Tuesday, February 22, 2011

How many military go to HBS?

I've recently collected some data very closely approximating the level of veterans at HBS... basically membership numbers for the Armed Forces Alumni Association (the veteran club on campus) over the past decade or so. It shows that the average number per year (this includes a few non-US veterans) to be 40, with a range of 27-50. It's probably fair to assume about 4-6 of the veterans are from non-US militaries, often from conscripted services but not always.

Below is a chart of the AFAA strength since 2000:



If one was to look for meaning in the patterns though, it can be deceiving. For one thing, one has to look at the year of application (assuming the Fall of the year counts for round 1 and round 2, and thus the bulk of the applicants). If one therefore subtracts 3 years from the graduation year to look at the application year, the following is observed:


The fewest number of veterans were admitted in late 2002 (and early 2003). But what does this mean? Does this mean that fewer military people applied that year? Does that mean it was more competitive that year? Or perhaps it was less competitive because so few applied? Is the reverse true in 2003-2004 when the most were admitted? I don't think one can conclude any such position given just this information.

The data shows a mean of 40 with a standard deviation of 9. Most likely, the minor changes year to year are mostly random, and reinforces the fact that HBS does not have "hard" quotas.

Please also note that I don't have data on HBS class sizes going back all those years, so that could have a consequence if military numbers change with class size. To the best of my knowledge, HBS class sizes don't change very often.

This data may be interesting to provide historical context, but shouldn't be interpreted to mean much more than that.

Saturday, February 5, 2011

Fiat Currency Default Risk

This blog entry will be unlike my previous ones in that it will not be business school or military related, but rather be a specific discussion about gold and currency. This is a thesis I have developed over a while and have discussed enough times with people to warrant writing it for all to see. Please continue to read if you are interested in the US Dollar and gold and want to get a good beginner's guide as well as an introduction to a brand new concept (new to the best of my knowledge at least).

In this article I will first introduce a concept which I call "Fiat Currency Default Risk." The Fiat Currency Default Risk attempts to represent the implied global market sentiment as to the risk of US dollar default and collapse. I will follow this up with some basic context and background, and do so by addressing three questions:
  1. What does the price of gold indicate about the rest of the economy?
  2. Why is gold considered a storage of wealth?
  3. Why has gold gone up so much in price, and what will happen next?

What does the price of gold indicate about the rest of the economy?

How much should gold cost? One gets very different answers from different people because of the way people treat gold. Gold costs a little under $500/oz to get it out of the ground, and it is mined to the tune of about 2500 tons a year, or around $100 billion worth, at today's market value. If one thought that gold was just a metal, and had commodity-like behavior (for example, like copper or iron ), then gold should only cost around $500/oz on the open market.

If however one hypothesizes that gold is not just a metal (like copper or iron), but rather has currency-like properties, then it is worth much more. But how much more? $1350 like today? Why not $1000? Why not $3000?

Before I answer this question, let's first address the issue of commodity-like behavior and currency-like behavior. A $100 US bill costs about six cents to print (or so I've heard). If treated like a pure commodity, a hundred dollar bill is therefore only worth six cents, because that is the amount of value that went into it. However, today of course it is not worth six cents, but 100 dollars. It has value which reflects its pure currency state. If the next day the US government announced that the US was changing its currency to the Peso, then a hundred dollar bill (and all bills) might fall down to six cents. Its value would shift from currency-like value, to commodity-like value.

I believe a very similar argument can be made about gold. The commodity end of the spectrum is relatively straight forward... if treated like copper or iron, it should cost around $500 based on how much it costs to produce. But now let's play a simple thought experiment. Let's pretend that the US dollar begins to become devalued at uncontrollable rates. Let's pretend that the US is on the verge of defaulting its debt. You may say that kind of thing could never happen here. It can only happen in places like Argentina and Greece, and maybe Spain, but never the United States. Ok, but let's just pretend for a moment that it's a non-zero probability. The dollar experiences high levels of inflation, people are spending cash like crazy because they don't know what it will be worth tomorrow, etc. They start to buy real assets because they don't have confidence in the dollar any more, therefore only accelerating the vicious cycle even further. What might the US government do?

One thing it could do to bring back monetary stability and social order is to announce that it will back all its currency with its gold reserve, the second largest gold reserve in the world, consisting of 8,133 metric tons. The fiat currency, at this point, will have come to a quick historical end.

What would gold be worth in this highly unlikely scenario? If that situation happened today, it would be $7350/oz. That is simply calculated by taking the US monetary base and dividing it by its gold reserve. The worst case today for the US dollar is for it to devalue to $7350/oz, because the government can always back it with gold at that point.

Is the above scenario likely? Probably not. However, stock and commodity valuations are not just priced based on the most likely binary outcomes, but inherently price in probability of the aggregate of all possible events. For example, BP was not likely to go bankrupt when it had the Gulf oil spill disaster in the summer of 2010, but as it became a decently possible outcome, its stock fell in half to reflect that possibility.

All of the above is captured in what I have coined as the FIAT CURRENCY DEFAULT RISK (FCDR). To the best of my knowledge, this ratio has not been put out in any other literature or analysis. The fiat currency default risk is calculated as follows:

Where "commodity price" reflects the average cost of mining gold, "market price" reflects the current sport price of gold, and the denominator reflects what the price of gold would be if the US decided to back the entire monetary base by its gold reserve, adjusted for the mining cost of gold. The ratio reflects how far into the disastrous scenario of total US dollar collapse the world market is implicitly pricing its probability.

Looking at today's numbers, we have ($1350 - $500) /($7350 - $500) = 12.4%

Let's test these numbers at the extremes to see if they make any sense. If gold was selling for $7350 today, then the Fiat Currency Risk Default would be 100%, which makes sense since we are already there and people are treating gold as pure currency. If gold were at $3925 today, it would mean the global markets implicitly price the Fiat Currency Default Risk at exactly 50%. If gold was $500 today, the FCDR would be 0%, since people are treating gold as a pure commodity.

The US eliminated the gold standard 40 years ago, and indeed if gold lost all of its potential for currency-like behavior, then why would anybody pay anything more than its commodity price? The answer is because there is inherent risk in everything, including total fiat currency collapse, no matter how small that probability is today, and the markets will reflect it.

Another benefit of using this measure is that it appropriately takes into account simple inflation. Let's say the monetary base increases by 2% a year, and the prices of everything increases at 2% a year, including gold and the cost of mining it... then the Fiat Currency Default Risk will not move, because the price of gold simply went up proportional to theoretical monetary base price adjusted to the gold reserves. For the Fiat Currency Risk Default number to actually move, it must reflect a movement of gold price closer to the currency-like value of gold faster than inflation, and a strong rational explanation for investors making this investment is reflected in their concerns about US fiat currency collapse. Not all investors may be explicitly thinking in these terms, but their behavior implies such concerns.

If anything, the numbers give us reason to worry less, not more. I calculated the FCDR for the year 2000, and while I don't have exact numbers on cost of mining, etc, I calculated a number around ~10%. This tell us that over the past decade the increase in the price of gold is mostly reflected in an expansive monetary base and a devalued dollar, not in investor panic based on a fear of currency collapse. However, given the central role that the US debt will play in the future, likely continued discussions about the status of the US dollar as the world's reserve currency, and the price of gold, it may be wise to monitor the FCDR to differentiate the rising price of gold due to inflation (printing money) versus market sentiment that the US dollar is at risk at defaulting.

Note: I purposefully used the term Fiat CURRENCY Default Risk, vice Fiat DOLLAR Default Risk because if the US Dollar were ever to default, it's most likely that other fiat currencies such as the Euro will immediately follow suit. Given the central role that the USD plays in the world market, a default would likely reflect a global loss of confidence in paper money everywhere. If the Dollar goes down, so do all fiat currencies which have a floating exchange rate and exposure to free capital markets.

Now for some more background to those interested...

Why is gold even considered a storage of wealth?

Gold has a distinguishing set of characteristics which has led nearly all societies to adopt it as a storage of wealth. Many materials have some of the following traits, but it's difficult to find them all in one element:
  • Gold is rare: About 0.001 parts per million of the Earth's crust.
  • Gold is imperishable: It does not decay, rust, or degrade. A treasure chest full of gold sunk in salt water hundreds of years ago will be in as good shape today as the day it was lost.
  • Gold cannot be faked: It is denser than any other accessible metal except tungsten, so any metal which tries to pass off as gold can easily be detected by simply weighing it and comparing volumes. Unlike tungsten, gold is soft, so that risk is mitigated (it's why people used to bite gold). Any metal denser than gold is also more expensive than gold (ie Platinum). Gold is even nearly twice as dense as lead.
  • Gold is easily stored and transported: You can put it in your pocket or put it in a treasure chest and throw it on a ship. For permanent storage, you don't need any special conditions.
  • Gold is visually distinctive: While not 100% unique, it is far more distinctive than items such as lead or iron, or even silver, which a completely untrained eye can easily confuse. Few things in the world look like gold (when combined with its difficulty of being faked, this becomes powerful).
  • Gold is fungible: Its units are capable of mutual substitution. So your ounce of pure gold is the same as my ounce of pure gold, and I can combine them to form two ounces of pure gold which is the same and somebody else's two ounces of pure gold. This for example is not true for diamonds, in which every diamond is different and cannot be combined or divided without changing its intrinsic value.
  • Gold cannot be created or printed at will: Gold cannot be created by governments or the wealthy. It cannot be produced in a lab, although history has shown that certainly many have tried. This means that those holding gold can rest assured that their gold will not be reduced in value by the mass creation or printing of more gold.
From the beginning of agricultural civilization, humans have needed a means to store wealth. If you are a wheat farmer and you have surplus, you exchange (or sell) that surplus for something else. That is one fundamental way that one can accumulate wealth. However, what do you get in return? Corn? Livestock? At a certain point, you can't continue to accumulate "stuff" because "stuff" can go bad, and may need maintenance, and may rot, decay, or die off. So ancient society designated the notion of a currency - a material that is universally accepted as a storage of value. The fact that it is relatively easy for an untrained person to spot fake gold, that it is rare, and does not degrade, among the other reasons listed above, left it as a natural choice. Indeed, it was adopted nearly universally in all societies as a storage of wealth... so much so that it is virtually ingrained in the human collective unconscious.

Some may say that this is all silly. That gold is just a metal, and hence basically worthless. They would argue that it only has value assigned to it by society. I suppose those people would prefer to hold US dollars. I would ask the same people to apply the same test to modern currency. Is it not actually currency which is just paper, and only carries value because society assigns it that value? Does paper currency have any more intrinsic value than gold? Since paper currency is easy to print and is not rare, it can be argued that it is actually gold which carries more intrinsic value. The fact is that neither currency nor gold have any value unless people choose to assign it that value. The question is, which is a better permanent storage of wealth?

Why has gold gone up so much in price, and what will happen next?

In the last four years gold has gone up from around $625/oz to $1350/oz, more than doubling in price. A natural question is to ask why is gold so much more expensive? Does that mean it's going to come back down? What's driving all this? Why would anybody trade $1350 in cold cash for an ounce of a seemingly useless metal? What has changed to make gold worth so much more?

An interesting way to think about this is that gold did not go up in value, but rather, it just takes more dollars to buy the same amount of gold.



The above chart shows that historically it has taken around 100-300 ounces of gold to buy an average priced house in the US. This rule holds true in both deflationary (1930) as well as inflationary (1980) periods. Another item to look at is cars. The Model-T in 1925 cost around $240, or almost 12 ounces of gold. Today 12 ounces of gold coins will get you around $16,500... which seems like a fair price to pay for a regular car. Given all the changes in home styles and sizes, in car sophistication and improvements, about the same amount of gold is required to buy them during most economic cycles. This is because gold's is largely a permanent storage of value, whereas the dollar is subject to other variables, such as government printing. For this reason, I am fairly certain that 50 years from now, 12 ounces of gold will still buy the latest Ford model of 2061, whereas $16,500 will probably only buy you a paint job.

Here is a chart showing the US Monetary Base from 1984 through 2010:


The exact definition of monetary base is a bit more involved, but you can think of the monetary base as the amount of liquid money floating around in society. Sum up everything that people have in their wallets, in their bank accounts, and in bank holdings. By now you may have noticed the alarming spike in 2008 when the US significantly increased its monetary base by printing a ton of money... in fact, it doubled the amount of money available for circulation in order to prevent (or delay) economic collapse.

While the complete pros and cons of the government's decision to double the monetary base in 2008 is beyond the scope of this article, it may help give some insight as to why gold has gone up around 75% since 2008. It may not be that gold is worth that much more, it's just that there are twice as many dollars chasing the same amount of gold. The next logical question to ask is why isn't everything else twice as expensive. That is also a complicated question, and the short answer I put forward is that things simply have not had time to adjust. Much of the money introduced to flood the market in 2008 just hasn't hit the street yet; it's still in banks. Gold however, is traded by sophisticated traders in essentially efficient capital markets placing bets on the future price of everything. The same is not true for a dozen eggs for example. For this reason, some people see the price of gold as a more fundamental read on the devaluation of the US Dollar (versus the CPI for example). Complicating this is that the value of the US Dollar is a function of not only basic supply/demand of money, but of global psychology and perception. If you want to get out of the Dollar because it is being devalued, where else do you put your money? The Euro isn't doing so great and the Chinese Yuan is controlled by its government. For these reason, among others (see history of Bretton Woods and Reserve System for more background), the US Dollar is still perceived as the safest storage of value by most of the world. There is an increasing number of people however who consider gold as a potential alternative and hedge.

This is particularly true for a country which has so much debt and deficits that realistically, nobody every expects to pay it off... it is only a question of managing it for as long as we can. The US debt, in absolute terms, is virtually guaranteed never to be reduced. It's not that it cannot be resolved, but there is simply no political will for it today. The last time people began to flock to gold and away from the dollar, the US responded by confiscating gold and making it illegal to hold. This remained in effect until the 1970s when the US could no longer honor its foreign debt conversion into gold and abandoned the gold standard altogether.

Since 1971 we have had a purely fiat currency, meaning currency which is just paper and not backed by anything. When people say "the dollar is backed by the US government," what does that actually mean? The experiment in which the world's money is not backed by physical gold is a very recent development. In fact, the experiment is only 40 years old. Fiat currency is not destined to fail, but the assumption that it will continue indefinitely and successfully is far from a certain one. As long as the US Dollar is the world's reserve currency, and there are no viable alternatives, it will continue to hold much of its value. However, a hundred years ago the British Pound had the same role that the USD has today, and if 100 years ago one would have said that the sun would set on the Pound in just two decades, that person would most likely be considered a lunatic. The reality is that changes do occur in history, and the Dollar is in trouble. It's being sustained by its world reserve currency status, lack of alternatives, and the fact that so many other countries have bought into it so that a severe devaluation of the Dollar would hurt them as well. However, that is not enough to sustain it forever.

What will become of the US Dollar over the next few decades is still an open question and its destiny has not been determined. Nothing is inevitable. We must become both monetarily and fiscally responsible if this country is to reverse course. However, many believe that a shift away from the USD as the world's reserve currency is very likely to come... either slowly (like the Pound), or dramatically and suddenly (like the stock market crash of 1929 or 2008). Some people with these concerns are putting a portion of their money into gold because 1) gold is a storage of wealth which can't be devalued by the printing press and 2) in case of total monetary crises, the US or others may look to gold as a stabilizing force in some capacity. If the latter is true, it means that gold will once again be evoked by governments to restore stability and order, and gold's nominal value will reflect such an act. The world depended on gold for over 6000 of monetary order. We have only been using fiat currency for 40 years, which depends on the wisdom and discipline of our political leaders to act appropriately. We still have time to fix our monetary and fiscal problems, but it will take strong and principled leaders to do so.