Thursday, May 19, 2022

The Bitcoin Scam

The fundamental thesis behind owning Bitcoin is that it is a inflation hedge that protects holders from excessive government money-printing. The logic behind this is fairly straightforward: it is desirable because it can be used functionally as a currency without traditional banking intermediaries (Note: this is true on a micro basis but NOT at scale) and because there will only ever be 21 million created, it will be in scarce quantity relative to government fiat currencies, thus its price will go up.

While this is intellectually intoxicating, particularly for hard-money, Austrian/libertarian types, it is nonetheless built on false premises. The most obvious flaw in this thesis is that there are real costs (particularly capital costs) that Bitcoin miners need to incur in order for the Bitcoin network to remain intact. Bitcoin exists on computers, and computers are real capital equipment that degrade over time and therefore must be replaced. The replacement cost of these computers will inevitably rise over time with inflation. Therein lies the scam - as long as there are enough suckers to buy Bitcoin from the miners at prices in excess of their cost of capital, they will make money. And given there are guardrails built into the Bitcoin code against rapid market share accumulation, the only way for Bitcoin miners to increase their profits is to pump up Bitcoin's price. More on this below:

Bitcoin mining used to be a lot more profitable than it is today, because early adopters had less competition. See below:

Miners could generate a higher ROIC, because they could accumulate and sell more Bitcoin per unit of capital employed (i.e. computers needed for mining).

As mining became more crowded, ROIC collapsed. Given that miners have high fixed costs ($10k computers need to be replaced after 2.5yrs, current b/e estimates around $32k), they went on a massive marketing/propaganda campaign. They needed the price of Bitcoin to be higher because otherwise they burn cash. If everyone is burning cash, then eventually they run out of money and the network collapses. So, they need to pump up the price in order for their operation to remain profitable. Hence, they created the inflation narrative/meme.

To reiterate: the business model of Bitcoin is to purchase computers to do the mining work, then creating a narrative and selling it to suckers. There are built-in protections that make it more difficult to accumulate Bitcoin as more miners enter the market and compete. This is a system design to ensure the quantity of Bitcoin mined sticks to the cadence set forth by its creator. So, it is impossible for someone to come in and grab a ton of market share at a rapid rate. Without the ability to grab market share, the only alternative for increasing profits is to hype up Bitcoin so that you can sell it at the highest price possible. As long as its price doesn’t drop below b/e rate, miners can stay in business. That’s literally the business model.

The capital intensity of such a business makes the “inflation hedge” narrative complete nonsense. Bitcoin only has value if its network is running, which by definition requires miners to incur real capital costs. Those costs will go up over time with inflation - that much is guaranteed. What is uncertain is whether the price of Bitcoin will continue to go up.

This fact is crucial when considering Bitcoin as a “store of value.” Families may retain precious stones or metals like gold as heirlooms to honor and respect their ancestors. We see this all the time when people want to build a new engagement ring with their grandmother’s stone. The chemical properties of those materials ensures they will still be around in 500 years, which makes them desirable possessions. The likelihood of the Bitcoin network being around 500 years from now is close to 0%. One can’t reasonably pass it down as a family heirloom, so it is actually an inferior store of value to something like gold.

Wednesday, May 18, 2022

Mea Culpa: We Got the Long Treasuries Call Wrong (Or Were Just Too Early)

Back in January, we wrote a post outlining our thesis for buying long-dated US Treasuries (and I did just that in my personal account). The main points of the thesis was that there was evidence that collateral was becoming scarce, a recession was likely on the horizon, and QT has historically resulted in yields on the long end coming down. That trade has, up to now, been a disaster. However, it is my view that the underlying thesis was correct; we were just early.

As MMT proves, US Treasury securities are not "loans" made to the US government. Rather, they are best thought of as savings accounts for large financial institutions and foreign countries. They are a place to park excess cash for a rainy day. They are a gift in the sense that they offer no credit risk and pay interest, typically at higher rates than those offered on reserves held at the Fed.

Treasuries are safe, liquid assets that have historically served as a safe haven during times of market stress and recessions, as investors view holding other "risk" assets as undesirable and would rather preserve their purchasing power.

What's been unique about the last few months, however, is the extreme scale of financial tightening caused by 1) the Biden administration's relentless push to lower the public deficit and 2) elevated commodity prices thanks to supply/demand imbalances, exacerbated by Russia's war in Ukraine. We've already written about how running surpluses drains reserves from the banking system, and is causing stress in financial markets. However, the energy/commodity market tightness has caused a dollar squeeze on foreign nations who import commodities, such as oil.

Case in point: let's take a look at Japan. The US dollar has been rapidly rising in value relative to the Japanese Yen:

Japan has the third largest economy in the world, yet is only about size of California. Its lack of consumable natural resources means that it must rely on importing energy and raw materials from other countries in order for its economy to function. The vast majority of global contracts for energy and raw materials are settled in dollars, which means Japan needs to acquire dollars in order to purchase the commodities that power its economy. They acquire dollars by selling goods such as automobiles and TVs to the United States. Because the US cares about taking care of its trading partners, we generously offer Japan the option to exchange surplus dollars into US Treasury securities, which are basically dollar savings accounts. For these reasons, Japan is the largest foreign holder of US Treasuries in the world.

According to the latest Treasury International Capital (TIC) data, since reaching its high-water mark of US Treasury holdings in November 2021, Japan has since sold $96 billion worth of Treasuries - a fairly substantial figure. Looking year-on-year, and its holdings have decreased by $8 billion:

This is because rising energy costs have made it more expensive to import raw materials (dollar USE goes up). At the same time, supply chain problems and chip shortages limit the sale of items like TVs and automobiles, two staples of Japan's export economy (dollar SOURCE goes down). This forced Japan to draw down on its dollar savings, i.e. its US Treasuries. It needs to sell Treasuries to raise dollars in order to meet near-term payment obligations for increasingly expensive commodities. This came at a time when the supply of dollars became more scarce, hence the dramatic move in USD/JPY (USD strengthens vs. JPY). Fortunately, the weakened Yen makes exports to the US more attractive, so there is a self-correcting mechanism at work.

In a sense, the weakness in US Treasuries is related to inflation, because prices have indeed gone up, causing an immediate need for dollars. But it's not because of investors intentionally dumping Treasuries out of fear for a loss of purchasing power they way that's described in Econ 101 textbooks; it is more mechanical/technical than that. Literally, Japan needs dollars and the easiest way for it to get more dollars is to sell Treasuries. Hence, Treasuries have sold off precipitously.

To reiterate, the spike in yields reflects a shortage of dollars needed to fund near-term obligations. This runs contra to the narrative that there are too many dollars which causes inflation, and that's why bonds have sold off. MMT shows us that adding dollars to the banking system/economy drives yields lower. The dollar shortage makes the cost/price (i.e. rates) of dollars go up. It signals market stress as liquidity is removed. This didn't happen because of Fed rate hikes; it happened because real dollars were removed from the banking system by the Biden admin, and rising energy costs further sucked out dollars from the global economy. A barrel of oil is still the same barrel of oil, it just costs more today than a year ago.

The initial reaction to the global dollar scarcity has been to sell financial assets of all stripes - both stocks and bonds. This causes stress and liquidity problems in the economy, which will likely lead to recession. That is when the bid for bonds will come.

So to conclude, we certainly got the timing on this call wrong, and didn't anticipate the impact on short-term commodity squeezes would have on the price of Treasuries. That being said, I have not sold a single bond, and am doubling down on this call. The bonds are cheaper, and there are more signs a recession is coming. There is talk among the institutional investor community about how government bonds seem somewhat attractive at these levels. Investors would be prudent to accumulate long-dated Treasuries at these levels. I also think shorting the front end makes sense as Jerome Powell seems determined to channel his inner-Volcker. So if the Fed surprises with rate hikes, that will likely further flatten and potentially invert the yield curve. For a pair trade, consider shorting SHY (iShares 1-3 year Treasury Bond ETF) and using the proceeds to purchase TLT (iShares 20+ year Treasury Bond ETF).

Disclosure: Long US Treasuries, short SHY

Random Thoughts

US Treasury Notes are counted as part of the national debt. US Federal Reserve Notes (i.e. the cash held in your pocket) are not. Both are obligations of the federal government and are guaranteed by Uncle Sam. We shouldn't obsess over swapping one for the other. Waste of time.

Paying federal taxes doesn't "fund" the government's spending programs. It preserves the value of our currency and, in doing so, protects our monetary sovereignty. Monetary sovereignty and national sovereignty are tied at the hip. We cannot be truly "free" as a nation if we do not have control of our own currency.

Finance is a Social Science. It concerns the interaction between money and businesses, both of which are ostensibly social concerns, with shared roots in property laws.

The study of economics without consideration for laws and institutions is fraudulent.

Lowering the Deficit is Ludicrous Public Policy

The Bureau of Economic Analysis (BEA) released preliminary GDP figures for 1Q22 that indicated a contraction of -1.4%. This came as a surprise for just about everyone, but we had been warning that Biden’s emphasis on running fiscal surpluses to reduce the deficit would cause a recession (although we didn’t think it would happen this quick!).

The Congressional Budget Office (CBO) just released preliminary figures for the first 7mos of the fiscal year 2022, which shows a deficit that is only one-fifth of what the government paid out over the same period in 2021. Said differently, the US federal government’s net spending into the economy y/y is down 80% from a year ago. That is a dramatic drop. Given that economies generally require an increase in the total money supply in order to grow, an 80% drop in money injections from the world’s monopoly supplier of the reserve currency is bound to cause significant financial stress and pain. No wonder we have experienced an absolute bloodbath in financial markets year-to-date. As I write this, the major US stock market returns for the year so far have been as follows:

DJIA -10.14%
S&P 500 -14.21%
NASDAQ -23.40%

And bonds haven’t offered any cushion. The US 10-year Treasury Note began the year with a yield in the mid-1.6% range; in just four months, it now sits at 3%.

President Biden has been doing a “victory lap” (if you could call it that) on his administration’s supposed fiscal responsibility. His remarks per CBS News:

"The bottom line is that the deficit went up every year under my predecessor before the pandemic and during the pandemic. And it's gone down both years since I've been here. Period," he said.

There are two problems with this. First, voters don’t seem to actually care, as Biden’s approval rating continues to make new lows. Let me repeat: people do not actually care about the national debt and/or deficits. This is despite all the rhetoric, usually from Republicans and conservatives, about the evils of government deficit spending and the national debt. Here is a quote from the previously referenced CBS News article from Norman Orstein, an emeritus scholar at the conservative-leaning American Enterprise Institute:

Norman Ornstein, an emeritus scholar at the conservative American Enterprise Institute, noted that deficits are often "abstract" for voters. The recent low interest rates have also muted any potential economic drags from higher deficits, which have risen following the COVID-19 pandemic and, separately, the 2008 financial crisis, to help the economy recover.

"They're more likely to respond to things that are in their wheelhouse or that they believe will have a more direct effect on their lives," Ornstein said. Deficits are "a step removed for most voters, and we've been through periods where we've had the big deficits and debt and it's not like it devastated directly people's lives."

Republicans use the debt limit as a political weapon to make life difficult for Democrats not because they care about deficits and debt, but for raw political power i.e. “because they can.” That’s right: children go hungry because Republicans want political power.

What's fascinating about this take too is that it runs directly counter mainstream conservative, Republican narratives. We wrote previously about John Cochrane, economist and senior fellow at the conservative Hoover Institution, and his incoherent view that government deficits make the public anxious about its ability to repay, which causes inflation. So which is it? Do deficits cause people to fear the government won't be able to pay back its debt, or are they too far removed from the public for people to care? These two positions are mutually exclusive.

But singling out Republicans isn’t fair. The reality is that it’s Biden’s Democrats who are actively working to reduce the deficit and make children starve by denying families the Child Tax Credit. And Democrat Bill Clinton was the last president to run a budget surplus, while Democrat Barack Obama spoke of the United States' moral obligation to "tighten its belt." So, both political parities are clueless and unnecessarily cruel.

But ignoring the accounting realities of “debt reduction” - it removes from, rather than adds to, national savings - let’s think about the actual mechanics of debt/deficit reduction. Earlier in this article, we referenced the US 10-year Treasury Note. It’s generally understood that Notes issued by the US Treasury are backed by the full faith and credit of the United States federal government, and is included in the calculation for the “national debt.” However, “paying down” the debt would require tendering such Notes for dollars. As we’ve pointed out before, the dollar bill in your pocket is also a Note, only it’s issued by the US Federal Reserve rather than the Treasury. It literally says “Federal Reserve Note” at the top. These notes are likewise backed by the full faith and credit of the United States federal government. So “paying down the debt” really just means swapping one type of debt, US Treasury debt, with another type of debt, US Federal Reserve debt. Both are essentially the same “credit” - they are guaranteed by the same parent entity, the US federal government. It just so happens that one type of debt, that issued by the Federal Reserve, has special “legal tender” properties: it is legal tender for cancelling all debts, public and private. That’s why we think of it as “cash.” But at the end of the day, it is still a (credit risk-free) debt instrument that is an obligation of the US federal government. Which is why lowering the deficit is such ludicrous public policy - it doesn’t actually accomplish anything, except for removing financial savings from the real economy. How any “conservative” would support confiscation of private savings as sensible policy is simply baffling.

Friday, May 6, 2022

Warren Buffett Endorses MMT, and Explains Why Bitcoin Isn't Money and Not Worth Anything

Image source: CNBC

I was in Omaha this past weekend for the annual “Woodstock for Capitalism” i.e. the Berkshire Hathaway annual shareholder’s meeting, the first in-person meeting since the onset of the COVID-19 pandemic.

The weekend was filled with a mix of emotions and takeaways. While there was certainly a lot of “pent-up demand” for a return by the Berkshire faithful, one couldn’t help but also feel a little nostalgic. Buffett and his right-hand man Charlie Munger are approaching a combined 190 years of age. The fact that they still have the energy and mental acuity to operate at the level they do is astounding. Nevertheless, it was clear their communications skills have deteriorated somewhat. Buffett used a lot more “ah’s” when he spoke, and at times tended to ramble. It’s possible that is also a function of the last two years - it’s been a while since the old man spoke in front of a 25,000+ live audience! I think it’s safe to say we all have been more insulated over the past couple years than normal. At times, all I’ve wanted is to just talk about all the crazy stuff that’s been happening. Naturally, of course, I started a blog instead!

One point of emphasis that Buffett clearly had on his agenda for the meeting was to explain to everyone what money is. This shouldn’t come as a surprise after being called a “sociopathic grandpa” and Bitcoin’s “enemy no. 1” by Peter Thiel at a conference in Miami a few weeks ago. Thiel referred to Bitcoin as a “movement” and called not buying Bitcoin a “deeply political” choice. There’s a lot to unpack there but I’ll just say this: if your investment thesis relies on a successful political revolution that undermines the legitimacy of the most dominant nation in the world that has created immense wealth for its citizens and has the most powerful military in history by orders of magnitude, you may want to reconsider.

Returning to the subject at hand, Buffett led the meeting off with a clarification on money. While projecting a $20 bill on the screen, he remarked the following [emphasis added throughout]:

"This note is legal tender for all debts public and private, and that's what makes it money. Money is the only thing that the IRS is going to take from you. You can offer them all kinds of things, but this is what settles debts in the United States. You'll hear a lot about various kinds of money, but this is the only kind of money you're going to see throughout your lifetime." 

This is precisely what MMT has been preaching for nearly three decades: taxes drive money! Money (cash) and debt are one in the same; every financial asset has an offsetting and equal liability. Sort of like Newton's Third Law of Physics, i.e. every action has an equal and opposite reaction. And if they are equal, that means they can cancel each other out. Money is used to cancel debt, and taxes are a form of debt. Therefore, if the State levies a tax charge payable exclusively in its own currency, then that creates demand for the currency.

Buffett was keen to emphasize the $20 bill's "legal tender" status. A fantastic historical account of the origins of "legal tender" laws in the US can be found in Roger Lowenstein's fantastic new release Ways and Means: Lincoln and His Cabinet and the Financing of the Civil War. Consider the following passage from that book, which refers to what became known as "greenbacks," an early form of government fiat money which was issued by the US Treasury in order to fund the Civil War:

"the legal tender notes would constitute a 'debt.' True, they bore no interest, and carried no maturity; nonetheless, it was widely assumed that, after the war, they would be redeemed for gold. Today, people think of 'money' as having inherent value. In 1862, even proponents of legal tender thought of the paper as provisional, casting a debt up on the future."

Today, we use the term dollar bills but they are technically Federal Reserve notes. Note the nomenclature, as we use the same terms in reference to debt issued by the US Treasury (T-bills, Treasury Notes, Treasury Bonds). Indeed, the dollar bills in your pocket are essentially zero-interest, perpetual, non-callable debt issued by the Fed. They are essentially a tax credit created by the government in order to fund productive work. 

Of course, this is not the first time Buffett has been linked to MMT. He is quoted in Stephanie Kelton's The Deficit Myth with the following:

"[the US] cannot have a debt crisis of any kind as long as we keep issuing our notes in our own currency...Greece lost the power to print their money. If they could print drachmas, they would have other problems, but they would not have a debt problem."

Buffett does not subscribe to, nor does he endorse, MMT by name. But he absolutely does so in principle.

Buffett also brought up the notion of a "value." He has mocked so-called "goldbugs" for their obsession with the "barbarous relic." He took it easy on that crowd this year and instead turned his attention to Bitcoin, using similar arguments. He claimed that Bitcoin isn't worth anything because it doesn't produce anything, as opposed to other assets such as farmland or apartment buildings. However, he also made the following comment on art, too:

"Certain things have value that don't produce something tangible. I mean you can say a great painting will probably have some value 500 years from now."

He then goes on to say that if people find it interesting, they will pay someone else money to see it. This is an important point. If a piece of art leaves a strong enough impression on people, they will pay to have that experience. Taking this a step further, the world will need to spend incomprehensible amounts of money in order for Bitcoin to be around 500 years from now. This is because it relies on a network made up of physical computers that degrade over time. That's not a prediction, that is just physics. Depreciation is a real cost. There are actual physical cables running on the oceans' floors that physically link together countries in order for them to be on the same internet network. Undoubtedly those will wear out.

Not only that, but do you really think your thumb drive that holds the keys to your Bitcoin won't degrade at all, and will function properly, in 500 years? That is before considering the fact that technology tends to evolve, and computers will still be around in 500 years with thumb drive inputs. A single piece of art is easy enough to store for 500 years; the Mona Lisa was painted in 1503! And gold itself has natural properties where, for all intents and purposes, it doesn't degrade. That characteristic made it a useful money technology in the past, but the world's population grew so large that the supply of gold couldn't support a global monetary system. The fact that gold doesn't degrade means it is basically the exact opposite of Bitcoin, despite the comparisons between the two. Eventually, all of today's Bitcoin holders will die. I'm sure many will take their passwords with them, meaning there will be fewer and fewer Bitcoins available, and the network will cease to exist. By contrast, for someone who owns gold, it doesn't necessarily all disappear when they die.

Some Bitcoin and crypto fanatics seem to think that rising price for a currency is an overwhelmingly positive development. It's not. Consider a farmer who borrows Bitcoin to pay for property, equipment, and supplies he or she needs to cultivate crops to help feed the country. If they borrow in Bitcoin, and in the time between planting and harvesting/selling their crops the price of Bitcoin increases by 4x, well now the sales they generate will be one quarter of what they had originally planned with they took out the loan. They won't be able to pay back their debt if they can't generate sufficient revenues to do so, so they are forced to default on their loan and file for bankruptcy protection. If all the farmers went bust all at once, it would cause mass starvation and famine. But hey, at least the Bitcoin HODLers saw their price go up!

Like Buffett says, investors should stick to assets that produce something useful. This is likewise very MMT-like, which emphasizes that people should focus on real resources rather than made up financial ones. It's easy to forget that the companies that Buffett has so successfully invested in have produced incredible amounts of goods and services for the citizens of America for decades. And while the near-term benefit of things like gold and art don't necessarily produce something in the immediate, the cost of keeping those assets in-tact is tiny compared to Bitcoin.

Finally, when asked about the best way to fight against inflation, Buffett gave an amazing response: become exceptionally good at something!

On Inflation

[Note: I originally started writing this piece on December 23, 2022, then got held up with holiday festivities. More posts for the new year ...