Lyn Alden (02:56):
And the one I used in this piece was Plutarch wrote about the ancient King Solon in Greece and this was an excerpt from Lessons of History by Will and Ariel Durant. I’ll just read it because it’s actually a really good paragraph. And in the Athens of 594 b.c., the poor finding their status worsened with each year, the government in the hands of their masters and the corrupt courts deriving every issue against them, began to talk a violent revolt. The rich, angry at the challenge to their property, prepared to defend themselves by force. Good sense prevailed, moderate element secured the election of Solon, a businessman of aristocratic lineage to the supreme archonship. He devalued the currency thereby easing the burden of all debtors, although he himself was a creditor.

Lyn Alden (03:43):
He reduced all personal debts and ended imprisonment for debt. He canceled arrears for taxes and mortgage interest. He established a graduated income tax that made the rich pay at a rate 12 times that required of the poor. He reorganized the courts on a more popular basis. He arranged that the sons of those who had died in war for Athens should be brought up and educated at the government’s expense. The rich protested that these measures were outright confiscation and then the radicals on the other side complained that he had not redivided the land. But within a generation, almost all had agreed that his reforms had saved Athens from revolution.

Lyn Alden (04:21):
And so, basically, when we talk about this multi-decade, multi-generational compoundings, usually, what you have is these sharp events at some point where either people revolt, right? Everyone’s a debt slave now. So, they say, “Wait a second. We outnumber these guys 100 to 1. Let’s just go burn their house down.” So, there’s that. Or they through politics basically say, “Okay, this is not sustainable. The courts are corrupt. We have so entrenched cronyism and the policy is not good. Let’s sharply reverse some of this without going too far.” And so, this was an example where they managed to moderate it. Most examples are not that successful.

Lyn Alden (05:00):
And so, this shows over time that when you have massive debts and wealth concentration built up in a society, there’s usually some release valve that in various ways, it’s painful for various groups. And then depending on how it goes, it could be extraordinarily painful for everyone if you have a collapse or a revolution of some sort.

Stig Brodersen (05:20):
It’s just very interesting to see what we can learn and then what happens. We know in just in times like this, it can go either way. And I think historically, it has typically ended with a conflict. I’ve seen some stats that in situations like these, with the declining power and the new superpower coming, the probabilities of war around 75% historically, but we always hope for clearly not a war and for a more peaceful solution. But I just hope that we can take a piece from the Greek playbook, if not doing exactly like it. That’s not my point. So, please don’t read between the lines, but just more a hope that it won’t go into war or anything like that.

Stig Brodersen (06:00):
Lyn, shifting gears here a bit but not quite, in episode 426, you recommended the book Money Dethroned to our audience. And I want to say that central to the book was that debasement was the core of falling empires. And we both read Ray Dalio’s book, The Changing World Order. And in that book, it goes through how the English empire took over from the Dutch to being taking over from the US. And now we’re at a point with the Chinese gaining relative global influence at a rapid pace.

Stig Brodersen (06:32):
As I’m reading The Changing World Order, money debasement in the book is surely a factor, but it’s not the central theme of falling empires. It’s more derivative of something that happened before. The cause and correlation is very important to separate here. I am curious about in which place you think currency debasement has in the rise and fall of empires.

Lyn Alden (06:54):
I would side with Dalio on that, essentially that over time, that currency devaluation is an offshoot of declining national status, empire status. Empires are inherently unnatural things, right? It’s unnatural for one group of people to become so dominant compared to all the surrounding regions and then the whole world. And that takes a lot of organization and momentum and structure to change, because over time, entropy wears that down. There are asymmetric attacks that competitors can use against that group, right? So, things that are organized come with the degree of fragility to them compared to chaos, right? So, you centralize attack points and you have more to defend. And so, over time, empires start to just entropy decays on itself.

Lyn Alden (07:41):
And I would say that the same thing is true for a currency that is in human power. That if humans are able to influence the currency in any way, that eventually they will start cheating. They will start say having gaps for one reason or another and then having to debase and having to manipulate it over time. And so, I would say that both currency debasement and falling up by our status are the idea that both of them require basically the rulers to be perfect forever in order to not fall. And of course, given a long enough chain of rulers and governments, they’re not perfect and so they will eventually fall.

Lyn Alden (08:15):
But going back to the book, Money Dethroned, I think the big takeaway I have in that book is less about that and more about how money works in different societies, especially about commodity money. So, I think my takeaway from that book is that money’s a technology that a money can work for a while, but then if it comes into contact with an external culture that has better technology, they can undermine your money. Things that are scarce in one region might be abundant in another region and that over time, as our technology changes, our usage of say commodity money changes. And so, that’s one of my big takeaways of the book is basically this historical look at how money works.

Lyn Alden (09:01):
The book didn’t really cover this, but an interesting point is that there’s that… I believe it’s called the Dunbar effect basically, the research that suggests that the typical human person can keep track of about 150 people, more or less. We can keep track of a 100, 150 people. We know, “What are their traits? What is our past relationship with the person? What did they do for us? What did we do for them? How do we stand relative to each other?” And so, if you have a small enough group, if you have a tribe, you don’t really need a money, because it’s a small enough set of interactions that you can rely on barter. It’s basically like tribal communism, right? It’s a big clan. A big family status is derived through your position, right?

Lyn Alden (09:46):
So, if you’re really good at something, you might become the chief. Otherwise, you might be more shunned in society, but basically, they can account for all their needs and abilities because they have a small enough group that they all know each other. But once you go above a certain size, once you’re at town status, civilization status, you need a more liquid accounting tool to keep track of things. And that has to be resistant to debasement, resistant to manipulation. And so, that’s generally why you see it. If you go to all these different cultures, once they get to a significant size where either their own unit is big enough or that they’re interacting with enough external groups that they don’t necessarily fully trust, then you start to see a development of a money.

Lyn Alden (10:31):
And basically, there’s early stages. It ends up being some commodity that is desirable, hard to produce, but pretty liquid and fungible. And so, basically, some commodity gets a monetary premium on top of it, where it might be used for its utility, but it’s even more used because it’s recognized as something that you can hold. And that eventually, it’s the most saleable good, that you can always find someone who will want this thing, because it’s almost universal. And so, Money Dethroned goes through from the perspective of travelers and other people how different societies had these monies emerge over time.

Stig Brodersen (11:09):
And on that note, we often hear that the best money wins. Whenever we talk about the best monies, we often talk about currency that have the fewest units that can be supplied compared to the current stock of those units. Some people might know of this as the stock to flow model. And gold could be one example, because the supply of gold only increases by 1.5% annually. Do you agree that the best money always wins? And if it does, is that consistent with Ray Dalio’s observations that historically, money has always followed the same three steps, hard money, claim on hard money, fiat money, and then back to hard money again.

Lyn Alden (11:47):
The best money isn’t always the absolute hardest. There’s other attributes like the ease of transaction, the divisibility, the speed with which you could move it around. And that’s why I would argue for example that for the past 150 years, paper currencies have really outpaced gold, because even though gold’s harder, in practical terms, it has trouble keeping up. So, for thousands of years, commerce and money moved at about the same speed, which is the speed of humans, right? So, we go around on horses and chips and on foot and we transact with each other with gold, silver, copper pieces, or even our ledgers. Even if we started keeping ledgers, those physical ledgers could still only move at the speed of humans.

Lyn Alden (12:29):
We had to really bring them somewhere if you want to give them to another city. But with the introduction of telecommunications equipment in the 1800s, first with the telegraph and then the telephone, we lay these undersea cables under the Atlantic, starting in the 1800s. And so, by the time you got to late 1800s, institutions around the world could talk to each other almost instantly. And so, you could update ledgers and perform certain types of transactions on multi-continent basis far faster than physical goods, including physical money, could settle. And so, gold was no longer able to keep up with the speed of human commerce, and that really further, I think, led to the need for abstraction.

Lyn Alden (13:12):
So, historically, gold was abstracted, because it had limits on its visibility. Whereas now, we also had the even more important thing where we had limits to its speed relative to the speed we wanted transact. So, we had to abstract it more and that eventually opened up the divide between gold and paper currencies. And then eventually, they could be separated. Whereas, in some other world, if there was an element like gold that we could just mentally teleport to each other, it would’ve been much harder to ever introduce paper currencies, because it would’ve been seen right away as an inferior product, but because gold had those limitations and there was an advantage to using paper claims for gold, it was able to lead to that separation.

Lyn Alden (13:53):
So, in many ways, even though dollars are less hard than gold, they have other advantages over the past 150 years or so that has allowed them to at least keep up with gold and that more people use dollars than use gold, even though gold is a better store of value. So, gold as its hardness is better retained its store of value property, but it lost the medium of exchange and unit of account aspects to what is basically better technology. When you look at pure commodity monies, the stock to flow ratio is pretty paramount. There’s actually a really good example in the early American colonies. There was almost an accelerated version of why most monies fail.

Lyn Alden (14:39):
And basically, in pre-American before the revolution, you had these Southern colonies in the 1600s and they started using tobacco as money. They grew tobacco. It was a high value crop. It was reasonably liquid and fungible. And so, they started using tobacco as money. They even made it legal tender in some colonies like Virginia, where you could pay your taxes, you could pay all debts in tobacco. And so, it became money. Problem is that when you put on a monetary premium to something, you basically give everyone an incentive to make more of it. And so, tobacco’s not very resistant to debasement, so anyone could go and plant more tobacco. And so, they started to inflate the value of tobacco away.

Lyn Alden (15:22):
Basically, the prices of things as dominant to tobacco began to increase. And then so the government imposed restrictions. They said certain class of people couldn’t grow tobacco or there’s only so much tobacco that can be grown a year. They’re trying to artificially increase the stock to flow ratios. Then you had another problem where unlike gold, tobacco is not very fungible, right? So, there’s higher quality tobacco, there’s lower quality tobacco. And so, there’s an incentive to pay your debts in this marginal tobacco, the worst tobacco, and then to say, sell the good tobacco overseas or smoke that or whatever you want to do. Use that for better purposes. Give other people the worst ones.

Lyn Alden (16:00):
You basically have Gresham’s law in play, where the weak money dries out the good money. So, everyone’s trading around the bad tobacco. Then they had to say, “Okay, well, we need external auditors to come in and check the quality of tobacco.” So, they put tobacco in warehouses, grade it, and then trade paper claims for that tobacco. So, they basically had to try to increase the fungibility. And then eventually, they abandoned the whole situation, because it was untenable. And so, that’s an accelerated version of why any commodity that’s not resistant to debasement, meaning it can’t maintain a high stock to flow ratio given our level of technology, ultimately fails as money.

Lyn Alden (16:41):
When you look at the broad spectrum, all the different commodities of history, that’s one reason why gold keeps reemerging, because no matter how good our technology is, we’re not really good at making more gold. So, in the 1970s, for example, when the price of gold went up more than tenfold, if you look at the gold production, it barely changes at all, because we just literally don’t have the capability to make a ton of new gold in a short period of time.

Stig Brodersen (17:08):
I’m holding this amazing blog post. It’s another one of Lyn’s great blog post. The title is, “What is Money, Anyway?” I’ll make sure to link to that in show notes and you tell different stories about commodity money. I love all of them. One of them is about African beads, which is amazing itself and really the illustration of what you’re saying there about new technology coming in. I don’t know if I could ask you to share that story with the audience.

Lyn Alden (17:31):
Yeah. So, the African bead story, that’s probably the most tragic one, one of the most tragic examples in that piece. So, basically, for a long period of time, you had different groups in West Africa using beads as money. So, again, that goes back to the idea that money is technology. So, what is rare, liquid, fungible, desirable in an area could be different in other area. So, in that region, they didn’t have glass-making technology. And so, glass beads were very rare and desirable. And then also you had a pastoral society. So, you might have your herd of animals, shepherd. You’re moving around. So, you want to be able to bring your money with you. So, you could literally wear your beads. You could wear your wealth. And so, that was a useful type of money.

Lyn Alden (18:17):
They also used things like fine fabrics and things like that and certain herbs. These were money-like instruments, but beads were a key one for them. And the tragedy was that Europeans who at the time had glass-making technology when they were traveling around, they would identify and say, “These people like to use beads as money and so we can use that to our advantage. It’s cheap for us to make fancy glass beads and then we can start trading it for things of actual value. We can buy their animals. We can buy their resources.” And then sadly, there was a slave trade. So, you could buy slaves with these beads that you could make for almost free. So, they became known as slave beads in some circles. But then of course, the Africans had resistances against this.

Lyn Alden (19:06):
So, if the Europeans flooded everything with these say clear glass beads, they would start to say, “Okay, these clear glass ones are… No, they’re not good money. We want the purple kind.” But then of course, over time, the Europeans would adapt and say, “Okay, well, they want the purple kind now.” So, there was this cat and mouse game where beads were not fully fungible. There were different types and so there were different taste preferences. And then there were different reactions to the perceived scarcity of different types of beads. But eventually, that money became untenable for obvious reasons that there was a technology asymmetry between the cultures and then over time, that technology spread everywhere.

Lyn Alden (19:46):
And so, glass beads are in the long arc of time not good money. And it also that shows that if you don’t have hard money and if your money is not hard and if you’re using something as money that another culture or that some other group within your society can produce more of, then you’re at a disadvantage. So, that’s one of the tragic examples of why money is so critical, especially when different groups interact with each other.

Stig Brodersen (20:21):
Just keep asking until you have an answer. And one of the stories I like to go back to is the story of Marco Polo and Kublai Khan. So, we are back in the 13th century. At the time, Kublai Khan and his administration came up with this great technology that could make money paper notes out of mulberry tree bark. And so, it was this neat size. It was 9 times 13 inches. And you might be thinking, “That’s not a great size for a note,” but it was equivalent to 1,000 coins and 1,000 coins weighed around eight pounds. It was actually quite efficient. And to this story, if you were merchant in Asia at the time, in Asia, you would have generally holes in your coins, which you have someplace in Europe, but not all of Europe.

Stig Brodersen (21:14):
And so, you put a string in, so it’ll make it easier to transport, but as you needed more and more money, there was simply money demands. It just became really, really heavy. For example, the word yen, the Japanese currency, and they originally got their money from China. It means round coin. So, it’s very integrated in society. And so, that technology, having those 1,000 coins in one note, even though it was 9 times 13, was very, very efficient. And before then, you were trading mainly in silver and in silk, which also had its limitations. The problem about that system was that it wasn’t really backed by anything other than the sword. It was all backed by if you do not accept this currency, Kublai Khan would have you hanged.

Stig Brodersen (22:00):
So, there was this weird dynamic where you could enter his kingdom and everyone would be forced to give all of their belongings like gold, silver, silk, whatnot. And then they would get these notes in return. And it was perfectly fine because you could just walk around in that kingdom as long as that exist and get that. Everyone would accept that as currency. I know that was a bit of a detour, but as a geek, I wanted to look back in history. It’s so interesting learning about how money has evolved.

Stig Brodersen (22:29):
Then I would see if I can avoid turning this into a book club, but yet again, I’m holding up a book here and the name of the book is Check Your Financial Privilege. You’ll referenced quite a few times in the book and we had Alex on the show on the Bitcoin fundamentals, episode 71. It’s such a wonderful book. One of the concepts discussed in the book was that the fiat currency system created an inherent instability, because it allowed for the option of going to war. And specifically, it was also mentioned in the book, how European powers went on and off the gold standard, depending on the state of the two World Wars. How do you think about the relationship between fiat currency and the ability to go to war?

Lyn Alden (23:12):
I think a lot of it goes hand in hand, but I wouldn’t phrase it as it creates the ability to go to war, because any student of history knows that war goes back as far as our records go. It goes back way before fiat currencies, but what Fiat currencies do… So, let’s say without fiat currencies, right? Let’s say money is gold for example. If a government wants to wage war on another country, they obviously have expenses to do that. They have to buy expenses. A lot of wars, you use external mercenaries, right? So, for example, in American revolution, Germans were used in that war. And so, basically, there’s equipment or soldiers that could be used as well as paying their own citizens to drop what they’re doing.

Lyn Alden (23:55):
Say, “Okay, stop being a blacksmith. Come fight this other group of people that you never met. So, we’ll pay you.” And so, wars are expensive. And so, if gold is money, the government has two options to pay for it. One is that they have a stockpile of gold that they can start draining in order to do the war. That obviously has limits of how far they can go. And then two, if that does get low, they can tax their citizens. They can say, “Okay, we need a special war tax.” Now the problem with that is that those two methods are inherently limited. If you keep taxing people more and more for this war that they don’t perceive themselves as benefiting from, you’re increasing the odds that you’re going to get pushback and revolution.

Lyn Alden (24:32):
Either they’re going to stop voting for it or if it’s a kingdom of some sort, they have no voting power, they’re going to revolt. They’re going to say, “Stop. You’re stealing my money to go kill people I don’t know.” Whereas what fiat currencies do is they give the government basically unilateral ability to drain value from the citizens without them knowing and without their permission right away. They only find out after the fact. So, if everybody say no longer uses gold but they own a currency that is say peg to gold, the government can print a lot of that money, pay people with it, do all this.

Lyn Alden (25:07):
And then over time as that increased money supply trickles through society, a year or two or three later, they start to realize how it inflated their savings were, but war at that point have been raging for years. And so, basically, it gives the government a third ability. If one country can’t drain its citizen’s wealth to fight a war and another one can, that second one has a better chance of winning, right? And so, once this became possible, it’s spread everywhere, right? If one entity can do it, other entities either do it or they probably fail. And so, one of the arguments I make is that while I fully think that’s true, I also think unfortunately it was inevitable that going back to the whole thing where the speed of commerce due to telecommunications technology became faster than the speed of gold.

Lyn Alden (26:01):
So, we had to abstract the gold and that abstraction gave basically the government and policy makers arbitrage that they could then use in ways that they couldn’t use before. It was much quicker for them to debase money and much easier for them to control money. And so, I do think that there is a lot of merit in the argument that the abstraction of money, either paper currencies are backed by nothing or paper currencies that are backed by gold but that can be depegged or devalued a stroke of a pen, that those technologies basically do enhance a country’s ability to do war, which in the grand scale is a bad thing. We would prefer if globally, there were more limits on war, but it’s unfortunate that when this technology exists and one country exploits it, it can be everywhere.

Stig Brodersen (26:49):
I’d like to discuss the Triffin dilemma. Please present to audience, first of all, what it is and if we can still use some of the teaching from the Triffin dilemma in a fiat currency world.

Lyn Alden (27:02):
Now, the Triffin dilemma goes back to economist, Robert Triffin. Basically, it’s an observation that the domestic needs of currency and the foreign needs of that currency, especially for a reserve currency or one of the reserve currencies, that those needs are often in conflict. And so, it’s changed over time as our money changed over time. So, it’s been used in different ways. So, back when it was proposed in the ’50s, for example, he was basically proposing why the Woods system would fail. So, the United States had the dollars pegged to gold. Other currencies pegged themselves to the dollar and he observed that this would eventually fail.

Lyn Alden (27:43):
And basically, the failure point of that system was that the number of dollars were increasing substantially, including for needs for those dollars. So, basically, any bank when they make loans create more dollars and broad money was convertible to gold by international creditors, even though it was banned for Americans to use, but international creditors could convert dollars to gold. And then even offshore banks, if they had dollars, they could also loan dollars and basically create more dollars to a limited extent but still possible. And so, over time, the number of dollars greatly exceeded the amount of gold.

Lyn Alden (28:20):
And so, we had gold drawing down, American gold reserve drawing down, and the number of dollars proliferating until that system became untenable. Foreigners have an incentive to convert those dollars to gold. Americans have an incentive to make that harder to do or discourage it or even say, “Look, if you keep doing this, we’re not going to defend you against the Soviet union. You’re annoying us right now.” And so, you had this weird geopolitical dynamic, where the domestic needs of the currency and the foreign needs of that currency diverged until the system broke. And then after that, the reformulated version basically took Triffin’s observation and then apply it to the new system.

Lyn Alden (28:58):
We can call it the Euro-Dollar system or the Petrodollar system, basically the fiat currency that has been in place since the ’70s, which basically goes around the premise that the United States has been the largest economy for that period, the largest naval power, right? The ability to go around and enforce supply chains, basically, the nation who’s been able to project its power the most is the one that’s able to wage war on other continents more so than other countries can. And they were able to make agreements with say, oil exporting nations and they say, “Look, only price your oil in dollars and then also take those dollars and hold some of our treasuries as your reserves.

Lyn Alden (29:36):
So, no matter who’s buying oil from you, you only do it in dollars and then in exchange, we have all this military and capability. We’ll help protect you. We’ll sell you arms. We’ll keep your oil supply chains open.” And so, we purposely build up our network effect of the dollar even more than it already was. And of course, network effects compound on each other. So, once you become the most liquid currency, the most dominant currency, the currency that most global debt is dominated in, it becomes rather self-sustaining. And so, in that situation, the Triffin dilemma diverges a little bit, because the observation then applies to the current account. Basically, the United States has created all this external demand for its dollars.

Lyn Alden (30:16):
So, the dollar is now stronger than you’d expect on a trade balance basis. So, normally, if a country starts running a persistent trade deficit, you’d eventually expect some recession leading to a currency devaluation that tweaks that back to some balance. Whereas by having this network effect entrenched for decades, the United States has run 50 years of widening trade deficits, especially over the second half of that. Especially over the past 25 years or so, we’ve run these massive structural trade deficits, current account deficits. It never gets a chance to correct itself because of this network effect of all this foreign demand for that currency. At first, that sounds like a good thing. There’s all this demand for our currency. It’s so strong. It’s good for all these different reasons.

Lyn Alden (31:07):
And of course, there are people that benefit, especially the military industrial complex. Basically, our ability to have foreign bases by oil project our power is enhanced by that, but the weakness of that system is that our domestic manufacturing really suffers from that system. It becomes harder for American manufacturers to keep up, let alone with emerging markets, but even with other developed countries like Germany and Japan that don’t have that extra overlay of currency strength. And so, we run a disadvantage in terms of keeping up with them. Now, there could be obviously situations, for example, the recent energy crisis is impacting Europe more.

Lyn Alden (31:50):
And so, for example, that can impair German manufacturing competitiveness as an example, but over the long arc of time, basically, Triffin’s dilemma suggests that instead of drilling down our gold reserves to maintain the current system, basically, we’re drawing down our domestic industrial base as a percentage of our GDP or as a percentage of global industrial capacity to maintain this system of persistent current account deficits. And for the rest of the world’s perspective, they’re saying, “Okay, we have $13 trillion in dollar dominated debt. We use the dollar as a global funding currency. So, we need a steady supply of dollars to keep that system up. And that steady supply of dollars comes from in large part United States structural current account deficits.”

Lyn Alden (32:36):
And so again, you have this dynamic where the rest of world has a certain use for dollars and needs dollars. And the United States has a certain use for dollars and needs dollars, but those needs conflict with each other, especially for certain groups that are most impacted by it one way or another. And so, right now, I mean, after decades of this, ever since the ’70s, the United States has accumulated $14 trillion in accumulated trade deficits and foreigners then take those assets and they buy those dollars and they buy US financial assets. So, we’re basically selling our dollars for mostly depreciating assets, manufactured goods out of China, things like that.

Lyn Alden (33:17):
And then they take those dollars and then they buy our appreciating assets. They buy percentages of our real estate market. They buy percentage of our stock market. They buy our bond market, which is maybe less appreciating. They buy our financial assets after we gave them those dollars to get depreciating assets. And so, over time, our net international investment position has become the worst in the world in absolute terms and it’s also one of the worst as a percentage of GDP, where the foreign sector collectively owns a lot more American assets than Americans own of foreign financial assets.

Stig Brodersen (33:52):
Yeah. And on that note, I would like to talk about the private to public de-leveraging. Usually, that is a process that’s inflationary and then we look at a country like Japan. They mainly stood for decades without almost any price inflation and with very low monetary inflation, but still many macro analysts look at this and they assume that “Well, if this is what’s happening to Japan, it’s going to happen to the US, to the rest of the world perhaps even.” You think that they’re wrong, why is that?

Lyn Alden (34:24):
Two main reasons. One, they own a lot more foreign assets than the collective foreign sector owns of Japanese assets. So, they actually have over trillion dollars, trillions of dollars of claims basically, that they can draw in to pay obligations as needed, right? So, they have this large investment base relative to the size of their GDP. So, that gives them one advantage that many countries now don’t have, especially United States. Number two is that that whole massive private de-leveraging and public leveraging happened primarily during the 2010s decade, which was a very disinflationary decade in terms of commodity market. So, there’s roughly this 10- to 15- to 20-year commodity cycle that happens worldwide where prices are low.

Lyn Alden (35:15):
So, nobody invests in commodities. They don’t build new production. Eventually, that causes a shortage. So, lots of money rushes in for a decade and builds all sorts of new commodity production. And eventually, we oversupply the world with commodities and then that breaks the price. And we start this cycle anew and that takes quite a while. That takes maybe 10 years of building and then 10 years working it out and 10 years of building and 10 years of working it out. Most countries are not big enough to really affect that cycle. United States and China are, but if you’re a country that’s a small percentage of GDP, you don’t really affect that on a global scale.

Lyn Alden (35:51):
And so, Japan happened to do this de-leveraging during a time of substantial commodity disinflation or actually outright deflation. Commodities were literally going down in price while they were doing this. And so, they basically had all the commodity needs available to them at low prices and you weren’t getting this scarcity and undersupply of commodities. That is a much harder thing to do if you’re not at the right part of the commodity cycle or if you’re big enough to affect the commodity cycle. And so, I would argue that Japan represents an almost perfect example of doing this with the right conditions and at the right time that we shouldn’t then just look at that and say, “Well, when all the other countries go through a similar process, it’s going to be just like Japan.”

Lyn Alden (36:41):
Actually, third factor I would say is that unlike most countries in the developed world, Japan has very little political polarization or rising populism intentions in the country. And part of that’s you have a rather homogeneous society and they’ve governed pretty well domestically. They don’t spend a lot of money on military, things like that. And so, a lot of the money just goes back to the people. You have a rather harmonious society. That doesn’t mean it’s perfect. There are obviously disagreements in society, but when you look at just quantitative ways of measuring political polarization, the United States and most European countries are in a much tougher spot there, whereas Japan has a rather harmonious society rather low levels of wealth concentration.

Lyn Alden (37:30):
And so, that gives them a deeper tool chest, I would say, to handle those storms. But of course, their main disadvantages right now are that they are a commodity importer, which now is becoming relevant. And then they also do have now a ton of public debt. And so, they have less ability to raise rates or otherwise protect the value of their currency because they can’t really service that debt otherwise. And so, I think, people over extrapolate the Japanese example by not realizing a lot of the nuances around the timing and the details for how they’re able to do that without it being inflationary.

Stig Brodersen (38:07):
So, let’s talk more about that. It’s very hard to talk about Japan macroeconomic terms without looking that huge debt burden they have. And we started out this interview by talking about forgiveness of debt restructuring. And so, keeping that in mind, the listener might be sitting out there thinking, “Well, we do know that a lot of money is being printed and that’s on the Bank of Japan’s balance sheet. Can’t they just forgive the government debt that they hold and thereby bringing down the debt burden?” I know that’s a question that you have asked yourself. What’s the answer to that?

Lyn Alden (38:44):
The answer is mostly no, but it is a good question, right? So, people think, “Okay, so if the central bank buys a lot of the government bonds and the central bank is more or less the government, why can’t they just forgive the debt that they more or less owe to themselves?” So, if the Bank of Japan ends up owning 75% of Japanese government debt, why can’t they just wipe that off their ledger and then they’ve lowered Japanese government debt by 75% and they start fresh? The problem is that the whole crux of this fiat currency system runs on the premise that a central bank and the government have some degree of independence from each other, right?

Lyn Alden (39:27):
Because if you have a dictator with absolute power over the money, that money’s going to get debased a lot quicker, just the way human nature works. Even if say there’s some philosopher king running a country, as soon as he dies, the next one’s going to be worse and he’s going to miss it, right? So, if you have centralized power, you’re more quickly going to debase the money. Whereas if you have all these checks and balances to make it hard to create more money, so you have to have Congress approve it, then you have to have the central bank finance it, you have to have the president not veto it, so you have to have all these different groups agree to create a lot more money, that really slows down the money creation.

Lyn Alden (40:08):
And that’s why countries with strong institutions and independent institutions generally have a much longer track record of maintaining a reasonably successful fiat currency compared to smaller countries with less histories of institutions and then the institutions get co-opted by some more authoritarian type of ruler. And so, going back to the premise, central banks are at least in theory supposed to be independent. Obviously, in times of war and things like that, that independence get seriously threatened, but it’s still not the president or a head of a country can just go and tell the central bank head to do exactly what he wants. If they do, they’re more like a banana republic. They’re more like that authoritarian model.

Lyn Alden (40:52):
And so, even though they might appoint the central bank chief, that central bank chief now has a term that can potentially persist through multiple administrations and that has checks and balances for how they can be removed, how a new one can be added, right? And so, there’s some degree of separation there. So, a president can’t just do something like cut interest rates three months before the election, make everyone happy, and then go back to having higher rates, right? So, they don’t have that fine control over interest rates, because it’s in someone else’s hands. It’s supposed to be independent.

Lyn Alden (41:24):
And part of maintaining central bank independence is that they can’t be insolvent, that they have to have assets that are equal or higher than their liabilities, because otherwise, they’re reliant on financing from the government and that they’re entirely reliant on that government. And therefore, they no longer have any credible independence. And so, the way central bank balance sheets work is that the currency is their liability. So, physical currency is their liability and bank reserves of commercial banks that are assets for them are liabilities of the central bank. So, those are their primary liabilities. And on the other side of that ledger, their assets are things like primarily their government debt that they own. That’s their key asset.

Lyn Alden (42:10):
And then depending on the different central banks, some of them have mortgage-backed securities. Some of them even have equities, but the core of their assets is that government debt. And so, if they were to erase that government debt and say, “Look, you don’t owe us anymore. Let’s just start fresh,” well, now, that central bank has a multitrillion dollar hole on the asset side of its ledger but still has all those liabilities. And so, they are now technically insolvent organization. They have no independence. They’re entirely reliant on government financing. And so, that whole model of some degree of credible decentralization goes away, credible independence.

Lyn Alden (42:51):
And so, while you might not have any overnight effect from just say, wiping away central bank owned government debt, it’s not like you wake up tomorrow and the currency hyperinflated. But going forward, that central bank is now 100% captured by the government more or less. And so, the long term ability to do that degrades and that’s why most of them have laws in place to prevent that from happening, that the central bank can’t just wipe it away. Now, there are other tricks that they can do, right? So, you could, for example, make the government could issue a special bond that is 100-year bond that doesn’t pay interest.

Lyn Alden (43:30):
Now, you have this bond that’s different from the other government debt that doesn’t pay interest. And so, basically, there are things that they can do like that and there are other tricks they can do to keep the ledger, the asset side, and the liability side technically solvent, but merely deleting the asset side is generally untenable at least the way that we’ve structured the system now for a century or more in many countries.

Stig Brodersen (43:57):
So, if we continue this discussion about the relationship between the government or treasury, if you want, and the center of bank and perhaps we can use the US example. So, in 1934 in the Gold Reserve Act, the fed was required to give its goal to the treasury. Because it is a double entry bookkeeping, in return, the fed was given equal amount of so-called gold certificates. And these gold certificates in theory represented a gold claim, but they really didn’t have any worth because they couldn’t really be redeemed.

Stig Brodersen (44:29):
But what this maneuver did was that it technically kept the fiat solvent. Fast forward and we are looking at this huge debt burden. You’ve mentioned three different options from the US. You briefly touched upon the 100-year zero interest bond. One could talk about revalue gold on the balance sheet or we could also hold interest rate below inflation and effectively burn away debt. Could you please elaborate on these three options and what the consequences would be?

Lyn Alden (44:58):
Going back to what we talked about before, so over time, while we have this long term debt cycle unfold, debt moves generally from the private sector up to the public sector. So, you have some private debt bubble pops. So, the government comes in, prints money, and those things that eventually get a lot of that debt onto the public balance sheet, the sovereign balance sheet, sovereign debt. And so, that’s generally what you saw in let’s say United States, for example, after you had the global financial crisis, the subprime mortgage crisis, banks blow up. You started to see some degree of privacy leveraging, but a lot more debt on the public balance sheet.

Lyn Alden (45:34):
And Japan’s an even more extreme example where over the past, call it, two decades, going into that period, you had a massive corporate debt bubble, just tremendous amounts of debt, corporate balance sheets. And over time, they gradually de-leveraged, but it was offset by the government leveraging up quite a bit. And so, a lot of that debt was indirectly transferred from the private sector, the corporate sector to the public balance sheet. And the problem there is that there’s really nowhere to go once it’s at that spot. There’s no higher place to put that burden. It’s just there now. And so, when you have externally high government debt to GDP, really, the only way around it is to default. But the question is how do you default.

Lyn Alden (46:27):
There’s polite ways to default and then there’s messy ways to default. And so, there’s a study by, I think, Hershman Capital that showed over the past 200 years, every country that got over 130% public debt to GDP defaulted in one way or another over the next call it 15 years. They either inflated that debt away or if they’re an emerging market and they owe debt in a currency they can’t print like dollars, they just would outright default. They’d restructure. They’d default in various ways. And actually, the only exception was Japan. They were able to push that longer than anyone else, because again, they had really good conditions. They had huge net international investment position. They had harmonious society.

Lyn Alden (47:07):
They did it all during a commodity bear market or at least a big chunk of it. The worst part of it was during a commodity bear market. And so, they had a lot of ways to push that longer than anyone else, but they’re the outlier. And so, going back to your list of options, when you have super high government debt relative to the size of the economy to support that debt, assuming it’s nominated in their own currency like we see in developed markets, they have a handful of options, because as we discussed, they can’t just delete that from the central bank ledger. Like I said, they can issue something that represents an asset that keeps the central bank whole but that is different, right?

Lyn Alden (47:49):
So, for example, as you discussed, the treasury in the US made the fed give them all their gold, but that would’ve just made them completely insolvent. And so, instead, they gave them gold certificates. The fed could then have on their ledger that gave them legal solvency. And so, you can have things like that where the government basically creates this unique type of bond, directly or indirectly sells it to the central bank for printed money. And that just gets stuck there for decades and is a whole separate type of asset than normal government debt. And so, you can have the money supply and the nominal GDP end up growing faster than the rest of that government debt pool, because you offloaded it onto this weird instrument. That’s one method.

Lyn Alden (48:34):
Another method is that a country can sharply devalue its currency relative to gold. And then therefore, basically, you’ve effectively increased everything else. You’ve increased nominal GDP as measured in that devalued currency. You’ve increased asset prices as denominated in that devalued currency while debt obligations are fixed, right? So, you’ve basically deleveraged in that sense. A similar way is to do that over time gradually, where a country can say, “Look, we’re going to target 2% inflation or we’re going to hold bond yields.” Let’s use Japan as an example. Japan officially has a 2% long term inflation target per year, but they’re doing yield curve control where they’re holding short duration rates below zero and they’re holding long duration rates at 0.25%.

Lyn Alden (49:22):
And so, they’re basically saying that we’re going to over time try to gradually devalue our sovereign debt compared to nominal GDP, compared to nominal total asset base in Japan. In most situations like this, that ends up being more extreme. So, for example, the 1940s United States, we were fighting World War II. How did we finance it? Well, we’ve run these absolutely massive government deficits to pay all the soldiers and manufacturing facilities and wages war. And then when they came back, we paid those soldiers to go to college. We helped backstop their mortgages. We did all sorts of things that were all collectively very expensive. The way we financed it was we basically captured our central bank and said, “Look, you’re going to make sure that our cost of debt is low.”

Lyn Alden (50:09):
And so, the central bank said, “Okay, we’re going to keep short term interest rates at near zero and long duration bonds, we’re going to cap at 2.5% by being willing to buy unlimited amount of them and printed money.” And so that whole decade in the 1940s, we averaged 6% annual inflation while industry rates paid 0 to 2.5%. And so, we devalued a big chunk of that debt without hyper inflating it, without going too far. We over time gradually devalued that. There was like one year, we had 19% year to year inflation while interest rates are still 0 to 2.5%.

Lyn Alden (50:48):
And so, that’s the third method, where if sovereign debt is denominated in their own currency, they over time devalue that debt relative to nominal GDP and nominal asset prices by having inflation run much higher than interest rates. So, the government is now basically borrowing at a deeply negative real interest rate. And then if they can eventually get their deficit under control, they can shrink their obligations relative to the size of the economy, which is effectively a form of default, but it’s not a default as measured in the contract of their bonds.

Stig Brodersen (51:24):
Let’s continue talking about some of the things we learned during this interview and how to apply this in practice. If we talk about how to invest during a period of stockflation, that you might argue that we now have entered, so stockflation is high inflation and then lower negative growth. And I know you looked into the performance of different asset classes during such a time. What can history teach us about the performance of say bonds, real estate, industrial, commodities such as oil, and monetary commodity such as gold?

Lyn Alden (51:56):
In general, inflationary periods happen in large part due to rising commodity prices, right? It’s really hard to get a period of high sustained inflation if commodities are cheap, right? They’re one of the key inputs for what contributes to inflation. And that can happen, of course, on both sides of ledger. You can have the currency itself being rapidly devalued or you can have scarcity in the commodity itself causing that to go up against other financial assets. So, either way, commodities are rapidly increasing in price. And so, by extension, you have this inflation environment, commodities tend to be historically the best place to be. So, that’s one of the most highly correlated assets that does well in inflation environments.

Lyn Alden (52:38):
Now, the challenge with that though is of course that they’re very volatile. So, even in inflationary environments, you can have sharp pullbacks in commodity prices. So, commodities are one of the key places to be, but you have to be able to put up with that volatility. So, the general trend of commodities over time is that they’re usually not very good forms over the long run. It’s not a really good compounding places toward capital, but specifically during inflationary decades is when they really shine.

Lyn Alden (53:04):
Because if you think about it, the traditional stock bond portfolio is actually a pretty disinflationary portfolio. Meaning, it prefers a disinflationary environment, because obviously the bonds prefer a disinflation, but then even the stocks, they would prefer easy access to commodities, low commodity prices, high margins, right? So, generally, when you have that inflation environment, bonds suffer, but then also stocks generally run into turbulence. They have margin pressures. They often face lower valuations due to higher interest rates and higher investor uncertainty about the future of those cash flows. And so, generally, broad stock and bond indices usually stagnate or suffer in those environments.

Lyn Alden (53:44):
Whereas specifically, besides commodities, value stocks generally hold up pretty well. So, if you go back to the 2000s decade, which was a somewhat inflationary decade, it was all set by globalization. So, we didn’t really feel too much as an inflationary decade, but it was rather inflationary decade, as well as the 1970s inflationary decade, as well as the 1940s inflationary decade. Basically, the three most inflationary decades of the past century, value stocks were major winners versus growth stocks in those environments. One way to describe it is that stocks that are at the top of an index are generally optimized for the environment that persisted over the past decade or so, right?

Lyn Alden (54:25):
So, in a disinflationary environment, after a long period of that, you generally get a lot of growth stocks, the top of an index. They’re the biggest companies, the most successful companies. And then when they encounter inflationary decade, they’re overvalued and they’re encountering now a period that’s not well suited to them. And so, they generally tend to suffer. Growth stocks tend to suffer. They’re overvalued and their whole business model is relying on cheap access to commodities and disinflationary growth. Meanwhile, a lot of the reasons why you have inflation is that you’ve underinvested in real assets.

Lyn Alden (55:01):
So, commodity production, infrastructure to transport those commodities around, maybe to make manufacturing chemicals, whatever the case may be, a lot of more value-oriented type of sectors that might not be cutting edge, but they’re necessary. And so, generally, for multiple reasons, you get that value factor outperformance compared to growth stocks. And that obviously can frustrate value investors during disinflationary decades, but tend to reward them during those more inflationary decades. So, commodities value stocks. And then often gold and other hard monies can do well in that inflationary environment.

Lyn Alden (55:37):
Partly because again, they’re a type of commodity essentially, but then also, compared to say oil and copper that are used for their utility value, something like gold is being paired to those treasuries or compared to cash in the bank. And investors globally are saying, “Do I want to hold this asset that’s only increasing in supply by 1.5% a year or do I want to hold this other thing that’s going up at double digit percent in terms of supply every year?” And you have to look at that both the individual level where they say, “Okay, as a household, do I want to have some gold, maybe off-setting some of my bonds in cash?”

Lyn Alden (56:15):
We can also look at the sovereign level. If a country’s deciding where to put its sovereign reserves, does it want to invest in a treasury yielding 3% while inflation’s 8% let’s say or did they maybe say, “We could actually increase our gold reserves here. We could even self-custody of them, so they can’t be censored or confiscated by another country, but then they’re also inherently inflation resistant”? Maybe not year to year, obviously, it’s volatile, but over the very long term, I’m basically holding a much scarcer thing than a treasury bond that pays negative real interest rates.

Lyn Alden (56:47):
And so, generally, those harder monies, with historically gold being the key example, do pretty well along with commodities with a little bit less volatility in those types of inflationary environments. In addition, if you have appropriately priced real estate with a fixed rate mortgage attached to it, that’s also generally done pretty well in inflationary environment. So, it did really well in the ’40s, did really well in the ’70s United States, and did really well in the 2000s. And so, you basically have the value of the land, the materials, the relative degree scarcity. That’s all going up in denominated and that devaluing currency while the debt attached that property’s fixed. And therefore, that’s all getting devalued.

Lyn Alden (57:30):
So, the home equity’s actually doing pretty well. Now, the challenge is that if you overpaid in the beginning, that can offset by the home value’s melting in real terms. And so, for example, I’d be concerned about using that strategy in overpriced cities or many countries that are just overpriced in general like Canada and Australia and China, very inflated housing markets. And so, that strategy might not work as well. So, really it comes down to looking at more utility, more scarcity, more cashflow-oriented assets, and less paper assets, and less disinflationary, high growth, long duration type of assets.

Stig Brodersen (58:10):
Lyn, this was just amazing. I learned so much, reading your blog post, speaking with you. And please give a handoff to your blog, first and foremost, but really to anything you want. I’m sure the audience would love to learn more from you.

Lyn Alden (58:23):
Yeah. So, I appreciate that. This is definitely a challenging time with basically not only are asset prices changing around, we go from a disinflationary to an inflationary type of environment, and then we’re determining how long that inflation’s going to last. All these different asset prices are shuffling around and then we’re picking and choosing to the extent that we want to hold money, “What types of money are we going to hold?” It’s almost like investing in different money. That becomes a whole problem of its own. So, it’s definitely a challenging environment and I’ve enjoyed writing and researching and trying to share what I can about that. Most of my content is at lynalden.com. And I’m also out on Twitter, @lynaldencontact.

Stig Brodersen (58:59):
Thank you so much for making time, once again, for The Investor’s Podcast.

Lyn Alden (59:03):
Thanks for having me.

Outro (59:04):
Thank you for listening to TIP. Make sure to subscribe to Millennial Investing by The Investor’s Podcast Network and learn how to achieve financial independence. To access our show notes, transcripts, or courses, go to theinvestorspodcast.com. This show is for entertainment purposes only. Before making any decision, consult a professional. This show is copyrighted by The Investor’s Podcast Network. Written permission must be granted before syndication or rebroadcasting.