Fate of the Fiat…

Fate of the Fiat…

Vivek Bhandari, June 2019 

Picture 1 - Yugoslav 500Bn currency note

Last month my daughter asked me to buy high denomination, defunct currency notes from certain east European, African and south American countries for a project. Of course I had read about hyperinflation in college. I do remember the turbulence in the Balkans in the early nineties. I also know that a number of governments and by extension their currencies have failed in the twentieth century.

That said, I was still unprepared for the denominations that started jumping out at me. Right from hundreds of thousands, millions, hundreds of millions, billions, hundreds of billions and trillions. There were a lot of zeros and it was important for us to count the zeros slowly and carefully to make sure one identified the note correctly. Obviously at the time these governments were unstable (war, disorder, major human suffering, shortages) and they did not hesitate to leverage their central banks. The central banks obliged with a generous money supply (can't call it stimulus although it definitely stimulated inflation) and were not shy in using the printing press. Problem is that the people with goods and services are reluctant to trade in such currencies, as any holding period (week, even a day) can lead to erosion of value. In other words the holder of such a currency has to find the greater fool quickly. And when the music inevitably stops, someone is left with a lot of paper. Needless to say such notes are either currency collectors delight or sought by students of economics and history. There are definitely some lessons to be learnt here.

Money is generally defined in terms of three main functions, 1) Medium of exchange, 2) Store of value and 3) Unit of account. For such failed fiat currencies, the public lost confidence in its status as the medium of exchange. There was no intrinsic value in the paper, so all thats left is a collectors delight or currency notes fit for a school project.

Historically, at the other extreme there is legal tender in form of precious coins. American Eagles, American Buffalo, Canadian Maple Leaves, Krugerrand, Australian Koala and the Queens Beasts to name the main ones. All these coins have a nominal face value based on their home country. However, the intrinsic value of the metal far exceeds the face value of the coin, thus making these unsuitable as a medium of exchange. Most of the ones cited earlier are one ounce gold coins with value of around USD 1,300 per coin. The face values are normally around USD 50 to USD 100. To be clear these are all legal tender, but you don't want to exchange them at a fraction of the metal value for paper. Their position as legal tender provides an advantage (versus standard bullion) when moving these internationally and also some protection against counterfeits.

Given below is a picture of a pre-independence King George VI silver coin from India with face value of Rupee 1. While this coin has long stopped being legal tender, its kept up and even outperformed inflation with its current value of Rs 700 - Rs 800. In general precious metal coins do provide investors with meaningful asset diversification and inflation protection.

Picture 2 - George VI Coin

No discussion on money today can be complete without talking about cryptocurrencies. My view is that while cryptocurrencies don't provide a store of value, they do have some unique attributes as a medium of exchange, (a) Not controlled by any government, (b) Transaction and transfer costs are lower than formal banking channels, (c) High portability and (d) Anonymity. Any cryptocurrency needs a large user base to legitimize its status as a medium of exchange. In theory, if the rules of creation of new units are well defined and managed through a distributed ledger, its impossible for anyone to unilaterally print more money. At the same time not being under the purview of any government allows for avoidance of rules (Capital Account Convertibility) and taxes. So to simplify, cryptos are not only disrupting the inefficient banking system, they are also disrupting the government revenues. Amusing as the concept is, there is likely to be serious resistance from governments, central banks and regulators to this disruption.

My view is that, given its fail on store of value, its unlikely that any unregulated crypto will be widely used by public for their day to day transactions in the foreseeable future. Well heeled investors with capital to spare, will continue to hold a part of their wealth in cryptocurrencies as a high risk/return asset class. Large banks and clearing houses will likely use blockchain/distributed ledger to reform the slow and expensive international wire transfers. They are likely to come up with solutions that address the issues (speed and cost) with international transfers while being acceptable to governments and regulators.

To summarize, I believe that fiat is here to stay. Sure, there will always be some jostling for position via trade wars and currency wars, but there is too much at stake for the G20, IMF and World Bank to rock the boat. To diversify their investments, investors may consider allocating a portion of their capital to precious coins and preferably legal tender. Cryptocurrencies in their current avatar don't provide an adequate store of value and are likely to be a speculative play for the seriously rich. Blockchain and distributed ledger will be harnessed by large banks and financial intermediaries to reform international transfers.

I look forward to hear other views and counterpoints.