Post Modern Monetary Theory: A Tale of Two Currencies — Cash and Crypto

There is a debate raging amongst economists and politicians that goes to the very heart of what governments should and shouldn’t do to manage future prosperity. The monetary and fiscal policies adopted by many nations, over the last few decades, have garnered strong support for the so-called Modern Monetary Theory (MMT). MMT’s proponents claim that any nation that produces its own sovereign (fiat) currency cannot run out of money because it can always just print more. In other words, the government essentially has no financial constraints.

MMT was originally a description of how spending in the economy already happens. In that sense, the debate isn’t so much whether it should or shouldn’t be implemented, but to what degree and under what circumstances. Challengers say MMT would be a highly irresponsible mismanagement of the economy. The policies, they say, will lead to a massive increase of the money supply that is bound to trigger inflation at levels not seen since the seventies and eighties and perhaps even trend higher. The application of MMT will require tax increases, to control any inflationary pressures, which can be hugely unpopular and hard to implement.

The debate boils down to whether you believe politicians and officials have the data, knowledge, and skills to delicately balance their spending to deliver full employment while hitting an inflation target. MMT, coming at a time of general economic uncertainty, could have a profound impact on investment management, DeFi and how corporations and ordinary citizens secure their wealth.

MMT and MPT are Starting to Sound Empty

Modern Portfolio Theory (MPT) is the theory behind most current investment strategies, but it is under threat. It uses elegant mathematics to formalize many intuitive ideas about risk and return. MPT is one of the primary tools used by fund managers to construct portfolios that match expected reward to accepted risk. MPT is driven by a wide diversification of assets to even out any downturns and achieve consistent growth. Asset classes such as bonds are usually included to reduce risk, but with US 10-year Treasury bond yields at less than 1.3% (as of the date of this publication) investors are having to look around for alternatives. Bitcoin is suddenly coming up in more conversations.

Despite its success, MPT is not immune from inflation. Economic expectations are priced in, but unexpected economic shocks are not. An economy running according to MMT principles carries a higher risk of missing the inflation target as the government tries to juggle its spending and taxation. Bonds offer no protection here either, as witnessed during the high inflation 1970s, when they are virtually guaranteed to make a loss.

Another environmental risk comes from economic growth targets. MMT’s main aim is to secure full employment thereby maximizing productivity and GDP. Again, as governments try to spend and tax their way to their objectives, they are unlikely to get consistent results.

Anatomy of the Money Machine: Interest rates and Inflation

We look at a simple analogy to get a better understanding of money, interest rates, inflation, and the importance of these concepts for economic growth / wealth generation including how technology is shaping the future of money.

And the best example can be found in our nature. Let’s examine the role and importance of water to nature and compare it to that of money to an economy.

Water gives life and sustains it. It is required everywhere for life, as we know it, to exist. In a similar vein, it is hard to imagine a modern economy without money or money-equivalents. This comparison is only partly valid since life, as we know it, would cease to prevail without water. While we can essentially have a barter economy without money. Barring this key limitation, the smooth functioning of a modern economy requires the flow of money.

Money has three main utilities: a) medium of exchange, b) unit of measurement and c) store for wealth (value). Water has numerous uses, but we list three main ones to develop our comparison: it helps to transports nutrients and minerals both within our bodies and all around us; it regulates the temperature of our bodies and the external environment and gives shape and structure to many things around us; and it dissolves and stores more substances than any other liquid known to mankind, earning it the name, “the universal solvent”.

We have constructed elaborate devices and machines, to control and divert the flow of water, to maximize the growth of life. Likewise, we have the financial services sector that controls and diverts the flow of money-equivalents, to maximize the growth of an economy. Taking the analogy a step further: our central reservoirs, irrigation canals, water tankers, pumping stations, pipes and water sprinklers are devised to keep water flowing around. Similarly, centralized, and regional financial institutions, wire transfers, credit cards, checks, bank drafts, the internet and related technologies are meant to keep money-equivalents sloshing around.

When central banks create liquidity or pump money into the financial system, it is like rainfall or snowmelt that feeds rivers and streams which carry the water around. The centralized institutions, or monetary policy makers, then become, for a lack of better terminology, our rain gods or water gods. We do not know exactly when and how much rain we are likely to receive. But we have some decent expectations, which is what we call our seasons, and we have views on what to anticipate based on previous experiences. Central bank meetings, which do have a fair bit of regularity, to decide future monetary measures are like the seasonal patterns we have come to rely on.

Inflation, which happens when there is too much money in the system, is like a flood scenario. Drought then becomes a recessionary episode. Clearly both are not desirable. These are unintended consequences, both in an economy and other aspects of life, due to the nature of uncertainty around us, all of which we will discuss in later articles as it pertains to investment management.

Interest rates can be viewed as the ways in which money is taken away by the system that is designed to send it around. As water flows around, part of it is lost due to evaporation, seeping into the ground, or flowing into the ocean. This rate at which water is lost by the system is similar to the base interest rate set by the monetary authorities. All rates (interest and water loss) and transaction costs are then modifications of these fundamentals rates specific to different situations. As our analogy illustrates, when interest rates are higher inflation will tend to be lower and vice versa.

There are two main issues with the central monetary or water system. One boils down to the essence of centralization and the overt dependence on the main source of water or money, which relies heavily on what the gods or policy makers do. Central bankers have sole control over money machines, which have become crucial for financial well-being. The other issue is that when fresh water does find its way into the system, the people that can collect most of it are the ones that are already connected to and well established in the existing network. In a water system, this is simply the life around rivers and streams that benefit the most from rainfall. Similarly new wealth ends up getting concentrated in the hands of those already well entrenched into the current money transfer mechanisms.

Unfortunately, the money gods are also likely to be influenced (aka lobbying) by those that benefit the most whenever new money is printed. In some ways, the vegetation around a water network precipitates further rainfall. It would not be entirely incorrect to state that most, if not all, policy makers have good intentions with no desire to cause monetary mutilation. We want to emphasize that there are no good or bad people. Policy makers do what they do, in response to seemingly tough situations, based on the application of what they have learnt from mediocre role models. Things have gone haywire due to the lack of better solutions. The reason for the lack of superior methods is due to the need to be conservative when tinkering with economy wide policies as discussed in the next section.

It is also worth mentioning that the natural system of rainfall or snowfall and the corresponding watering network, which we should someday hope to more thoroughly emulate, has no strict parallels for now in our economy. But the comparison we have outlined serves as a way to illustrate how the existing monetary system works and to make a strong case for the necessity of the DeFi technological innovations, which we discuss next.

What Money is to Business Water is to Life.

Decrypting Crypto and DeFi Investing

The Defi phenomenon is offering a radically different paradigm. The DeFi movement is creating entirely new sources, operating systems and plumbing infrastructure of money-transfer. This is like tapping into new and alternate sources of water and building novel techniques to spread it around. Cryptocurrencies are creating channels that can stay independent of the centralized systems in many ways. These new pathways are more accessible for anyone to benefit from them. This plethora of wealth generation opportunities are due to the many alternate ways to create and raise money. Technology and other innovations are also ensuring that these new sources of money have safety measures designed to prevent inflationary scenarios and several forms of fraudulent activity.

This does not imply that sailing on crypto waves will be smooth. There will be unintended consequences in DeFi, just as in every aspect of life. But a strong argument can be made that many independently controlled systems are likely to weather tougher storms, which makes for a more robust overall framework for financial welfare.

Better solutions are obtained when we can have a trial-and-error approach. Such a trial-and-error approach happens naturally in the DeFi environment when compared to the full economy. The risk of any crypto blowing up is unlikely to be fatally detrimental to the entire system. Taking fundamentally different approaches would be extremely ill advised in a central banking atmosphere. As the crypto ecosystem grows, innovators will have greater flexibility in trying new and unproven techniques. Everyone benefits since the lessons learnt, even from failed projects, can be applied elsewhere. As Formation Fi leads the way in bringing sophisticated risk mitigation principles to the DeFi space, innovation will flourish and continue to happen in an unperturbed manner.

Back To the Future: Decentralized to Centralized and Back

Money started as a decentralized unit, (in the form of animal skins, salt, shells etc), to facilitate commerce. It then became centralized (in the form of coins and notes) when monarchs and later governments took over the task of supplying currency. Now money, which is increasingly becoming digital, is moving back from under the control of any authority. History does repeat itself.

As the acceptance of crypto currency increases, and most daily business transactions happen in the alternative world of crypto, the influence of centralized banking systems and the corresponding policies will wane. Using our water analogy in this case, as alternative water sources become important, we can see that the system of rainfall and other water courses have little effect on our lives. It is a scenario wherein we are living very far from natural water pathways so that floods and droughts in this system have little bearing on us. Clearly, we are not there yet both in the water and monetary system. There is no backup for national currencies right now. With crypto currencies on the rise, wealth will get more options to flee to an alternate asset quite easily.

Central bank digital currencies (CBDCs) or centralized ‘decentralized’ currencies, oxymoronic as it sounds, have many pros and cons. Not wanting to be left out, many national monetary authorities are planning or actively contemplating such a scheme. CBDCs can offer stable diversification benefits and act as a safe-haven, if they are governed like other crypto currencies with strict guidelines on money supply and other related aspects. But if it just becomes a national currency in digital form, it will not be very different from other conventional currencies. If participants are required to follow extensive guidelines before they can participate, money flow patterns can be traced back to the originators and CDBC will be less anonymous than pure crypto. Some participants might favor CDBCs because of the extent of traceability that comes with recording and displaying all transactions in a blockchain. But for the same reason, many might stay away from it entirely. This will be an interesting development to watch once CBDCs become a reality and try to fit in with the rest of the crypto landscape.

A counter argument to support centralized currencies can be that it is easy to manage one currency, whereas too many competing currencies are bound to cause chaos. To see that this argument holds little merit, it is important to realize that each crypto-currency is self-governing with members having a transparent view of the policies and in many cases even having a say on how things should be run. Despite these measures, things can go wrong sporadically but money will be able to flee to other sources in such instances given the plenty of alternatives available.

There will be turbulence when new and heavy flows of water, or money, start pouring in. We experience this as volatility in prices when money moves in and out of crypto-assets. The next wave of innovations in DeFi will be geared around reducing fluctuations and ensuring the adoption of crypto as a mainstream asset class. Formation Fi is pioneering the way by bringing many well-established techniques that have worked well in traditional investing, including many innovations tailored for the DeFi arena.

Crypto-Mania versus MMT Mayhem

Crypto is starting to be perceived as a hedge against a devaluing dollar. Square Inc.,for instance, revealed it owned just over 8,000 Bitcoin back in March 2021 and took the current correction in the crypto market as a chance to add to this position. Most crypto assets are engineered to be actively deflationary with features such as fixed supply/flow, token burns, etc. Whether it is going to be completely effective or not is still to be seen. But the general positive correlation between Bitcoin and the S&P 500 suggests that a strategy of simply holding crypto assets is not necessarily a wise move. A diversification through a portfolio of assets would be a better approach. Nonetheless, if inflation continues to rise then demand for crypto is likely to go up, driven by corporations wanting to diversify their reserves.

There will be another side effect of MMT policies too. As unemployment falls, there will be more money in people’s pockets and their ability to save will increase. Some will be attracted by crypto’s get rich quick headlines, some by the stories of inflation protection. A few will be drawn by the transparency of DeFi, or in other words, driven away from banks by the centralized and politicized feel of MMT.

DeFi Yield Farming: The Fields of Gold

In 2020, many people in the crypto space discovered yield farming — the ability to increase returns on holdings through complex combinations of stablecoins, staking, liquidity pools, lending, etc. Some managed to achieve annualized returns of over 100%, for a short time anyway. It is tempting then, to consider if yield farming will protect against market fluctuations and environmental shocks.

So far, yield farming has achieved higher real yields than can be achieved by cash or bonds, but all assets don’t behave equally. Yield farming strategies should be considered as growth assets, highly dependent upon crypto market volatility and volumes. Crypto deposited in Uniswap liquidity pools, for instance, earns a fixed 0.03% of all trades pro-rata, but the total return depends on the volume of trades going through the exchange and the capital is also at risk of impermanent loss. Sometimes high fees and price volatility also reduce the usefulness as a hedge. Lending crypto, on the other hand, is not so volatile. USDT deposited with Aave earnt 11.76% interest in May 2021. Rates will vary but they are likely to beat income from traditional cash deposits. Lending crypto can therefore be equated to the role of bonds in MPT. Formation Fi will use it for this purpose in its Gamma index (more below).

Yield farming, however, even with lending, is still at risk from MMT inflation. Most yield farming is denominated in stablecoins so any gains will be subjected to the same devaluation as the dollar. Crypto has not yet lived through an inflationary period, the reliable data only goes back to 2013 and DeFi platforms are much younger still, so we do not know for sure how it will behave.

Some DeFi platforms are attempting to use MPT to construct balanced crypto indexes. Although it is still open how these may perform during a market downturn (they will be tested during the next bear market), as we have seen above, MPT does not defend against environmental shocks. Another strategy is required to bring this layer of protection from external impacts.

The Ark of Formation Fi for the Great Flood of QE.

In mid-2021, we find ourselves in an unenviable position. Permanently low interest rates have broken monetary policy. QE (Quantitative Easing) hasn’t reached past the banks, forcing MMT style policies. This massive fiscal stimulus could backfire by causing steep inflation. MMT centralizes more power in the hands of politicians who distort the spending patterns, adding further inflation risk.

Evidence of rising inflation will drive further corporate and consumer demand towards crypto and DeFi. However, crypto and DeFi are not necessarily immune either. We need a new (or proven, repurposed) strategy that will offer protection against environmental shocks. Risk Parity is such a strategy.

Risk Parity is an extraordinarily successful methodology from traditional finance pioneered by Ray Dalio at Bridgewater Associates. It is specifically designed to resist environmental factors such as unexpected inflation and growth. Formation Fi is bringing decentralized Risk Parity to cross-chain DeFi, using crypto native assets, to achieve what Dalio did with stocks and bonds.

Formation Fi is engineering a set of four indexes — Alpha, Beta, Gamma and Parity. Together, they will capture the market highs, track consistent growth, even out downturns and protect against shocks. By assigning different weights to each one, we will be able to offer balanced, risk-adjusted portfolios.

Risk Parity will bring long-term stability to DeFi and Formation Fi will bring Risk Parity to the Crypto Party.

Where to Find Us?

Website: https://formation.fi

Telegram: https://t.me/FormationFi

Twitter: https://twitter.com/FormationFi

Medium: https://formation-fi.medium.com