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After ten years of preparations and several delays, China is launching its national emissions trading scheme this summer (at least that is what is expected as I write this…). In the European Union and in the UK, we have a carbon emissions trading scheme in place for the biggest polluters since 2005, so that now, only the United States is missing amongst the three major blocs of greenhouse gas emitters.

And while there are several smaller schemes in place in different regions of the United States, there is still substantial uncertainty if the country as a whole will put a mandatory price on carbon either in the form of an emissions trading scheme or a carbon tax. And that may be a problem.

Here in the UK, we have just come out of a period of five years of uncertainty about the implications of Brexit. And the uncertainty about the future terms of trade with the EU has caused significant problems for the economy already. The chart below is one that I have been using for the last year or so when talking about capital expenditures of UK businesses. It shows the investment in machinery and equipment together with the pre-Brexit trend. Once the referendum was held and it became clear that the UK would leave the EU, businesses held back additional investments because they didn’t know what the future relationship with the largest export partner would look like. They continued to maintain machinery and equipment, but growth was absent for five years. And to top it all off, in 2020 a massive pandemic hit. But at least now that the UK has left the EU, it is clear what the rules are and there is a substantial investment boom in the UK which is essentially a catch-up with five years of missed investments.

Investment in machinery and equipment in the UK

Source: ONS

And if you ask me – and the economists at the San Francisco Fed – the uncertainty around the price of carbon is holding back investment in the United States as well. If you are running a steel mill in the United States, or a cement factory, etc. the biggest unknown for you may be the possibility of having to pay a carbon tax in the future. Your company may be able to compete with foreign makers of steel and cement if there is no carbon tax, and it may even be able to compete if there is a low price of carbon of, say $20 or $40 per tonne. But it may not be able to compete if the price of carbon is $100 per tonne. Personally, I think the price of a tonne of carbon emissions should be around $100 per tonne, but the political reality is that it will be lower in practice, no matter which party is in charge in Washington. 

But the thousands of businesses that would be impacted by a carbon tax or a national emissions trading scheme don’t know what the price of carbon would be and when they would be subject to it. And given that uncertainty, projects that have too narrow a margin of safety will simply not be built and investments will be held back. And this means that by keeping businesses in limbo, the US is missing out on jobs and growth. Better to get on with it and follow the example of Europe and China where emissions trading schemes have if anything, caused domestic companies to become more efficient and productive and internationally more competitive.  

Before I begin with today’s post, please remember that on Friday’s I focus on quirky and weird results that are not meant to be taken seriously. But if you are a corporate executive or director of a company and can’t laugh about yourself, you shouldn’t read this one.

Okay, now that the people who have no sense of humour left, I want to show you a study that made me smile. There is growing evidence that there is a partial link between our genes and risk-taking in general. As I have described here, people with a specific genetic make-up of the Dopamine Receptor D4 gene take on 25% more risk in all kinds of risk tasks ranging from financial risk-taking to risky activities like para shooting or car racing. They are also more likely to become addicted to drugs and alcohol since they are constantly seeking the next thrill.

However, they are also more likely to become self-employed, entrepreneurs, or achieve high managerial positions in business. Risk-takers take on more risks (duh) in their profession and while many of them fail, there are some that will be successful, and they are rewarded with promotions.

Thus, when two researchers from Yale and Purdue University looked at the correlation between the genetic make-up of corporate managers, CEOs, and directors and other activities and skills, they found that these high achievers all were more likely to engage in riskier activities outside the boardroom. In fact, below is the list of traits that have the highest correlation with being a manager at a corporation. The factors that had the highest correlations were a tendency to speed while driving, drinking alcohol, having many sexual partners and a high metabolic rate (they are literally hot-blooded).

Correlation between being a manager and other activities and skills

Source: Lin and Zhao (2021). 

The above chart shows correlations for all kinds of managers, but what if we restrict the sample to CEOs and directors? Well, the same traits emerge, just this time speeding while driving, having more sexual partners and a high metabolic rate are even more pronounced than other traits.

Correlation between being a CEO or director and other activities and skills

Source: Lin and Zhao (2021). 

So, the next time you meet a sex-crazed, sports car-driving, drinking, and generally ill-tempered CEO, rest assured, he cannot help himself. He was born that way…

On Tuesday, I wrote about an experiment done by French and Russian researchers that showed that if short-termism becomes more common, then – at least in an artificial market – trends continue to last longer and momentum investing more profitable. One of the key concerns of momentum investing and trend following strategies is that they may lead to bubbles and crashes as longer trends create stocks that are severely mispriced relative to fundamentals. It turns out that the antidote to this risk may be greed. 

In another setup of their market, the researchers programmed some of the bots trading stocks to have another psychological bias. Instead of making them more short-term oriented, they made them greedier, investing more money into stocks that are forecast to have higher returns. Note that this forecast doesn’t necessarily have to be based on past price momentum. It could be based on fundamental valuation, volatility or other factors. The only thing greedy investors have in common is that no matter the investment approach they use, they invest heavily in those stocks that are forecast to be more profitable and ignore the ones that are forecast to be less profitable. The result of a market with more and more greedy investors was a decline in crashes and stock market bubbles, not an increase as one may have expected.

Number of market crashes (drop > 20%) if greedy traders increase from 0% (P=0) to 100% (P=100)

Source: Lussange et al. (2019)

This kind of behaviour can be observed in markets with human investors as well. In an experiment, people were invited to participate in an artificial stock market and trade with other people. Unbeknownst to them, the participants were sorted into low greed and high greed groups and ten experiments were run in each group. 

One fun side remark here is that it apparently is easy to find out who are the greedy people and who are not: Just ask them if they think they are greedy. If you calculate correlations between greedy behaviour in investments and everyday life with different questions, the questions “I always want more” and “Actually, I am kind of greedy” have the highest correlation with real-life behaviour. 

In any case, the experimental markets with human investors showed that prices deviated more from the fundamental value in markets with less greedy investors than in markets with greedy investors. The maximum size of the price bubbles observed in these markets was also higher for markets full of less greedy investors than in markets with greedy investors. 

Price bubbles and deviation from fundamentals with greedy and less greedy investors

Source: Hoyer et al. (2021)

One key to understanding the higher efficiency in markets with greedier investors is to look at market turnover. There, we see that markets with higher turnover tend to have more efficient prices and smaller deviations from fundamentals.

Market turnover and deviation from fundamentals with greedy and less greedy investors

Source: Hoyer et al. (2021)

What is happening here is that if investors are really greedy, they don’t stick with investments for too long; If they see a better opportunity elsewhere, they sell what they own and buy something else. Because we have a mix of fundamental investors and trend followers in the market, this means that if a stock becomes too detached from fundamentals, the trend followers will continue to buy that stock, but the fundamental investors will aggressively bet against it. That will slowly reduce the returns of that stocks and eventually reverse the previous trend. At this point, fundamental investors still bet aggressively against the stock because it is still overvalued, but momentum investors are switching sides and now bet against that stock, too. The result is that the stock quickly moves back towards fundamental value thanks to the greed of investors who want to make as much money as they can. 

Thus, there are circumstances when greed can be a force for good in investing. But remember that this experiment assumes that people with many different opinions are around who follow different strategies. And it assumes that there are different assets available. If you go into a market where there is only one asset or one type of asset and there are no substitutes (e.g. CDOs in the run-up to the financial crisis 2008) then you can be as greedy as you want to, you can only invest in one thing and that means you are forced to push the price of overvalued assets even higher. Similarly, if there is no difference in opinion (e.g. if all investors in a market are momentum investors because there is no fundamental value) then there will be no investors betting against trend followers and momentum investors and prices can deviate massively from whatever the fundamental value is and bubbles and crashes become more likely.

Greed can be good, but it depends on the circumstances.

In the first two parts of this series on Central Bank Digital Currencies (CBDC), I have focused on why central banks are looking into launching digital currencies and the trade-offs that have to be made to launch one. In this third part, I will look at the risks involved with a CBDC, focussing mostly on the risks for users.

From a technology perspective, there are two ways to prove that you rightfully own a unit of CBDC. You either have stored them in an account like a bank account or a crypto exchange, or you stored them in an e-wallet that contains the ‘anonymous’ private keys to the tokens of the CBDC (or any other cryptocurrency, for that matter).

The two basic forms of ownership of a CBDC

Source: BIS.

If CBDC are stored in an account, the distributor of the account (typically a commercial bank or a cryptocurrency exchange) needs to verify your identity before they can open the account. These KYC rules are designed to prevent money laundering, terrorism financing, etc. The big advantage of account-based ownership is that it reduces criminal activities and we by now know quite well how to effectively protect these accounts from hackers. Furthermore – and this is generally an underappreciated advantage – if an account owner forgets the password to the account, the money isn’t lost. Access to the account can be restored once the rightful owner has been identified beyond doubt.

But of course, the problem with account-based ownership of CBDC is that it is not anonymous and that especially in emerging markets, millions of people do not have access to banks. There are legitimate reasons, why people want or have to use physical cash as a medium of exchange and if we want to introduce CBDC as a true alternative (or substitute) of physical cash, there needs to be some form of privacy protection. 

This is where tokenisation comes in. Tokens are anonymous by design, and owners of these tokens prove their ownership by showing a private encryption key. In theory, these private keys can be stored anonymously on e-wallets. But as always, nothing is anonymous on the internet. Every transaction ever made with the token is recorded in the blockchain of cryptocurrencies and if one can link an encryption key with an individual, everything becomes traceable and identifiable. A couple of months ago, the FBI showed the world that it can trace Bitcoin and identify the owners of each Bitcoin. And if they can do it with sophisticated criminals that presumably are better at hiding their identities than most, then they can do it with everyone. 

Now, some crypto fans will say that there are zerocoins that are extensions of traditional cryptocurrencies designed to preserve anonymity. Well, you might not have heard, but in 2018 it was shown how these zerocoins can be hacked and destroyed. Hackers cannot steal the zerocoins, but they can definitely destroy them and thus cause enormous damage.

Finally, if we leave the privacy concerns behind, there are the usual security concerns of digital coins being stolen. The Bank of Canada has done a very good job of summarizing all the risks to a token-based CBDC. In essence, the problem is that criminals typically don’t know how much money is stored in individual wallets. Thus, they flock to the biggest pool of money and tend to focus their attacks on the largest cryptocurrency exchanges, the largest banks, or in the case of CBDC, the central bank itself. In particular state-sponsored hackers from countries like North Korea that have already successfully hacked into the central bank of Bangladesh in the past, will be targeting CBDC networks. 

The simplest way to steal CBDC would be to take over the majority of nodes in a distributed ledger which would allow the criminals to control all the tokens. This is a key reason, why CBDC will likely not use a public network but be restricted to a permissioned network of participating banks and institutions that are heavily regulated and have the means to protect their computers.

Even so, computing power constantly increases, and thus what appears unhackable today may not be unhackable in a few years. In fact, we are at the cusp of quantum computing becoming reality. Quantum computing would deliver a true revolution in computing power and enable us to perform calculations in a few minutes that currently would take hundreds or thousands of years. No cryptographic protocol currently in use in any digital currency could withstand quantum computing attacks. Thus, with the emergence of quantum computers, all digital currencies will immediately become unsafe (including any CBDC), or CBDC will need to be designed in such a way that they can be made ‘quantum safe’ in no time or that they will be ‘quantum safe’ by design. But making a digital currency ‘quantum safe’ will almost inevitably reduce the number of transactions that can be made per second and thus reduce its efficacy as a medium of exchange (see last week’s discussion).

But for now, quantum computing is science fiction, yet the key security gap for any CBDC already exists. It’s you.

I tell people that modern cryptographic protocols are so safe that I am not worried they will be hacked all the time to steal digital currencies. Criminals simply don’t need to go through all that hard work when the biggest security risk to digital currencies sits in front of the computer. E-wallets and accounts of cryptocurrencies and any CBDC will be owned by normal people and secured by passwords. And people use rubbish passwords all the time. Or they forget their passwords which is not so bad if they own an account with a bank, but if they forget the password to their e-wallet where all the highly secure cryptographic keys to their CBDC are stored, then, well, they are out of luck and have lost all their money forever.

People have told me that this is the same as carrying physical cash in a wallet and then having that wallet stolen by a pickpocket. And we accept that risk as well without complaining. Yes, but the analogy is not quite the same. If you go shopping in a mall with your physical cash in a wallet there may be one or two pickpockets around that will try to steal your wallet. If you use an e-wallet to pay on the internet it is as if you are walking in a shopping mall where every pickpocket in the entire world is hanging around, ready to steal your wallet given the opportunity. How likely do you think it is that your wallet will be stolen in that environment?

And this security risk is innate in every digital currency, and it means that no matter how the CBDC is designed, it will always be less secure than physical cash for a user because it can be stolen much more easily. It will be a security risk we will have to live with.

I started my career as a value investor but as people who know me for a long time (or who have followed these missives for a long time) I have become somewhat of a ‘lapsed value investor’. I still appreciate value investing but I have learned to love momentum over the years, something that so many traditional value investors refuse to do but that has helped me significantly improve my performance over the last decade. 

Momentum investing seems like the antithesis of value investing since value investing usually requires a lot of patience and a long investment horizon to exploit trend reversals while momentum investing tried to exploit the most recent trend for short-term gains. No wonder then that so many professional value investors also complain about how their clients and other investors have become so short-term oriented and impatient. There is no doubt that the rise of electronic trading and high-frequency trading (HFT) has led to a proliferation of short-term investment strategies, but it could be that this rise in short-term trading strategies has also led to the demise of value investing. It may be more than a coincidence that value investing became less successful after the financial crisis just when HFT increased its influence on market trading.

Of course, the fact that interest rates have been close to zero since the financial crisis is in my view still the most important driver for declining value investing returns, but an experiment by a group of researchers from Paris and Moscow showed that increased short-termism may have contributed to the decline of value investing as well. 

In their experiment, they created a series of bots that were equipped with machine learning algorithms to simulate real-life traders and investors. Some of these bots were chart technical investors following only price information, while others were fundamental investors following the valuation of stocks in a market. Both kinds of ‘investors’ learned from past actions through reinforcement learning algorithms (the standard learning mechanism in AI) and started with one strategy and but adjusted their investment strategy based on the profits and losses they made in the experimental market. Over time, they did more of the things that made them money in the past and less of the things that created losses.

The twist in this experiment was that all the bots also had a psychological make-up. In one of three experiments, some of the bots participating in the market were programmed to be more short-term oriented and overweight quick profits relative to long-term gains. What happened as a larger and larger share of market participants were programmed to be short-term oriented is instructive. It comes as no surprise that as a larger and larger share of bots was short-term oriented, transaction volumes in the market increased and bis ask spreads for stocks declined. The market simply became more liquid. 

Trading volume in experiment if short-term traders increase from 0% (P=0) to 100% (P=100)

Source: Lussange et al. (2019)

However, something else happened as well as more investors became more short-term oriented: Trends (both positive and negative) started to last longer. If more investors are short-term-oriented, they are looking for quick gains. And the best way to make a quick profit in markets is to bet that what has gone up will continue to go up. But if more investors act like that, this expectation becomes a self-fulfilling prophecy because more short-term investors buy stocks that have gone up and shun stocks that have gone down. The result is that trends last longer and momentum investing and trend-following becomes more profitable. And of course, since bots do more of what has made them money and less of what has lost them money, value investors slowly exit, and momentum investing starts to dominate the market. Over the last couple of years, more and more prominent value investors have closed their funds or retired. That is often seen as a sign that value investing must be due for a comeback, but if these experimental markets are a guide to real-life events, this might not be the case. Instead, value investing may be due for a permanent decline as markets become ever more short-term oriented.

Length of positive and negative trends in markets if short-term traders increase from 0% (p_0) to 100% (p_100)

Source: Lussange et al. (2019)

A little while ago, I was reading an article in the Texas Observer on Mexican politicians moving the bribes they collected to Texas and the United States. Ironically, when some of the middlemen became indicted, both the corrupt politicians and their middlemen argued that paying kickbacks (not bribes) was just normal business practice in Mexico. 

Which made me look up some research on bribery and its impact on business…

If you never have been in countries that are ripe with corruption then you might think paying bribes is criminal or at least unethical and should never be done. That is correct in theory and I do agree with you, but the real world isn’t so black and white. 

First, corruption is often a matter of definition. If you are paying a doctor in a third world country to get better treatment, it is called corruption. But if you pay an insurance company for private health care to get better treatment, it is called capitalism.

In the past, the wealth management industry was ripe with “corruption” because financial advisers were able to collect kickbacks for funds they recommended and sold to their clients. The result was that client portfolios were mostly populated not by cheap low cost funds but by active funds that paid the largest kickbacks. This practice has by now been outlawed in most developed countries or at the very least, wealth managers have to disclose the fees they collect from the funds and their clients have the right to claim these kickbacks for themselves. The result was another margin squeeze for wealth managers.

Similarly, before the introduction of MiFID, institutional investors typically paid for sell-side research via soft dollars, e.g. by routing trading to a specific broker. That is no longer possible and today, sell-side research has to be unbundled and priced separately.

In other places, such referral fees and soft dollar arrangements are still common.

And this is the crux with corruption (be it outright corruption of incentive fees). In the end it is lost money that does not end up in productive purposes.

An international study on the link between paying bribes and growing your business showed that the more money a business pays in bribes the more money it wastes and the lower the growth of the business. Businesses that pay fewer bribes and smaller bribes show systematically higher growth in the long run. 

But companies that refuse to pay bribes altogether show systematically lower growth than companies that pay bribes. Paying no bribes at all is not an option because it will end in a shutout of the business and risk the future of the business altogether. In the end, paying bribes literally becomes the cost of doing business because if you refuse, you will not do business and your employees will lose their jobs.

As a matter of practice, it is thus best for a company in a corrupt country to pay bribes but only as little as possible. 

I don’t like that conclusion, but I have to accept the reality of doing business in these countries. Obviously, the solution would be to fight corruption on a national level but let’s be honest, besides Greece, how many countries do you know that have successfully reduced corruption in the last decade? And Greece certainly didn’t fight corruption voluntarily…

In the world we live in we sometimes have to accept that companies act unethically in order to help people make a living and improve their lives. It’s a moral dilemma ingrained in ESG investing that I have no answer for.

One of the eternal questions to me is how much of our life is spent with useless and unproductive things. This is not to say that we should always be productive. There is a time for fun and my Friday posts are one such exercise in writing about economics and finance without it necessarily being useful. But what bugs me is if companies exploit their customers through unfair means. For example, I have written in the past that there are some experiments that show that Facebook and other social media sites are addictive like tobacco.

This obviously begs the question of how addictive they are and how much time is lost to us users succumbing to our social media addiction. In my previous post, the researchers tried to get to the bottom of it by asking people how much they would be willing to pay to get access to social media for a week or a month. Now, a group of researchers from Stanford University and Microsoft have done another set of experiments. They asked people if they think they are using social media and other apps too often and too much. And indeed, most people are aware that they use these apps too much. Asked about how much time they would spend doing other things if these apps weren’t readily available on their phones and computers, people expected that they would spend about 20% less time on Facebook, about 10% less time gaming, and about 5% less time with YouTube, Snapchat, Twitter, etc.

Then these people were restricted in their social media use for several weeks either by having a limiter installed on their phones that limits the amount of time they can spend or by being offered a bonus if they reduced their social media use below a certain number of hours per week. Note that even in the limiter case, users could decide themselves, what limit they wanted to set themselves and they could change that time limit daily, so it is not an enforced limit.

What happened afterward shed some light on how addictive social media apps are. First, people reduced their social media use substantially more than they expected when they were offered a limiter or a bonus. But once that restriction was removed again, they again underestimated how much they would reduce their social media use if they could. In other words, people are aware that they are using social media too much and they substantially reduce their usage if they are incentivised to do so. But they systematically underestimate the amount of excess use they have on social media. If that sounds like an alcoholic who is aware that he drinks too much but only by a little, or a smoker who is aware that smoking is bad he only smokes a few cigarettes a day, then this is no coincidence. It is classic addictive behaviour that is observed with social media.

And the experiments provide a hint at how much social media is due to addictive overuse. In the case of Facebook, about 20 minutes per day, or roughly 30% of daily use. Imagine what you could achieve in your life if you could reduce your time on social media by 30% each day. You wouldn’t miss out on any of the fun, and become more productive at the same time.

Reduction in social media use under self-imposed restrictions

Source: Allcott et al. (2021).

The Covid shock has been extraordinary in so many ways. It clearly has been the most severe shock to the revenues of companies in almost all sectors and can truly be called a black swan event. Especially in the leisure and retail sectors, companies had to cope with revenue declines of 30% or more and struggled to survive. Thank goodness, government and central banks acted swiftly and decisively to help many of these companies survive. 

But government support is running out in many countries in the next few months and we may not have seen all the fallout from the pandemic on the corporate front, yet. Nevertheless, both corporate executives and investors should use the coming months to assess how to deal with the next big shock to the system. Because this time, the government was there to help since it was a global shock that affected all of society, but next time, it could be a shock that affects only a specific industry or an individual company. And these shocks become more frequent across all industries. The chart below shows the share of companies in different sectors with revenue drops of 30% to 90% year-on-year (red) and 50% to 90% year-on-year (green).

Share of companies with extreme revenue drops

Source: Christie et al. (2021).

The chart is taken from a study of all companies in the Compustat database globally that investigated how many companies are subject to such extreme revenue shocks, which ones survive, and what drives the chance of survival. So here is the good news. The vast majority of companies (77%) that experience a revenue decline of more than 30% year-on-year survive. Only 23% of listed companies exit the market by being acquired, filing for bankruptcy, or other means. Of the 77% that survive, 44% show positive revenue growth the following year and 33% continue to experience declining revenues. But amongst those companies where revenues rebound the following year, the rebound tends to be weak. Only 13% experienced a strong rebound of 75% or more of lost revenue. 

Extreme revenue shocks are typically not a short-term phenomenon but the fallout stays with a company for a long time, even if it survives the direct hit.

The fate of companies after a revenue shock

Source: Christie et al. (2021)

From a corporate perspective, there are basically three ways to cope with such extreme shocks and survive both the immediate impact as well as the following years. A company can have enough cash and liquidity reserves, it can have a high equity capital ratio and increase borrowing, or it can change its operations and become more flexible and leaner.

And when it comes to these three levers, the historical evidence seems pretty clear cut. The only thing that helps a company survive these extreme revenue shocks is access to cash. Companies that either had lots of liquidity at hand or could tap into existing credit lines to increase their cash at hand were more likely to survive and recovered more quickly. 

Companies that had low financial leverage and a high equity capital ratio may want to borrow money to raise cash but once the revenue hit has come, banks and bond markets prove remarkably reluctant to extend any new credit to these companies. It’s the classic tale of banks willing to give a man an umbrella when the sun shines but asking for it to be returned when it starts to rain. 

That an abundance of equity capital does not increase the chance of survival and that cash at hand does should also be a warning to investors in private equity. LBOs and other private equity strategies rely on an increase in leverage to improve profitability and accelerate a return of cash to investors. But that makes these companies extremely vulnerable to adverse market shocks – more so than listed companies. In essence, many private equity firms optimise their holdings for a sunny day and reduce the resilience of their portfolio companies to a thunderstorm. 

Personally, I think this is what we will see in the aftermath of the pandemic as well. If I look at the publicly listed leisure companies in the UK, I find that so many of them are flush with cash. Many of them could survive a full year or more without any revenues. Meanwhile, so many restaurant chains and coffee shops owned by private equity firms had to enter into voluntary arrangements (the UK version of chapter 11 bankruptcy) because they simply didn’t have the liquidity to continue to operate and couldn’t get any new lines of credit.

But what about the third lever available to companies: Making the company leaner and increasing its operating flexibility. This is what so many private equity firms pride themselves on and what so many executives of listed companies try to do as flanking measures besides raising cash.

Well, it turns out that these efforts have hardly any impact on the chance of survival at all. In many cases, increasing operational flexibility takes a long time to achieve, often too long to be a meaningful help for a company struggling to survive. And making the company leaner aka cutting costs aka firing people has its own problems. Typically, it helps a company survive in the short run but reduces its ability to bounce back from the shock in the medium term. By firing lots of people, the company loses institutional knowledge and cuts into the very growth initiatives that could ensure a rebound after the crisis (often, “nice to have” growth projects are the first to face the chopping board in a crisis).

It’s not what managers learn in business school, but cutting costs is in the best case, useless and in the worst case puts a company on a path of continuous decline. Just look at companies like IAG, American Airlines, GM, US Steel, GE, Deutsche Bank, etc. Compared to their international peers and local challengers, they have cut their costs right into a bankruptcy or into market losers. 

Last week, I introduced the concept of retail Central Bank Digital Currencies (CBDC) and why central banks may want to issue them. In this part, I am going to look at the practical difficulties that CBDC must overcome. I will do this by looking at the three basic functions of cash, namely to act as a medium of exchange, a store of value, and a unit of accounting. Hopefully, by doing this, you will understand why it is so much harder to launch a CBDC than any run-of-the-mill cryptocurrency or electronic payment system and get an appreciation for what a genius invention physical cash really is.

Store of value vs. medium of exchange

When we think of physical cash, we immediately think of it as a store of value and a medium of exchange. Cash is worth the same tomorrow (at least nominally) as it is today, and I can readily buy things with it in a store.

The problem with CBDC is that they are electronic and the folks in Silicon Valley and big cities might not realise this, but there are a lot of people who cannot live without physical cash. In 2019 the Access to Cash Review concluded that 17% of the population in the UK need physical cash to live their lives. Having only electronic cash available to them would cause serious disruptions in their business or make it impossible for them to purchase the goods they need for daily life. And this is in one of the most developed countries in the world. Across the Euro Area (EA) and Japan, the use of physical cash is far more prevalent than in the UK or the United States as the chart below shows.

Share of retail transactions done with cash

Source: BIS

One key reason for this need for physical cash is that the IT and telecom infrastructure is not available to access modern electronic payment systems 24/7. And this is one of the key challenges for CBDC to overcome. A CBDC needs to be available 24/7 and cannot experience server outages or downtimes. This means that either there is an enormously robust IT infrastructure available everywhere (which would require billions in infrastructure investments even in the most developed countries), or the CBDC must be transferable and be usable as a method of exchange offline. The current thinking is that CBDC will likely be transferrable offline in limited amounts to enable its use as a method of exchange even in the absence of internet connections. 

But here is the rub. If you can transfer it offline, how do you make sure it is a valid transaction? Distributed ledger technologies that are at the heart of all cryptocurrencies are based on the proof of work or the proof of stake concept where a transaction is validated by calculations on computers that proof you are the rightful owner of a coin. If you don’t have a connection to a computer, how do you come up with a proof of work or proof of stake? This is why there will likely be limits to the amount of CBDC that can change hands before a proof of stake will become necessary. If the proof of stake fails, the transactions can be unwound without disrupting the overall payment system too much.

But here is the next difficulty. If you use distributed ledger technology as the foundation of a CBDC, you increase its security because the information about the CBDC and past transactions is stored on many computers and thus less prone to hacks and cyber-attacks. Yet, by distributing the information about the CBDC tokens (or coins) you also reduce the transaction speed. Payment systems that are handled by a central ledger like every credit card system, electronic payment systems, or bank accounts can handle tens of thousands of transactions per second. Bitcoin can handle only a handful. Progress is being made in enabling cryptocurrencies to perform more transactions, but we are nowhere near the number of transactions that need to be made for a currency to act as a universal replacement for physical cash. If you want to create a CBDC that is a universal method of exchange, you need to compromise its safety and thus reduce the trust people have in it as a store of value.

This tension between store of value and medium of exchange is nothing new, by the way. In the days of the gold standard, a central bank could only increase the amount of money in circulation if it had enough gold bullions in its safe. This meant that if cash became scarce (e.g. during a recession or a run on banks), central banks had to increase interest rates to incentivise people to put more gold into its safe so it could issue more cash to the public. This is one of the key reasons why the Great Depression turned out so bad. The moment the economy faced a liquidity crunch, the central bank had to reduce liquidity even more to protect its gold holdings. This is unfortunately something gold fetishists forget all too often. It is only with the introduction of fiat money and the end of the gold standard that we could start to manage recession better and prevent waves of default during every economic downturn. Look at the decline in economic activity and the spike in unemployment during economic downturns in the era of the gold standard and the years since and you will see what we have gained by abandoning it.

The current thinking is that with CBDC it is probably best to err on the side of enabling more transactions rather than making it an incredibly safe store of value. Probably the best way to strike a balance is the use of CBDC that are either based on a centralised ledger or a distributed ledger technology but with a limited number of permissioned participants in the distributed ledger. Most likely such a technology would use commercial banks that are regulated by the central bank as the nodes of a distributed ledger network.

Even so, if you have a generally accepted store of value that can handle many transactions per second, you suddenly run into another problem. If CBDC are proper stores of value like physical cash, they could be used like traditional bank accounts. People could transfer electronic money from their bank accounts into CBDC and store their wealth there. You may say that this surely isn’t a problem, since you can just go to your bank and ask to get all the money in your bank account paid out in cash and your bank teller will readily oblige. That may be true for you and me, but in practice, there are limits to how much physical cash you can hold. First, there are the obvious limits that physical cash takes up space and you need to store it safely (you can also opt to leave it out in the open, but then its characteristic as a store of value may be undermined by its extreme fungibility as other people will help themselves to your stored value). But even if you managed to build a massive safe and hire a couple of security people and armoured vehicles to transport the cash from your bank to your safe, try getting any large amounts paid out to you. Why do you think there are no ETFs backed by physical cash anywhere in the world? In theory, these ETFs would accept people’s electronic money and invest it into physical cash stored in a vault. It’s a remarkably simple concept and in a world of negative interest rates, it can become a profitable investment since the cost of safekeeping for these large amounts is a few basis points compared to the 40 basis points or so people have to pay on bank deposits in the Eurozone, for example.

So, if we accept that in practice, you cannot hold unlimited amounts of physical cash, but with CBDC, it is easily possible to accumulate enormous amounts in a few seconds or minutes, we have to think about how we can limit the amount of CBDC held by any individual. This means limiting the amount of CBDC that can be held in any one electronic wallet. But more than that, it means that central banks or commercial banks have to be able to identify many different electronic wallets that belong to the same owner because otherwise, we would quickly see a virtual run on banks where bank deposits would be raided and moved into CBDC wallets thus creating a universal financial crisis that would make 2008 look like child’s play. But if we want to be able to control how much CBDC any one user can own across many different electronic wallets, we have to be able to identify the owner of each wallet. And this means that CBDC is no longer anonymous, but ownership can be linked to an individual. It’s like having to sign every bill you get in the shop with your name and the shopkeeper notifying the central bank of the new owner of the bill.

Now assume we introduce such an identification mechanism (even if it is anonymised) and combine it with distributed ledger technology. This means that the ownership of every unit of CBDC is not only stored at a computer in the central bank but a copy of it is stored on every computer participating in the network. And if that computer gets hacked, it might not bring down the network, but it will expose ownership of the different CBDC units. To make things even more fun, the GDPR in Europe enshrined a right to be forgotten into law. But a blockchain-based distributed ledger technology doesn’t forget. One of the components that makes it so safe and trustworthy is that it has an eternal memory of all transactions ever made with an electronic coin. But if you ingrain that technology into a CBDC and only one person in the EU buys one of these coins, the GDPR becomes applicable and with it this person’s right to be forgotten. Now you go deal with all the privacy lawyers in the world to sort that one out.

Currently, the only way out of this misery is to rely on centralised ledgers owned by the central bank or use distributed ledgers with only commercial banks permitted as nodes after they have done a proper KYC on their clients. For emerging markets with millions of unbanked people, a distributed ledger technology is probably not feasible anyway due to the required infrastructure. so, in these countries, one would expect a CBDC to be based on one central ledger held by the central bank. But that still means that the central bank can see your identity. The Chinese efforts in developing a CBDC go down this route by allowing every user of the CBDC to control who can see their identity. This way, users of CBDC can remain anonymous with the exception of one counterparty: The People’s Bank of China will always know who each user is. This is necessary to run the ledger but of course, it potentially could prove to be a weak point if a central bank is not independent of the government and may be forced by governments to hand over identifying information about CBDC ownership.

Meanwhile, the ECB has experimented with ‘anonymity vouchers’ that allow users of CBDC to transfer ownership of a limited amount of currency over a limited amount of time without their identity being known to counterparties or the central bank. But the problem here is still that the vouchers themselves have to be monitored and audited, which opens up the possibility to identify the users of these vouchers.

Method of exchange vs. unit of accounting

By now you have probably thrown your hands into the air about the difficulties of CBDC and their prospects of replacing physical cash. But let me throw one more obstacle at you. Physical cash is a natural unit of accounting in a way that most electronic cash is not. If you go to PayPal, for example, and you deposit money on your account, it becomes part of PayPal’s balance sheet. This is fine most of the time, but as I have discussed here, it can become a massive problem if PayPal becomes illiquid or bankrupt. Then, your money becomes part of the insolvency proceedings and you become an unsecured creditor of PayPal. This is not the case with physical cash or central bank-issued electronic money. That stuff has to stay around even if the payment provider goes under. One natural way to roll out a CBDC is for the central bank to issue the currency to commercial banks just like they do at the moment with traditional money (both physical and electronic). These commercial banks then distribute the money through loans, etc. Because of the fractional reserve system, the amount of money distributed across the economy is a multiple of the actual central bank money created in the first place. Because CBDC would be a replacement for physical cash, we have to assume that to roll out the CBDC, the commercial banks would be the distributors. Then, either these commercial banks or third-party firms would develop technologies like payment systems and electronic wallets to enable people to use CBDC as a method of exchange. 

But these third-party firms that develop payment systems and electronic wallets can (and will) go bankrupt. And the CBDC has to be still in place after these companies have gone bankrupt. In fact, there has to be an easy mechanism to transfer CBDC from an insolvent payment provider to a solvent one in order to keep the financial system stable and avoid a run on banks.

But to do this, every payment provider needs to have separate accounts for its electronic cash and payments and for the CBDC so that it is straightforward to identify the CBDC if needed. That also means that every payment provider needs to know who owns which CBDC at any given point in time. Et voila, we are back to the privacy issue because now, all of a sudden, every CBDC coin has to be at least linked to a private key and ultimately an owner and that reduces privacy and makes it inferior to physical cash. I can already hear the cryptocurrency fans shouting at me that private keys for a token are anonymous, but these keys are either held in e-wallets or in accounts on crypto exchanges. Next week, I will talk about the security risks associated with these storage systems and why they may not be as anonymous as many people think.

If all of this feels like we are going in circles it’s because we are. The latest thinking is that CBDC will be less private than physical cash and that with the ownership of a CBDC coin will come an anonymised identifier of current ownership. This way, it is possible to track who owns the coins without identifying the person by name. Only once the person demands access to the CBDC can he or she show the identifier and proof of ownership. Nevertheless, the translation mechanism between the anonymous identifier and the name of the owner can be hacked and provides another security risk. But this is where we stop this week in order to pick it up next week to discuss the myriads of IT security issues with CBDC.

Let’s admit it, the financial industry pays investment professionals quite well and this is one reason why so many young people are attracted to the profession. It isn’t necessarily a passion for markets and investments and more the ability to make lots of money. Especially in bull markets these two things can very quickly become mixed up in the mind of young professionals. But in a bull market, it is easy to make money. It is only when things go wrong that you start to see who is really passionate and who is just trying to make money.

And you don’t need to wait until a bear market comes along to see who is passionate about markets. So many things can and do go wrong in investing that on an individual basis, things can go wrong for you but not others all the time. 2013 was my annus horribilis because I was long gold and short equities in a year when gold prices collapsed by 25% and the S&P 500 was up 25% over the same time. Not a good feeling, but by far not the only time I was wrong, just the most prominent one.

During such periods of disappointment, it is key to stay engaged and work on your performance, but this is when so many people who aren’t in it with their heart and soul tend to mentally check out or give up. And I don’t blame them. I had to learn to remain engaged myself over many years and even in 2013 when I had more than 10 years of professional experience as an investor, I got the occasional feeling of hopelessness. I had to force myself to change my approach to investing and learn from my mistakes. This learning process is hard. It takes something that not many people have: grit. Grit, or the ability to work hard and long towards a goal is a vital ingredient if you want to be a successful investor.

In my case, the hard work was to admit my mistakes and learn how to change my investment process to not make the same mistake again. 2013 was the year when I started to take stop losses and momentum seriously because one thing that cost me a lot of performance was that I clung to my investment positions for too long despite the market going against me. Temperamentally, I was never inclined to follow simple momentum strategies. I was trained as a value investor and am a natural contrarian. Momentum investing or the use of stop losses are both antithetical to these investment approaches. It took a lot of hard work and frustration to change my investment process to include momentum and stop losses into it, but it eventually paid out. My performance has become much better since then. 

But had I not been passionate about markets I might not have put up the hard work, but just stuck to my old ways. The next time I was sitting on a losing investment, I might not have cut my losses but let them run and this may have cost me dearly once again. And this is what grit does for you. It helps you not make the same mistake again and again but instead forces you to learn to cut your losses and move on.

Interestingly, this can be shown in lab experiments as William Bazley and his colleagues have done. They recruited a group of volunteers and split them into two groups. Half of all participants were randomly selected and asked to recall an instance in their life when they had to work hard to achieve something that they could be proud of. After this recall of a situation where they showed grit, they were asked to perform a few typical lab experiments to determine their disposition effect, i.e. their tendency to sell winners too soon and hold on to losing investments for too long. After the investment tasks were all done, they were asked to rate their personal grittiness to check if they were still in a mindset that was influenced by a notion of hard work. 

Meanwhile, the other half of the participants did no exercise in recalling past episodes of grit but engaged right away in the investment tasks.

The result was interesting. Comparing the people who were primed to think about grit and hard work did not hold on to their winning investments longer than people who weren’t primed to do so. But thinking about grit led to investors realising their losses faster and more frequently. Because they were primed to think about hard work, they were more likely to overcome the painful feeling of having to admit to themselves that they have been wrong. The result: In the lab experiment, the investors who were primed to think about grit ended up with 7% higher wealth at the end of the experiment than the control group. 

In other words, grit made them better investors by keeping them engaged in the face of adversity and avoiding bigger losses than necessary.

Propensity to sell winners and losers when primed about grit

Source: Bazley et al. (2021)

In November, COP26 will be the highlight of the year in terms of climate policy. The goal is to commit to further reductions in greenhouse gas emissions to reduce the harmful effects of climate change. In the first half of this year, we have already seen several nations (most prominently the US) commit to more ambitious reduction targets.

And throughout this year, investors who cared to pay attention could hardly take a break between all the announcements of companies committing to becoming net-zero by 2030, 2050, or any other year. This is good news, but the problem may lie in the three letters ‘n’, ‘e’, and ‘t’. Implicit in these net-zero goals is that one tonne of greenhouse gas emissions removed from the atmosphere counts as much as one tonne of greenhouse gas emissions released. In other words, the underlying assumption is that the climate is a linear function of the amount of greenhouse gases contained in it. 

This linearity may hold on the margin when we are talking about one person driving his or her car and emitting a couple of tons of CO2 and other greenhouse gases. But on a global scale, we are emitting thousands of tonnes every year and at that scale, it is unknown, if the reaction of the climate to greenhouse gas emissions is still linear.

In fact, a new article in Nature Climate Change hints that this might be a major flaw in our climate targets and in the actions taken to mitigate climate change. Using a climate model of medium complexity, the researchers looked at the reaction to shocks of different sizes and the long-term change in CO2 levels. It turned out that adding 100Gt of CO2 to the atmosphere has a bigger effect than removing 100Gt of CO2. The net effect is roughly 3% for a 100Gt shock but increases to 18% for a 500Gt shock. The chart below shows the difference in long-term CO2 concentrations for a 200Gt addition and a 200Gt reduction in CO2 as well as the net effect between the two which is slightly positive.

Effect of 200Gt shocks of CO2 to the atmosphere

Source: Zickfeld et al. (2021)

I know, every forecast is only as good as the model used to make it and these are model forecasts, but there might be good reasons for this asymmetric response. For example, we know that with higher CO2 concentrations in the atmosphere, trees and other plants grow faster and thus remove more CO2 from the atmosphere. But this CO2 fertilisation effect is nonlinear and declines for higher CO2 concentrations. If you have ever dealt with plants you know that fertilising them will help them grow, but above a certain level, more fertiliser just doesn’t give you any added benefits and if you increase the dosage even more, you might kill the plant. The same is true for CO2.

Also, the oceans are able to store enormous amounts of excess CO2 from the atmosphere. But this ability to absorb CO2 declines as the earth’s temperature and CO2 concentration rise. 

In summary, once we hit certain thresholds, we move beyond the famous tipping points and then need to extract even more CO2 from the atmosphere to reverse climate change than if we had never emitted this CO2 in the first place. 

As I said, so far all we have are model predictions, but if they are correct (and even the most rudimentary climate models from the 1980s have been able to predict CO2 concentrations in the atmosphere to a precision of 1% to 2% as we now know) then we might need to aim for even more ambitious goals than becoming net zero in 2050.

One of the things that still irritate me is the concept of casual Friday. First, it is very much an American invention. I grew up in Germany and lived for 21 years in Switzerland, two societies that are more formal than the UK or the US. Even worse, for most of my career, I worked in wealth management, which is more formal than investment banking and brokerage. 

Today, I have ditched the tie on most days even though it still irritates me to meet clients wearing a suit but no tie. But what I really will never ever comply with is casual Friday. It will be a cold day in hell before I show up in the office on a Friday wearing jeans and a shirt. And one reason for that is simply that my job involves a lot of analytical and abstract analysis and that gets worse if you wear casual clothing.

Wait what? I hear you say. Yes, there is an effect called enclothed cognition first described by Hajo Adam and Adam Galinsky in 2012. They asked a couple of students to perform an attention test. The trick about the test was that sometimes they had to perform the test in casual clothing, sometimes in a lab coat that was described to them as a doctor’s coat, and sometimes in a lab coat that was described to them as a painter’s coat. We all associate doctors with increased conscientiousness and greater attention to detail, so making people wear a lab coat described as a doctor’s coat forced them to take on the role of a doctor. As a result, the students that wore a doctor’s coat were better at the attention test and made fewer mistakes than students that were dressed casually. They literally paid more attention to the attention test because the clothes they wore made them act more conscientious. By the way, just putting a lab coat into the room without making the students wear it did not increase performance, and making students wear the lab coat but telling them it was a painter’s coat didn’t improve performance either. People had to be put into the position of a doctor by wearing what they believed to be a doctor’s coat to act differently.

Lab coats are one thing but wearing a suit or other formal clothing may be a different thing altogether, but that is not true. A different set of experiments showed that students who wore clothes that they ‘would wear at a job interview’ performed better at analytical tasks and abstract association tasks. Formal clothing puts you into a different mindset that is more professional and associated with different behaviour. And this leads to different behaviour in practice. Because I am a research analyst and professional investor, my job is full of data analysis tasks and abstract reasoning and these are exactly the tasks that get easier if you wear formal clothing. On the other hand, casual clothing is typically perceived as more relaxed and approachable, so if you have a job in sales a more casual outfit may be more advantageous for you because it reduces the social distance between you and your customer.

But I for one, will stick to formal clothing, and not wearing a tie is about as much of a compromise I will ever make in the office. And I can do that because I can compensate for the lack of formality of going tie-less by wearing more formal clothing that isn’t typically noticed by other people as more formal.

Cyber-attacks and cyber warfare have increasingly made the headlines this year. When I wrote my book on geopolitics for investors in 2019, I included a chapter on cyber warfare as a major threat for this decade that investors weren’t paying enough attention to. I didn’t expect to be proven right quite that fast. 

A new paper by Hélène Rey from the London Business School and her colleagues does two interesting things. Using text analysis, they go through earnings calls of companies around the world to analyse the discussion of cyber risks. And they use the trends in these discussions to try to predict how likely it is that a company will be the target of a cyber-attack in the future. Their methodology shows a weak ability to be able to predict future cyber-attacks, so I would say it is a good start but nothing ready for prime time, yet.

However, what is interesting to see is how cyber risks have spread and grown over the last few years. First, from 2010 to 2015, cyber risks were mostly targeted at US companies and there mostly at companies with high levels of intellectual property like IT companies or companies with lots of customer data. But by 2020 companies in all major countries have become targets of cyber-attacks and cyber risks have become relevant everywhere. Even companies in India and Brazil are now popular targets of cybercriminals.

Intensity of cyber risk by country 2020

Source: Jamilov et al. (2021)

The other interesting observation is how frequent discussions of cyber risks have become on company earnings calls. In 2013, less than 2% of earnings calls discussed cyber risks. By the end of 2020, that had increased to almost 5%. And if that sounds low, then remember that companies usually only discuss cyber risks for one of two reasons on their earnings calls. Either, they have been attacked or they have made major investments in IT to protect against these attacks. And if one in twenty earnings calls discusses these topics today, it means that the costs of cyber attacks (either to prevent them or the losses from them) have become a major factor.

Share of earnings calls that discuss cyber risks (%)

Source: Jamilov et al. (2021)

Some time ago, I was asked by a reader to write about Central Bank Digital Currencies (CBDC) and the latest thinking around this new form of payment/asset. And while I am on record as being sceptical about Bitcoin and other first-generation cryptocurrencies, I am quite optimistic that CBDC will become a reality and an important and possibly the dominant form of digital currency in the future. There is a lot of research going on in this field with 86% of all central banks surveyed by the BIS last year stating that they are engaged in CBDC work. That is up from 65% three years earlier. And let’s not forget that in 2020, the central bank of the Bahamas became the first one to issue retail CBDC.

However, there are so many things going on in the world of CBDC that it is impossible for me to summarise everything in one post. So, I came up with a series of four posts to explain the four key issues around CBDC. Starting with this one, every Wednesday, I will write about CBDC. In this first part, I will describe what I mean by CBDC and what the reasons are for a central bank to consider creating them. Next week, I will write about the operational challenges of CBDC as a replacement for physical cash and in part three about the risks of CBDC. In the final part, I will focus on the relationship between CBDC and physical cash and monetary policy. If you haven’t planned any vacation this summer, this should be something fun to look forward to.

What are CBDC?

To start with, let’s be clear that when I use the term CBDC I will mostly talk about retail CBDC, that is digital currency issued by a central bank, accepted as legal tender in a country, and widely available in public. There are also wholesale CBDC which are designed for special purposes like trade finance that I will ignore in this series. And then there are synthetic CBDC, i.e. digital currencies backed by central bank assets that could be issued by commercial banks or money market funds, in theory. The problem with synthetic CBDC is that they are unlikely to become legal tender while cash and CBDC are. And if you ask me what it means to be legal tender, I will not go into a lengthy discussion of the legal requirements and simply state that for all practical purposes, legal tender is everything that you can pay your taxes with. It is this status as legal tender and the fact that it is issued by a central bank that differentiates CBDC from other forms of electronic money and makes it a form of cash.

Difference between CBDC and other forms of digital and physical currency

Source: Kiff et al. (2020)

Why CBDCs?

But if CBDC are just a form of digital cash, why do central banks want to issue that in the first place? There are several reasons why CBDC might be a good idea:

• Financial stability: At the moment, we witness a proliferation of digital currencies. While the supply of any one digital currency like Bitcoin may be limited, there is absolutely no limit to how many digital currencies are created and put into circulation. I once read a story about a guy who wanted to create a cryptocurrency for cosmetic and plastic surgery… You may say that this “democratisation” of finance and money is a good thing, but I can assure you, it is possibly the most dangerous side effect of the current cryptocurrency boom. There is a good reason why central bank currencies were invented in the first place. If you study medieval Europe when every principality issued its own currency, you will quickly learn that trade and economic activity were severely hampered by this plethora of currencies. At every transaction, people had to look up the exchange rate between one currency and another, and the exchange rate varied over time and as a function of distance from the nearest bank who would accept it as a form of payment. Think about a world in which you would have the US Dollar, British Pounds, Euros, Romanian Leus, Mongolian Tögrögs and dozens of other currencies all used at the same time at the same shop. Good luck figuring out how much something costs and if you have been ripped off by the vendor.

  In fact, even with one single currency in place, the cost of paying with cash is much larger than most people are aware of. Studies have shown a cost of using physical cash to private businesses (mostly the retail sector and banks) of 0.2% of GDP in Norway and Australia, 0.5% of GDP in Canada, and 0.6% in Belgium. Creating a plethora of digital currencies competing with each other would increase these costs significantly and increase the risk of currency crashes within an economy and reduced financial stability. Thus, if you can’t avoid the rise of digital currencies, you at least can make sure they are designed and managed in the safest and cheapest way possible.

• Payment efficiency: The significant costs of payments performed with physical cash and other forms of payment may be reduced with digital currencies if they are fast enough to handle the thousands, if not millions of transactions per second that are done in cash every day. First-generation digital currencies are unable to handle these transaction volumes (another reason, why I think they are merely a gimmick), but central bank digital currencies are designed from the get-go as an efficient means of payment and would provide central banks more control over a crucial part of our financial infrastructure and thus further reduce risks of financial instability.

• Payment safety: Contrary to what private companies may want you to believe, it is in the best interest of businesses to spend as little on IT security as possible. IT is a crucial balancing act. Spend too little on IT security and your data will be stolen and you may even go out of business. Spend too much and your profit margins will shrink and your share price declines. Thus, for a private company, the incentive is to always spend as little as necessary to avoid major disasters. A central bank does not have these profitability concerns and only has to maximise the trust in its digital currency. Thus the incentive of a central bank is to spend as much on IT security as possible in order not to endanger a loss of trust by the public in CBDC.

• Antitrust: With the use of digital currencies comes the ability to collect an enormous amount of data on how people use the currency. Private companies can use this data to sell it to advertisers and other businesses (see Google or Facebook). Furthermore, if a company is big enough, it can effectively prevent any competition from rising due to its market power (see here for a discussion). 

• Financial inclusion: This is arguably not a big issue in developed markets as can be seen in the chart below, but in emerging markets, there are often millions of unbanked citizens and people who are unable to even get access to a bank. The success of electronic payment systems like PayTM in India shows that with the help of digital currencies, millions of people could get easy access to money.

• Monetary policy implementation: Finally, many central banks think about CBDC as a means to enhance the implementation and effectiveness of monetary policy. This is such a wide-ranging and (in developed markets) important topic, that part 4 of this series will entirely be dedicated to this topic.

The reasons for CBDC

Source: BIS

Much has been said about the decline of the value premium in stock markets. For at least a decade now, value investors have had a terrible time and the resurgence of value stocks this year has been pretty mild in the United States, though much stronger in the UK, for example. 

But the question if value is dead is one that still haunts us and when it comes to US stock markets (but not the UK or Europe), so does the question if small-cap stocks really earn a premium.

In this respect, I like the approach by Simon Smith and Allan Timmermann who looked at 23,000 US stocks from 1950 to 2018 and calculated not just the risk premium for value stocks, small-cap stocks, and other factors over time, but also tried to identify breakpoints in the performance of these stocks. The chart below shows the identified breakpoints for risk premia since 1970. The four “regime changes” happened at the oil price shock in 1972 that triggered the high inflation era of the 1970s, the change in monetary policy by the Fed in 1981 and the switch to interest rate and inflation targeting under Volcker, the crash of the tech bubble in 2001 and the financial crisis and introduction of zero interest rates in 2008.

Ex post identified breakpoints in stock markets

Source: Smith and Timmermann (2020)

How momentous these events would be for stock markets and investment styles like small-cap or value investing would only become clear years after the fact, but they significantly changed the risk premia earned with these styles as shown in the chat below.

Change in risk premia of different risk factors

Source: Smith and Timmermann (2020)

The risk premium due to equity market risk (the famous beta of the CAPM model) has basically disappeared since the Fed changed its monetary policy to focus more on inflation and stabilising the economy. And where there is less economic volatility, there is less systematic volatility in share prices and the equity premium disappears. The equity premium got a revival between 2000 and 2010 but that turned out to be short-lived.

The value premium, meanwhile, has lost more and more of its appeal with every breakpoint. Less inflation in the 1980s reduced the value premium. Even after the tech bubble burst, the outperformance of value was not so much due to a resurgent value premium but more to a resurgence of other risk factors that overlapped with the value premium. But ever since central banks have introduced zero interest rates and QE, the value premium has definitely disappeared.

Small-cap stocks, meanwhile have stopped outperforming pretty much the moment the size premium was documented by researchers in the late 1970s. IT seems that more macroeconomic stability introduced by the changed Fed policies in the early 1980s has led to a shrinking premium for small-cap stocks in the United States since small-cap stocks are typically more sensitive to economic swings. 

Instead, what has increased over time is the momentum premium. Markets have started to trend more and these trends have lasted longer and longer, giving momentum approaches to investing an edge and increasing performance.

Of course, the problem with this entire analysis is that we just had another massive shock to the system in the form of a pandemic. We will only know in a couple of years if this has triggered another change in market dynamics and risk premia for value, momentum, and small-cap stocks. In my view, the best way to invest is to assume that there was no break in market regime, simply because, as I have explained in my 10 rules for forecasting, as an investor, it is never a good idea to assume massive changes or extreme outcomes. It is tempting to listen to all the people who claim that the world has changed and we are now entering a new era, but in reality, the world changes less than we want to believe and for investment performance, it is usually better to assume that things haven’t changed all that much after all. To me, this means that while I am optimistic for value stocks in the short term (i.e. over the next 12 to 24 months), I don’t see a bright future for value in the long run.

By now we know that investors in sustainable equity funds are somewhat different from investors in traditional equity funds. For example, the sustainable funds with the highest ratings attracted inflows from investors at the height of the pandemic while conventional funds suffered heavy outflows. Investors in sustainable investments are also willing to pay more for these investment products even if they have somewhat lower returns. In short, the money invested in sustainable equities is stickier and more forgiving of short-term underperformance.

And that is a good thing, especially, if we think about saving for retirement and other long-term goals where one of the key problems for financial advisers is that their investors don’t always stick to their investment plans during the hard times of a recession or a bear market.

What sustainable investments provide investors is a form of expressive value as they call it in the literature. In plain English: Investors are proud to be invested in sustainable funds (or more so than in traditional funds) and can brag about their investments at the golf club.

I am normally not a fan of investments with bragging rights because most of the time these investments are often fashionable bubbly investments that don’t have particularly attractive long-term return prospects. Or they are outright fraudulent investments like the funds of Bernard Madoff. But as I said, I don’t think that sustainable investing is a fad or something that has necessarily lower returns than conventional equities.

And now, it seems I have come across another positive effect of sustainable investments. They seem to entice people to put more of their retirement nest egg into equities and thus create larger retirement nest eggs in the long run. A study of 913,000 French employees with investments in more than 6,500 pension funds showed that the introduction of sustainable funds as possible investments in pension funds in 2017 had some significant impact on the portfolios of the insured. On average across all employees, the equity allocation in their retirement savings rose from 12.1% to 14.2% a 17% relative increase. And lest you are surprised about the low level of equity allocations in French pension plans, welcome to the world outside the Anglo-Saxon equity investment culture. In countries like France, Germany, or Italy, these kinds of allocations are pretty normal.

But going back to the 2.1 percentage point increase in equity allocations, the study showed that this was almost entirely due to the increase in sustainable equity funds. The introduction of new traditional equity funds to a pension plan did not change the appetite for equities much, but when a sustainable option was introduced to the plan, the appetite for equity investments in the affected plans rose by 7.2%. And when you save for thirty to forty years in your pension plan, that makes a huge difference in the size of your nest egg.

Ironically, in the United States, the country of equity worship, the Department of Labor has introduced new rules that prevent pension plans from considering anything but financial criteria when selecting investment options. And while there are reasonable objections to some ESG investments as misleading and effectively greenwashed, the new rule may lead to worse outcomes for the insured because they simply don’t invest as much in these plans as they otherwise would.

Football is a funny game. It is a team game, so superstar players like Lionel Messi or Christiano Ronaldo can’t win championships on their own. Yet, while “money doesn’t score goals” the teams with high-class superstar players like Real Madrid and Bayern Munich constantly win not only the trophies at home but also the trophies at the European level. This is obviously what drives many second-rate teams to invest in individual superstar players to improve the team. Yet, the track record of clubs with these individual superstars and a mediocre rest of the team is pretty bad. Meanwhile, there are the occasional no-name teams that work so well together that they win championships. Just think of Leicester FC winning the Premier League in 2016 or FC Kaiserslautern winning the Bundesliga in 1998 after being newly promoted to the highest tier in German Football.

In essence, it seems that in football a team has to be pretty balanced to be successful. Too much of a difference between the superstar and the rest of the team and the team fails. Nowhere is this easier to see than on the national level where players cannot be bought or sold. Teams like the Italian national football team of today and many of their best teams in the past tend to be void of global superstars but have a range of players that are all world-class. Similarly, the Spanish team that won everything from 2008 to 2012 were full of world-class players without an individual superstar. Meanwhile, Neymar as the lone superstar in the Brazilian team or Ibrahimovic in Sweden didn’t do them any favour and these teams were often better without their superstar than with him.

According to a study amongst chess players, this superstar effect is pretty universal and rooted in the psychology of social interactions. The study looked at the individual performance of chess players when they faced a superstar player like Magnus Carlson or Gary Kasparov. In theory, there are two ways a player can handle the superstar. Either he is intimidated and employs less effort and hence plays worse, thinking that the opponent is so good he has no chance of winning anyway. Or the weaker player uses the superstar as an inspiration to get better and improve his game.

It turns out that the direct effect of the superstar is always negative. When facing a superstar opponent, all players played worse and exert less effort. And when they have a superstar on their team, players exert less effort because they expect the superstar to take care of it.

On the other hand, the secondary effect of a superstar player can be positive or negative. If the skill gap between the superstar is small, the weaker players can see that with some effort they can get on that level and they exert more effort and get better over time. If the skill gap is too large, however, they give up and simply get demoralised and do a worse job.

The lesson should be clear if you are trying to build a team of fund managers, analysts, or whatever team you are building in your business. Try to build a team like Chelsea FC, Manchester City or the Italian national football team where all the players are world-class and none of them is the standout global superstar. If you can’t do that (because who has the money that Manchester City has?), try to build a team of people with relatively equal skill sets and use the ones with the slightly higher skill sets than the rest as leaders to train the group and get them on a higher level. This way, you are creating something like Leicester FC. A team without stars that consistently plays above its level where the sum of the parts creates something bigger.

But please, don’t build a team like the Brazilian national team with Neymar or Manchester United with Wayne Rooney. A team where one superstar is above everyone else and thus the team doesn’t play as a team but just expects the star to take care of everything or get the glory for any successes, deservedly or not. That is a recipe for failure.

The other day I wrote about new research from the IMF that showed that in the Eurozone at least, government spending was far more effective in an environment when real interest rates were lower than real potential GDP growth (i.e. r-g<0). The chart below summarises the results of that research. In an environment where interest rates are low compared to growth, businesses and households have little incentive to save and at the same time grasp that the government may not have to enact austerity measures to pay for higher deficits. And the longer such a low-interest rate environment persists, the more effective government spending becomes, because fewer and fewer people hold on to their money to save for potentially higher taxes in the future.

Fiscal multiplier depending on the level of interest rates vs. growth

Source: IMF

This is great news because it shows that the recent government spending measures to get us out of the recession of 2020 were highly effective and have definitely helped to speed up the recovery.

But there is a flip side to this story. We know that once an economy is back to full capacity any additional growth will trigger labour shortages and thus higher wages. And it may also trigger excess demand for raw materials that cannot be matched by the existing supply. The result is, of course, higher inflation. And this is where the chat above becomes a bit disconcerting. Because the fiscal multiplier of government spending doesn’t decrease over time, but instead slightly increases, any government spending in years 3, 4, 5, etc. will become even more effective. But typically, in years 3, 4, or 5 after a recession, the economy is already back to full capacity. Currently, economists expect the US and UK economies to fully recover from the pandemic lows by late 2021 and in the Eurozone in 2022. Any additional government spending beyond that point will push inflation higher. And that includes the fiscal spending that was part of the pandemic rescue packages enacted in 2020 and 2021 but scheduled to be spent only in later years.

Is that going to be enough to create high inflation for years to come or even a runaway inflation scenario like the 1970s? No. According to my calculations, the government spending enacted so far should lead to somewhat higher but not worrisome inflation. In the United States and the UK inflation may in the long run level off at 2.5% instead of 2%, while in the Eurozone, inflation may level off around 2% instead of 1.5%. And that assumes that central banks just sit on the sideline and do nothing. But they are of course already toying with the idea of tapering asset purchases and guiding the market to interest rate hikes in 2023 or potentially sooner. And I am pretty sure, that if they see inflation remain high for too long, they will accelerate their rate hikes and help push inflation lower. But they will also be happy to let inflation run slightly above 2% for a while, so realistically, we should probably expect inflation to run above 2% in the next five years or so, but not by much.

It is common knowledge among economists though not always with investors that fiscal stimulus is more effective when the economy is in recession than when it is growing. The fiscal multiplier that measures the change in GDP for every dollar spent by the government tends to be below 1 in boom times and above 1 in recessions. In other words, additional government spending in boom times tends to be a wasteful exercise where some of the government spending does not enhance economic growth. But in a recession, government spending significantly boosts economic growth and accelerates the recovery from the depths of the recession. That is why I am very much in favour of the government stimulus programmes enacted during the pandemic. Governments were doing the right thing at the right time.

But a new study by the IMF indicates that the fiscal multiplier of government spending may not only be higher than normal during a recession but also in boom times when economic growth is larger than the level of interest rates. Looking at 10 countries in the Eurozone, they estimated fiscal multipliers for two different regimes. Instead of the usual recession/boom split, they used the difference between real short-term interest rates and real potential economic growth (the famous r-g) as a differentiating factor.

If the real interest rate is lower than the real potential economic growth (i.e. r-g<0) then additional fiscal spending may lead to additional budget deficits, but because growth exceeds real interest rates, there might not be the need to increase government revenues (read ‘taxes’) in the future to pay for today’s spending spree. Higher growth, in this case, may lead to higher tax revenues that outpace the higher interest expenses from the additional spending. Note, that in the Eurozone, we have been in this regime since the financial crisis of 2008 and in the United States and the UK, we are currently definitely in this regime.

If, on the other hand, real interest rates are higher than real potential growth, additional spending causes a larger increase in interest cost than can be made up by higher tax income from higher growth. In this case, it is pretty likely that at some point in the future, the government will have to increase revenues to pay for the spending of today. This is the regime that the United States, the UK, and Europe were in throughout much of the post-WW2 period and it is what still determines the mental models of many investors.

Businesses and households who understand that the government cannot spend forever, but at some point, have to pay for its debt will take that into account when deciding how much money to save or spend. And if they think that the government will eventually have to increase taxes to pay for current spending (i.e. the second case of r-g>0) then they will ever so slightly increase their savings and reduce consumption and investments. The result is that government spending to incentivise businesses to invest or to incentivise consumers to spend may be less effective.

But in an environment when interest rates are low (i.e. the case of r-g<0 prevalent today), businesses and consumers are less incentivised to save and at the same time less reluctant to spend because they grasp that governments can afford to spend more due to lower cost of debt. So why save some of your income to pay for higher taxes that may never come?

The result is that in a low-interest rate environment, fiscal multipliers for government spending are not only larger than 1, but they tend to grow larger over time. In other words, as more and more people realise that the government won’t need to enact austerity measures to rein in debt, they start to spend and invest more and more, thus making government incentives like child tax credits, government grants for research and development or government infrastructure investments even more effective and powerful. At least in the Eurozone, where we now have ten years of experience, this is what happened and it seems likely to me that a similar effect will take hold in the UK and the United States in coming years.

Fiscal multiplier depending on the level of interest rates vs. growth

Source: IMF

It is well known that once we own something, we are inclined to value it more than someone who doesn’t own it. This endowment effect is most at play when it comes to the housing market where homeowners systematically overestimate how much their house is worth in the eyes of a potential buyer.

But that endowment effect doesn’t always go in one direction. In fact, it tends to work only for assets that have increased in value. If we are confronted with losses, we tend to experience a “negative endowment effect” in the sense that something that has caused us pain in the form of losses seems worth less to us than to a more neutral outsider.

Take my recent experience with a new car we bought last year. I won’t mention the brand, but it was my first full-electric car, and I was proud to own it and thought it drove really well. For about seven months, both my wife and I were promoting the car to friends until one day, my wife had a catastrophic breakdown on her way to work. It had nothing to do with the battery or the electric drivetrain. Instead, a bearing on the rear axle broke, and essentially the car’s axle broke down completely. I will spare you the details of my arguments with the manufacturer and the garage, but the most likely thing that happened was that we bought a lemon with a one-off manufacturing flaw. But one thing I can assure you is that whenever I talk to my friends about my car these days, I make sure to tell them what a piece of crap it is and that I will never buy a car from that brand again.

Funnily, enough, something similar seems to work for assets that we own and that have made a profit or a loss. The chart below shows the beliefs about the quality of an asset in the eyes of people who own the asset vs. people who don’t own the asset and the return of the asset. As you can see, if the asset had a positive return, owners think that it is of higher quality than non-owners. But if the asset has a negative return, owners think it is worse than non-owners do.

Beliefs about the quality of a good

Source: Hartzmark et al. (2020)

According to the study, what happens is that once we own an asset, we are paying more attention to the news flow around that asset. I bet every reader will know more about the stocks they own and the recent company news around these stocks than about stocks they don’t own. But this focus on the news of assets we own creates a bias in our memory. The more we focus on news on specific assets, the easier it is to recall it from memory. And this recency effect of memory recall creates a tendency to extrapolate recent performance into the future. So, we start to be biased about our assets in a very systematic way and become “mental momentum investors” thinking that a streak of positive news has to continue as does a streak of recent negative news. 

And how do you combat this kind of emerging bias due to ownership, you ask? I don’t really know. My experience as a practitioner is that one way to become less passionate and “invested” in an asset or a position is to pay less attention to it. This doesn’t mean ignoring it, but there is typically no need to follow the news on your stocks every day. If you are a long-term investor (e.g. you are saving for retirement or are a university endowment) then looking at the news flow every quarter as the company reports earnings etc. is probably enough. If you are a trader, then looking at the news flow on a daily basis is probably necessary. But what to do if you are a fund manager? My experience is that most fund managers are too obsessed with the day-to-day news flow and would be better served if they look at the news only once a week or so. This way you still get the key trends but are not distracted by the noise. And don’t worry, you will not miss the really important stuff. Because even if you don’t read the news at all, you can be sure that if something really important happens, people will alert you to it because they are getting scared. And being somewhat removed from the daily news flow will automatically allow you to remain calm and collected when others panic.