Economics in disarray

Economics has problems. Because of Samuelson, it got a half-century case of physics envy. Then people read Schumpeter and McCloskey, and realized economics can’t predict a whit. Economics became useful (ex post) stories, a bit like archaeology or geology.

Then came The End of History (1989) and The Great Recession (2008), and weirdos still talk of evolving economics, but into what they can’t explain. Like Marx redux, they blame ‘capitalism’ or neoliberals, though they can’t go whole hog back to old-style apparatchik economics. Some think that the missing link is a co-equal infant science called psychology.

What to do? At one point, one way out was to study ‘institutions.’ But this seemed like hard work — too much scholarly pain for little gain. But gains there were if you read Coase or Ostrom, or (if you want Keynes to shudder) Hayek.

Perhaps that’s just the way it is. Economists are more like chickens with no heads but imaginarily pecking away at crumbs of intellectual progress. Some toil away at saving the world from falling over a cliff, much like Salinger’s Catcher in the Rye. That’s at least humanitarian if mostly unheralded.

Keynes did say that economists should be more like dentists. Dentists are good guys who help people prevent cavities and enable them to smile. The economist can then go home after a day’s work knowing the economy will still do its wayward thing but not die.

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What next, after 2008? A book review

Mervyn King (The End of Alchemy, W. W. Norton, 2016) has a message. We are not safe. The economics profession has failed us. So have the economic policy makers of the US, Germany, China, and Europe. The banks still play a game that King calls ‘alchemy.’ Central banks won’t or can’t escape the infamous Keynesian liquidity trap. And we are prisoners facing dilemmas, macroeconomic policy is a paradox, sovereign debts are unbearable, and the world is full of ‘radical’ uncertainty.

In short, what we have today is pretty much a lull before the end of the world; 2008 was just the preview trailer. Alternatively, the world may not end but it will take a long while for robust economic growth to re-emerge, and there is very little that can be done about the matter. Either way, it’s a sobering conclusion.

Is the book worth reading? Yes, if only to get a handle on how central banks thought as they dealt with 2008 and its immediate aftermath. In addition, the curious but uninitiated reader gets introduced to the concepts of Prisoners’ Dilemma, the Keynesian Liquidity trap, liquidity transformation by banks, and the difference between risk and uncertainty.

King’s book also contains a longish but bureaucratic take on why 2008 happened. King gets to it on pp. 26-39 and pp. 317-328. Going by his view, as well as that of others in the fields of central banking and macroeconomics, the ‘conventional wisdom’ on 2008 might be summarized as follows.

It began with the fall of the Wall in 1989, also known as The End of History, that ushered in the Great Stability, an era of low inflation and robust economic growth all around. The main central banks finally imbibed the religion of the Quantity Theory in the 1990s and early 2000s, making themselves accountable to the public through pledges to abide by (low) inflation targets. King calls this period The Great Stability. (Never mind the hiccups of the 1997 Asian crisis or the bubble-crash of dotcoms in 1997-2001.)

Beneath the gloss of prosperity were gathering problems. Banks were raising their leverage in the hunt for profit. Prices in stock and real estate markets outpaced inflation of everyday goods, and central banks felt that paper wealth was not a worrisome thing (after all, one cannot eat stocks or houses), and the US Fed actually thought it would boost consumer spending. Some countries pushed their luck with foreign borrowings, notably Greece, Italy, Ireland, Portugal, and Argentina.

The failure of Lehman Brothers in September 2008 is considered the trigger of the crisis. It was, with hindsight, the outcome of the unexpected fall of real estate prices in the summer of 2007 and associated mortgage defaults in the US. The failure exposed the extreme leverage in the US financial system, and with banks unwilling to recognize their paper losses in the derivatives market for sub-prime mortgages, a run for liquidity, called The Great Panic, ensued. The panic was arrested only by official rescues. Consequently, in 2008-2009, the financial crisis affected real economies, with world trade falling and global GDP decelerating into The Great Recession.

King, as do other observers such as Edwin Truman, believes that underlying macroeconomic imbalances were also to blame. The extreme example often cited was the ‘savings glut’ in China that fueled ‘overconsumption’ in the US. Supposedly, the excess saving in China was intermediated by the banking systems of both countries. The theory is that without such imbalances, there would have been no resources that could fuel the asset price inflation in the US and in other countries.

So far so good. King then ends up suggesting that the re-capitalization of major banks since 2008 is a good thing but probably not enough.

As to the book’s shortcomings, they are:

King seemingly ignores the work of Charles Kindleberger (Manias, Panics, and Crashes, 2005) where Kindleberger had formulated an economic model of financial crises, based on the work of Hyman Minsky. King does mention Minsky but in a somewhat negative light.

King nonetheless cites (on p. 34), with some tongue in cheek, two ‘laws’ on financial crises, which he attributes to Dornbusch. One is that ‘an unsustainable position can continue for far longer than you would believe possible.’ The other is: ‘When an unsustainable position ends it happens faster than you could imagine.’ It is of course almost vintage Minsky.

And yet, to date, the economics profession’s best ever model of financial crises still seems to be the Kindleberger-Minsky model. That model cannot be used to make precise predictions, but it does give the best explanation, ex post, of how a financial crisis plays out. The major central banks had been using, in 2008, something called DSGE (‘dynamic stochastic general equilibrium’) macro models. These models were not at all designed to incorporate Keynes’ deus ex machina of ‘animal spirits,’ except as ‘shocks’ external to the structure of DSGE models, which meant that the central banks had essentially no inkling of the crisis before it hit. The IMF insiders called it ‘group think.’

If we could ask Kindleberger or Minsky today on their views on 2008, most likely they would say that it fits their model that sees a financial crisis in three parts — mania, panic, crash. The story is not much different from King’s, except that Minsky would give greater emphasis on the trigger of 2008 as one rooted in overconfidence, what Greenspan had called ‘irrational exuberance.’ That there had to be other villains is a given. In 2008, they included the toxification of bank balance sheets (with inexplicable financial derivatives) that was an outcome of a ‘deregulation’ tilt that allowed subprime debts to be brazenly sold by lenders as ‘almost prime.’ Since King doesn’t like the fractional reserve nature of modern banking, he gives more emphasis to the alchemy-like leveraging that modern banks practice. In effect, King would not disagree with Minsky that it was a kind of Ponzi game that allowed banks to trap themselves into a corner that would eventually ‘blow up.’

This comparison of models means that King’s main proposal — his view that central banks should act like a ‘pawnbroker for all seasons’ — to narrow monetary base creation to ‘safe’ banks, while widening the securitization of other lending by bank-like institutions, is just another way of allowing excessive exuberance to be seen as a can to be kicked down the (future) road of ‘fundamental uncertainty.’ In short, since King has set up the medium and long term as a problem of fundamental uncertainty, there isn’t much that central banks or governments can do to tame business cycles. That is not different from Minsky and his ‘moments.’ There is an inexorable underlying tension between free capital markets and macroeconomic management by governments and central banks, something Robert Shiller and others had more or less also observed (see Shiller and Akerlof’s Animal Spirits, 2009).

King does not quite succeed in explaining the arcana of modern economics in the areas of: (a) how Keynes was co-opted into the ‘neoclassical synthesis’ (King merely says that Keynes was at odds with ‘neoclassical economics,’ a basic lesson from an introductory economics class); (b) the ‘paradox of policy,’ where he asserts that the short-run need to overcome the liquidity trap is inconsistent with the need in the long run to let the private sector decide how to correct ‘structural imbalances’ in the economy; and (c) how ‘fixed’ exchange rates and differences in saving rates across countries lead to ‘imbalances’ that in the long run need to be addressed.

It appears that it is up to others to try to make better sense of what King wants to recommend as a way out of the economic doldrums post-2008. Perhaps this explains why the book blurbs on the outside back cover hint of mystery amid faint praise from the usual suspects.

Bitcoins are forever

This is a story of mania, panic, and crash. It’s not new. 

Today’s market cap is roughly $150 billion. Averaged over, say, 3 million holders, that’s $50,000 each. Peanuts, if you belong to the 1%.

The trick is to kite the price to anywhere from 5 to 20 times the current level of $4,000.

The sales are essentially wash sales, as coins just go round and round. That’s why they’re coins, see.

Spectators – the victims – then want in, and the insiders pump and dump swimmingly, until the 3 million can get out with huge profits, at the expense of the latecomers.

The end is a classic Minsky Moment, when the latecomers try to sell. The algorithms in the trading platforms would ask: ‘To whom?’ And the price spirals to nothing.

Question for economists: Can the end trigger a financial or economic crisis? A dire scenario is that the latecomers’ loss results in bankruptcies and loan defaults, a retrenchment in purchases of housing and consumer durables, or in a general malaise in business and consumer confidence. Banks may fail if they finance bitcoin purchases.

With the benefit of foresight, monetary authorities will likely institute safeguards. Trading platforms are like banks, and will need adequate capital in case of an epidemic of ‘fails,’ which can happen if traders engage in short sales, or in margin trading. The Know Your Customer rule will have to be integrated into the block chain data base, and imposed by banks on customers operating trading platforms. 

Of course, theoretically, since virtual currencies can function as money, all trading can take place outside the banking system. If that were the case, the ponzi won’t work: How would the victims’ money enter into the bitcoin system? The price would go up and down forever, but that’s all. It’s funny money after all.

Virtual currencies and their institutions

Or why Bitcoin and its variants are risky assets.

It’s fair to say that virtual currencies need block chain. Block chain is an essential or necessary innovation behind such currencies. That block chain is not sufficient becomes obvious when we consider the question of how many virtual currencies can exist.

This is pretty much a question in institutional economics. It would be like asking which fiat currency would dominate global transactions.

Ronald Coase’s transaction-cost theory of the firm probably has the answer.

The dominant virtual currency is the one with the least transactions cost. While trust is an unmeasurable element that reduces transactions cost, transaction cost can itself be measured.

There are other factors along with trust that augur well for the dominant virtual currency. Among these factors are:

It should have ‘standing’ with central banks if only because they issue legal tender, whereas virtual currencies are not.

Its value in terms of the dominant fiat currencies must be reasonably stable. For now, the leading virtual currency, Bitcoin, fails.

Also equally important is transparency in its creation and modification. It seems that users of a virtual currency will need at least an unwritten constitution that lays out the fundamental laws of the community of users, even if they wish to be as ‘decentralized’ as possible. Again, here, Bitcoin fails, as can be seen with the ongoing ‘fork’ controversy over Segwit2.

CONCLUSION. It’s too soon right now to say that Bitcoin is here to stay.

SATOSHI 2.0, or how to create a better Bitcoin

Will Bitcoin survive? In what form? These are the two most pressing questions on the most popular ‘virtual’ currency, or crypto currency, today.

Bitcoin emerged along with a computing technology called block chain. Once understood, block chain promises to permit security arrangements for payment and even barter systems that are vastly superior to existing ‘centralized’ systems.

For the use of a virtual currency, the block chain has already proved itself as a solution to the counterfeiting problem while also giving transactors a relative degree of privacy. With the internet, the portability of a cryptocurrency clearly surpasses that of gold. Because of advances in computing technology, the transaction costs of a virtual currency are likely to be smaller than for existing payment systems, including the use of cash. Economists and thoughtful policy makers, including some heads of central banks, consider that virtual currencies have a useful role to play.

But the existing Bitcoin has a fundamental flaw. Its market price is too volatile for anything that aims to be a substitute for fiat money.

The problem can be traced to Bitcoin’s fixed supply (21 million coins) coupled with its lack of a ‘commodity anchor.’ The first means that the market price will be volatile, subject to shifts in demand. The latter – the lack of an anchor – underlies and exacerbates the price volatility problem.

The extreme upside is supposedly when bitcoin could supplant gold, and one calculation suggests that it would do so at $500,000 per coin. This scenario has driven wide-eyed fanaticism and speculators into the Bitcoin ecosystem.

The extreme downside, on the other hand, is that bitcoin holders could for some reason ditch the cryptocurrency and make it worthless.

In between, there could be ‘pump and dump’ scenarios, characteristic of a legal-but-Ponzi-like speculative asset that would occasionally have its Minsky Moments.

A better approach may be to think of a cryptocurrency as a ‘digital’ banknote that at least maintains its real purchasing power. To some extent, the banknotes of central banks with low inflation targets already provide the best protection there is to those who hold their monies. Can there be a better, kinder, saner version of Bitcoin?

Perhaps, if the pricing problem could be solved.

The way out seems to be as follows.

A new virtual currency, to be called, say, the bitdollar, is initially priced at par with the existing dollar. Its initial supply is then set as elastic as can be — the first ‘investors’ in the bitdollar will decide, through the amounts they commit to buy, the initial stock of bitdollars.

From there, bitdollars would go on ‘secondary’ trading just like the current Bitcoin.

If the price of a bitdollar falls below par, the initial investors would realize that they were too optimistic. Nothing else happens, and the crypto currency may fall into disuse.

But the initial stock of bitdollars is fixed, and sooner or later its price would recover if it attains usefulness as an alternative to currencies. It may then be seen as an alternative to banknotes but with a supply that an issuing central bank cannot control or alter.

When the price gets to exceed, say, 20% of the fiat dollar, by prior agreement among bitdollar holders, they would expand the supply by 10%. This should be enough to keep the price from shooting up, and also enough to keep it above ‘par.’ If the price continues to remain above 20% over parity, a sliding scale of new ‘issuance,’ say, 5% of the initial stock is calendared.

If the initial issuance is judged too small relative to (growing) demand, new secondary offerings would be issued at prices close to then market prices.

Over time, the price is likely to fluctuate in a range above par, but perhaps close to 10-15% over par. The stock of bitdollars would naturally rise to meet demand but at a price that is essentially anchored to that of the fiat dollar.

This scheme depends on the soundness of the anchor currency. If the central bank prints too much money, the bitdollar holders can or would decide to slow down issuance with a view to stabilizing the purchasing power of bitdollars. In effect, the fiat and virtual currencies will compete as different but similar moneys.

An important question: What happens to the money paid in by initial investors? I suggest that this be sequestered into essentially risk-free long-term government securities held by an agreed custodian bank. It will be set up as a trust fund to cover the possibility that the bitdollar would be unwound. The same rule can be applied to any new secondary public offerings of the cryptocurrency. This approach sets up the crypto currency as akin to commodity money, with the anchor currency as the underlying ‘commodity.’ (It is also akin to a share of stock in the trust fund holding the backing for the virtual currency.)

How would the block chain system be maintained if there is no ‘mining’ as in the current Bitcoin scheme? The obvious answer is that the computing services needed for validating the block chain will be bidded or contracted out in such a way that their cost can be recovered through fees paid by cryptocurrency holders.

Who will profit from the new scheme? As with the current Bitcoin, competing platforms for validating transactions (‘mining’), trading, and transferring of bitdollars will emerge, and would earn fees for transaction processing. Merchants who accept bitdollars would profit from paying a lower transaction fee than that paid to credit card companies. The trustee holding the backing for the bitdollar earns seigniorage in the same way that issuers of travelers checks do, and some of that seigniorage could be distributed to bitdollar holders.

Although in theory the block chain and efficiencies in computing would minimize the cost of operating the system, any crypto currency remains vulnerable to untoward events that generate mistrust in its operation. Trust in the cryptocurrency will have to be earned, requiring the participants to abide by legislation and guidance from monetary authorities. This is particularly important in combatting money laundering and use of virtual currencies by organized crime or terrorists. New platform providers who might try to cartelize transaction fees could also undermine the demand for virtual currencies.

CONCLUSION. Like Humpty Dumpty, Bitcoin is good but with its fixed supply, it is likely to take holders and speculators on a frenzied ride headed for a great fall. Caveat emptor.

Will Bitcoin crash and resurrect?

NOT BITCOIN but better.

One use of Bitcoin is for anonymous transactions, i.e., as a substitute for ordinary cash or bank notes.

The problem is that the currently available bitcoins fluctuate in value. The ideal is a bitcoin that is stable for at least a certain determinate or even indefinite time against a major currency, such as the US dollar. In short, we want or need an alternative bitcoin that is like a dollar banknote. We imagine this alternative works better than keeping banknotes under the mattress or in a safe deposit box, because it avoids thievery and the transaction costs of going to the safe deposit box.

It can be done. The easiest is for the US Fed to do it. It would allow anyone to buy something we might call the official bitcoin dollar in exchange for a guarantee that bitcoin dollars are exchangeable into US banknotes. If this works, it will be because it would reduce the costs now paid by the central bank for printing currency and going after counterfeits. In this scenario, the blockchain ensures that counterfeit official bitcoins cannot exist.

Another way is for a major private bank to ‘create’ its bitcoin dollar. Imagine that Chase does it, and calls it the Chase bitcoin dollar. All it is is a special debit card account where Chase guarantees to make the Chase bitcoin dollar exchangeable for cash. The guarantee is in effect a promise that Chase will honor Chase bitcoin dollar liabilities ahead of its any other liabilities. To ensure such a guarantee, Chase would enter into a ‘currency board’ arrangement with the US Fed by maintaining Fed fund balances in a separate special account solely for the purpose of redeeming Chase bitcoin dollars. In short, the fractional nature of the private banking system will not apply to bitcoin dollars.  

The blockchain also allows Chase to ensure that no other entity can create Chase bitcoin dollars. The ‘supply’ of Chase bitcoin dollars will always be the same as the demand for such dollars.

Any other private bank would be allowed to participate in a ‘branded’ bitcoin currency. I can imagine HSBC issuing special debit cards for HSBC bitcoin dollars, HSBC bitcoin euros, or HSBC bitcoin yen. They may be allowed to compete through enhancements on convenience of use, allowing for fee-free global transfers, or even the payment of interest.  

One important enhancement would be US consumer protections against fraud now being given to users of credit cards. Any merchant declining to honor a bitcoin debit card would be presumed to be up to no good.

The similarity with bank notes will have to be carried to an extreme that meets certain anonymity and privacy standards. The issuer of a bitcoin dollar will have to honor the bearer of the account provided that said bearer satisfies identity requirements. 

At the same time, the use of such accounts will have to be protected by bank secrecy rules, but subject to money-laundering limits. For example, bitcoin dollar transactions in a particular account cannot exceed $10,000 per day, and a bank cannot allow a depositor more than one bitcoin dollar account. A maximum-balance limit of, say, $100,000 per account, could be imposed, in parallel with limits now applied under existing deposit insurance schemes.
Central banks could also impose limits on how many bitcoin dollar accounts an individual can have. To protect banks from money-laundering, bitcoin dollar accounts would not be available to corporations.

Will the advent of such official or private bitcoin dollars kill the existing bitcoins? It could, especially if bitcoins continue to be more attractive as speculation vehicles than as means of payment.

But bitcoin exchanges could create ‘hybrid’ bitcoins whose ‘mining’ or supply-side arrangements are fully transparent, and whose value could be stabilized in some fashion desired by the bitcoin holder. In short, there could be different bitcoins for different purposes. Caveat emptor and ‘know your customer’ rules would still be needed. However, such bitcoins would remain without guarantees similar to deposit insurance, and they may still be vehicles for speculation.

My best guess: Bitcoins will evolve, i.e., the fittest will survive. The Dutch tulip variety will become extinct. As of now, they’re pretty much as primitive as Dutch tulips.