Boats, Bitcoin, and (Asset) Bubbles…

[W]hereas gambling consists in placing money on artificially created risks of some fortuitous event, speculation consists in assuming the inevitable risks of changes in value.

H.C. Emory

 

“In order to pay out profits, the South Sea Company needed both to raise more capital and to have the price of its stock moving continuously upward… And it needed both increases at an accelerating rate, as in a chain letter or a Ponzi scheme.”

Kindelberger, Manias, Panics, and Crashes. 1986

 

“But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?”

Alan Greenspan, 1996

This is a bit different from my usual postings at the moment, but the overarching theme of this blog, from the name onwards, is economic history, the relationship between banking and the economy,  and investment and asset bubbles. One of the reasons the subsea market interests me so much, aside from obviously having worked in it, is that the latter stages of the 2014 boom were clearly the denouement of an investment bubble.

I have been interested in Bitcoin and other crypocurrencies from the standpoint of monetary economics and history. For those who want a primer on money and cryptocurrencies there is a good post here. I think they are basically an asset bubble with no discernable differences to Dutch tulips in terms of intrinsic value (there is a great article here on the Dutch Tulip Bubble that makes clear it really was irrational). There are also at least 842 crypotcurrencies, which looks like the IPO board of 1999, and you can now do an Initial Coin Offering (ICO)! I think this is a technology induced investment bubble where the distributed ledger technology combined with the token coin aspect is creating the hype. The distributed ledger technology is beyond my full comprehension, although from my basic knowledge it strikes me as a powerful technology, (although its worth noting that it is overloaded and transactions and there is a backlog) and that the Bank of Canada having assessed it:

 [t]he bank reached that conclusion after a closely watched year-long trial code-named “Jasper,” which sought to determine whether the technology, known as DLT, could be used to improve the performance of Canada’s wholesale interbank payment system.

“A pure stand-alone DLT wholesale payment system is unlikely to match the net benefits of a centralized wholesale payment system,” the Bank said in a report.

So mine is hardly an original opinion as Bitcoin prices are extremely volatile and rose to a new high this week of over USD 4000 but the case for the defence is here if you are interested (I don’t agree with it). It seems really simple that on a limited base of coins as the price has risen more people are simply betting it will rise more.

The hard part of an investment bubble is of course spotting it beforehand and defining exactly what one is? This defintion is commonly accepted:

Bubbles are typically associated with dramatic asset price increases followed by a collapse. Bubbles arise if the price exceeds the asset’s fundamental value. This can occur if investors hold the asset because they believe that they can sell it at a higher price to some other investor even though the asset’s price exceeds its fundamental value.

There are  two kinds of asset price bubbles:

  1. Unleveraged ‘irrational exuberance’ bubbles
  2. Credit boom bubbles with a positive feedback loop.

The reason the internet boom ended with a whimper was that it was equity financed. A large number of VC funds and investors took equity risk and lost. Technology induced investment bubbles are not new; the most obscure one I have found yet is the British Bicycle Mania (1895-1900) when share prices of the associated companies rose over 200% over the period, and were divorced from earnings potential.

In comparison offshore (and shipping) was leveraged credit boom and these are more serious “because their bursting can lead to episodes of financial instability that have damaging effects on the economy“. The reduction in shipping loan volumes I discussed earlier are an indicator of that and as Mishkin outlines here is what happened in offshore and shipping (in addition to the underlying dropping dramatically in both):

[a] rise in asset values, in turn, encourages further lending against these assets, increasing demand, and hence their prices, even more. This feedback loop can generate a bubble, and the bubble can cause credit standards to ease as lenders become less concerned about the ability of the borrowers to repay loans and instead rely on further appreciation of the asset to shield themselves from losses.

At some point, however, the bubble bursts. The collapse in asset prices then leads to a reversal of the feedback loop in which loans go sour, lenders cut back on credit supply, the demand for the assets declines further, and prices drop even more. The resulting loan losses and declines in asset prices erode the balance sheets at financial institutions, further diminishing credit and investment across a broad range of assets.

Again this is no recent phenomena and asset heavy industries are particularly susceptible: the railway boom of the 1840s was based on partly paid shares (“derivative like”) and as the author notes:

[t]he use of leverage can exacerbate both the boom and bust in asset price reversals, and it may be wise for policy makers to continually monitor changes in the use of leverage.

If you want to see a microcosm of this look no further than DVB Bank where losses in offshore effectively wiped out the entire tier 1 capital of the bank.

Bitcoin is an ‘irrational exuberance’ bubble and clearly into the realms of behavioural influences as its utility as a currency is minimal, exlcuding black market transactions, and it flutuates enormously as a store of value. Normal state issued paper (“fiat money“) can settle tax obligations and from this its a core part of its value derives, it is impossible to see the state giving up this prerogative. Bitcoin is a technology inspired bubble without any fundamental economic value. 

The core attraction, if you believe the Bitcoin adherents, beyond the obvious anonymity is the apparent stability of the base unit as there is a limit to how quickly new units are “mined” and an overall cap on many cryptocurrencies including Bitcoin (21m units). And indeed one valuation methodology for the currency bases it as a % of all black market transactions. The monetary system being emulated is the gold standard (with nomenclature of mining clearly being no accident) where national currencies were exchangeable for gold (at its peak). The gold standard failed, precisely because the monetary base was too inflexible, and led to and exacerbated the Great Depression.

 

That isn’t to say there isn’t a place for local monies and that they cannot help economic growth. Local currencies, such as the Bristol Pound, exist in the UK. Maybe Bitcoin can serve a similar functional value for the ethereal world.

The interesting thing for those with only passing knowledge of the subject is that this is a monetary system that is being created in relatively short order but because of its open source nature, and the specialised technical knowledge required to enter it, means it is dominated by computer programmers. Yet the Bitcoin system is actually very similar to a crude medieval monetary system and if you want to see how economic history can add some value to a current debate this is a good example. Medieval money systems had a relatively fixed base of currency as The Commercial Revolution was just beginning and much of the coinage used was reminted from Roman times with mining out insufficient to affect the overall supply level until the “New Silver” from Freiberg was found and started moving to Venice. So a lot like bitcoin the money supply expanded only very slowly.

One of the key drivers of the Bitcoin price rise recently has been the split of Bitcoins to Bitcoin cash and there has been a fight between those for and against the split along the lines of preserving coin value and purity versus the need for transactions and the increase in value that will come from acceptance. The Bitcoin cash split comes by splitting the size of each Bitcoin such that it can be mined independently as smaller file sizes containing a number of transactions. The technical innovation is also that it speeds up processing but it also makes it available for micropayments. This is very similar to how medieval mints operated by exchanging larger coins for smaller coins and the difference in the exchange ratio was the seignorage to the mint – although Bitcoin exchanges are private whereas mints were the domain of the King.  The small denomination split is well known to economic historians: In 1956 Cipolla noted:

‘Every elementary textbook of economics gives the standard formula for maintaining a sound system of fractional money: to issue on government account small coins having a commodity value lower than their monetary value; to limit the quantity of these small coins in circulation; to provide convertibility with unit money. . . . Simple as this formula may seem, it took centuries to work it out. In England it was not applied until 1816, and in the United States it was not accepted before 1853.’

This became known as ‘The Big Problem of Small Change‘ which observed that since medieval times during episodes  of inflation small coins disappeared from circulation as they were made up of the exact proportion of value in metal of the larger coins they represented. Small coins frequently disappeared from circulation and made transactional commerce difficult for micropayments (in the current Fintech jargon). The same problem occured during ‘The Great Inflation’ in the United States (1967-1982) when copper coins disappeared from circulation as they were worth more as scrap. It is a great paradox in economics where more money generates rising prices but rising prices generate a shortage of money.

The problem that the Bitcoin cash “fork” in the chain (as it known) is trying to solve is the “penny-in-advance” constraint where “small denomination coins can be used to purchase expensive items, but large denomination coins cannot be used to buy cheap items’. Over time, until the invention of “token” money for small denominations smaller coins depreciated more relative to larger over time. The Bitcoin solution is to develop Bitcoin cash which represents a monetary fraction of a Bitcoin and forks into a seperate chain in the blockchain and in this respect is similar to:

the gradual debasement of the denarius between AD 800 and AD 1200 [that] was not fiscally motivated,but was a reasonable response to economic expansion that exceeded the growth of monetary metal

This was also found in Venice where the :

debasement of imperial pennies by Italian mints from the ninth century to the twelfth has usually been attributed to the greed and completion of local lords, but it probably was in the public interest, because it met a growing need for coin that arose from the increased use of markets and the general expansion of trade.

Bitcoin cash may prove that technology that can solve some of the issues that took medieval monetarists such a long time to work out. Mint technology advanced making forgeries harder and in this case the Bitcoin cash is an exact unit of Bitcoin. But the Bitcoin cash fork is still going to have the same problem that different chains forks over different exchanges and locations still need to be brought together at a common rate to transact. I don’t see it but there is no doubt that in medieval times changing the types and value of coins changed welfare outcomes. So there is a sound economic basis for the Bitcoin split, the question is who will benefit from the changes. Like the mints the Bitcoin exchanges are privately owned and I suspect welfare benefits will accrue disproportionately to them.

Like all economic issues there is not universal acceptance of the solution to the Big Problem of Small Change. An excellent paper here argues that at times small coins experienced periods of munificence as often as scarcity and that the value of large demonimation coins is the “dollar-in-advance” problem where small coins are impractical for large puurchases due to high transaction costs (i.e. verification and clearing).  The other problem with the “Big Problem” is that it may have been small because actually credit was common and debts were settled in kind or when they reached a certain limit.

The distributed ledger technology is also reminiscent of private clearing of notes that used to take place amongst banks when private money was more common. Research into the antebellum Suffolk Bank by the Minnepolis Fed (and others) concluded that there was a natural monopoly in note clearingand explains why clearinghouses and banks such as Suffolk developed that ties into the technology of argument the Bank of Canada. 

The increasing number of cryptocurrencies seem to mimic the early period of US banks where notes were privately issued and traded at a discount depending on the perceived regulatory effectiveness on the state in which they were domiciled or the strength of the bank issuing the currency (in an era prior to depsoit insurance). An extremely readable 20 page history of how complicated it was for the US to actually get a national unit of currency is here (and highlights some of the challenges for the Euro).

Bitcoin strikes me as technology being done because it can (as opposed to the blockchain technology behind it which is clearly powerful), and because, like selling tulips in the 1630’s, it is extremely profitable for some people. Is it an advance? I don’t think so, it adds nothing to the utility of money, doesn’t seem to make the economy more productive and offers the possibility of eroding the tax base. I have made this note here to mark how my views change over time more than any other reason and I will be interested in how this evolves.

On holiday…

I have been coming to Greece for years and every year for the past three years there has nealy been a currency and banking crisis before we arrive (last year only foreign Visa cards worked at the ATM)… I have no wish to open the Euro debate while on holiday I just note the past which is one of the reasons I like economic history:

“Throughout the latter half of the 1920s Germany was living on borrowed time. Foreign debts, many of which called be recalled at short notice, were allowed to pile up to an extent which, in view of the industrial development of the country and high tariff barriers imposed by the creditors, could never be justified by her actual or potential export earnings. How Germany was supposed to meet her obligations once capital imports ceased seems never to have been seriously considered by creditors, a lack of foresight difficult to explain. Even had there been no economic crisis or check to lending at the end of the decade it was inconcievable that Germany could have gone on absorbing such large capital imports for much longer. The alternatives were limited; any attempt to secure an improved external balance would have required severe deflation and even ths would hardly have been sufficient. It is possible that the Germans shrank from positive action to demonstrate their aversion to the obligations imposed by the Aliies. That the Allies should have attempted to conceal the impossibility of the burden, at least in the short term, by pouring capital into Germany speaks volumes for their economic wisdom”

Derek Alcroft, From Versailles to Wall Street, p257

From Reuters June 15:

But the Washington-based Fund, which Europeans value for its rigor but had fallen out with over its demands they forgive Athens some of its debt, will not disburse any of its money yet. It still wants the euro zone to offer sufficient extra detail on possible debt relief in 2018 to let the Fund calculate that it will be enough for Athens to sustain its debt in the long run.

The standby arrangement was a second best solution to a full debt deal, Lagarde said, but it would buy the euro zone, Greece and the IMF time to work out the details for next year.

A senior IMF official said they were still not satisfied the euro zone was ready to do enough on debt relief but had joined the bailout anyway as Greece risked being in difficulty again.

To accommodate the IMF’s need for more specifics on debt relief, the euro zone finance ministers said in a statement that in 2018 they would be ready to consider extending the maturities and grace periods of their loans to Greece by a range from zero to 15 years. The average maturity now is 30 years.

But they did not go any further than that and the IMF said it was not enough to calculate Greek debt sustainability.

I therefore may read this on my holiday:

Once upon a time, in the 1990s, it was widely agreed that neither Europe nor the United States was an optimum currency area, although moderating this concern was the finding that it was possible to distinguish a regional core and periphery (Bayoumi and Eichengreen,1993). Revisiting these issues, we find that the United States is remains closer to an optimum currency area than the Euro Area. More intriguingly, the Euro Area shows striking changes in correlations and responses which we interpret as reflecting hysteresis with a financial twist, in which the financial system causes aggregate supply and demand shocks to reinforce each other. An implication is that the Euro Area needs vigorous, coordinated regulation of its banking and financial systems by a single supervisor—that monetary union without banking union will not work.

Although this is one of the best books I have read in while… Caio for 2 weeks from Skala Eresou, Lesvos…

 

Baumol cost disease and offshore productivity versus shale

Economic progress, in capitalist society, means turmoil.

Joeseph Schumpeter

I don’t want to say I told you so, not more than once anyway, but in an article in the FT yesterday Ed Morse from Citibank called what I have been saying for some time:

They way the market has responded is a reminder not to underestimate shale. The unconventional oil revolution looks unstoppable. US shale production looks likely to rise by more than 5m barrels a day by 2022. Shale costs have fallen 35 per cent since 2014 and are beginning to rise again. But shale cost inflation is limited to well completion, not drilling, and productivity gains look to be rising even faster. Estimated ultimate recovery levels have doubled over the last few years and such bottlenecks as delivering fracking sands are being overcome. And don’t ignore either deep water or oil sands, which could each contribute more than 1m b/d of growth by 2022. Deep and difficult water costs have fallen 20-25 per cent and appear to have another 20-25 per cent to go.

Read the whole thing if you can. The article also highlights that shale may not be subject to the volume constraints the offshore industry has always assumed.

In a tribute to their forecasting accuracy, and with all the resources of Citibank on offer, the team have managed to “forecast” a price variation of somewhere between USD 20-25 per barrel (a c. 50% of the current price) and note the peak price should max out at 65, but may reach 70… I hope these quotes are for general distribution and the banks clients get a more accurate view… I digress….

I have mentioned productivity before, one of my favourite quotes is Krugman’s line   “productivity may not be everything, but in the long run it’s nearly everything” (okay he was talking about East Asia but actually the growth models used for modelling are pretty similar). But there is something deeper going on here. Last week a giant in the economics world passed away: William Baumol. Baumol literally wrote my undergrad economics textbook, as a discipline Microeconomics (the study of firms) has advanced significantly in the last 25 years in a really positive way that diverges from the obsession with perfect competition, and much of it due to his insights, many of which infuse this blog (I hope).

The first major insight Baumol had has shaped our worldview literally and is directly applicable in viewing offshore versus shale. In the 1960’s Baumol noticed that musicians weren’t any more productive than they were 100 years ago. A string quartet still takes four people just as it did 100 years before. Manufacturing is subject to increasing returns to scale, unit costs drop as production increases (up to a certain point), but that isn’t true in service organisations where there are limits to productivity increases and wages are fixed in a nominal sense (especially in the short-run). Bamoul cost disease or the Bamoul effect, is a world of progressive decline in real prices for manufactured goods, subject to standardisation and mass production, and therefore productivity improvements, these become cheaper, while goods with a high service element or input remain at that level.

Notice in the above Morse references offshore cost drops not productivity improvements. A DSV still has a safe manning certificate of 12 just like it did last week, and last year (while shale well output has increased 20% for the same inputs), what has happened in offshore is there has been a transfer of wealth from vessel owners and banks to E&P companies. The equity has in effect been wiped-out in this transfer. It’s not that offshore has got more efficient, it is that it has distributed the losses throughout the supply chain. That is unsustainable.

Offshore has not been subject to any standardisation, in fact it is by design an industry with a high human service element and input basis. Rigs and vessels, while following similar designs, are essentially custom built (or maybe one of a series of 3 or 4), field development is bespoke, installation methodology is unique, risers are one-off’s etc. By design the offshore industry is a high service output and not subject to productivity improvements. Cost disease isn’t meant to be pejorative in this case, rather a statement of fact. Everyone in offshore has tales of outrageous waste (I once found a TV repairman from Aberdeen on a vessel in Malaysia), but this was a sympton not a cause of an industry where getting first oil topped all other considerations. The world has changed.

Compare that with shale. Shale is a manufacturing process at the start of its technological journey. I don’t know how quickly companies will continue to improve shale productivity, but I do know large rig companies, like Nabors, with huge assets and R&D arms, have teams of people working every day to work out how to get a little bit better and deliver a little more and over time they will improve, industrialise the process across the fleet and drive unit costs down. It will be very hard for offshore to match this.

Bamoul’s other great contribution, that is also relevant to offshore, was to realise that large firms don’t actually compete by trying to drive prices down all the time (which was close to heresy in the economics community when he suggested this), they compete on innovation and productivity.

I won’t go into the full argument here but it involves a theory of how the economy grows as well as firms that is based on constant innovation. This process is underpinning the service firms driving the shale revolution, a constant fear that if they do not seek to drive this productivity they will lose market share, firms in this situation don’t sit still and move to static efficiency, the concentrate on innovation.

Offshore has an unattractive development cycle compared to shale: you need to get some seismic data, hire a rig for exploration and assessment, raise money (if you are a small company), get a different rig back to drill the wells, and then put the subsea kit in. It’s risky and expensive, and the pay-off cycle is long with break points at which you can lose all previous investment. Fields/tie-backs that used to be developed for 5-15 000 bpd output look severely at risk. It is very easy to see offshore turning into an industry where large fields, with high flow rates, are developed and smaller fields become a rarity (until technology improves). Large fields, with very low lift costs and high volumes can offset the huge investment in one-off design that this requires. Such an outcome would see a vastly different supply chain to the current one.