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.

I’d rather be lucky than smart…

and these people were clearly both…

For the past year, Google’s car project has been a talent sieve, thanks to leadership changes, strategy doubts, new startup dreams and rivals luring self-driving technology experts. Another force pushing people out? Money. A lot of it. 

Early staffers had an unusual compensation system that awarded supersized payouts based on the project’s value. By late 2015, the numbers were so big that several veteran members didn’t need the job security anymore, making them more open to other opportunities, according to people familiar with the situation. Two people called it “F-you money.”

Scotcoin… I don’t get it?

As Minsky said “everyone can create money, the problem is getting it accepted”. I think I get Bitcoin, not the technology, but the broad idea. I think it suits people who buy stuff in the Dark Web and don’t want the government to see what they are doing, particularly tax wise. Because Bitcoin is an anonymous, and stateless, issuer of currency, it really can’t be taxed; and because its a fringe currency I don’t think governments worry about what is closing essentially a loophole.

But I don’t get Scotcoin that I just discovered the in the FT. Scotland has a tradition of free banking and note issue quite distinct from England and maybe this follows on. But while RBS and Clydesdale note issues make interesting historical relics they sit within the tax system and each note is fully cash collateralised at the Bank of England (hence the difference between legal tender and legal currency).  The old Scottish Free Banking system had no central bank and a number of historical anomalies that I don’t think would be accepted as most people in Scotland seem to be pushing the Euro (again why a small nation with an economy completely divorced from the German economy would want this is beyond me, but it seems so far fetched at the moment I’ll park it). Free banking also had its own credit crisis with the collapse of Ayr Bank in 1772 (Douglas, Heron & Co) which influenced Adam Smith and arguably had a huge effect on modern central banking. Even if you accept the economic logic of non-monopoly issue of free money (and I don’t think I do) it’s dead on arrival at the ECB. So this relies on an independent Scotland and an independent currency (which I think would be the right answer in terms of economic flexibility).

From what I can gather they have limited the issue to 1bn coins permanently and the company seems to make its money from the exchange and over time processing fees. Scotcoin seems to sit somewhere between the Bitcoin and state money and thus I give it a zero chance of success.

The seignorage has been privatised and actually seemingly limited to the initial issue and the processing which negates one of the key advantages of issuing private money, and by necessity this has been done when the currency was at its weakest. I won’t even get into the fact that as with the gold standard replacing fluctuations in the price of goods with fluctuations in the currency is not ideal (a point Ben Bernanke makes here while arguing for the logic of central banking) and this will also have a link to a monetary unit of account which will really confuse people.

Most importantly if it ever became economically important the government would worry about tax leakage. Taxes drive money. Its the most important prerogative of a modern state and the requirement that tax liabilities are settled in the (monopoly issue) currency of the state is vital. Unlike Scotcoin all the government has to do is demand all taxes are paid in its own currency and not accept Scotcoin and this project looks fatally flawed.

But I like innovation and new start-ups so I wish them every success. Apart from the concerns above it looks like a great idea.

 

Macro, gold, and private credit

Like most economic historians I get the gold standard was a bad idea and we shouldn’t go back to it. But I think the hankerings for it really reflect a deeper desire for some sort of control on the monetary base. As Bordo et al ., note:

We find that [financial and banking] crisis frequency since 1973 has been double that of the Bretton Woods and classical gold standard periods and is rivaled only by the crisis-ridden 1920s and 1930s. History thus confirms that there is something different and disturbing about our age.

The problem is credit. Specifically privately created credit and frankly clearly linked to housing and commercial property lending.

bank-lending-1870-2013

The Bretton Woods agreement controlled the capital account and acted as a brake on the pro-cyclicality of asset price inflation (unintentionally) by making it harder to fund these transactions from offshore borrowing. In some ways it linked the domestic asset base to a trading value of the currency. Now land values have gone crazy because capital is international and property has simply become an international asset class.

And as part of this change tThe banking system has been transformed:

The share of mortgage loans in banks’ total lending portfolios has roughly doubled over the course of the past century—from about 30% in 1900 to about 60% today. To a large extent the core business model of banks in advanced economies today resembles that of real estate funds: banks are borrowing (short) from the public and capital markets to invest (long) into assets linked to real estate.

The driving force in this has been lending to households as the article makes clear.

In the modern economy fractional reserve banking is a myth although it may have functioned like that under the gold standard. But now we understand that banks create money via deposits and there is no theoretical limit on money supply creation other than the monetary policy of the central bank, and there are questions as to the effectiveness of this given the openness of the modern international monetary system and banks ability to fund themselves in the wholesale market. In a modern economy, where home ownership is exalted above almost all other policy goals, combined with open bank funding on a international scale,  I struggle to see a limit on the creation of private credit to property and thus it is a system with a self-induced propensity to pro-cyclicality with a put option on the state. Anything less would imperil the banking system itself.

To me, the question isn’t whether we should be going back to the Gold Standard but really could the Bretton Woods agreement be improved and tried with Bancors? Like the Chicago Plan for domestic money, I am too cynical to believe an institutional mechanism that requires so much change is likely to occur, but it is clear that the link between credit and the macroeconomy is the crucial variable that needs to be understood better and be the driver of economic models. A fundamental model of understanding the modern macroeconomy needs to be the driver of credit, something Minsky well understood.