It only makes sense to compare ETF issuers to currency issuers if issuing currency is like issuing ETFs. In my other posts I assumed that to be the case. But perhaps that isn’t obvious. So the question becomes, what do ETFs and currency have in common that make one an appropriate model for the other?
The answer is that ETFs and currency are both examples of risk-free nominal assets. The language stems from philosophy where there are thought to be things and names, and the names are used to retrieve the things. So nominal assets are the names and real assets are the things that they retrieve. Just as it is unhelpful to have multiple names referring to the same thing, it is unhelpful to have too many nominal assets trying to make claim on a given pool of real assets. While interesting from an etymological point of view, it is not entirely accurate to think of nominal assets as names referring to specific things.
That is because in the real world, nominal assets normally claim a fraction of an entire pool of assets, rather than one specific asset out of the pool. One share of AAPL stock is a nominal asset, but it doesn’t claim a specific iphone sitting in inventory. Instead it is thought to claim a tiny sliver of EACH individual line item on the company balance sheet. So stocks are nominal assets that claim a fraction of the entire balance sheet of a firm like AAPL. But there is a fixed size pool of shares, and the value of the balance sheet fluctuates according to the p&l of the firm. This makes company stock a RISKY nominal asset. The risk comes from the fact that the quantity of shares is not tied to the value of the underlying balance sheet. The share quantity is fixed while the value of the balance sheet is allowed to float. This risk is not necessarily a bad thing. It is what allows for the possibility of price appreciation as the real assets on the balance sheet expand while the nominal assets remain fixed in supply. Without that, there would be no reason to invest.
Let’s compare this to an ETF. In this case the ETF shares are nominal assets, and balance sheet of the ETF are what those shares claim, just as AAPL shares are claims on the balance sheet of Apple Computer the firm. The ETF balance sheet contains company stock, which are risky nominal assets as discussed above. But as I explained in previous posts, the pool of ETF shares is allowed to expand and contract to keep it perfectly in line with the underlying balance sheet. The result is that the ETF itself is a risk-free nominal asset, meaning that the ETF shares always claim a specific quantity of the underlying basket. Please do not read me as saying there is no financial risk to ETF shareholders. It means that the ETF itself does not pose ADDITIONAL risk to the shareholder, beyond the risk that already exists in the underlying shares. The risk of the underlying shares is huge. This means you will not get a premium or discount on the underlying shares when you trade the ETF. This stands in contrast to trading company stock where you may have to pay too little or too much for the underlying value of the balance sheet.
Now let’s talk about currency. Like stocks and ETFs, currency are nominal assets. Their value is based on the fact that they can be used to claim a fraction of a pool of underlying assets known as the real economy or real wealth basket. It is simply incorrect to say that fiat currency is not backed by anything. It is backed by EVERYTHING for sale in that currency! The bigger the basket, the better the currency. And as the basket gets bigger and the currency gets better, people want more of it, and the issuer has to create more. That is why fiat currency issuers run deficits. It isn’t because they are irresponsible, it is because people love the currency and once they get it they don’t want to let go of it. But as I discussed previously, economists are generally in favor of restricting the growth of the currency supply. They do this is by allowing the labor market liquidity to fail. But while the growth of the currency supply is restricted, the real wealth basket keeps growing and growing. If more earnings were available, it could grow even more. The result is that the currency does not trade like an ETF for a fixed share of the basket. It trades like a risky stock! Whenever you buy or sell currency, you are likely to experience a premium or a discount to fair value for whatever you are trying to sell or buy. And if you are not able to wait for a fair price, you are probably going to end up selling at a discount and buying at a premium. This is because economists want to restrict the supply of currency where it should be allowed to float freely. The currency supply should expand or contract to exactly match the size of the real wealth basket.
So there is a general pattern here. Nominal assets are assets whose value depends on the ability of a holder to claim a portion of some other basket of assets. Nominal assets are risky if the quantity is fixed even while the underlying basket expands or contracts. And they are risk-free if the quantity of nominal assets floats to track the size of the underlying basket.
So stocks, ETFs, currency, mortgage loans, bitcoins, futures contracts, and gift cards are all examples of nominal assets. Rice, oil, cars, homes and office space are not. Out of the list of nominal assets, only ETFs, futures contracts and gift cards fit the definition of risk-free nominal assets. But futures contracts do not have a single issuer; anyone can be a seller of futures contracts and therefore an issuer. This makes it hard to talk about the appropriate strategy for a monopoly issuer. Gift cards don’t have a secondary market so it isn’t very interesting to discuss liquidity or stable pricing in that context. This makes ETFs a uniquely valuable analogy. Like currency, ETFs have a monopolist as the issuer and a stable, liquid secondary market.
But our currency, under the control of economists, is not truly a risk-free nominal asset because its quantity doesn’t reliably adjust to track the size of its underlying basket. On one hand, the currency is trying to appreciate as the basket grows faster than the supply of currency. But on the other hand, the lack of sufficient liquidity is keeping a lid on that expansion. When things get really bad, people take to the streets and we get a little net spending in response, but never enough to allow for sustained growth. Meanwhile, currency issuers continue to print free money (mostly for the wealthy who enjoy political influence) in the form of tax credits, subsidies, and interest payments which dilute the value of the currency over time. With this many crosscurrents in effect, the result is a pool of nominal assets that track the real wealth basket very poorly, and a currency that trades like volatile stock, not like an ETF with stable pricing and great liquidity.
The economy is not an ETF. But it is a pool of valuable assets undergoing expansion and possible contraction, like an ETF. The currency are not shares of an ETF, but they are a pool of nominal assets that act as claims on the real wealth basket. Therefore, if a stable valued and liquid currency is the goal, the quantity of currency must be allowed to float up when the basket expands and down when it contracts. And the strategy followed by ETF issuers is an appropriate model for making this happen.