On Bitcoin

My thoughts on Bitcoin, originally a comment here: http://rwer.wordpress.com/2014/03/22/bitcoins/

Bitcoins are virtual gold, or maybe palladium. The have low use value, high scarcity, can’t be forged, and aren’t controlled by any government. They’re clearly designed to facilitate payments and store value. People aren’t obliged to accept them, but they do so voluntarily. Very few real-world vendors accept Bitcoins, making their use value low and uncertain, but the speculation is that acceptance will grow making them valuable. Currently they’re like an obscure precious metal, say palladium. Proponents hope they’ll become mainstream like gold, silver, money.

So are they money? They’re clearly an attempt at commodity money, like gold. Let’s assume the proponents/speculators are correct and they achieve broader acceptance. What are the implications?

Like gold and houses, Bitcoins are in fixed supply and thus deflationary. If you hoard an amount of Bitcoins it’ll rise in value with GDP. Arguably this is unfair and promotes inequality. It also rewards idle saving instead of consumption, trade, or real-world investing and depresses the economy. Investments whose real risk-adjusted return is below GDP growth aren’t made, which of course lowers GDP. If Bitcoins became pervasive as money they’d bring the same deflationary problems as the gold standard. If they became pervasive as investment instruments they’d resemble housing bubbles.

The introduction of Bitcoins itself expands the money supply in the short term. Vendors of low marginal cost products such as information goods will increase supply in order to gain Bitcoins, and that is good. However this is a temporary and bounded effect. The total amount of Bitcoins is fixed, and eventually the much stronger deflationary effects will prevail.

To prevent these problems, modern states exercise monetary policy, which comes down to two things:

- Inflate money at a low positive rate to force surplus to be invested and generate growth.
- Directly recycle surplus though a combination of taxation and inflationary spending.

The first use of inflation is monetary, like interest rates. The second is fiscal, using inflation to catch what nominal taxation can’t. Bitcoin evades both taxation and inflation, making monetary policy impossible (if it succeeds in a big way). This is of course what libertarian supporters want.

The libertarian supporters are either extremely selfish or deluded. The world of their dreams would be characterised by extreme and increasing concentration of wealth and income as well as declining yields for every kind of investment. When surplus isn’t recycled in nominal terms and the money supply isn’t increasing, investments necessarily will yield diminishing returns. The price/earnings ratio of all assets will keep climbing, while total output and consumption will be well below capacity and keep falling.

Bitcoins are good for individuals, but very detrimental to the common good.

Why I’ll vote against Scottish independence

I’ll be voting against Scottish independence this year. Here’s why. In Summary:

  • The cultural vision is weak
  • The specifics are bad
  • It’s a terrible time to be doing it
  • I don’t trust the offer, especially in this political climate

Background: I’m Greek and have lived in Scotland since 1988. I’d be in favour of Scotland becoming an independent Celtic state like Ireland, or joining Ireland. But I think the offer on the table by Alex Salmond and the SNP is bad in the specifics, and since we can only say yes or no to specifics it’s a no. Missed opportunity. I’d like to see a better offer by someone else.

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How to price air travel properly

The current pricing model for air travel is nonsense stacked upon nonsense. Single fares, return fares, fees for changes, discounted and flexi fares, business fares, loyalty bonuses… all nonsense. It developed as an anti-competitive arms race between the airlines of the 70s and escalated from there. Nonsense. Here’s how to price air travel properly.

The cost of a seat has three components:

  • A fare, valid for a segment class, season, and class of service. For example “Between UK and East Coast US, standard service (economy), spring-summer 2014” £345.
  • An option to travel on a particular date, flight, and seat. For example “Option to travel on VS45, LHR-JFK, May 17, 2014, rows 28-37” £73.
  • An efficiency bonus. For example “Returning within a week, returning on the same weekday, checked baggage, full flight” -£65 (discount). Or another example “Short connection, Roll-on luggage, meal” £35 (surcharge).

To travel, you need to purchase a fare and at least one option for the flight you want. When you check in you may get money back as an efficiency bonus, or if you do certain things you may be asked to pay surcharges.

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Asmussen leaves, Schaüble stays. Bad.

German coalition government announces cabinet ministers

Bad: Joerg Asmussen is leaving the ECB. He was an austerity hawk / debt dove. He’s likely to be replaced by a Bundesbank hawk on both fronts, who will then undermine Mario Draghi’s OMT bond-buying program. The OMT is the one policy currently holding the Eurozone in relative stability and removing it will likely let the crisis spiral out of control.

Bad: Wolfgang Schaeuble is staying as German Eurozone finance minister. He will then continue on his brave plan to burn down Europe’s economy outside of Germany, while funnelling to Germany massive financial profits through capital flight and manufactured risk arbitrage. German stocks, which dipped 5% in anticipation of the cabinet announcements, will jump back. Non-german European industry will fall.

The Eurozone crisis is about taxation vs. inflation

This formidable crisis that we’re having is, still, about taxation vs. inflation as a means of surplus recycling. A handful of countries including Germany have managed to make taxation work sufficiently well for surplus recycling (sort of, given high surpluses and still rising inequality). The Germans have foolishly written that into the constitution. All other countries, including the US and Japan, find taxation politically or practically insufficient as a means of surplus recycling and make up with a measure of monetary expansion. We’ll call that inflation although it’s not the same thing.

Monetary expansion taxes all assets denominated in a currency and is thus a form of recycling. In the US the market rises when easing is expected. Why? Because investors know that firms will have an opportunity to capture the surplus that is so recycled. Otherwise surplus will be more and more concentrated in retained profits, it won’t return to the market, and investments will have diminishing yield.

Southern Europe and the so-called lazy Greeks have been especially bad at taxation and especially reliant on inflation, devaluation, and the like. All countries pay their way if inflation is allowed. Fiscal obligations are covered in nominal terms and purchasing power for imports diminishes. The Eurozone was created, foolishly, with a German-inspired “there shall be no inflation” clause, and foolishly Greece applied and was admitted knowing that making taxation work in the timescale was unrealistic (and it’s a tall order for any country ever). The Eurozone then persisted, foolishly, in denial. The Greeks will endure anything but make taxation work, and the Germans will contemplate any measure but admit that taxation is insufficient and monetary expansion is a necessary pillar.

So please, let’s not moralise about lazy this and cruel that. Let’s see how we can back out of past decisions that were foolish, and that means talking about the role of both taxation and inflation (monetary expansion) in the Eurozone.

Inspired from Yanis Varoufakis’s blog here

A short critique of the Efficient Market Hypothesis

The so-called Nobel prize in economics has been awarded to Gene Fama for his Efficient Market Hypothesis. EMH states that markets instantly price in all available information and so nobody would be able to outsmart or otherwise outperform the market consistently in the long run.

Here’s my short critique of the theory.

The EMH assumes there’s an event horizon. Events behind the horizon, be they unknown future events or insider secrets, have no bearing on prices. Then events pop up over the horizon and instantly the market computes new asset prices to fully reflect the new information. Ergo you can’t out-compute the market.

The assumption that the market computes prices instantly is idealistic but we’ll go with that. The market is pretty fast, down to seconds or less.

Real-world events don’t flip from fully unknown unbiased probability to fully known outcomes. There’s a bias i.e. any particular event is predicted as more likely to happen than not, or vice versa, and better confidence estimates of the event’s probability become available over time. But so long as we assume everyone has access to the same stream of predictions the EMH still makes sense.

Where the EMH falls down is that prices don’t change to reflect the final valuation of a future state as soon as that future is known. New information gets priced in over time, from when the information is revealed to the time when the new situation actually takes effect and directly bears on the fundamentals. People see the instant tick of the pricing and say “ha, EMH!” but there’s a lot more pricing yet to come, and that’s why prices change continuously even in the absence of important news.

The reason markets price in information over time is twofold:

  • Market participants have different trading time frames. If we know for certain that the US will default in one year that will cause stocks to drop instantly, but there’s still time to invest and get out during the year, so people do. If the time frame is uncertain there’s more scope for price change. Miscalculations about trader’s ability to enter and exit cause bubbles to inflate and then crash.
  • Since the market isn’t pressured to price in the impact of future events until the exit window of each type of trader closes it doesn’t, and how it will eventually price the impact remains unknown. Market participants have to predict it and and the analyst with the better prediction of the market’s reaction wins. For example if you and I predict that a default will cause a 5% or 30% drop in asset prices one of us will come out looking smarter.

So, even in a world where everyone has full access to information about events, including likelihood and confidence, there are still opportunities. Opportunities arise from being better or worse at estimating how the market will compute price changes over time given known inputs, which is a notoriously hard but valid computational problem.

How the 2013 US default will play out

Here’s what will happen with the US debt ceiling over the next few weeks.

Neither side will compromise to raise the debt ceiling. President Obama, who is in the right, won’t negotiate because caving in to blackmail will undermine his and every future president’s authority. Hardline Republicans won’t negotiate because they’re reckless and want to bring about a default and a fiscal collapse in order to implement libertarian utopia.

Wall Street, defence, and regular business leaders will call their republican senators and tell them in no uncertain terms that future campaign contributions will go to Democrats unless they back off. Most Republicans will be burned by this, but the Tea Party wont back down because they have grass roots and rich libertarian supporters.

The treasury will run out of money on October 15 or thereabouts, and then will hold back all payments equally until they can be covered by tax receipts. That will include Treasury bond payments, and the US will be in default. Rating agencies will downgrade US debt to hot potato status. The market will maintain the belief that the US will eventually pay the arrears after an unknown delay.

The Fed, being the only well-funded and well-run branch of government, will intervene massively. Mr Bernanke will generate trillions of reserves (Fed credit to US banks) and use it to buy Treasury bonds from the banks. This will keep Wall Street banks solvent and mitigate the fall of Treasury prices. They’ll fall by a few percent instead of crashing. The Fed may also elect to buy stocks to calm stock markets and later gain revenue. This intervention will be held tightly by banks and not generate consumer price inflation.

A fall in the value of US treasuries means a rise in the interest rate that the US has to pay for all its accumulated debt, not just new debt (although the new rate gets phased in over around five years as bonds mature). Something like a 2% rise is burdensome. At some level, be that 4% or 5% or similar the market starts to believe that the US will never pay some of the debt and interest rates spiral to 25% or more because of the risk. That makes it certain that the debt won’t be paid in full, and US debt changes form a safe asset to a speculator’s trade. That’s what happened to Greece. It’s not clear if the Fed will be able to avert the latter scenario.

Either way, if the debt limit isn’t raised and the US defaults the US will have to pay higher interest. It may be much higher or impossibly higher. If you’re concerned about lowering the US debt burden, default is not what you want!

Central banks outside the US, particularly in Japan, may elect to cover their own financial institutions’ exposure to Treasuries by generating reserves in Yen, Pounds, etc. This will keep the financial system from collapsing and convert immediate paper losses to long-term recession, as happened 2008. The ECB, because it’s in the grip of Teutonic myths about money and debt, will be the last to react and will do so in half-measures, putting several European financial institutions in peril and adding to the ongoing Eurozone crisis.

The collapse of demand for Treasuries doesn’t pose survival challenges to real economy firms. Successful US firms have large cash reserves. The abrupt fiscal tightening will significantly hurt firms in certain sectors. However the secondary effects are severe and they’ll come back to affect all US businesses through the world economy.

The largest foreign holders of US Treasuries, China and Japan, have these bonds because for years they maintained a trade surplus with the US. Every year Americans (the private sector) import more things from China than they sell to China, so that excess dollars pile up at the Chinese central bank. Then along comes Uncle Sam, takes back the dollars and spends them in the US economy, and gives China yellow debt certificates called Treasury bonds. The Chinese effectively subsidise American consumption (they work for less) in order to boost their own production, and Americans maintain unaffordable consumption by going into paper debt. To a lesser extent the same happens vis-a-vis Japan, Korea, Taiwan, and Germany. Outside of a crisis scenario, no-one expects the US to pay back accumulated debt. To creditors it’s a long-term safe investment that pays interest.

When the US defaults, this arrangement breaks down. Suddenly the Chinese will no longer accept Treasury bonds and will demand dollars to replace the amount they hold as they mature. The Fed may decide to fly plane loads of newly printed Benjamins ($100 bills) to China and take back expiring Treasuries to shred them. China won’t accumulate the dollars but will try to spend them immediately on asset purchases, in the US and abroad. This will have three major effects:

  • The value of the dollar will fall sharply compared to other currencies, as there will be a flood of dollars chasing assets worldwide. American wealth will be reduced significantly, and there will be inflation through imports.
  • Imports to the US, including things like industrial components and iPads, will be much more expensive for Americans or unaffordable to US firms. Demand, production, profits, and stocks will fall sharply around the world.
  • America’s creditors will pick up devalued stocks worldwide, making a long term shift of capital from American to Asian and a few European holders. Iconic US firms such as Apple may come under hostile takeover by foreign capital.

The US may instead refuse to pay cash for Treasuries that mature and no-one can force them because the US has aircraft carriers. However the economic effect will be the same or worse: If the US bluntly refuses to honour Treasuries the dollar will fall further and trade will halt as foreigners will trust neither Treasuries nor dollars.

Eventually, perhaps after a few weeks, the US will find a procedural way to end the debt ceiling stalemate. They’ll remove or convince recalcitrant congressmen to vote for a permanent increase. However, the damage done to the economy will be permanent. Markets will resume their upward trajectory but will not recover their lost value. Capital will have been permanently transferred from the US to its creditors. Global demand, income, and profits will be permanently lower than they were before the crisis. The US will not regain credibility with bond investors until they make a constitutional change to put debt under control of the executive.

In the medium term the default will hurt China, Germany, and other Asian countries harder than the US. They will lose a profligate customer who’s buying on credit and will have to substitute US demand with demand of their own. That may happen, if money flows liberally enough in the Asian middle and upper income classes, but most likely demand and the overall economies will be permanently depressed. In the long run world economies will move past their dependency on US demand and move on.

The US will be left a much more insular and backward economy than it is today. With the dollar sharply devalued and no foreign credit the US will have to produce and consume domestically, which it can do. Expect American cars, American PCs and smartphones actually made in the US, a resurgence of blue-collar workers, higher nominal incomes and much higher consumer prices. People will buy durable goods and not gadgets. Sort of how it was in the 60s. In a way this will be more balanced and robust and may appeal to conservative nostalgia. However, it’s not the path to a libertarian powerhouse. If anything, with capital severely weakened and a greater need for domestic labour, a stronger social contract or New Deal will be needed to see America through the aftermath.