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Two young fish are swimming along when they happen to meet an older fish swimming the other way, who nods at them and says "Morning, boys. How's the water?" The two young fish swim on for a bit, and then eventually one of them looks over at the other and says, "What on earth is water?”
The moral of the story is that we do not always understand the fundamental nature of things that surround us every day. Just as the younger fish did not have any concept of water, many people today do not fully appreciate the nature of that thing that is so ubiquitous to us humans - money.
Here, at the dawn of a new decade, humankind faces a predicament when it comes to money: cash, the simplest form of money, is losing value faster than ever before. This will affect businesses and individuals alike, especially if we are unaware of the fact that it is happening. This series of blog posts attempts to uncover the ways in which businesses can mitigate the effects of the rapidly declining purchasing power of cash.
Money is a technology. It has evolved over millennia to facilitate exchanges of value between people, and to store that value over long periods of time to be used as and when the holder of that money sees fit. We’ve seen various iterations and manifestations of money over the years: shells, precious stones, glass beads, gold, and, most recently, government-issued “fiat” currency.
Fiat currency is not backed by a physical commodity but relies on a shared faith in the power it holds. Being disconnected from a commodity means that the purchasing power of fiat currency can vary. Inflation results in the purchasing power of fiat currency dropping, and this means that you get less bang for your buck.
Many people are surprised when they learn that the world’s currencies are no longer backed by gold reserves. This is why, since the outbreak of Covid-19, central banks the world over have been able to stimulate the economy by creating new cash and injecting it into the economy. The Federal Reserve in the United States has created around $9 trillion since March 2020. To give you an appreciation for the scale of that injection, approximately 20% of all dollars that have ever existed were created last year.
This is shocking, and it has a direct impact on every person and business holding cash. This is because the purchasing power of cash, in real terms, is being diminished at an alarming rate. Cash has steadily lost purchasing power to inflation over the last 50 years, and the rate of loss is now increasing more and more rapidly. Michael Saylor, founder and CEO of MicroStrategy, has dubbed this a “melting ice cube”.
The decline in purchasing power of the US dollar between 1913 and 2019.
If your business holds significant amounts of cash on its balance sheet, you may need to consider creating a buffer against incoming inflation to prevent erosion of the value that your business has already created. Monetary inflation and “quantitative easing” by central banks is a surreptitious force which steals time and value from businesses and citizens alike by inflating away the purchasing power of the cash that they hold. This may have sounded like a conspiracy theory ten years ago, but now it is becoming a fact that most economists and “finance people” agree on.
The question arises of what to do about this precarious situation. Clearly, we must take some form of defensive action against the approaching inflationary storm. Ignoring these economic realities in the hope that it sorts itself out is not a proactive strategy. In fact, it is no strategy at all. First, we must be aware of the underlying problem. Then we must formulate a solution.
A business needs cash on hand to move quickly, and to be flexible and responsive on short notice to changes in the external environment. The cash a business holds on its balance sheet is like an internally generated insurance policy to deal with unforeseen circumstances in the short term.
Now, this “insurance policy” need not be held 100% in the form of cash in the bank. It can be broken up into tranches of various degrees of liquidity and accessibility, depending on the needs of the business.
For example, if a business holds three months’ worth of operational expense cover in cash, it can be held in different forms, ranging in short-term accessibility. The table below shows an example of this type of diversification.
The example above is by no means prescriptive. Each business should consider its own position and requirements, and develop a strategy accordingly.
The concept behind this table is that each block represents a percentage of the total cash held by the business, starting at the top. A bucket of water makes a useful analogy - we scoop from the top first, not from the bottom. The top of the table is the most immediately accessible, the middle slightly less so (perhaps the money market account has a 32-day notice period in order to yield a higher return), and the bottom is the least accessible, and also the least likely to be required in the short term, if ever.
The chances are lower that a business would need to dip into the darker shades, and so that cash can be converted into a form that will produce a stronger hedge against inflation since the likelihood of having to draw on it is much lower over the long term.
The opportunity cost of holding the entire operational expense cover in cash, however, is very high. The lower levels of the reserve might never be touched, but it is still prudent to hold this internal buffer within the business. The form in which it is held is important, and each alternative will come with its own set of pros and cons. These need to be considered in detail by the business before making an allocation to a specific inflation hedge.
The Melting Ice Cube Series will attempt to explore the intricacies of the phenomenon of the loss of purchasing power of fiat currency during the first quarter of 2021, at a time when awareness of these larger global economic forces is more essential than ever before.
We hope that you will join us on this inquiry over the next few months. The greater macroeconomic realities with which we are faced at the present time affect us all - both personally and on a business level. In order to navigate this potentially turbulent and volatile time, we must keep an open mind and be willing to learn and explore avenues which, up until now, were considered non-essential “nice-to-haves”. Very soon, they will be critical.
As we look ahead at the year and decade which lies before us, we may be filled with uncertainty, worry and even fear - but there is always hope. Arming ourselves with knowledge and education will be our best chance of collectively navigating ourselves towards greener pastures and a brighter future.
Let’s make the journey together.
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