Thread by @diogojoma

What is FIAT and how broken is the system?

FIAT money is government-issued currency that is not backed by a physical commodity, such as gold or silver. The value of FIAT is derived from the relationship between supply and demand and the stability of the issuing government

1/n

Most modern paper currencies are FIAT currencies, including the U.S. dollar, the euro, and other major global currencies.

It was introduced as an alternative to commodity and representative money (a medium which has its own intrinsic value).

2/n

Government-issued banknotes were used first during the 11th century in China. Since then, they have been used by various countries. FIAT money started to predominate during the 20th century. Since President Nixon's decision to decouple the US dollar from gold in 1971.

3/n

The process of new money creation happens with a central bank purchasing financial assets or lending money to commercial banks. Banks then redeploy this base money by credit creation through fractional reserve, which expands the total supply of "broad money".

4/n

All the above technical jargon can be translated in a simpler manner:

FIAT money is DEBT based. It represents debt, and debt is a promise for the future.

A PROMISE that occasionally is not fulfilled.

5/n

Debt default is common, it happens everyday at private level. It is not a bug, it is a feature.

The problem is when the default happens in a systemic level.

But that's an event never personally lived by most people alive today. At least in the "developed" countries.

6/n

So FIAT money is a promise about future wealth. Something that you could trade for in the future.

Think about your salary. You don't receive goods or services in your account, you receive money.

You use that money LATTER to purchase something.

7/n

With your salary is not about the value in $ you are paid but instead the goods and services you have access.

Money is just a medium for the real goods.

Doesn't matter how many raises you get if the amount of goods it allows you to get is shrinking. This is inflation.

8/n

Now let's look at this at scale.

The total amount of debt in the world represents the expectation of future wealth creation in the world.

And that expectation is reflected in FIAT currency.

The available money will eventually be redeemed in something with real value.

9/n

Of course there is no perfect system and the problem of debt are defaults.

Defaults at private level are a feature.

They are common and expected.

Bank rates account for expected losses.

Any venture has underlying risk that is priced in the capital allocation.

10/n

The beauty of capitalism is the risk/reward feature. There is a premium for those that take risks.

The cost is to support the loses. Risk takers have a huge incentive to succeed at the cost of personal loses.

Loses are limited to the venture participants.

11/n

When you raise money for your venture if you fail the loses are limited for your venture participants.

The system as a whole gains with the winners that hopefully compensate the loses from those who fail.

Something that may seem odd:

12/n

The most innovative industries are those with the bigger failure rates.

There is no place with so many companies going bankrupt as there is in silicone valley.

If you want to burn your live savings try to open a restaurant. There is hardly a more competitive sector.

13/n

The engine of wealth creation seems to be powered by a cycle of experimentation with unavoidable failures.

Failures supported by risk takers that have a huge incentive to succeed.

And a big payout in the case of success.

14/n

A fundamental aspect of capitalism is the risk ownership.

It works as a key incentive to keep systems working.

The following stories are real and illustrate very well what I'm trying to state about risk ownership.

15/n

At some point in time a company was delivering a project for a client. It was a multi million dollar endeavour.

The team was part of a corporation totally owned by the CEO.

The project success was of course the company success and the CEO success.

16/n

The project ownership was assigned to a hired manager that worked with the team to deliver the first milestone.

When the date for the first milestone was close the manager could not hide anymore from the CEO the problems related with the first delivery.

17/n

The project deviated from the initial scope. Some defects were accumulating and some delays in key components were unavoidable.

The problems were a mixture of some naiveness in the team, unanticipated issues and delaying on assuming the real dimension of the problem.

18/n

The CEO was tough with the team and the extra costs on the project were not taken lightly.

But in the end the CEO's ultimate goal was to deliver the best possible given the context.

He spent the following months working closely with the team.

19/n

Weekends and nights.

They worked together to find some compromises with the client.

In the end the total loss was avoided and the project was still a success for the client.

This story is an example of what it means to have skin in the game.

20/n

The other story is quite the opposite.

There was some EU funds that distribute money to fund some companies that try to innovate in some key areas.

The program here is Portugal 2020.

The program candidature demands some paperwork that obligate several commitments.

21/n

When the project is approved the money is released when the commitments are reached in the proper timelines.

So there is some rules that are set to stone and the game is to fulfil them.

Now the problem is reality rarely is what we expect. Remember the previous story?

22/n

Now if the project faces any challenge to make the deadline there is no stakeholder with skin in the game to charge you neither to help you with any workaround.

What you find are poker face bureaucrats that only function is to point to some metric you didn't reach.

23/n

Wood supplier delivered defect doors and it delayed the work? not my problem.

The pipe broke and the inundation put extra costs to the budget? not my problem.

You found a better opportunity in the market to sell hot dogs instead of vegan burgers? not in the original plan

24/n

These bureaucrats don't own the money or the risk or nothing. They are just part of a broken system that is not designed to make things work.

They are not there to help you. Nobody is. They are there just to make sure you deliver everything within the original plan.

25/n

Some irony is this, if we look for he most successful companies in history, many of them started with an idea or product that just didn't worked.

The fabric of reality is too much unpredictable.

Success is about adaptation.

26/n

Coca-cola? it started as a remedy.

Samsung? started selling noodles and latter textiles.

Nokia? Paper mill.

Nintendo set up a taxi company, a hotel chain, a TV network, and a food company.

Even twitter we are using was created to be used as a SMS service.

27/n

But this is not the only negative aspect of these "government" funds.

They create an incentive to game the system.

There are now many companies that only exist to exploit those funds.

28/n

These companies make the candidature. They ensure you gain those funds.

And they keep the funds for them, in change of whatever service you need.

You need a rebranding, digital presence, e-commerce? They give you any solution in change of the "free" money of the system.

29/n

The problem here is simple. There is no accountability in the capital allocation.

I know personally dozens of zombie companies that exploit those funds.

No private investor would ever put a penny on those broken firms.

But the state put money in rotten companies.

30/n

What we see here is a transfer of risk. From decision makers to the public that funds this madness with taxes.

And this is critical because it subverts the fundamentals of capitalism.

Remember? Risk ownership and accountability of loses?

31/n

Now this idea of risk transfer is much deeper than this.

Let's rewind to 2008 and the subprime crisis.

If you remember the crisis was originated by a systematic risk transferring.

32/n

What happened was nothing more than a direct risk transfer from the mortgage lenders to mortgage funds.

Those who sold mortgages had a huge incentive to lend to the max clients possible, regardless of the risk.

Because the risk was artificial hidden and sold to a fund.

33/n

This created a systematic incentive for risk accumulation that was transferred to mortgage funds.

And everyone knows the rest of the story.

Or maybe most people don't really know the extend of the problem that did happened.

The financial system was almost shut down.

34/n

The entire global financial system was almost shut down because a single class of risk was systematically transferred.

If this is not freakin scary I don't know what it is.

But the story is only in the beginning.

35/n

The measures taken by the central banks then were so deep that the consequences are still to be fully understood.

Central Banks (CBs) implemented what is called the atomic bomb of financial measures.

OR quantitative easing (QE).

36/n

QE is a monetary policy where a central bank purchases at scale government bonds and other assets to inject money into the economy.

QE is an unconventional monetary policy which is usually used when inflation is very low and standard monetary policy have become ineffective

37/n

A central bank implements QE by buying assets from commercial banks and other financial institutions, raising the prices of those assets and lowering their yield, while simultaneously increasing the money supply.

38/n

In contrast to conventional open-market operations, quantitative easing involve the purchase of more risky assets (than short-term government bonds) and at a large scale, over a pre-committed period of time.

39/n

All major central banks in the world didn't stop QE since 2008!

What QE caused in the last decade is the accumulation of the largest amount of zombi companies in history.

Zombies are companies that earn just enough money to continue operating and service debt.

40/n

These firms death is delayed in environments where yields are very low, allowing new debt to be issued to pay old debt and so on.

Going a little back recalling the idea that innovation needs lots of trial and error.

Fail fast is something desirable.

41/n

An environment where failure is delayed produces exactly the opposite result, stagnation. Or even worse, net negative wealth creation.

All resources that could be used to a new venture are being wasted in dead firms.

But this doesn't stop here.

42/n

The purchase of financial assets like treasuries, bonds and even stocks from central banks create another breaking change in capitalism fundamentals.

Now the markets are run by governmental institutions.

The prices of financial assets are not set by free-markets anymore.

43/n

The risk pricing that is included in capital allocation is reflected in the yield.

Central banks set a strong message that QE will last for how long it takes "till the economy get strong".

This is the message from the last decade.

44/n

In a market run by QE policies that purchase whatever it takes, the risk of running out of liquidity is close to 0.

With all yields close to 0 or even negative, treasury and other traditionally less risky assets become less and less attractive.

45/n

And central banks promise of liquidity gives a push to throw capital to stocks.

Looking to the stock market there is something odd happening.

By any indicator stocks are in all time highs.

The last decade accumulation of zombies is huge.

46/n

But capital keeps moving to there.

The odd thing is that investors know the systemic risk is there, but the cake is so big they cannot be out of it.

And while central banks keep the liquidity, the balloon seems to never pop.

47/n

What we have today is a big fucked up system with every fundamentals of capitalism flawed.

We have billions in government run funds to create "incentives" for the economy.

Systemic risk transfer that started in 2008 and just got way bigger.

No free-markets.

48/n

Zombi companies everywhere.

All of these was pre 2020 and pre covid.

But now we have a global pandemic.

And know what is being done?

Nothing new.

The same old QE programs just returned.

They would be kept anyway.

But now it is accelerating.

48/n

And the real economy slowed down like never.

So this could be the start of something very singular.

Let's look for what possibilities we have.

We hope everything returns to the "normal".

What is normal then?

49/n

It is the "regularisation" of the building blocks of a capitalist system.

Free-markets, price discovery, personal risk.

No central banks non-conventional interventionism.

Risk ownership.

Failure as a feature and not a bug to be avoided at all cost.

50/n

Of course for it to happen there is one obvious elephant that needs to get out of the room: central banks.

Question is: will ever be possible for the central banks to get out of the markets?

My believe is a very sound NO.

It will never happen.

At least in an ordered way

51/n

I'll explain why, it is quite obvious.

After a decade of debt and systemic risk accumulation we have the conjunction of:

Historic high stock prices.
Historic low yields.
Historic high debt.
Historic high zombies.

52/n

If central banks withdraw:

- yields will jump
- confidence in liquidity will fall
- zombies start to die (in an epic synchronised manner)
- debt service will grow in a non-linear way (debt grows exponential)

This would be the most epic failure in the history of mankind.

53/n

And all of this is predictable.

That's the reason of why NO ONE will ever unplug the central banks from the markets.

No central bank chairman, no government, NO ONE will ever back off from these unconventional monetary policies.

54/n

The only clean exit possible would be the economy to start to grow in numbers never seen before.

If the economic growth miracle could happen maybe we could have a clean exit from all this mess.

Remember that debt is promise of future wealth?

55/n

If such miraculous wealth creation happens it would solve the problem of debt we have.

Allowing to redeem all the liquidity we created in the last decade for the next generations, in a sustainable way.

But it is very unlikely with all the systemic disfunction we've seen

56/n

It leaves us with only one possible outcome.

And my friends. This outcome is not new.

It is not new because it is the only possible outcome in this contexts.

In the last 1000 years this story repeats over and over and over.

And we never learn

57/n

This is the story of the end of another FIAT system.

Every single FIAT currency in history ended exactly in the same way.

All FIAT currencies were printed out of existence.

This time it will be no different.

58/n

Central baks are trapped in the trap set by themselves.

The liquidity trap cannot be undone.

Euro, dollar and others will be printed out of existence.

Of course the exactly timing for this is unpredictable.

And there are always things we can do for protection.

59/n

Like they say, we can see the glass half full or half empty.

The glass this time is from epic proportions.

My only concern is never have seen a glass breaking slowly.

60/60