Monthly Archives: October 2016

Why Does Fiat Money Become Worthless?

  • Fiat money has a long history of losing value. Generally, this process is gradual and prices rise slowly over long periods of time. However, sometimes a particular fiat currency becomes almost worthless overnight and prices soar in terms of that currency.
  • But what drives the loss of all value in a currency? And what are the necessary conditions for fiat money to become worthless?
  • In this week’s article, we explore this issue by analogy. More specifically, we examine why certain stocks, under certain conditions, tend to lose most of their value very quickly. We then apply these ideas to the analysis of fiat money.
  • While some may argue that equities and fiat currencies are not comparable, the view of The Money Enigma is that their behavior can and should be compared side by side because they are, in fact, very similar financial instruments.
  • More specifically, fiat money, just like a share of common stock, represents a proportional claim on some future economic benefit.
  • Equities represent a proportional claim on future residual cash flows: the value of an equity (share of common stock) varies according to expectations of future cash flow and expectations regarding the number of shares outstanding, i.e. the number of shares that will have a claim against that cash flow.
  • In contrast fiat money represents a variable claim on the future output: the value of fiat money varies according to expectations of future output and expectations regarding the size of the monetary base, i.e. the number of monetary units that will act as a claim against that future output.
  • The value of a stock collapses when the outlook for cash flow plunges and expectations for share issuance soar. Similarly, the value of fiat currency collapses when the outlook for economic activity plunges and expectations for monetary base expansion soar.

Lessons in Resource Stock Investing

If you spend a decade investing in resource stocks, then you are almost bound to learn some painful lessons.

In the right set of circumstances, resource stocks, particularly those in the exploration space, represent a path to quick riches. Those in the industry who have made great discoveries have made many a fortune. Moreover, many investors, who have had the insight and courage to buy resource stocks at the right point in the cycle, have also made a killing.

However, the fact is that the resources sector is also a risky place to invest and many have lost significant sums in the pursuit of great returns. From 2012 to the end of 2015, many resource stocks lost 90% or more of their value as demand for China dried up and the sector fell out of fashion.

As a general rule (and this is a “general rule” and therefore should be considered as any investors reading as a vast overgeneralization), a resource stock does well when expectations regarding future cash flow generation improve and expectations regarding future share dilution begin to moderate.

Conversely, a resource stock does poorly when expectations regarding future cash flow generation deteriorate and expectations regarding the level of future share issuance begin to rise.

In general, it is the combination of deteriorating fundamental prospects for the deposits or mines that the company owns plus the issuance of large numbers of new shares that quickly erodes the share price. In the worst case scenario, a period of heavy dilution of existing shareholders can drive a resource stock down 90% or more, i.e. the share becomes almost worthless.

Clearly, the two phenomena are related. An erosion of confidence in the long-term fundamental prospects of the company wipe out other sources of potential finance and the company is forced to issue shares at lower prices just to raise enough cash to keep the lights on. If confidence remains low for an extended period of time, then the company will be forced to keep issuing shares at lower and lower prices.

The Value of Fiat Money and Long-Term Economic Confidence

Resource stock investing is interesting from an economic perspective because it may provide us with a perspective on why fiat currencies become worthless. Why? Well, the view of The Money Enigma is that fiat money is a financial instrument (it derives its value from its implied contractual properties) and fiat money, like stocks, represents a proportional claim on a future set of economic benefits.

Most economists don’t think of money in these terms, but most economists don’t offer a sensible theory regarding (a) why does fiat money have value, and (b) what determines that value over time.

If you ask most economists why the paper money in your pocket has value, they will give you some waffle along the lines that paper money has value because it is accepted in exchange. The problem with this line of reasoning is that it creates a circular argument: Why is money accepted in exchange? Because it has value. Why does money have value? Because it is accepted in exchange.

The fact is that every asset derives its value in only one of two ways. Either it is a real asset, i.e. it derives it value from it physical properties, or it is a financial instrument, i.e. it derives its value from its contractual properties.

This paradigm applies to every asset we know: bonds, equities, commodities, real estate etc. And yet, when it comes to fiat money, economists like to side step this fundamental paradigm and try to invent new theories regarding how one particular asset derives its value!

Prima facie, economists should attempt to answer the question “why does fiat money have value?” using the paradigm described above. After all, it works for the first forms of money: commodity money (money that is literally a commodity such as gold and silver) and representative money (money that is backed by a commodity, i.e. early paper money that was exchangeable into gold on request). Commodity money is a real asset and derives its value from its real properties. Representative money is a financial instrument and derives its value from its contractual properties.

The question that economics fails to answer is why did paper money continue to have value when the explicit contract that governed representative money (the asset conversion feature) was rendered null and void.

The view of The Money Enigma is that when the asset-backed feature of paper money was removed, the explicit contract that governed paper money was replaced by an implied contract. In essence, money became a proportional claim on the future output of society. Therefore, its value now depended on two key factors: (a) the long-term expected future output of society and (b) the long-term expected number of units of money to be issued (more specifically, the long-term expected path of the monetary base).

Complicated? Yes. Hence, we use the analogy with resource stocks.

Stocks represent a proportional claim on a set of long-term future cash flows. They are a “proportional claim” because each stock only claims a certain proportion of those future cash flows. The proportion that each stock claims depends on the number of shares outstanding today and the number of shares outstanding in all future periods. (Note: people are trained to think about this in static terms and only use shares outstanding today… but this is incorrect. The value of a share today depends upon not only shares outstanding today but expectations of shares outstanding in all future periods).

Similarly, my view is that fiat money represents a proportional claim on a long-term set of future economic benefits, namely the economic output of society. Fiat money is a proportional claim because the proportion of output that each unit of money claims depends on the size of the monetary base today and the size of the monetary base in all future periods.

A more nuanced, but important point, is that fiat money shares another characteristic of equities: fiat money is a long-duration asset. What does this mean? It means that the value of fiat money depends on long-term (30-40 year) expectations regarding the outlook for both economic output and the monetary base.

Why Might a Fiat Currency Become Worthless?

So, why might a fiat currency lose most of its value over a relatively short period of time?

Let’s think about it in terms of our earlier discussion. We noted that a resource stock tends to lose most of its value when confidence regarding its future prospects greatly diminishes. More specifically, it is the combination of deteriorating expectations regarding future cash flow generation plus the expectation that many more shares will be issued that leads to a collapse in the value of the stock.

Let’s apply this to fiat money. If fiat money is also a proportional claim on some future benefit, then it stands to reason that fiat money would lose most of its value under similar circumstances.

More specifically, fiat money will lose most of its value if (a) expectations regarding the long-term future output of society markedly deteriorate, and (b) expectations shift such that people expect a much greater issuance of money over the next couple of decades.

What sort of circumstances might create this? Well, war would be one. If war breaks out and people believe that it will last a long time, drive a marked collapse in the long-term outlook for real GDP and force the government to print money to survive, then one would reasonably expect the value of the fiat money of that society to collapse (and prices to soar in terms of that currency!)

Lessons for Today?

The big question for investors today is whether we are on the verge of a shift in expectations that could lead to a collapse in the value of the major fiat currencies.

At least part of the stage for such a shift in expectations has been set. Government debt levels have soared which could limit future financing options for the major governments. Moreover, the monetary base in most major Western countries has also soared.

Yet, the value of the major fiat currencies has, to date, held up relatively well. Why? Well, probably because the other key part of the equation is missing: expectations regarding long-term economic growth have not collapsed. Rather, it seems that most people remain quite optimistic regarding the long-term economic growth of Western society, despite the fact that, over the past ten years, it has taken a massive deterioration in the balance sheet of Western society just to eke out a small amount of real economic growth.

The bottom line is that we will just have to wait and see. If the market is right, and economic growth continues strongly over the next ten years, then it is likely that the major fiat currencies will maintain their value. But, if confidence in the long-term future of Western society is lost, then it is almost a certainty that the value of the major currencies will erode quickly leading to a sustained period of severe inflation across the Western World.