Banks And The Digital Dollar

Submitted by Chris Argyrople, of Pivot Analytics

Paper money is going away in the very near future.  Sooner than you realize, paper money will be replaced by a “digital-USD”.  Money is already digital.  Your bank and brokerage accounts are book entries in a digital database.  These book entries are claims that can be exchanged for paper money or paper stock certificates.  Governments, including the US government, will be mandating the exchange of all paper money for its digital “upgrade.”  Why and when will this happen?  More importantly, what implications does it have for investing?

Regarding the when, its going to happen soon, very soon.  Within 7 or 10 years, paper money will be history and not legal tender anymore.  China is already testing a digital RMB, so our leading nation is well behind its competitor, and once China rolls out its digital RMB in 2023, our government will spearhead the rollout of our USD version.  In reality, China is already fully digital.  Nobody in China uses cash anymore, and credit cards are a very small piece of their market.  Chinese people use Alipay and other digital payment mechanisms on their phones. 

Americans say “that can’t happen here, we value our privacy.”  That’s ridiculous.  If you buy with a debit or credit card, your grocery store knows when you buy broccoli and they know your brand of ice cream.  If you have a smartphone, your phone company knows where you are at all times, and, yes, they sell that location data to hundreds of companies who pay for it.   This location data is stripped of identifying records, rendering the data “blind” and “safe.”  Most people inherently understand this, but what they don’t know is that basic algorithms can then figure out exactly who you are even based on this blind data.  My friends at MIT get “blind” mobile phone data, merge it with other databases, and after they run it through algorithms, they know mostly everything about you, including your locations.   In 2020, if you used a smartphone and a credit card, “they” know everything about you.  In fact, most Americans choose to have very little privacy at all.  Google knows when you are at your girlfriend’s house, they know what gifts you buy her and most of your favorite topics.  This makes the digital dollar an easy sell for the government.  Try taking away free gmail, smartphones and credit cards and see the voters scream – people don’t want privacy. 

Later this decade, once the digital dollar is in place, the government can finally implement policy more effectively.  For example, right now, the main way that the government “prints money” is to buy bonds in the open market and hope that banks will lend the money.  The lent money is the increase in the money supply.  This system has contributed to the wealth gap, and it has also led to a lot of leverage in the system. 

Furthermore, the Fed has tried to spur inflation with no luck.  Why?  The Fed really can’t make the banks lend under the current system.  The digital dollar can cure some of these issues because the government, if its smart, will retain the right to manufacture digital dollars, thus bypassing the banks.  The Feds are sick of trying to make the banks lend then regulating them because they are over-levered.  It’s a faulty system and it is likely to be replaced by digitally created money supply which can then be sent out to the people directly.  This will enable universal basic income (UBI) models to proliferate, and it will finally be easy enough for the government to make inflation go higher when they want. 

It will also wreak havoc on the underground economy, specifically drugs and tax evasion.  With the digital dollar, everything will be traced and tax evasion will drop substantially.  Giving the government more power over the money supply (disintermediating the banks) will eventually be very inflationary. It could also be negative for the dollar exchange rate, but ultimately all governments will go this way so the FX rate implications are unclear at this juncture.  What is likely is that an aging workforce will get UBI payments in an inflation-first environment.  The government will try to inflate away the massive debt obligations, and they are likely to be successful. In 10 or 15 years, we will see massive inflation on the order of the 1970s or even worse. The Fed is on record saying they want inflation, and the politicians and public are addicted to the stimulus, so its print print print until we finally get sustained inflation.

How can one position themselves in this environment? 

Think about purchasing multi-unit apartments with long-term fixed rate debt.  Getting a 25 year fixed rate mortgage in the year 2025 is going to be the safe way to short bonds in the inflationary environment.  Note that 2025 is a number of years away, and you will want to structure these purchases before the digital dollar is in place.   It doesn’t really look like we will get the runaway inflation now, so there are a few years prior to the inflationary spiral.

If you don’t want to own real estate, then consider buying medium-P/E equities.  In today’s market, the best stocks have the highest P/Es because they are the best companies and distant profits are discounted back at very low rates, making these high P/E stocks beneficiaries of the low rate environment.  When really-high inflation hits around 2030, these high P/Es are likely to be cut in half as interest rates spike upward.  You want to still pay up for some quality, but market-average valuations should suffice.  As always, stay away from the really “cheap” stocks unless you have done a ton of homework on each situation.

Finally, be wary of investing in traditional banking models.  Right now all bank stocks are very cheap on both earnings and tangible book values.  Banks are under siege from fintech solutions.  The fintechs are fee-based and are slowly disintermediating the banks turf.  Its safe and easy to have an online account, you don’t need a bank branch anymore.  Branches are quickly becoming an anachronistic cost-hurdle that disadvantage traditional banks vs. fintechs.  Even worse, fractional reserve banking is a terrible business model.  Imagine a 0.7% or 1% ROA, then you have to lever up 10x to get a reasonable ROE.  Of course, at 10x leverage, a 10% drop in collateral value mostly wipes you out.  The next round of inflation, late in the decade or in the early 2030s, will basically wipe out all the banks.  I predict the end of fractional reserve banking in its current form. 

If the government retains the right to print and distribute digital dollars, banks in the fractional reserve system won’t be as necessary.   Its quite possible the next bank debacle will be significantly worse than 2008, so be wary of investing in banks later in the decade.  Right now, bank investors are waiting for higher interest rates, which could add to profitability.  Unfortunately, if rates really were to rise a significant amount, property values (collateral values) would fall, wiping out huge portions of bank equity – bank investors should be careful of what they wish for.  In my view, bank investing is difficult if rates stay low and also difficult if rates rise.  Keep time horizons shorter-to-medium term in any bank investments – don’t give the stocks more than a year to work.

In our next post, we will look at real estate: what will thrive post covid and what won’t.