's an 2005 paper on Peer to Peer Securities Trading by Gehrke, Daldrup, and Seidenfaden

Beyond bond bubbles: Liquidity-adjusted bond valuation

Real t-bill and bond yields have been falling for decades and are incredibly low right now, even negative (see chart below). With an eye to historical real returns of 2%, folks like Martin Feldstein think that bonds are currently mis-priced and warn that a bond bubble is ready to burst.

Investors need to be careful about comparing real interest rates over different time periods. Today's bond is a sleek electronic entry that trades at lightning speed. Your grandfather's bond was a clunky piece of paper transferred by foot. It's very possible that a modern bond doesn't need to provide investors with the same 2% real coupon that it provided in times past because it provides a compensating return in the form of a higher liquidity yield.

[By now, faithful readers of this blog will know that I'm just repeating the same argument I made about equity yields.]

Here's a way to think about a bond's liquidity yield. Bonds are not merely impassive stores-of-value, they also yield a stream of useful services that investors can "consume" over time. In finance, these consumption streams are referred to as an asset's convenience yield. (HT Mike Sproul)

For instance, the convenience yield of a house is made up of the shelter that the house owner can expect to consume. A Porsche's convenience yield amounts to travel services. What about a bond's convenience yield? I'd argue that a large part of a bond's convenience yield is comprised of the liquidity services that investors can expect to consume over the life time of the bond. Let's call this a monetary convenience yield.

In an uncertain world, it pays to hold a portfolio of goods and financial assets that can be reliably mobilized come some unforeseen event. A fire alarm, a cache of canned beans, and a bible all come to mind. Liquid financial instruments, say cash or marketable bonds, are also useful since they can be sold off quickly in order to procure more appropriate items. This ability to easily liquidate bonds and cash is a meaure of their monetary convenience.

Even if the unforeseen event for which someone has stockpiled canned beans or bonds never materializes, their holder nevertheless will enjoy the convenience of knowing that in all scenarios they will be secure. The stream of uncertainty-shielding services provided by both a bond and a can of beans are "consumed" by their holder as they pass through time.

This monetary convenience yield is an important part of pricing bonds. Prior to purchasing a bond, investors will appraise not only the real return the bond provides (the nominal interest rate minus expected inflation) but will also tally up the stream of future consumption claims that they expect the bond to provide, discounting these claims into the present. The more liquid a bond, the greater the stream of consumption claims it will yield, and the higher its monetary convenience yield. The greater the stream of consumption claims, the smaller the real-return the bond need provide to tempt an investor into buying. (HT once again to Mike Sproul on consumption claims)

Which brings us back to the initial hypothesis. If the liquidity of government debt has increased since the early 1980s, then we need to consider the possibility that bonds are providing an ever larger proportion of their return in the form of a monetary convenience yield, or streams of future consumption claims. If so, the observed fall in real rates isn't a bond bubble. Rather, negative real rates on treasuries may reflect technological advances in market microstructure and improvements in bond market governance that together facilitate the increased moneyness of bonds. Put differently, investors aren't buying bonds at negative real interest rates because they're stupid. It's possible that investors are willing to accept negative real interest rates because they are being sufficiently compensated by improving monetary convenience yields on bonds.

I find this story interesting because we usually think that in the long term, real interest rates are determined primarily by nonmonetary factors, including the expected return to capital investments and the time preferences of consumers. The story here is a bit different. In the long term, real interest rates on bonds are determined (in part) by monetary forces. The higher a bond's monetary convenience yield, the lower its real interest rate. Oddly, bonds may be bought not by consumers who are willing to delay gratification, but by impatient consumers who want to immediately begin consuming a bond's convenience yield (ie. using up future consumption claims). The line between consumption and saving is blurred and fuzzy.

In my previous post on equities, I gave some numbers as evidence for the increased liquidity of stocks. Bonds aren't my shtick, so I won't try to prove my hypothesis. All I'll say is that the rise of repo markets would have contributed dramatically to bond market liquidity since repo increases the ability to use immobilized bonds as transactions media. Give Scott Skyrm a read, for instance.

There is a case of missing markets here. If we could properly prices a bond's monetary convenience yield, then we could get a better understanding of the various components driving bond market prices over time.

Imagine a market that allowed bond investors to auction off their bond's monetary convenience yield while keeping the real interest component. Thus a bond investor could buy a bond in the market, sell (or lease) the entire chain of consumption claims related to a bond's liquidity, invest the proceeds, and be left holding an illiquid bond whose sole function is to pay real interest. By stripping out and pricing whatever portion of a bond's value is related to its monetary nature, investors might now precisely appraise the real price of a bond relative to its real interest payments. Excessively high real prices relative to real interest would indicate overvaluation and a bubble, the opposite would indicate undervaluation and a buying opportunity.

But until we have these sorts of markets, we simply can't say if bond prices are in a bubble. Sure, real rates could be unjustly low because bonds prices have been irrationally bid up. But they could also be justly low if bonds are simply providing alternative returns in the form of monetary convenience. Without a moneyness market, or a convenience yield market, we simply lack the requisite information to be sure.

A rush for US paper dollars: the rejuvenation of the world's most popular brand

Here are Paul Krugman and James Hamilton on the renewed demand for dollar bills.

So what's behind the soaring demand for US paper dollars? A simple strategy for getting a grasp on US data is to compare it to the equivalent in Canada. Comparisons between Canada and the US serve as ideal natural experiments since both of us have similar customs and geographies. By controlling for a whole range of possible factors we can tease out the defining ones.

The chart below shows the demand for Canadian paper dollars and US paper dollars over time. To make visual comparison easier, I've normalized the two series so we start at 10 in 1984. On top of each series I've overlayed an exponential trendline based on the 1984-2006 period. I've zoomed in on 1997 for no other reason than to provide a higher resolution image of the typical shape of cash demand over a year.

Some interesting observations:

1. Not a huge surprise, but the demand for US paper has been accelerating far faster than the demand for Canadian paper. As James Hamilton points out, this is no doubt due to the huge transactional demand for US dollars overseas. The emerging countries in which US paper is demanded often have high growth rates, and their requirement for transaction media is correspondingly elevated. Unlike greenbacks, Canadian loonies are only demanded in Canada. As a slow-growth country, we don't require rapidly expanding amounts of physical transactions media.

2. Zooming in on any given year (I've chosen 1997) the demand for Canadian paper is far more jagged than the demand for US paper. Why is this? My guess is that the demand for US paper is diffused across multiple nations with diverging business practices and cultures. The demand for Canadian paper, on the other hand, is tightly linked to specific Canadian customs, holiday seasons, and payroll scheduling practices. The overseas demand that smooths out and counterbalance the peculiarities of domestic US paper demand don't exist for loonies.

3. There are some neat patterns in the chart. No, not all cash is demanded by criminals. There's always a cash spike at Christmas/New Years, and if you look carefully you can see jumps in Canadian cash demand coincide with major holidays, including Thanksgiving and the September long weekend. As Lenin once said, give me data on your nation's money supply and I can tell you when its holidays are. And note the huge Y2K-inspired rush to hold paper. Cash is still the ultimate medium for coping with raw uncertainty.

4. US paper demand started to slacken relative to trend in the early 2000s. One might be tempted to blame technological advances or changes in US preferences over payment media for slowing demand. Cash is a dinosaur, right? But this can't be the case. Canadians benefit from the same technologies as the US, nor do payment preferences change when one moves from 50 miles south of the 49th parallel to 50 kilometres north of it. If technology or preferences had changes, then Canadian cash demand would have deteriorated too, but as the chart shows, it continued to rise on trend. The best explanation for the US dollar's divergence from its long term growth just as Canada hewed to its trend is that foreign demand for US paper began to decline.

It's a reasonable explanation. Around 2002, the value of the US dollar begin a long and steady deterioration against most of the world's currencies, in particular the euro. It's very probable that consumers of the US$ brand punished the brand owner, the Federal Reserve, by returning dollars enmasse to their source, thus reducing the supply of paper dollars (or at least reducing its rate of increase). As incontrovertible proof, I submit exhibit A—a 2007 video of Jay-Z flashing euros instead of dollars (skip to 0:51).

5. So it seems to me that from 2003-2008 there was a mini run on the Fed by overseas cash holders. What Jaz-Z doesn't show is the process by which US dollars would have refluxed back to the US. Euroization, or de-dollarization, goes like this. A foreigner goes to their local bank to trade US dollars for euros. The local bank, flush with dollars, puts this paper on a plane for redeposit at their US correspondent bank in New York. The New York bank, which now has too much vault cash, loads these dollars into a Brinks truck and sends them to the New York Fed. And the FRBNY shreds the notes up.

This mini run would have put downward pressure on the federal funds rate. Here's how. Having accumulated excess cash from overseas, US banks would have sent this cash to the Fed in return for reserves. But now these banks have excess reserves. Desperate to get rid of them, they all try to lend their reserves at once, driving the federal funds rate down. To ensure that the federal funds rate doesn't fall below target, the Fed would has to sell treasuries in order to suck in reserves, thereby reducing the oversupply in the federal funds market and keeping the fed funds fixed.

The lesson being, when folks like Jambo in Zimbabwe and Julio in Panama get distraught about the quality of their Ben Franklins, the effects of their unhappiness will be felt, with some delay, all the way back at the Fed's open market desk.

6. US paper demand has since rebounded. Paul Krugman posts a chart that shows a massive accumulation of US cash holdings relative to GDP beginning in 2008. But Krugman's chart overstates the effect by constricting his time frame. As my chart shows, the rate of growth in US paper has only returned to the trend it demonstrated in previous decades.

Krugman attributes this increase in dollar holdings to the fact that the US is in a liquidity trap. When rates are near zero, people have no problems holding zero-yielding cash. I'm not so sure about his explanation. Canada had incredibly low rates for a few years, yet as our chart shows, Canadian paper never budged from its trendline growth. The same goes for the Euro. Rates have been low there, but we haven't seen a flight into paper money. Because cash is inconvenient and bulky, rates have to go pretty far below zero before people flee to paper.

No, the more likely explanation for the rebound in the US paper outstanding is the rejuvenation of the US dollar brand. The ECB has had to deal with waves of negative publicity for the last few years. Given the alternatives, the world wants to hold Benjamins again. This seems to be borne out in the chart below, which shows the ratio of ECB-to-Fed banknotes in circulation.



The US dollar, it would seem, is back. Cash holdings are only one sign off a currency's hegemony. It would be telling if there's also been a rebound in the use of the dollar to denominate bonds and other debt instruments, as well as increased holdings of US dollar-denominated assets in the reserves of major central banks. The US's "exorbitant privilege", as Barry Eichengreen calls it, continues apace.

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Note: As I was writing this, I stumbled on a paper by Ruth Judson via James Hamilton called Crisis and Calm: Demand for U.S. Currency at Home and Abroad from the Fall of the Berlin Wall to 2011. And what do you know. She uses Canada as a foil for determining US cash demand, just like I did. I haven't read it yet, but am quite looking forward to doing so and am willing to yack about it in the comments.

On Lenin, read White & Schuler.

Nineteen-eighty-three

Not only did Star Wars Episode VI come out in 1983, but gold experienced its largest one-day fall in recorded market history. On February 28, 1983 the metal fell $56, a whopping 11.5%. The context in which this collapse happened is worth revisiting since it might help explain some of what we are seeing now. I'll take a short diversion through 1983 oil markets before getting back to gold.

There were plenty of worries of an oil glut leading up to the metal's 1983 collapse. OPEC, which had kept an iron grip on oil prices by adjusting production, had been steadily losing its dominant position as oil producer. In the 1970s the cartel controlled over 60% of world production. Small adjustments to the rate at which it extracted crude were sufficient to set a floor in the oil market. But increased supply in the UK, Norway, USSR, and Mexico had eroded this share to under 40% by the early 1980s. As a result, OPEC nations were required to remove ever larger amounts of oil from the market to support prices.

The coordination necessary to motivate these adjustments was lacking. Beginning in June 1982, OPEC tried and failed three times within seven months to set quotas. As a result, spot prices had begun to trade well below OPEC's benchmark Saudi light price of $34, a gap that started to expand quite dramatically in winter and early 1983, as the chart below shows.

Because of the glut, the cartel was breaking at the seams. On February 17, 1983, the British National Oil Company (a government marketing board that bought 51% of North Sea output) dropped its North Sea price by $3 to $30.50, quickly followed by Norway. Nigeria, an OPEC member, reacted on February 19 by ignoring OPEC and reducing the price of Bonny light, a crude stream similar to Brent, from $35 to $30.

A week later the gold price collapsed. And on March 14, 1983, OPEC announced the first ever decrease in its benchmark price, with Saudi light now being priced at $29, down $5 from $34. We know what happened next. The glut continued and oil prices steadily declined until all-out collapse to $12 in early 1986 when Saudi Arabia, tired of OPEC squabbling, decided to open the taps and let all their partners suffer.

Zoom forward thirty years and we also have an oil glut:

The tight-oil revolution, the realization that the drill bit can liberate oil from reservoirs once-considered insufficiently porous to yield sufficient oil flows, is coursing through North America and will inevitably spread to the rest of the world. There's so much oil collecting in the US that the price at Cushing, Oklahoma trades 10% below European Brent.

What are we to make of these twin episodes of crude glut/gold collapse? When returns on non-crude related capital projects are low, negative, or falling, there's little incentive to invest. Investors may as well hold some durable asset that costs only a few bucks to store, like gold. After all, in a zero return world a project will likely be a dud, but at least an ounce of gold will still be an ounce of gold a few years hence. As a result, gold prices get bid up, just like they did in the 1970s and 2000s. Gold bull markets are less about inflation than they are a reflection of poor returns on capital projects.

A glut-induced reduction in the price of oil suddenly improves the return on all non-oil related capital projects. The world now looks rosier to everyone who isn't an oil extractor. There's no point in storing gold when the return on most capital projects has perked up. Investors quickly reallocate portfolio space to productive projects, gold prices get ratcheted down, and equity valuations get bid up.

What about equities? In early 1983, the Dow Jones Industrial Average broke convincingly through the famous 1000 level, a line it had knocked up against repeatedly through the 1970s. In similar fashion, it was only a few weeks ago that the S&P500 broke through 1500, a ceiling that has contained it for all of the 2000s. There has been a disturbance in the force, it would seem, and just like 1983, we're watching the Return of the Equity.

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PS. If you're interested in the history of gold, do check out my wallchart: A Recent History of Gold, 1954-2010.

For more perspectives on the gold collapse, read David Glasner, Tyler Cowen, Izabella Kaminska, Washington's Blog, and Menzie Chinn.