Inflation Causes Deflation

I can't believe there are still people saying inflation isn't transitory, so instead of expressing the concepts like last time, I'll anchor them in my actual experience of owning a business through all of this to show you how inflation causes deflation, then we'll explore a time frame, and see if the market is confirming this view (spoiler: it is). 

Let's start with the customer. Whether people are aware of it or not, everyone is running a business by being alive. At the end of every month you can subtract your expenses from your income and calculate your month's profit. Pick a number, but for the bottom X% of the population that disposable income is very limited, and it gets squeezed by rising costs if their wages don't keep up. I assume we can agree on that. 

My small business used to have seven employees; now it has five. My number 1 & number 2 have been with me from the beginning. My number 3 replaced two part-time family members who graduated and moved on. At the end of each year I give everyone a raise and a bonus.  I already paid above market rates because I value loyalty over squeezing out a little extra profit, and I think of them like family.  This year I overheard them grumbling about rising living costs, so I gave them an additional raise in the summer.  I plan on another at the end of the year.  Thus far I've been able to grow revenues to compensate for this, so the bottom line has increased. In fact, in four years, I've grown the top and bottom line 3x while paying my employees nearly twice what the previous owner paid hers. Some of this was due to skill in selecting the right business and executing on it, some was luck, and some was divine intervention. 

My suppliers have all been complaining about their input costs rising, so they've been raising their prices to maintain their margins and free cash flow because obviously they too are a business.  

With the disposable income of my customers getting squeezed by higher expenses, last quarter (Q3) (ending August 31st) is the first time my revenue and net profit is significantly down (the net profit is 50% of Q3 2020 and 25% of Q3 of 2021). I also had to run a 20% and 10% discount this Q3 to move "inventory," so the net profit is down due to higher employee costs, higher supplier costs, and less demand. If I was a publicly traded company I would have to pre-announce to soften the blow and give vague guidance because I don't know for sure that some of the cause isn't people spending way more on vacations this summer, but I do know there is a significant drop in customer spending. 

One thing I did was consolidate hours. I had 2 employees who only worked one day a week (for depth of staff), but they didn't take it seriously because they kept calling in, and since my number 2 wanted more hours, I gave their shifts to him. Even though it's the same amount of hours, in theory, 2 people lost their part-time job. 

I've also negotiated with my suppliers for better prices, hinting that I may have to look elsewhere (meaning, I'm the customer not wanting to pay full price, so give me a discount). Business is a game of who needs who more? Do I need the employees more than they need the job? Do the suppliers need me more than I need them? Do I need this customer wanting a discount more than they need me? It's a balancing act of negotiation that requires constantly reading people. Fortunately, I'm good at that. So the suppliers came down a bit to share the burden, which means it eats into their margins and free cash flow too, but if this continues we are both going to get squeezed even more. 

With demand down I will be careful not to order too much, in fact, I'm ordering less, so the supplier gets the feedback to produce less, which translates into less economic activity. When customer demand softens, particularly if it's because their discretionary income is shrinking because their expenses are rising faster than their wages, then I have to lower my prices to clear "inventory," but most of my expenses are fixed, so it leads to less earnings as seen in Q3. Since I'm in year four of a six year lease, rent hasn't gone up - yet. Utilities are up, which, of course, is tied to commodities as the baseline input to everyone's business on every level.

Do you see how inflation causes deflation? It's all about the free cash flow of the customer, which is limited. If it gets squeezed by expenses being higher than wage increases they will spend less and it spirals downward back onto businesses and their supply chains, squeezing margins, and causing less production and economic activity. If it keeps going it leads to layoffs and spending cuts that perpetuates the cycle, but debts remain, so inevitably people start using credit cards to pay bills, but eventually they run out of credit, so they stop paying credit cards, then mortgages, then cars. If it keeps going, centralized credit institutions get impaired, which causes either significant write-downs, or systemic risk if it's bad enough, which forces the central bank to socialize losses by buying up toxic debt, so the downward spiral must be stopped and reversed at some point. This is why there will always be a Fed put. It's not a choice. The only bright spot is the shortage of labor could help keep wages up while we go through this, but it doesn't seem sufficient to me. 

With what I just described in mind, how is it possible to have a permanent condition of inflation? The term transitory is not to predict the length of time, it's to describe the mechanism of markets limiting the effects of inflation because it causes its own demise by consuming disposable income, which starts a deflationary spiral that destroys earnings, spending, and jobs. This has nothing to do with the Fed. It's simply markets at work. Wages lag rising costs. The Fed can't print creditworthy borrowers, wage increases, or money into my customer's bank accounts. They can cause the stock and bond markets to inflate, which has some degree of wealth and psychological effect, but it doesn't put money into the hands of my customers to spend.  I don't care what the economic textbooks say - I'm living it. And I should note just because my Q3 was down so much doesn't mean the greatest businesses in the world will see the same result, but it sure is a potential warning sign for the next 6-12 months. Deflation is at work, as seen with Fedex and Walmart. 

Let's do a reality check to see if the market is confirming this view:

Treasury curve: inverted, doesn't care about CPI

Eurodollar curve: inverted, no fucks given. 

5y 5y Forward Inflation Expectation: 2.27%

5-year breakeven: 2.49%

Oil, lumber, copper, silver, wheat, corn, gold, and nearly every commodity: currently downtrending. 

Housing: coming down, but kinda sticky. With mortgage rates very high relative to recent years, and disposable income getting squeezed, this should continue to slow down.  This lags the most because it's not driven by speculators pricing in the future like the other markets, so it's not surprising it will be last to be dragged down by a contracting economy as people tighten their spending or lose their jobs. Meaning, derivative markets look ahead and price in the future while housing and OER reflects the sentiment of the present and policies of the past.   

CPI - Reverberations of the Past

The inflationists are strutting around like proud peacocks again, but they aren't making sense. And I do give the ones who aren't perma-inflationists all the credit for the correct call when inflation was happening two years ago.  The CPI data we see now is the reverberations of the inflationary policies from 2020, which have long ago ended. Why is the concept of time so disregarded? I don't get it.  It's like someone drank a bottle of whiskey and started acting intoxicated buying up everything on the internet, then the booze starts wearing off as fatigue and confusion sets in, and he's still flailing at the button for that last available foot massager, but as the pain of the impending hangover starts kicking in, the inflationists are saying he's gonna stay drunk forever, in fact, next year he'll be double digit drunk! How? The alcohol ran out. It's just working through his system. If your thesis is inflation will happen again when the Fed pivots, which will cause the dollar to descend (especially if the war ends and Europe's acute woes subside), so commodities will rally and increase input costs, that makes sense, which means you agree inflation is transitory, and so is the deflation happening now that will cause the Fed pivot.  It's all cycles.  And the next wave of inflation is going to depend on how low commodities like oil go during the deflation because don't forget the Fed doesn't put money into people's hands, so demand will be a concern.  (Let me note as well, if commodity prices were to relentlessly rally despite collapsing consumer disposable income, then I would agree CPI would resume an uptrend, or stay elevated until equilibrium occurred. I've noted before my concern about oil supply, but based on what I'm seeing in my business and what the leading indicators are pricing, it doesn't seem possible because the demand will come down just as fast as supply during a deflationary period, but should that occur, then what I'm writing would be wrong. I don't really care about my opinion. I let the markets tell me what to think and adjust when necessary. Is there any other way?) 

Unfortunately, it seems like we will have to listen to the inflationists for a few more months due to base effects.  Here's the actual CPI data of the last year.  Note the big MoM% changes in yellow that will drop off as we get to them. We also have to keep in mind that housing is slooow moving, so OER could be what I would argue as falsely elevated for awhile (in relation to what is actually happening in the surrounding economic data reflecting actual customer spending affected by squeezing disposable income). 

Also, residential rents renew yearly, so that's a rolling issue going forward, but as housing slows it will slow too.  Certainly, food was a bigger problem than it has been, both recently, and this year, and gasoline last month was down 10%, so if gas stops going down at this rate of change, other items have to go down to makeup the difference.  Probably the biggest short-term concerns are housing and food from the fertilizer disruption. Also note over the last 3 months the level of CPI (in the 296's) has stopped going up. 

Date	CPI Level	% MoM	% YoY
9/21	274.31	0.27%	5.40%
10/21	276.59	0.83%	6.20%
11/21	277.95	0.49%	6.80%
12/21	278.8	0.31%	7%
1/22	281.15	0.84%	7.50%
2/22	283.72	0.91%	7.90%
3/22	287.5	1.34%	8.50%
4/22	289.11	0.56%	8.30%
5/22	292.3	1.10%	8.60%
6/22	296.31	1.37%	9.10%
7/22	296.28	-0.01%	8.50%
8/22	296.17	0.10%	8.30%
9/22	Oct 13th
10/22	Nov 10th

Markets

I think the markets are reacting appropriately. Stocks are coming down to price in an earnings slowdown, and who knows how much is priced in so far, or how long it will last.  This week is probably the last chance the S&P has to make a move up before rolling over again.  

The bullish thesis is this: 75bps is peak hawkishness from the Fed, so if we do get a "buy the news" on Wednesday AND there's follow through on Thursday, we could see a short covering rally to the downtrend line (or the next CPI in Oct).  The bearish view would simply be emboldened shorts who win the battle because they have conviction of a coming earnings disaster, CPI which only has a .27% rolling off next month, a Fed trying to regain credibility so they will overtighten because the world only sees the lagging data they're looking at (like employment and housing) and not leading data.  It's kinda like being an amateur trader making decisions off present time data and not anticipating the headlines of the future.  If the stock market gets crushed this week, it's likely to be an ugly October.  There is hope in November with a big .83% rolling off on the 10th, a lesser Fed raise Nov 2nd, and the midterms behind us, so if oil stays chill or even goes lower, we could finally see headline CPI start to really come down.  You'll have to game out the housing and core yourself.  

Personally, I'm just waiting. I think the best trade on the board is the 2-year at 4%.  I started my position around 3% so I'm underwater on that as well as just about everything else, but I'm mostly cash still. I'm thinking the 2-year will rally before the stock market bottoms, so I might scale all of my available cash into it at 4, then 4.5%, then all-in if we get to 5%, which I doubt, but I'm surprised it's at 4, so who knows.  This is literally free money.  The worst case is just sitting on it for 2 years.  The only bad scenario would be if stocks screamed higher without the 2-year rallying ahead of it to sell first, but I think that's unlikely.  The 1-year is about the same yield but it will only get half the price appreciation return if yields collapse. As someone who doesn't have clients I have the appropriate stock exposure to be disappointed in either direction: if stocks somehow go back to the highs because this is all overblown and the war ends, I'll be disappointed I don't have more; and if they go to the lows I'll be disappointed I have too much.  That's the sweet spot of disappointment for me.  If we get down to 3150, I plan to blindly buy with limit orders up to 60% of my intended amount and wait for confirmation for the rest, but that's just a guess.  

One final note to the guy who wrote me an angry message about oil: I never endorsed any political policy or party.  If I was in charge I'd be subsidizing oil production to make energy cheap as the cost of EV's comes down over time through scale and innovation while I built regional nuclear plants and upgraded the grid to seamlessly shift energy around. That kind of infrastructure spending would pay for itself as the increased economic activity from a widespread boost in the disposable income of all consumers and businesses via cheap energy led to more income and sales tax receipts for the government. Energy should be the number one priority of any government. It's not rocket science.  

The Natural Restraints on Inflation

Intro

I might be losing my motivation for this blog because I keep choosing to look for my golf ball on the wrong fairway than write this article. Here's my argument for why structural inflation is impossible. 

The Two Faces of CPI

Traditionally, inflation is defined as a monetary phenomenon, which is when CPI rises due to an increase in the money supply, so technically a supply shock that causes CPI to rise is not inflation, it's just CPI rising. The reason this is an important distinction is because supply shocks are anchored in the law of supply and demand and the incentives of free market participants, so they always return to equilibrium; whereas an increase in the money supply could be the result of a structural economic boom in a fractional reserve system, or the structural recklessness of excessive fiscal money. In other words, the bond market doesn't care about supply shocks because the companies involved are restrained by free market competition, so the prices can't spiral out of control permanently. If the profit becomes too large it will attract competitors to bring it back to the cost of production plus the market allowed profit, or if the price rises too high it will kill its own demand. There's no escaping this restraint, except for temporary dislocations, so the treasury market will look past it. The reason CPI was over 9 with the 10-year yield under 3 is because trillions of dollars in the treasury market is saying the bulk is CPI is not inflation; it's other temporary reasons like the labor gap, supply chain issues, and a temporary disruption in oil. 

The Fed Rides Caboose

The Fed has almost nothing to do with the current increase in CPI, and they're not even capable of causing it to rise. It's not a power they have. Here are the three biggest false assumptions many on Wall Street believe: QE is inflationary; the Fed controls interest rates; and banks loan out deposits. All three have profound downstream effects in how the economy and markets behave, so let's explore them. 

The Fed couldn't make CPI rise if they tried (and they did for 10 years), mostly because their transmission mechanism into the real economy is weak and diluted. If the money they create doesn't enter the economy it can't drive up consumer prices, so let's follow the money because there's some nuance here. 

When the Fed buys treasuries it indirectly funds the government beyond their tax receipts, which is the definition of inflation, but all government spending programs (until Covid) were narrowly focused on specific Acts that created winners and losers in certain sectors, so it was never broad enough to cause CPI to rise as a whole. 

When the Fed buys MBS it frees up room on the balance sheet of banks, which allows them to make loans they wouldn't otherwise be able to make, which creates money into circulation and is also the definition of inflation. While banks create the bulk of the money supply through loan issuance, they are not restrained by deposits or reserves - they're restrained by the creditworthiness of borrowers and the viability of the loan, which is why the Fed was unable to cause CPI to rise for a decade. They needed creditworthy borrowers with down payments in order to have a broad based effect on consumer prices. 

Light My Fire

Along comes Covid, and the MMT crowd gets to see their foolish ideas play out as a real-time experiment. Combine several rounds of stimulus checks, additional unemployment money, the PPP loans, the extra child tax credits...and all of a sudden the country was full of creditworthy borrowers with down payments, which created a housing and car boom. Clearly, there is nothing better for the economy than a strong housing market since there's abundant ancillary spending that surrounds it. What resulted is the typical "pig through a python" inflation of CPI as this free fiscal money worked through the system, but without a continual source of funding it can't be anything more than a transitory, albeit exaggerated, effect. That money will be spent and end up in the bank accounts of businesses and once again get stuck in the banking system, restrained by the need for creditworthy borrowers with down payments or collateral to keep it circulating in the economy bidding up consumer prices. 

In contrast, the 1970s inflation was driven by a relentless, persistent demand for money by a freak demographic boom all moving through peak borrowing years at the same time for a long stretch of time (amplified by the oil supply shock, of course). Since CPI is a measurement of change, in order to maintain a high and rising CPI, the borrowing and spending must persist over years, which it did in the '70s because it wasn't driven by an artificial and temporary source of funds like government stimulus. 

Spiral Squeeze 

You might argue there's a psychological effect that takes over and creates a wage/price spiral that pressures CPI higher continually unless it's stopped, but this too has natural restraints because it doesn't happen broadly all at once, so it tends to be haphazard, staggered, and narrow. In an inflationary environment businesses are faced with higher input costs and the simultaneous shrinking of a customer's discretionary income, so they can try to raise their prices to maintain their margins, but some businesses have more pricing power than others, and some customers receive quicker and better wage increases than others, so the haphazard and staggered distribution of these increases acts like a built-in mechanism that prevents a runaway upward spiral in wages and prices as both customers and businesses get squeezed, which results in spending cuts and layoffs to counteract it. 

Technically, we've been in a wage/price spiral for a century. The average salary in 1913 was $575 per year, and it's now $54,000, so while wages often lag, they do rise because that's how markets adjust. An environment of 9% CPI doesn't mean you're losing that much purchasing power if your wages went up or you own assets that countered it. It also depends on what you're spending it on. If it's sitting in a brokerage account and what you want to buy went down 30%, then not only did your purchasing power go up by that amount, but also by the 30% to get back to where it started (assuming it does).  It's not a simple calculation. 

Fed Bread

When the Fed buys treasuries, most of the money printed out of thin air ends up sitting in the bank reserves of primary dealers. Fed apologists claim this is an asset swap, but it's not because the Fed doesn't have any assets. To illustrate the difference, if the Fed ran an underground bakery and they produced the best bread you can imagine and they stole market share from other bread companies by selling their bread to consumers who paid for it with the money they earned by owning, or working for, profitable businesses, the Fed would end up accumulating savings, and if they used those savings to buy treasuries in a QE program that would be as asset swap. The Fed doesn't have any assets. It's accounting gimmickry. 

Purchasing Power Pilferage

The people who get hurt the most by inflation are the ones who need to not get hurt the most by inflation because they don't own assets or have enough cash to buy stocks that went down, or they are living on fixed income that understates their loss of purchasing power, so their fixed income doesn't keep up with their rising expenses. Inflating away the debt means stealing purchasing power from savers, the poor, and those living on fixed income, so a better alternative might be knocking on the door of poor people and punching them in face. Runaway inflation is impossible because the market forces of competition and the need for creditworthy borrowers will restrain prices even without the help of the Fed, which does not even control interest rates. 

The Inversion Rebellion 

If the entire Treasury curve bear-steepened in proportion as the Fed raised overnight rates, then I would agree the Fed controls interest rates. If mortgage rates followed Fed Funds in lockstep, then I would agree the Fed controls interest rates, but they don't. Interest rates are controlled by the market. This is the whole idea of why a yield curve inversion is such a powerful signal. It's the vast, diverse participants in the market disagreeing with the Fed as it responds to the same evolving economic data. Banks are going to charge as much interest as the customer will pay in the context of the bank's competitors. Mortgage rates skyrocketed as the housing market boomed, which created high prices in both housing and interest rates, and caused their own demise by cooling off demand. And if you eliminated the fiscal stimulus it wouldn't have mattered how many MBS or treasuries the Fed purchased, there would be no rise in CPI - just like the post-GFC decade - because there wouldn't be creditworthy borrowers with down payments. The Fed does not have the power to cause CPI to rise. They need the Treasury as an accomplice to send people money. 

Fed critics like to say "the Fed is causing financial repression by artificially holding down interest rates," but ZIRP and QE happen during weak economies, so interest rates are already low from a widespread willingness to buy treasuries at lower and lower yields. I'm not saying the Fed buying treasuries has zero effect, but it's not nearly as much as the "financial repressionists" proclaim. Evidence for this would be the Taper Tantrum of 2013. Yields initially raced higher, then stopped at the appropriate yield for the time, and resumed their downtrend because globalization has stripped the engine out of our economy, which is the real cause of financial repression.

Poppycock Talk

Offshoring our manufacturing base not only removed tens of millions of the most secure high paying blue collar jobs, but it also resulted in exporting trillions of dollars. This is the disinflationary black hole in our economy that forces the Fed and Treasury to continually reinflate asset bubbles. This is the reason interest rates are structurally low. This is the cause of financial repression. And the people who think we're entering an era of deglobalization are full of poppycock. 

The entire reason our CEO's moved those jobs offshore is to lower their expenses by evading our taxes, regulations, and unions. None of that has changed.  There's no way any CEO is going to reshore those jobs back to the same exact conditions that prompted the exodus in the first place, voluntarily increasing payroll expenses many times over. Pointing to a few semiconductor plants as evidence of deglobalization is disingenuous because they are being heavily subsidized as a geopolitical strategy to protect our semiconductor production. There is nothing better that can happen to this country than reshoring our manufacturing base, but it is not a choice a CEO can make. If they don't like China anymore they can move to Vietnam or Africa or Mexico, but not the US. And I'm sure every single one of them want to reshore, but I want to flap my arms and take flight, which is equally as likely, so go ahead and scratch that off your structural inflation bingo card. Deglobalization would be career suicide for whoever attempts it. No one is going to buy a $10,000 iphone. The math doesn't work.

Thug Life Currencies

And this idea that somehow Russia and China are making a power play to create a new currency that's going to displace the dollar is not appreciating the fact that no one is going to denominate their international business in the currency of lawless communist dictators who don't respect the rule of law or free markets.  The US might be flawed but we're not communist-dictator flawed. It's our rule of law, individual rights, democracy, and free markets that stand behind our dollar and override its flaws. There is no alternative. At the end of this, Putin will be dead, and Russia will be devastated for a generation as the whole world accelerates their flight away from Russian energy. 

The Great Conflation

One reason everyone thinks the Fed has more power than they do is because the stock market is so dependent on the shortest end of the yield curve, which the Fed does influence, so people conflate the stock market effects with the real economy. Any institution, corporation, or fund that is able to borrow at practically zero can leverage up risk assets, which unquestionably forces more and more people out the risk curve, and amplifies an expansionary period. Money flows into tech as a proxy for duration because the cash flows of the present are dwarfed by returns from growth stocks pricing in the cash flows of the future, so multiples expand. This has almost no effect on CPI in the real economy at all besides a very weak wealth effect that comes from people seeing their retirement accounts, or the value of their house, increasing. Additionally, if the Fed buys bonds from non-banks the cash can bid up stock prices. 

When the Fed keeps overnight rates below where the market would set them, zombie companies are kept alive that shouldn't be, but those jobs and that economic activity is not nearly enough to nudge the broad prices of CPI higher. When corporations can borrow cheap to fund buyback programs, reduce their share count, and drive up both their EPS and the stock price, the effect is also not broad enough to nudge CPI higher.  QE and ZIRP only inflate asset prices, so the Fed's bubble blowing machine is constrained to financial markets.

Financial bubbles don't need higher interest rates to pop - simple human psychology is enough. People have an intuitive sense of what the price should be, and while that gets muted by greed and irrational thinking during bubbles, eventually the buyers hesitate, and the whole thing implodes. That's literally the restraint on every speculative market in history. The Fed just quickens the end.

Dodo Bird Death 

The lack of oil capex is certainly a compelling narrative, not so much as a source of runaway CPI, but as a catalyst for recession. The way to gauge the burden of oil is to determine what percentage of discretionary income oil consumes and compare it to other eras, as opposed to thinking $80 oil is twice as bad as $40 in the 90s because wages have gone up to compensate, and debt levels are higher too. As the slow transition to EV's unfolds over the decade and oil companies are disincentivized to keep drilling, oil could find an equilibrium at a higher price, but that doesn't have to be any more disruptive than when it's moved up in the past. Until the '70s oil was well under $10 a barrel. Since then everything has moved up in price permanently, including the wages to pay for it. And why is everyone so sure that the current capex spending isn't the right amount given EV adoption will be moving from the lower left to the upper right?  That seems like an assumption which is hard to calculate and may or may not be true. 

It is certainly an interesting dynamic, and while there might be crazy spikes from temporary geopolitical dislocations, and a mismatched timing of wages catching up, the price of oil can only rise so much in such an indebted economy before it causes its own demise by killing the demand. 

(I do agree the most self-evident solution to our energy problem is to power the grid with nuclear, and power vehicles with batteries - and if you're concerned about lithium, research sodium-ion batteries and perovskite solar cells - both are not ready for primetime, but they are steadily improving their charge capacity and efficiency. Innovation will lead the way.) 

Great Temptations

The only cause of structural inflation would be a permanent Universal Basic Income program that artificially overrides the natural restraints of the banking system by sending money directly to the people without the need for collateral, down payments, or adequate income since it's not a loan. The MMT crowd refuses to acknowledge the money they want the Treasury to spend comes from someone else. There's no free lunch.  If you imagine a dollar bill made up of 100 little squares of purchasing power, inflation is taking handfuls of those squares from those who hold cash (or cash equivalents), or those who earn cash but don't own assets, and distributing them to those who own assets that adjust higher in price as the currency is diluted. 

The increase in house prices is a transfer of purchasing power from existing debt instruments like cash and bonds, and it disproportionately hurts the poor because they don't own assets, so their lagging wages squeezes their spending. If the Treasury determined the magic number was $10,000 to send to everyone making less than $30,000 a year, it would offset the pain on the poor, but it still comes from someone else. UBI would be a persistent, structural inflation the treasury market would have to account for, so purchasing power would be transferred from bondholders to UBI recipients to the stockholders of the businesses with the products and services they spend it on. Any inflationary impulse short of this lacks the persistent source of funds to maintain it, so it will be restrained by the natural forces of the markets, even if it takes longer for the money to work through the system than anyone believes. Underlying economic principles don't change just because things take time.

Summary

Without creditworthy borrowers with down payments or collateral there is a natural restraint on the inflation created by banks, and the only other source of inflation is the Treasury since the Fed by itself has a weak and dilutive transmission mechanism, and they don't really control interest rates, except the shortest of durations, which is contained to financial markets. Treasury spending programs are not broad enough to create lasting inflation with the exception of UBI, and since rising oil kills its own demand, especially in an environment of heavy debt, any and all CPI spikes have built-in natural restraints that will make them transitory. And since Congress is likely to become even more divided this November, the conditions for structural inflation do not currently exist, and don't appear to be on the horizon. 

If this view is correct, what you would expect to see is the YoY% change in M2 go straight up and straight back down, commodity prices go straight up and straight back down, earnings go straight up in the Covid beneficiary businesses then revert to normal, inversions of the Treasury and Eurodollar curves, the rising price of oil hurting spending at businesses like Walmart, and if recession happens from here just about all businesses and their stocks will suffer. 

Possible CPI Delays

Since nothing goes in a straight line, here's two main concerns: 

1. I don't see why Putin wouldn't use his power over natural gas flows to accomplish what he wants this winter when Europe is the most vulnerable. If he does (and to his credit he did allow wheat exports, which is somewhat surprising for a sociopath), it will likely cause another temporary geopolitical spike in the front months of oil that could cause CPI to stick even longer, but all geopolitical dislocations of price eventually revert to the cost of production plus the market allowed profit. Personally, I'm not into trading the irrational behavior of sociopaths, so I'll stick to my long-term investing allocations. If this does occur, it will be recessionary. Maybe this is what the inverted curves are anticipating, unless it's just a growth slowdown from a Fed overshoot. 

2.  Another concern is the 2-for-1 job openings-to-unemployed ratio of the labor gap. Covid caused upwards of a million domestic deaths, baby boomers scrambled into retirement, and the flow of immigrants slowed to a halt, putting upward pressure on wages, so if this labor gap doesn't close it could continue to squeeze employers and profit margins. There seems to be an enormous discrepancy between the Establishment and Household methodologies, so I don't know what data to believe anymore, but the people making a stagflation argument have a valid point if oil becomes a problem again at the same time labor keeps putting upward pressure on wages. 

However, stagflation is supposed to be driven by a weak dollar, which is how commodity prices keep input costs high regardless of weakening demand. Otherwise, the burden of existing debt leaves no room in discretionary income to weather a period of rising oil, so demand is quickly cooled. While the Fed has no power to cause CPI to rise, they can certainly cause it to fall by inverting the yield curve for as long as it takes to kill any remaining bank lending, which would hurt the consumer and cause the layoffs needed to induce a recession. Combine that with an oil supply shock and you get temporary stagflation, but because there isn't underlying growth caused by a high demand for money like the 70s, and the dollar isn't falling, it's more likely to be a disinflationary recession instead of stagflation.  Meaning, in a period of weak economic demand the only thing that can maintain high prices is a supply shock or a weak dollar. 

3.  There's three things working against stocks: Putin tightening the screws; the labor gap squeezing margins; and, most importantly, QT. The Fed wants to wind down its balance sheet, which is impossible, but I don't see why they would stop unless a plunging stock market forces them like in 2018.  That's my belief.  If you disagree, it's on you to explain why QE excites stock prices up, but QT doesn't depress them down. 

In fact, if you'd like to disagree with this article, here's ten questions to answer:

1. How does money sitting in bank reserves make broad consumer prices go up? 

2.  How can the consumer afford oil at $150 without devastating their other spending and then dragging down oil? 

3.  Without a strong demand for bank loans in ever increasing amounts for many years, where is the source of funds coming from to continually pressure consumer prices in ever increasing amounts since CPI is a measurement of change? 

4.  With CPI over 9, why did treasury yields stop between 3-3.50%?  

5.  If inflation was a concern why is the yield curve inverted?  Shouldn't it be bear-steepening aggressively?  

6.  If the Fed controls interest rates, how is it possible for the yield curve to invert?  Why don't mortgage rates track Fed Funds in lock step? 

7.  How is a CEO going to reshore any jobs that aren't subsidized if it increases input costs many times over?  How will the consumer afford those prices? 

8.  Why would international businesses choose to transact in Thug Life currencies? 

9.  If growth slows and commodity prices drop to reflect it, what's the mechanism to drive consumer prices higher?  

10.  How can a wage/price spiral maintain upward pressure if it doesn't happen broadly all at once? And why would now be different than the last 100 years of rising prices and wages?  

The bottom line is nothing has changed. There is a deflationary fire in the black hole of missing manufacturing at the heart of the developed world that is pulling interest rates and growth lower as central banks and governments attempt to fight it with hoses of liquidity. 

One chart - SPX daily.  Note it's between the 200-day EMA and 200-day SMA.  A backtest of the 4168 area would be normal, then we'll see if it can assault the downtrend line.  Also, note the positioning on the COT chart that follows. Dealers are extremely net long.  They almost never lose.  All they need to do is bid the market into Sept OPEX and they will make out like bandits as a huge percentage of those contracts expire and all that money transfers to their accounts.  That's not a prediction, it's just a highly unusual situation, and with oil still languishing it's not likely CPI is going to be a huge upside miss.  I suppose Powell or NFP could be downside catalysts, but if you ask yourself what is the nastiest thing that could happen it would be a breakout of this triangle into OPEX.  The short yellow line is the 61.8% retracement. Look at all the shorts who are currently trapped.  Don't you think they have to puke up their position before the market goes lower?  Just food for thought.  Personally, I don't think the bear market will be over until we revisit the lows or likely make new ones, but that doesn't mean we can't double top, or reverse off the 61.8 retracement.  From a trading perspective, these are the key levels setting up for Sept.  I'm mostly an investor now, so I don't really care.  Apple's going to $350, so if it makes new lows first, isn't that a good thing?  

COT chart

Bonus Song - if this doesn't blow your hair back, we can be cordial acquaintances, but we will never really know each other. 

RHCP - Don't Forget Me

Dear Elon

 Dear Elon, 

     How's this for a proposal of how to fix Twitter in three easy steps:

1. Verification. Eliminate the bots through some form of verification that a real human is behind an @.  There are several ways to do this.  You can use some kind of zero knowledge proof service, or whatever the IRS uses where it matches the picture on your government issued ID to your live face, or you can give people the option of putting down a deposit, but once every address is a real person, the intelligence of the crowd can be leveraged to self-police everyone by aligning incentives. 

2.  Weighted Voting On Truth. Install a new button on each tweet, or maybe a simple drop down menu, that allows the community to vote on its truth from 1 - 10.  Obviously, a lot of tweets are just self-expression and wouldn't need to be voted on at all, so the community wouldn't, but the option is always there. The backend programming would keep track of everyone's ability to recognize and vote for the Truth, and then weight the votes of the.people who are consistently correct more than people who aren't. The idea here is to incentivize voting for the truth to eliminate bias or agendas. The assumption being that a broad based diverse community of people can determine the Truth better than any other method, so if an individual is consistently voting with the overwhelming majority of votes, they are rewarded for their objectivity and dedication to the Truth by earning a more weighted vote. Maybe there's a threshold that requires any Tweet considered to be the Truth to have at least 90% agreement (adjusted as needed). This way nothing get censored and only what everyone agrees is factual is treated as fact. Everything else is opinion. 

The Tweet itself would display the percent in the corner showing how trusted the community feels this information to be. Or factual content could be another color to stand out amongst the noise of opinions. The backend programming would also keep track of the Tweeter's track record of expressing what the community feels is the Truth. This percentage would be prominently displayed next to their name to incentivize sincere attempts at expressing the truth when they are trying to, as opposed to self-expression. Maybe tweets that are getting a lot of votes linger at the top of feeds to encourage more engagement. When initially posting, an individual could privately opt out of the need for votes because they are knowingly just expressing an opinion, so those tweets don't drag down their percentage. The tweets that achieve a majority endorsement from the community as factual truth will be displayed with a percentage of agreement and different color. Everything else is opinion and self-expression, so there' no restraints on free speech.  

3.  Eliminate Excessive Negativity. Thoughtful disagreement or constructive criticism is an important process in the discovery of Truth, so there's nothing wrong with lively debate. The problem is people have a tendency to devolve into angry trolls through online platforms and lash out at the world with excessive and unnecessary negativity, including hate speech, which could also be policed by the community through voting on comments with a scale of 1-10 in terms of excessive anger and hate, or thoughtful critique. If a person gets a 90% unnecessary meanness vote five times there's some kind of penalty whether they lose their deposit (if there is one), or they are suspended for a time, or they have a Wall of Shame color red appear on their tweets and comments for month. This would allow people to say whatever they want, but provide a way for the community to train everyone like a puppy to figure out how to express their disagreement without the toxicity that exists today. 

Here's a motto: The Toxic Cleanse - Incentives Realigned. 

Or even better: Twitter 2 - Electric Boogaloo.  

Inflection Pointy

 While I still think markets are likely headed lower until the Fed capitulates on tightening, this week could provide a great risk/reward if it's another buy the news event coupled with goldilocks NFP and maybe the first downward miss in CPI next week, although it doesn't really matter - if the market decides it's time to send the shorts into assisted living facilities again, the dips will get gobbled up regardless of the data. Meaning, if the market reverses it could have 400+ points in it back to the range highs, and if it breaks down and stays down, the loss would be a fraction of that with proper risk control. I find when trading reversals it's better to use offsetting puts than stops, then dump them later because a 30+ VIX is actively trying to ruin to life.  Gotta keep those losses small.

NDX daily.  SPX is the same.  A signal would be a washout below the Feb low and a reversal. The tricky part about several news events stacked up in a row is it could happen twice, but that's the nature of trading. You never know, and you don't need to.

Apple weekly.  The $152 area needs to hold or it's gonna get ugly - it's kinda inflection pointy.  

TNX monthly.  The 10-year yield seems like it's on a mission to tag that 3.2% level.  It clearly took off after the initial Ukraine invasion risk off move reversed due to awareness of how the supply shocks would cause CPI to stick longer.  I'm working on an article that disagrees completely with anyone saying inflation is structural, mostly because it's impossible.  

There's two stock market scenarios starting this week: one is a major reversal bounce that likely rolls over near the range highs and continues bear marketing until the Fed stops. Or, get your black painter's tape ready to cover the parts of your screen that you don't want to see for anymore. 

Cyclical Is Not Secular

    There's a lot of people out there calling this cyclical move in rates a secular one. And if you already have an inflationary bias, these cyclical numbers will just confirm your bias and make it nearly impossible to make the right read. The much discussed secular disinflationary forces are debt, demographics, globalization, and technology. They've been applying downward pressure on interest rates for 40 years.  These are deep forces that are way beyond the temporary disruptions seen today.  The current inflation is being driven by several cyclical forces: 

1. The government stimulus checks and added unemployment money gave millions of people down payments for houses and cars, money to fix up the house, buy goods, etc..  Some of this money just replaced lost income, but a lot of it exceeded that.  When you amplify this with people relocating, and not enough supply of houses, it's no wonder house and car prices went up so much.  Since there tends to be an 12-18 month lag in the numbers, it's not surprising CPI is so high.  However, the source of that inflation ended long ago. This is not a secular force. This is cyclical. 

2.  The supply side suffered from rolling periodic shutdowns globally.  Since the supply chain tends to be scattered with different components coming from all over, it's also not surprising that prices would go up as businesses are forced to pay whatever is necessary to get what they need. Some of this gets absorbed by the business, some gets passed onto the customer. However, unless you think there will be supply chain bottlenecks from now until the end of time, this is not a secular force. It is cyclical. Supply chains will self-correct as Covid dissipates.  

3.  The wage increases are caused by workers staying home to avoid Covid risk and the relocation shuffle. Workers also left jobs they didn't like for other jobs they won't like. This creates upward pressure on wages as businesses like mine have to pay more to keep or hire competent people. Some of this is absorbed by the business, some is passed on to customers with higher prices.  Last month I questioned if boomers were going to come back when this is over, but they will have no choice simply due to fixed income not keeping up with the new level of prices. In fact, we might see even more boomers emerge to make up the difference, which will close the labor gap and stop the upward pressure on wages, which is not a secular force.  It is cyclical.  It will end.

4.  Commodity prices are going up, but unless you think the increased demand of the consumer is permanently rising, then high prices will extinguish themselves like every other time since the beginning of Earth.  The cure for high prices is higher prices.  Rising oil is the only real concern due to the potential reduced supply from lack of capex, but high oil prices is what kills business cycles and causes its own demise. I'm not saying this is imminent.  I own XOM too.  I'm just saying this isn't enough to sustain inflation and it murders itself in time.  Oil is cyclical, not secular.  Backwardation is saying the oil market doesn't believe in sustained oil prices. Obviously, that's not a timing signal and can stay that way for prolonged periods, or even change, but it should be noted.  To be clear, I'm not saying oil can't test its all-time highs.  I am saying high oil prices will undo themselves. 

     We lived in a 1.5% - 2% world since the GFC due to secular disinflationary forces.  Along comes Covid and throws a wrench in the economic machine. Everything goes haywire for awhile, but none of the secular forces have changed. In fact, they're all worse. There is no self-reinforcing cycle. People paid their debts or spent the stimmy money at businesses like mine and now it's in bank accounts like mine.  I'm not spending any different than I was before.  I'm looking to invest it when the time is right.  

     What we're seeing now is a potential preview of how the whole thing blows up, but it's not the real deal because these aren't sustainable causes of inflation.  Real monetary inflation is caused by a demographic explosion all demanding bank loans for a sustained period of time in a pre-globalization world before an explosion of technology.  Since that is no longer even possible, the only other way to get sustainable inflation is through sustained fiscal stimulus like Universal Basic Income because it bypasses the bank/loan equation and sends inflation directly to people to spend every week.  There's no chance of that happening right now, and Congress is likely to turn more red than blue in November, but in the future if there's a severe recession and the Fed is buying junk bonds and equities and doing yield curve control and it's still not working, that's when the end game begins as the Treasury sends out free money permanently as they battle the deflation of this historic bubble.  The Fed will be forced to raise rates to contain inflation while pinning the long-end by buying every bond, which will cause gold to skyrocket as the dollar implodes. If that was happening now, I would agree with the inflationists, but it's not. The deflationists are right that deflation is the problem, but the inflationists are right that the Fed and Treasury will not go down without deploying the full arsenal of tools to keep reinflating until their hands are tied and they must stop inflation (and/or a plunging dollar) by popping the bubble, or the bubble will pop under its own weight. I think we're years away from that.  Bond bears need to understand they're actually gold bulls.  Bonds have a perma put under them.  

     It's impossible to predict exactly when this cyclical inflation will start to rollover, but my guess is a couple more months.  I'm looking for the stock market is seek out the Fed put, which it will be able to provide because inflation will start going down.  In the meantime, the combination of inflation and Russia fears will likely cause a meaningful drawdown.  I'm thinking we're in a Fib retracement of the Covid rally.  Here's a few charts. 

30-year monthly bonds.  This is almost at the point where it's free money.  Maybe the Russian invasion will prevent it, but if this starts breaking down through this long-term trendline, I'll be layering in.  The conditions don't exist for a secular move down in bonds.  I don't really care if I miss this.  

10-year monthly notes.  Same thing.  Inflation is a train running out of fuel. 

SPX daily.  This double topped at exactly the 61.8% retracement of the impulse leg lower. If there's a series of bullish developments like Russia not invading combined with Fed officials admitting there's no inter-meeting move etc., it will likely rally once more but be a dead cat bounce.  Bears held their ground, so you have to assume they're in control until these headwinds lift.  

Here's the Fib levels of the Covid rally.  Don't be surprised to see a sharp move down.  Honestly, I'm looking at between the 50% and 61.8%, but that could be wishful thinking because I'm not even close to fully invested.  If the market finds a way to correct sideways instead of down, I'd be willing to change my mind on a break and close above the 4600 level for a couple of days.  I give that possibility a zero percent chance of happening, but the market is in control.  

Fib levels for the NDX.  Taking out the Biden presidency could be a thing. 

Another point on the chart to reconsider bearishness is the 200-day EMA on the NDX. If the market can close above there, that would force a change of thinking.  This is how you can avoid getting caught in a meltdown.  Force the bulls to prove themselves first. This is the first real impulse leg lower since the Covid bottom.  It should be respected. 

The megacap tech stocks are going to crush everything else out there once this is over.  This is not the dotcom crash, which was fledgling technology.  These are the world's greatest businesses producing record profits and cash flow with enormous global TAM, new products and services, and incredible growth ahead.  This drawdown is a gift.  All that happened is the fiscal/monetary-unleashed-pent-up-demand-and-reopening thesis got ahead of itself.  Now it's time to correct and backfill, shake people out, and let the Fed get off the zero bound, etc.  By April/May the market will have priced in the entire hiking campaign and recession, inflation will be dropping, and the Fed will be able to slow jam their dance, eventually pause, and maybe reverse.  That's my view.  Disagree as you see fit.  

BONUS CHART: AAPL drawdowns from 2004-2018.  Over this time period one out of every 4 days you were in 20% drawdown or more, 61% of the time spent in 5% drawdown or more, but if you held through it, you made 36% annually.  And that's not counting since the end of 2018 (which isn't fair because it's the bottom of a 40% drawdown, but it's up 5x since then). And they're producing record profits and cash flow. Since 2018, you can add Sept 2020 -17%, May 2019 -21%, Mar 2020 -38%.  And every time there's a bunch of risk averse people who shake their fists at the sky and proclaim it's over.   

  

  

Random Market Thoughts

        I'll start by both praising and criticizing the recent chest pounding of value investors. Clearly, you were right about Fed tightening compressing multiples and hitting hyper growth stocks first. I did figure it out because I purposely pay attention to people who have the opposite view of mine. The criticism I have of value investing can be best expressed in a story. I recently stumbled on a video of a value guy from May 2012 doing DCF analysis on Disney, which was trading at $44, and the 10-year yield he used as the discount rate was 1.79 at the time, so the discount to book value price he came up with was $40, therefore he said he would never buy Disney because it was overvalued.  For technicians, on the chart Disney was breaking out above three long-term technical peaks around $42. Last March Disney was up nearly 500% since then (not including dividends). You could sell right now 30% off the highs and still be up over 300%. And that's just one stock. Apple split-adjusted is around $36,000, and it's not likely it fit in any value investor framework for many years unless you broke the rules like Warren Buffet did. If digging through the dredges for near bankrupt companies trading below book value works for you, then have at it. I would never succeed at that. 

     I like clearly established megacap tech companies with huge growth potential and eyes on the metaverse. That includes APPL, GOOGL, MSFT, AMZN, TSLA. I've always irrationally hated NFLX. I think FB will be good in the long-term, but I'm too worried about the issue with Apple in the short-term. I like Disney for its metaverse potential and think Omnicron and the Fed is offering a good buying opportunity, although I happen to think the upcoming short-covering rally will fizzle so everything has lower to go, but who knows. My guess is TSLA revisits the $600's and then 10x's from there. I expect megacap tech to double from here.  It's just likely to go down a lot more before then. In smaller size I also like RBLX and U, and other metaverse stocks that have taken a beating. 

     Here's another reason value investing doesn't work for me. Twenty years from now after TSLA has grown 200,000% from inception like Apple did, and they have so much cash they're buying back shares and distributing dividends, and the P/E ratio is like 20, it will finally pop on the radar of value investors scrapping the barrel for safe dividend yields. Valuations are misleading. Here's what matters:

1. Is the business meeting or exceeding growth expectations? (Meaning, are you right that you bought a world class business that is expanding its market share and TAM.)

2. Position size.

3. Time in the market. 

4. Outside income to dollar cost average. 

5. Cross-asset and cross-strategy diversification.

     What you want is a balanced portfolio that can weather different market regimes. The problem with balancing bonds with tech is they both go down when rates rise. Value stocks will hold up better than tech, but when the market really gets hit all correlations go to 1, and the idea of beating a benchmark because you lost less is absurd if you don't have clients to appease. You can sell into strength or rebalance in a tax deferred account, but the reality is unless you're good at trading, which requires a specific skill set, and the dedication to put in the time, most people are better off not making decisions. The only thing you can control is how much you're willing to risk and then gauge the probabilistic drawdowns based on your portfolio construction, and be aware of what market regimes will hurt or help you, and make adjustments, or put on hedges, accordingly (although that's decisions).  The number one rule in investing and trading is you have to know how much you're risking and then deeply accept that risk. If you're risking too much you find out at the worst possible time. 

     The worst case scenario for nearly every portfolio construction (and how this entire bubble blows up) is when the Fed loses the ability to ease because inflation is spiraling out of control. I happen to think both camps are right about the current situation. It isn't fair to call it transitory, but it also isn't going to last because it's mostly supply chain problems that will self-correct, and the bond markets are saying this. There are two concerning elements, though. 

    1. The labor gap seems to be largely caused by boomers retiring to avoid Covid risk, which is creating upward pressure on wages to fill those positions. I'm not sure if they will come out of retirement or not when this is over. Wage increases that level off will cause price increases that level off.  But if the boomers stay retired for good, it could be a longer-lasting change. 

    2. If the long oil crowd is right about the lack of capex leading to reduced supply, then a reopening economy going back to full tilt will keep upward pressure on oil, which is fine as a trade, but it's as dumb as being short bonds for any length of time because the success of the trade causes its own demise. Higher rates and higher oil cause lower rates and lower oil. In comparison, Apple is $36, 000 a share because its success causes more success.  

     I want less decisions in my life, so the more I can buy great businesses with a time frame of forever and with size I can tolerate drawdowns and dollar cost average, the better.  It's unfortunate that I developed decision fatigue and realized this after the market doubled in 18 months, so I'm being cautious because dealing with drawdowns is not my speciality, but that's because size in trading is way different than size in investing, which I've already learned the hard way. I also suffered from mixing up time frames doing both myself, so I gave half my money to a broker friend for investing, and half I'll have for shorter-term or opportunistic stuff. 

     Now that the market making banks stole billions from option buyers by crushing the market into OPEX, maybe we get an oversold rally. I personally think any rallies will be hard to sustain due to lack of conviction and emboldened shorts in a rising rate environment, but as long as the Fed doesn't surprise hawkishly, it would make sense to chase shorts out before rolling over again, especially into earnings. Personally, I'm thinking of waiting until the first rate hike. We'll see.

     This market seems like it's not a V bottom kind of market. Obviously, anything is possible, but it sure seems like there's not much fear of missing out, so before I get fully invested, I want to see a double bottom, or a clear reversal hammer on the weekly.  It sure seems like it can go a lot lower. Another way is waiting for a downtrend line to break for several days and then buy weakness. If your time frame is 5-10 years, then why fret over a couple of percent?  A trick I've used on shorter time frames is picking a spot on the chart that means the bottom is likely in, and then waiting for it to cross over that area, which is usually a breakout of some sort, then waiting for weakness because breakouts never work in stocks. You do miss out on some gains, but you also avoid a lot of fake-out rallies that go south before you can finish a sandwich. 

     Everyone is looking for an answer and there isn't one. What you realize at some point is the worst thing you can have is an idea because if the market goes in your direction you will feel like you are right when you might be, but those are two separate things most of the time. And when the market goes against you, you'll end up not wanting to sell and miss out on your thesis, which can turn into deep trouble. How much are you risking?  After you make both mistakes enough times, or misjudge a market regime, or get blindsided in one way or another, or your thesis doesn't work out, what you figure out is that it's best to be balanced and never risk too much in one thing, except I must admit I do agree with the notion that once in awhile your perfect pitch comes along (and it's different for everyone) (one for me was Oct Opex), so that is the time to swing for the fences and be aggressive. The rest of the time it's more important to figure out how to keep the gains. At some point in the future, and I'm currently thinking it's years away, the Fed's hands will be tied and the market will once again go down 80% and erase a generation of gains.  That's what happens in debt-fueled markets. I like the idea of thinking about how you would construct a portfolio that lasts 100 years with no changes. Usually, lessening drawdowns means giving up some upside too, but how do you make it through the waterfalls? 

The Universal Stablecoin

~3500 words ~15 minutes

 

Dear Federal Reserve Board and Bank For International Settlements,

 

    The history of this world is a relentless battle between freedom and power - militarily, economically, and philosophically. The three-branch self-governing American system is built on a foundation of restricting power to protect freedom. The original purpose of using non sovereign gold to back the currency was to silo political power from economic power and prevent the corruption of overruling kingdoms from whence our founders fled. But gold proved to be insufficient as the chains of restraint were broken and a historic tsunami of fiscal spending and private debt enabled by the monetary policies of the Fed have engulfed this world like a degenerative disease. For the first time in history, modern technology has created an opportunity to redesign our monetary system in a way that reasserts the separation of economic and political power, which will avert and transcend the human causes of economic collapse littered throughout history. 

    This article explores private and public money, Bitcoin, gold, and the nature of value to illuminate a path forward in the spirit of public service. The thinking of government officials leans too far in the direction of control and surveillance while free market participants dismiss the need for regulation and protection of the people. The problems with our financial system date back to decisions made before any of us were born when technology was lacking to solve limitations of the physical world. Today, we stand at the dawn of a new digital age that can give birth to a system not cobbled together with haphazard and hasty ideas patched together from the remnants of the previous collapse, but thoughtfully, and proactively, designed for long lasting, even permanent, stability. 

 

Universal Monetary Problems

 

     The flaws with our financial system are all solvable with blockchain technology, but it requires a recognition and willingness to fix them proactively, or we will be doomed to repeat the same mistakes seen throughout history. Here are four major flaws: 

 

1. Interest rates underpin our entire debt-based financial system that emerged from a barter/gold system to meet the demand for credit. Since the only way to access capital was to borrow from someone else, the time value of money was born as borrowers and lenders negotiated the price of interest rates. Until now, there was no other way to do it. 

2. Centralized credit institutions arose as lenders attracted capital at one interest rate and loaned it out at a higher rate to make a profit. This evolved into complex derivatives and daisy chains of collateral connecting massive sources of capital as centralized hubs in an international network supporting the world economy.

3. Single sovereign fiat currencies are debt instruments borrowed into existence at the prevailing interest rate for both the public economic activity of government spending and the private economic activity of businesses and people borrowing from banks. But using the same currency for both private and public borrowing creates systemic risk since the government is incentivized toward fiscal profligacy, which dilutes the purchasing power of the money borrowed in the private realm as well. Until now, there was no other way to do it. 

4. Using public money as the unit of account to denominate the prices of goods and services in the economy creates an unstable inflation/deflation variable based on the market’s outlook of how government policies will affect the single sovereign currency.  Until now, there was no other way to do it.

 

Foreign Exchange Problems

 

     Throughout history we’ve tried different systems of exchange rates for our global monetary system, but all of them have tradeoffs. 

 

1. The Gold Standard is commodity money, which introduces the variable of supply and demand for gold that has nothing to do with its role of money. However, when gold backs the issuance of a paper currency it does create a restraint on the issuance of debt, and a check-and-balance on power because if too much paper currency is issued, or a problem with counterfeits arises, people (or nations) can redeem their currency for gold. As it turns out, this restraint is easy to break because it happened twice in the 20th century, so while gold does restrain governments it lacks the flexibility to meet the legitimate needs for credit in a growing economy, and it requires centralization for borrowing. 

 

2. Fixed Exchange Rates provide certainty in international trade, which makes foreign investments safer because it eliminates currency risk. Fixed rates constrain government policies from excessive spending or it results in a run on foreign exchange reserves to exit the profligate currency much like the gold standard. However, there’s no mechanism for the government to respond to shocks that cause a balance of payments crisis between countries. Fixed rates also require enormous foreign reserves, which could result in liquidity issues or opportunity costs, and while there’s no ongoing speculation, if forex markets sniff out an imminent revaluation or devaluation, event speculation amplifies it. But the biggest tradeoff of fixed rates is the inflexibility with domestic economic policies for growth, inflation and unemployment whether the rate is too high or too low. Fixed rates hamstring the government to a degree that causes its own demise - much like gold.

 

3. Floating Exchange Rates provide protection from external shocks because policymakers can respond to unexpected events - like spiking oil prices. This flexibility allows the government to pursue policies they feel are appropriate for the domestic economy. A floating rate can depreciate to compensate for a balance of payments deficit and restore competitiveness of exports. However, uncertainty of the exchange rate causes currency risk for international firms because foreign investment and trade may be adversely affected. The lack of constraint on domestic policy also allows governments to pursue excessively expansionary policies, which leads to abuse of the currency to avoid short-term volatility, or for political gain. 

 

     The common problem of these exchange rate systems is the use of single sovereign currencies as the basis for the entire monetary system in each country. What is needed is a dual system of public money and a separate universal currency based on the value creation of private businesses and the labor of people, which maintains the stability of fixed exchange rates in international trade, but leaves policymakers the flexibility of floating rates to adjust the public currency to domestic conditions. 

     What would be the best source of a universal currency to fill this role?  

 

Bitcoin Problems

 

     If you analyze the history of goods and services of this world, there is an underlying economic law: with the exception of art and collectibles, value is determined by utility. Apple is the largest market cap in the world because its products and services are embedded in our everyday life. The only time my iphone isn’t within three feet of me is when water is involved. Maybe one day it will be a chip in my head with tiny waterproof speakers implanted in my ears. That is utility. 

     While gold is no longer embedded in our everyday life, it functioned as physical money for thousands of years due to its innate qualities of being fungible, divisible, durable, malleable etc., which gave it utility as a medium of exchange and a store of value. When gold was demonetized and slowly dropped out of use, its price maintained a relationship to fiat currencies and real interest rates. As the value of the dollar was diluted, gold went up in price, thereby storing value. That utility carried on from history. 

     The US dollar could not be more embedded in our everyday lives. It’s the most widely used currency in the world. We get paid in it, everything is priced in it, we need it for taxes, and we use it for nearly every transaction everyday. The dollar’s widespread utility is the main reason it hasn’t collapsed in the face of unprecedented fiscal and monetary policies.

     Bitcoin is an innovative payment mechanism that solves the issue of trustlessly transferring value, but a group of people cannot decide something has value just because they’re buying it. Whether it has the necessary properties to develop the utility of being embedded in our lives is pure speculation, and the reasons Bitcoin bulls give are not convincing. I own a business. There’s no way I would risk my profit margins accepting a form of payment that can drop 10% in an hour from leveraged speculation that will never change. If I want to speculate, or hedge inflation risk, I can allocate after tax net profits to buy whatever is necessary to accomplish that. None of the layer one cryptocurrencies have the stability to be used as a currency in everyday transactions, which will prevent them from ever gaining the widespread utility of public money. It’s not their purpose.  

     Another reason layer one cryptos won’t work as currencies is because people buy them as investments. No one would spend their Apple stock to buy groceries either. The whole idea of investing is because you expect to make a return on the price appreciation or cash flow. Investments and currencies are two separate things, which is the primary reason for public money to exist. Public money has its own set of problems, but it works great as a currency because it’s not an investment, so people freely spend it because they’re not trying to profit on its price appreciation. The properties of gold didn’t require believing in them to give it utility, and the deep network of public money is way less volatile. The role of layer ones is to track the transfer of value on the distributed ledger and act as a seedbed for Dapps to blossom into our everyday lives to create value from utility, not to function as a currency in transactions, which requires stability.

 

The Solution: A Universal Stablecoin

 

     The goal of a stablecoin is to solve four problems:

 

1. Create a restraint on the issuance of public money.

2. Provide a stable currency to spend and accept in everyday business transactions domestically and internationally that is separate from public money. 

3. Create decentralized credit by utilizing trustless blockchain technology to allow people and established businesses to issue the stablecoin within limits. 

4. Use the value of the stablecoin as a universal unit of account.

 

     The universal stablecoin is a version of SDR + gold. Each sovereign currency would have a weighting in the basket determined by a formula based on the size of the economy, balance of payments, debt-to-GDP, interest rates etc., so the basket always equals 1. Since gold has deep historical roots as physical money and has maintained a relationship with fiat currencies, its inclusion acts as a counter to prevent a race to the bottom of all sovereigns devaluing simultaneously. 

     For example, if the weighting of the US dollar is .35, but the US debt to GDP ratio is steadily climbing past a predetermined threshold of 80% (we wish), the weighting would slowly inch downward to .34, which means another component of the basket must go up to maintain the value of 1. If the US is growing its debt faster than Europe (all else equal), then the Euro inches upward in proportion. If both are growing their debt equally, then some combination of the other sovereigns goes up, or if they’re all the same, then gold goes up, but the stablecoin always equals 1. This stable value can then function as a universal unit of account to denominate the prices of goods and services worldwide.

 

The Universal Unit Of Account

 

     Having a stable unit of account that isn’t a single sovereign currency and doesn’t fluctuate in value eliminates the currency risk for foreign investment and international trade because the same universal currency is accepted everywhere. In the U.S. a loaf of bread might cost 3.50 Unis, and while there could be local supply and demand issues temporarily affecting certain products and services, or other variables like local cost of living or other business expense differentials between countries that make the real prices of the same goods somewhat different, the inflation/deflation variable caused by prices denominated in the constantly fluctuating sovereign currencies would be eliminated. This would result in truly stable prices and offer a riskless universal currency created by private economic activity to hold your savings in as a true store of value that is accepted in worldwide business transactions.   

 

The Issuer Of The Currency 

 

      Every sovereign nation would keep its own currency to spend on government programs. Sovereign bonds would enable that spending and be interest-bearing. Banks would continue issuing interest-bearing loans to riskier borrowers. But people and established businesses would issue the Universal Stablecoin (Unis) - limited by their discretionary income - as interest-free money because there’s no middle man creating a loan and expecting a return. It is decentralized self-created credit enabled and restrained by blockchain technology.

     This money would be backed by the products, services, and future labor of the people and businesses, which creates a dual system of interest-bearing fiat sovereign currency borrowed into existence as debt, and interest-free universal currency issued by people and businesses creating goods and services. This separates the policies of the central banks and governments from affecting business activity as Unis flow through the world as the universal currency of the private realm.

     All sovereign currencies would fluctuate in value against 1 Uni, which prevents excessive fiscal spending because if everything is priced in Unis, the government currency would lose purchasing power against it and cause everything to be more expensive. By separating government currency from the universal currency issued by the value creators of people and businesses it eliminates the point of failure of using single sovereign currencies for both public and private economic activity. Central bank policies would only affect their own sovereign currency, so governments would finally be restrained from the systemic risk created by their misaligned incentives. 

 

The Universal Bank 

 

     An individual would have several accounts of interest-free credit (denominated in Unis) available to them based on their discretionary income for a house, a car, college, and credit cards. The available credit in each of these accounts would grow or shrink based on their real-time finances, and their wallet would project future credit based on increases or decreases in income and expenses. 

     The credit in each account is created out of thin air but backed by their future labor, which is the exact same process as a bank loan today except without the bank. The debt is a liability for the individual and an asset on the ledger of the system itself, which acts as a universal bank. Qualified, established businesses would issue interest-free Unis to pay their employees and supply chain to create their products and services, which would act like a currency and not a stock investment, so there wouldn’t be a hesitancy to spend it. (I wrote more about this in The Universal Bank.)

 

The Universal Wallet

 

     Zero-knowledge proofs allow wallets to be linked to a real person without revealing their identity. This makes it possible to have a system of verified users who can only send money to other verified users, and allows the wallet to be programmed to automatically send taxes to the government but without revealing the identity. The government would know who paid their taxes, but not the wallet the individual owns, so it would be impossible to evade taxes, and yet still maintain privacy of transactions. 

     Personally, I think a consumption tax system would be better but it could work either way. Consumption taxes are very regressive, but the wallets could be programmed so if you make under a certain income threshold you don’t pay any taxes at all. And the sales taxes could be automatically sent to the government wallet in real-time. 

     Universal Wallets also solve a lot of SEC issues about regulating securities because the wallets could be programmed to only “unlock” access to accredited investment opportunities if the person is qualified by income, net worth, or a course they took. Wallets that offer investment opportunities could only accept money from wallets unlocked for that tier of investment, which could also send any information the SEC requires, so there wouldn’t be any concerns over investor protection in a predominately decentralized system because it’s all controllable through open source programming people could see and trust. 

     The wallets would contain all your stocks, bonds, and currencies (US dollars and Unis), and only be allowed to spend with some combination of security features like facial recognition, 2-step text, whitelist…etc.. Smart contracts could even embed money spent with a 7-day clawback feature akin to how chargebacks work to reduce fraud. Insurance and custody solutions would naturally arise. (I wrote about this in The Universal Wallet.)

 

 Permissioned Problems

 

     The government wants a permissioned centralized system where everyone has an account at the Fed or the Treasury, and while the most important feature of what I’m proposing is the interest-free credit and universal stablecoin, which could be done that way, it’s extremely important to not allow a purely centralized system to happen for no other reason than the government (present or future) would be able to enforce negative rates and other incentives or interventions that perpetuate the same behavior of repressing short-term volatility for long-term instability, not to mention invasive surveillance of our transactions, all in the name of political gain and control. The system must be designed to be dictator proof so any kind of unforeseen hostile takeover in the future is impossible. The entire point of the universal stablecoin is to impose a restraint on power like our three branches of government. A controlled, permissioned system is the opposite of that, and it’s exponentially more vulnerable to security attacks, which creates systemic risk. 

      

The Path

 

     I understand this proposal sounds impossible to implement, but it’s not, mostly because it benefits everyone except banks. Even politicians would love to run on the people pleasing idea of interest-free credit. When something is as beneficial as this to as many people as this it’s not a matter of whether it’s possible, it’s a matter of what path it will take, and while there are two avenues forward, both involve the governments of this world recognizing we’re headed for global standards. 

     While the status quo doesn’t tend to be proactive, I believe our political and monetary leaders recognize the fragility of our financial system and can’t admit it publicly, so I implore them to not bury their heads deeper in denial and do nothing because they will force a revolution when the current system implodes, which I don’t believe is imminent, but time will run out. It is broken. With the amount of fiscal spending that happens nowadays it would be wise to at least develop this as a backup. 

     Alternatively, this could be privately developed. The free market could choose to use the stablecoin and wallet in everyday business transactions, but the interest-free credit would still require the government to allow it as legal tender. Founding investors would make billions from tiny transaction fees. I believe this project would be better funded by public money for public good, but if no one in government is interested, the private path of revolution would be scintillating.

     Once the stablecoin and universal wallet system was ready, and the government recognized the need - whether proactively or through revolt amid a crisis - everyone would transfer their interest-bearing house, car, college, and credit card loans from banks into their universal wallets denominated in interest-free Unis. Nationalizing the banks implies government ownership, which this is not. It’s more like universalizing the banks, which would dramatically shrink their size, and the vulnerability centralized credit creates. Financial crises would become obsolete. 

     Here’s a few basic categories of a wallet:   

 

 UNIS: 44,876   USD: $22,438

 

Loans	Car	House	College	Credit Cards
Balance	17,985	156,931	34,549	7,902
Tiers	Income Bracket	Sales Tax	Investor Status	Bills
	75,000	18%	Intermediate	Utility…

 

Notes

 

1. The fluctuations within the Universal Stablecoin as one fiat goes up countered by other components going down could be determined solely by a formula, or utilize forex markets that trade every currency against 1 UNI: USD/UNI, EUR/UNI, JPY/UNI etc.. (or both)  

2. Another idea beyond the scope of this article is attaching interest to the issuance of the stablecoin beyond a predetermined threshold. For example, the first 100% of a person’s discretionary income is interest-free, the next 25% has 1% interest attached and so on, which is automatically extracted from their income, and increases up to a limit where it’s capped. This would create a market of people who want to hold that money to collect interest, which would reduce the need for banks even further. This could also be applied to riskier businesses like the way junk bonds function, except it’s currency they create with high interest attached. Government money could also function the same: the higher the level of debt, the higher the level of interest automatically. In theory, the bond market wouldn’t exist because the interest rate would be determined by a mathematical formula, attached to the created currency, which would cap the level of debt as it gets prohibitively expensive. 

3. The second half of Freebird is the best four minutes of music ever recorded.