TIFFIT Episode 4: Debasement Wars

TIFFIT Recap

So far in this TIFFIT mini-series, I’ve outlined that well over US$11 trillion in Pandemic money was printed into circulation by the four biggest central banks via asset purchases programs; and US$5 trillion in U.S. fiscal stimulus (alone) was dropped from helicopters to households.

If you add COVID relief packages dispensed by other sovereigns, it’s likely that the world received at least $20 trillion in Pandemic stimulus to keep the lights on during lockdowns. That’s equivalent to one full year of personal consumption expenditure of goods and services in the U.S. And that’s massive.

It was done under the guise of ensuring the world’s collateral base (stocks, bonds, real estate, etc.) remained intact after GDP was switched off by governments during lockdowns.

We also discussed inflationary pressures faced by the Fed as its seeks to get inflation sustainably down to 2%.

Episode 3 concluded with the comment, ‘Wen spend end? Wen productivity return!’ and the comment that the massive increase in central bank balance sheets since 2009 has created another tax several orders of magnitude higher, and more pernicious than inflation.

And the name of that silent but nasty tax? Currency debasement.

This episode is devoted to currency debasement, so without further delay, let’s dig in.

The curious case of debasement

One of the outcomes of increasing the amount of money in circulation is that it enables governments to kick debts and deficits, but that comes at a price.

And the price is currency debasement, which is a tax on the dollar’s purchasing power.

What does that mean? It means that as productivity and taxes fall, and government spending remains constant or increases, the shortfall is papered over with new debt and that results in larger deficits.

Increasing deficits lead to more debts and higher interest bills, and that forces a treasury to borrow more, typically by issuing new government paper (treasuries, gilts, and bunds).

Unfortunately, the productivity replacement from AI and nuclear robots is still at least a decade away in most ageing nations. Maybe more. That means this papering over the cracks needs to continue. It’s not a want, it’s a need for more borrowing.

As a result, fiscal spending from treasuries, together with old and new debts and deficits now dominate the liquidity mix.

At present, Treasury has built up and/or has access to ~US$1.5 trillion in reserve funds to paper over some cracks as we discussed in Episode 3. But when this runs out and/or when more government debt obligations come up for refinance, Treasury will need to borrow more, and eventually rely on the Fed.

And if the world continues to rely on central banks, through programs QE Infinity style programs, to bail out treasuries through debt monetisation, there’s a significant ongoing cost looming.

That cost is ongoing currency debasement of around 15% per annum (which you will know from my blog series on the GFD), over and above CPI that might remain above 2% for quite some time.

Why 15%?

The answer is that since the GFC, a massive amount of net buying of Treasuries and MBS (mortgage back securities) has remained on the Fed’s balance sheet in order to maintain a stable system of money and credit (not too hot not too cold) and to monetise Treasury debts and past government deficits.

Buying started at a level of just $900 billion before the GFC and peaked at just under $9 trillion in April 2022.

As the balance sheet grew bigger from excess reserves created over that time, this effectively debased the currency.

What that means is that the process of central banks buying financial assets to stimulate the economy (via QE and other programs) led to an increase in reserves, or new ‘money’ digitally credited to the accounts of sellers in exchange for selling treasuries/MBS to the Fed.

Those reserves became part of the money supply after fractional banks lent them out, thereby increasing the supply of money.

Increases in money supply, without a corresponding increase in economic output or productivity i.e., chasing the same or a declining amount of goods and services, leads to a decrease in the value of the currency over time, or debasement.

Think of debasement like the gradual debasement of coins in history when cheaper metals were added to turn one silver pound into two, at 50% of the silver content.

Importantly, if we use the growth in the Fed’s balance sheet as a proxy measure of debasement since the GFC, the rate of debasement reached ~15.4% at the peak of the Fed’s balance sheet, by 2022.

Debasement is a silent, invisible, and nasty annual tax of ~15%, and a profound loss of purchasing power as the value of currency diminishes over time.

The empire won’t talk about it

Central bankers don’t talk about debasement for obvious reasons. However, it’s the price for powering the QE Infinity train to nowhere which allows sovereigns to continue to kick their debts and deficits further down the train tracks.

But the important punchline is that if you have not been able to generate returns exceeding the cost of capital, plus this debasement rate (in your projects, business, wages, or your investment portfolio) you’ve effectively experienced financial repression and have been trapped in a depression for roughly 15 years.

While some investors have seen significant gains, largely due to VC, private equity, crypto or tech stock appreciation outpacing currency debasement, the majority have felt the pinch of stagnant wages, rising prices, and higher taxes.

Considering the negative wealth effect of this ~15% annual debasement, it's evident that we're not merely experiencing a monetary recession, but a genuine depression that’s global.

Why is the depression global, you ask?

Because all financial markets are connected via the world reserve currency, which makes U.S. economic and interest rate policy far-reaching, along with the effects of debasement.

Moreover, the devalued USD, which serves as the basis for measuring prices and investment returns, along with ongoing Consumer Price Index (CPI) increases, has at best led to what I've labelled a global financial depression (GFD).

That’s a massive hurdle for businesses and investors to jump over each year!

Debasement implications for finance and investments

This change in thinking challenges traditional investment frameworks, including the concept of the risk-free rate (RFR), which refers to the expected return on an investment with no risk of monetary loss. It’s a key input into the capital asset pricing model (CAPM) which derives the cost of equity.

Debasement has profound implications for CAPM and finance generally because one unit of money continues to debase by ~15% per annum and that means investment returns should be reduced by that amount by debasing (increasing) the denominator or the ‘asset cost base’.

It means that under debasement, the same income or gain makes up a smaller percentage of the expanded cost base. That means a lower return.

As an example, a gain or income of $10 in one year on a $100 asset cost base equals a 10% pre-tax annual return in a world where the money supply is backed by productivity and zero central bank asset purchases.

However, if QE, for example, results in the balance sheet growing by say 15%, then the asset base has been debased by 15%, and should be adjusted to $115, resulting in a lower return of 8.69%.

And if you extrapolate that out over say 15 years since the GFC, you will end up with a few hundred basis points return.

How should we think about this?

Well, firstly let me say that my math is rough, and presented below simply to illustrate the concept.

Secondly, I’m thinking about this in the context of CAPM which is not perfect, but I’m using a well established financial tool to illustrate my point.

Having established that context, one way to factor in debasement is to debase, or increase, the cost of money by increasing the RFR (where it is used in the left-hand side of the CAPM formula) from say 4.5% to 19.5%, such that the cost of equity or expected return on an asset would be closer to 21.0%!

That result assumes: (a) we only debase RFR on the left-hand side of the CAPM formula; (b) we do not debase RFR where it’s used to calculate the non-diversifiable market risk premium (which is calculated inside the brackets on the right-hand side of the formula) such that the market risk premium, or (rm-rf) continues to utilise the relevant yield on a risk-free government security; and (c) beta is set to 1.0.

And if a cost of capital or expected return on a security of 21.0% doesn’t scare you, I don’t know what will. And on that, feel free to send me hate mail.

I’d also just say that most if not all bankers do not see it this way. While they do take inflation into account (in the context of a nominal model where they would increase capex and operating expenses), they will continue to look at unadjusted CAPM and ignore currency deflation.

Similarly, corporate treasurers seeking to calculate ROI and ROA will typically ignore debasement.

However, the process of central banks purchasing financial assets to boost the economy has led to currency debasement. And my TIFFIT theory indicates that this trend is likely to persist and may even accelerate beyond 15%, after a brief pause.

At the corporate development level, it means choosing projects with significantly higher return expectations, and/or acquiring more high growth technology-enabled businesses.

At the personal investment portfolio level, it provides pause for thought as we question the benefits of diversification. Under a GFD construct accelerated by TIFFIT, diversification will likely lead to underperformance versus concentrated bets in high return alternatives.

Of course, if debasement were to reverse and if ~US$26 trillion of central bank assets were to be run-off or sold back into markets (which at this time is an impossibility) then we could go back to a 4.5% RFR.

But, while we’re happy to pay this global debasement tax, the QE Infinity train to nowhere will continue its journey, and the world’s collateral base will live to fight another day, even though it will buy less, every second of every day.

In Episode 5 of this TIFFIT mini-series, we will conclude with why we should all keep currency debasement on our radars.

Until then, see you in the market.

Mike

Michael GanonMay 8, 2024#strategy, commodities, #corporatefinance, #markets, #equities, #stocks, #bonds, #finance, #economics, #macroeconomics, #business, #ethereum, #bitcoin, #inflation, #gold, #silver, #qeinfinity, #economy, #interestrates, #trade, #transformation, #ceos, #directors, #founders, #cfos, #currencies, #construction, #mining, #renewables, #technology, #leadership, #india, #china, #australia, #perthbusiness, #education, #research, #businessowners, #future, #brexit, #nextlevelcorporate, #mikeganon, #community, #covid, #populism, #crypto, #successionplanning, #uranium, #copper, #nickel, #linkedin, #Fed, #federalreserve, #monetarypolicy, #centralbanks, #marketoutlook, #financialmarkets, #stockmarket, #humanresources, #productivity, #earnings, #demography, #babyboom, #babyboomers, #continuingeducation, #financialanalyst, #financialanalysis, #CPA, #CFP, #money, #management, #investing, #executivesandmanagement, #businessintelligence, #fundraising. #strategy, #managementconsulting, #wealthmanagement, #sustainability, #venturecapital, #investmentbanking, #entrepreneurship, #corporatedev #corporatedevelopment #miningandconstruction, #commodities, #familyoffices, #CFA