Because intelligent investing can’t happen in a world with extreme currency risk, the intelligence assisting in asset management would need to understand currency risk. Now with the world entering the digital currencies alternative asset boom, currency risk needs a rethink. At a certain level, a global currency has to be stable, lower in volatility and also have tangible value like Gold. Peter Bernstein's "Power of Gold" gives insight into the history of Gold as a currency. The future of stable currency could belong to digital currencies and the innovation around them, if they could balance the difficult path between value and utility.
I wrote the following feature for Alrroya Newspaper, Dubai. Strange coincidence that I am speaking about UAE, while I am headed there for a conference on 20 February for Agora’s 9th Edition Blockchain Conference along with the ingenious Mike Costache.
November 8, 2010
The global monetary system needs financial and technological innovation.
Peter Bernstein looked at gold from a historical aspect in his book ‘The Power of Gold, the history of an obsession. From the start of the Egyptian era in 3100 BC when Pharaohs ruled the Roman Empire, the author illustrated how gold slowly and steadily became real money.
The current stage of gold also gives it an aura, but this time it’s the public that has been enamored by it not the central bankers. I don’t know how Robert M. Solow will connect gold with economic growth, but just like Benjamin Disraeli, he would say the same thing, “Gold is not a cause of growth but a consequence of it”
Solow proved that only technological progress leads to real growth. A closer look at Bernstein’s history from a Solowian perspective based on technological innovations and other financial innovations reveals interesting aspects about gold.
Travel Technology Innovation: If it was not for the bold Spanish and Portuguese explorers, the golden benchmark for money would not have reached Europe. It was this innovation that opened up floodgates for trade, a ransom for kings, an obsession. Some technological innovations came much before their time like Hien Tsung’s (860-21) introduction of paper money. This innovation was early, as trade innovation was still in its infancy and the amount of global gold tonnage and produce was still less.
Minting Innovation: Bank of England could not have become the global financial center if it was not for the minting innovations. Bernstein mentions that once the horses were so busy that £ 700 was paid to clear up their manure. It took metal rolling, stamping, milling the coin edges, and evolving currency and bi-metallic systems before Europe could overcome clipping, supply, and measurement problems.
Banking and trade innovation: It was the banking and trade innovations owing to the acceptability of legal paper tenders first issued by Tsung. This was also the reason trade and currency wars took prominence as the fixed gold era started to control political issues. It was trading at the heart of issues when Charles de Gaulle voiced his concerns regarding the policies of the then the upstart nation, the USA. It was also banking and trade innovations that muddled the view for Hoover. J Pierpont Morgan on more than an occasion used financial innovations for America and European countries.
Keynes and Nixon: In 1925 Keynes argued against a return to the gold standard after the war. He said that it was no longer a net benefit for countries such as Britain to participate in the gold standard, as it ran counter to the need for domestic policy autonomy. It could force countries to pursue deflationary policies at exactly the time when expansionary measures were called for to address rising unemployment. The Treasury and Bank of England were still in favor of the gold standard, which had a depressing effect on British industry. Keynes responded by writing ‘The Economic Consequences of Mr. Churchill’ and continued to argue against the gold standard until Britain finally abandoned it in 1931.
Nixon dared to detach the dollar from the gold standard. By the time Nixon took office, U.S. gold reserves had declined from $25 billion to $10.5 billion. Gold was an underpriced commodity, as the dollar was overpriced as a currency. The United States was on the verge of running its first trade deficit in over 75 years. Nixon’s decision (financial innovation) was the main reason for the dollar getting competitive and a strong alternative to the dollar for almost three decades. Dollar prominence gave paper money the credibility it has today as a value for money.
Market Innovation: Robert Mundell’s currency innovation in terms of the Euro has worked till now. Free trade innovations allowed gold mining companies to trade and hedge their gold risk with central bankers who wanted to reduce their large gold reserves. Market innovation was also the reason gold became a widely traded investment alternative for the public at large. And this brings us to 2010 QE1, QE2, historically low-interest rates, and a situation desperately looking for a new technological and financial innovation.
The New Gold: Gold as the value of money has assumed mass fascination giving risk management a volatile meaning. Above this storage and delivery remains cumbersome issue. Bernstein’s indifference (being the best economic historian of his time) to connect history with cyclicality (seasonality) does not help us find a solution. Peter details Schumpeter, Jevons, and other cyclists but not even once mentions the visible cyclicality in the growth and decay of popularity in gold. So what to do? What markets need is a new gold, a new financial innovation, a new currency that averages the strength, weakness, and volatility of the current major currency pairs. A stable currency system is what we need to come out of this currency war. Can it be done? How should we trade it? On the exchange or over the internet? But before everything you need to measure your obsession with gold.
The further we go away from a core idea, the bigger trouble we get into. The unfortunate part is that the very nature of economics, nature, and society is going further to extremes, invariably to an unbalancing situation.
The derivatives we blame today were created for the farmer who needed a risk management solution for his farm produce. He did not want to be left to the vagaries of natures and speculative volatilities. These derivatives were good and useful. The instruments are still fulfilling the same role for the farmer. The only problem is that along with the hedger came the speculator who was not only offering a counterparty hedge but also leveraging. This brings in all the risks of volatility to a society. This is no normal volatility. This is volatility that creates risk, leading to bankruptcies and financial disasters.
Risk management today is the case of extended risk. Gold failed the risk management solution as speculators took a fancy to gold. Speculators could play and imbalance the system while governments tried hard to balance it. The unbalancing made money for speculators and balancing was what the state needed. The government was playing against the nature of markets, trying to balance things against the turbulent nature of markets. And now with gold at an all-time high, secularly outperforming the rest, Gold’s ability to offer risk management stands challenged. If you are not too sure, wait till the time it offers negative volatility. The yellow shine on gold will always work against the cooked myth of it being a great risk manager.
Mundell and Stable Currency: Mundell’s global currency is impractical in current times. The other attempt by Prechter and Smorch to create the Stable Currency Index (SCI) has its positives and is more stable than many currency pairs. According to the creators, “SCI was created to serve as a more reliable (less elastic) yardstick (unit of measure) and to behave as a global currency, removing much of the noise (currency fluctuation) as well as mitigating the single currency risk that most investors have embedded into their portfolios. The SCI is a basket of four currencies, chosen for their unique potential to offer relative stability in expressing global purchasing value when combined as a single measure of value.”
However, SCI makes a few assumptions. First: Four currency pairs are enough to create a proxy, a stable currency index. Second: The unique potential of the respective currencies cannot change in time. The authors get into the same thinking of trying to create balance without accepting the unbalancing nature of performance cyclicality, which is a part of market nature. If performance is cyclical, the top currencies, the most stable currencies of today might not be the best alternative tomorrow. Mr. Prechter, you coined Socionomics, which illustrates cyclical social mood. With your four currency basket, are you not betting against performance cyclicality? Don’t you think as larger asset cycles change, a basket of four currencies might offer an ineffective hedge?
We need a simpler approach, maybe an Occam’s razor. We need an approach that the farmer, the corporate can understand, something which does not tell us to just look at the top four stable currencies. Society needs a currency solution that can get popular and still be effective at the same time. We need something that is designed to be risk-reducing but does not assume past knowledge. Hindsight, as we know, could be a bias. We need to derive a solution that garners hedging interest and can be embraced.
A solution for global currency and risk management could be simple. The idea assumes performance cyclicality at all degrees. It assumes that markets and assets will move seasonally and cyclically at all time degrees. This means that if we take most traded currency pairs together say for an investment horizon of three degrees of time, minor (few days), intermediate (few weeks), and primary (more than 9 months), and rank them for volatility, we will get cycles of volatility for all of them. For example, the dollar could be in a reducing volatility stage and sometimes in a decreasing volatility stage. The system will give an overview of currency volatility cycles. There will be currencies with increasing volatility and currencies with decreasing volatility aggregated for three degrees of time.
The currency model could take the top 10 percentile currencies (top volatile) and combine them with the bottom 10% currencies (least volatile). The new index could be the new currency mirroring the average volatility of the global economy. The currency could be stable as it’s designed to average market currency volatility, it will be stable because of a large basket of currency volatilities netting against each other and it will be dynamic with a constantly changing portfolio. Whenever the top or bottom percentile changes the allocations will change.
We have constructed this cycle currency model, but the tougher challenge for society now is to accept that something like volatility could also be cyclical and whether they need a new gold that has no shine.