The Panama Canal and why Public vs Private is the Wrong Debate

This is the story of the financing behind what at separate points in time was once the world’s largest IPO and the largest real estate deal ever. Even more, this is the story about an undertaking which actually changed the course of world history. This is also the story of French capitalism and American socialism. Let me explain, drawing heavily from The Path Between the Seas, an excellent book, one I highly recommended, by David McCullough on the construction of the Panama Canal for the relevant history.

On November 17, 1869, the Suez Canal opened to remarkable fanfare. The event instantly made Ferdinand de Lesseps an international hero. de Lesseps work wasn’t done with this one accomplishment. To that end, he used his position of fame in order to attempt to conquer an even bigger task: building a canal to connect the Atlantic Ocean and Pacific Ocean in Central America.

The Suez Canal had been built with private money and existed as a publicly held corporation (public as in freely liquid ownership amongst private citizens, not government ownership). de Lesseps saw the Central American project similarly, and felt its financing via private money was an important and “American” way to pursue the undertaking. Private financing was a strategic move, for at the time, the U.S. government still took the Monroe Doctrine declaring the Western Hemisphere the American domain very seriously. It was also a sentimental move which de Lesseps spoke about tying the importance of private capital with the notion that it would merely facilitate him as “but an executor of the American idea.” (McCullough, David (2001-10-27). The Path Between the Seas: The Creation of the Panama Canal, 1870-1914 (Kindle Locations 1754-1757). Touchstone. Kindle Edition.)

This made sense on several levels. The U.S. stood to benefit substantially from the completion of a “path between the seas,” as the book bearing that title explains:

A Wall Street man named Frederick Kelley calculated that a canal through Central America could mean an annual saving to American trade as a whole of no less than $ 36,000,000— in reduced insurance , interest on cargoes, wear and tear on ships, wages, provisions, crews—and a total saving of all maritime nations of $ 48,000,000. This alone, he asserted, would be enough, irrespective of tolls, to pay for the entire canal in a few years, even if it were to cost as much as $ 100,000,000, a possibility almost no one foresaw. (Ibid, Kindle Locations 457-460)

Americans had plenty of experience with private capital invested in Panama. At one point, the Panama Railroad was the highest priced stock on the New York Stock Exchange, and its shares paid an average 15% dividend over its publicly traded period (here's a fun list of "amazing facts" on the Panama Railroad). When de Lessing commenced the Panama Canal project, it was to be the single largest financing in the history of the world, up to that point. Much was on the line alongside the money, including de Lessing’s legacy as a man who could build the impossible, and French pride as a global engineering powerhouse. Further, this was about capitalism and democracy, two ideas rapidly changing the world at that time, and the “limitless expectations associated with venture capitalism—pionnier capitalisme. The talk was of ‘the poetry of capitalism’ and of ‘the shareholders’ democracy.’”

As history would have it, the French, capitalist version of the Panama Canal wasn’t meant to be. For the French, the financial losses were drastic, as was society’s backlash. This is embodied in the aftermath of the Panama Canal Company’s failure, which today in France is known as “L’Affaire Panama.” Over 100 French legislators were accused of corruption and several governments collapsed. In the aftermath, anti-Semitism spiked sharply due to various conspiracy theories, ultimately climaxing in another French affair, “L’Affaire Dreyfus.”

Amidst the chaos in France, a successor to the Panama Canal Company was established in order to dispose of the company’s remaining assets, including its equipment, land rights, railroad ownership and digging completed to-date. The U.S. government emerged as the best, most logical buyer, eventually completing a deal with historic implications:

The purchase of the French holdings at Panama was the largest real-estate transaction in history until then. The Treasury warrant for $ 40,000,000 made out to “J. Pierpont Morgan & Company, New York City, Special Dispensing Agent,” was the largest yet issued by the government of the United States, the largest previous warrant having been for the $ 7,200,000 paid to Russia for Alaska in 1867. Participation by the house of Morgan had been agreed to by both the buyer and the seller and in late April, prior to receipt of the Treasury warrant, J. P. Morgan sailed for France to oversee the transaction personally. His bank shipped $ 18,000,000 in gold bullion to Paris, bought exchange on Paris for the balance, and paid the full sum into the Banque de France for the account of the Compagnie Nouvelle and the liquidator of the Compagnie Universelle. On May 2, at the offices of the Compagnie Nouvelle on the narrow, little Rue Louis-le-Grand, the deeds and bills of the sale were executed. On May 9 in New York the United States repaid the $ 40,000,000 to the house of Morgan. Morgan’s fee for services, charged to the Compagnie Nouvelle, was $ 35,000. With the $ 10,000,000 paid to Panama and the $ 40,000,000 to the Compagnie Nouvelle, the United States had spent more for the rights, privileges, and properties that went with the Canal Zone— an area roughly a third the size of Long Island— than for any actual territorial acquisition in its history, more than for the Louisiana Territory ($ 15,000,000), Alaska ($ 7,200,000), and the Philippines ($ 20,000,000) combined.” (Ibid, Kindle Locations 6847-6851)

Since this is the story of the financing of the construction of the canal, we’ll willfully ignore some of the “diplomacy” and its associated costs. The U.S. commenced construction in 1904 with the government overseeing a team of private contractors. One such contractor that emerged as an important American industrial power was Bucyrus Corporation (now part of Caterpillar). Bucyrus’ steam-shovels became the standard during the construction of the Canal and they did their job magnificently. A second contractor with massive success was the General Electric Company:

For the still young, still comparatively small General Electric Company the successful performance of all such apparatus, indeed the perfect efficiency of the entire electrical system, was of the utmost importance. This was not merely a very large government contract, the company’s first large government contract, but one that would attract worldwide attention. It was a chance like none other to display the virtues of electric power, to bring to bear the creative resources of the electrical engineer. The canal, declared one technical journal, would be a “monument to the electrical art.” It had been less than a year since the first factory in the United States had been electrified” (Ibid, Kindle Locations 10237-10242)

Unfortunately, the vast majority contractors the government hired couldn’t do their jobs all that efficiently. In 1907, the Army Corps of Engineers, under Major George Washington Goethals (yep that’s where the bridge got its name), took control of oversight and construction of the canal.

Let’s take a step back and think about where things were here. What started as a privately financed enterprise collapsed miserably, taking down the entire French economy and nearly the entire French empire with it. In the wake of this collapse, the American government took over the project and outsourced its completion to private contractors. Over three years, these private contractors failed to meet their deadlines, effectively forcing the U.S. government to take over the project entirely. When this happened, the military’s oversight of the project worked so well that some feared this would tip the U.S. towards socialism. These fears were discussed openly in prominent intellectual circles, with complaints like the following:

When these well paid, lightly worked, well and cheaply fed men return to their native land [warned a New York banker], they will form a powerful addition to the Socialist party . . . . By their votes and the enormous following they can rally to their standard they will force the government to take over the public utilities, if not all the large corporations , of the country. They will force the adoption of government standards of work, wages and cost of living as exemplified in the work on the Canal. Yet how could it be socialism, some pondered, when those in charge were all technical men and “little interested in political philosophy,” as one reporter commented. “The marvel is,” wrote this same man, “that even under administrators unfriendly or indifferent to Socialism , these socialistic experiments have succeeded— without exception.” (Ibid, Kindle Locations 9562-9568)

Instead there was to be no such thing as Socialism in America, but there are many lessons we can learn from today, here are just a few:

1) de Lesseps, the Frenchman behind their canal effort, was a figure reminiscent of the likes of Steve Jobs and Elon Musk for his capacity to “do the impossible” and change the world. Before de Lessep’s started the Panama Canal project he was a man who “could do no wrong.” People who buy into that mentality blindly, based not on sound economics, but rather a combination of nationalist pride and belief in an individual are setting themselves up for financial problems. This immense, almost super-natural belief in the capacity of French engineering to overcome all problems led to crucial blind-spots that Mother Nature exploited.

2) One of the decisive differences with the American and French efforts was William Gorgas’ initiative to rid the Canal Zone of malaria. Many viewed the fight against malaria and yellow fever as costly wastes of resources in an expensive undertaking. It was not without conflict that Gorgas was able to undertake his nearly “impossible” task of eradicating the mosquito-wrought region of these illnesses, yet without this colossal effort the Panama Canal itself would never have been built. For these cost-based concerns, a focus on public health was inconsequential to the private endeavor, until the problem became too severe and the entire project collapsed under this weight. Meanwhile, for a government to send its own emissaries to a region rife with deadly illness meant the potential for severe backlash from various groups. Truth be told, a healthy environment and a healthy workforce is crucial for large-scale successes.

3) The question of public vs private is the wrong one altogether, as efficiency matters first and foremost. The French went about the project privately. The U.S. went about it largely privately at first, and then with complete government oversight and execution. Today’s discourse here in the U.S. would have one believe the Americans are born capitalists and the French are born socialists, but that was not always true. American success happened independent of any public vs private debate, with both significant public and private rewards as a result.

4) Public benefits are also private and vice versa. The completion of the Panama Canal had an unquestionably awesome effect on the rise of United States in the 20th century--both militaristically and commercially. But, even with the project under control of the U.S. government, American industry benefitted tremendously. This was a major catalyst in General Electric becoming the behemoth it is today.The Panama Canal was one project, and it alone helped the United States become the dominant global naval power. It is not an understatement to say that without the Panama Canal, American history would be decisively less grand. At the same time, American industry used the canal to buy and sell goods into the global market at an accelerating rate. Though its opening was followed by World War I, the Great Depression, the rise of protectionism and then World War II, so this commercial benefit of increasing global trade was not evident for decades down the line. Time and subsequent innovations were important factors in perceived failure turning to success. Today, as it undergoes its largest renovation to date in an attempt to double the volume of goods which can pass between the Atlantic and Pacific, the Panama Canal remains a vital artery for global trade and its benefits are enjoyed by both the public and private alike.

The Profit Margin Debate: A Look at Capitalism and Competition

Over the past two years there’s been a lot of talk about the mean-reverting nature of margins as a crucial source of the market’s “overvaluation” today. John Hussman and Jeremy Grantham have been two vocal advocates of this point. Here is Hussman’s chart to that effect:

In this debate, Bulls have pointed out a relevant counterpoint: that mean reversion can be to the trend, which has been higher due to more capital lean businesses, greater productive efficiencies, and international diversification, rather than simply to the longer-term average (here's a good post from Joe Wiesenthal which covers this point and more). This trend/mean distinction is important, for a reversion to trend would imply margins still move higher over time, albeit only after a move back to and most likely beneath the more recent trendline.

Mean Reversion in Markets

Mean reversion is a powerful force in markets. One of the reasons why it works so neatly in is that when certain spreads divert from their long-run means, there is an economic incentive in the form of arbitrage for position takers to drive the spread back down to its normal level. An anecdote would be helpful. The following is a chart of the spread between West Texas Intermediate (WTI) Crude Oil (ie the “American” oil supply) and London Brent Crude Oil (ie the rest of the world’s oil supply):

We can see that over the long run, this spread exists within a relatively narrow channel; however, something happens in 2011 that sends the price of London Brent shooting upward relative to WTI. We’ll forget about why and focus on how this spread ultimately reverted back to its normal confines (though it does seem to have perked up again). While there are logistical challenges in sending crude from North America to Europe and vice versa, when the price of oil gets too high in one place relative to another, arbitrageurs can make free money simply by buying oil where it’s cheap and selling it where it’s too high. This is the definition of riskless profit. As more and more arbitrageurs engage in this activity, what is a large spread gets whittled down until there is no more “free lunch” as they say. This is how efficient capitalist markets work.

Capitalism, Economic Profit and Competition

In the latest GMO Commentary, Ben Inker makes the following point about margins, market valuation and corporate investment: “The pleasant way we could be wrong is if the U.S. is about to embark on a golden age of corporate investment and economic growth that will gradually compete down the current return on capital such that overall profits manage to grow decently as the P/E of the stock market wafts slowly down.” What I find ironic is that corporate investment is the most common way margins can and do come down in capitalism, therefore, the most likely way for GMO to be right requires that they are wrong. Let me explain.

In a capitalist system, economic profit is not supposed to exist. Economic profit is the difference between returns on investment and the cost of capital for a business. When economic profit does exist, it is supposed to be followed by a period of economic loss, such that over a cycle, there is no economic profit. This is where the idea that margins mean revert comes from. Here’s Wikipedia’s explanation for how economic profit results in competition and no winners (ie excess profiteers) over the long-run:

Economic profit does not occur in perfect competition in long run equilibrium; if it did, there would be an incentive for new firms to enter the industry, aided by a lack of barriers to entry until there was no longer any economic profit. As new firms enter the industry, they increase the supply of the product available in the market, and these new firms are forced to charge a lower price to entice consumers to buy the additional supply these new firms are supplying as the firms all compete for customers. Incumbent firms within the industry face losing their existing customers to the new firms entering the industry, and are therefore forced to lower their prices to match the lower prices set by the new firms. New firms will continue to enter the industry until the price of the product is lowered to the point that it is the same as the average cost of producing the product, and all of the economic profit disappears. When this happens, economic agents outside of the industry find no advantage to forming new firms that enter into the industry, the supply of the product stops increasing, and the price charged for the product stabilizes, settling into an equilibrium.

This is good explanation, but I have presented it in the form of an oversimplification. Some kinds of companies are able to generate economic profit for long periods of time. These are the so-called quality companies with a moat (aka a sustainable competitive advantage) that Warren Buffett looks for. Since such firms are the rare exception, not the rule, it’s worth studying them and learning about the traits they share. This is something I do on a regular basis, though for the purposes of this essay, it’s a digression. I bring up this point because considering how rare such firms are, it’s safe to apply the concept of zero economic profit to the economy at large, and in doing so, assuming that margins do in fact mean revert.

In essence, high profit margins revert to the mean much the same way as the spread between WTI and London Brent Crude Oil, though the subtle differences are important. Whereas the WTI/Brent spread is brought down with arbitrageurs, the economic profit of high margins is brought down with entrepreneurs. When entrepreneurs see high profit margins, they see an opportunity to undercut those margins, and in doing so, capturing some of the profits for themselves. However, entrepreneurs can’t buy something and sell it elsewhere to capture this profit opportunity. They are called entrepreneurs as distinct from arbitrageurs because they actually have to engage in the “process of identifying and starting a business venture, sourcing and organizing the required resources and taking both the risks and rewards associated with the venture” (the definition of entrepreneur from Wikipedia).

To paraphrase, in order to capture the excess economic profit born of a too high profit margin, entrepreneurs need to raise capital, they need to make tangible investments in building the infrastructure of a business, and they need to hire people on the ground to make the business work. Simply put, margins don’t just go down, they get competed down and eroded over time through factors and forces that actually improve the economy at large, with the benefit at the end of the day being lower prices and better supply available for end consumers. This reversion in margins is always a process, never a one-off event, and it surely happens faster in some areas than others (Clayton Christensen’s Innovator’s Dilemma is a great example of the forces of competition and innovation in the rapidly evolving hard disk drive industry, see my post on The Essential Mental Model for Understanding Innovation).

Two Tales of Margin Erosion Today

Sometimes these entrepreneurs are startups with a cheaper, more scalable way of capturing the margin, and other times they are large competitors with lower margins who see an opportunity to grow their own business. Two anecdotes would be helpful. Let me note, for the purposes of these comparisons I’ll use only operating margins.

First is the case of RadioShack losing to Best Buy who in turn is losing to Amazon (it’s worth mentioning that Circuit City would be a nice addition to this chart, for it was competed into bankruptcy).

In some ways Amazon is not the perfect example, because its own margins are virtually unprofitable, but if we can see past that for a second it becomes clear why they are a fine example. RadioShack started with the highest margins of the bunch, but the longer Best Buy and Amazon stayed beneath them in margin, the more pressure there was building on RadioShack’s own business model to cut prices. Sadly for RadioShack, the company doesn’t have the infrastructure to compete on today’s playing field. While Best Buy held up admirably during the initial assault on RadioShack, we see clear signs that Amazon’s own low-margin model has been pulling Best Buy down with it.

How was Amazon able to drive the margins down of some of its biggest competitors (note: this happened in books with Border’s and Barnes and Noble having experienced Amazon’s rath before the consumer electronics companies)? They did this with massive amounts of investment. If you total Amazon’s investments over the past 5 years (capital expenditures + acquisitions + technology and content) you see that Amazon invested $21.1 billion. Compare this to Best Buy and RadioShack’s combined market cap of $13.5 billion and you can see why Amazon is a feared competitor. Again, it’s important to point out: Amazon was able to drive down Best Buy, RadioShack and Circuit City’s margins, much to the detriment of those companies, one of whom no longer exists and another of which is on the brink. In doing so, Amazon experienced tremendous growth in its own revenues of about 33% compounded over the past 5 years, all resulting from the company investing substantial sums of money and hiring a whole lot of workers. This is how capitalism is supposed to work.

Some might counter that this obviously won’t end well for the economy too, because Amazon makes 0 profit and any multiple of 0 is inherently 0 (ie 0 profit for the S&P multiplied by an average P/E of 15 equals $0). My counter would be a) Amazon could make a whole lot more money than they do, though we can never be sure exactly how much, but they choose to invest in future growth instead; and, b) that’s why I have this next example for you.

Here are Apple and Samsung’s respective operating margins over the past either years:

Apple wowed the world with its innovative iPod, iPhone and iPad. This trifecta launched Apple’s operating margins up from a puny 3.94% in 2003 to a high of 35.3% in 2011. The problem for Apple was that it’s profit margins became too juicy. They were so juicy they were practically begging competitors to steal some of their profits, and in the chart above, we can see clearly how as Apple’s margins fall from peak levels, Samsung’s shoot up. Up to this point, Samsung was only a bit player in the handheld phone business, and did most of their business in more commoditized, low-margin consumer electronics like TVs. With such a huge opportunity to undercut Apple in price and to improve their own margins in doing so, Samsung jumped in with great success. While Apple’s margins took a hit in the past year, their revenues continued to grow, as Samsung’s revenues surged (Apple’s revenues grew 9.2%, while Samsung registered 22% yoy growth). All in all, the size of the smartphone market pie grew tremendously over the past year, though the margins earned by its earliest, most profitable player declined. Meanwhile, both in aggregate and individually, Apple and Samsung were tremendously profitable.

Macro Applications of Micro Lessons

If we compare this to GDP and corporate profit margins, the GDP (ie smartphone market size) increased tremendously, the aggregate profits earned also increased, but the average margin across the market dropped. This is a win/win for the market, for consumers and for the competitors, though is not necessarily ideal for some of the status quo players. Again though, this is how capitalist markets work: things evolve and move forward, with growing greater good in aggregate. And this is how profit margins inevitably will decline.

Using microeconomic examples is a worthy exercise in order to extrapolate what should happen on the macro level. Who knows exactly when/where/how margins will decline, if they do. There is every reason to believe they will at least eventually regress towards the trend of the recent past, which is towards higher profit margins but at a more tepid pace than has been seen of late. Most importantly though, microeconomics teaches us how it is that margins contract when they do. High margins are an important component of the capitalist process. They are one of the most obvious factors which openly invites new market entrants, ultimately encouraging new investment and new hiring.

Disclosure: No position in any company mentioned in this post.

Bitcoin's Worldview and Why It Matters

There are a few questions I’ve received in response to my post on The Rise and (Inevitable) Fall of Bitcoin that are worth elaborating on.

Do you have a stake in Bitcoin?

I have no “skin in the game,” no stake, no monetary interest in Bitcoin or a Bitcoin-based enterprise. How soon will this happen? I think this process will take a long time to play out. There has yet to be an economy developed using Bitcoin and it has been purely used as a speculative vehicle. One of the first catalysts to inspire me to read about deeper about Bitcoin, beyond the sensational headlines, was when several prominent venture capitalists expressed interest and invested in Bitcoin-based enterprises. When Silk Road was shut down, shortly thereafter, I fully bought into the argument this would help nurture the legitimacy of Bitcoin. In my hypothesis, we are in the early stages of the rise period.

About this hypothesis, what do you mean by “operating hypothesis?”

Bitcoin is something entirely new, neither seen nor tried before and as such, it is impossible to perfectly predict what its path will look like. That doesn’t mean it’s not worth developing an understanding of, and having an opinion on where it could go. It also does not mean we can’t make an educated guess as to how it should transpire, while also leaving ourselves room to be intellectually flexible enough to evolve our opinions as events play out. As Bitcoin exists today and given the possible future paths within the rules already in place, this is fully what I expect to happen.

There will always be the opportunity for outside interventions to change the path for Bitcoin. For example, someone can build a parallel network, called something like “Bitbillz” and peg its value at 1:1 with Bitcoin, while offering anyone the capacity to freely exchange their Bitcoins for Bitbillz at no cost to the one making the transaction. This new Bitbillz money can then recreate its own rules-based system for the currency and its own economic paradigm with better rules.

Why do you care?

I am really intrigued by the idea of a digital currency. It has amazing potential on many levels. Such an economic development would dramatically alter the economic landscape for many global citizens. Some of the globe's worst currencies (think Zimbabwe) are in effect a punishment on the country’s citizens. Currency crises and volatility have actual costs on the lives of many people. The success of a digital currency would have interesting implications for citizens of developed nations as well, though I think the disruptive impact is overstated by the Bitcoin demagoguery and detractors alike. A digital currency, in my opinion, would never be more than a medium through which to buy some things easier or diversify one’s currency exposure. Most importantly though, the engineered mechanics of Bitcoin are brilliant and worth expanding upon to streamline, simplify and secure e-commerce transactions for everyone. This is indeed a majorly innovative breakthrough.

The problem I have is that Bitcoin was built with such a severe, fatal flaw that it’s success would inevitably hold the potential to do more harm than good. It’s early enough in the evolution of Bitcoin to create a digital currency with fewer problems, with more staying power, and most importantly, with a better worldview.

What did you mean by “ideological nature of some of these questions?”

Bitcoin was built with a worldview, and it’s a rather unattractive one. Bitcoin is the creation of Anarcho-Capitalist aka Market Anarchist, a fringe group at the intersection of outright anarchy and the Austrian School of Economics. This is something Bitcoin advocates purposely gloss over. Bitcoin’s early history, essentially from it’s first day up until October 1 of this year, 2013, was entirely created by, used by, financed by and for anarchists. Here are the words of one the man who built the first large Bitcoin community about why he was into Bitcoins (take note of who he is appealing to):

Hackers, anarchists, and criminals have been dreaming about these days since forever. Where you can turn on your computer, browse the web anonymously, make an untraceable cash-like transaction, and have a product in your hands, regardless of what any government or authority decides... This is about real freedom. Freedom from violence, from arbitrary morals and law, from corrupt centralized authorities, and from centralization altogether. While Silk Road and Bitcoin may fade or be crushed by their enemies, we've seen what free, leaderless systems can do. You can only chop off so many heads.

Bitcoin was built for a specific purpose, and by people with a specific fringe ideology. This particular school of anarchists believe strongly in hard money, with religious fervor. Instead of trying to learn about why gold standards don’t work in reality, they purposely took the single worst characteristic of the gold standard (its inelasticity of supply) to the logical extreme. This is what happens when people are blinded by extreme adherence to an extreme ideology. I don’t know what the “perfect” currency should look like, but I think many economists from all schools would agree that Bitcoin could do a whole lot better. Given that reality, why not try to improve the entire system before building an economy on top of it?

Well even if you don’t know what a “perfect” currency, isn’t Bitcoin worth trying because it’s the best we have? And shouldn’t you have to offer at least something that would be better?

Ok I’ll throw out one possible solution for thought, which is derivative of John Maynard Keynes’ idea proposed at the first Bretton Woods conference (he called it Bancor): maybe make the previously mentioned “Bitbillz” some kind of global reserve currency, where each Bitbill is backed by a basket of all of the world’s currencies (say 15-25 of the most liquid global currencies) in proportion to their relative share of GDP? 

I plotted what a hypothetical global reserve currency would look like, priced in dollars and benchmarked to 2011 global GDP levels. It's something worth thinking about.

When some currencies are strong, others will be weak, making it a less volatile, but still liquid kind of money. Further, arbitrageurs can then impose market discipline in the same way new shares of open-ended ETFs are created: when demand for Bitbillz outstrips supply arbitrageurs can buying up the exactly proportion and value of the constituent currencies and deposit them to mine/print/create new Bitbillz. The supply would have a finite constraint (the entire global monetary base), that should grow in-line with global GDP, and with a built-in natural check on volatility. Just an idea...I would love to hear if others have even better ones. It’s a question worth asking.

The Rise and (Inevitable) Fall of Bitcoin

Bitcoin is receiving much attention these days for its parabolic ascent. The attention seems to stem from people’s concerns with monetary policy and the growing disdain with government intervention and oversight, generally speaking. It is no coincidence that Bitcoin’s surge this year corresponds with the growing public backlash over these large issues. To that end, Bitcoin is a great story, but is it a great idea?

A Bitcoin Economy?

The textbook definition of money holds that it must be a medium of exchange, a unit of account and a store of value. Colloquially when many say "currency" they in fact mean "money," especially with regard to Bitcoin. We will ignore the argument as to whether Bitcoin is an effective store of value given its volatility and focus purely on the philosophical question of whether Bitcoin makes sense as money. For Bitcoin to truly emerge as “money” there must be an economy with the actual transfer of goods built on top of it. In such an economy, there will be some people who “save” money. This means that some will put off consumption today for the capacity to consume at a future date.

It’s hard to project exactly how much commerce will be done on Bitcoin, or how big the “economy” will be, but we do know that venture capitalists like Fred Wilson are investing in the Bitcoin ecosystem, and Marc Andreessen has expressed interest in following suit. Further, the US government’s arrest of the Silk Road founder and crackdown on the black market drug trade via Bitcoin could help lend great legitimacy to the broader Bitcoin economy. Given the evolution of credibility and interest amongst venture capitalists to grow an economy on Bitcoin, we can presume that Bitcoin’s price today reflects a belief that an economy will in fact be able to develop.

The Monetary Mechanics of Bitcoin

Before we can answer whether Bitcoin can work as “money,” let’s talk about the mechanics behind it (and by mechanics, we will ignore the cryptography and security element and focus purely on the monetary mechanics). Here are the mechanics for how Bitcoins are created:

The reward for solving a block is automatically adjusted so that roughly every four years of operation of the Bitcoin network, half the amount of bitcoins created in the prior 4 years are created. 10,500,000 bitcoins were created in the first 4 (approx.) years from January 2009 to November 2012. Every four years thereafter this amount halves, so it will be 5,250,000 over years 4-8, 2,625,000 over years 8-12, and so on. Thus the total number of bitcoins in existence will never exceed 21,000,000.

With this informatino, we can plot exactly what the money supply of Bitcoins will look like over time:

As such, we know that somewhere around 2040, the entire supply of Bitcoins will have been “created” and that no new incremental supply of will emerge from that point, onward.

The next important feature of Bitcoins that’s important to understand is the “granularity” of the currency. As they are constructed, each Bitcoin can be broken down into denominations of up to 8 decimal places (with 0.00000001 BTC being the smallest denomination). The currency was created this way, so that as Bitcoins increase in value, people are able to make purchases with fractions of the increasingly valuable coinage, rather than needing to use whole things at a time.

Lastly, and related to the idea of granularity is the deflationary bias embedded in Bitcoins, as explained by the Bitcoin community itself:

Because of the law of supply and demand, when fewer bitcoins are available the ones that are left will be in higher demand, and therefore will have a higher value. So, as Bitcoins are lost, the remaining bitcoins will eventually increase in value to compensate. As the value of a bitcoin increases, the number of bitcoins required to purchase an item decreases. This is a deflationary economic model.

So we know that people are trying to build a real economy on Bitcoin and we know mechanically how Bitcoin is designed to work, but how does it work in practice? For the purposes of this analysis, the two features of money that are most important are its role as a medium of exchange and its role as a store of value. As an economy grows, more Bitcoins will be used in exchange for goods and services, while at the same time, some who use Bitcoin will use their currency as a store of value in order to “save” money. In theory, Bitcoin is admittedly designed to increase in value over time (ie the deflationary model of currency) and therefore, “savers” will be rewarded simply by not spending their Bitcoins. This is a problem we’ll discuss shortly, but until then, I digress.

Over the past decade, the US has a fairly low savings rate compared with the rest of the world. Americans save between 11-12% of GDP per year. If we were to apply this savings rate to Bitcoin, already knowing the future path of the Bitcoin money supply, a problem starts to emerge--were 11.5% of Bitcoins saved per year, by 2021, 95.3% of the entire supply of the currency will have been stashed away as savings rendering commerce effectively impossible. A system of credit can be built on top of the Bitcoin economy (and most likely will be built), but while this can push back the date at which savings account for too large a share of the entire economy, it can only delay the inevitable. At some point, Bitcoins saved will start to approach total Bitcoins in circulation, making commerce effectively impossible.

Bitcoin is Good as Gold

This is in fact how the gold standard worked as money for years. While there is a finite amount of gold on planet earth, humans still have yet to mine all gold, and the supply of gold accordingly increases at some kind of modest annualized rate. When the price of gold spikes, miners are incentivized to increase their exploration and production efforts, and as such, spikes in the price of gold tend to come with spikes in production. Hard-money types tend to hate the growth of the money supply, though they like gold because the supply growth is not controlled by a centralized pseudo-government actor. Because no government controls supply growth, hard-money types are able to ignore the fact that gold’s supply growth tends to be lumpy (ie how the California Gold Rush led to a rapidly increasing money supply and its subsequent end led to stagnation) in focusing on how it is largely immune to inflations.

Bitcoin and gold are similar right now in how “mining” (alongside savings) is incentivized by a rising price. The increase of supply and rising price encourage those who have “saved” to spend by offering a price that is too good to pass up. This theoretically helps maintain a balance between commerce and savings over the long-run; however, we know theory and practice often differ and we’ll soon get to why, but first, let’s talk about how Bitcoin and gold differ. With gold, we have never had to contemplate a date at which the supply in circulation stops increasing, while with Bitcoin the end of supply growth has a known date. 

Here’s how the Bitcoin community explains this problem:

Worries about Bitcoin being destroyed by deflation are not entirely unfounded. Unlike most currencies, which experience inflation as their founding institutions create more and more units, Bitcoin will likely experience gradual deflation with the passage of time. Bitcoin is unique in that only a small amount of units will ever be produced (twenty-one million to be exact), this number has been known since the project's inception, and the units are created at a predictable rate.

In fact, infinite divisibility should allow Bitcoins to function in cases of extreme wallet loss. Even if, in the far future, so many people have lost their wallets that only a single Bitcoin, or a fraction of one, remains, Bitcoin should continue to function just fine. No one can claim to be sure what is going to happen, but deflation may prove to present a smaller threat than many expect.

Also, Bitcoin users are faced with a danger that doesn't threaten users of any other currency: if a Bitcoin user loses his wallet, his money is gone forever, unless he finds it again. And not just to him; it's gone completely out of circulation, rendered utterly inaccessible to anyone. As people will lose their wallets, the total number of Bitcoins will slowly decrease.

Therefore, Bitcoin seems to be faced with a unique problem. Whereas most currencies inflate over time, Bitcoin will mostly likely do just the opposite. Time will see the irretrievable loss of an ever-increasing number of Bitcoins. An already small number will be permanently whittled down further and further. And as there become fewer and fewer Bitcoins, the laws of supply and demand suggest that their value will probably continually rise.

Thus Bitcoin is bound to once again stray into mysterious territory, because no one exactly knows what happens to a currency that grows continually more valuable. Many economists claim that a low level of inflation is a good thing for a currency, but nobody is quite sure about what might happens to one that continually deflates. Although deflation could hardly be called a rare phenomenon, steady, constant deflation is unheard of. There may be a lot of speculation, no one has any hard data to back up their claims.

That being said, there is a mechanism in place to combat the obvious consequences. Extreme deflation would render most currencies highly impractical: if a single Canadian dollar could suddenly buy the holder a car, how would one go about buying bread or candy? Even pennies would fetch more than a person could carry. Bitcoin, however, offers a simple and stylish solution: infinite divisibility. Bitcoins can be divided up and trade into as small of pieces as one wants, so no matter how valuable Bitcoins become, one can trade them in practical quantities.

In fact, infinite divisibility should allow Bitcoins to function in cases of extreme wallet loss. Even if, in the far future, so many people have lost their wallets that only a single Bitcoin, or a fraction of one, remains, Bitcoin should continue to function just fine. No one can claim to be sure what is going to happen, but deflation may prove to present a smaller threat than many expect.

Why does all this matter and what am I getting at? 

Historically there have been points in time where the propensity to save (and thus not spend) has outstripped the supply of currency available to be saved, thus choking off the flow of commerce. This is a big part of what happened in the Great Depression and is something that both Keynesians and Monetarists alike agree on. When countries “left” the gold standard, they effectively devalued their currency all at once (and it's no coincidence that the recovery from the Great Depression started with such a devaluation). This similar mechanical move has happened in the floating-currency regime whereby countries who peg their currency to a foreign currency (like Argentina’s peso pegged to the dollar), must abandon the peg with a devaluation in order to protect their currency.

What happens when too much of Bitcoin’s supply gets stashed as savings? Granularity provides a built-in answer. 1 bitcoin will be divided by 10 in its purchasing power (note: 0.1 Bitcoins is presently known as a centibitcoin). This is how spending and commerce will then return to the Bitcoin economy. The Bitcoin community argues that this will be a slow, “gradual deflation,” which is “unheard of” in world history. There is a reason for this: gradual deflation is a paradox that simply does not and cannot exist.

Remember above I told you I would eventually get to why theory and practice differ once savings exceed a certain level, and prices rise? I didn’t forget. Theory and practice diverge because theory presupposes a certain kind of human rationality that simply does not exist. When the price of a currency itself starts to rise, and supply starts to get scarce, instead of prior savers now spending money and solving the problem of too little circulating money, reality has time-and-again demonstrated that people who previously were not savers, and were engaged in commerce, see that more money was made by saving money than investing it. In response, prior commercial actors decide they too can make more money by hoarding money than they can by investing it, and upon that realization, they too turn into incrementally new savers.  John Maynard Keynes dubbed this "The Paradox of Thrift" and the incorporation of paradox in the title is self-explanatory here. This positive feedback loop of saving begetting more saving continues until some kind of breakpoint is reached. This breakpoint is either a devaluation or a complete collapse in an economy, but either way, it is not and never has been pretty. 

Considering Bitcoins are the ultimate fiat currency, backed by neither a hard asset, nor the capacity to tax, faith in the currency is immensely important, but also far easier to destroy than build up. This harkens back to Warren Buffett’s wise observation that “it takes 20 years to build a reputation and five minutes to ruin it.” Once trust is lost in Bitcoin, it will be impossible to make it back.

Again, why does it matter?

Since I am speaking about this decline as inevitable, and obvious, let me explain why I think this even warrants conversation in the first place. I think Bitcoin is a fascinating experiment that will eventually have considerable value to help improve our knowledge of monetary systems, and to help dispel some of the myths that have built up in some recently popular economic circles. With the crisis, “hard-money” like the gold standard has become a popular “solution” despite the fact that we know both empirically and theoretically exactly how and why they don’t, won’t and never could work. Paul Krugman has tried to explain this problem with his explanation of the Capitol Hill Baby-Sitting co-op and Pascal-Emmanuel Gobry has highlighted this connection with Bitcoin, but considering the ideological nature of some of these questions, such proof will never be taken as positive. Bitcoin will eventually show us this reality in real-time.

The second source of my interest in Bitcoin is the role of feedback loops and reflexive processes in markets. George Soros’ Alchemy of Finance is one of my favorite market philosophy books and one I am a believer in. The essence of Soros’ “General Theory of Reflexivity” holds that markets are driven by feedback loops whereby prices influence the course of events, which influence prices, which in turn influence the course of events. I’ll let Soros further explain:

Feedback loops can be either negative or positive. Negative feedback brings the participants’ views and the actual situation closer together; positive feedback drives them further apart. In other words, a negative feedback process is self-correcting. It can go on forever and if there are no significant changes in external reality, it may eventually lead to an equilibrium where the participants’ views come to correspond to the actual state of affairs. That is what is supposed to happen in financial markets…

...By contrast, a positive feedback process is self-reinforcing. It cannot go on forever because eventually the participants’ views would become so far removed from objective reality that the participants would have to recognize them as unrealistic. Nor can the iterative process occur without any change in the actual state of affairs, because it is in the nature of positive feedback that it reinforces whatever tendency prevails in the real world. Instead of equilibrium, we are faced with a dynamic disequilibrium or what may be described as far-from-equilibrium conditions. Usually in far-from-equilibrium situations the divergence between perceptions and reality leads to a climax which sets in motion a positive feedback process in the opposite direction. Such initially self-reinforcing but eventually self-defeating boom-bust processes or bubbles are characteristic of financial markets, but they can also be found in other spheres.

Understanding and spotting feedback loops in financial markets is one of the most important things an investor can do. Feedback loops are one of the sources of my interest in the Santa Fe Institute and its work on markets as a complex adaptive system (see my recent interview with Michael Mauboussin which spends some time on feedback loops). In fact, feedback loops are one of the telltale features of complexity.  It is my operating hypothesis that Bitcoin is one such “positive feedback process” which will first lead to a spectacular risein prices, that will ultimately reverse and crumble into an even more remarkable decline.

As it stands today, per my thesis, Bitcoin’s “rise” should be in the early stages. This rise has been fueled by a combination of speculation and the promise for the development of actual commerce on Bitcoin. The adoption of broader uses for the currency will be the catalyst for the next stage of ascent. I’m not sure how far Bitcoin can go on the way up, nor am I sure exactly when the inflection point from rise to fall will occur, but one thing I am fairly certain of is that when the fall comes, it will be swift and violent. In the end, it's success will be its own demise. As they say, “what goes up on an escalator goes down on an elevator” and I would not want to be the one left holding the proverbial bag on the way down.

A Tale of 3 Tech IPOs and the Punditry Narrative

When LinkedIn IPO'd in May 2011, underwriters priced the offering at $45 per share. The stock closed the day up 109%, at $94/share. Henry Blodgett at Business Insider quickly published an article entitled "Congratulations LinkedIn, You Just Got Screwed Out of $130 Million," bashing the underwriters for misreading demand and reaping immense profits for themselves at the company's expense. Blodgett wasn't alone in critiquing LinkedIn's underwriters, as the media and financial commentators worked into a frenzy about just how poorly the IPO was priced. Jim Cramer chimed in with his own fury over how the underwriters "juiced" the IPO.

As Facebook geared up for its IPO, to much enthusiasm, people were asking whether Wall Street would avoid doing what it did to LinkedIn (aka "robbing" them) by pricing the offering fairly. A "fair price" would enable the company itself to maximize its own proceeds. In response, Facebook was priced as aggressively as possible. It was priced so aggressively that Blodgett called the IPO "Muppet Bait" for how dangerous a proposition buying into Facebook was for retail investors. We all know what happened next. There were no buyers of the shares hitting public markets, and the stock instantly entered a tailspin dubbed the "Facebook Faceplant." Here the underwriters were accused of "botching" the IPO at the expense of retail investors.

Leading up to Twitter's IPO, the biggest question was "how could we avoid another Facebook?" (too many such links to pick one worth sharing). Twitter purposely wanted to temper enthusiasm and price its offering low enough to encourage long-term investors to buy shares. Sure enough, Twitter opened over 70% above the $26 offering price and the company similarly left boatloads of money on the table a la LinkedIn. In each subsequent tech IPO, the prior "victim" ended up reaping the rewards.

Across these three big IPOs, we have seen punditry complain about the underwriters, company insiders, and the exchanges, amongst others, without ever looking into the proverbial mirror.  The media whirlwind surrounding these events has created a narrative which permeates society. This narrative then influences the actors in the next scene to attempt to avoid the pitfalls of the prior narrative, only to fall victim to new problems seen one long cycle ago. Punditry continuously drives a vicious cycle of reactionary moves with commensurate media complaints and the same problems sadly repeat themselves over and again. All we have learned in all this is that the underwriters simply can't win a PR windfall with these IPOs (though they do make plenty of money), and punditry will inevitably find a villain and a victim to create a story at its leisure. 

Disclosure: No position in any of the stocks mentioned.