Imagine the U.S. government deciding that a visionary entrepreneur like Jeff Bezos or Elon Musk was too rich and too outspoken.

Then imagine Bezos or Musk being kidnapped — and completely removed from the public eye — even as the government openly and aggressively put their tech empire under siege.

This is apparently happening to Jack Ma, the e-commerce visionary who founded Alibaba in 1999.

In China, Jack Ma is the rough equivalent of Bezos and Musk combined. Alibaba, the first company Ma founded, is like a cross between Amazon, Google, and eBay. And with a personal fortune that topped $62 billion in 2020, Ma had long been a technology rock star and an inspiration to up-and-coming Chinese entrepreneurs.

At one time, Ma’s public presence, and cultural influence, seemed to be everywhere in China. He made guest appearances in Chinese action movies; sang duets with Chinese pop divas; appeared routinely in a television program he created (a talent contest for Africa-based entrepreneurs); and had a widely used nickname, “Daddy Ma,” cementing his status as an icon.

All of that could be over now.

The trouble started a few months ago, with the initial public offering (IPO) for Ant Financial Group.

Ant Financial was another hugely successful enterprise, focused on consumer lending and digital payments, that was attached to Ma. The Ant Financial IPO was set to raise nearly $35 billion by way of a dual listing in Hong Kong and Shanghai, and it would have been the largest IPO of all time. (We wrote about it on Oct. 28.)

But then, at almost the last possible moment, the Chinese government killed the Ant Financial IPO citing regulatory issues. (We wrote about that on Nov. 10.)

Rumor had it that Xi Jinping, China’s leader-for-life, had ordered the cancellation himself. Ma had apparently pushed the envelope too far with public criticism of China’s banks and regulatory agencies.

Cancelling the Ant Financial IPO was a brutal shock. But that was only the beginning.

On Dec. 24, the NYSE-listed shares for Alibaba Group (BABA) saw an 18% decline — their largest single-day decline ever — on news that the government had launched an investigation into Alibaba for monopolistic practices (China’s version of antitrust).

And now, in the first week of 2021, a drumbeat of concern is rising over Ma’s disappearance.

The television program Ma created, African Business Heroes, was known to be a project close to Ma’s heart. He routinely appeared on the show as a talent judge.

But in the December 2020 finale for African Business Heroes, Ma was replaced with another judge. His photo was also removed from the show’s website, and his name removed from the promotional materials.

When observers of Ma’s business and social circles realized the changes that had been made to the show, it further dawned on them Ma had not been seen in the flesh since October. He was simply gone.

In the dystopian novel 1984, author George Orwell introduced a concept known as “the memory hole.” If the Ministry of Truth wanted something to be forgotten, they would use a memory hole.

Jack Ma himself may have been thrown down the memory hole.

This matters to Western investors in part because Alibaba (BABA) is a popular holding. The company is a true technology juggernaut, in the mold of Amazon or Google, and the price chart is now a disaster. How much further could BABA fall? That may depend on what the government has in mind.

Another common factor here is a growing backlash against high-profile, multi-billionaire tech entrepreneurs. In describing how Ma’s fortunes have turned, New York Times columnist Li Yuan wrote the following on Dec. 24:

But lately, public sentiment has soured and Daddy Ma has become the man people in China love to hate. He has been called a “villain,” an “evil capitalist” and a “bloodsucking ghost.” A writer listed Mr. Ma’s “10 deadly sins.” Instead of Daddy, some people have started to call him “son” or “grandson.” In stories about him, a growing number of people leave comments quoting Marx: “Workers of the world, unite!”

While the U.S. does not look poised to subject its tech founders to Marxist backlash, ill winds of mounting regulatory and political pressure have been blowing around the juggernauts (Google, Facebook, Amazon, Apple) for a decent while now.

All are under intensifying scrutiny, and at least two of the four (Google and Facebook as of this writing) are facing full-blown antitrust actions.

Investors thus far have been complacent in regard to these actions. The share prices for Google and Facebook climbed and otherwise shrugged, respectively, in the aftermath of major investigation announcements (which we covered here on Oct. 22, and here on Dec. 11).

Be aware, though, that a regime change in the U.S. Senate — with, say, Democrats cementing majority control after the Georgia run-offs — could change the complacency picture quickly.

3D printing — also known as additive printing — is a transformative technology that will usher in dramatic change. The disruptive dominance of 3D printing, which is closer than most realize, will be a hallmark of the transition to mankind’s fourth great age, the information age. (The prior three were the stone age, agricultural age, and industrial age.).

This might sound funny, because investor excitement around 3D printing peaked about seven years ago.

You can see it in the share prices of 3D Systems (DDD) and Stratasys (SSYS), two prominent 3D-printing companies. DDD and SSYS topped circa January 2014, and then tumbled as if falling off a mountain. 

The first wave of 3D-printing bullishness was far too early, and the initial premise was wrong.

The belief back then was more or less that hundreds of millions of consumers would have a 3D printer in their home — like a Polaroid camera for physical objects — and that the average person would be able to print whatever they wanted from designs pulled off the internet.

That idea didn’t work. Or rather, the economics of it didn’t work. The excitement got too far ahead of the technology, which frequently happens, and the first iteration of the business model was miles off, which also frequently happens. 3D-printing stocks thus got rocked when the enthusiasm bubble popped.

But the 3D-printing concept didn’t go away. Instead, it has spent the past seven years getting incrementally better in the shadows.

3D-printing technology has continued to mature, and make strides away from the spotlight, as factors like the falling cost of computing power and the rise of machine learning and big data make the economics more viable by the day.

In 2021, the realistic outlook for 3D printing as a transformative industry is something like this:

• There will be large 3D-printing manufacturing facilities, on the order of tens of thousands to hundreds of thousands of square feet, built next to equally large distribution centers.

• Some of these facilities will crank out mass volume for industrial purposes — think high quality engine parts — and some will handle retail customer orders in mass volume, with a production catalog of hundreds of thousands, or even millions, of proprietary product designs.

• These 3D printing mega-facilities will be partnered with, or more likely owned by, fulfillment and distribution giants like Amazon or Walmart. They will take the customer’s order online, send it to a 3D-printing facility, and then ship to the customer directly, possibly via drone or automated self-driving vehicle.

That 3D printing future is closer than most realize.

We can say this with confidence partly based on the current state of the industry, partly based on how fast various supportive technologies are advancing (microchips, machine learning, and so on), and partly based on the seven-year time frame between today and the last enthusiasm peak.

For truly transformative technologies, the last mile of development is often far harder than it looks. This can create a kind of mirage years before the technology is truly ready for prime time: It can look like the industry is almost there, but there are still a great many gaps to close and kinks to be worked out.

As such, for a transformative technology, closing the gap between a prototype concept and an actual, viable industry with profitable economics can take a long time.

Sometimes the gap closure can even take decades: Think online grocery delivery as conceived 20 years ago — when the concept was way too early in terms of the surrounding technology ecosystem — versus 2020, when grocery delivery truly began to take off.

This is why investor excitement tends to peak early for a game-changing technology, then slip into a kind of “winter of discontent” that can last for years. The mirage gets everyone excited, but the oasis of profits isn’t real.

If there really is a profit oasis to be reached, though, development of the technology keeps going.

As investors focus on other things, the industry keeps marching forward, collecting small, incremental improvements that amount to significant viability gains each year. And then, at some point, critical mass is achieved as the technology becomes viable at scale. This is when the real promise starts to be fulfilled.

It looks like 3D printing, as a game-changing transformative technology, is following this pattern.

But the 3D-printing revolution could be far larger than most expect, to the extent it will touch almost everything. As mentioned, it could serve as a bridge from the industrial age to the information age.

And in so doing, it will up-end or destroy a great many 20th century assumptions of how business is supposed to work.

To see this clearly, imagine the following scenario:

• A teenager uses a smartphone to order a new pair of Nike shoes. The shoes have a signature design endorsed by the teen’s favorite athlete and have multiple customization options in terms of mix-and-match colors and textures.

• Instead of going to Nike, the shoe order goes to a 3D-printing mega-facility joint-owned by the 3D manufacturer and Amazon. The shoes are printed on the spot, with custom specifications, and shipped within 48 hours. The facility is side-by-side with an Amazon distribution center, and the shoes are delivered by Amazon drone delivery.

• The shoes are priced at just $16. The cost of materials is $7; the cost of the manufacturing process is $2; the cost of physical delivery is $1. The remaining $6 goes to Nike.

The ability to buy a signature-endorsed, mix-and-match customized, high-tech pair of athletic shoes for just $16 sounds impossible by 20th century standards. But with 3D printing and automated delivery, that kind of price drop becomes not only viable, but likely.

Remember that 3D-printing mega-facilities could be producing hundreds of thousands of items per day, using a catalog of stored designs that draw on materials kept in bulk.

And if the delivery process is completed via drone or self-driving transport, the whole thing can be automated from start to finish. Human hands don’t have to be involved unless something goes wrong.

We know Amazon can do well in this scenario, but what about Nike?

It turns out the Nikes of the world could become even more profitable than before. Why? Because nearly all of Nike’s 20th century costs have been stripped out of the equation, leaving pure profit behind.

In the 20th century, running a global apparel company meant the actual creation of physical products.

The making and selling of physical apparel products (e.g., shoes) required factories in far-away countries; shipping and logistics supply chains; physical warehouses to hold inventory; last-mile delivery of product to physical retail stores; the need to resell excess inventories or take write downs on it; and so on. 

In the 3D-printing scenario we described, all of that goes away. Every single bit of it. Nike, as a global apparel company, has a business model that goes entirely digital and virtual.

In this 3D-printing world, Nike still designs shoe and apparel products, and runs brilliant and provocative marketing campaigns, and pays big endorsement dollars to top athletes to endorse the latest shoe or windbreaker or whatever it is.

But once the intellectual property, marketing, and branding aspects are complete, Nike’s role is done. It won’t have to deal with the logistical headaches of the physical world.

In our scenario, Nike collects $6 for every pair of shoes sold. That sounds like a small amount, but what was Nike’s total cost? Again, the factories are gone, the warehouses are gone, the ships and vans and trucks are all gone.

Nike’s cost footprint shrinks radically, even as the lower price point makes it easy to greatly expand the audience of people who can afford to buy Nike shoes. At $16 a pair, teens could have ten pairs of shoes if they wanted, or they could buy a new pair every month. Nike could roll out a shoe-of-the-month subscription model if it chose. And the profits would likely be greater than before. 

So far, so good. But now think about the industries that disappear, or shrink to almost nothing, in a world like this. While mass-scale 3D printing will be explosively profitable for globally dominant intellectual property owners — masters of design, marketing, and branding like Nike — for physically oriented production and logistics industries, it could be an extinction event.

In a world where the bulk of physical products are 3D printed, you don’t need factories in far-away countries. You don’t need giant container ships crisscrossing oceans. You don’t need dock workers. You don’t need truck drivers. You don’t need physical warehouses — on and on.

And this transformation won’t just happen with, say, shoes or apparel. It will happen with any product where 3D-printing economics can viably apply. That means we are talking about millions of products.

3D printing is interesting to think about because it represents one of the signature moves of the information age — taking the physical and making it virtual.

After all, what could be more physical than a pair of shoes you wear on your feet? And yet, from a business standpoint, the information age can make 90% of the shoe business virtual — right up to the point the shoes are 3D printed from a proprietary design kept on file.

This means more than just “creative destruction” as investors are used to hearing the term. For some companies and industries, it will mean stratospheric profits and expanding margins, as the value of intellectual property skyrockets and the cost of physical production falls toward zero.

Other entities and industries will be looking at a fate comparable to the fax machine or the classified ads business for local newspapers: Total oblivion.

Editor’s Note: As we finally enter 2021 — goodbye forever, 2020! —  the old Wall Street phrase “Don’t Fight the Fed” could be recast as “Don’t Fight the Fiscal.” With government spending set to dominate the investment look for years to come, the final installment of our “best of” series revisits the difference between monetary policy measures and fiscal ones. Happy New Year! –JCL

October 2020 was an ugly month for the U.S. stock market. The Dow Jones Industrial Average, S&P 500, and Nasdaq Composite all declined more than 2%, registering their second down month in a row.

Some will attribute this market weakness to pre-election jitters. In our view, it is more a reflection of post-election jitters — that is to say, what happens in the months after the election, rather than what happens with the election itself.

For the stock market, the immediately relevant question is not “Who is going to win the election?” but rather, “When will we get more fiscal stimulus?”

The real U.S. economy — meaning Main Street, rather than Wall Street — needs help from the government to keep consumers and small businesses from going under, particularly with COVID-19 cases topping 100,000 per day and the threat of new evictions and shutdowns looming.

Wall Street craves fiscal action too because, when the government injects currency into the real economy, a good portion of that money winds up flowing into stocks. This is what happened earlier this year, with financial surveys indicating that “buying stocks” was a popular use of the $1,200 stimulus check.

The market weakness of the past two months can be traced to uncertainty over a deal. For months now, Republicans and Democrats have been debating the terms of a new relief bill, and nothing has happened.

The president has also been all over the map on this issue, first tweeting a desire to cancel all stimulus negotiations until after the election, then hinting at terms for a partial deal, then saying he wanted a larger stimulus than the Democrats (which Senate majority leader Mitch McConnell certainly does not).

The bottom line is that, if another round of multi-trillion-dollar fiscal stimulus comes through before Christmas, the U.S. economy will get a boost and markets will be happy.

But if it looks like the fighting will persist, with nothing on the table until February 2021, the U.S. economy could convulse in fear as the pandemic worsens, and the stock market could see a sharp drop.

Struggling consumers and small businesses need more help to keep from going under, and tech stocks with wildly inflated multiples need another wave of stimulus-funded retail support to stay sky-high. In the absence of such help as provided by Congress, look out below. 

Given this state of affairs, it is worth discussing the crucial differences between monetary policy and fiscal policy. The two are very different, but many investors don’t know why or how. Let’s take a look.

The first thing to understand is that fiscal policy is far more powerful than monetary policy.

If monetary policy is like caffeine, then fiscal policy is a high-potency prescription drug.

A pot of coffee can help keep you awake, but if you are feeling incredibly tired, the coffee won’t help. Prescription drugs like amphetamines or methamphetamines, in contrast, can make you want to stay up for 72 hours straight, to paint your house, clean your basement, and organize the garage besides.

Monetary policy has a limited effect because it is wholly oriented to borrowing.

The interest rate at which one can borrow is like the price of money. When interest rates are high, the price of money is high (and borrowing is expensive). When interest rates are low, the price of money is low (and borrowing is cheap).

When a central bank uses monetary policy to boost the economy, they typically lower the short-term interest rate, which is like lowering the price of money. Cheaper money, in theory, makes it easier for consumers and businesses to borrow, which encourages lending and spending.

The problem is that, at a certain point, consumers and businesses lose their appetite for borrowing. In a deflationary environment, interest rates can fall to zero and yet the borrowing impulse is still weak.

When this happens, monetary policy is described as “pushing on a string,” because borrowing is made about as cheap as possible and yet nothing happens.

Another problem with monetary policy is that, as a general rule, it works through the banking system.

Most of the money and credit in circulation is not created by the central bank. It is created by the banking system itself.

When the central bank lowers interest rates, the idea is that consumers and businesses should go to the banks and borrow more, and the banks should lend willingly. This lending and spending then increases monetary velocity (the speed at which money changes hands) through the effects of fractional reserve banking and stepped-up consumer behavior.

But if the central bank lowers interest rates to zero, and engages in quantitative easing (QE) by purchasing hundreds of billions of dollars’ worth of assets, what is happening is that liquidity is piling up inside the banking system and isn’t getting lent or spent.

If, say, the banking system has a trillion dollars in liquidity just sitting in its vaults, stagnant, then that liquidity will not have an inflationary effect. This is why the dire predictions of inflation after the 2008 financial crisis were wrong: Most of the liquidity created by the Fed’s multi-trillion-dollar balance-sheet expansion stayed inside the banks. The funds didn’t venture out into the economy and speed the pace of borrowing and spending, so prices didn’t go up, and no inflation occurred.

The one place where inflation did occur after the 2008 financial crisis was in asset markets, and this is because a particular type of borrower benefited hugely from quantitative easing (QE).

While businesses in the real economy did not borrow much after 2008, blue chip corporations took advantage of near-zero interest rates to borrow money to buy back shares. So, QE was great for the stock market in the 2009-2019 period, but not for much else.

Here and now in 2020, monetary policy is believed to be maxed out in the sense that the Federal Reserve has done nearly all it can do.

There is only so much effort you can take to entice someone to borrow money, particularly if that person, or business, is already in debt.

Fiscal policy, however, is completely different, in ways that are much more powerful.

With fiscal policy, the government can simply hand out money, and let people spend it however they want. Alternatively, the government can use fiscal policy to buy things itself, injecting currency into the system through direct transactions with private-sector businesses.

Either way, the core of fiscal policy is not about lending or borrowing. It is about the “helicopter drop,” in the sense that the government goes out and drops money from helicopters on people.

With fiscal policy, there is an element of borrowing that takes place — but the debt is assumed by the government itself. So if, say, Congress decides to authorize $2 trillion in new pandemic relief, and then disperses that money to consumers and businesses, that is the U.S. government deciding to increase the national debt by $2 trillion for the sake of boosting the economy here and now.

When it comes to being a credible borrower, the U.S. government has powerful advantages.

• It is immortal, meaning the U.S. government does not have a lifespan and never retires.

• It is a military superpower (think aircraft carriers and control of two oceans), a technology superpower (Amazon, Apple, Google), an agricultural superpower (U.S. farm output), and an energy superpower (U.S. shale output).

• It has taxation rights, backed by the authorization of force, on U.S. economic output that represents about 24% of total world output.

• It maintains the world’s deepest and most liquid debt market (the U.S. government debt market).

• It issues the world’s reserve currency.

For all the above reasons, the U.S. government is the only entity in the world that could decide to borrow $2 trillion, based on an act of Congress, and more or less say “we’re good for it,” and have the world believe it (as evidenced by the U.S. bond market not collapsing).

This isn’t to say that emergency fiscal policy is always a good idea. It is only to point out that, when the U.S. government itself decides to pump currency into the economy by taking debt onto its own balance sheet, that is a very different proposition than asking consumers or businesses to borrow more, even at near-zero rates.

Just think about the difference between, say, a person or a business being offered a loan of $10,000 versus receiving an outright gift of $10,000.

With the loan offer, a decision has to be made by the borrower whether to take the loan or not, and that decision will hinge on factors like how much debt the person already has, and whether they have a responsible use for the funds that will result in the loan being paid back.

But if someone is given $10,000 in the form of a direct stimulus check, or unemployment top-ups, or small-business relief funds, there is no encumbrance. It is more like “here is some currency, go spend it however you want.” That money can then be spent on food or utilities or paying down other debts, or a down payment on a brand-new car, or even on near-dated call options on Tesla or Peloton or Netflix; there is no obligation to pay the money back, so the funds provided tend to slingshot back into the economy, or the stock market. 

The incredible potency of fiscal policy is the thing that gets proponents of Modern Monetary Theory (MMT) so excited.

If the government can borrow trillions upon trillions with no ill effects, the MMT theory goes, then why not target that spending in specific ways and put the money to good use?

We are probably going to test the limits of the MMT theory in the coming years. In a very real sense, we don’t have to wait for MMT to arrive — thanks to the pandemic, it showed up without anyone noticing.

In a meaningful sense, mega-powerful fiscal policy is, in fact, MMT in action. The main difference is that advocates of MMT want to use the government borrowing and spending bazooka on a regular basis, and not just in the depths of an economic emergency as created by a 100-year pandemic.

The dangers of out-of-control fiscal policy revolve around undesirable inflation and, ultimately, the destruction of the currency.

If a government borrows too much relative to its balance sheet, or prints too much currency relative to the size of its economy, the result can be inflation that gets out of control, or a debt market that threatens to collapse, or a glut of currency that causes its value to freefall (which then leads to devaluation-fueled price inflation).

In laying out the risks of overactive fiscal policy and MMT, we come full circle to the metaphor of caffeine versus a powerful prescription drug.

You can drink a lot of coffee, maybe even too much coffee, and you will probably still be OK, other than feeling jittery and nauseated. If you overdose on amphetamines, on the other hand, the side effects can hospitalize you or kill you.

Those who fear a full-on embrace of MMT-style thinking, in using the government’s deep pockets and vast balance sheet strength to prop up the economy with trillions, and then trillions more, are looking down the road at the prospect of 1970s-style inflation but far worse, or a dying currency, or both.

In the short run, though, the announcement of a new multi-trillion-dollar stimulus package would likely be seen as a good thing for both the U.S. economy and the stock market alike — because the market would first focus on consumers and businesses being saved here and now, rather than what comes later, and would also anticipate a direct refueling of retail investor buying-power.

Editor’s Note: Japan was the first rich industrial nation to experience a modern-day “Balance Sheet Recession” — the phenomenon where bloated private sector corporations focus on slimming down balance sheets, or buying back shares, rather than investing for future growth. In today’s “best of” installment, we explain how balance sheet recessions work — and look ahead to the inflationary endgame. –JCL

To understand the times we are in, it is helpful to know what a “Balance Sheet Recession” is, and why it is so hard to get out of one.

The Balance Sheet Recession — which can last for years, or even decades — is another crucial concept for investors to grasp, along with other concepts we’ve explained like financial repression, fiscal dominance, and the long-term debt cycle.

To recap those other terms very briefly:

• Financial repression is the process by which interest rates are kept artificially low, in order to inflate away the debt. In periods of financial repression, government bonds lose their value to inflation (which is part of the point). The Federal Reserve has committed to near-zero interest rates until 2023 — this is textbook financial repression.

• Fiscal dominance is an environment where the government is forced to spend in such large amounts, normal monetary policy is overwhelmed by the task of managing the flood of new currency and debt created by the government. With trillions in spending already on the books for 2020, and trillions more to come, we are in the early innings of a new fiscal dominance era.

• The long-term debt cycle is the natural ebb and flow of debt over a very long period of time. For multiple decades, debt, credit, and leverage are built up to ever higher levels. Once the debt load reaches its outer limit, the cycle reverses course. After that, multiple decades are spent either reducing the debt or inflating it away — and then the process starts again.

The term “Balance Sheet Recession” was introduced to the field of macroeconomics by Richard Koo, a Taiwanese-American economist, in 2003. Koo is the Chief Economist at the Nomura Research Institute in Japan.

In the early 2000s, Koo wanted to figure out the strange thing that had happened to Japan. After many years of research and contemplation of the data, the “Balance Sheet Recession” concept is what he came up with. He had to coin a new term because Japan’s post-1990 experience was new — the economics world had never seen anything like it before.

In the 1980s, Japan experienced one of the biggest equity market and real estate bubbles of all time. To give you an idea how big that bubble was, at one point the land under the Tokyo Imperial Palace — an area roughly one-quarter the size of San Francisco’s Golden Gate Park — was worth more than all the real estate in California.

In 1990, the Japan bubble burst in spectacular fashion. Thirty years later in 2020, the Nikkei 225 Index (Japan’s version of the S&P 500) is still 40% below its 1990 highs.

The Japanese economy struggled all throughout the 1990s. All attempts to revive the economy seemed to fail. And so, in 1999, the Bank of Japan (BOJ) took the wild step of introducing zero-interest-rate policy, or “ZIRP” for short. Then, in 2001, the BOJ introduced Quantitative Easing, or “QE.” 

Today the world is all too familiar with ZIRP and QE. But in the 1999-2001 period, these actions were bizarre and completely new. What would happen when interest rates went to zero? What would happen when the central bank started buying bonds en masse? Nobody knew.

As it turns out, nothing much happened at all. The introduction of ZIRP and QE did not revive Japan’s economy. If anything, it might have made things worse.

Koo wanted to figure out why. He asked himself, “How in the world can there be no economic growth when Japanese companies have the ability to borrow at 0% interest rates?”

What Koo realized is that corporate balance sheets were the problem. As a result of Japan’s great 1980 bubble, and the 1990s bust, Japanese corporations had a massive overhang of debt on their balance sheets. Because of that overhang, the Japanese private sector was focused on paying down the debt and didn’t want to borrow any more — even with interest rates at zero.

Think of a household, or a business, that still has money coming in the door, but also has a gigantic debt burden to deal with. Instead of investing the extra cash flow for growth, it is likely the cash will go toward paying down debt.

When the entire private sector of a nation’s economy is oriented to paying down debt — not in terms of every single company, but aggregate saving rather than spending on the whole — it becomes almost impossible to make the economy grow.

Koo coined the term “Balance Sheet Recession” to describe what happened to Japan. There was so much debt on the books, the private sector in aggregate did not want to borrow and spend for growth. They were too busy paying off the debt that already existed.

As a result of that condition, Japan’s economy got stuck in the mud. When the BOJ tried to get things going by implementing ZIRP and then QE, nothing happened — because ZIRP and QE were not helpful in solving the Balance Sheet Recession problem. 

Unlike normal recessions, which typically come and go in the course of a year or two, Balance Sheet Recessions can go on and on, sometimes lasting for decades. They can last for as long as it takes the private sector to work off a large overhang of debt, as such that companies on the whole start borrowing and spending for growth again.

To be clear, there will always be a handful of companies borrowing and spending for growth at any given time. But macroeconomics deals with whole-economy impacts, which are determined by the net effect of what all the companies are doing as a group.

If a few companies are borrowing and spending, but the vast majority of companies are hunkered down, the net result is that the economy shrinks or flatlines rather than grows. That is what happened to Japan. It is a Balance Sheet Recession because debt-burdened balance sheets are the problem: That debt has to be worked off or dealt with.

For a number of years, the Balance Sheet Recession was a Japan-only phenomenon. There wasn’t any academic literature on the subject, because the phenomenon was too new and isolated.

As Koo pointed out, no economist was taught this stuff in their university courses, because nobody had ever seen interest rates at zero, and companies refused to borrow at rates near zero, prior to Japan’s introduction of ZIRP and QE.

After the 2008 global financial crisis, the United States and Europe entered Balance Sheet Recessions, too. While some U.S. companies continued to borrow — like publicly traded blue chips using cheap funding to buy back shares — the private sector on the whole saw its net borrowing levels shrink.

The chart below, from TradingEconomics.com, shows U.S. private sector debt to GDP dating back to 1995. As you can see from the chart, aggregate debt levels rose almost every year from the mid-1990s onward. Then, in the 2007-2009 period — when the global financial crisis unfolded — the lever was thrown into reverse.

The Balance Sheet Recession phenomenon is also worse than it appears, because so much of the borrowing done post-2009 was done for the purpose of share buybacks.

When companies borrow money to buy back shares, they artificially increase their earnings per share estimates (so the same amount of earnings is spread over a smaller number of shares). This helps the stock price go up, but it doesn’t actually increase profits, or employ more workers, or result in a positive economic impact.

The chart below, via the St. Louis Federal Reserve, shows U.S. corporate profits after tax, on a quarterly reporting basis, since 1999. As you can see from the chart, corporate profit growth saw an impressive rebound after the global financial crisis, but then started to flatline around 2012 or so. 

The years of sideways profit growth that occurred from 2012 onward are consistent with a Balance Sheet Recession. Stock prices were going up at this time, and companies were borrowing somewhat, but again, a lot of that was financial engineering — using share buybacks to juice corporate earnings.

For the U.S. to get out of its Balance Sheet Recession — and Europe, too, for that matter — the private sector will have to dig out from under the load of debt that still weighs heavily on its balance sheets.

And remember, we aren’t talking about the cash-rich tech juggernauts here, or the handful of S&P 500 companies that are making money hand over fist. We are talking about the private sector on the whole, which includes millions of struggling small businesses. (Small- and medium-sized businesses, not giant corporations, are historically the engine of job growth in the United States.)

So what about all of that zero interest rate policy (ZIRP) and quantitative easing (QE) that the Federal Reserve, European Central Bank (ECB), and Bank of England (BOE) engaged in for years, following Japan’s lead after 2008? Did QE and ZIRP help the situation any?

Unfortunately, no. According to Koo — and we agree with this — QE and ZIRP probably made the situation worse. This also goes for Europe, where they actually tried negative interest rates — an absolutely terrible idea, because it destroys the outlook for banks while doing nothing to solve the problem (too much private sector debt).

There are multiple reasons for this apart from the big one that, in a Balance Sheet Recession, trying to force-feed loans to the private sector at 0% interest rates doesn’t work. If there is no net appetite for borrowing, apart from blue-chip companies buying back shares, monetary policy doesn’t help.

The real problem with QE, though, is what happens when the Balance Sheet Recession finally ends. After years and years of Quantitative Easing, trillions of dollars’ worth of reserves have built up in the banking system, and also on central bank balance sheets.

All of those trillions are not a problem as long as the private sector is comatose. When nobody wants to borrow, trillions in excess reserves are like underground pools of water, or perhaps like wet gunpowder. They don’t circulate through the economy, and they don’t ignite inflation.

But at some point, when the private sector wakes up again and returns to aggregate borrowing, the situation changes dramatically. At that point, you get competitive demand for investor funds drawing down on trillions’ worth of reserves — which can lead to explosive inflation.

The net result of this, as Koo explains, is that getting out of the “QE trap” becomes an even bigger problem than beating the Balance Sheet Recession.

If the government implements enough fiscal spending to reignite the economy, as such that corporations want to start borrowing and spending for growth again, they simultaneously wind up activating the trillions of dollars in liquidity reserves that were previously stagnant, having built up via years and years of QE.

That, in turn, creates a threat of explosive inflation — which is also a threat via concerns of currency debasement — which then in turn forces the central bank to raise interest rates in order to head off inflation risks.

But of course, the central bank can’t raise inflation rates too quickly when the economic recovery is vulnerable — because if they try, the markets will crash and the economy will slip back into downturn or recession status.

In 2014 the Federal Reserve tried to “normalize” interest rates, the markets fell sharply, and they had to back off. In December 2018, the Federal Reserve under Jerome Powell tried again, with the same result: They tried to normalize monetary policy (take things back to normal), the markets freaked out, and they had to back off. Okay, so how do we get out of the Balance Sheet Recession and the QE trap associated with it? The short answer is, we don’t really know and neither does anyone else — this is another one of those brand-new things, nobody has ever tried to exit a ZIRP and QE regime — but we wouldn’t be surprised to see gold in the $10,000 per ounce range and Bitcoin well into six figures, many years from now, by the time all is said and done.

Editor’s Note: When a mountain of debt builds up over the course of many decades — as we have seen over the past 40 years or so — you wind up with huge amounts of government spending to keep economies going, even as central banks conspire to inflate the debt away. In today’s “best of” series, we cover two must-know terms — financial repression and fiscal dominance — that explain how it works. –JCL 

There are two financial terms that explain what is happening right now. Most investors don’t know these terms, but they are common knowledge among central bankers.

The Bank of International Settlements, also known as “the central bank for central banks,” has even published white papers discussing them.

The terms are “Financial Repression” and “Fiscal Dominance.”

Financial Repression is about what the Federal Reserve is doing now.

Fiscal Dominance, meanwhile, covers the factors that force the Fed to engage in Financial Repression in the first place.

To begin, the term “Financial Repression” was coined by two Stanford economists, Edward Shaw and Ronald McKinnon, in 1973.

Back in the early 1970s, Shaw and McKinnon were describing the behavior patterns of dysfunctional emerging markets. They likely had no idea financial repression would one day dominate the West.

Financial repression is a term for policies that create deliberately low interest rates, and, in particular, low nominal rates that fall below the cost of inflation.

To put it another way, financial repression is a policy of deliberately making real yields negative. When real yields are negative, meaning the nominal yield is less than the cost of inflation, that state of affairs does multiple things.  

First, financial repression incentivizes savers to buy risky assets with their cash. When the value of cash is falling, it makes sense to get rid of cash and buy paper assets (like stocks) instead.

Second, financial repression makes it easier for public and private entities to keep on borrowing money at artificially low rates. In the midst of the pandemic, U.S. corporations have gone on another wild debt bender. Their ability to do this was enabled by financial repression, that is to say, the Fed keeping interest rates low while backstopping credit markets, and even promising to buy corporate debt.

Third, financial repression is a means of inflating away the value of outstanding debt.

When interest rates are below the cost of inflation, and the central bank keeps them there, government debt is gradually losing value in real terms. That is the outcome the central bank wants to generate. A lighter debt load, in real terms, means less of a weight on future growth prospects.

The second term, Fiscal Dominance, describes the backdrop that leads to Financial Repression.

Fiscal dominance occurs when fiscal policy — the borrowing and spending habits of a sovereign government — gets so out of control that fiscal policy “dominates” monetary policy.

When this happens, the central bank has to devote its effort to managing the government debt burden, and helping to finance new government purchases, rather than its normal mandate of fighting inflation and keeping prices stable.

Here is the Cato Institute describing how fiscal dominance led to hyperinflation in various Latin American countries:

Most populist experiences in Latin America, including the best-known ones — Peru (1985–90), Argentina (2003–17), and Venezuela (2002–present) — have been characterized by “fiscal dominance.”

Monetary policy is dominated by fiscal policy, and the central bank finances (very) large increases in public expenditures. The central bank purchases national and subnational debt (municipalities and provinces) and provides loans to state‐​owned enterprises.

In this way, it finances large transfers to the lower and middle classes, provides funds to huge public investment projects, and helps pay for the nationalization of large firms.

Fiscal dominance has been behind the explosion of inflation in the vast majority of Latin American populist episodes. Peru under President Alan García ended up with hyperinflation of 7,000% in 1990, and Venezuela is on its way to 1,000,000%.

Argentina under the Kirchners avoided hyperinflation, but in 2016, the last full year of President Cristina Fernández de Kirchner in office, the consumer price index increased at an annual rate of 41%.

What the Cato Institute describes above is more or less where the United States is headed. And between the two terms, financial repression and fiscal dominance, we have a reasonably full picture of what the Federal Reserve is doing and why.

Via financial repression, they are keeping interest rates low (and real yields negative) to force savers into risky assets, make it easy for entities to borrow, and inflate away the value of the debt. And via fiscal dominance, the Federal Reserve is paving the way for ever greater expenditures on the government side, as the central bank monetizes newly issued debt by adding it to its balance sheet.

Meanwhile the near-vertical recent upward movement in the gold price, the silver price, and the Bitcoin price is a recognition of this phenomenon, and a reflection of growing awareness on the part of investors.

It looks like financial repression and fiscal dominance will stick around for years, as the balance sheet numbers grow larger. Barring some miracle of super-productive real economic growth, there is no way off this path.

Editor’s Note: When we explained the concept of money earlier this year, we immediately received a thoughtful follow-up question on inflation. That inquiry led to the next “best of” piece in our lookback series, “Where does inflation come from?” The short answer is that inflation is an emergent property, born of a complex adaptive system. For the longer answer, read on. –JCL

A reader asked a great question about inflation. Here it is, slightly edited for clarity:

Your article, Money is a Social Protocol, Built on a Network, Enabled by Technology, is one of my favorites. It describes the actual essence of money, and instead of employing empty phrases like, “Money is a medium of exchange,” which is true, but is obvious and not instructive.

Rather, your article discusses what money actually is to real people in real social networks in the real world and it is profound.

Alas, then you say:

“A currency can also be degraded by way of hidden inflation, which happens when an increased supply of currency enters the network.

“If the general supply of money increases, and the money is being lent and spent (as opposed to just sitting in bank vaults), prices can seem to rise mysteriously with no one able to pinpoint why. The hidden reason is because a greater volume of currency is chasing a relatively smaller volume of goods and services, causing prices to naturally rise.”

Who actually sees that the money supply is rising relative to goods and services? Who decides to raise prices as a result? If Mr. Mysterious didn’t raise prices, everyone, including him, could buy more and have more stuff since there is more money to go around.

Please consider publishing another article laying out exactly how inflation happens, who does it, why they do it, what is their benefit for doing it, how they sneakily do it, and why does no one stop them?

I know I am missing something but have no idea what it is.

Thanks, and keep up the super writing.

Thanks so much for the kind words! As a reminder to all readers, if you have a question, or a comment, or find yourself curious about something, feel free to write in via [email protected].

When we say inflation can be mysterious, we don’t mean it’s a literal mystery. Rather, when inflation gets going, there isn’t any single cause to point to, and thus no simple way to control it or identify the source. This can be especially true with monetary inflation, where the public may not be aware the supply of money and credit is increasing.

To understand inflation, it helps to understand complexity, because inflation is an emergent property generated by a complex adaptive system.

A complex system is a thing with multiple components, where the components interact with each other in unpredictable ways.

For instance, a tropical storm that turns into a hurricane is an example of a complex system.

We can understand the science of hurricanes, but we can’t predict their formation in real time, because there are too many variables interacting within the weather pattern as it happens.

That is what it means for a system to be complex, rather than complicated.

A complicated system may have lots of moving parts, but straightforward transmission mechanisms. You can reverse engineer the linkages of a complicated system. With a complex system, everything tends to affect everything, making the linkage pathways hard or impossible to determine.

A complex system that is also adaptive — making it a complex adaptive system — adds another layer of mystery to the mix.

A complex adaptive system will actively respond to feedback, and behaves differently in different environments, and may even react to its own reactions and respond to its own responses.

Complex adaptive systems can create positive feedback loops, where a trend becomes self-reinforcing, causing the trend to feed on itself and grow more powerful over time

For example, think of what happens in the midst of a financial crisis: People get scared and withdraw assets from banks. The banks say reassuring things, but their reassurance that “everything is fine” only frightens people more. The fear feeds on itself, causing asset reserves to shrink as larger quantities of assets are withdrawn, until the banks face a liquidity crisis, on their way to a solvency crisis.

At this point, the government is forced to announce some kind of intervention. If financial contagion occurs, the fear leaps from country to country and goes international.

Resonating feedback loops in complex adaptive systems are the means by which all manner of extreme events can happen, from market crashes, to world wars, to the rise of dangerous mass movements.

For more on this topic, an excellent book to read is Ubiquity: Why Catastrophes Happen, by Mark Buchanan.

If you want to better understand the science of how markets behave under stress — and why extreme events happen far more often than one might expect, and why “fat tail” phenomena appear to be everywhere — you will love it.

As mentioned earlier, inflation can feel mysterious in regard to its origins because inflation is an emergent property, born of a complex adaptive system. Under the right circumstances, it can seem to appear out of nowhere.

An emergent property is a phenomenon that seems to have no source — because it emerges from an interplay of behaviors within a system.

We can find emergent phenomena in all kinds of places. Consider birds and termites, for example.

When geese migrate, they fly in a highly aerodynamic V-shape that helps conserve energy and reduce wind drag. The lead goose experiences the greatest wind drag, but then drops back in a rotation from time to time, so a fresh goose can take the lead.

This V formation is a super-efficient way to go, but there is no plan to create it, and no deliberate coordination among the geese. The V simply emerges as a natural behavioral outcome, based on the instinctive programmed behavior of each individual goose.

In 1986, a computer graphics expert named Craig Reynolds designed an artificial life program called “Boids,” meant to simulate the flocking behavior of birds.

With the Boids program, Reynolds demonstrated that, if you programmed a few simple rules into each boid — which was really just a blob of pixels guided by a few lines of code — and then ran the program with the boids placed close together, they would flock just like birds do.

With the Boids program, simple rules begat complex group behaviors that were not found in the code. That is what it means for an outcome to be emergent.

Or think of giant termite mounds, which can sometimes last for thousands of years, and which occasionally look like elaborate alien cathedrals with tall gothic spires.

There is no such thing as a termite architect, and the towering spires of these mounds are not planned. Rather, a simple set of building behaviors programmed into each individual termite — under circumstance X, do Y — leads to the emergence of the spires.

Emergence is a constant theme in nature. It is also present in human organizations. For instance, where does company culture come from? A leader might set the tone, but in truth the culture sort of bubbles up, a resulting mix of collective behaviors and beliefs.

Market prices can also be emergent. Who sets the closing value of the S&P 500 each day? In a certain sense, nobody does. In another sense, everybody does. Price discovery is emergent, born of countless buy-and-sell decisions.

Inflation, too, is an emergent property because, when it happens, nobody controls it or directs it from the top down. It emerges as a bottom-up response.

Consider the phenomenon of McDonald’s drive-through workers in North Dakota getting paid $20 an hour — a substantial episode of wage inflation — during the Bakken shale boom. How did this happen?

When the Bakken shale boom took off, western North Dakota suddenly found itself bustling with shale workers. These workers needed places to eat, along with all kinds of other accommodations — housing, medical and dental services, entertainment, places to buy consumer staples, and so on.

The explosion of economic activity from the Bakken shale boom thus created a job shortage, because all kinds of local jobs were needed to support the expansion of the local economy spurred by an influx of shale workers.

All of this activity in a once-sleepy place meant that workers were hard to find, which in turn meant wages started to rise in order to attract scarce labor.

This, in turn, meant McDonald’s couldn’t find workers at its normal wage — so it ultimately raised the wage for drive-through workers to $20 an hour.

Because inflation is an emergent property, it can, and does, bubble up from the micro behaviors of a great many individuals. This is how asset bubbles happen, too.

As a general rule, nobody sets out to deliberately create an asset bubble. Instead, many different entities, acting in response to their own local circumstances, can collectively drive prices up with nobody orchestrating the change.

Like the termite colony or the V-shaped flock, there isn’t any top-down decision maker. It just happens.

This is especially true when the supply of money and credit is artificially increased.

With money and credit levels rising, consumers may be willing to spend more — simply because more currency is locally available to spend — which increases the aggregate level of demand.

Providers of goods and services then notice that demand is rising, so they decide to raise prices a bit. Meanwhile, thanks to an increase in credit, it is easier to get consumer loans and business loans, so businesses go into expansion mode, which results in more hiring, or higher wages in worker’s pockets. This increases the propensity to buy stuff, which increases demand relative to supply, which causes prices to rise yet again.

That whole chain of events can happen through an uptick in the supply of money and credit, even if nobody knows the supply of money and credit has increased.

This is because each individual actor in the system is responding to their own individual setup. They as an individual have a little bit more money, so they buy a bit more. Or they as a business are seeing healthy demand, so they raise prices a bit. Decisions are narrow and local. The overall inflation result is emergent.

Because inflation is an emergent property, and because an increase in the supply of money and credit can create inflation all by itself, the resulting implications can be strange.

For example, there is a strong argument that the Spanish housing bubble of the mid-2000s was largely created by German banks. The Spanish housing bubble was ultimately not so much about the choices of the locals, as the decisions of bankers in a different country.

How did German banks fuel a Spanish housing bubble? By pumping Spain’s financial system full of low-cost capital, which in turn fueled a mortgage boom and a real estate development boom, which then created a feedback loop which fed a housing bubble.

Germany is a surplus country, meaning Germany as a country tends to export more than it imports, creating a surplus of export profits taken in from abroad.

Meanwhile, instead of circulating these profits back into the German economy, in the mid-2000s the profits mostly piled up in low-activity corporate bank accounts.

The German banks, meanwhile, were scratching their heads as to how to be more profitable, with lending activity in the German economy relatively quiet.

The German banks then realized they could lend out their excess capital to Spain, where the economy was hotter and money was moving around. The extra capital that flowed into Spain from Germany then turned an active Spanish housing market into a full-on bubble, through a feedback loop of cheap loans and rising construction.

At no point was there a top-down figure in Germany who told the banks, “start pouring your money into Spain,” just as over in Spain, no individual home buyer or builder decided to willingly participate in a housing bubble.

All of the participants, in Germany and Spain alike, were acting in their own narrow interest, based on the set of circumstances directly in front of them.

The asset inflation that drove a bubble just sort of bubbled up, no pun intended, as a form of emergent behavior born of the interacting parts of a complex adaptive system.

A key point here is that nobody really controls a complex adaptive system.

With a large and powerful complex adaptive system — and markets represent one of the largest interlinked series of complex adaptive systems in the world — all you can do is try to influence the system, sort of tinker with the inputs and see what happens.

This also explains why a highly successful economic region, like Silicon Valley, can’t simply be replicated or copied.

Silicon Valley is a complex adaptive system with feeder inputs going back decades. Even if someone knew the exact recipe for creating Silicon Valley 2.0, they could never assemble the same ingredients.

Getting back to inflation, there are many different kinds of inflation. There is monetary inflation, asset inflation, wage inflation, and cost-push and demand-pull inflation, and so on.

Just to make things fun, there are also different varieties of deflation, and even disinflation (when inflation is still present, but the inflation rate is falling).

The mix of inflation types is diverse because a complex adaptive system can have dozens, hundreds, or even thousands of emergent outputs, all at the same time.

Inflation is also hard to pin down to the degree it is driven by expectations. Human behavior is especially tricky to model because behavior patterns can bridge the gap between perception and reality.

For instance, if enough people within a monetary system believe monetary inflation is real, their belief alone can make it a self-fulfilling prophecy by way of emergent behavior, in the same manner that fear of a banking crisis can turn into a real banking crisis.

Imagine that Alice is worried about inflation, so she sells the bonds in her portfolio and buys gold and Bitcoin instead. Bob thinks Alice is smart, so he follows her lead and does the same thing.

Craig, who is friends with Alice and Bob, thinks inflation is coming, too — and because Craig is a business owner, he decides to buy a bunch of inventory early, before prices go up.

Doug, the supplier who sells to Craig, sees demand going up from customers like Craig, so he raises prices. Alice notices the price hike from Doug, thinks “Ah-ha, I was right!” and starts converting her incoming dollars into gold and Bitcoin at an even faster rate.

Now multiply individual actions like the ones described above across the collective behavior patterns of tens of millions of people.

Then imagine the data starts to show signs of monetary inflation — asset prices up, currency values down, various other prices rising — and more people start to notice the inflation trend and talk about it, and the feedback loop gets stronger, and starts to reinforce itself.

And if, meanwhile, the supply of money and credit is steadily increasing — because, say, the government is spraying money around in the midst of a pandemic, and the central bank is buying junk bonds — excess currency may keep getting swapped out for assets, as savers and investors buy whatever they can for the sake of ditching the currency. This reinforces the feedback loop, and you wind up where we are now.

In some ways it’s all a giant game, like Hot Potato or Musical Chairs. But this game is for adults instead of kids, with real financial consequences on the line — and sometimes with war or hyperinflation or economic depression as a dystopian grand finale.

If you really understand the game — and few do, because complex adaptive systems are so tricky — you can use that knowledge, combined with vigilant observation of the system, to determine which assets to buy, and the right time to buy them, and in so doing turn knowledge into profit.

Editor’s Note: What is money exactly? In today’s “best of review,” we answer that question by explaining that money is a social protocol, built on a network, and enabled by technology. Ah, but what does that mean? Read on and we’ll explain, hopefully giving you a clearer sense of what the abstract notion of “money” really means. –JCL

Money is a social protocol, built on a network, with technology enabling the network. This goes for all forms of money, even gold. It also applies to all pre-metallic forms of money, and all manner of monetary objects that have existed through the ages. 

The concept of money as a networked social protocol is inherently a strange thing. This helps explain why so many people have such a hard time understanding money, in terms of what it really is and how it actually works.

We can demonstrate that money is a social protocol via thought experiments involving gold.

First, imagine an alternate version of reality where nobody had ever heard of gold — where it had never established a global reputation as a store of value and as something to be hoarded and treasured.

If you were transported to this alternate reality — and able to take a chest full of gold with you — the gold would essentially be worthless.

It might have value as a metallic commodity — you could make jewelry out of it — but the value of the gold would not be recognized, because in this alternate world gold has no reputation preceding it. Nobody knows why they are supposed to believe in gold — and so they don’t.

As such, you couldn’t trade the gold for high-value items. You would just be the stranger with a chest full of weird metal.

Then, too, think about how much gold would be worth in a world with no people, or no goods and services to buy. If you had a warehouse full of gold, but nobody to transact with, the gold would similarly be worthless in functional terms.

The thing that gives gold value, even to this day, is the social protocol. Thousands of years ago, the favorable aspects of gold were recognized as a medium of exchange: Doesn’t rust; portable, divisible; scarce within the earth’s crust; and so on.

But those favorable aspects required a sort of long-game, word-of-mouth marketing campaign to impart value to gold on a day-to-day basis.

In order for an ancient spice merchant to take gold as a form of payment, he would need to be socially connected with respect to gold’s inherent message. At some point, the merchant would need to have “heard the word” about gold. Just as importantly, the merchant would need to be confident he can pass the gold on, if need be, to someone else who has heard the word, too.

We take this for granted, but the social aspect is critical. How do you know gold is valuable? Because, at some point along the line, someone told you so. And you decided to believe it.

As another thought experiment, imagine an explorer coming across a technologically advanced Mayan city-state where, by order of the emperor, only silver is acceptable as money, and the use of gold as money is considered blasphemy.

Within that realm, how much would the gold coins in an explorer’s knapsack be worth? Zero, or possibly less than zero — trying to use them might get the explorer killed.

Money is a medium of exchange. The “exchange” part means making useful trades with other people. To do that, a useful form of money needs social buy-in along the lines of “yes, this medium of exchange is worth something.”

When you expand this social buy-in concept across a meaningful number of people, you get a network.

Let’s say an ancient village of 100 people decides to use cattle as money. (This was a regular thing at one time, thousands of years before the first metallic coins were minted.)

With 100 people, you’ve got a small-but-decent network. As such, within the 100-person village community, live cattle could be used as a medium of exchange for meat, grain, tools, weapons, clothing, herbal medicines, and whatever else circulates in terms of local commerce.

If the network then expands to 1,000 people, or 100,000 people, the value of money at the heart of that network rises substantially, by way of a far larger volume of goods and services available (likely with far more choices to boot).

This highlights another interesting thing about the network.

The value of money is not just tied to the size of the social network that accepts said money as a medium of exchange, but also to the available goods and services produced by that network.

Now we are getting closer to modern-day arrangements. A national currency, in a sense, is like a social network for a country. It has value because everyone accepts it as a medium of exchange.

At the same time, the productive output range and technological sophistication of a country — the range and diversity and inherent value of goods and services produced — will help determine the value of the money associated with that network.

So, we’ve hopefully established that money is a social protocol built on a network.

The social part comes from people knowing about the money (medium of exchange), and accepting it, and agreeing to assign value to it.

The network part comes from the fact that, the more individuals and entities who are part of a network, the more useful the network becomes, with money the means of participating.

Technology comes into play in terms of security and accessibility. Before a form of money is accepted and used widely, it has to feel safe. That means making the network secure.

Then, too, you have the accessibility factor. This is also a function of the network — determining how easy the network is to use, and who gets access to it. 

At this point, we can go ahead and assert that money has value, even though money is still an abstract concept at the end of the day — a social protocol built on a network, with technology making the network secure and accessible.

But where does money’s value come from? It comes from the implied value of what you can buy within the network.

If you have, say, a pile of dollars in a country that doesn’t accept dollars, the dollars are useless for that particular time and place. When your dollars are outside the boundaries of the U.S. dollar network, they cannot be exchanged for anything valuable (because no one will take them).

But with a pile of dollars in the United States, you can buy a nearly infinite range of things, from goods and services and experiences to stocks and bonds and real estate. Within the dollar network, the dollars have value precisely because you can readily convert them into attractive things that you want.

Outside the United States, meanwhile, dollars have value for the same reason.

The U.S. dollar as a world reserve currency is another form of widely accepted social protocol, with a network that blankets the planet, and security and access to technology that includes everything from international bank accounts to aircraft carriers.

Meanwhile the reason why fiat currencies can lose value, and sometimes do so quite suddenly, is because faith in the social protocol takes a hit.

If a central bank is seen as rapidly expanding the currency supply, or a government is seen as issuing prodigious amounts of debt — or both at the same time — the value of the social network can become psychologically degraded, with holders of dollar-denominated assets feeling less marginally inclined to hold assets priced in that currency.

A currency can also be degraded by way of hidden inflation, which happens when an increased supply of currency enters the network.

If the general supply of money increases, and the money is being lent and spent (as opposed to just sitting in bank vaults), prices can seem to rise mysteriously with no one able to pinpoint why. The hidden reason is because a greater volume of currency is chasing a relatively smaller volume of goods and services, causing prices to naturally rise.

These monetary basics can further help explain why Bitcoin is so powerful. Given the criteria as described, Bitcoin has all the hallmarks of sovereign global money.

We’ve established that money is a social protocol. People have to know about it, have heard about it, and agree it has worth in order to be useful. Bitcoin has that unquestionably. 

We’ve established that money, as a social protocol, is built on a technology-enabled network. Bitcoin has that, too.

The Bitcoin network encompasses people and technology, with neither more important than the other. Technology enables the safety and security of the Bitcoin network, while people strengthen the network through active use and ongoing development (adding payment rails, improving security and accessibility, and so on).

In the final twist, the value of Bitcoin keeps increasing as the network expands, because greater adoption means a wider array of goods and services that can technically be purchased with it.

Nor do these purchases have to be a one-to-one exchange — it is more about general accessibility on a worldwide basis.

If you wanted to pay in Bitcoin to purchase a Swiss chalet, for example, and the chalet owner wanted Swiss francs, all you would have to do is exchange Bitcoin for Swiss francs at the point of sale.

The key idea is that the Bitcoin network is robust enough and liquid enough that, if you want a Swiss chalet priced in Swiss francs, there is someone out there happy to trade Swiss francs for Bitcoin on any given day, allowing you to then make the purchase.

Some like to say the value of money is an illusion, that money is not inherently worth anything. This is somewhat true, in a technically correct sense, and yet categorically false at the same time.

The value of money, in a real and tangible way, can be extrapolated from the scope and depth and security of the technology-enabled network that turns a medium of exchange into a social protocol. Fluctuations in the price of money, meanwhile, are tied to units of currency supply relative to the supply of goods and services within the given network.

And by that simple standard, Bitcoin is deeply and inherently valuable at this point. It just is.

The technology-enabled network that supports Bitcoin as a social protocol — which consists of not just hardware and software but people — cannot be replicated or counterfeited.

And as more individuals and institutions opt into the Bitcoin network, and more layers of security and accessibility are added, along with greater levels of recognition worldwide, the Bitcoin value proposition only grows stronger with each passing day. 

Editor’s Note: For Christmas day, a Christmas riddle: When does a weak hand beat a strong one? In today’s “best of” lookback, we compare investing to high stakes poker — two activities with a great deal of overlap — and explain why it is often the surrounding situation that matters most, with the shape of events sometimes making the weaker hand (or weaker company) the better play. –JCL

Say you have an investment choice between two gold mining companies. They are similar except for a single variable, the average production cost per ounce.

One miner produces gold at an average production cost of $900 per ounce; the other does so at $1,800 per ounce. Which miner is the better investment, in terms of 12-month price appreciation?

It’s actually a trick question. The answer depends on the price of gold, the price-action history for both companies, and what is happening in the precious metals investment cycle.

Say, for example, that gold is at $2,000 and on the way to $2,400 at the time of making the choice.

In a gold price transition from $2,000 to $2,400, the profit margin per ounce for the low-cost miner will increase by roughly 36%. At the same time, the profit margin for the high-cost miner will increase by 200%.

By the time gold is at $2,000 per ounce, the price of the low-cost miner will have already risen a significant amount. Between $2,000 and $2,400, the low-cost miner’s share price could comfortably rise by another 30 to 40% in proportion to its further profit margin expansion.

Whereas the high-cost miner, which had been underwater until the gold price crossed the $1,800 per ounce threshold, could see its profit margins triple between $2,000 and $2,400 — and see its share price double in that time frame.

The interesting takeaway is that, at a certain point in the cycle, gold miners with strong fundamentals could have a modest amount of share price upside left — because they have already gone up a lot — whereas gold miners with weaker fundamentals could have far more upside left, on the order of 400% more, because their margin expansion doesn’t kick into gear until gold breaks a late ceiling.

And so, in terms of the question, “Is it better to invest in a low-cost miner ($900 per ounce) or a high-cost one ($1,800 per ounce),” the answer is dependent on price-action history (which has already gone up, and which has not moved as much yet) along with the journey of the gold price itself, and the overall state of the precious metals cycle.

To put it broadly, what matters here is situational analysis and not fundamentals alone.

Poker players are well familiar with the situational analysis concept. The fundamentals of an individual company are like the strength of the players’ hole cards in a poker hand (the two cards the player is dealt before the flop) in Texas Hold ’Em.

The key thing is that no poker hand is ever played in a vacuum. The cards in one hand are only the start. There is always a surrounding situation, and sometimes the total situational impact makes a weaker hand better than a strong one.

For example, say you are playing deep stack No Limit Hold ’Em, and you are involved in a hand with four other people before the flop is dealt. Which would you rather have in that situation: Pocket kings first to act, or nine-ten suited last to act?

In this situation, nine-ten suited last to act is the more desirable holding, by far, because of the circumstances and the positioning in the hand.

In many cases, the pocket kings will be beaten by a concealed drawing hand, but the player holding the kings will have a hard time throwing them away (because the kings look so attractive). The player holding kings will also be “flying blind” to the extent they are first to act (with four other players acting behind the first player with each new card that is dealt).

At the same time, nine-ten suited last to act will be easy to throw away in most circumstances — and will completely miss most flops — but could turn into a hugely profitable hand with the right board flop (e.g., a board that delivers two pair, or a combination flush draw and open-ended straight draw).

At the same time, because the nine-ten suited hand is last to act — a key part of the situation as we described it — the player will have maximum information at each decision point. They will be able to see how all four opponents behave, and what their decisions are, before making their own decision in each round.

This makes nine-ten suited a better hand than pocket kings in the situation described, because it will be far less prone to unwieldy large losses — if the hand does not connect, it is thrown away — whereas if the hand catches the right card combination, it can generate a very large return (by winning a giant pot with a straight or flush, or bluffing opponents out on the strength of a strong draw).

The applicable poker lesson, related to investing, is once again the value of situational analysis: Look at the total picture, rather than just the cards alone (or the fundamentals of the company alone).

The fundamentals of an individual publicly traded company, when considered for investment, are like the strength of the cards one holds in a Texas Hold ’Em hand before the flop. The cards are never played in a vacuum; there is always a situational context. It is the same with investment opportunities.

Situational analysis also helps explain why it is dangerous to weigh the fundamentals of a company above and beyond anything else. In poker, this is known as playing your cards but not the table, or playing your hand but not your opponents. It is not the way to go.

If consumers are wildly enthusiastic about a product, for example, but wild enthusiasm is already factored into the share-price valuation, there is no edge to be found by investing on the basis of consumer sentiment.

This is one of the deep problems with, say, the narrow view of company fundamentals pushed by a majority of Wall Street analysts. It is never the company story in a vacuum that matters, because nobody ever invests in a vacuum. It is always the story in relation to situational context at a given point in time.

To what extent does the company’s valuation already reflect excitement for the product? To what extent have likely investors in this company already bought? What catalyst exists that could change the picture in a manner that is not priced in? These are crucial questions to ask.

For example, as shown with our gold miner example earlier, the lower-cost miner might be a better company in absolute terms, or at an early point in the cycle, but a higher-cost miner could be a far better investment, in terms of 12-month price appreciation, later in the cycle.

In the end, it makes perfect sense that weak fundamentals are sometimes better than strong ones, just as a weak poker hand is better than a strong one, because fundamentals and situational context matter together, side by side. It is never just one or the other. It is always the net combination of both.

Sometimes situational context subtracts from the value of an intrinsically stronger hand — as with pocket kings in a lousy situation — while adding to the value of an intrinsically weaker hand, as with nine-ten suited in a fantastic situation. The pathway to maximizing reward versus risk thus with understanding the bigger picture.

It is true that most investors are not well-versed in taking in the bigger picture, which is exactly what situational analysis requires.

This is probably related to the reasons why new poker players are not good at looking beyond the hole cards in their hand, and considering situational factors like the nature of their opponents, their positioning in the hand, and the relative size of chip stacks on the table.

Editor’s Note: In today’s “best of” lookback, we revisit why Bitcoin, as a digital store of value, has no need for aircraft carriers. Up until 10 years ago or so, sovereign currencies were associated with governments that had assets to protect and borders to defend. Store-of-value assets like gold, meanwhile, had to be locked in physical vaults, or even protected by armed guards. But now, through a mechanism of global consensus, Bitcoin establishes its own kind of sovereignty — and changes the game. –JCL

“How many divisions does the pope have?”

The question (possibly apocryphal) was asked rhetorically by Joseph Stalin, the iron-fisted dictator, to emphasize the military might of the USSR.

Stalin measured rivals by how many tanks and guns they had. He is long gone now, but people still think about currencies the same way. The value of a currency is backstopped by the power of the state; the more powerful the state, the more benefit the currency receives.

The U.S. dollar, for example, is backstopped by the U.S. military (and a U.S. defense budget that is larger than the next seven nations combined). You can measure U.S. strength in terms of bombers and aircraft carriers.

The logic makes sense up to a point. A country with no military is vulnerable to being attacked, which means an attacker could seize that country’s assets, overturn its legal system, appropriate the means of production, and so on. That would be bad for the currency (obviously).

A country with a powerful military, on the other hand, can guard the homeland, safeguard trade routes, project “soft power” via diplomatic relations, and, when push comes to shove, rely on “hard power” via military threat. All those things are good for the currency.

Then, too, the power of the state ensures government revenue. Governments are funded by taxes, and the ultimate incentive to pay taxes is avoiding prison or the threat of state-sanctioned violence.

If you don’t pay your taxes and get caught, the government can throw you in jail — and if you try to resist, they can taser you or shoot you. If a government lacked this power, the people could ignore their tax obligations and the Treasury would be broke.

Some crypto skeptics use this argument against Bitcoin.

In effect they ask the question: “How many divisions does Bitcoin have?”

Bitcoin, the questioners say, has no ability to enforce contracts with a state-sanctioned monopoly of violence. It has no means of enforcing its will, or defending its territory, or requiring its use for mandatory transactions (like taxes).

So how can Bitcoin have value in the way state-backed currencies do? Where are Bitcoin’s aircraft carriers?

The answer is that Bitcoin doesn’t need aircraft carriers. It is a stateless currency with no need for political power.

Step back and think about the obligations of the state — particularly a state with a large, powerful military (to deter enemies) and a muscular police force (to enforce legal judgements and collect taxes).

Militaries are expensive. So are court systems and law-enforcement measures. A functional nation-state has to fund those things, which means it has to collect revenue in order to get the funding.

In abstract terms, a state has to protect its assets (citizens, property, technology, and so on) and also has to extract revenue from its assets (collect taxes) in order to fund itself.

Bitcoin doesn’t require any of that. The only thing Bitcoin has to “protect” is the integrity of the distributed ledger, a process that is built into the software code. As such, Bitcoin does not require state-backed force to be viable.

Some will ask: “What if Bitcoin is outlawed?”

What happens, in other words, if the state tries to use its monopoly on violence to block access to Bitcoin?

The answer is that, if a state tried to kill off Bitcoin today, it would fail. That ship has already sailed. Bitcoin is too global, and too easily accessible, to suffer a mortal blow from being outlawed.

At this point, trying to outlaw Bitcoin would be like trying to outlaw gold. Acknowledging Bitcoin’s power in such a way would almost function like a public relations announcement: “Bitcoin is a big-enough deal to scare the government — maybe you should own some.”

Yet, Bitcoin is a head-scratcher for many analysts because it has asset properties never before seen in history.

Take the value of gold as a comparison. Gold has value because of its physical properties. It is the only element that is scarce, eternal, and easily usable at room temperature. Gold never rusts, it never goes away, and it doesn’t disintegrate or turn into a poisonous gas.

For basic reasons relating to physical composition and rarity of supply — gold’s physical advantages as a metal — the world gold supply has been accumulating for literally thousands of years, which gives it a very stable asset base. It is physically impossible to add to the world gold supply at a rate above 2% per year. Too much gold already exists, compared to what is being mined.

That is why gold is a “stateless currency,” too. It has nothing to defend other than its advantageous position on the periodic table.

But getting back to Bitcoin, some are flummoxed by the fact that Bitcoin has properties like gold’s — which is why it is nicknamed “digital gold” — while having no physical form.

To see the parallels, you have to think in the abstract.

Bitcoin, like gold, has global circulation and global brand recognition. Try getting the word out on a product, any product, to 150 countries around the world. Think about how challenging that would be, and reflect on the fact that Bitcoin has a 10-year head start.

Then, too, Bitcoin’s integrity is enforced by the distributed ledger, and its limited supply is enforced by mathematics. These are the equivalent of physical properties — like the properties of a precious metal — but expressed in code. When you put together global brand recognition, the integrity of the ledger, and limitations of supply, you get an asset that demonstrates the key properties of gold without having to exist in physical space.

What’s more, Bitcoin and gold share the power of network effects. Gold is widely accepted as an asset — and has been for thousands of years — because a far-flung network of human beings have awareness of gold and respect for its attributes.

Imagine if gold was the same in every way except nobody had heard of it. The network effect would then be zero, and gold would have no value as a medium of exchange. Network effects are important, even for something as old and venerable as gold. Reversing that logic, we can see the value of the network that Bitcoin has built here and now.

So Bitcoin doesn’t need the power of the state — that is to say, militaries or law-enforcement mechanisms — because it doesn’t have property or revenue streams to defend.

And yet, as a kind of amusing twist, nation-states may one day need Bitcoin.

When the world’s nation-states are done debasing their own currencies to a point of fiscal ruin, and a total loss of faith on the part of the citizenry, a stable medium of exchange could come in handy.

Bitcoin might not in fact “stabilize” until it has taken a fat percentage of gold’s global market share — but there is more than enough room for two stateless currencies in the world, one physical and one digital, and that will be a fun journey.

Apple still wants to disrupt the electric vehicle (EV) industry, and it could have some form of EV in production as soon as 2024. This comes from a Reuters scoop, as told to Reuters by an inside source.

No matter how you slice it, Apple getting into the EV space would be a seriously big deal. Nor would they be starting from scratch: Apple has played with the idea for years.

Project Titan, the code name for the Apple car, has been around since 2014 and at one point staffed hundreds of people. Apple’s interest in Project Titan has waxed and waned.

At one point, Apple seemed to give up on Project Titan, scaling it back to the point of irrelevance. Perhaps it was just in streaked mode. And now, according to the Reuters source, it is back in full swing with an aggressive timeline.

Apple has game-changing technology in the works with respect to EV battery design. They are reportedly working with a “monocell” design, which would remove casing materials and allow more juice to be packed into less space, significantly increasing driving range.

Apple is also experimenting with variations on EV battery materials, with a variant known as lithium iron phosphate holding promise for safer output at lower temperatures (and less risk of battery fires).

Apple has a history of doing amazing things with battery technology and compressed chip designs, dating back to the original iPhone.

When the iPhone was first launched in 2007, Apple’s main competitor, the maker of the Blackberry, thought the stated battery life was physically impossible due to technological limits of the day.

When they finally got their hands on an iPhone and pried it open, they discovered the innards of the phone were almost entirely devoted to battery space, with all of the chip functionality jammed into a corner.

From the launch of the iPhone onward, Apple has arguably been the undisputed world leader in complex supply-chain logistics. The iPhone, arguably the most profitable consumer hardware product of all time, is a dazzling feat of coordinated development, with design elements that are sourced and prepared for years in advance.

All of this bodes well for Apple’s efforts in making a car, as does Apple’s cash hoard of roughly $200 billion, its extremely profitable line of existing products, and its installed user base of 900 million iPhone users worldwide.

For the longtime iPhone user, the possibility of a smartphone-integrated experience is also intriguing. Imagine unlocking your car with a glance (via face recognition, the same way you unlock your phone); having the “find my iPhone” also apply to your vehicle; telling Siri to parallel park, or to have the car pull up and meet you at the store entrance; all while having the entire dashboard, audio and climate control system, and overall in-car user experience embody the elegance of “insanely great” Apple design.

The real question is why Apple would want to get into the car business at all, given the historically lousy profit margins and brutally competitive landscape.

On the one hand, Apple has grown so large as a business, it has to find huge new markets to conquer just to move the needle on revenue and profit expansion. From that point of view, cars and health care are two of the only mega-opportunities left.

On the other hand, it is hard to imagine Apple giving up the 20 to 25% profit margins it has enjoyed for years, and bending steel is such a cost-heavy, brutally competitive endeavor that it seems impossible to maintain the kind of juicy margins the tech juggernauts are used to (with the exception of Amazon, which has the internal capability of flipping the margin switch, but prefers to grow like kudzu).

There are at least three ways Apple could go when it comes to EV strategy:

• It could set out to build its own Apple car from scratch, working with existing suppliers like Foxconn to build Apple-only factories that produce hundreds of thousands of vehicles per year.

• It could partner with a high-end original equipment manufacturer (OEM) like Mercedes and create an Apple-branded car that sits on a luxury car chassis, with production handled by OEM facilities.

• It could stick to the higher margin aspects of battery technology and user interface design, offering to meld the Apple experience with a high-end OEM brand. Imagine, say, buying your next Porsche or Range Rover with an Apple Gold package.

It will be interesting to see which path they choose, as all of them have trade-offs.

Apple’s historical tendency to be controlling, and to prefer end-to-end dominance of the user experience, argues for building an Apple car from scratch. But a taste for fat profit margins argues the complete opposite — leaving the steel bending to an OEM, while staying with the high-value-add parts of the equation (the battery technology and driver interface).

Either way, Apple’s reported seriousness in disrupting the EV market is more bad news for Tesla.

Recent sales trends in the European EV market show that traditional automakers can more than compete with Tesla at the “good enough” low end of the buyer spectrum, where affordability matters more than luxury or cachet.

And now Apple will be storming the luxury and cachet end of the EV space — along with plenty of others — either with its own auto brand, or perhaps by enhancing the experience of one or more existing OEMs (think Mercedes, Lexus, Porsche, and so on).

If we had to choose an outcome, our wager would be that Apple chooses the high-margin route while letting someone else make the cars, comparable to Waymo’s emphasis on providing the high-end tech for self-driving fleets while an OEM handles the tonnage.

When doing the math in terms of capital efficiency at scale, this is the way to go: Some businesses will never support fat profit margins at scale, and the automaker business is one of them. Our strong hunch is that Tesla bulls find this out the hard way, in part as Apple’s EV strides cut into buzz and market share.