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.


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.

How are money and inflation institutions?

The macro textbooks usually say that inflation comes from the supply of money. In a regime of fiat monies, central banks “compete” at providing stable money. However, some central banks’ hands are tied by their governments’ desire to use the inflation tax. If you don’t trust the local money, you can always switch to foreign exchange, gold, or even Bitcoin.

But if money is what folks accept as such, its devaluation must also come from folks collectively thinking that the central bank intends to print more.  Its rise in purchasing power can also come from holders thinking of it as a “safe” money.

Veblen once defined institutions as collective habits of thought (at p.107).  That means that to predict inflation, one must anticipate the price expectations and strategies of buyers and sellers of money. Today, cash is king, so that it makes sense to see low or even negative inflation and interest rates.

This means that the macro textbooks don’t have the full story. Inflation is also a story of institutions in the sense of Veblen.

How to let big banks fail

The idea of “too big to fail” comes from the experience of bank runs in the early 20th century.  The answer then and now is deposit insurance. But such insurance has its limits, just like any insurance contract.

Lawrence White suggests that bank runs can be prevented if we redesign the banking system.  He suggests a money substitute that just might work, except that the big banks will have, perhaps, a hard time making money on fees.

It seems that the idea can be integrated with the emerging market for cryptocurrencies.  How?


Bitcoin as money

BITCOIN Screen Shot 2016-01-29 at 10.04.16 AM

The following is a note found on Facebook.

Random ideas on what makes money money
by Kermit Kefafel,  Friday, January 29, 2016

Is money a public or private good? It is a private good imbued with public interest. The public goods that attach to money are the safety of the banking system and price stability, as conventionally promised by a central bank.

What are cryptocurrencies? They act as substitutes for the use of cash in untraceable transactions, the idea of Bitcoin. You can even buy bitcoins at your local 7-Eleven.

The market for Bitcoin has lately been shaken with the arrest of one of its principals; there is talk that it could collapse. Will other cryptocurrencies have the same problems?

I suspect that for a cryptocurrency to become viable, it must hurdle the trust problem — its users and holders must be assured that its supply and valuation are, in some sense, sacrosanct. That its price could bubble up and down like a financial asset is a negative. Even fiat-currency central banks pay some kind of lip service to exchange stability under the current system of floating exchange rates.

Because of the public-goods aspect of money, a stateless currency requires an enforcement mechanism that is private but viable. Does such an enforcement mechanism exist?

Or, are cryptocurrencies just another Ponzi scheme?


For reference, see Lawrence White’s article in the Cato Journal.

The central bank (Bangko Sentral ng Pilipinas) has issued an advisory regarding the lack of regulation on virtual currencies.

A recent assessment predicts continued growth of Bitcoin in the Philippines.



Where is the Philippine peso going? Up and away? Up and down?

There has been some recent wrangling over the plight of OFW families because the peso has risen. One foreign bank active in local financial markets has predicted a P40 to US$ exchange rate for 2013-14. In an academic paper, Prof. Gerardo Sicat of the University of the Philippines has raised the issue of whether the economic managers, mainly the central bank (the BSP) and the fiscal authorities, should do something about the matter. Sicat’s main beef is that the government has adopted a very conservative fiscal policy that has contributed to the peso appreciation.

The conventional wisdom is that the peso has strengthened because foreigners are optimistic about the domestic economy, and they have been a major factor behind the recent stock market gains. The peso rise has hurt the families receiving dollar remittances as well as our local exporters and the call center-BPO sector, but then at the same time it benefits those who own peso assets. This piece of arithmetic is also a given, although some people seem to focus more on the supposed ill effects of peso appreciation. The latest IMF report considered the peso ‘not overvalued’ in 2011 and early 2012 when the US$ rate was P43.3. Observers like Prof. Sicat are right to ask whether a P40 rate might be overvalued.

Continue reading “Where is the Philippine peso going? Up and away? Up and down?”