'Tis the season for large cash withdrawals

A recent tweet from Matthew Yglesias made me smile:

'Tis the season for large cash withdrawals in anticipation of holiday tipping

— Matthew Yglesias (@mattyglesias) December 17, 2015

Inspired, I've updated my December 2012 Merry Cashmas chart showing the annual Christmas and New Year's cash demand spike. See below.

Tipping might certainly be one reason for the annual cash spike, but I'd bet if you look at data from Europe where tipping is not a tradition you'll still see a jump.  Because we can't anticipate all the random events that will arise when we travel long distances to meet our loved ones, we purchase insurance in the form of larger cash holdings. Thus you can see a consistent seasonal spike in currency in circulation in the weeks before Christmas. Those amounts falls heavily in January. Having returned to our regular schedules, insurance against uncertainty is no longer necessary so we redeposit our cash at the bank.

The U.S. Christmas spike has gotten less marked over the years, most likely because of increasing usage of U.S. banknotes in non-Christian countries and by criminals. But you can still pick it out on the chart.

A few differences between my December 2012 post and this one...

Whereas the 2007-2014 period (the light blue line) opened with stagnant U.S. cash demand, the 2015-2022 period (the black line) has shown a return to 1990 growth rates. People want U.S. dollars again.

Why is this? Well, it has nothing to do with interest rates being near their lower bound. Rather, consider that the U.S. dollar had become quite unpopular as a world transactions medium during the 2000s thanks to its steady decline in value relative to other currencies, especially the euro. Once the euro crisis hit in 2011, that changed. Since then, the U.S. dollar has appreciated relative to almost every currency in the world. Along with this, its cachet outside the U.S. has returned. I go over all these factors in this post.

---

This may be my last post in 2015, so once again, thanks to all my readers, lurkers, haters, and commenters.

My most popular blog posts this year according to number of page views were:

1. The final chapter in the Zimbabwe dollar saga?
2. Why bitcoin has failed to achieve liftoff as a medium of exchange
3. Freshwater macro, China's silver standard, and the yuan peg
4. Sweden and Peak Cash
5. The ZLB and the impending race into Swiss CHF1000 notes
6. A Lazy Central Banker's Guide to Escaping Liquidity Traps
7. Euros without the eurozone
8. Zimbabwe's new bond coins and the demonetization of the rand

...of which, I'd say my Lazy Central Banker's guide is the most important. For some reason no one liked Why Big Fat Greek Bank Premiums, despite the fact that I think I pretty much nailed it. And as usual, I wrote my share of material that, at the time, seemed stellar to the author but upon rereading a few months later, t'was dreck.

My main blog referrers in 2015 were Mark Thoma, FT Alphaville, Marginal Revolution, Chris Dillow, and David Andolfatto. Thanks!

Was Bretton Woods a real gold standard?

John Maynard Keynes and Harry Dexter White, who contributed to the design of the Bretton Woods system

David Glasner's piece on the gold standard got me thinking about the Bretton Woods system, the monetary system that prevailed after WWII up until the early 1970s.

There are many differences between Bretton Woods and the classical gold standard of the 1800s. My claim is that despite these differences, for a short period of time the Bretton Woods system did everything that the classical gold standard did. I'm using David's definition of a gold standard whereby the monetary unit, the dollar, is tied to a set amount of gold. This linkage ensures that there can never be an excess quantity of monetary liabilities in circulation—unwanted notes will simply reflux back to the issuer in return for gold. When most people criticize Bretton Woods, they say that it lacked such a linkage.

A narrowing redemption mechanism

For a gold standard to be in effect, a central bank's notes and deposits have typically been tied down to gold via some sort of redemption mechanism. In the days of the classical gold standard, central banks didn't discriminate; the right to redeem was universal. Whether black or white, big or small, male or female, you could bring your notes or deposits to a central bank teller and have them be converted into an equivalent quantity of gold coin. Any unwanted notes and deposits quickly found their way back to the issuer.

After 1925, the world adopted a narrower redemption mechanism; a gold bullion standard. Economist and trader David Ricardo had recommended this system a century before as a way to reduce the resource costs of running a gold standard. Gold coins were withdrawn from circulation, and rather than offering to redeem notes and deposits in coin, the monetary authorities would only offer bulky gold bars. This excluded most of the population from redemption since only a tiny minority would ever be wealthy enough to own a bar's worth of notes.

It might seem that this narrowing of the redemption mechanism compromised the gold standard. After all, if too many dollars were created by a central bank, and these fell into the hands of those too poor to redeem for bullion bars, than the excess might remain outstanding rather than refluxing back to the issuer.

But consider what happens if a free secondary market in gold is allowed to operate. Unable to send excess notes to the central bank, less wealthy gold owners can sell them in the free market. This would drive notes to a discount relative to their official price, at which point large dealers will buy them and bring them back to the central bank for redemption in bars, earning arbitrage profits. The free market price is thus kept in line with the central bank's redemption price. So as long as the wealthy and not-so wealthy are joined by a market in which they can exchange together, then a narrower redemption mechanism needn't impinge on the proper functioning of a gold standard.

Anyone who has toyed around with ETFs will know what I'm talking about. Despite the fact that a gold ETF limits direct redemption to a tiny population of investors (so called authorized participants), the price of the ETF will stay locked in line with the market price of gold. Authorized participants earn profits by arbitraging differences between the ETF and the underlying, thus maintaining the peg on behalf of all ETF owners. You don't need many of them; just a few well-heeled ones.

When authorized participants don't do their job

The U.S. narrowed the gold redemption mechanism even further when, in 1934, Roosevelt limited redemption to foreign governments. As long as foreign governments and the public were joined by a market, then excess notes could be sold to these governments and returned to the U.S. for gold at the official price. The free market price and the U.S.'s official price would converge and a gold standard would still be in effect.

Things didn't work that way. After it entered WWII, the U.S. continued to buy and sell gold to governments at $35, but gold traded far above that level in so-called free gold or premium markets in Zurich (see chart below), Paris, Beirut, Macau, Tangiers, Hong Kong, and elsewhere. The existence of premium markets continued through the 1940s and well into the 1950s.

While private dealers have incentives to engage in arbitrage, national governments are driven by political motives. Governments no doubt could have earned large profits by buying gold from the U.S. at $35, shipping it home, and selling it in their domestic free gold markets at $45 or $50, but they chose not to, most likely to avoid raising the ire of American officials.

The monetary system in the 1940s and 1950s was a malfunctioning ETF. For various reason the authorized participants (ie. foreign governments) were not arbitraging differences between the price of the ETF and the underlying, and the ETF was therefore wandering from its appropriate price.

With the redemption mechanism compromised, the supply of U.S. monetary liabilities in circulation could exceed the demand, the result being that the market price of dollars sagged to a discount to their official price. Bretton Woods, with its multiple prices for gold, was not a gold standard, at least not yet.

The London gold market

It was only in 1954 that the so-called "free gold" price in Zurich and elsewhere finally converged with the official price of $35. This happened more by accident than purposeful arbitrage conducted via the redemption mechanism. On the supply side, the Soviets were bringing large supplies of "red gold"  to sell on free markets while the South Africans were diverting more gold away from official buyers in order to earn wider margins. At the same time, the end of the Korean War was reducing safe haven demand.

Source: The Economist

Once parity between free gold prices and the U.S. official price was established, the London gold market reopened for business. London had always been the largest gold market in the world, far eclipsing Paris, Zurich, and the rest. Its re-opening had probably been delayed for face-saving reasons. Given that the Brits and the Americans effectively ran the world's monetary system, they could safely ignore premium markets in Zurich and Paris. But the existence of a British gold price in excess of the official price would have been embarrassing. Upon the market's reopening, British authorities limited the ability of locals to buy on the market (they could freely sell) but put no restrictions on the ability of foreigners to participate in the London gold market.

From the time it opened in 1954 to 1960 the London price was well-behaved, staying locked in line with the official price. In October 1960, however, speculators took over control of the London gold market and sent the price of gold to an intraday high of $40, well above its official price of $35. Rather than arbitraging the market by buying from the U.S. Treasury at $35 and selling in London at $40, foreign central banks stepped aside.

The London gold pool

The authorities' response to the 1960 gold crisis is what finally turned Bretton Woods into a real gold standard, at least in my opinion. While the U.S. had ignored premium markets in the 1940s and early 50s, they couldn't ignore a premium market in their own backyard. At the behest of the U.S., the London gold pool was formed. Under the management of the Bank of England, the pool assembled a gold war chest with contributions from the U.S., U.K., Germany, Holland, France, Italy, Belgium, and Switzerland. Whenever gold rose above $35.20, the pool sold gold on the London market in order to keep the price steady. When it fell to $34.80, it bought in order to support the price. The existence of the pool was never officially declared, but everyone knew it was in operation and had the task of setting the London gold price.

This effectively created a functioning gold standard. Before, the only mechanism connecting the public's excess dollars with the U.S.'s gold was the somewhat unpredictable predilection of foreign governments to buy that excess and exercise the right to return it for redemption. Now the public could deal directly with the U.S. government by selling on the London gold exchange to the U.S.-led London gold pool, which guaranteed a price of at least $35.20.

And as the chart below shows, the pool worked pretty well for the next few years, keeping the price of gold in a narrow range. However, the devaluation of the British pound in 1967 and the departure of the French from the gold pool shook confidence in the $35 peg. The system imploded in March 1968 when a steady jog into gold accelerated into an all out run. Rather than continue to bleed gold to speculators, the London gold pool disbanded and the price of gold in London shot up to over $40, well above the official price of $35.20.

But from 1961 to 1968, the world pretty much had a gold standard. Or, put differently, thanks to the opening of the London gold market and the arming of the London gold pool, the world's monetary system between 1961 and 1968 did pretty much everything that the  gold standard of the 1800s did. After 1968, the U.S. dollar slid back into its earlier Bretton Woods pattern of having more than one price in terms of gold; the $35 official price and the "free" London price. This was no gold standard. When Nixon famously dismantled the already-narrow redemption mechanism in 1971, most of the damage had already been done.

The desert dollar industry

January 1, 2021

Jessie Smith, who owns a dusty motel in Beowawe, Nevada, had to turn away customers yesterday. No vacancy, Smith told the recent arrivals, the first time she has uttered those words since she bought the motel twenty years ago.

These days, the desert is swimming in cash... literally. Over the last six months, a booming business in illegal cash storage has sprung up in Nevada, New Mexico, and Arizona where analysts estimate that $30 billion worth of $100 notes have been hidden. By day, smugglers drive deep into the desert, SUVs loaded down with suitcases full of Ben Franklins. Once they've found an ideal spot, they wait till the sun goes down and frantically dig a hole, only to drive away the next morning with nothing but the cache's GPS coordinates and a drone or two to guard it. When asked about the sorts of people staying at her motel these days, Smith shrugs. "I don't ask who they are and they pay cash."

This is life in the Great Deflation. What began as a steady disinflation early last decade (a decline in the global rate of inflation) slowly turned into all out deflation by the turn of the decade. In response, central bankers around the world simultaneously increased their inflation targets from 2% to 4% and fully re-loaded their quantitative easing programs. To their embarrassment, consumer prices only continued to decline, crescendoing into what the press has dubbed hyperdeflation; annual global price declines of 2-3%. The Fed is currently in its fifth round of QE and, along with most central banks, has kept its key interest rate at the effective lower bound of -1.25% since 2019. To no avail.

Consensus among central bankers is that -1.25%, and not 0%, is the lowest interest rate that the public will endure before converting deposits into 0%-yielding cash. This level emerged as the consensus when the Swiss National Bank reduced rates to -1.5% back in 2018. A stampede into Swiss banknotes ensued. When the Bank dialed the rate back to -1.25%, the Swiss public re-deposited notes back into their bank accounts. Since then, no central banker has dared reduce rates below this magic level. If they did, they'd risk losing control of monetary policy (as if they haven't already) as well as causing a run on the banking system.

But wait. The world's newest monetary experiment is about to be unveiled...

Throughout 2019 and 2020 the world's monetary architects have been steadily dismantling effective lower bounds in many large economies, giving central bankers, until now stuck at -1.25%, the ability to reduce interest rates deep into negative territory. Many say that the world is on the cusp of something so new that we don't even have a word for it. The opposite of disinflation (disdeflation?), the dawning phenomenon of gradually declining deflation is being dubbed by the econblogosphere the Great Reflation. Some are forecasting that we'll soon be moving back up to -2 or -1% deflation... maybe even zero.

The Europeans started to dismantle their lower bound in 2019. They did so by having the ECB cancel all 500, 100, and 50 notes, leaving only the lowly 20 to circulate as the eurozone's highest denomination bill. And when a new 20 euro note was issued in January of last year, the ECB doubled its surface area from 72x133 mm to a cumbersome 108x200 mm. A standard suitcase now only fits half as much raw value, thus burdening noteholders with extra storage and handling costs. Even when folded in half, a single 20 note no longer fits snugly into a pocket. Which means that when the ECB drops rates into deeply negative territory (which it is expected to do at its next meeting), the European public probably won't bother converting deposits into clunky cash.

The U.S. was soon to follow. Unlike Euro notes, American bills are 70% cotton. So when the Fed first floated the possibility of removing $100 and $50 denominations from circulation last year, the cotton lobby exerted enough pressure that Fed officials decided to rethink their strategy. Instead of withdrawing $100s and $50s, the Fed asked Congress to make mass cash storage illegal. As of July 2020, any member of the public caught holding more than $1000 in bills risks having their stash confiscated, with corporations and financial institutions facing cash limits of their own. In theory, this should allow the Fed to set deeply negative interest rates.

Which explains why Nevada's deserts are being punched full of holes. The $1000 limit, combined with the possibility of deeply negative rates next year, means that storage of 0%-yielding paper has the potential to be incredibly profitable. To combat the so-called desert dollar industry, the U.S. Secret Service's counterfeit currency team has been retasked with patrolling vast empty patches of desert. So far their raids have had mixed success; smugglers have been diverting their hoardes across the border into Mexico or Canada. New legislation is being tabled to restrict cash exports and should be passed later this month. In any case, the significant costs that smugglers face in evading the Secret Service means that the Fed should be able to safely bring rates to -3% or so at its next meeting without facing mass flight into paper dollars.

Despite having dismantled its lower bound, the Fed held back from a rate cut at its recent policy meeting. Why? There is a growing faction in the Fed that says that reducing interest rates could very well prove disastrous. Not only would a cut not stoke inflation, it could exacerbate the existing hyperdeflation. To replace hyperdeflation with inflation, you need to raise interest rates, not drop them, claim members of this faction. Ratchet the interest rate up to 3% and arbitrage dictates that a gentle inflation will be restored. After all, if the Fed is compensating investors with a 3% return on its highly-liquid risk-free liabilities, then those investors will be content with an expected decline in the purchasing power of those liabilities, say a 1-2% inflation.

Once a taboo idea, the ongoing inability on the part of central banks to reign in deflation has brought this sort of turn-the-wheel-left-to-go-right thinking into vogue. Not only are central bankers finding it increasingly difficult to understand their traditional interest rate tool—it may not do what they always thought it did—but bond traders have been thrown into confusion. For years, the ECON 101 courses they learnt in college taught them that a reduction in interest rates leads to higher prices, not lower ones. Now they're not sure.

Jessie Smith, however, is 100% sure where she casts her lot; whichever direction keeps the cash flowing into Nevada. She's hoping that the Fed plunges rates to -5% next year, which would only increase her customers' incentives to store cash. As for a hike back into positive territory, the thought makes her shudder. Why hold 0% cash when you can earn 2 or 3% in the bank? Nevada's desert, now full of cash, would rapidly return to normal, and Smith's hotel would go back to having vacancies again.

Riding on the coattails of Sergey Brin and Larry Page...or not

How much is a corporate vote worth? To answer this question, look no further than behemoth Google. One of Google's voting share costs $779, around 1.7% more than a non-voting share at $764.

Why has a "voting premium" emerged in Google shares? How might the shape of this premium evolve?

A bit of background first. The public can invest in one of two Google share classes: Class A shares, listed as GOOGL, or Class C shares, listed as GOOG. Class A shareholders benefit from one vote per share whereas Class C shareholders get no vote. Because a vote is the only difference between the two classes, we can infer that the Class A premium represents the value that investors attach to voting power. The total market cap ascribed to the 288 million or so Class A votes is $4.3 billion. (Note that Google has been recently renamed Alphabet).

I've mapped out the history the Class A voting premium below:

Since non-voting shares were first issued in 2014, voting shares have been worth as much as 5% more than non-voting shares with a minimum premium of 0.5%.

It just so happens that Canada, my home and native land, provides plenty of fodder for understanding Google's odd capital structure. For decades wealthy Canadian families have been using dual share class structures to simultaneously get access to capital markets while retaining control of the family firm. Sell the public non-voting shares (or single voting shares) and retain the voting class (or multiple voting). Think of the Bombardier family, the Desmarais clan (Power Corp), or the Billes bunch (Canadian Tire).

Large gaps, or voting premia, have often developed between the price of Canadian-listed voting and non-voting stock. Case in point is the differential between Rogers Communications' non-voting and multiple voting shares, controlled by the Rogers family, which has averaged around 5% going back to 2000:

With Google's dual share structure still  relatively new, should Google's investors expect a differential that reaches the size of Rogers' differential, which has hit as high as 15%?

Let's work through the logic. In Canada, the existence of a gap is usually traced to the unequal way that the two classes are sometimes treated in takeovers. A buyer desperate to consummate a deal with a Canadian-listed company characterized by a dual share structure will often offer voting shareholders a large premium to buy their vote while dangling a much smaller reward in front of non-voting shareholders.

For instance, in 2006 Bell Globe Media paid the owners of CHUM’s voting shares 12% more than it paid owners of non-voting shares when it took the company over. When BCE acquired Astral Media in 2012, it offered non-voting shareholders $50 per share (a 39% premium to the market price), single voting shareholders $54.83 (a 9.7% premium on top of the 39% premium accorded to non-voting shares) and multiple voting shareholders $769, an astonishing 1438% premium!

This sort of favoritism is detrimental to small shareholders. If an acquirer has earmarked a fixed amount of dollars to make a deal, non-voting investors may very well have to give up a large chunk of that pie to the voting elite. That may explain why Google's voting shares trade at such a large premium to the non-voting shares. When you buy non-voting Google shares, you do so at your peril. Buy the voting shares and at least you have a degree of protection against a low-ball takeover offer.

Note that this sort of unequal treatment may apply in share collapses too. When Toronto-listed ShawCor eliminated its dual class share structure in 2013 in order to adopt a standard single share structure, Class B multiple voting shareholders received 10% more of the newly-created shares than Class A subordinate voting shareholders did. By analogy, should Google ever choose to revert to a regular structure, Google Class C non-voting shareholders may not get as much of the new entity as its voting shareholders get—which might help explain the current 1.7% premium.

Non-voting shareholders are not without protection here in Canada. The degree of protection afforded depends on the coattail provisions that may (or may not have) been accorded to non-voting shareholders in a company's charter. Coattail provisions dictate that should a takeover occur, all classes of shareholders are to receive equal terms. In essence, the weaker group gets to "ride on the coattails" of the stronger. Since 1987, the Toronto Stock Exchange requires that all new share listings that suffer from voting restrictions include coattail provisions in their corporate charter. However, shares with restricted voting rights issued prior to 1987 were grandfathered their existing structure and not obligated to provide coattail provisions.

The protection offered by coattail provisions tends to reduce dual share pricing disparities. For instance, the difference between the subordinated and superior voting shares of Dorel, issued in 1991 and therefore not enjoying grandfathered status, have averaged around 1.05% since listing, much narrower than the 5% gap between Rogers share classes (which was grandfathered its unequal structure).

As these Canadian examples illustrate, the size of Google’s Class A premium over Class C non-voting shares should be very sensitive to the protections afforded to Google Class C shareholders in the event of a corporate change of control. So what about Google's coattails? Does it have any?

Unlike the Toronto Stock Exchange, the NASDAQ, the exchange on which Google is listed, does not require issuers to include coattail provisions. However, according Google’s articles of incorporation Class A and C shares enjoy some degree of protection. I've screenshotted one of the relevant passages, the so-called "Equal Status" clause:

From Google's Articles of Incorporation

In a nutshell, in the event of a merger, consolidation or other business combination requiring the approval of shareholders, holders of the Class A and C common stock have the right to receive the “same form of consideration” as the holders of the privately-held Class B common stock, the latter being the shares owned by founders Sergey Brin and Larry Page. So if Brin and Page are offered $800 for their shares, and they accept, then all other shareholders get the same right.

So given a cursory read through of Google's articles, a takeover premium on Class A shares should not exist and Google's share gap should not be wide like Rogers' share differential. Google coattail provisions as set out in the 'equal status' clause prevent it. Go out right now and short the living daylights of voting shares while going long the non-voting. It's an easy arbitrage.

Or not. The Canadian business community has a long history of successfully evading the triggering of coattail provisions. In 1997, for instance, Emily Griffiths offloaded the Griffith family's business, Western International Communications, or WIC, by selling its voting and non-voting shares to Shaw Communications, the voting shares being pawned off at a $22 premium to non-voting shares. WIC's articles contained coattail provisions that, in principle at least, should have allowed the non-voting shareholders to enjoy the same takeout price as the voting shareholders. Griffiths were able to structure the deal to avoid setting off the coattail provision (specifically, she sold her stake to multiple parties along with Shaw) and thus extracted the entire takeover premium for herself.

What does this have to say about the value of a Google vote? Beware the fine-print. As in WIC's case, an able team of lawyers might be able to hack Google's Class C coattail provision in order to steal money from the pockets of non-voting shareholders to put in the pockets of voting shareholders. If so, that would explain why a voting premium exists; it represents the price that investors are willing to pay to insure themselves against such chicanery.

Zimbabwe's new bond coins and the demonetization of the rand

Issued a little less than a year ago, Zimbabwe's bond coin is one of the world's newest monetary units. The bond coin is designed to solve one of the most venerable problems in the pantheon of monetary conundrums; the big problem of small change—a nice turn of phrase coined by economists Tom Sargent and François Velde (excuse the pun).

Some background first. When Zimbabweans spontaneously ceased to use worthless Zimbabwe dollars in 2009 they simultaneously adopted a ragtag collection of currencies including the South African rand and U.S. dollar. Unlike cash, coins are heavy—shipping them over to Zimbabwe from the U.S. is prohibitively expensive. So while Federal Reserve banknotes have tended to be used in large value transactions, rand coinage from neighbouring South Africa has been recruited for use in smaller transactions. Unfortunately, there has never been enough coins to conduct trade. The demand for small change is so large that items like gum or candies or IOUs have often been used as coin-substitutes.

The bond coin is a brave attempt by the Reserve Bank of Zimbabwe's (RBZ) incoming Governor John Mangudya to fix the small change problem. Issued in denominations of 1, 50, 10, 25, and 50 cents, each bond coin is worth an equivalent amount of U.S. cents. Issuing small change is an entirely sensible goal for a central banker to pursue. It's low hanging fruit—a cheap solution to a significant problem that disproportionately hurts those who rely on coins the most, the poor.

But how can an institution that has lost all credibility—and deservedly so—successfully float a new monetary unit? Only with a little bit of help, it seems. The RBZ's FAQ on bond coins says that the new issue is backed by a "bond facility." What does this mean? Unfortunately the RBZ forgot to answer that question in its FAQ, as the screenshot below indicates (ht Twitter finance's @guan).

Oh dear.

Reading through some earlier news reports, let me try and answer on their behalf. We know that the African Export-Import Bank (Afreximbank), based in Cairo, opened up a US$200 million line of credit with the RBZ last year. Presumably some portion of this line of credit will be used to ensure that bond coins stay pegged to the U.S. dollar. Should the bond coin fall below the dollar, for instance, the RBZ will have to draw down on its bond facility with Afreximbank to repurchase the coins. Thus the moniker "bond coin." At least, that's the story that the RBZ Governor John Mangudya has been providing. So far the value of bond coins has held, so Zimbabweans see Afreximbank backing as credible.

The minting of U.S. dollar tokens isn't a novel idea. Other dollarized nations have introduced coins to make up for the lack of U.S. change. Panama, for instance, has the balboa while Ecuador and East Timor have the centavo. Zimbabwe's is a well-trodden path.

The RBZ's new coins were initially greeted with a large amount of skepticism. No wonder. This is an institution that generated an inflation rate of 79.6 billion percent (with the help of Robert Mugabe's insane fiscal policy). However, a sudden glut of news articles say that Zimbabweans have begun to embrace bond coins in earnest. At the same time, no one wants South African currency anymore, with retailers and banks increasingly refusing rand coins.

Why is that? Zimbabweans have been transacting with both rand and dollars since 2009 but they have been setting prices in the latter. The dollar, not the rand, is the unit of account. This means that any transaction involving rand is inconvenient as it requires a foreign exchange conversion back into dollars prior to consummation. Over the last few years, Zimbabweans have solved this problem by the informal adoption of a "street" rate of ten rand-to-the dollar.  They use this rate as a rule of thumb even though the market exchange rate has deviated quite far from it. The advantage of a nice round number is that it reduces the calculational burden of a two currency system.

For instance, one of the more ubiquitous commercial experiences in Zimbabwe, a ride on a privately operated bus, or kombi, has been priced at $0.50, or five rand, for many years now. It's interesting that this price has undervalued the rand relative to its actual market rate. In 2012-2013 the U.S. dollar was worth around eight rand, so a kombi ride should have only cost commuters four rand, not five. But convenience seems to have trumped exactitude, especially with small change being so hard to come by.

With the greenback having spiked in late 2014 and 2015, the U.S. dollar is now worth around fourteen rand. In this context, the old informal ten-to-one exchange rate no longer makes much sense. A massive coordination problem seems to have developed. While kombi drivers still charge fifty U.S. cents per ride, they have reportedly begun to charge as much as seven rand for a trip, or a 14-to-one exchange rate, thus breaking with the traditional ten-to-one street rate. Customers are not happy. When they pay with US$1, they are now asking for a 50 cent bond coin as change. After all, if they get five rand in change, that won't be enough to afford the new seven rand price on their next ride.

The period of economy-wide haggling necessary to settle on a new generally accepted "street price" for the rand no doubt imposes significant costs on Zimbabwean society. Thorny issues of fairness come to the forefront. And if the new rate isn't a nice round number, payment calculations becomes a burden. Before the bond coin's appearance on the scene, Zimbabwe would simply have endured this period of rand-induced calculational turmoil as it slowly groped to a new equilibrium. But this time there's a small change alternative to the rand. The sudden adoption of the once unpopular bond coin by Zimbabwean society may be a convenient hack for getting around the complexity of adjusting to rand volatility. If so, all that the bond coin needed for mass adoption was either a sharp rise or fall in the rand. Without that volatility—i.e. if the rand exchange rate had stayed near ten-to-one forever—then the requisite chaos for bond coin acceptance would never have appeared.

Monetary economists have long debated the idea of a divorce between a nation's unit-of-account and its medium-of-exchange. (See Tyler Cowen, for instance, on New Monetary Economics). This is the notion that a nation's prices can be set in terms of one unit and its transactions carried out in another; a notion exemplified in Zimbabwe where prices are set in dollars but rand trades hands. I think Zimbabwe's recent adoption of the bond coin bears out economist and blogger Larry White's stance on the subject. White, who wrote a skeptical paper on the prospects for medium-unit divergence, maintains that the practice of harmonizing the unit in which we transact with the unit for posting prices is an evolutionary inevitability. A divorce is simply not in the self interest of economic actors. Harmonization-

...economizes on time spent in negotiation over what commodities are acceptable in payment and at what rate of exchange. More importantly, it economizes on the information necessary for the buyer's and the seller's economic calculation.

For these reasons, a unit of account is typically "wedded" to a general medium of exchange, says White. In Zimbabwe, the convenience of wedding the medium-of-exchange with the unit-of-account is playing out in the mass disgorgement of rand and adoption of US$-denominated bond coins. This is just another chapter in Zimbabwe's ongoing game of monetary musical chairs. Having spontaneously demonetized the Zimbabwe dollar in 2009 for the rand, they are now demonetizing the rand in favour of Zimbabwean U.S. dollars. If White is correct, expect this new evolution to be a permanent one.

Arbitraging the 49th parallel

Thanks to a floating exchange rate and one of the longest undefended frontiers in the world, the U.S.-Canada border is the thoroughfare for what may be one of the world's most popular ongoing consumer arbitrages.

Canada and the U.S. interlist all sorts of goods, services and financial assets. We both sell McDonald's hamburgers, we both offer tickets to NHL games, and we both list Valeant Pharmaceutical shares. The relative price of Valeant shares, which trade in New York and Toronto, will rapidly adjust to any change in the exchange rate. If not, then upon an appreciation of the U.S. dollar an investor will be able sell Valeant short in New York at an artificially high price, buy Canadian dollars with the proceeds, and acquire shares in Toronto on the cheap, using those shares to cover the short position in New York at a profit. Exploitation of this opportunity will realign Valeant's New York and Toronto share price until the window closes, thus cannibalizing the potential for arbitrage gains. This process takes seconds.

Financial prices are set "immorally." In the moral economy of Main Street, goods and services prices stay fixed for long periods of time. At time = 0, say that Big Macs and hockey tickets have the same real price in the U.S. and Canada so that people have no reason to prefer shopping in one country or the other. The moment that the Canadian dollar appreciates, a consumer arbitrage window opens that allows Canadians a chance to boost their welfare. Since sticker prices in the U.S. don't change, Canadians can now cross the border and buy more Big Macs and hockey tickets than they could if they had stayed parked in Canada. So much for the law of one price. This window will stay open for quite some time. Bils and Klenow (pdf), for instance, report that lunch menu prices in the U.S. only change once every 10.6 months while sporting event admission prices only adjust once every 3.9 months. (That's almost eleven months of free lunches.)

The chart below, which uses data from the Canadian Border Services Agency, illustrates how North American migration patterns fluctuate as the arbitrage window switches in favor of either the U.S. or Canada.

As the chart shows, the difference between Canadians visiting the U.S. and Americans visiting Canada (the green dotted line) is correlated to movements in the exchange rate. A weak loonie in the early 1980s and 1992-2002 encouraged more Americans to visit Canada while decimating the hoards of snowbirds headed south. The strong Canadian dollar from 1986-1992 and 2002-2011 did the opposite, stifling American visits while inspiring Canadian exits. The loonie's plunge over the last twelve months, aggravated by the collapse in crude oil prices, has finally begun to bring increasing amounts of Americans over the border for the first time in over a decade.

Going forward, expect to see more stories like this ("explosive growth" in Alberta ski hill bookings for this winter), this (Montreal sees best tourism season in years), this (Thunder Bay's tourism picks up) and this (bad news for Buffalo's airport).

Or course, you can't get something for nothing forever. Prices are rationing devices. When a good's price is fixed at an artificially low level then costly lineups will develop, substituting for price signals as a rationing device. The sudden undervaluation of goods & services on either side of the 49th parallel as the exchange rate fluctuates should give rise to congestion at the border, modulating the size of the consumer arbitrage window.

By the way, the chart above illustrates one of the advantages of having a floating exchange rate. Without a collapse in the loonie, price ratios between the U.S. and Canada would have remained much more rigid over the last twelve months, preventing the emergence of a consumer arbitrage opportunity in favour of American consumers. Canadian aggregate demand, already depressed by weakness in the energy sector, wouldn't be benefiting from an influx of American shoppers and returning Canadians. Unemployed oil workers in Fort McMurray wouldn't be getting the opportunity to find work on Banff's booming ski hills.

Human capital bonds

After last week's post on the relative benefits of renting versus buying a home, Ryan Decker sent me to his earlier post on the subject. In it Ryan mentions an interesting concept I'd never heard of before; lifecycle investing.  Developed by Ian Aryes and Barry Nalebuff (pdf), the idea is that investors in their twenties can reduce risk and improve returns not only by investing all their savings in the stock market, but by going one step further and taking out a loan to buy stock.

Odd advice, right? But there are good reasons for this. Aryes and Nalebuff's thesis begins with the idea that we all own something called a "human capital bond." This is the present value of our lifetime stream of saved wages. Imagine a young investor with an average tolerance for risk who has just entered the labour force. He/she possesses a human capital bond that is currently worth, say, $500,000. Let's assume that this bond is expected to be quite stable in value, maybe because the young investor has just taken on a unionized government job. It make senses for our investor to reduce their allocation to this low-risk human capital bond in order to get exposure to an appropriate amount of riskier equity, thus boosting overall returns. Say the ideal equity share is around 50%, or $250,000. Waiting for the paychecks to roll in is far too slow a way to build a $250,000 stake in equities. Far quicker to sell half the human capital bond right now—or $250,000—and use it to buy the stake in equities outright.

The problem is that our investor can't simply sell away $250,000 worth of human capital. A spot market for human capital bonds doesn't exist. Absent the appropriate market, Aryes and Nalebuff believe that the way to approximate the ideal ratio is to use debt. By leveraging their meagre savings at a ratio of 2:1, a young investor with (say) $5,000 in savings in the first year of employment can get exposure to  $10,000 worth of stock, thus getting twice as close to the ideal amount of diversification. Ayres and Nalebuff refer to this as time diversification. Rather than waiting till mid age to have accumulated an appropriately diversified portfolio, do so as early as possible.

I think that it makes a lot of sense to imagine ourselves as if we held a Ayres/Nalebuff human capital bond and make our best effort to diversify around this asset. However, what if our bond is risky rather than safe? Maybe we make ends meet via a series of freelance jobs rather than perpetual government employment, or maybe we get by on commission income which can vary dramatically year-over-year. If so, the asset that represents our capitalized savings should probably be conceived not as a bond, but as a relatively volatile human capital "share." Instead of levering up to buy even more shares, a freelancer or salesperson seeking to diversify across time should borrow and acquire a stable asset with low drift, say like a mortgaged home.*

Liquidity is another facet worth considering. To own a human capital bond (or share) means to be terribly illiquid. Unlike a regular bond (or share), these instruments can't be rapidly swapped for other assets.

Owning an illiquid portfolio comes at large emotional cost. Consider that we are mere specks of dust being tossed around by currents far too large and complex to control, let alone understand. Against this awful uncertainty, extremely liquid financial assets, specifically instruments like deposits and banknotes, are our best lines of defence. When the universe suddenly knocks us down, liquid assets can be deployed to cope. When it throws us a bone, they can help us seize the moment. So while deposits and cash provide little in the form of a financial return (they are expected to steadily inflate away in value), they compensate by providing huge non-pecuniary flows of convenience, relief, and confidence.

When a young investor is advised to lever up and invest in either stocks or real estate, both of which are more liquid than a human bond but still not terribly liquid, they are being asked to bear some of the burdens of uncertainty. After all, leverage means running down inventories of cash and deploying back up lines of credit. Too much leverage and our investor loses their only hedge against the unknown. This lack of liquidity could subject them to enormous emotional costs when the proverbial shit hits the fan (or an unforeseen life changing opportunity must be passed up).

So young investors need to be careful that they take on an appropriate amount of debt (too little may be as bad as too much) and acquire suitable assets. To begin with, they must do their best to estimate the present value and riskiness of their largest asset, their Aryes/Nalebuff human capital bond. Only then can they determine the merits of borrowing to diversify across time; some assets promise significant returns (like shares) and some of them don't (like houses), the best option depending on the nature of the individual's capital bond. They also need to ask themselves a philosophical question: to what degree can the world be understand and controlled and to what degree is their fate governed by random and unpredictable forces? The more chaos our young investor sees, the more they should keep themselves liquid; the more order they see, the less liquid. There is no one-size fits all solution here, no trustworthy rule of thumb. But I'm sure you'll figure it out.

---

Related post: Labour Shares™: Beating capital at its own game

*Could housing booms be a function of forces that make human capital bonds increasingly risky, say like increased contract work and the demise of the traditional promise of lifetime employment offered by corporations? To offset the growing risk of the standard human capital bond, everyone may simultaneously try to offset by purchasing a home, traditionally a low return asset.

Why (not) rent your home?

Ted Nasmith, An Unexpected Morning Visit

"Why not just get a mortgage and buy the place rather than throwing money away on rent?" That's what people often say to folks like me who rent rather than buy. This post is my response.

Let me start off by saying that I'm neither a housing bear nor a bull. I have no idea which way Canadian real estate prices are going to go. My decision to choose renting over ownership has to do with other factors.

I don't have enough resources to buy a house or condo without getting a mortgage. Those who tell me I'm throwing my money away on rent and should buy are implicitly counseling me to take on a lot of leverage. Let's pretend that I'm comfortable accepting that level of debt. Why should I purchase a home with the borrowed funds and not buy some combination of the Vanguard Total World Stock ETF and the Total International Bond ETF?

To favor a home over the Vanguard ETF option is to assume that the risk-adjusted total return on the home exceeds that of the ETFs. Let's unpack this comparison a bit. ETFs provide a return that is purely pecuniary; some combination of price appreciation, interest, and dividends. Homes also provide a pecuniary return—they can appreciate in value. But a home is special. In addition to the pecuniary return, it simultaneously offers a non-pecuniary return, namely shelter. We can't eat in an ETF, or sleep in it, or entertain friends in it, but we can do these things with a house.

The total return on a home should be about equal to ETFs. Markets are competitive, after all, so if one asset offers an excess return, people will compete to harvest those gains, eventually arbitraging them away. Thus the total expected dividends, interest, and price appreciation from an ETF should be about equal to the sum of a home's expected price appreciation and the value of the shelter it provides. Shelter is a sizable service. This means that a home's expected life-time price appreciation needn't be very large to attract buyers. So an ETF's expected return will exceed a home's potential for price appreciation by a significant wedge. This wedge is the extra pecuniary return on ETFs held.

How big is the wedge? We can try to get a feel for it by looking at long term data. Using numbers compiled by Robert Shiller, I've calculated annualized real returns (i.e. adjusted for inflation) for both U.S. homes and equities going back to 1890. I don't have data that would approximate the Vanguard Bond ETF, and I don't know of any comparably long Canadian data series.

Equities, as represented by the S&P, have provided a real return of 6.5% per year including  price appreciation and reinvested dividends. Shiller's U.S. housing price index has yielded a much smaller 0.35% annualized real return over the last 120 years. Even if we omit the brutal credit crisis years of 2006-2015, U.S. homes still only provide a 0.54% return.

So when anyone boasts that unlike me they're not wasting money on rent, I accuse them of throwing away the extra wedge they could be earning by owning Vanguard ETFs.

Anyone who borrows to harvest the extra wedge on ETFs is left with a problem, however. They can't just sleep on the street, they need to acquire shelter. We're all born with a short position in housing. And that means giving up part of the excess wedge to a landlord. How much of this wedge? Again, since markets are competitive, my bet is that pretty much all of the wedge will have to be forfeited. If there was a significant chunk left over, everyone would choose to rent, driving rents higher until returns had equalized. At the end of the day, there probably aren't significant excess returns to be harvested by either home ownership or renting/investing in ETFs.

There are a few other stylized facts that colour the rent versus buy decision. Buying and selling a home will set you back thousands of dollars in transaction costs whereas it costs less than $25 to buy and sell ETFs. Secondly, a Vanguard ETF can be sold in a few seconds; a home can take weeks. Lastly, it costs just a few basis points to maintain an ETF (think management fees) whereas a house can cost thousands to keep in shape. To compensate for all these drawbacks (which are sizable), a home must offer a pretty high expected return.

What ultimately tips me towards the ETF option is the opportunity for diversification. Leveraging up on a single asset exposed to one street in a single city is a gamble. The two Vanguard ETFs, on the other hand, offer global exposure to thousands of different businesses, both large and small. Between renting and buying, renting seems to me to be the more prudent approach. I'm no gunslinger.

Which leads me in a meandering way back to Robert Shiller, specifically his derivatives markets for home prices. I'd certainly reconsider the home ownership route is if I could hedge away some of the risk of housing price declines, say by swapping out exposure to changes in the price of my home for a more diversified return. Most attempts to create housing derivative markets have failed, so until we have a futures market in housing prices, give me ETFs.

What if Apple pegged its stock price at $1?

 Would it make sense for Apple to peg its stock price at $1? If so, how would it go about doing this?

From the perspective of shareholders, there's an advantage to a firm's shares being valued not only as a pure store of value but also as useful in trade, or as money. All things staying the same, the increase in demand that is created by the monetary usefulness of a share will ratchet up the multiple applied to a firm's earnings, resulting in a higher market capitalization and richer (and happier) shareholders. As long as the costs of making shares more moneylike aren't too high (I'll assume they aren't), Apple will prefer that its shares be ubiquitous and pervade all corners of an economy, much like a U.S. dollar note or a bank deposit.

The problem is that people aren't fond of unstable exchange media (see here & here). Bills and deposits tend to show low price variability. And because retailers keep prices sticky in terms of the unit of account, a $100 deposit or $100 bill is guaranteed to purchase $100 worth of stuff one month hence. Unlike bills and deposits, volatile assets like Apple shares can crater at any moment, thus ruining their effectiveness as a monetary medium.

Could Apple solve this problem? If Apple were to peg its stock price at $1, it would provide individuals with all the benefits of a dollar bill or deposit. Add in some infrastructure for allowing payment via stock (say a permissioned block chain), and demand for Apple shares would treble as they stole business from banks. Apple's market cap would spike.

What about investors, say hedge funds and mutual funds? Why would they want to own an asset that never deviates from $1? They need a return, after all, to justify holding Apple in their portfolio. The answer, in short, is that the peg wouldn't reduce Apple's return to zero; rather, it would change the form of the return. Instead of rewarding shareholders with a higher share price, Apple management would reward them by augmenting the quantity of stable-value shares they own.

Say Apple's earnings are to grow 10% over the course of a year. Without a peg, investors expect one share of Apple, currently trading at $1, to be worth $1.10 in one year, providing a 10% return. With a peg, investors will instead expect the quantity of $1 shares in their portfolio to grow from 1 to 1.1, thus providing the same 10% return. Think of the 0.1 increase in shares as a stock dividend to all existing shareholders.

If Apple has a blowout year and earnings grow 20% rather than just 10%, investor demand for Apple shares will rise, putting upwards pressure on the peg. Management will grant existing owners whatever extra stock dividends are necessary to relieve the pressure. Likewise, a rise in the monetary demand for Apple shares, perhaps due to a liquidity crisis, will by counterbalanced by a stepped up pace of stock dividends, ensuring the peg's integrity.

Conversely, downwards pressure on the peg will be relieved with a series of reverse stock dividends. Shareholders will find that, where before they had $1 share worth $1, they have been docked 0.01 shares and only have 0.99 shares worth $1 dollar.

For the public to accept Apple's pegged shares as an exchange medium, they need to suffer from some sort of money illusion. After all, even though Apple is enforcing its $1 peg and providing nominal stability, this is little more than an illusion. The reverse stock dividend mechanism threatens to reduce the quantity of shares in each individual's portfolios, thus diminishing their overall purchasing power. Will people be fooled by the $1 price? I don't know, but if so, Apple can increase its market capitalization for free and thus enrich its shareholders.

This leads into a bigger question that I'll let others try and answer. What quirks of human psyche (or institutions) lead publicly traded companies to universally set a floating stock price and a fixed quantity of shares? Why not let the quantity float and the price stay fixed? If we were perfectly logical beasts, we should be indifferent between the two.