Weekender: Stores of Value, Feedback Loops, and Gresham’s Law

December 26, 2010
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In between family, presents, and the eating of Christmas cookies, the holidays gave time to revisit a book or two.

One such book was Paper Money by Adam Smith (aka George Goodman). Paper Money is a timely chronicle of 1970s economic conditions  — housing bubble, energy crisis, runaway inflation and so on — published in 1981.

In thinking about the conditions that exist today (or could soon exist in future), this passage from Paper Money stood out:

The binge of the Second Oil Crisis, you will now see, is very relevant to this discussion of paper money. Remember Sir Thomas Gresham, whose law said bad money drives out good, meaning bad money drives good money out of circulation and into savings. The bad money is spent. In the Second Oil Crisis what was saved was oil, and what was spent was money. The store of value had become oil. The yen, the marks, the dollars, the francs, were spent; the oil was saved.

The lesson was not lost. Oil was the good currency, money the bad. When the Iranians restored production, they made more money producing at 3 million barrels a day than they would have made at their former rate of 6 million barrels a day. The Kuwaitis said they might cut back by 500,000 barrels a day, the Nigerians said they would cut back 200,000 barrels a day, the Venezuelans 150,000 barrels a day.

Oil does not make very good money. It does not sit neatly in bank vaults. You cannot trade a quart of it for a tuna sandwich, or a barrel for a pair of shoes. On a very large scale you might be able to trade it for a million pairs of shoes, but the trade would be cumbersome. Gold became money because it was so destructible and finite; the destiny of oil is to burn. Ironically, monetizing the oil helped to produce the age of paper money, and the destiny of paper money is also to burn, except that paper money is really a misnomer, because the money is really blips in a computer, and blips do not burn. Not literally.

This goes back to an intriguing line of thought: Hard assets as a store of value.

Those who belittle gold, for example, fail to understand that gold’s value comes from being “the one alternative currency not subject to the whims of a printing press.”

Gold is like a wallet to put one’s wealth in, where the government moths cannot eat it.

But gold is a rather small wallet. Other potential “store of value” wallets, like oil and possibly other raw materials, are much bigger.

Oil of course gets used up over time. But the demand curve is readily apparent. One can view oil as a reasonably constant store of value as long as buyers are hungry to burn it.

In his book (written 30 years ago) Smith talks about why oil does not make a very good currency. But as we talked about in The Trouble With MMT, this digital age of instant transactions makes it very easy for investors to shift their preferences. And that, in turn, makes it easier to view a “store of value” commodity as a form of alternative currency. Especially when the officially sanctioned (government supplied) currency has become a wasting asset.

Twenty or thirty years ago, it would have been a challenge to keep your wealth in a mix of, say, fossil fuels, base metals, and timberland. But now the concept is much easier to execute.

When it comes time to make a cash transaction — buy the milk or pay the tax bill or what have you — it becomes possible to slice off a little corner of one’s “store of value” hoard and turn it into dollars, or euros, or whatever suffices for temporary transaction needs.

The Gresham’s law idea is also powerful because it addresses abuse of privilege, another topic we discussed at length in the critique of MMT. The more that fiat-issuing governments hamfistedly over-exploit their leverage and spending options, the greater incentive investors have to play a “different game” with the bulk of their investable savings — Gresham’s law at work.

On top of this, there are many who have a direct vested interest in promoting the hard asset game as a great one to play.

In Paper Money, Smith recounts a list of players who happily benefited from the 1970s energy crisis — participants who saw more dollars in their pockets than higher energy costs took out:

  • The Brits and Norwegians — because they owned the North Sea oil fields
  • Non-OPEC oil export centers, like Mexico, Louisiana, Alaska and Texas, that tangibly benefited from a rocketing oil price
  • The major oil companies who carried and refined OPEC’s oil (along with their own non-OPEC stores), and saw gross volumes and profit opportunities go up as the raw material value went up
  • The investment bankers who “sold the bonds for the pipelines” and otherwise conducted lucrative energy-centered deals (M&A, IPOs etc)
  • The broader energy industry on the whole (oil service, exploration, and so on)
  • The “armorers and sutlers to the Middle East” — those who sold hundreds of billions worth of military hardware to OPEC nations
  • The “thirty biggest banks in the world,” who by and large handled and invested OPEC’s petrodollar deposits (and fractionally lent out the proceeds)
  • Giant construction conglomerates — Bechtel, Fluor and so on — who contracted the massive oil-related infrastructure deals
  • Countless middle men, purchase agents, lawyers, lobbyists and negotiators — the professional problem solvers and wheel greasers who handled disputes, solidified contracts and facilitated deals
  • The research and consulting fields — oil and energy experts commissioned to do vast studies, write thick research reports, investigate alternatives and so on

The point of that long list being that, even in a Western energy “crisis,” there are many players that benefit, some of them substantially, and those players have an implicit vested interest in seeing a scarce resource get scarcer (or a “store of value” premium get fatter).

Another feedback loop?

The danger here is another hard asset feedback loop, in which investor behavior becomes self-confirming and self-sustaining based on rising price trends.

The loop could work like this:

  • Hard asset values rise on perceived long-term demand trends
  • Western fiat debasement underscores the “store of value” idea
  • As valuations rise, the hard asset bias confirms itself
  • Rising food and energy costs act as a regressive tax
  • Compressed income / high debt levels = persistent stagnation
  • Western governments respond w/ more aggressive debasement
  • A weakening West is contrasted with strong emerging markets
  • Return to step 1, amplify and repeat.

The above loop, which clearly has the potential to become self-reinforcing — with many vested interests encouraging it — is an example of what George Soros meant when he said this:

“Classical economic theory assumes that market participants act on the basis of perfect knowledge. That assumption is false. The participant’s perceptions influence the market in which they participate, but the market action also influences the participant’s perceptions. They cannot obtain perfect knowledge of the market because their thinking is always affecting the market and the market is affecting their thinking.”

The trouble is that, from a social cohesion standpoint, this type of feedback loop is not sustainable.

Given that rising raw materials costs are a sort of regressive tax — one that hits the poor and middle income classes hardest — an acceleration of fiat flight and hard asset hoarding divides up “winners” and “losers” in a potentially explosive way.

This is especially true against a backdrop of globalized wage pressures and persistent long-term unemployment. (In their Christmas issue, The Economist grimly touched on this.)

As yours truly explained in reply to a recent comment:

Unfortunately the debasement process is more likely to speed up than slow down.

The “graying of the west” (retiring baby boomers) is coming at a most inopportune time, with already excessive debt levels set to build further even as the emerging world produces and consumes more aggressively (which in turn compresses wages and increases the cost of food and energy).

To a significant degree the upper income classes will be okay with this debasement acceleration, because they have the ability to 1) better exploit the profit-producing aspects of globalization and 2) combat wealth erosion via cost of living increase by participating in paper asset booms.

Bottom line: For those on the bottom rung of the income and education ladder in the Western world, life was already hard — and it’s only going to get harder…

JS

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