Teenage dream: Making Money System

Sumitted by Mike Krieger of Kam LP

The people must be helped to think naturally about money. They must be told what it is, and what makes it money, and what are the possible tricks of the present system which put nations and peoples under control of the few.

- Henry Ford

U.S. investors should welcome, not fear, climbing commodity prices. The increases are "largely a reflection of the fact that the pace of economic growth, particularly in the U.S., has picked up," said Nariman Behravesh, chief economist at consultants IHS in Lexington, Massachusetts, and a former Federal Reserve official who has been covering the global economy for more than 35 years. "It's not something to be worried about."

- Bloomberg article from yesterday

Why Fiat Money is Immoral

Today’s email is going to be a little different. A couple of weeks ago a friend of mine from NYC who is not in the business but is on my weekly email distribution list asked me to explain fiat money and why I think it is the wrong way to go. Below I am going to paste my response to her. There is so much disinformation out there about money it is scary. Sadly, the strategist at my former employer added to this several weeks ago. He wrote: “Gold, which is effectively just another fiat currency.”

Clearly he failed to look up the definition of fiat currency.

Fiat money is money that has value only because of government regulation or law.

Definition of Fiat: An authoritative or often arbitrary official order or decree. THIS DOES NOT EXIST TO GOLD AS MONEY TODAY AT ALL.

Gold is not money under “fiat” in any country at the moment. Rather the market is making gold as money today which is the OPPOSITE of fiat money.

With that off my chest, here is the response to my friend…

Ok, so let’s do a brief thought exercise on why I believe commodity money is preferable to fiat money. When you have fiat money, a government, or in the case of the United States today, a banking cartel (the Federal Reserve), is granted exclusive authority to create the nation’s money. Laws are used to enforce the use of this money otherwise people probably wouldn’t use it. Under a commodity money system, where let’s say the U.S. issues dollars but those dollars are backed or convertible to a commodity (in many cases gold but it can be other things) there is a limit to the amount the government or banking cartel can print or issue and this is in relation to the amount of the commodity that exists or is available to the government or central bank. The current propaganda that is rife throughout economics textbooks and the like tell is the notion that commodity money is bad since it stifles human innovation in relation to the amount of gold or whatever commodity used. They say this is bad and that there should be no “limit” on money creation based on something as arbitrary as a commodity and that this is bad for growth. This is complete nonsense and is used to keep people in the current fiat system where money power is exercised most egregiously by the few against the many. The reason they defend the current system is simple. With the power to create unlimited currency at will (via the Federal Reserve) you possess total and absolute power over almost EVERYTHING in the economy and society at large. The Fed not only creates the money but they distribute it where they want. In QE1 and QE2 they decided to buy specific assets. In the case of QE1 where they bought toxic assets, this was just another bailout of the banks and others that made poor investment decisions. Did the money go to build new schools? No. Did the money go to build high speed trains as is done in China? No. Did it go to building out massive alternative energy infrastructure? No. It went to save the banks because at the end of the day the Fed exists as a backstop to the banks and it is to the banks that the Fed answers to at the end of the day. It is a brilliant scam that 95% of Americans do not comprehend. So in this case all of the money is going to the banks (which destroyed the global economy in the first place) and other players in the financial world. Remember, the banks ARE the Fed and the Fed creates the money. Gate keepers at the Federal Reserve and academia make understanding economics, the Fed and money seem so “complex” but the scam is really VERY simple.

I am not saying that I necessarily back the classic gold standard but it is much more of a moral and genuine capitalistic system than what we have today. One of the arguments against the gold standard is that the rich have all the gold anyway and they will still have the power. Ok, well let’s suppose this is true. Under a gold standard they would need to mobilize this gold to exercise their power and influence and pay people off to do their bidding. This has a real cost to them. Gold will be spent. At some point they will choose not to spend it on this or that and ultimately they will lose their power/money by spending too much gold. They can’t just create more out of thin air to exercise unlimited money power on the populace.

This is in complete contrast to how things work today. With the dollar they can create more and more everyday and buy people off without ANY cost in the short term (until the dollar itself collapses). This is why the most dangerous thing that can happen would be a global fiat currency to replace the U.S. dollar.   They could start over in their never ending system of money power with a new currency that can be printed at will and used to buy up the world and all its resources at no cost to them. The end result would be slavery for the masses of humanity. The global monetary system as it stands is one of the most immoral social structures ever created by man. Most of us in America do not understand this since we have been the beneficiaries of it up until now. We are like the feudal lords in pre-revolutionary that couldn’t see the world beyond their favored social status until they lost their heads. The system as it stands has led extreme exploitation and corruption, not true capitalism. If we continue on this path the next stop is a feudalistic fascism.

In a Fiat System Banks Must be Like Utilities

At the Sanford Bernstein conference several years ago Joseph Stiglitz spoke and said a good and healthy financial system is a small financial system. I couldn’t agree more. This is especially the case in a purely fiat money system. Money is too important to allow greedy children in expensive suits on Wall Street and dangerous academics at the Fed to play around with. I do not claim to know what the ideal money system is but I want to be very clear on this point. If we have a fiat system like today the banks should be the most regulated industry on the planet and operate like utilities. They are supposed to help the productive economy innovate and create wealth. They are not supposed to be parasites that suck the lifeblood out of the real economy and compose 16% of the weight in the S&P500 (only technology is bigger at 17%). Something is VERY, VERY wrong here.

I placed the quote at the top of the email to demonstrate just how entirely disconnected the corrupt elite class is in the United States is today from the average citizen. Many historians assert that Marie Antoinette never said “let them eat cake,” but surely she made comments similar to those at the top of this email from the Bloomberg article. What is happening now is nothing new. It has happened over and over again for millennium. The elites of every era always think they will stay in control no matter what. They will be wrong once again.

Watching the circus from Colorado,
Mike

Editor’s note: Guest author Chris Yeh is an independent angel investor and VP of Marketing for PBworks, one of his investments. He has been involved with Internet startups since 1995. His Twitter handle is @chrisyeh.

Update: This post originally referred to DST as the investor in Start Fund when it actually is Yuri Milner personally investing, along with Ron Conway’s fund SV Angel.

Update II: This has been corrected below.

The big news this morning is Yuri Milner’s announcement that he and Ron Conway will be investing $150,000 in *every* Y Combinator startup on a no-discount, no-cap convertible loan.

Many people have already weighed in with instant reactions—”It’s a bubble!” “It’s the greatest thing to happen to the US economy!” As usual, these off-the-cuff reactions focus on a single part of the story, rather than looking at the big picture.

Let’s walk through the news, step-by-step, and see what it really means. Ultimately, my take is that it’s good for Y Combinator and Milner, but bad for the rest of Silicon Valley.

1) “Yuri is a fool who believes he can sell to a greater fool.”

Many people mocked DST when it began investing in companies like Facebook at “outlandish” valuations. DST invested in Facebook at a $10 billion valuation; with the valuation now above $50 billion, I’d say Yuri is having the last laugh (for now).

If Milner is investing in YC companies on these terms, it’s because Milner believes it can make money on these terms (more on this later).

2) “I can’t believe all the money going into YC’s dipshit companies.”

Once upon a time, Y Combinator’s companies were features masquerading as companies. But anyone who still thinks that isn’t paying attention. The quality of YC companies has risen considerably; the companies graduating from YC these days are much more polished and accomplished. And with monster successes like Dropbox and AirBnB (along with Heroku’s exit), YC’s company quality is looking better and better.

3) “Finally, someone who’s willing to take risks, unlike today’s pantywaist angels and VCs!”

Now we’re getting to something more substantive. There seems to be a feeling among entrepreneurs that investors are no longer willing to take risks, and that no one is willing to invest in ideas any more. My response to that is simple—if startups are really so low-risk, why is it that only a tiny fraction of the companies that do get funded (which are presumably “no-brainer” investments for all the cautious VCs) actually return any money to investors?

Of course I try to invest in companies that I expect to be “sure things,” but I also know that history predicts that at least 60% of my investments are going to be complete financial failures. The reason Milner is willing to take on such risk is simple—in addition to the actual investment, it’s also buying option value.

Option value is what makes the VC system work—by investing in stages, investors are able to abandon companies that don’t look likely to succeed. This is why startups are so much more effective than big companies at innovation—a big company’s internal politics make it difficult to try lots of things that will probably fail. Milner has additional option value available to them that traditional angels do not because of its ability to invest at later stages. By investing in the seed round, Yuri – and DST – gets the inside track on any future financings.

Let’s say that I was lucky enough to invest in Facebook’s seed round (I wasn’t). As the company raised further rounds of funding at $100 million and $10 billion valuations, I would have to come up with increasingly large checks to maintain my ownership position. Buying 0.1% of the company is pretty easy at a $5 million valuation (that’s just $5,000). It gets harder at $100 million ($100,000) and $10 billion ($10,000,000).

For Milner, however, investing a few million in YC companies is well worth it if it gives him the inside track to do a $100 million expansion round in the future. Moreover, is Milner really making it easier for entrepreneurs to raise money? I was not under the impression that YC grads were having difficulties raising money. It’s not like Milner is giving $150K to anyone who asks—the investment is reserved for companies which pass YC’s rigorous screening process.

4) Okay, Mr. Smarty-Pants, why is this bad for Silicon Valley then?

In the TechCrunch comments, Ted Rheingold of Dogster fame says simply, “This is not going to be healthy for the ecosystem.” I think he’s right, but the reasons he’s right are subtle. Allow me to explain.

a) Independent angel investors need to be able to invest at reasonable valuations.

As I explained in (3) above, folks like me need to be able to invest at reasonable valuations. That means either priced rounds or convertibles with valuation caps, and seed round valuations of $1-3 million. We don’t have the money to stay in the game with the VCs and DSTs of the world, so if seed funding shifted to a model of no-cap convertibles, we would be priced out of the ecosystem.

In today’s environment, many companies skip straight from a seed round to $20 million+ valuations, and angels simply won’t get rewarded for the extra risk they assume without priced rounds or caps.

b) The Milner/YC partnership could end up upsetting this delicate balance

As I’ve argued in the past, angel investing is a fragmented game. No one has enough power to collude on valuations. However, someone who is influential enough can influence what is and isn’t considered “standard.”

Once upon a time, there was no such thing as a convertible note with a cap. There were convertible notes, and there were priced rounds, and nothing in between. Then a few years ago, a number of prominent players in the ecosystem (YC included) began pushing the concept of a capped convertible. Today, even though there are plenty of angels who despise any kind of convertible note, capped or not, the capped convertible is pretty much the standard seed financing instrument.

Now imagine the impact of YC, the most influential incubator, standardizing on uncapped, no-discount convertibles. It’s not difficult to envision a scenario in which the entire industry moves in this direction. The problem is that this shift eliminates the incentive for independent angels to participate in the ecosystem.

Angels play an important part in the ecosystem because we are willing to take on more risk than the VCs. Some of that is non-economic behavior, but some of that is also due to the fact that we get compensated for that risk-taking with much lower valuations. Eliminating that compensation will surely reduce the number of independent angel investments.

The irony is that the Milner/YC deal didn’t have to cause problems for independent angel investors. If Milner committed to providing $150K to every YC company, at whatever terms were determined by the lead investor in the syndicate, he wouldn’t be pricing the angels out of the ecosystem.

c) Removing independent angel investors from the ecosystem is a bad idea

Naturally, angels like me will be upset about getting shut out of the ecosystem, but why is that bad for Silicon Valley? After all, between YC, TechStars, the Founders Institute, and all the other incubators and quasi-incubators, who needs us? Let the incubators pick the winners, and let the DSTs fund them.

The problem is that the chaotic, fragmented, Darwinian nature of Silicon Valley is an integral part of what makes it great. We need those random mutations to generate innovation, especially breakthrough innovation.

If we concentrate the decision-making on who does and doesn’t get funding in the hands of a small number of institutions, we hurt Silicon Valley as a whole, no matter how smart those institutions are.

I tell many people that Paul Graham is a genius. He saw the opportunity to start YC, and he’s done the Valley a huge favor by broadening the pool of company founders. But I don’t want Paul to be one of a small group of people who decides which companies get funding—not because he isn’t smart (he is) or a great guy (he is). When it comes to innovation, central decision-making is bad, no matter how good the decision-makers are.

For all our flaws, independent angels serve the important role of enabling the “genetic diversity” of the startup population. That diversity is at the heart of Silicon Valley’s success, and that’s something we don’t want to lose.

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