Capital markets commentary « discourse and notes

In his biography of the Rothschild banking dynasty, the economic historian Niall Ferguson depicts an organization that was founded on several core principles: internal unity, external relevancy, and long-term commitment. The particulars and circumstances in the late-18th and early-19th centuries, when the Rothschild firm was built, were obviously different from our own, but history can teach us important lessons if it isn’t read too literally. Two hundred years ago the firm’s clients were governments and politicians, and this clientele benefited from patience and a view to the long term. Two hundred years ago relevancy to this base was optimized by one’s ability to reach across many jurisdictions and markets. Unity, in the Rothschild context – a firm that branched out to all major capitals to serve multiple factions – was made possible by strong family bonds and manifested itself in consistency. Without this, the other two factors would have been rendered meaningless.

That was then, and even though we pride ourselves today on being innovative and almost scientific in our approach to strategy, the success drivers of the Rothschild firm were essentially the same as those to which we give more modern names. Family unity is now called teamwork, partnership, and a strong company culture. External relevancy is now less a matter of geographic tentacles, but the concept of diversifying beyond a solitary core remains as critical. Long-term orientation is now not only the development of asset value, not only potential sacrifice today for more lasting reward down the road, but as importantly an ability to adapt and maneuver with changing circumstance over an extended period.

These qualities and strategic elements point to a seemingly contradictory blend: specialization on one hand, and diversification on the other. Specialization is essential for a deep commitment to one’s customer base, but it must be a commitment that anticipates change – a defining characteristic of the era – and wide variance of customer needs. While specialization allows one to recognize these, diversification makes it possible to assist in multiple ways, as fitting the circumstance. Long-term relevancy is not easy to achieve, but it is essential to success in any segment.

CoRise is a merchant banking firm in the classic sense, structured for current realities. We aim to be relevant into the long term with a unified approach. Our three core services – investment banking, industry research, and strategic equity – augment, enhance and leverage each other to the combined benefit of clients, investors and entrepreneurs. We can be advisors or principals as the situation dictates, we are experienced and versed in all capital markets and corporate finance product, and we are long-term focused on the themes that impact our clientele. As our very name suggests, unity and partnership are the essence of our culture. Our tagline describes the firm completely: Merchant banking for the age of invention.

A strategic philosopher once advised his students to follow in the path of history’s greatest. Thus, even if failing to live up to such loftiness they would fall short of a very high target. Like all professionals, we are eager to find instruction in the strategies of our most successful predecessors (and there have been many after the Rothschilds). The greatest among these, it seems, excelled at something besides strategy: Execution and a job well done. We will be very attentive to this aspect of the trade in the months and many years ahead.

It can be an amusing exercise sometimes to second-guess causes, effects and other matters of relativity in the economy. For instance, is this now being pulled down by consumer deleveraging or are consumers deleveraging because of a soft economy? Further, if leverage at all levels should never have risen to where it rose in the first place, is the economy technically soft or just where it belongs? When we refer to a Depression or a Great Recessions we imply something about economic unhealth, disruption, and abnormality; but what if the abnormal state, the disease, the disruption are not in the down-cycle but rather the period and circumstances preceding it? I suppose we refer to those periods and such corresponding elements as bubbles, but we tend not to be particularly fussed about these when they occur. We treat bubbles with a tone of academic detachment, we debate their existence, we sometimes joke or make up silly names, and after they pop we look for economic cures to the ailment.

I am vaguely reminded of the business school adage by way of ancient Chinese wisdom: the battle is won or lost before it is fought. This has to do with preparation and strategy, at least in the business school context, but it also relates to causality in the sense of issues raised in the previous paragraph. In that same spirit, I sometimes wonder if the causality begins and ends with leverage, with bubbles, or if these too have been an effect rather than a cause, a manifestation of a deeper fundamental driver. Conventional wisdom has dealt with this very issue often enough, and the conclusion is usually along the lines of short-term orientation in the market, short-term oriented compensation structures for those who impact the market’s directions, and at the consumer level the multitude of fads that come and go and the variety of programs that tend to blur the line between necessary and discretionary spending. But this either doesn’t delve deeply enough into the subject or more likely fails to connect the dots, as it were, for a more complete picture.

To complete the picture, or at least to add depth to it, there is another quality that must be considered, which has something to do with efficiency, competency, and the counterpart to these things, apathy. To illustrate, let’s look at a selection of corporate news stories from the past week: One major international bank is suffering a multi-billion dollar loss as a result of poor executive supervision, one major technology company is replacing its CEO and reversing his strategy after less than one year on a job for which he was not actually interviewed by the board, one major Internet company is firing off conflicting emails to its employees about the future of the company as it currently steers without a clear path, one major entertainment and information hub has become its own scandalous story, and one of the highest-profile IPO candidates is having to restate its gimmicky filing now for the third time while its executive ranks unsettle. To underscore the point with contrast, we concurrently lament the departure of modern industry’s most successful executive, who led the development of the world’s most valuable company with vision as well as attention to detail.

The examples cited bring home, I think, all of the issues raised: short-term and long-term orientation, efficiency and apathy, bubbles and fundamentals, causes and effects, battles won and lost. When we consider the state of the economy – worldwide – we should not dismiss such issues as irrelevant simply because less quantifiable than aggregate leverage and money supply. Economies are based on enterprise, and the principal lesson all good entrepreneurs can recite by rote is that success and failure is all about execution. It’s time for this lesson to be applied with utmost seriousness and urgency across all segments, private as well as public, because when circumstances change as drastically as these have in the last few years even the most mature entities contain elements of the startup.

There have been two news items to consider, one major and the other, in its own way, too. The two are disconnected at the surface, but underneath it they relate. One: The Fed announced its more or less expected Twist. Two: Bloomberg is reporting that the alleged IPO plans by the second largest deal platform, Living Social, are being reconsidered. In particular, the IPO would be replaced with a private round that may also include debt capital.

The Fed’s Twist underwhelmed the market, which has proceeded without hesitation to crater. According to some estimates that had hinted at market expectationÂ of roughly $300-$350 billion of Fed action, the actual sum of $400 billion should not have beenÂ disappointing. The slight upside “surprise” is even consistent with this Fed regime’s passion for seeking to move markets and its attentiveness to the trading desk. The goal was less than successful this time, and the reason was probably along these lines: On one hand, the FOMC statement contained an economic outlook paragraph more bleakly worded than the last time around, and on the other hand the magnitude of Twist was only slightly above expectation. I mean, what’s $50 billion more when $1 trillion and change has already been spent or committed between QE2 and this current round? In short, the Fed that markets have grown to appreciate for the enthusiasm of its easings should have wanted to do much more – both in order to surprise and in order to offset weakening economic prospects. The fact that this little sum is all the Fed has come up with implies that it’s all it could do, and all it will do for a while.Â The market’s reaction indicates that this message has been understood.

And then, there was another market reaction that warrants mentioning. The long end of the yield curve – the stated target of Twist – tanked. Now, part of that stands to reason, because, as stated, the aim of Twist is to drive long term rates down. But with most of $400 billion already priced in, the magnitude of the yield shift seems to have been more than a mere adjustment for the extra $50 billion. In combination with a negative stock market reaction, it was more like a rotation out of risk and into relative safety. It was, in other words, a movement up the rungs in the seniority and liquidation preference of the global capital structure. (Please see this prior article here for a more detailed interpretation of corporate finance fundamentals as applied to global market flows.)

Which brings us to the other news story previously mentioned: Living Social is said to be abandoning its IPO (which would have been straight common stock) in favor of a private round (which, if typical, would be structured as preferred equity) that also features a debt tranche (presumably senior). The climb up the risk ladder to rungs of increased seniority is rippling beyond the point of symbolism. In light of current economic events, one should expect to see such ripples continue.

To understand a complex system it is sometimes useful to isolate its characteristics in a simplified example and let the imagination wonder from there. Recognizing that enterprise, economies, and markets are highly complex and intertwined systems, let’s investigate two simplified extremes – at polar ends of a continuum – and proceed to draw conclusions.

Let’s assume that there are two types of enterprise: the pure startup and the perfectly mature. The pure startup is made up of pure possibility and nothing actual, and the perfectly mature enterprise is completely actual and has no potential outside of that. At one extreme, thus, all value is option value, and at the other the business value is the value of the underlying asset (in its most fundamental state). The pure startup represents the most speculative form of equity and will be funded with the most flexible form of capital, and the mature asset will be funded with debt because it is completely predictable and has no upside at all.

Beyond this, the two isolated ends of the described enterprise continuum also differ in operational and strategic ways. There is, for example, a difference in management style required – as has been touched upon in a previous article here – with vision and leadership ranking high for the startup, where nimbleness, competitive positioning, and direction in a volatile scenario are all critical to growth. For the mature business, pure operating management and maintenance of the status quo are the necessary executive objectives. The respective management teams will accordingly require different types of boards, different forms of advice, and different offerings from its assorted service providers: On one hand a highly strategic, forward looking, aggressive and anticipatory approach; and on the other a conservative method based on historical observation, predetermined formulas, and careful asset conservation. To state this slightly differently, the difference is between entry and exit.

Now, while there are countless real examples of the two extreme scenarios, the vast majority of enterprise is likely to fall at one point or another in between. At such points there will be greater or lesser emphasis – combinations and permutations – of the characteristics described above. Depending on where an enterprise exists along the trajectory from entry to exit, as it were, it will have to be analyzed, managed, funded, and serviced accordingly. Sometimes there is a challenge in doing so effectively, because analysts, managers, funding sources and service providers are commonly only prepped and ready in one thing. This is especially true in an era of high specialization, and sometimes this disconnect is exacerbated by revolutionary changes that take place within whole sectors or, even more notably, as whole new sectors are born. To take the subject to an even higher plateau, the described nuances may even be manifest at the macro-economic level.

Regardless of one’s perspective in such matters – whether it is analytic, strategic, operational, financial, (political), or service oriented – it would be, I believe, a correct approach – maybe even the most correct – to first and foremost isolate the subject of one’s perspective and try to find its place along the evolutionary continuum. As hopefully demonstrated herein, not all such places are to be handled identically and not all such places demand cookie-cutter solutions. From a very high level looking down, one could even argue that our global economy, our technology, and our capital markets, are at a general point that is closer to the startup extreme – and all this signifies – than the other. The greatest mistake anyone can make – assuming one has an interest in the subject – is to fail to recognize this reality. Consequences and repercussions are multiple.

Money flows and information flows often resemble one another, and both resemble the nature of water in its pursuit of least resistance from one point to the next. Perhaps for this reason the nomenclature calls liquidity to mind – the aspect of flowing may be embedded in our linguistic consciousness. Information spreads around the surface evenly, or is guided into channels, or stopped by dams. Similarly, capital runs to its most attractive destination in a free market environment, or is otherwise pushed and prodded – which is to say, manipulated – in a market that engages in such things. The two flows, information and capital, sometimes coincide, but not always.

Some think about patents and licenses and trade secrets as protective mechanisms, while others would argue that these tools are only used to disrupt the flow of information. Both perspectives are to some extent accurate, and these are not necessarily contradictory. Dams and other barriers might also be used for someone’s protection by disrupting flows. It’s all a question of perspective, no doubt, and balancing of interests. Ecosystems may be damaged by such manipulation, even if discrete constituencies thrive. So too with patents, so too with capital markets. Always a matter of looking out for the whole and serving the greater interest. Who’s to say…

Ironically I attended a gathering of open hardware enthusiasts today while global central banks announced a coordinated effort to manipulate markets. On one hand, a celebration of the open flow of information, and on the other an artificial source of capital. The idea of open hardware (and its close associate, open source hardware, apparently not strictly speaking the same thing) is to bring to hardware production similar concepts of sharing, modularity, idea exchange and creative interaction that characterized parts of the software segment since its birth. This is now becoming possible in hardware, and while nobody really knows where it will lead, the excitement in the packed auditorium promised great things.

It would stand to reason. With free sharing of information, with enhanced flows and liquidity to cover broad surfaces, fertility should blossom. One could argue, using similar analogies about water and so on, that artificial liquidity infused into capital markets should bring similar results. There is however an important difference, which has something to do with nature. In open source technology, flow relates to liquidity that already exists and is allowed to travel where it will. In the case of monetary intervention, liquidity is artificial and the ecosystem is disrupted. In short, while open source encourages nature to run its course, relying on issues to resolve themselves – as issues have pretty much done since the invention of weapons – central banking authorities don’t hold nature in much regard and choose instead to experiment with its possibilities for mutation.

That being as it may, it is also the case that money flows are tangible and are for that reason more malleable. Information, on the other hand, is harder to fence in. When the two realms intersect, that truly becomes a fascinating study. Take, for example, the IPO process. Great pains are always taken to match up the two disparate flows, and it is a challenge indeed to mechanize the natural. An article was recently published on the subject, (in which the image of a river was invoked). Others have complained about the many flaws of the IPO process and the rules by which it is governed. In such complaints the disjointed runs of information and money are usually in the spotlight.

The more one thinks about these flows and others, about patents and their supposed protections, their economic value (supposedly); the more one thinks about the analogous situations in artificially stimulated markets; and the more one is exposed – on the other hand – to the progress that runs its course in unmonitored segments of industry; the more one is prone to conclude: Just let the flows happen, these systems take care of themselves, the path of least resistance is the best path, and liquidity always finds it on its own.

In a television interview to promote his new book, the author, consultant, venture capitalist and student of technology trends, Geoffrey Moore, describes the difference between management and leadership. He uses this contrast to shape a perspective of recent events at Yahoo!, as well as other Silicon Valley notables – from the current headlines, Hewlett-Packard and Cisco, and from the archives, Netscape. In Mr. Moore’s opinion, the difference between management and leadership is the difference between using one’s existing resources with optimal efficiency, and knowing how to reallocate such resources for anticipated changes ahead. The former is management and the latter is leadership. Stated differently, management parallels execution and leadership reflects vision.

The conversation touches on an additional variant – integral to any analysis of such distinctions – which is the pace of change in the external environment. It being a television interview of limited scope and time allotment, the discussion is unfortunately choppy and superficial, but the principal point can be surmised: In an extreme scenario in which there is no change at all, management alone suffices; while at the other extreme (i.e., pure and constant change) leadership (which is to say, vision) is the only necessary feature of enterprise success. Reality is never at either of these ends, and so the question is more about combining the right mix of management and leadership to correspond with the pace of change, and with the way an enterprise performs in response to its opportunity.

There was a time, not long ago, when the technology sector – at least so far as technology was defined as the evolution of the Internet and those things associated with it – was in a state quite close to absolute transformation. The state was never absolute, (these states can never be quite absolute, either one way or the other), but it tended that way and, such being the case, qualities of vision, imagination, and recognition of possibilities comprised the leadership profile for success. The needle has moved since then, and although we are nowhere close to the opposite extreme of a static environment, the segment is steadily distancing itself from the point of birth (where the rate of evolution is highest).

As a sector and with countless individual exceptions, technology may now be at a point where a blend of vision and management is the correct enterprise recipe. This is a very difficult environment in which to compete. Extremes are always easy because they’re obvious and follow simple precepts. The gray areas, where nuance and mixture take over, are more delicate and comprise a myriad variables, any of which can shape direction and throw the vessel (temporarily or permanently) off course. We have seen illustrations and case studies of this theme in recent events in the Internet world, and many have been quick to point out the issue in such cases.

Beyond technology, however, the time has arrived to recognize that the same issues apply in all aspects of the global economy. There have been enormous changes underway in capital markets, for example, and management alone is no longer sufficient. Similarly, the monetary disruption that began in 2008 is far from over, and its impact on economies and systems is yet to be fully understood. If technology is in a state of motion away from the extreme of perfect transformation to a more stable point along the continuum, these other fields are moving towards the same middle-ground but from the opposite direction. Settling on an equilibrium to combine leadership with management is now a universal challenge, transcending individual segments, reflecting an era singularly defined by change at a combination of multiple velocities.

Some of us can remember the market crash of 1987. A recent college graduate, bright eyed and bushy tailed, eager to learn from peers and many levels of superiors, with Wall Street Journal ink stains on my hands around the clock, my desk at the time was with a group of others like me, next to institutional salespeople on a mid-sized floor by current standards. The manager, who was wise, had access to a computer terminal with greenish market quotes and all sorts of fine-print, but that was inaccessible to us young’uns. We had to call a special number that played a message, updated irregularly, in order to catch the latest vibe. We ran up the phone tab that day, and that was at a time when the flat-rate plan, even for local calls, had not yet been invented. There were almost no wireless phones, not even for wise managers, not even the brick-like ones that would become more widespread later, so we were frozen solid at our desks all day, dialing. Wall Street, back then, was almost a cottage industry.

That’s an exaggeration, but only a mild one. The balance sheets of the biggest banks, as I recall, bumped up against $100 billion. For the RJR Nabisco deal to get done the bank syndicate was the whole finance SIC code. The whole industry, more or less, was a co-manager and got league table credit. That was in the early days of league table credit, but Wall Street firms were inventive that way right from the start. Then came the S&L crisis and we invented product with more conservative risk elements than buying companies at… ten times cash flow! (I smile as I type, we were so cute back then, so delicate.) This is how asset securitization came into existence – to strip out risks that were undue – which started out with credit card receivables and was eventually extended to other financial assets and led, eventually, to Enron and the sub-prime mortgage bubble.

That’s also an exaggeration, also a mild one. And anyway it skips over the NASDAQ bubble. That started as a dot-com phenomenon and quickly branched into other fields, including the development of what had actually been a cottage industry to that point – venture capital – transforming it to a global institutional giant. Like all things, this too passed, and this too returned, and we pretty much know the rest, even the youngest among us who may still remember 2008 and 2009 and 2010. And as I look back on these years and decades with their ebbs and cycles all the way to 1987, I can’t help but feel as though Wall Street – despite asset securitization, as mentioned, and other novelties like mechanized trading and greater global financial flows that were made possible, in no small part, by a smaller cellphone that also churns out price quotes in colorful apps – is more or less the same.

Well, that’s not entirely true, it’s probably overstated and I wouldn’t recommend a literal reading of the statement. Having lived through the changes and eras described, I am keenly aware of the differences in the segment between then and now. But by the same token it seems to me that bigger, faster, louder, is not in essence the same thing as moreÂ advanced, and, on a certain level, is not even particularly different. To explain myself more clearly, let’s take a look at the sector by way of contrast. When we think of innovation in healthcare, for example, we think of technologies and drugs that have and can lead to a complete transformation of human possibilities. When we think of innovation in energy, we think of new sources that can turn personal consumption and the geopolitical landscape on its head. In aerospace and transportation, we are contemplating space travel. And in communication and media, we wouldn’t even know where to begin as we scan the timeframe covered by this article.

In finance, on the other hand, innovation has been mostly superficial. We have introduced electronics and computing into the mix – using technology advancements made in other sectors – but the nature of the business is unchanged. We have sliced up risks in different ways, but that has only made the same balance sheets bigger. Fundamentally, Wall Street is no different from what it was in 1987, even as other sectors have evolved – in some cases to the point of becoming unrecognizable. Â And yet those other segments (i.e., industry and consumerism) are what ultimately shapes banking and finance, even if Wall Street dictates capital flows. For this reason, and particularly in light of economic disruption that has impacted all categories, I expect innovation to start happening in finance and banking in much more meaningful ways ahead. I expect to see advances that mirror the era of invention and change in which we live.

The dynamic that’s taking shape between public markets and central banking is more interesting by the day. And the role played by technology in compounding the effect is not to be discounted. Beyond its fascination value, however, the ripple effects of financial flows that appear isolated are actually quite broad and substantial. Even in the remotest corners of private investing, the public markets are the constant manipulator: The secondary market hiccups and the IPO market shakes, the one public vehicle stumbles and a variety of private sources bruise, and the converse on the way up for these. We can’t forget the Sequoia RIP slides, for instance, which were not the result of anything intrinsic to venture capital but were rather the domino effect of damaged institutional (L.P.) portfolios spilling into adjacent spaces. And yet that same venture firm’s huge bet, subsequently, on a vague startup so soon after the ominous slides had been circulated, can’t be too many steps removed from a public market that also had reversed its course by that point.

Regardless of where you stand in relation to capital flows, therefore – and we all stand somewhere in relation to these, whether we realize it or not – it is important to pay attention to the public markets. In doing so, price levels and swings tell only half the story, and perhaps even the less meaningful half. The other part consists of all the variables behind the volatility – volume and its implied signals, economic data that sometimes elicits wild reactions and other times not, global causes and effects, or effects that sometimes precede causes – the list is long and growing. Which brings us back to the opening statement at the top of this page, about the relationship between monetary policy, technology, and markets. It is increasingly like a game played between sides that are brilliant and simple from one moment to the next, and it’s a game that might baffle even the most expert followers.

Last week the Fed pre-announced an intention to think later about the possibility of monetary stimulus, which may or may not take the shape of quantitative easing programs we have seen from them in the past; and the market pre-tanked and then immediately post-thought better of it and decided that the Fed announced something significant after all. Ever since, the market appears to have maintained that thought: Good economic news is bad, as it pertains to monetary stimulus potential, and bad news is good. The Fed, each day, throws in a spark or two to maintain the fire. The point has come, in fact, where it is only this correspondence between anticipated Fed action and market reaction thereto (even if only to the anticipation) that is the sole driver of any price movement. And there is something even more noteworthy: Individual stocks – not all, but many, a statistical mass – are trending towards the mean and rising or falling in accordance with the market index rather than any specific fundamentals. This is where technology factors in.

The technology of high frequency trading that is based on headline scanning algorithms and the pursuit of whatever may be left of price differentials and opportunities from one microsecond to the next, is no doubt a contributing factor to the environment described. That these systems have controlled a growing portion of the daily trade in the past few years is no secret, nor is it particularly difficult now to guess the reaction of these to various types of headlines. With that in mind, the Fed’s strategy to communicate or not communicate direction, and the direction itself, take on an added layer of consequence (or lack thereof), and the Fed is surely mindful of the angles. The reality that these consequences would ripple into individual stocks regardless of their particularities, and into private investments regardless of their direct relation to public markets, and into business borrowing and other asset classes, this is a facet of the game to which none can remain indifferent.

The subjects raised remind me, somehow, of a news story about an artificial intelligence project in which two computers were programmed to chat with each other. The results were at once quirky and logical, if that’s possible to imagine. So too, nowadays, the changing dynamic between markets, external drivers, and internal systems is speaking to us in a new language. The onus of adjustment is with us.

When capital risk ceases to be about repayment and becomes a matter of liquid refinancing, capital categories and return hurdles converge. This is only an observation. It was covered in a previous article here. When refinance rather than repayment is at the crux of capital markets, analysis shifts from fundamental to technical. More precisely, the fundamental is less about intrinsic asset value and more about market liquidity as a way to perpetuate its funding. As this occurs, the investment consideration is mainly about exits and trading scenarios, and when such resources are ample the only consideration is the market’s willingness to participate. In short, capital flow becomes more truly a capital cycle, and a recycle, which is a healthy situation as long as the wheel continues to spin.

The thought must have occurred to Chairman Bernanke as he prepared for his annual and increasingly sensational appearance at Jackson Hole, WY. At this time last year the idea hadn’t yet jelled, perhaps, or maybe the time wasn’t ripe. In any case, the concept of quantitative easing was very literally, very somberly, framed. It was an actual infusion of liquidity of many hundreds of billions of dollars, (after a while we lost count). This year, a more evolved, more subtle, almost more genial manifestation seems to be in the making. The new and improved idea is that quantitative easing doesn’t need to be real – doesn’t need to be… quantitative – in order to achieve its goal. It needs only to be suggested. (The operative word is easing, I suppose.) Perception is reality, after all, especially when perception is institutionally sanctioned.

Thus, given a capital market context in which technical is the new fundamental, in which liquidity drives refinancing and exits and trades in a cyclical flow of passing the baton, the market only really needs some soothing phrases, as it were, a letter of intent, for its liquidity to continue moving. Such a signal was today delivered, and the market did indeed respond appropriately. The signal, (I paraphrase), was this: We stand ready to act, and, as importantly, we have the necessary weapons. Our weaponry is in fact so ample that not one but two (2!) full days of FOMC discussion will be necessary to fit all the verbiage. I’m only guessing now (i.e., no longer paraphrasing) but maybe next time around three days will be needed, and then four? Well… anyway… these signals have weekend constraints.

Until then, the wheels may have been pushed with sufficient force to create some semblance of momentum… which in turn will flow and trickle into the IPO pipeline (that has been building) and the venture capital market and other seemingly disparate parts of the economy. If these and other segments continue to move, a time may come when further prodding is no longer required. That, we suspect, is the Fed’s true hope (and ours). But these wheels can sometimes be fickle. Sometimes they turn one way, sometimes another. Sometimes they stop or veer off to the side. We’ll all monitor the situation closely (as will the Fed).

Fiat money is a form of currency that has value only because… It is an asset of commercial exchange determined by perception, supply and demand, and such even more esoteric and delicate variables like a central authority and support. A common way to understand the concept of fiat money has been to contrast it with money that is backed by something real (rather than the conceptual list just referenced). Typically, at least in historical discussion, the real asset backing such money is gold. Gold doesn’t back money anymore, but it remains a valuable commodity that is in limited supply and is, in theory, interchangeable with currency. Many have argued that gold is worth more than money – which is debatable – but it is certainly worth more money than it was worth last week, last month, last year, and many years ago.

The antithetical positions of gold and fiat money have become so etched in public discourse that it now almost goes without saying that ownership of gold is ownership of substance, while ownership of (fiat) money is something at the mercy of economic and geopolitical flux. This, at least, is how many of my generation had been trained to think, as a matter independent of market value and price volatility. So when we are presented with a passing observation – buried in the depths of an editorial about bullion and tonnage and other such phraseology associated with physical gold – that “the gold ‘physical market’ is approximately 100 times the size of the amount of actual underlying metal by which it is purportedly backed,” we do a double-take. We read the passage one more time, just to make sure we didn’t miss a typo.

Now, I am very much an amateur in these matters. I know about the precious metals’ market precisely what is necessary to be dangerous, not more and not less. And I can’t vouch for the accuracy of the cited passage or reliability of its source, (although the online publication where the subject article was found is among the most widely read blogs on matters financial and economic). So taking it for granted, rightly or wrongly, that it is accurate to say that the amount of physical gold is equivalent to only about 1% of all the gold that’s “owned,” we have to wonder what happens to the other 99% of “owned” gold.

Which ruminations lead one eventually to wonder what would happen if some large quantity of physical gold should be demanded at once from whatever place of safekeeping it resides. Granted, a substantial demand is necessary to cause trouble and it’s unlikely this would occur in one shot. But if the point of gold, from the perspective of monetary discussion, is its substance and reality, then what would such an enormous supply and demand disruption signify? On one hand it may be argued that the value of the asset will be that much more firmly rooted in scarcity, and the few who are in possession will benefit more. On the other hand, however, are we not really talking about a precious metal that isn’t even backed by its own standard? Is gold, in actuality, guided by a fiat of its own?

As we approach the annual conference at Jackson Hole this week, most recently famed for an influx of fiat money that lasted through the quarter just ended, the contrasts and thoughts presented herein should be considered. We ought not be too harsh on money supply, just as we ought not be too sure about gold supply. Here too, as in many other subjects, absolutes are few and nuances are relative.

discourse and notes

Category Archives: Capital markets commentary

Merchant banking for the age of invention

Inefficiency at the root of an ailing economy

The Fed, the reconsidered IPO, and the climb up the capital ladder

Adaptation of perspective along the evolutionary path

Letting liquidity flow where it will

Managing with leadership in a time for both

Growth is not actually change, and speed is not actually innovation

Of markets, Fedspeak and other quirks of artificial intelligence

The mention of liquidity sufficed

The relativity of fiat