Thursday, 8 November 2012

The illusion of safety

I have recently been reviewing various proposals for making the financial system "safer". Most of them involve some kind of full reserve banking, while one (Gary Gorton's) looks at improving the safety of the shadow banking system without subjecting it to the same rules as licensed banking. But all of them rest on the idea that there is such a thing as a "safe" asset.

The concept of "safe" (i.e. risk-free) assets has existed for a long time. Pricing models base themselves on the "risk-free rate". The instrument that is usually used as the proxy for "risk-free asset" is the United States Treasury (UST), but until recently all sovereign debt was regarded as risk-free, at least for bank capital adequacy requirements.

This led to banks loading up on the debt of Greece, Spain, Portugal etc. because those assets required no capital allocation but gave a better return than German bunds or UK gilts. They should have paid more attention to the yield. Yield is a much better indication of real risk than any regulatory view of an asset class. "If it pays better, it's riskier" is axiomatic in financial markets. It is unfortunate that in recent years investors and banks alike forgot this basic rule and believed that they could get high returns for zero risk. And even more unfortunate that retail bank depositors thought so, too.

Gary Gorton notes that one of the main drivers of the 2007/8 financial crisis was the failure of supposedly "safe" assets created by the private sector. This is a much neglected matter. The popular perception is that mortgage backed securities and their derivatives were known to be risky assets that banks and others chose to trade because they believed they would be bailed out if the assets went sour. The last statement here is correct - the financial sector did indeed believe it would be bailed out. But the first statement is not. The financial sector believed that these instruments were safe, because they were backed by property which (in the US) had been a stable appreciating market for a very long time. The UK does of course have a history of property market crashes, so it is slightly surprising that banks in the UK were fooled: perhaps they thought that the US property market was not subject to the same instability as the UK - or perhaps they just had short memories.

So Gorton argues - correctly - that it is not possible for the private sector to create safe assets. But he then states that only governments can create "safe" assets. This is in my view where he comes unstuck, for reasons that I shall explain shortly.

Gorton is not the only one who thinks government debt is "safe". John Kay also thinks so - or at least he used to. His "narrow banking" proposal would back all bank deposits with gilts. However, in his recent evidence to the Banking Standards Committee at the House of Commons, he was questioned about this by former Chancellor of the Exchequer  Lord Lawson, and was forced to concede that gilts could not be regarded as 100% safe.

A quick look at the history of sovereign debt defaults gives the lie to the idea that sovereign debt is in any way "risk free". However, there is no doubt that some sovereigns are "safer" than others: the UK and the US have never defaulted on their sovereign debt. So why shouldn't their debt be regarded as "risk free"?

There are two risks with sovereign debt. The first is sovereign debt default, which for the UK and US is a pretty low risk, though not zero. But the second - a much more serious risk as far as the US and UK are concerned - is variation in value. Gilts and USTs are actively traded and their price varies day-to-day. That creates a problem when using them to back customer cash deposits. As the whole point of holding these instruments would be to liquidate them quickly if necessary in order to meet deposit withdrawal requests, they would have to be marked to market daily. If  the bank was legally required to maintain 100% government securities backing, the bank would therefore have to trade gilts and/or USTs itself on a daily basis. A sharp drop in the value of government securities and/or freezing of the markets could bankrupt it in much the same way that writedowns of mortgage backed securities bankrupted banks worldwide in the financial crisis.

On the face of it, this weakens Kay's proposal and gives greater weight to cash-based 100% reserve banking proposals such as those from the IMF and Lawrence Kotlikoff. And although it doesn't completely wreck Gorton's ideas (since UK and US government debt is probably safer than private sector assets) it does mean that absolute safety of cash deposits in the shadow banking system cannot be guaranteed.

But a quick look at the inflation records of the US and the UK gives the lie to the idea that cash is "safe" either. Some people argue that "safe" means "won't suffer loss of principal" rather than "won't decline in value". But since the sole purpose of cash is to buy real goods and services, if £1 buys you a large loaf of bread today but only a small one tomorrow, the effect is that you have lost half your money. You still have £1, but you can only buy half as much with it. The value of cash depends on the willingness of government (via its central bank, usually) to control inflation. And that depends on a range of political and economic factors.

And it's not just cash whose value is affected by inflation. The value of government debt is, too. I've noted before the equivalence between yields on government debt and the inflation rate. Generally speaking, the higher the inflation rate, the higher the yield on government debt (and therefore the lower its value). This equivalence doesn't hold on daily basis, of course - government debt and currency values fluctuate independently of each other - and it doesn't hold in fixed currency systems such as the Eurozone, but over time it is a useful rule of thumb for floating exchange rate systems with no restrictions on movement of capital.  

So is anything safe? Well, proponents of gold think so. Those who support gold as a currency point to the stability of the "true" Gold Standard period of the late 19th century as a time when cash held its purchasing power. But in this article from Economic History (EH), the author questions why the gold standard during that time was stable, because on the face of it it shouldn't have been - and he concludes that there were two reasons: firstly, there were no major wars at that time, and secondly, both the private sector and the principal governments involved were fully committed to ensuring its stability. In other words, gold ITSELF is no more stable in value than any other sort of currency - as indeed the gold price chart shows. It is the backing of governments and trust from private agents that makes it so. EH notes that the "backing of governments" involves a commitment to settle trade deficits in gold: but the UK defaulted on its international trade obligations when it abandoned the gold standard in 1931, and the US did likewise when it ended the Bretton Woods system in 1971. The UK and US may not have defaulted on sovereign debt, but that doesn't mean they have never defaulted.

We also know from history that gold standard currencies don't survive major economic shocks, such as wars. The gold standard was suspended in the UK during the Napoleonic Wars, the First World War and the Depression: in the US during the Civil War, the First World War and the Depression: in France during the French Revolution and the First World War....I could go on, but do we need more evidence? Wars and major economic shocks need governments to create money in large quantities, which they can't do if they are locked into a gold standard - or any other kind of fixed currency regime, for that matter. And wars and major economic shocks disrupt international trade, which also undermines the gold standard. Returning to the gold standard at the pre-shock price is almost never achievable in reality. Abandoning the gold standard - which inevitably happens when there are major exogenous shocks - results in debasement of cash savings.

Those who support gold as an investment, but not as a currency, point to the rising value of gold over time. It is true that over the long term, gold does tend to appreciate in value - though so do property and land. But as a short-term investment it is volatile, which makes it completely unsuitable as collateral in a fast-moving financial marketplace or as backing for transaction accounts. And as a vehicle for personal savings it carries another risk - it is a target for thieves. In those countries where for cultural reasons people tend to put their savings into gold, theft (often violent) is a constant threat - which is why the World Bank is trying to encourage people to put their savings into banks rather than gold or cash. To the people of the West, scarred by recent events and fearful of bank failures, this looks like madness. But in developing countries, banks are definitely safer places to keep savings than mud huts. Gold stashed under the mat may not lose its value, but it can be lost.

So, over the long-term there may be assets that can be regarded as "safe".....but on a short-term basis, there is no such thing as a completely safe asset. Which brings me to my final concern about the search for assets that are "safe".

The belief that certain assets are "safe" encourages risk-averse investors to buy them. This pushes up the price and reduces the return on these assets. We saw in the run up to the financial crisis how the demand for assets that were considered "safe" drove production of these assets, leading their creators to take on more and more risk. The nature of the asset changed: it was no longer low-risk, but the investors did not know that, so continued to buy it until the rising tide of defaults in the underlying property portfolios caused a massive price correction. Once the true risk of these assets was fully exposed, their price collapsed and they became worthless.

The same is possible if either government debt or currency is produced in sufficient quantities to meet demand without domestic production rising to match. If this happens to government debt, eventually the price drops and the yield rises: if it happens to currency, the exchange value drops and there is high inflation.

However, I want to make it clear at this point that I do not believe we are anywhere near this state of affairs in Western economies generally at the moment, except for some members of the Eurozone. We have the opposite problem, namely that governments are unwilling to produce either debt or cash in sufficient quantities to satisfy the demand for "safe" assets, so we are seeing the price of government debt and the value of currency rising (and yields on debt and trend inflation falling) in those countries that are considered "safe havens".  Once yields are in negative territory, investors LOSE MONEY. And that is what is happening at the moment. Investors are so concerned not to lose their principal that they are loading up on supposedly "safe" assets which actually cost them money to hold. Remember I said that, for cash, loss of value due to inflation is just as real a loss as principal wipeout in bank default? In the same way, negative yields on government debt are just as real a loss as principal wipeout due to government debt default. No way are they "risk free".

And one final thought. We do not know what causes asset bubbles, but Austrian theory of business cycles suggests that the next bubble starts to form during the aftermath of the bursting of the previous one. In the aftermath of a major crash, investors are understandably risk-averse - as we are seeing at the moment, with their flight to traditional "safe havens" and their willingness to accept principal erosion rather than risk total wipeout. That suggests that, rather than greed and the hope of a high return, it may be fear and the search for safety that drives the creation of asset bubbles. In seeking the illusion of safety, investors may set up the very disaster they wish to avoid.


32 comments:

  1. Can gold and oil be considered a bubble? Both are artificially inflated after any other bubble bursts, but rather than popping it deflates (relatively) slowly as markets stabilise.

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    1. I think it is more that these are traditionally the ultimate "safe havens" for highly risk-averse investors, so after a crash they always rise in value. Once markets return to a more normal risk attitude, their value drops again. Not so much a bubble as a counter-cyclical response.

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  2. The poo in my bottom is safe. No one dare touch it.

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  3. In a full-reserve banking system, cash is 'safe' in so far as a bank's liabilities are floating-rate deposits. Treasuries are 'safe' in so far as liabilities are fixed-rate deposits of matching term. So with the appropriate mix, banks really can eliminate risk, so long as they're not in the business of maturity transformation.

    Personally I think such a system would work horribly. But perhaps we should pay a small country somewhere to try it, just to find out. Greece maybe...

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    1. Most cash-based full reserve proposals envisage the interest rate on sight cash deposits being zero - or in practice actually negative because of fees - so those depositors would suffer value erosion when there is inflation, despite the cash backing. Banks would of course protect themselves from inflation by charging higher nominal fees, but that would erode depositors' money even faster. If interest rates on cash-backed sight deposits were variable, they could adjust to compensate for value erosion, but then the bank would be exposed to loss. I can't see how cash backing could possibly protect both depositors and banks from inflation risk.

      As far as treasuries are concerned: I suppose you could match collateral and deposit terms in shadow banking. But bank deposits (sight and time) do not have maturity dates, so how could you match terms? You could match the notice period on time deposits, but you would have to do that on a daily basis. Crikey, that's complicated. The day-to-day management of such a system would require the skills of fund managers, not retail bankers - and the bank would be terribly exposed to market freeze. Just imagine if the daily match funding couldn't be done because the gilt market had frozen.... And I don't see how you could match fund sight deposits at all. They are zero-term and, in transaction accounts, have constantly moving balances.

      To my mind "narrow banking" using Treasuries as backing simply would not work, because it could not cope with the constantly changing pattern of sight deposits. The overhead of managing such a system would make it prohibitively expensive. Cash backing is more promising, but I have yet to obtain an answer to the inflation risk problem. Of the full reserve proposals I've seen, Positive Money's is the only one that would really cope with sight deposits, but it does place the central bank at risk.

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    2. I agree that under narrow banking, government debt should not be used as “backing”.

      Re protecting depositors from inflation, I don’t see why society as a whole has any obligation to protect depositors, particularly large depositors. I.e. where someone can think of no use for their wealth other than to store it in the form of cash (i.e. numbers in computers), why should we care about them? Inflation is effectively a tax on such people, and I favour such a tax.

      In contrast there are small depositors, and it can well be argued that everyone has a right to a specific and fairly small sum that is inflation proof. In fact this facility is already provided by National Savings, though on a somewhat erratic basis.

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    3. National Savings and index-linked gilts are indistinguishable except for their target market.

      I suppose a large investor would argue that if their money is placed "at risk", so can be lent out productively, it is sensible to protect it from inflation, as otherwise there is less to invest in the economy. In fact a large investor might argue that there is MORE justification for protecting large sums placed "at risk" than there is for protecting small sums that are not placed at risk, because the investments made with those large sums benefit far more people.

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    4. I agree that National Savings and gilts are near indistinguishable.

      I don’t have much sympathy with your hypothetical large investor. First, if someone invests directly in a small business or in stock exchange and it all goes pear shaped, they lose their money. But if they plonk money in a bank and the bank invests in or lends to small or large businesses and it all goes pear shaped, the taxpayer rescues them. That’s a completely unwarranted subsidy for banks, depositors, etc.

      Re guaranteeing inflation proofing for large investors, much the same point applies. That is, inflation proofing can only be absolutely guaranteed if the taxpayer is standing in the background.

      Obviously if large investors are provided with inflation proofing thanks to taxpayers then you’ll get more investment. But I don’t think you can justify “more investment” or more anything else simply on the grounds that subsidising it produces more of the commodity concerned. Subsidise baked beans and more baked beans will be produced and consumed. To justify a subsidy, you have to demonstrate market failure, i.e. prove that the market is underproviding the commodity concerned.

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    5. Your argument that taxpayer support protects large investors is false. The present deposit insurance scheme is limited to £85K - hardly a lot of money. When Southsea bank went south earlier this year, people with deposits over £85K lost money. And can I remind you that in Musgrave world, there would be no protection at all for "at risk" deposits - the ones that actually would be lent out and used productively?

      Your arguments against inflation proofing for large deposits equally apply to small ones. The taxpayer loses - and many of those are people who have NO savings. I can't begin to justify protecting even small amounts of savings by extracting money from people who are too poor to save at all.

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    6. I’m in 90% agreement with your last sentence: “I can't begin to justify protecting even small amounts of savings by extracting money from people who are too poor to save at all.” That’s pretty much full reserve thinking.

      So I’m now in a muddle as to exactly where we agree and disagree. So to summarise, I say:

      1. No taxpayer support whatever (inflation proofing, or insuring the capital sum) where the depositor wants to act in a COMMERCIAL fashion and have their bank lend on or invest their money.

      2. Taxpayer backing for the capital sum IS ALLOWED where the depositor wants 100% safety, but in that case the money is NOT loaned on or invested, thus the money is almost 100% safe anyway. I.e. the additional support from taxpayers won’t cost the taxpayer much. But no inflation proofing is involved there.

      3. As a sop to the plebs kicking up a fuss about not having savings accounts that are inflation proofed and pay interest, perhaps let everyone have up to say £10,000 in a National Savings inflation proofed and interest paying account. But that’s pure politics: it doesn’t make economic sense.


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    7. I regard protecting transaction accounts as sensible - I'm sure I've said that before. The debate is around the best way of achieving that, given that transaction accounts are constantly moving and the value of the money they represent is also constantly changing. Positive Money's scheme would actually cope with this, although there would be a problem with accounts dipping in and out of overdraft. My only concern, as I've said, is that without a debt jubilee it places the central bank's solvency at risk.

      I also agree with you that there should be no taxpayer protection for investments, including interest-bearing deposit accounts. However, I would like there to be voluntary insurance available for risk-averse individuals. They need to understand that the price of this insurance is a lower rate of return on their investment. That way it becomes their choice. The present insurance is compulsory and paid for by bank levy rather than directly by the customer. I don't think customers should be "nannied" like this, and I don't think it is fair to penalise well-managed banks for the losses of badly-managed ones. I'm aware of the potential mis-selling problem, but that is a matter for regulation - and as I have noted elsewhere, a culture change in retail banking.

      Where you and I part company MASSIVELY is on money creation. I've said a number of times now that it is not Positive Money's banking I disagree with, it's their economics. I don't want to go into that again, but I do not agree that moving to a situation where banks can only lend money they already have would be better for the economy.

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  4. just a few thoughts in response

    http://jpblaw.wordpress.com/

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  5. You write that "war...need[s] governments to create money", as if war is some pre-determined and avoidable thing, thrust upon innocent government employees. Rather, governments choose to engage in war and as a consequence of that stupid decision sometimes feel the need to conjure up money to satisfy their misguided aspirations. This lecture explains

    http://www.youtube.com/watch?v=Tl9lS5k7H5M

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    1. Alister,

      I did not make any judgements about the cause of war. I was merely discussing the economic consequences.

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  6. I just think it's important to note that 75+ percent of people on Earth do not like violence or war, and that throughout history it seems to have in most cases been obscure politicians who have instigated most of the (pointless) wars, and that this is possible mainly because of the chance to tax through inflation rather than impose taxes that are more easily observable to their poor subjects. Employees of the BBC even produced a 1 hour documentary based on the historical record to demonstrate that some of the bankers who financed Hitler were "British" & "American" (http://www.youtube.com/watch?v=YauM5dHLn1s). Inelastic money supplies absolve rulers of the need to pay for their aggressive adventurism, in short, surely a feature of the modern financial system that is suboptimal.

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    1. I think you aren't looking far enough back in history. Kings have always gone into wars that their subjects haven't liked, and they have financed them generally through direct taxation and borrowing, not through money creation and inflation - those are modern phenomena.

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  7. I'm happy to admit that you're probably a better historian than myself, but nowadays with the Internet - which really does rival the Gutenberg revolution; which in itself is really saying something, considering how quickly & far that invention advanced Western civilisation - it's not as easy for rulers to misbehave as it was 2 or 300 years ago. Yale Uni Law school is running academic work shops analysing the power of information to shape (or prevent the implementation of) laws, for example. See "The Constraining, Liberating, and Informational Effects of Non-Binding Law" @ http://www.law.yale.edu/documents/pdf/LEO/LEO_Stephenson.pdf. Unfortunately, I agree there's a high chance some aggressive/warlike behaviour will always exist amongst humans, but obviously sane people agree it is optimal to reduce this as much as possible. What's the point to wealth if you live in a war zone, after all? My point was that if rulers/democrats/politicians/bankers had to impose, directly and forcefully, taxes on subjects to run wars like in the times you I suppose are referring to in the above - our world would be more peaceful.

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    1. I don't agree with you that direct taxation would prevent wars. History does not support your argument. The information revolution is a much better preventive. And the sheer horror of modern warfare, of course.

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  8. Don't forget, Alister, that during the times of Kings...as well...there was then at least one individual who signed a contract with financiers and could (theoretically, at least) be held accountable...compared to now...where it is totally unclear...if not from a technical, legal point of view...then at least from a moral standpoint...who exactly it is that's supposed to be shouldering the giant burden of all these public debts

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    1. That's easy - everyone!

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    2. Robbing Peter to pay for Paul means Peter is less likely to save from producing wealth so you can pacify Paul, however! Even socialists need an income!

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  9. Prevent wars? Direct taxation? Neither do I think that this would serve as any type of panacea to the sheer horror, as you put it, no matter how desirable that may be. Perhaps I was unthinking in my communication; I suppose I just meant to say that relieving decision makers of options that are inherently more costly to them (ie: choosing/needing to tax subjects) for the sake of, in turn, making war a less undesirable option to them, in terms of their political aspirations, is suboptimal.

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  10. I am watching this thing at the moment...It is mind boggling how much sense this man is making...Everything revolves around GDP, apparently, yet GDP is at best an extremely vague and fairly random indicator of mere activity, arguably quite detached from wealth creation... Must Watch

    http://www.youtube.com/watch?v=WQ9x1RiV6HI

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  11. The idea that living within your means is a form of austerity, and not (other than in exceptional circumstances) the elementary moral duty of people of honor, shows that, underlying the economic crisis is a profound moral crisis in western society

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    1. I have several responses to this.

      1) Why is the moral imperative to "live within your means" greater than the moral imperative to relieve and prevent poverty?

      2) "Living within your means" is meaningless for a democratic open economy. Yes, in theory governments can only spend what they can extract in taxes from their population. But it isn't that way round! Tax revenues depend on economic performance, which itself is influenced by government spending patterns. Trying to match government spending and income over a single budgetary cycle resembles alchemy and is about as successful, frankly.

      3) Government austerity can result in reduction of real incomes for the people of the country, which reduces government income forcing more austerity....this is the Eurozone death spiral in a nutshell.

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    2. The debt is not payable. Business leaders will convene and all taxes will be cut to around 0.

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    3. Also, relieving and preventing poverty requires means (of production, for example). Living outside the relevant means actually produces poverty!

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    4. Alister,

      Yes, in the LONG TERM government spending more than the production of the country can comfortably support through taxation would produce poverty. But over a budgetary cycle, or even over several budgetary cycles, that is not true.

      I'm not going to discuss your belief that taxes will be eliminated.

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    5. Here, here! But there is no one, single "budgetary cycle". It's a rolling show, never ending, always has been and always will be. Dividing time up into slices of varying length does not effect the general direction, or rather the velocity of an action(s). Also, this idea of a "country" invites confusion. Nation States don't really exist anymore. You have some rulers, sure, and they reference symbols like flags and particular buildings, ok, but there is no real "country"; just people.

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  12. It stands to reason that as rates continue to rise...entrepreneurs have a greater incentive to shuffle and hide the existing wealth...opposed to concentrating on creating new wealth...

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  13. Frances, An excellent analysis on this important subject. Thank you. However, perhaps you could take a look at the list at the bottom of this page (especially in regard to the US and UK entries). http://en.wikipedia.org/wiki/Sovereign_default#List_of_sovereign_debt_defaults_or_debt_restructuring

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  14. KeenFan

    The link to that page is in the post.

    Wikipedia has included in its definition of "sovereign default" devaluation of the currency used to pay trade deficits and/or reneging on trade obligations under a gold standard. Neither of these constitutes "sovereign default" in the sense that we would normally understand it, i.e. failure to meet obligations incurred through issuance of debt instruments. Neither the US nor the UK has ever defaulted on sovereign debt instruments, but both have reneged on international trade obligations and/or devalued trade currency on more than one occasion. I mentioned one occasion of each in the post - the UK in 1932 (I said 1931) and the US in 1971. Both were a consequence of abandoning the gold standard.

    We should, as always, be a little careful with Wikipedia. The citation for the defaults listed is the Ludwig Von Mises institute - hardly a supporter of fiat currency.

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