Bonds & Money Supply

Over the past week I have noticed several voices from respectable investors or investment managers that the expected returns on bonds are finally attractive. See the thoughts of Jeffrey Gundlach’s and Ben Carlson’s.

The biggest risk to (nominal) bonds is, obviously, inflation. The latest figure for the US is for the month of August and is as high as 8.3%. It has come down from the four decade high of 9.1% in June. That’s quite a bit higher than recent yields for Treasury bonds, which are generally in the 3.70%-4.20% range for maturities between 1 year and 30 years. Quite simply, the inflation is generally expected to come down substantially, towards the 2% mark, as the FED is very serious about fighting the dragon.

Not everyone agrees. Larry Summers, who was the Secretary of Treasury under Clinton and President of Harvard afterwards warned recently: “If we’re going to bring down inflation, you likely need a policy more restrictive than the policy that’s contemplated by the markets or the Fed. The Fed continues to be excessively optimistic.” There you have it. FED is tightening at a fastest pace in several decades, some think it has gone too far, others think it will not be enough. The thing is, Larry Summers was generally right being concerned about too much money being created/given away, so one should definitely listen to him as a valid side in this discussion.

I had a look at the data for the money supply (M2), Real GDP growth (RGDP) and inflation (CPI) in order to look for some hints concerning the future trajectory of inflation. I took long time series of data (since 1960) and have analysed the growth of these aggregates over 10 years. I was mildly surprised to notice that the average 10y growth rate of M2 was 6.9%, RGDP averaged 2.9%, while CPI averaged 4.0% over this period. In a sense, this should be expected: the M2 should increase with the growth of the economy, and the “excessive” M2 growth should be reflected in the average price growth – the CPI index’s. But my surprise was that this relationship was so close: 6.9% = 2.9% + 4.0%. This is likely a coincidence, as the compounded average growth rates over the past 62 years (as opposed to average 10 years growth rates) are slightly off: 7.1% for the M2, 3.0% for the RGDP and 3.8% for the CPI. In any case, the relationship seems to hold. This is how the growth rates look over the past 5+ decades:

What one can notice is that there are two distinct periods. The first one is of monetary tightness (1978-2004), when the 10y growth of the monetary supply was below the combined growth rates of RGDP and CPI. In the second period (2004-present) the opposite is true: the M2 growth rates were in excess of the growth of GDP and price index. Note that these are 10y growth rates, the dates mentioned are the end-dates of a 10y period. What we can notice is that ever since 2004, and more so from 2008, the growth in the monetary aggregate was stronger than the growth of RGDP and CPI. While GDP and prices grew at about 2% pace, M2 grew at 6% or slightly higher for ~15 years. The pandemic exacerbated the disconnect – over the past 2 years the difference between the money supply growth and the GDP+price growth increased to more than 4pp. I have quantified the cumulative monetary ‘overhang’ of the past 14-18 years (since 2004-08) and it amounts to 60-65%. This is the red area between the blue and orange lines. What might it all mean?

It might mean that there has been a lot of money printed over the past decade+ which is more than enough to ‘service’ future GDP and price growth. If the whole overhang is to be ‘used’ over the next decade, we’d get about 5% annual RGDP+CPI growth. With a GDP growth of 2% we’d get a 3% CPI growth, which is not bad. But that assumes no increase in money supply for a decade! Which has never happened and is unlikely to happen. If the money supply expanded at a slow pace of 4% p.a. and the whole overhang were to be reflected in prices, we’d get a 7% inflation for a decade. Not a good environment for bonds – especially nominal bonds.

However, the uncertainty concerning future inflation does not concern the TIPS – inflation protected Treasury bonds. They have offered 2.2% real return at the end of September ’22 (for short term TIPS of 1-5 years – STIP ETF) or 1.86% for the TIP ETF, which holds all of the TIPS bonds (with average maturity of 7.3 years). The STIP ETF had a volatility of 2.6% over the past 3 years, while the TIP ETF – 5.7%. This seems like a safer bet to me given all the uncertainty surrounding future inflation rates.

– the model might be wrong, inaccurate or too simplified. Even though the relationship between M2, RGDP and CPI held closely over the past 5+decades, doesn’t mean it will hold in the future.
– the starting point for the period of excessive money printing (2004-08) might be too early and one should only look at the past several years. If one took the monetary overhang only since the start of the pandemic, it is just ~17% and the potential for future inflation is much smaller.

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The Moneyness of Fiat, Gold, and Crypto

I’m aware that I’m using the term “moneyness” outside the typical meaning of the word. It usually describes the likelihood that a financial option can be exercised and earn money, rather than expire worthless. The measure can vary between 0% and 100%. I like the word “moneyness”, so I decided to repurpose it for a slightly different use. The intended meaning of the statement: “The Moneyness of Crypto” is: to what extent cryptos are or could be considered money? 0%? 100%? Or somewhere in between?

Amber, beads, beaver pelts, bottle caps, bronze ingots, candy, cigarettes, cocoa beans, copper, cowry shells, cows, fish, gold, knives, lead ingots, meteorite iron, obsidian, parmesan cheese, potato mashers, rum, salt, silver, squirrel pelts, stone wheels, tea bricks, whale teeth.

The list looks like a zoo of things that have nothing to do with one another. An yet – all these things have been used as money in the past. So, what is money? Money can best be described by either its characteristics or economic functions it serves. The characteristics of money are: durability, homogeneity/uniformity, divisibility, limited supply, recognizability/acceptability and portability. The economic functions of money are: a unit of account, a medium of exchange, and a store of value. The analysis is divided into two parts. This essay deals with the characteristics of money, while part 2 with its economic functions.

I’ll attempt to score three types of money: the money issued by governments (often called the “fiat” money), precious metals and cryptos on a scale of 0-10 in these areas. This is not a systematic review, as it is nearly impossible to consider the details of all state-issued monies, all cryptos, all potential uses or all transaction methods. The scoring system is also pretty subjective, so I’m sure the reader would score some of them differently, even given the data and perspective provided in these essays.

The government-issued or fiat money is a system consisting of at least three forms of money: coinage, paper money and electronic money. Therefore, even within one type of money there will be considerable difference of characteristics and functionalities. Consider, for example, the portability of coins vs. wire transfer for intercontinental transaction. Gold and silver are more uniform, but there are still some differences depending on whether we’re talking raw metal, coins, retail bars and ‘Good Delivery’ bars. Concerning cryptos, at the time of writing lists 20,597 cryptocurrencies. They vary considerably, and it would be impractical to analyse even a small subset of them. I have concentrated on the main ones – Bitcoin (BTC), Ethereum (ETH) as well as several smaller ones that enable much higher transaction speed and throughput.

Let’s start with a summary table of how well a given type of money (fiat, precious metals, cryptos) fulfils the required characteristics. A detailed discussion follows.


 State issued (fiat) moneyGold and silverCryptos
Limited supply0-88-98-10

The durability of fiat money depends on its form. Coins are rather durable, US Mint provides a 30-year life time while UK’s Royal Mint states that coins can stay in circulation for 40+ years. I assign a score of 9 to durability of coins.

We tend to call the banknotes “paper money”, but nowadays they are rarely made of wood pulp. US dollars are 75% cotton and 25% linen, while euro banknotes are 100% cotton fibre, with protective coating. Notes issued by Bank of Canada and Bank of England are made of polymer. Widely circulating banknotes can last only as little as 1-2 years, but longer on average. US denominations between $1 and $20 last 5-8 years before succumbing to wear and tear, while the more rarely used $100 note lasts 23 years on average. UK’s new polymer banknotes are supposed to last 2.5 times longer than the previously issued notes, but the expected durability is in line with the US, 5 to 20 years. Notes are susceptible to damage, the paper based ones could rather easily be creased or torn. High temperatures and fire destroy both fibre-based and polymer notes. Paper banknotes can also be damaged by a washing machine, when forgetfully left in garment’s pockets, but fortunately usually not to the extent that they cannot be replaced by a bank. On the low side, I assign a score of 6 to the durability of paper and fibre banknotes, when used for daily transactions. On the one hand, their lifetime is really low, on the other they can get replaced by central bank rather “invisibly” to daily users. On the high side, I assign a score of 8 to the high denomination polymer bank notes as they can theoretically be used as a store of value for decades, assuming no or low increase in money supply.

The electronic money we own as deposits are maintained as part of bank’s IT infrastructure. Ultimately, the data pertaining to your balance are likely stored on a hard drive and/or magnetic tape. While the failure rate of hard drives is relatively high at nearly 1% annually, this does not mean that the durability of the electronic money should be counted in years or decades. Banks have extremely sophisticated systems that need to take into account not only equipment failure but also, much more importantly, the malice of cybercriminals. Banking institutions employ near-instant data backups, recovery and restoration, sometimes with backup intervals as frequent as mere minutes. Copies of data are geo-redundant, meaning that on top of on-site backup, several remote or cloud storage sites will likely be used. IT infrastructure (operating systems, applications and configurations) is also similarly backed up for a fast restoration in case of outage. Clients are more likely to lose money in bank’s run and/or bank’s failure. Fortunately, the deposits are currently insured in over 100 countries; the sums are for up to $250k in the US, €100k in European Union and £85k in the UK for one depositor and one bank. Safeguarding €500k or $1 million from bank’s failure is possible, all one needs is several accounts in different institutions.  Choosing banks with stronger balance sheets also helps. Large, systematically important banks will likely be saved by governments via bailouts. As the modern world is on the current banking/money system for just several decades, it not certain what the durability of electronic money really is. It is plausible we should assume timeframes of centuries or longer. I score the durability of electronic money as 10 for smaller depositors and 9 for those above insurance limits.

Gold and silver are notable for their durability, as stashes of coins from 2000 years ago are still being discovered. They are considered noble metals for a host of reasons: they are resistant to elements, fire, and nearly all chemical substances with the exception of cyanide, strong acids or their mixture (aqua regia). Contrary to James Bond “Goldfinger’s” movie plot, it is even impossible to irradiate pure gold, as it has only one stable isotope, and the unstable one has a half-life of about six months. Unfortunately, as unique as they physical and chemical properties are, they are not 100% resistant to wear and illegal debasement. There are two types of the so-called “sweating” techniques, a mechanical one and a chemical one, that allow to illegally obtain metal from circulating coins. The first method, known for centuries, required putting a large number of gold coins in a bag and shaking it for an hour or so. This would produce small metal clippings and gold dust that would be gathered by criminals. The newer the coins, the better the results. The second method required immersing gold coins for a short period of time in a solution of aqua regia, then washing and polishing them. Gold dissolved in the mixture of acids was easily obtained by evaporating the solution and melting the residue.  This methods gained popularity in American West towards the end of 19th century. I’m scoring both metals as 10 for long-term store of value. For the durability as medium of exchange I’m scoring gold as 9 due to its softness and susceptibility to aqua regia. Silver is slightly lower at 8, as it wears faster due to daily use, tarnishes in air and is soluble in rather easily available acids.

The distributed nature of blockchain nodes that contain the history of all crypto transactions ensures that the durability of data in the storage is very long lived. Given the sheer processing power required to confirm the Proof of Work (PoW) transactions on BTC and ETH blockchains, the system is likely better protected than banking systems. Even though Bitcoin has been around for only a dozen or so years, it seems very safe so far, as the blockchain itself is resistant to hacking or double-spend. We can assume that large enough number of programmers pored through its code, so that an incident like creating 184 billion BTC in one block is impossible now or will be corrected without any long-term consequences. Given current state of affairs, the durability of PoW blockchains could be described as indefinite – likely lasting many decades or perhaps even centuries, allowing for a score of 10. However, blockchain has several potential vulnerabilities. One of the better known is the so-called 51% attack. While Bitcoin has not yet suffered it, other cryptocurrencies (e.g. BSV, BTG, ETC) did. The costs to conduct a 51% attack are high, but not insurmountable and are within reach of a state agent or wealthy individual(s). Perhaps a solution to this problem is changing the consensus mechanism to Proof of Stake, as Ethereum is planning to do in the near future. Another threat comes from improvement in quantum computing. Some experts claim that progress in this area might make cryptocurrencies vulnerable as soon as 2035. Others point to potential vulnerability of the first 4 million or so Bitcoins mined prior to 2010, when the hashing function used a different, less safe format than now.

It is possible that solutions to potential problems will be found before they materialize and worrying more than a decade ahead is being overly cautious. However, even if there are no significant issues with Bitcoin or Ethereum in the future, it is possible that better solution to serve investors and clients within the crypto sphere will be developed. In that case, the durability of cryptos will be maintained, but the leaders will change. “On a long enough timeline, the survival rate for everyone drops to zero”, Fight Club taught us. “Diamonds Are Forever”, but we can’t be so sure about the most popular coins. I’m assigning a score of 9 on the low side of the estimate of durability, trying to account for current and future potential problems described above, but it is worth remembering that there’s non-zero probability of complete failure of any given coin.

The electronic money used in any given country is uniform, as any transaction is represented just by a number (score 10). The coins and banknotes are not uniform. There come in different designs, colours and they are made from different materials. This is done primarily to increase recognizability, but coupled with lack of divisibility, this may create occasional problems, such as inability to give back change due to lack of appropriate notes or coins in the cash register. You can’t tear a 20$ or 20€ note in half, to represent 10$ or 10€ of value. On top of that, uniformity is weakened when a new banknote series is issued, for example to increase security, and the old one maintains legal tender status. I’m assigning a score of 8 to account for these issues with coins and banknotes.

In theory gold and silver are extremely uniform as they are chemical elements (score 10). In practice, different countries employ(ed) different coins using different alloys and precious metal purity. Even when a coin lasted several centuries, the design changed with every ruler. I’d assign scores of 8 to 9 for most places and most times that have been on precious metals standards, but there were certainly times and places of monetary chaos, where a much lower score of coinage uniformity would be warranted.

Individual cryptocurrencies are fully uniform (score 10), as transactions values and balances are represented by a single number. The split into Bitcoins and satoshis or Ethers and weis is not actually reflected in the structure of blockchain transactions.

Electronic money are divisible, allowing for any transaction sum (score 10). Coins and banknotes are not fully dividable. They come in several denominations (for example, 1€, 2€, 5€, 10€), which makes a cash payment of sums like 33.77€ a bit cumbersome (score 8).

In theory, gold and silver are divisible to a single atom, hence a potential maximum score of 10. However, in practical applications (payment with gold and silver coins) they did suffer from the same denomination issues as modern coinage (score of 8).

Cryptocurrencies are sufficiently dividable (score 10). The smallest unit of Bitcoin (one satoshi or 10-8 BTC) is currently worth ~0.0002 USD, while the smallest unit on the Ethereum blockchain (one wei or 10-18 ETH) is worth an infinitesimally small amount, even expressed in US cents. In other words, the price of Bitcoin would have to increase to over 1 million USD in order to have first divisibility issues, as 1 satoshi would then be worth 1 US cent.


Fiat money has the biggest range of possible outcomes. Countries that hyperinflate their currencies receive the score of 0. Countries that enjoy the GDP growth of ~2% and target CPI inflation of ~2% will likely inflate the money supply by about 4% annually over the long term, receiving a score of 8. In mid-2022 there’s a whole range of CPI increases in different countries, with the worst offenders experiencing CPI inflation rate of between 30% and 500%, deserving very low scores, perhaps in the range of 1-5.

World Gold Council estimates above ground gold stocks of 205 thousand tonnes, while mine production of the yellow metal has been around 3000-3300 tonnes in recent years. This translates to about 1.5-1.6% of annual increase of gold supply and a score of 9. Silver’s above ground inventories are substantially more difficult to estimate, but let’s go with the CPM Group’s estimate of stock-to-flow ratio of 30-60. That’s an inflation of 1.7-3.3% and a score of 8-9.

Bitcoin’s supply increased by 1.8% in the year to June 30, 2022 while Ethereum’s supply increased by 4.2%, with respective scores of 9 and 8. However, the Bitcoin algorithm ensures that the new annual supply will asymptotically reach zero, so the future score of Bitcoin will be 10. Ethereum Foundation experiments with burning a small amount of ETH coins with every transaction are opening a possibility of a declining total money supply and a score of 10+.

The state issued money that we use every day has no issues with recognizability. In most countries we can readily identify both the banknotes and coins for what they are, as there are no objects closely resembling them due to strict laws against counterfeiting. Forged bills are very rare – about 0.02% of bills are fake in the UK, 0.01% to 0.025% in the US and only 0.001% in the EU. In most countries individual banknotes differ substantially in colour and size, while coins are often manufactured using different metal alloys or two alloys (see €1 and €2 coins). The electronic money is also easily recognizable as part of payment systems, whether wire transfers or card payments. I assign a score of 10 to all forms of fiat money.

Precious metals have an established place in nearly all cultures. Gold jewellery has a long history and even in modern times is rather popular. As most people get married it is more likely than not for an average adult to wear a gold ring at some point of their lives. Gold is relatively easy to recognize as metal, due to its unique yellow colour. In the antiquity silver was the only ‘silvery’ metal, however nowadays it has many lookalikes. Palladium, platinum, rhodium, nickel, chromium, aluminium, even cobalt are largely similar in colour. While nobody would use more expensive metals, such as rhodium, palladium and platinum to imitate silver, alloys of base metals, such as alpaca or ‘German silver’ had been. Various methods of counterfeiting precious metals have been used, from silver electroplating of copper coins to using tungsten inside gold bars. Receiving gold or silver from an unknown source carries risk. Acceptability of gold and silver coins varies substantially depending on the country and demographics. In this context it is perhaps worthwhile to mention a long tradition of using gold coins and gold objects as emergency money for US military and UK RAF’s pilots in WW II, Vietnam War and even in 1991 Gulf War. Apparently, it was established that recognizability and acceptability of these objects of value will be high, even behind enemy lines. However, given actual responses in videos like this and this, and many more like them in this particular youtube channel, it is tempting to assign a value of 0 or 1 to gold as money or an object with a recognizable value to an average citizen in the United State nowadays. One would, perhaps, be forgiven for suspecting that these responses have been staged or at least chosen from a larger subset given dramatically different responses elsewhere. On the streets of Singapore the knowledge of gold in is substantially better, perhaps warranting an acceptability score between 5 and 7. This could be attributed to Singapore being a financial centre as well as the impact of Chinese and Indian culture. One knowledgeable lady in the video apparently speaks a dialect of Chinese and skilfully translates gold values into renmibi. One gentlemen specifically states that he is Indian and his wife buys gold jewellery, so he knows the value of gold. The recognizability and acceptability of precious metals as money or investment seems to be rather low in most Western countries, perhaps with the exception of Switzerland, Germany and Austria, but higher in India, China and other Asian countries, especially in the Middle East. The analysis is further clouded by the fact that in some countries consumers buy gold mainly as coins and bars, in others mainly as jewellery. In the latter case it is sometimes not easy to disentangle to what extent the purchase has been done as an adornment or as an investment.

It is difficult to come up with one assessment for worldwide recognizability and acceptability of precious metals, as it seems to range between 1 and 10 depending on the specific population. I’ll go with a 5, but with low conviction of the estimate.

15 years ago the concept of cryptocurrencies did not exist, in the past 10 years there has been a gradual adoption and recognition of the idea. In a Pew Research’s September 2021 poll 86% of Americans said that they have heard at least a little about cryptocurrencies, while 24% heard a lot. 16% hey personally have invested in, traded or otherwise used one. It is a substantial increase vs. 2015, when only 48% of Americans recognized Bitcoin and just 1% said they had ever collected, traded or used it. On the high side there are countries where cryptocurrencies are even more popular. In a 2020 survey, 32% of Nigerians said they use or own crypto, as well as 21% of respondents in Vietnam, 20% in the Philippines and 16% in Turkey. However, the worldwide average is lower. The number of crypto users was estimated at about 300 million as of 2021, which translates to about 4% of global population.

So, acceptability is rather low currently, I score it as 1. Recognizability is much higher. As mentioned before, 86% of Americans have heard about cryptocurrencies. The numbers are similar in Japan (88%) and UK (93%). In 2018, an ING bank report put the UK awareness at 61% and American at 51%. It was somewhat higher in continental Europe (66%) with Poland and Austria even higher – 78% and 79% respectively. So, the basic recognizability in the Western countries likely is between 85% and 95% as of mid-2022. Another ING report, from 2019, asked several questions to measure the level of crypto-related knowledge. It categorized the responders as possessing either low (13%), medium (57%) or high knowledge (31%). Based on the Pew’s Research and ING Report it seems that about 25%-30% of Western population has the level of knowledge that could be described as sufficiently high. I assign a score of 3 to crypto recognizability. Given the high number of people who have heard about cryptos in general, this number is likely to grow with time.

The dictionary definition of portability is “the ability to be easily carried or moved”. With regards to money we have two concepts here: transportability and transferability. The former considers the ease of move over large distances, while the latter the ease of exchange between persons or institutions.

Coins and notes are easily transferred between people and on short distances, but due to their physical nature, not so easily over large, especially intercontinental distances. It takes just several seconds to reach to a wallet and hand over some notes and/or coins to another person. Arguably the process is too easy, given how effortlessly cash can sometimes be stolen. I assign a score of 10 for cash (coins and notes) transferability and a score of 5 for long distance cash transportability.

Gold and silver coins can be exchanged between persons on short distances with similar ease as the ‘normal’ coins and banknotes, which made them the staple of monetary systems for over 2500 years. However, given the global reach of our modern economy, a transfer between countries or even an intercontinental transfer is sometimes warranted. In 2013 Germany decided to repatriate a portion of its gold reserves held in New York and Paris to be stored in Frankfurt. Between 2013 and 2017 Bundesbank transferred 743 tonnes or about 1/5th of its reserves. The bars held in New York had to melted and recast in order to conform to ‘Good delivery’ standard of the LBMA. The whole transfer took 5 years and the price tag was €7.6 million. While undoubtedly high in nominal terms, it amounted to only 0.03% of the €31 billion worth of gold moved. I assign a score of 10 for person-to-person transferability of gold and silver coins and a score of 5 for large-distance, large-value gold transportability.

The core functionality of cryptocurrencies is that they can be transferred between any electronic devices in the world, be it personal computers, laptops or mobile phones. It is usually very efficient over long distances, but arguably not as convenient for short distances as hand-to-hand method of coins and notes. Transporting crypto around the world is very fast. While the transactions of the first crypto “incarnation” – bitcoin – require 10-60 minutes to get confirmed, there are plenty of solutions that allow for finality that is near-instant or takes seconds. However, transferability is a bit cumbersome compared to notes or coins as it takes more time and effort to transfer crypto than hand over cash, even with a convenient app and scanning of a QR code. As with any form of electronic money there can sometimes be problems with access due to poor internet connection – in the wilderness, outside of main cities, in tunnels, underground or inside buildings – which precludes us from making a transaction at a given place and time. I score the transportability very high, at 10, but the transferability currently at 8-9.

As we can see, determining whether a given type of money holds required characteristics is a complex task. Some qualities are stable and easy to score, but others quite cumbersome to analyse, different in various places and times and subjective. State issued money suffers mainly from instability of supply, which in the past year or two affected even the most venerable currencies of developed nations. Low durability of (paper) cash and inability to transfer it over large distances is mitigated by modern electronic money. Gold and silver score rather high on most characteristics, which is not surprising, as they have been at the core of monetary systems for 98-99% of human economic history. They currently have moderate-to-low recognizability, as they have been dethroned by fiat money. Crypto scores high on most traits, but suffers from low recognizability and even lower acceptability. It is also not certain whether cryptocurrencies are really durable, given their short history and potential threats.

Part 2 will deal with the functions of money: a unit of account, a medium of exchange, and a store of value. They are connected with characteristics of money, but we will look at these three types of money from different angles.

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