In today’s extraordinary environment many so-called market axioms are being violated: stocks and bond prices are rallying together, gold and the US dollar strengthening together, trillions of dollars of negative-yielding debt and many other atypical events are becoming more frequent. In trying to bring stability to a complex financial system we have been compounding risks and exacerbating the consequences. The frequency of these ‘atypical’ market events may suggest it’s nearing a tipping point and a regime change to a new equilibrium.
Part 1. Looks at the interdependent risks built into financial markets and considers the difference between risk and resilience in so-called safe havens such as gold and, potentially, Bitcoin. Part 2. Considers the paradigm of value is shifting with demographics as trust in money as a store of value erodes. This article will be followed by a quantitative investigation into the resilience of Bitcoin vs gold as a safe haven asset from cascading effects in the financial system.
Part 1. Complex Systems
Complex dynamics is the study of systems that are often in non-equilibrium states. These systems are made up of many nonlinear interactions and dependencies between its different parts and arise from spontaneous order in nature and society such as organisms, ecosystems, human cells, the economy and society generally. However, complexity theory is the opposite of today’s prevailing financial models which are all premised on equilibrium models of the economy.
Financial markets share the three characteristics of complex dynamical systems, as defined by the Stockholm Resilience Centre:
- highly unpredictable, due to their non-linear relationships / interactions.
- contagion effect, things can spread very quickly and
- modularity, although the whole system is well-connected parts of the system are more connected within than between, which may help its resilience.
Using forest fires as an example of complex dynamics, in spite of our success at reducing their frequency the size and devastation caused by forest fires has actually increased over the years. What has since been discovered is that human interference in suppressing the frequency of forest fires has actually resulted in more acres of forest being lost to fire.
The primary reasons for this are the lack of diversity in pine forests that are planted for their timber efficiency but lack resilience and because preventing fires allows invasive species, which grow faster, to outcompete the more resilient species which are a slower-growing species. This makes the forest less resilient to recovering from fires and the cycle continues.
Part 2. A Changing Paradigm Of Value
The paradigm of value or the digitization of value. Rather than money reverting back to a hard-backed standard, money is becoming globalized and it is unlikely there will ever be a return to a ‘gold standard’. However, gold still is held by all central banks as a form of non-sovereign base money as it is the one true globally accepted unit of settlement.
Central banks have continued to widen their margins on the cost of money production over the decades as they diluted the content of metal (silver and nickel) in coins and even changed the standard of the printed paper money. In 2018 the Federal Reserve printed $243m of physical USD at a cost of $800m — or 0.3% of the face value.
When fiat money is fully digitized and central banks issue their own digital currency the cost and ease of money production will be slashed again. This could allow for even greater fiscal spending that proponents of Quantitative Easing and Modern Monetary Theory (MMT) advocate.
Monetizing government debt as per the proposition of MMT would be entirely more plausible and even logical with a central bank digital currency (CBDC) as the government would have real-time data on all economic activity.
The concept of value is undergoing a paradigm shift as a new generation native to the world of digital value emerges as the dominant global demographic: Millennials and Gen Z. This cohort grew up with the internet, online banking, credit cards, Magic The Gathering cards and gaming virtual currencies and this new generation of consumers perceives value very differently from other generations and has an even more abstract concept of value.
This generation will shape the future of money and perhaps define the next reserve currency.
For the full length research article please click here