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The End Game for Fiat Currency

October 3, 2019

The End Game for Fiat Currency

Predicting the inevitable demise of a fiat currency cycle is neither bold nor incendiary. For thousands of years, every fiat currency cycle the world has ever known started and ended the same way. It happened during the Roman Empire with the Denarius, in China during the 11th century with paper “flying money,” in France multiple times beginning with infamous central banker John Law’s Banque General, in the early USA with paper Colonials and Continentals, and perhaps most famously in Weimar Germany with the Mark after WWI. All fiat currencies eventually collapse, and largely for the same reason: the issuing government becomes over-indebted and abuses its privilege by debasing its specie or over-printing its money, which results in a logical collapse of confidence. Timing the ultimate demise is difficult, but having confidence in its inevitability is not.

Cycles are a basic natural phenomenon and are thus unavoidable. For money, the cycle always begins with “hard” currency containing or backed by a physical asset, typically a valuable commodity like gold, copper or silver. Users of the currency have confidence in its value because they know it is or represents a certain amount of something tangible. The medium of exchange is trusted, transactions occur, the system runs smoothly and the economy grows. Eventually, the issuing government becomes over-confident in its success and grows tired of dealing with the constraints this hard-exchange requirement places upon its ability to borrow, spend and expand.

Enter fiat currency.

It is at this point in the cycle that the issuing government decrees by fiat (“let it be done” in Latin) that its currency is no longer exchangeable for any tangible asset or commodity, but is instead backed by a promise that the government is “good for it” via its taxing authority or other means. Thus, the money transitions from hard currency to “legal tender” fiat currency, with no intrinsic value beyond the word of its issuer.

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The Corporate Debt Bubble

October 31, 2018

The Corporate Debt Bubble

The largest asset bubbles occur while economic growth and inflation remain positive, but subdued, for extended periods of time.  According to its dual mandate, the Federal Reserve focuses primarily on growth and price stability, and tends to ignore the creation of asset bubbles as long as economic activity is not running too hot and inflation is benign.  Historically, the Fed has not considered it a priority to prevent or pop asset bubbles, despite inadvertently enabling their creation through various policy measures.

During the inflation of asset bubbles, it is common for excess liquidity (easy money) to follow the path of least regulation outside of traditional regulated banking systems.  These channels are known as the shadow banking system or shadow lending markets where it is more profitable for both lenders and borrowers to transact due to lower costs and lax oversight.  During the last financial crisis, companies like Countrywide, New Century and even certain money market funds helped fill this role.  Unfortunately, the boom-time “innovations” which emerge around these shadow lending markets are not battle-tested, and often fail spectacularly when inevitably stressed.

Today, we here at Fox Capital believe a bubble highly vulnerable to collapse lies in the corporate debt market and the passive investment vehicles accompanying it.  While C&I lending from the traditional banking system has been healthy since the last crisis ended, the corporate bond market has absolutely exploded, tripling in size from the peak of the prior cycle in 2007.  As a direct result of the Fed’s zero interest rate policy, investors of all kinds were forced out on the risk curve, scrambling for yields attractive enough to meet their own obligations. Pension funds, endowments, insurance companies and retail investors (through ETF’s and bond funds) gorged on corporate debt for extra yield in a ZIRP world.

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Olduvai IV: Courage
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Olduvai II: Exodus
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