Tuesday, February 14, 2023

Weak nations with strong currencies

Two unlikely currencies were among the world's strongest currencies in 2022: the Yemeni rial and the Afghan afghani. Yemen is currently in the middle of a civil war and Afghanistan is a failed state, so neither is your typical candidate for a buoyant currency.

Both countries share a peculiarity, however: unlike most nations, neither can increase the supply of their paper currency. That may explain their odd bout of strength against the dollar.

Let's start with Afghanistan.

It's worth reading this blog post I wrote back in 2021, but if you don't have time the gist is that Afghanistan's central bank – Da Afghanistan Bank (DAB) – is effectively cut off from the global banknote printing market thanks to sanctions. Cash is the dominant form of money in Afghanistan. With the supply of afghani notes fixed and the demand for them rising over time along with population growth, my guess at the time was that the afghani's purchasing power could be fairly stable. "In a chaotic economy, the afghani—or at least some version of the afghani—may be one of the country's more reliable elements."

And that seems to be what is happening. According to Bloomberg, the afghani gained 5.6% against the U.S. dollar in 2022, one of the strongest performances of any currency in the world.

The stock of afghani notes is not entirely fixed. Late in 2022 the DAB was permitted to accept one batch of new banknotes, according to Reuters.

However, the new notes didn't add to the stock of notes circulating in Afghanistan. Rather, they were used to replace existing notes, which are often "torn in shreds or held together with cellotape." The LA Times had a good article on the shabby state of the Afghan money supply, including pictures like this one:

"Afghanistan’s money is crumbling to pieces, just like its economy" [source] copyright LA Times

As for Yemen, diligent readers may recall from my two previous blog posts (here and here) that a civil war has split the Yemeni rial into two different currencies. The Houthi rebels in the North control one branch of the central bank, the Sana branch, and have adopted rial banknotes printed before 2016 as the region's official currency. The Saudi-backed government in the South runs the other branch and has claimed all notes printed after 2016.

The two rials are not longer fungible, their price having diverged over time as the chart below from ReliefWeb illustrates. The rebel's old rials, the ones printed before 2016 (in blue) have held their value against the U.S. dollar, and even risen a bit in 2022. But the value of the Saudi backed regime's rials (in orange) has plunged:

The U.S. dollar exchange rate of the rebel-controlled Yemeni rial and the official rial [Source: ReliefWeb]

The reason? The rebel North is isolated from the rest of the world and can't contract with printers for new notes. Not only that, but the stock of pre-2016 notes is by definition locked in time. A note printed in 2023 can't masquerade as a pre-2016 note, at least not easily so. The official regime even printed up a batch of fakes last year and tried to sneak them over the border in order to undermine the rebel economy, a story I recounted here. But the rebels spotted the difference and refused to accept them.

So like Afghanistan, if you start with a weak economy and a fixed note supply, then add population growth, you end up a strong currency.

Unlike the rebels, the official regime in south Yemen has access to the global banknote printing market, and has ordered new notes and spent them into circulation. Which explains why the official regime's Yemeni rial has steadily declined in value.

Friday, February 3, 2023

Hey bitcoin owners, how are you paying for bitcoin's energy costs?

Bitcoin miner in La Dor√©, Quebec via L'√Čtoile du Lac

In what form do bitcoin holders bear bitcoin's huge energy costs?

For the Bitcoin network to be secure, it requires miners to do a lot of work, and those miners will only do that work if they are compensated. The creation of new bitcoins every 10 minutes is the main method of paying them. The question in this post is how these mining costs get passed on to people who hold bitcoin. Bitcoin is bloody expensive, after all. Owning it can't be free.

Let's explore the problem by looking for an analogy in traditional finance. In the place of bitcoin, let's introduce CashCo. CashCo owns $100 in cash. It has 100 shares outstanding. For simplicity's sake, let's assume that the shares trade at fundamental value, so each share is worth $1 ($100 / 100 shares) and the company's market capitalization is $100.

Let's introduce Jack, who holds one share of CashCo, worth $1.

Next, let's make CashCo resemble Bitcoin by introducing a mechanism that functions like bitcoin rewards. On January 1, CashCo announces that it will henceforth issue a single new share at the end of every day to an independent entity to validate CashCo's database. CashCo will do this each day for the next 30 days.

Like Bitcoin rewards, the additional CashCo shares are created out of nowhere and are paid to an external validator. Furthermore, the policy is time-limited, in the same way that bitcoin rewards will no longer be paid after some terminal point in time.

This is how it looks. At the end of Day 1, CashCo will issue one new share to the independent entity. At that point CashCo will have 101 shares outstanding. The fundamental value of each share will be $0.99 ($100 cash in the bank / 101 shares). But the fundamental value of the company as a whole would stay the same, since CashCo would still have $100 cash in the bank.

As for Jack, he still holds one share at the end of Day 1, but the fundamental value of his share will have fallen to $0.99.

At the end of Day 2, CashCo will issue another share to the validator, who now owns two shares. CashCo will now have 102 shares outstanding. The shares will have a fundamental value of 98 cents ($100 / 102 shares). But the total fundamental value of the company will still be $100, since it remains backed by $100 in cash.

The fundamental value of Jack's single share will have fallen to $0.98.

Fast forward 30 days, and there will be 130 shares outstanding. Each share will have a fundamental value of 76.9 cents, but the fundamental value of the firm remains at $100.

Jack is a forward-thinking individual. When the new policy is announced on Day 0, he quickly runs through the above calculations and sees that the fundamental value of his single share will be marked down from $1 to 76.9 cents over the next 30 days. Aghast, he immediately tries to sell it. But the policy being common knowledge, everyone else will make this calculation this too. No one will pay Jack more than 76.9 cents for his share, knowing that in 30 days its fundamental value will be 76.9 cents.

And so on Day 0, the moment the announcement is made the value of CashCo shares falls to around 76.9 cents. That is, the new information about future costs of paying the validator gets brought forward in time and is quickly baked into the current price of CashCo shares.

Bitcoin operates along the same principles as CashCo.  

The schedule of new bitcoins to be paid to miners is already known. Because bitcoin buyers are like Jack and forward-thinking, this cost is effectively brought forward in time such that it is already built into bitcoin's price. That is, the original bitcoin owners (and all owners after them) prepaid for security the moment that the Bitcoin network was brought into existence.

So let's conclude by getting back to my original question. In what form do bitcoin holders bear bitcoin's huge energy costs?

Holders bear bitcoin's costs the same way that Jack bears CashCo's validation costs: in the form of foregone price appreciation.

Jack's share is worth 76.9 cents, but if CashCo suddenly found a way to avoid paying an external validator, his shares would immediately vault from 76.9 cents to $1. So the form in which Jack absorbs validation costs is through a lower-than-potential price for CashCo.

The same goes for bitcoin. We can think of the price of bitcoin as being much lower than it would otherwise be in a world where those costs didn't exist.

So bitcoin owners, the form in which you absorb bitcoin's huge energy prices is via a permanent discount on the value of your bitcoin stash. Instead of bitcoin being worth, say, $35,000 or $45,000, it's only worth $23,000 you're effectively missing out on a big one-time jump in the price.

Addendum:

Here's an exercise for you. Does this same logic apply to proof-of-stake coins like ether or tezos? Is the schedule of future Ethereum staking rewards already baked into today's price of ether, just like bitcoin mining rewards are baked into bitcoin's price? Yes? No? Provide your work. 

Wednesday, February 1, 2023

Why I prefer perpetual/premium bonds to the platinum coin

1877 $50 Thirty-year Registered 4% Consol [link]. (A consol is a perpetual bond.)

If I had to choose one of the tricks for getting around the debt ceiling, I'd go with premium bonds/perpetual bonds over the platinum coin.

I've known about the platinum coin idea for over a decade (Here's an old blog post I wrote on it back in 2013.) But I only recently found out about the premium bond idea courtesy of Ivan the K on Twitter. (Little did I know there's a long intellectual pedigree for this idea on the blogosphere.) Related is the idea of issuing perpetual bonds, or consols, to get around the ceiling (which seems to have first been discussed at the now defunct Monetary Realism blog, by Beowulf, the person who figured out the platinum coin loophole?).

The premium/perpetual bond trick, in short, is to get around the debt ceiling by issuing new bonds either at a premium to face value (premium bonds) or with no face value at all (perpetuals). Both types of bonds get around the debt ceiling because apparently only the face value of a bond counts to the ceiling.

I prefer issuing premium and/or perpetual bonds to the platinum coin because the former options don't encumber the Fed's balance sheet. The latter does. Evading the debt ceiling with any of the proposed tricks is already a dicey proposal. Choosing as your method a trick that also handicaps the Fed only multiplies the drawbacks of the whole thing.

Encumbering the Fed's balance sheet would reduce the Fed's independence, and independence is a good thing. The Fed's job is to set a target for the national monetary unit, the dollar, which along with the mile or the pound is one of the most important components of the U.S.'s system of weights & measures. To do it's job of calibrating the dollar unit, the Fed should be protected from the day-to-day ambitions of politicians, at least more so than other government institutions.

If you recall, the platinum coin requires the President to ask the U.S. Mint to manufacture a $1 trillion coin made of platinum and then deposit it at the Fed. The Fed then instantiates $1 trillion in deposits which the government can proceed to spend.

The platinum coin trick does neuter the debt ceiling. However, in the process the Fed has issued $1 trillion more dollars than it would have otherwise. This extra issuance is in turn secured by an illiquid non-interest earning asset on its balance sheet; the platinum coin. The Fed is hobbled. For a central bank to be independent, it helps to have a consistent stream of revenue to pay for expenses. That's where interest-earning assets are key. Liquid assets are also vital, because they can be sold in a snap to market participants if necessary for monetary policy purposes. Either way, a 0%-yielding trillion dollar platinum coin doesn't make the cut.

Compare this to the alternative of issuing premium bonds or perpetuals directly to the market.

In this scenario, the Fed's balance sheet hasn't changed at all. The Fed hasn't issued an extra trillion dollars into existence. And it still holds the same portfolio of highly-liquid interest-earning assets as before. Yet the debt ceiling has been evaded.

In sum, with premium and/or perpetual bonds, you get all of the debt ceiling evasion punch with none of the decline in central bank independence. It seems to me to be clearly the better of the two options. (Unless you're not a fan of Fed independence. If you aren't, the platinum coin conveniently shoots two birds with one stone: not only does it get around the debt ceiling, but it also short-circuits the independence of the central bank.)