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A conversation exploring topics from Aaron Segal's "The Revenge Of The Nodes", such as decentralization, declining fiat credit quality, and Bitcoin as pristine collateral.

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[00:00:08] CK: What is up everyone? Welcome to this amazing space. We're going to be talking with two legends, Aaron S and Greg Foss. Aaron, Row and has been discussing ideas around how our current market is primed for centralization, and how Bitcoin can be an opposing force to that.

Before we get into the conversation, I want to let you guys know about two things that Bitcoin Magazine was doing. First is, we just released a print magazine; the first print mag we've done in almost two years. That is available for pre order in the US via subscription right now on our store. By the end of the week, we will be having a BTC version, so you can purchase with BTC and ship internationally. The international and BTC payments are coming, I promise. For now, go to Bitcoin Magazine’s Twitter. There's a discount code plastered all over there. Get your discount on your US subscription to this amazing print magazine. You won't be disappointed.

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That's enough for me. Aaron, Greg, thanks for the patience. Aaron, I guess, why don't you introduce yourself really quick, and I'm going to go find your article and pin it to the top?

[00:02:17] AS: Hey, everybody. Thanks for taking the time to listen to this. CK, Bitcoin Magazine and Greg, thanks for all being here. Yeah. By way of just quick background, my experience and the lens that I guess I look at Bitcoin from is colored by my work experience, which is I've been in the hedge fund industry for around 16 years. Macro-hedge funds, equities. In more recent years, I've been doing a lot in the credit markets, and that's one area where Greg and I have overlapped a lot, and we've talked a good amount offline about the craziness in that market.

The way I approached this article, I've written a bunch for Bitcoin Magazine, my lens, again, is financial, but at the end of the day, all of these issues come down to philosophy and they come down to the ability to take what's going on in in financial markets, and distill it down in a lens that arrives where the incentives are. In the article I talk a lot about, I get to this point about a path of least resistance.

My initial mentor, speaking of background in my industry, was a guy by the name of Marty Zweig. He was a big hedge fund guy back in the 70s, 80s and 90s. He passed away a few years back, but he actually is the guy who coined the phrase that I'm sure everybody in this room by now knows, which is called, “Don't fight the Fed.” That was my initiation into the insanity of the Fed.

By the way, this was way back before all of the insanity that we've all witnessed in the last 15 years. The reason I bring up that as part of this introduction is because, it was just a simple axiom. It followed the very simple idea of path of least resistance. When I started to think about Bitcoin’s main killer attribute, which I think most people probably in this room would agree is decentralization. We've all gone down our rabbit holes, and we all have probably entered Bitcoin and had our own aha moments from various different perspectives in various different ways.

I think for me, decentralization is always, every time I tried to pinpoint what made Bitcoin so anti-fragile and so unique, and decentralization is a word that we throw around a lot. If you really think about how unique something that is truly decentralized is, like there are very few examples. Certainly, there are no examples in the economic realm, but there are certainly almost no examples in the natural world either, in current times, at least, that we can pinpoint something that's truly decentralized.

If something is truly decentralized, it can't be centralized. Otherwise, it's not truly decentralized. If it can't be it centralized, and getting back to what I'm seeing in the financial markets is more and more centralization, both politically and from capital markets’ perspective, then you have something that is operating completely exogenous to the system, and to a system that is getting bigger and bigger and bigger.

Yet, as we all know, Bitcoin is getting bigger and bigger and bigger. It's almost in a parallel universe. That led me to this notion, this dichotomy of what we're seeing, as the title says, this is the battle of the 21st century. We will see more and more centralization, and there's only one antidote. That antidote has to come from outside. In Guy’s take as you read the article, as Guy Swann or the article that is part of Bitcoin Audible, he really emphasized this part, because decentralization is something that he talks about all the time. The reason he emphasized that has to come from outside, is because if it comes from within, it is vulnerable to all the things that centralization touches.

I don't want to take too much time up with this introduction. We can get into the details. That's really the way I implore everyone to start thinking about things. I do stress that dichotomies and trying to really just boil things into this black and white binary situation are often over-simplified. That's why the article is so long, by the way. Because if I were to come out and say, “The world is centralizing. Bitcoin is decentralization by Bitcoin. See you later.” There would be nothing unique to that, first of all, and it would also be a lot of skepticism. There's still, of course, going to be tons of skepticism.

I really wanted to break it down by first principles. I did that, of course, since what I do for a living is in finance, as a macro investor, of course, that's the way in which I see the world. I'm sure, I'd love to see someone else come to the same conclusion from a completely different approach, which I'm sure is equally plausible. I had to do it by first principles deduction. That's why I call it the Socratic question. I took it through [inaudible 00:06:56] conjecture that he said offhandedly, at one point. Then, I see him tweet about it all the time, which is that we had an agrarian society in the 1800s, we had the proletariat workers, industrial workers society, laborer in the 1900s. Now, we have this investor class.

He said, I don't have my own article in front of me, so I'm probably going to misquote what he exactly said. To paraphrase, he basically said, that when people realize that money is abundant, everyone will become an investor. That is just based off incentives. He's not even talking about a system that is actively seeking that in a government and a policy tool that will actually try to incentivize that even further. That's where I take this to the next step.

The reason I use that statement is because it's an amazing jumping off point. Then from there, we can go step by step to see how this is not only just happening. There's empirical data all around this, that shows that this is happening, but also where this has to lead. That's where you get back to this binary aspect, because it is binary. It really is at the end of the day.

I don't say that haphazardly. I'm not hyperbolic. Like I said, I'm an investor. I initially came into Bitcoin to make money. I was invested heavily in gold, and I saw that gold was not performing the way it should be. I said, “Okay, I dipped my toes into Bitcoin in prior years, but never really gave it a lot of full attention.” I said, “Okay, I need to understand my competition, so to speak.” I'm a gold investor, I need to understand, okay, Bitcoin seems to be taking some mindset share, some market share. What's going on here?

I had a lot of friends who are more heavily involved, and they pointed me in the right direction. Then, I had my aha moment. I sold everything I owned a gold very, very quickly, and moved on to Bitcoin. The reason is because of this binary nature. Gold is centralized, basically. When you go from first principles, and you take this down, step by step, you see where it has to lead. With that, and CK, I know that was long-winded, and I'm not wanting to be short-winded, I should say, so I'll leave it back to you.

[00:09:09] CK: Yeah. Apparently, Greg can't hear me. Eli, can you make me not a co-host? Or actually, I might rescind my co- host ship. Aaron, why don't you ask Greg to introduce himself?

[00:09:21] AS: Hey, Greg. Well, I assume that you don't need too much of an introduction for this audience. Please, if you can hear me, go ahead and take the stage and introduce yourself.

[00:09:29] GF: Hi, guys. Thanks, Aaron. Yeah, I've had this problem before with Spaces. It's interesting. I have something to do with a co-host and I can't hear them. Sorry, Christian, if I couldn't hear you. We'll figure it out. I may have to sign on and off. For now, let's just keep it this way. Thanks for having me, everyone, and Bitcoin Magazine.

I spoke earlier. Aaron, I just want to compliment you on your research, your paper, your thought process and a couple of things that line up with my thinking. It's easier to think in things of binary outcomes, and I like the way you're talking there. In your paper, you talk about the suppression of volatility. That's exactly true from everything I've seen. The Fed essentially tried to suppress volatility by putting a backstop on high-yield bonds.

This past credit crisis, when the Fed for the first time in history said that they would open their portfolio to be able to buy high-yield bonds, that was a very simple exercise in trying to suppress volatility, because if some of you have listened to me before, I believe most volatility emanates from the credit markets. Lots of interesting things to discuss. I too, have spent 30 odd years trading risk. I love the fact that Aaron was able to see that his gold thesis was perhaps, leaking a little water and needed to make a very substantial change in his portfolio. I applaud you.

Certainly, there's other gold investors out there that are getting the – understanding the same thing. I call out specifically, Lawrence Leppard, a good friend of mine that I've met online on Twitter, but also at several conferences. He is really, really pounding the table on the fact that gold investors and Bitcoin investors understand the same first principles. It's just about what race horse you bet on. Yeah, I'm here to learn and participate and certainly to add value where I can forr your thought-provoking paper. Thanks.

[00:11:36] CK: Hey, Greg. Can you hear me?

[00:11:38] GF: I can now. I can, CK.

[00:11:40] CK: Okay, cool. I'm curious. We had a podcast on FEDWATCH, where yourself and Aaron and Ansel, we all discussed this idea of the current system, whether it's in China, or whether it's in US capital markets, is producing the same centralizing effect. I'm curious, and that's a big theme and the article that we're describing. Everyone is just joined recently, pinned to the top. Aaron Segal wrote an amazing article, outlining a lot of different patterns and things that are happening that are causing centralization, especially in Western markets. I'm curious, Greg, in terms of your general take on this idea of pretty much mathematically enforced centralization. What are your thoughts here? Then we can go back to Aaron.

[00:12:32] GF: Yeah, sure. I mean, again, in Aaron's paper, it just hits so many hot buttons of things I look at. One that stuck out in particular, and I don't want to go down this tangent, unless you guys want to, is the buyers of Fed, or US Treasury paper, the indirect bids at Fed auctions. The fact that fewer and fewer international buyers are showing up for US Treasury. Nice graph in the paper, if I remember correctly, Aaron.

What does all this mean? Even that is a form of centralization, if you will. What ultimately it means is, there will be a binary outcome that Aaron has already – he's already mentioned and will focus on in this talk. I don't want to take away any of his thunder, because there's so many places I can relate to, but I want him to walk through the process. Really, it's not a paper that as much as an absolute data dump and risk management process. It's quite brilliant, and he and I share a similar procedure of evaluating risk and return outcomes. That's comforting to me, but it's also a reflection of the fact that I've said this before, I'll say it on this. Any risk manager that cannot change their mind gets carried out on a gurney, on a trading floor.

You don't fight it. You sell your loser. You don't hold on to your loser and hope that it snaps back. The only way you survive is by selling your loser, okay? There's so many people out there. I don't want to bring a certain person's name up, but they've run a 100 yards. Well, they've run 99 yards. They're blazing down the sideline. They understand all the reasons you got to own Bitcoin, and then they fumble the ball on the one yard line, because they're married to the gold narrative. That's not the way you manage risk, people.

As information changes, you need to change your position, or you'll get carted off the trading floor. I guess, just to go in – no one is ever a 100% certain about very many things in investing. The only thing I'm a 100% certain of is that fiat currencies are programmed to debase, because we have entered a debt spiral, where escape velocity from the debt spiral is impossible. Mathematically certain that fiats will continue to debase. I just add on a conversation I had with you and Ansel this afternoon, I mentioned, CK, very simply, that what we have here is a failure of many global leaders to understand grade 11 mathematics.

We can't overthink this, people. It is very simple to lay out why the debt burden is growing and it is impossible for a global economy to keep pace purely with the interest burden on the debt. With that, I'll turn it back over to the floor, and just say, try and break things down to first principles. Remember, and even in Aaron's paper, I believe you brought up a second and third derivatives. I don't want to get too mathematically inclined with you guys. Bonds are pure mathematics. There is no subjective nature to the return on a bond portfolio. It is a fiat contract. It is not an equity. They don't change the interest coupon as the cash flow in the company changes. That accrues to the equity holders. Understand where your long volatility protection is against an asset class, or silos in the world that are inherently short volatility exposure. Over to you guys, and I'll go on mute.

[00:16:31] CK: Go Aaron. I’ll let you react to that.

[00:16:33] AS: Yeah. Obviously, everything that Greg just said resonates. You mentioned, and Greg also mentioned the recent FEDWATCH conversation that we had about what was going on in China. Actually, I believe that, I'm trying to remember, the summer is all blurred at this point. I believe that talk occurred before Evergrande. Evergrande was still background. Yeah.

[00:16:56] CK: Yeah. It was when only the macro people were looking at it.

[00:16:58] AS: Exactly. Yeah. I know, we were talking about it a little bit, the bigger topic of that conversation as it related to China, was what they were doing their tech industry and trying to grasp that in this bigger conversation as to, you have these two superpowers that are centralizing. They're doing so in very different ways, but you can take a different path and get to the same location. That's what I'm getting at a little bit in this essay, is the way in which obviously, I'm looking at it from a US perspective, because those are the markets that I know best, and I'm a US citizen. That's my biggest area of interest.

This is really true of all Western markets, of course, and all Western democracy. Then, China is doing something, rather perplexing right now. We were trying to get our head wrapped around that. Then of course, Evergrande got bigger. Then of course, the energy situation and China's energy shortages, also started to play into the mosaic of this conversation. I mean, there are very interesting and perplexing things going on in China right now. The bottom line is they are, and we are seeing them tighten their grip. We're seeing Shi tighten his grip materially in a very short period of time.

Tech investors here in the US have invested and a lot of these offshore listed Chinese companies have been bulldozed a tremendous amount of value. We're talking 50%, 60%, 70% drawdown. Something Bitcoiners are accustomed to, but the but tech investors are not. I bring this up, because first of all, the second piece in my series is going to go much more into decentralization. I talked in our conversation about my five tenants, these five axioms I was thinking of in terms of the way I processed the world, about how centralization and decentralization interact in this continuous flow, this oscillating flow.

We've been in a long period of centralization. Within that period, of course, there are just I talked about a prior article about Bitcoin information theory, which basically talks about how Bitcoin is a tool to suck up entropy, to create order out of disorder. Even in systems that are constantly experiencing greater and greater entropy, which is the universe and all systems, essentially, there are pockets of entropy, such as humanity, such as a planet, such as a car, such as any little thing that pops up. Of course, these things have a shelf life. They have an expiration date.

Within the context of centralization and decentralization, there is an oscillation, and we try to tease out that nuance that centralization is not always bad. I just want to clarify that before we get into centralization, and it's ruining everything. Some people might say, “But wait. What do you want? Chaos and disorder?” Well, first of all, there's a huge misunderstanding between decentralization and disorder.

Second, I also want to just say that I'm not saying that centralization is always bad. I'm saying that our system has gotten all it could get out of centralization. If you look back at money, and you think about money in various evolutions that it has gone from, there was a point in time when in order to advance the division of labor, and create the ability for humanity and economic systems to scale further, we needed a centralized money. We needed someone to put the king's name on a coin, create coinage and link it in a way that allowed a trust system. Then labor could feel more, okay.

I get into a little bit about this concept of a medium of specialization with Bitcoin. Because when you think about what creates growth, what creates progress, you need excess savings. We talk about, I think, in our conversation, we talked a little bit about the metaphor of a two-person economy on an island. You have two fishermen, right? They're both fishing the same thing. One of them comes up with a new way of – a new technology to accumulate more fish than they need. Suddenly, that person has excess fish and there's only two people on the island, so you can only really trade fish. It comes up with, because he has this extra time on his hands, he comes up with some other process. Suddenly, they're producing fish and something else. it spirals from there.

That is just the process. It's a very simplistic and dumbed down process of the division of labor. There's two ingredients that are required in that, which is savings, and specialization. If you don't have those, you don't have growth. You don't have progress. When you have centralization move to a certain tipping point, you suddenly can no longer scale for a medium of specialization. Because everybody in the system is now no longer trying to specialize further, they're trying to gain the existing system. That's what parts of the article get into.

At the outset, I did want to just clarify that centralization, because Ansel, I believe, you brought this up, too, which is, it's not always a bad thing. We wouldn't be where we are at this stage of human history without that. That leads back to why decentralization is absolutely so important. There's this notion that I believe, Andreas Antonopoulos, brought up once, called justice as a service. We all talk about, you've probably all heard this term, software as a service, or various XYZ as a service brought up.

When he talked about justice as a service, he was talking about why the government can't actually ban Bitcoin. It got me thinking, and this is going to get into the second part of this. I really want us all to think about this, because again, like I said at the outset, we use the word decentralization a lot, but we don't really sometimes stop and think what it means. We all say, yeah, the government can't ban Bitcoin. Why? Why can't they ban Bitcoin?

Let's talk about the mechanics of what would happen if they try. Let's look at a simple example of Tor, which is, of course, a decentralized version of the Internet. Now, I'm not saying that Tor has flourished. Tor is not used by billions of people, but it has been around for decades, correct me if I'm wrong, someone. Governments have tried to ban it and had a very, very difficult time.

Information on the Internet is very difficult to ban. VPNs. I mean, there's always access points to information. Even communists in China witness that. What I'm getting at here is that the reason that the Internet has a little more trouble, however, despite all those things, is that people use the internet for convenience, because they don't have an incentive to use it for anything else. They will always trade decentralization and personal liberty and all sorts of things that are important that may not be seen as important, because they will trade them because they don't own them in the first place. They don't have any skin in the game. That's because there are no digital property rights associated with the Internet.

Once you start to create a system of incentives, where there's people, there's miners doing work, putting work into securing the system, and people of course, obtaining property rights in a digital fashion, regarding that system, everybody now has skin in this game. They are doing it in a decentralized manner. If the government were to try to get you to stop using a decentralized portion of the Internet, they'll just make it a pain in the ass. They'll make it difficult, and you'll just voluntarily stop doing it, because you will choose convenience. We all do it. It's human nature. That's what Andreas was talking about.

For us to just assume that we're going to all take the path, the hard path, like I said before, the path of least resistance, that's what humanity as a whole will do. You have to create the incentives. Once you suddenly make the incentive such that to change that, to change from that system of decentralization, towards centralization, to stop using Tor and use Google, for example, and to stop using a decentralized money and go back to your fiat, well, there's a much bigger cost suddenly, because you have invested in that. You have skin in this game now. You have digital property rights. You have time and energy expended, invested in securing this network. You have a financial stake, of course, because you own Bitcoin.

You have come to realize in that time, how valuable a pristine, absolutely scarce, decentralized money is. No one would willingly give that up. A lot of people who are no-coiners, or pre-coiners, or whatever you want to call them, really don't appreciate what that is, because they've never seen it. Like I’ve said, we've all never really seen it. We never seen an action. The more we centralize, I talk about this need of persistence. Bitcoin is a tree. Persistence is really all that it needs to be able to accomplish. Because, as Peter Thiel in his 2014 book talked about the inertia of people moving from one system to another, requiring a 10X improvement, well, that 10X improvement is a 10X, basically, decrement in the fiat world.

The Bitcoin value proposition is going to be made evident purely by the deterioration of a centralizing system. With that, we can get into some of the data. Greg talked about this data dump. There is. There's a lot of financial data in this article. Again, it's nothing that anyone couldn't really understand. It's not broken down in some esoteric way that it's very hard to comprehend. It's really they're just too meant to show exactly how far from the regression line we are, how far we've come, and how it is a one way train.

It's not something that can mean revert. That's what I think a lot of people misunderstand, even Greg, you talked about how I mentioned volatility in this article. Essentially, that the way I think of moral hazard, for example, and basically, that's what the Fed is printing. I'm actually a believer that they are not actually printing money. I know we love the memes, to say, money printer go bur. They’re printing collateral is what they're really doing, in a system that only uses collateral. Now, everyone just uses that collateral to buy financial assets, or hoard that collateral, which is what a lot of the deflation is belief. That's why a lot of deflations believe that QE can't actually create inflation.

They're right so far, but there's other things going on now that the system is breaking further and centralizing more, and new tricks are being brought out to make it so that QE is more powerful. I digress.

[00:27:48] CK: Aaron, so you have a lot of charts that you sent me over Telegram. I think, you’re going to have to do a tweet. You’re going to have to do a tweet thread or something like that, to get some of these out. Yeah. I mean, I don't know, if you want to start on any of them. I don't know if Greg does has access to these charts, or what's the best way to –

[00:28:05] AS: Yeah, I wanted to throw some of them in here. I'm not at space with here. I mean, listen, the first chart that's in the article –

[00:28:13] CK: If there's a tweet, I can pin it to the top, pretty much. There needs to be a tweet with the chart in it.

[00:28:19] AS: I'll try to do that. I'm not good at multitasking.

[00:28:22] CK: Let me let me give you some time. Greg, why don't you jump in here and – Aaron is talking about this concept of us being really far away from the mean, in terms of what natural, or healthy growth in some of these metrics and some of these areas are. Do you want to talk about – to give your thoughts there as well? [Inaudible 00:28:42] some charts out?

[00:28:44] GF: Yeah, absolutely. I don't have Aaron's article in front of me. I'm going to try and remember some of the things. He talked about the measurement of the risk-free rate, which you've been taught in economics that the risk free rate is the US tenure rate, or somewhere along the yield curve of the US borrowing yield curve. Let's remember that the US is not risk-free. Because if it was, there'd be no credit default swap market existing on US Treasury debt, but there is. It's minuscule, but it's not zero.

That being said, given the US Treasury is the lowest risk central bank in the world of any size, meaning of the G7 nations, let's take that, his article, or his statement that yes, he's right. When I started trading in the 1980s, US tenure rates were 16%. That's an incredible number, if you think that based off of that risk free rate, you have to add another bread, essentially, to account for the incremental riskiness of various assets in the world.

Very simply, if you add investment-grade bonds on top of US Treasuries, you get a spread and that spread measures the credit quality, or potential for credit deterioration of an investment grade credit. Then, you go to successively risky asset classes. High-yield bonds, equities, arguably our large cap equities less risky than high-yield bonds. You get into an argument as, you can measure it using volatility, priority of claim, etc. The point is, the US tenure year has gone from 16% down to under 1%, ladies and gentlemen. That's pure mathematics.

Ray Dalio built an incredibly big risk parity business based on you own a certain amount of equities, and you hedge that by levering up bonds. Because when equity sell off, historically, the flight to quality was in bonds, and the flight to quality caused interest rates to go down, and bond prices to go up. Mr. Dalio, the genius that he is, was able to sell a risk parity money management tool to pretty well, everybody in the world, because he's, if not the largest hedge fund in the world, one of the largest.

That was based on a model that worked when interest rates were able to go down. When you hit the lower bound, they can't go any lower. You might say, “Oh, Foss. They can go negative.” Well, even Mr. Dalio’s smart enough not to pick up nickels in front of a steamroller and bet on a stupider person in the bond market to come along and pay a negative yield for a contractual obligation. You turn a bond into a liability.

It is an asset until yields go negative, and then it becomes a liability. Lots of people don't understand that. They say, “Oh, bonds. I've lived for 40 years. Bond prices have always risen, as interest rates fall.” That's true. When's the last time anybody who's managed a serious amount of money has actually lived in a rising rate environment? Then people say, “But Foss, we're going to have deflation.” I'll say, “I don't care.” We may have deflation, but the credit risk is the more important component of the US tenure year Treasury going forward.

You can have rising yields, and falling inflation. Why? Because the credit quality of the United States Treasury is going to continue to deteriorate. This is what people who've managed money for the last 40 years have no clue. I'm going to throw something out very interesting. There's three countries in the world, according to the International Institute of Finance, that saw outflows of foreign investments in government bonds in 2020. I'm going to name those three countries. Greece, Italy, and the USA. Holy, jump in whatever insert swear word here, okay. This is serious, people. This is not a drill.

Make sure you understand what it means when you are no longer evaluating bonds from an inflation perspective, and you change it to a credit quality perspective. It's a change paradigm. It is a changed way of managing money. Bitcoin is the long vol insurance policy. I'm not sure if you want me to keep going, or if you're ready to start talking to Aaron, but that's how I would insert three countries, once again, Greece, Italy, and the USA.

Less than 10 years ago, Greece and Italy were part of the proverbial pigs. Portugal, Italy, Greece and Spain, the four countries that almost brought down the EU, right? It's pretty good company, the USA is keeping these days, folks. Don't navel gaze too much. The world requires international investors. That's what a debt spiral is.

[00:33:52] AS: Yeah. The world also requires, just to add to that, Greg. The world requires pristine collateral. Now, it doesn't necessarily need to be that way. Our current system certainly does, especially with QE. QE has just made that collateral more scarce. Actually, in a way, QE is an amazing way of creating a network effect for the US dollar system. Now, people like Lynn Aldean have done a great job of explaining the historical context of the petrodollar system, how that rose.

If you think of the petrodollar system, it's just a network. It's a centralized network, but it's a network and it has all the same game theory attributes that you would look for in a network effect. Creating incentives to stay in the network. Creating friction to prevent people from leaving that network. An oil market, energy being the lifeblood of any economy, to index energy to the dollar is brilliant, to create that network effect for the dollar.

The problem is that we did too good of a job. Now, the dollar has become scarce in a lot of ways, for a lot of participants, because you have a world that relies on dollars. The central bank has had to become the producer of collateral for the entire world. That's not the mandate, right? Their mandate, or their mandate, they claim is basically, tame inflation at 2%. Target inflation at 2%, which they always miss and then unemployment. Well, that's not actually their mandate. That's a ex-post facto mandate that is more palatable. I'm not saying that to be a conspiracy theorist. That's just the history of it.

You bring up an amazing point. I think you referenced this earlier. I talked about this further into the article about the eurodollar system and the Treasury market. I brought up exactly who you just mentioned, which is Ray Dalio, because risk parity is a balanced vol strategy. Bridgewater is the Godfather. Ray Dalio himself is the godfather of the risk parity strategy, which allows you to own and lever up more financial assets, but to do so at a lower Sharpe ratio. Sharpe ratio just, your basically, excess spread, your risk adjusted return, divided by some measure of volatility, which is now in finance talk, is the standard deviation of returns of volatility. I also talked about that.

If you look, there's a chart. CK, I actually posted, I tweeted out a bunch of charts from the article. Like I said, Guy Swann does an amazing job reading the audio version. I don't know about all of you guys in here, but I need to listen to a lot of the Bitcoin material I read, the audio. I implore you guys to do so, if that's the way you read and you are interested in this article, because it is a long one. That said, I would also definitely look back at the chart package here and peruse it that way.

[00:36:41] CK: Aaron, I pretty much pinned them in order of tweet, like one, two, and three, so if you want to reference it that way. There's three slides pretty much, up top.

[00:36:53] AS: Yup. I see it here. The first one is in some ways, the most staggering chart. I can't take credit for this chart. This is a guy by the name of Michael Hartnett. He's a strategist at Bank of America. He's actually someone I've been talking to back in 2018, about the coming years looking a lot more like 1970s. Believe it or not, a lot of my colleagues back then, I worked at a different hedge fund, but a lot of my colleagues thought I was crazy back then. I actually started to not believe it, because it was way too early.

He's been talking about the system changing, but he calls it the peak. I think, the three P's. Peak policy, peak profitability, and I believe the last P is populism or something like that. This chart that he put up here, if you look at it, and I wrote this in the article, and we see all these crazy charts all the time, because we are so far off the rails, and we all got numb to it. Especially my industry. Wall Street people have gotten completely numb to this, to the point that they will just accept this data blindingly, like if it's okay. What this first chart is showing you, are cumulative equity flows. These are an annual basis. You can see right now –

[00:38:06] CK: Chart number one on pin tweet number one.

[00:38:08] AS: Yes. For 2021 year-to-date, if you annualize the flows year-to-date, we are over 1 trillion dollars for the year, if you were to annualize that number. For context, from the prior 20 years, the total, if you take every year in the prior 20 years and add it up together, the total was 800 billion. We are already, this year, seeing more inflows on a run rate basis into equities, versus every single year in the last 20 years combined.

I wrote in the article, just pause for a second, just pause and think about that. That is not normal. That is financialization on a massive scale. What it's telling you, and again, because we see these all the time, like okay, that's crazy. Money printer go bur. It's telling you something even deeper than that. It's telling you that money is not flowing into new productive assets. It's not creating new capital. It's not credit growth, in the way credit growth is supposed to occur in a normal healthy environment. It’s just being plowed back into an existing stock of capital. An existing stock of capital does not create new productivity. It does not create new savings.

The equity market has become a savings vehicle, but it is not a pristine asset. It's not a pristine collateral. It's not actually savings. That gets back to the predetermine nature of the course we're on. All of those flows that you see in that chart have now created a too big to fail system. I mean, we were already too big to fail, but this is just magnified that by orders of magnitude. The policymakers literally have no other choice. They have no other choice but to keep this going, because the alternative would be devastating to the system. Because this is the savings vehicle. This would be savings wiped out.

As we talked about before, the only ways for productivity and growth are savings and specialization. Well, right now, no one's doing either of those two things. People are investing on a massive scale into an existing capital stock, so they're not saving, and they're not specializing.

Another chart that I want to point out, if you look at the second chart here, I believe the second chart here is what it's showing you is it's another lens. It's some of the same insanity, which is the most recent Federal Reserve data of the household net worth, which takes basically, the net assets of a household, not including nonprofits, as a percentage of disposable income. This goes back to 1945.

If you look at the long-term average, what I call pre-financialization, which really was something that started in the 1980s, but really accelerated in earnest. I would say, from my perspective, after the Greenspan put in the mid-90s, the Greenspan put it was really just the Fed’s first flinch, when they basically flinched to the market's demands and said, “We'll do whatever it takes to create stability.” That was the first step function down in volatility. Once you hit moral hazard, it's like being in a poker game with somebody who's a horrible bluff. Once you've got their tell, you can never lose to this person in poker ever again. It's over for them. That's what moral hazard is. Once the Fed flinched, the market just knew it was there.

Could the Fed have gone back? Maybe that far back, they could have. Maybe back when we see this pre-financialization, average net worth to disposable income at basically a one-to-one. You see, there's 90%. It's actually below one-to-one. That's healthy. That's fine. When we start to get into crazy land after that, and crazy land is a 120%. That's the average from the post dotcom era, up until COVID. Now we're in the COVID world. We're currently at a max level in something we haven't really seen in history, in terms of financial assets relative to actual real income at a 150%.

That tells you that if financial assets were to be impaired in any way, whatsoever, people's entire – we talked about solvency, and people will be insolvent. The system would be insolvent. What do we need to do? We need to compel that to go even higher, because it can't stay stagnant either, because if it stays stagnant, then there's no incentive for incremental dollar to flow into it. People invest in financial assets for capital gains, as a source of wealth accumulation.

Now, for just a percent of maintaining wealth, especially when the real value of that wealth, because of inflation is being degraded on an annual basis. All of these are painting a mosaic, a mosaic of the trap that we're in, and how we're essentially, being forced to continue.

If you look at the third chart here, what this one is telling you is I talked about the lack of investment in new capital. This one is showing you that in a visual format, which is basically, plotting capital expenditures in nominal dollars, divided by base money in the system. Base money being in this case, I use M2 money supply. Money supply is not just the money that the Treasury prints. It is also credit growth that the banking system creates. Actually, historically, the vast majority of that money supply is supposed to come from the banking system. I believe, I could be getting my numbers wrong here, and I don't talk about this in the article. I believe that the average over the last 20 years used to be that only around 10% to 12% of the empty money supply in our system was originating from the Federal Reserve, from the central bank and from Treasury printing.

Right now, we're at 40%. The problem with that is we're creating this crowding out of private credit. Basically, this is why when we hear about the Fed talking about tapering, running QE, most people who follow this and understand what's going on under the surface, think it's a silly conversation, because it can't actually happen. I mean, we're at what? QE six now? QE is a permanent fixture now in our system. To talk about tapering and talking about pulling it back, would be to ignore the last 10 years of history, and would be to ignore all the data.

The data is telling you that they are so much part of the money supply now, that if they were to try to pull back incrementally, the amount of money that would need to be generated from the banking system to make up for that loss is essentially impossible. It just can't happen. Then, the money supply would crater and the whole system collapses. They have to stay with their skin in the game.

What this chart, again, is demonstrating is that Capex, which I'm using as a proxy for people investing and borrowing in actual new capital formation is just plummeting relative to that money supply, because it's just being plowed back into the existing system, as we saw in the above charts.

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[00:47:03] CK: Hey, Aaron. I want to jump in here, and I want to give Greg a chance to respond. Because I feel like, between those three charts, like you posted 12 charts. Those three just by themselves, paint a pretty insane picture, which is essentially, as the money supply is increasing or being manipulated closer, instead of being invested, they're being just plowed into “investments,” or stores and values elsewhere. I mean, forgive me if that is an incorrect summary. If that's okay, then let's pass it to Greg for a second to react.

[00:47:36] GF: Yeah. I love it, because there's not much I disagree with. Just that, perhaps, add a few things. Firstly, let's understand in terms of the Fed’s ability to taper from not just the money supply basis, but the reality. This is what Ansel and Christian and I talked about on a podcast that’s to be released tomorrow. We talked about the inability of the Fed to taper, because if they do taper, the US dollar strengthens. A strengthening US dollar is consistent with emerging markets that get blown out of the water.

A strengthening US dollar will lead to a global recession, essentially. This is well, you can see these correlations. We did have a chance perhaps at the end of the Greenspan years to rein things in, but I love the analogy of playing poker with a horrible bluffer, okay. They might be able to taper a little bit from a 120 billion dollars of bonds, but they will never be able to stop the printing and the QE. It is mathematically impossible. Again, because what happens? The world enters a global recession. You'll have defaults of emerging market nations. Global recession leads to credit withdrawing from the system.

When credit is withdrawn from the system and the leverage unwind starts, that's exactly what happened in 2007 through 2009. The Fed, in my opinion, is snookered. They have painted themselves into a corner, but this has been a long-term trend. Well done on that chart, Aaron. I mean, you can look at it from different perspectives. This is a chance for me to shout out a really good report that it's a historical report, or a report that's been around for a long time. It's called the bear traps report, okay. The bear traps report is it's a subscriber-only publication, but it's written by a credit trader, who's spent many, many years on Wall Street. His name is Larry McDonald. He writes this about this all the time. He calls out the same thing that Aaron's calling out.

Look, the Fed is playing a horrible game of poker, and sophisticated investors are calling their bluff continuously. I would argue that that is going to have to continue. I want to add this. I don't want the system to collapse. We're doing a pretty good job of building it up on sand stilts, to the point where you got all these spinning plates. There is no return left in bonds, yet you have pension funds, who still have a targeted 60/40 equities to debt, or bonds asset mix, and the 40%, which used to yield, meaning the bond component, which used to yield double digits when these investment guidelines were set up, are now yielding under 4% for high-yield bonds, before defaults, ladies and gentlemen.

This math does not work, unless the Fed keeps the equity machine going, because that's where everybody's savings has gravitated to, okay. Very simple. It's the only way of them exceeding their 8% targeted return is with equities that will give you the chance of earning something greater than 4%, because that's the best that you'll do in bonds. That's the mathematical side of it.

Wow, it's scary, but you can explain it. Therefore, you need other assets, which are not correlated to traditional assets and the new risk parity trade, Mr. Dalio, is going to include Bitcoin. I know he gets it. He's even said, Bitcoin is better than a bond. Then, someone from the Fed called him up and said, “Ray, I need you to recant that statement. Because Ray, we've taken care of you in the past,” and Mr. Dalio dialed it back. Very, very disappointing, because he understands the math.

[00:51:36] GS: Yeah. I mean, the math is really simple. Like Greg is saying, I mean, and that's why I wanted to really bring up volatility in this article, because a lot of you people in finance don't even really appreciate how much volatility is a variable in the financial asset values of all the instruments they trade. Everybody looks at volatility as a measure of uncertainty and of risk. They look at it through the lens of saying, “Okay, volatility is low. That means people are complacent, and that means we're more vulnerable to a hiccup.” On a more secular basis as volatility, and I did have a couple charts in here that showed just on a secular basis, how out of whack volatility is, versus historical norm.

I believe, from the vast majority of the last century, the volatility of the Dow index set the values to be the main benchmark index before the S&P came around. Most of the historical data of the equity markets going back to the early 1900s, through the World War II era are related to the Dow. If you extrapolate it all into one big market, the markets volatility used to be around 20%. Now over the last decade, it's moved to an average of 13% to 14%.

That might not sound like a big difference, but that's a third decline in volatility. Like I said earlier, people look at Sharpe ratio. Financial investors, especially people like, a Ray Dalio, don't just look at things on an absolute return basis. They look at return per unit of volatility. If the return over some measure of volatility is really what creates an output of what your valuation is, because that's what you're willing to pay for an asset. The lower the volatility per unit of return, the more desirable that asset is.

There's also this inextricable link between interest rates and volatility, which the math there, gets a little more complicated, and it's probably not right for this dialogue, but it's important to know that there is a strong relationship between interest rates and volatility, and that there's no small coincidence that they're both declining together. Let's just leave it at that for now. That's why I use this great Kurt Vonnegut quote in the article, which is a little bit absurdist. He's an absurdist writer, and he wrote everything is nothing with a twist.

There's even a great meme that shows a circle. If you tie the circle into a knot, it turns into infinity. You have zero infinity are two sides of the same coin. If you divide any number by zero, it is infinite, mathematically speaking. That's math. If volatility is heading towards zero, you do have a theoretical construct, where valuations can become infinite. I'm not saying that that's a practical reality. I'm just saying that as an illustration of how insane things are getting, and how insane they need to get. Because each cycle, the stakes get higher and higher. The debt burn gets higher. To maintain each level of equity valuation and asset prices requires a greater and greater sacrifice for less and less of an outcome. That's the math aspect.

I also wanted to emphasize here, because a lot of this can sound doom and gloom, and I want to emphasize, I think Bitcoiners – the beauty of being a Bitcoiner, is it's not doom and gloom. I mean, one of the reasons I was invested in gold is because I was so concerned about where things were going. I didn't know of an alternative solution. There was none. Until you understand Bitcoin, there is really no plausible way out of this predicament that we're all in.

I even mentioned this in the article, which is that none of these things are by design. Nolan, the Federal Reserve, these are all good, well-intentioned people, everything. You can say that, too, about what we're seeing, a great microcosm of that is what we're seeing in the ESG situation, for example, right? People are trying to virtue signal and tell everyone that they are stewards of the world and we all want lower carbon output, and we all want a better environment. No one disagrees with that, but we fail to see the incentives here and the intentions gone awry. The good intentions gone awry. The path that hell is paved with good intentions.

All the participants in the system do meanwhile, no one wants this to implode. Everyone is just doing the best that they can. Sure, there are individuals and there are policymakers who are disingenuous, and people who take advantage of the system and there are plenty of bad actors. There will be even if we see a Bitcoin-based economy. There's always bad actors. I mean, the beauty of a decentralized system, though, is that one bad actor will just become isolated from the rest of the network. One bad actor can easily be chopped off and be disposed of, and has much less of an impact, so that's one thing.

Greg made this point. He does not want these bad things to happen. Nobody wants these bad things to happen. I really, truly believe that we can create this off-ramp from this exogenous system that is running in parallel, and we'll get bigger in parallel as we centralized further, but we'll do so in parallel, because it's exogenous. The more we can get help people to understand this into gradually off-ramp from that system, and the more we can turn Bitcoin into that pristine collateral that the financial system needs, in order to not go off the rails, the more stable the transition will be to a better system.

We are all big thinkers. I think, one of the beauties of being a Bitcoiner is you are forced to be a big thinker. You're forced to think generations ahead. I've been recently reading The Three-Body Problem, which is a science fiction novel. I mean, that novel talks about humanity on such a large scale. It's a really beautiful concept to start thinking about things in that way. I think, Bitcoiners are very accustomed to that. A lot of ideologists are that way. Communism is that way, to some degree.

The difference is that nobody in a communist system has skin in the game. By having skin in the game, I don't know about you guys, but I'm constantly trying to figure out where I could be wrong. Greg, you mentioned earlier, a good investor can always pivot, can always change their mind. You can't do that. The reason that that's something that you tend to see with investors more than other big thinkers out there is because they already have skin in the game. If they're wrong, they will lose their shirts, they will lose their livelihood, they will lose their jobs, their career status, all of those things. There are certainly other situations where people might lose their career status, such as being wrong in an academic setting, being wrong in the workplace.

For the most part, in our current system, you can have big ideas, or in a communist system, you can have big ideas and be wrong, and not really pay a huge price. That's why Bitcoin marries the big ideas with the little ideas, because if you're going to say decentralization means that the government can't ban it, you have to think about the nuances of that. You can't just say it. You actually have to figure out if it's true.

Whereas, in so many other ideologies, or so many other concepts, or systems, you can make those claims, and there's no penalty if you're wrong. I just wanted to add that, because I do think that when you read a lot of these things, and you see a lot of the statistics, it can make you downbeat. I think, that's the beauty of Bitcoin is that it actually is a workable solution. It's one that gets tested more and more as the system evolves.

[00:59:13] GF: CK, it’s Foss. If I could just say one thing, and then I'm certainly want to, perhaps, open it up for questions. One of the things that I read in your paper that comes to mind on that is the necessity for creative destruction, right? I mean, that is a principle of pure capitalism. Creative destruction ensures the new growth, if you will. It's burning out the underbrush of a forest. It's something that my good friend and our good friend and leader, Jeff Booth, talks about in his book. Certainly, you talked about it in your paper, and that's a thing of beauty.

The creative destruction. The socializing of losses on Wall Street, my first experience with socializing of losses, was the long-term capital management debacle in 1998. They had two Nobel Prize winners on that fund that they levered 99 to one times, and all of Wall Street was buying volatility. They were selling vol to the street, and the street was lapping it up like never before, because there were crises going on in the world where they needed to own vol as a hedge. These long-term capital management, Nobel Prize winners, were basing their entire model on six years’ worth of data. My God, how do you socialize that? They should have been absolutely – Well, let's just leave it there. They socialized those losses and did not cost those very poor mathematicians any substantial personal losses. This is what doesn't work in a socialized and a communist system, and that is why we need to return to first principles, and Bitcoin helps us do that. Over to you, CK.

[01:01:00] CK: Well, I just do want to say that I actually don't really want to open it up. I feel like, Aaron has a lot of charts, and I'm just loving every bit of it. Whenever you let people in, it turns into a shit show.

[01:01:09] GF: Okay, sorry. Yeah. Okay, beautiful. Go ahead, Aaron. Go ahead.

[01:01:14] AS: No. Shit shows are good or bad. I hear you, this is maybe another time we can do something like that. Greg, you just mentioned a great point, too. This is something we've talked about as well, which is passive investment is essentially a socialization of capital. I mean, there's so many things that I mean, that's essentially the overarching motif of all these.

[01:01:35] CK: Aaron, you got to explain that concept.

[01:01:37] AS: Yeah. Just to encapsulate it. All of this, all what we're seeing is a socialization of capital. It has to be. Because as things become more fragile, and that's really a theme that I talked about in great detail here, is that as things become more fragile, you would say, “Oh, wait. Then, that's negative for centralization.” If you have a system that's losing grip on things, then it's just going to break. No, centralization thrives in an environment where things are fragile, because it can then justify its existence, its needed to exist, because as I talked about people search for authority. People search for stability in that environment.

Yeah, passive investing is communism, is something, you Greg and I have talked about, and an Ansel, we've all talked about this. You would think that passive investing is a benign force. It's actually a force for democratization of capital, you would think, right? Because it's giving different vehicles to more people to invest on their own, and that is a key tenant to Bitcoin, is that put your financial wealth in your own hands. Cut the middleman out. Well, the problem is, is that you're not cutting the middleman out. You're creating a much bigger custodian. That's first of all, because his ETF vehicles, while automated, are custodial.

Much more central to the problem is that these vehicles invest based on flows, not based on fundamentals. There's always a great, simple way of illustrating the unintended consequences. This is, if you imagine, it's a little bit of a tragedy of the commons, because maybe on an individual basis, it's a good thing to be able to own an ETF. It reduced your transaction costs. Everything is all basically a one-to-one correlation now anyways. When stock goes up, bonds go up. Dollar goes down, as Greg said, we need the dollar to go down.

All these assets have these very well-defined correlations at this point. You're like, “Why am I paying an active manager? Why am I paying a mutual fund doing all these fees?” Okay, I'm going to buy an ETF, cut out, the middleman, cut out the transaction costs, have exposure to the market, feel like I'm in control. I probably learned something in the process. There's this democratization of financial awareness, which is great. I mean, that part is great. I think, that's a huge part of what makes Bitcoin so amazing, too.

I mean, I'll give a shout out to Dylan in here. I mean, Dylan, I don't want to call out your age here. I don't know if he's in here or not. He's in his early 20s and he is sharper. I've been in this business for 16 years. I've hired a lot of young guys, and he is sharper than all of them. He is self-taught. Don't get me wrong when I say that financial awareness is an amazing tool of decentralization.

The problem is, is the way the incentives. This always goes back to incentives. The incentives of passive investing are to put capital to work, when there's a buyer, and to take capital out of the system when there's a seller. As we've talked about, the overall incentive right now is to keep putting capital to work. There's no discernment between good capital and bad capital. It just goes into an index and therefore, if you are an indexer, you can gain things based off of marketing gimmicks. For example, ESG right now. If you create an ESG ETF right now, you will gain inflows. It has nothing to do with whether or not the capitals that make up that basket are good company, and should be invested in. If that capital that is being poured into that ETF could have gone somewhere else much more productive, which are costs that we never see incurred. Those are opportunity costs. We don't even know what we're losing from that. That's something Jeff Booth talks about extremely clearly, because in his case, he talks about it with regard to inflation and technological innovation.

In order to innovate, you need capital. If good capital is being lost to dumb capital being just poured into an existing system, then we don't even know what innovations we're missing out on. We don't know the Einstein that we never got to meet. The problem with passive investing, therefore, is it just incentivizes putting capital into the existing winners, putting capital into the incumbent system. That's why you see, I have a chart in here. I don't think I posted it on this tweet. There's a chart that shows the percentage of the S&P 500 that's made up of six companies. You have Apple, Microsoft and people from the fangs. Apple, Microsoft, Google, Netflix, Amazon, and Nvidia, which is a semiconductor company.

Those six companies make up, I believe, around 45% of the S&P 500. I talk a lot in this article about the credo principle, which is basically, the colloquialism that most people in here may have heard about is the 80/20 rule. If you want to get more in the weeds on this, again, just read the article. The punchline is that so many things are non-linear and non-mean reverting. That can be a good thing when we're talking about decentralization. It can be a bad thing when we're talking about centralization, because 20% of the things can extract 80% of value, for example. That's just the general rule of thumb.

If you take that on its logical path, that 20% turns into 10%, extracting 90% of the value, and so on and so forth. That's what passive investing unintentionally leads to. In the great example, that guys like Mike Greene, and I know a lot of Bitcoiners hate that guy, because he's arrogant and obnoxious, but he is really smart when it comes to passive investing. That's the area that he's done a lot of work. I would implore Bitcoiners, just not throwing the baby out with the bathwater, was maybe in a seam to lab and anti-fragility. Listen to the ideas, not the person.

He essentially, talked about imagining a scenario where you have a company, and over 50% of the investment in that company is in passive vehicles. Eventually, you cross the threshold at some point where there might be no incremental, fundamental seller. The only way you can find a seller of something when someone is trying to buy is if a passive vehicle has outflows. If the only flows are inflows into passive vehicles, and there's no fundamental sellers out there who are making a discernment about good capital, or bad capital, then literally, getting back to infinite prices, the price of that stock could go to infinity, because there's literally no price where someone would sell it.

That buy

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