Bitcoin, Gold & Money

We start with a quote by Donald Trump, courtesy of CNN, May 16, 2016: “This is the United States government. First of all, you never have to default because you print the money, I hate to tell you, OK?”

We juxtapose that quote with Francesco Bianchi and Leonardo Melosi’s excellent research paper published by the Federal Reserve Bank of Chicago (working Paper 2017-19). We recommend readers thoughtfully review this paper, which is entitled “The Dire Effects of the Lack of Monetary and Fiscal Coordination.” You can access it here: https://www.chicagofed.org/publications/working-papers/2017/wp2017-19.

Now for a topical anecdote. The following story struck me, since I had just seen the movie Tulip Fever and written a review of it (available here: http://www.cumber.com/tulip-fever/). It seems a young Dutch family has decided to sell virtually everything they own and to plow the proceeds into Bitcoin. They have moved out of their house. They are making a brave but 100% speculative bet on this cryptocurrency. Here’s their story: https://www.cnbc.com/2017/10/17/this-family-bet-it-all-on-bitcoin.html.

Why? The behavior seems bizarre to me.

There are many dimensions in the debate about the relative merits and demerits of cryptocurrencies, fiat currencies, and gold, so today’s commentary may seem a disjointed missive. And it is. No consistent path has yet been determined for the rapidly growing crypto asset class. (I use the term asset class very loosely, since crypto is really still a very new and speculative phenomenon that has not yet gained the respect accorded a traditional asset). Gold, money, and financial instruments such as bonds or stocks denominated in money are generally accepted assets, but crypto is still the subject of intense head scratching.

Let’s get to some bullets.

Of the three asset classes we are considering, the easiest to comment on is fiat currency. There are over 100 in the world. They are available in paper form and can also be transferred electronically in most cases. They are the products of governments. Their transfer usually occurs through some form of government-monitored or -supervised system. They range from the largest, the US dollar – still the world’s reserve currency – to the local paper money of minor countries. The degree of governance varies widely. Venezuela, which has domestic hyperinflation, forces its citizens to use its debased currency and persecutes them when they resort to transactions in the dollar and other harder currencies via an underground system. This is a desperate situation that has been repeated many times in many countries over the past century.

At the other end of the spectrum, we find fiat money being managed by means of hard-money central bank policies that focus on the “classic store of value” function of money. Switzerland’s policy, for example, has been decades in the making: The Swiss have had one of the hardest currencies in the world, although it has ultimately succumbed to pressures from the huge and ongoing monetary experiment of its contiguous neighbors who use the euro. The Swiss National Bank was overwhelmed by the size and direction of monetary policy administered by the European Central Bank (ECB). Serious historians of monetary history will long recall how Switzerland once imposed a negative interest rate of 5% per year on Swiss franc deposits in order to discourage inflows into the “Swissie.” The world was seeking a store of value and didn’t trust the dollar at that time.

Cryptocurrencies have both passionate supporters and vehement detractors, though it is now possible to facilitate transfers between crypto and fiat currencies. Some folks think of crypto as an alternative to credit cards but with a payment mechanism that uses the new blockchain technology. Crypto detractors argue that governments will not go on allowing parties to bypass the fiat currency systems they have created. Here is a full discourse on that subject by Harvard professor Ken Rogoff: https://www.project-syndicate.org/commentary/bitcoin-long-term-price-collapse-by-kenneth-rogoff-2017-10. Rogoff raises important questions:

“What happens from here will depend a lot on how governments react. Will they tolerate anonymous payment systems that facilitate tax evasion and crime? Will they create digital currencies of their own? Another key question is how successfully Bitcoin’s numerous “alt-coin” competitors can penetrate the market.”

Evidence from China is that governments are starting to seriously resist crypto, as Rogoff suggests.

But not all governments are resisting.

In the Middle East, gold-backed crypto tokens are emerging, and they are sponsored by a government. TabbFORUM reports (10/20/2017) that “In the Sharia-compliant OneGram, each crypto token is backed by one gram of gold held in a vault in the Dubai Airport Free Zone. A similar scenario takes place when trading ZenGold, while GoldMint, which is based on a private blockchain, issues tokens backed by physical gold or ETFs as per the prevailing price of gold.”

Gold-backed crypto is very new, and we shall quickly see whether it catches on. Adding a gold backing counters the argument that cryptocurrencies have no tangible value. Gold can relieve and replace mathematically driven systems that attempt to create scarcity value, as in the present crypto mining operations.

We think there is potential for gold-backed crypto. For a full discussion, see “Where Bullion Meets Blockchain”: http://www.lbma.org.uk/assets/alchemist/Alchemist_87/Alch87Coghill.pdf.

Fundstrat’s Tom Lee, a supporter of crypto, has created five indices. One of those baskets contains 300 cryptocurrencies. Lee says, “The indices are designed to accurately reflect the comparative price performance of Bitcoin and other crypto-currencies.” Lee favors the “larger-cap crypto-currencies from a tactical positioning perspective.”

And now the explosion in crypto has taken on a new coloration with the launch of a fund of funds. See this Bloomberg story for details:  https://www.bloomberg.com/news/articles/2017-10-24/crypto-fund-of-funds-emerges-as-digital-coin-sector-explodes.

So far there is no index of gold-backed cryptocurrencies. Tom Lee is the crypto pioneer but not with gold backed included.  They are probably too new and too small. We shall see if that changes. We shall see if ETFs follow those indices.

We note that the world’s gold supply is finite. The central banks of the world hold about 18% of the entire world’s gold. They count it as part of their reserves. The government of China has been a constant buyer of gold and is now the sixth largest governmental gold holder in the world. The largest is the US, followed by Germany, the IMF, Italy, and France. Add Russia (right behind China) and Switzerland and you have just named the holders of about two thirds of the worlds’ officially held gold reserves.

From what we can see, no central bank uses a cryptocurrency as a reserve at this time. Tom Lee believes that they will start doing so once the total crypto asset class exceeds $500 billion in value.

So where do all the emerging developments in crypto leave us today?

Crypto is rapidly expanding. Other than for the new gold-backed entrants, the value of cryptocurrencies is unknown and highly volatile. Meanwhile, the gold price has been slowly rising for the last couple of years, and its volatility is usually tied to a weakening or strengthening US dollar movement in the foreign exchange markets.

Evolution is fascinating to watch, and we are seeing it. We do have a small position in the gold miner ETF in our US dollar-based portfolios.

David R. Kotok
Chairman and Chief Investment Officer
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