A money creation theory of offshore asset recovery…

The reason we are less enthused by companies which rely on tangible assets such as buildings or manufacturing plants [Ed: or rigs/jackups/ships?] is that anyone with a big enough budget can easily replicate (and compete with) their business. Indeed, they are often able to become better than the original simply by installing the latest technology in their new factory. Banks are also quite keen to lend against the collateral of tangible assets under the often illusory view that this gives them greater security, meaning that such assets can also be financed easily with debt, or as we call it, ‘other people’s money’. Debt is provided to such companies both cheaply, and with seeming abandon at certain times in the economic cycle, with often perilous results.

Smithson Investment Trust, Owners Manual

High confidence tends to be associated with inspirational stories, stories about new business initiatives, tales of how others are getting rich…

Akerlof and Shiller, Animal Spirits

…the instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rather than on a mathematical expectation, whether moral or hedonistic or economic. Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as a result of animal spirits — of a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.

Keynes, Chap 2: The State of Long Term Expectations, in The General Theory

While quite ready to change my opinion, I have, at present, a strong conviction that these two economic maladies, the debt disease and the price-level disease (or dollar disease), are, in the great booms and depressions, more important causes than all others put together…

Some of the other and usually minor factors often derive some importance when combined with one or both of the two dominant factors.

Thus over-investment and over-speculation are often important; but they would have far less serious results were they not conducted with borrowed money. That is, over-indebtedness may lend importance to over-investment or to over-speculation.

The same is true as to over-confidence. I fancy that over-confidence seldom does any great harm except when, as, and if, it beguiles its victims into debt.

Irving Fisher, The Debt Deflationary Theory of Great Depressions

… the modern debt-deflation process encompasses falling asset prices, debt repayment difficulties, a reluctance to lend, a financial crisis, the impact on the banks, and the inter-dependency of the financial system…

Wolfson, Cambridge Journal of Economics

Financial illiteracy is a recipe for debt, default and depression, whose effects appear to feedback on each another in a vicious spiral.

These individual costs are amplified when they are aggregated up to the macro level. How people’s expectations evolve – their degree of optimism or pessimism, exuberance or depression – is crucial for determining their individual decisions. It has long been recognised that these expectations can be shaped importantly by others’ expectations. For example, “popular narratives” can emerge which shape collective expectations among the public – optimism or pessimism, exuberance or depression – and which can then drive aggregate economic fluctuations…

At a macroeconomic level, the work of George Akerlof and Robert Shiller has looked at the popular narratives which emerge during periods of boom and bust.  Using words extracted from newspapers, they find the prevailing popular narratives about the economy have played a significant role in accounting for the heights of the peaks and depths of the troughs during macro-economic booms and busts. Public expectations, embedded in the stories they tell, are a key macro-economic driver.

Andrew Haldane, Bank of England, Folk Wisdom

Last week the Deputy Governor of the Reserve Bank of Australia gave a speech titled “Money – Born of Credit?”, in this speech he outlined an important, yet underappreciated fact, of modern economies: deposits in bank accounts are caused by loans. A lot of people think that by putting money in their bank account they are giving the bank the ability to make a loan, but actually in a systemic sense it is the other way around: the money in your account is the result of banks making loans that end up as deposits in your account. In case you think this is some bizarre, and wrong, economic tangent, the Bank of England has an explanatory article “Money creation in the modern economy” which states:

In the modern economy, most money takes the form of bank deposits. But how those bank deposits are created is often misunderstood: the principal way is through commercial banks making loans. Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money.

The Chief Economist of Standard and Poor’s summed it up in this article:

Banks lend by simultaneously creating a loan asset and a deposit liability on their balance sheet. That is why it is called credit “creation”–credit is created literally out of thin air (or with the stroke of a keyboard). The loan is not created out of reserves. And the loan is not created out of deposits: Loans create deposits, not the other way around.

This ability of privately owned banks to have the power of money creation is not often discussed. To many economists, although generally not those working at banks, this is a privilege where the ability to ‘privatize the profits and socialise the risk, is most flagrant and should perhaps be regulated more. The ‘Exorbitant Privilege‘ of the private sector. There is significant evidence that financial and banking crises have indeed become more common since the move to deregulate the financial system and credit creation that became especially strong post the end of the Bretton Woods era (post 1973).

If you are still reading at this point you may be wondering where I am going with this? The answer is that the implications for an industry like offshore, an asset-backed industry where values were sustained by huge amounts of bank leverage, are important for understanding what a “recovery” will look like. The psychology and ‘animal spirits’ of the commercial banks is likely to matter more than any single factor in dictating when an asset price recovery will be. Given that the loan books are closed to all but tier 1 borrowers, and contracting overall in offshore sector exposure, this would appear to be some way off.

Part of “the boom” in offshore since 2000, barring a short and sharp downturn in 2008/09, was the increasing value of rigs and offshore support vessels, but important too was the willingness of banks to lend against 2P reserves (Reserve Based Lending). This was a pro-cyclical boom where because everyone believed the offshore assets and reserves were worth more than their book value banks were willing to lend significant amounts of money against them. There was a positive and logical narrative of a resource-contrained oil world to unlock the animal spirits, it wasn’t irrational per se. As these assets changed hands banks created deposits in company accounts, they literally created “money” out of thin air by believing that the assets were worth more than they were previously. It is no different to a housing boom, and the more money the banks pumped in, the more everyone believed their assets were worth more (as the deposits grew). Ergo a pro-cyclical credit boom combined with an oil price boom. The demand for oil, and its price, has recovered, and this will affect the amount of offshore work undertaken, but the negative effects of an asset price boom will take longer to recover.

Right now the banks aren’t creating any new money for the offshore sector, collectively they are actually destroying it. When banks refuse to lend on ships or rigs no deposits flow through the system. Money from outside the system stops flowing into the offshore sector from the banks. Values and transactions are supported by the economic earning potential of current assets and the amount of equity and debt raised externally by funds. None of these “creates” money as banks do. These funds are “inside” money.

As an example last week Noble purchased a jack-up from a yard in Indonesia and was granted a loan by the yard selling the unit (a Gusto unit pcitured above). A piece of paper was exchanged and credit was created for the $60m loan of the total ~$94m price. Neither firm has any more money than they had prior to signing the loan contract. Credit isn’t the same as money… had a bank been involved (simplistically) it would have credited the yard with $60m, created a debt of $60m for Noble (a debit), and created an asset for $60m on its balance sheet. This money would have flowed from outside the offshore industry. The total value of the transaction would have been the same but the economic consequences, particularly for the liquidity of the yard, would have been very different. It is safe to say the reason this didn’t happen is because no bank would lend the money under similar terms. Relief rather than animal spirits seems a more likely emotion for this transaction.

It is not just the offshore contracting companies but also the E&P companies that are suffering from reduced bank credit and this is affecting the number of projects they can execute (despite a rise in the oil price). Premier is currently raising funds for the Sealion project, as part of this Drilquip has been given the contract for significant parts of the subsea scope, and they have provided this on a credit basis. In past times Premier would simply have borrowed the money from a bank and paid Drilquip. Now Drilquip has an asset in how much credit it has extended Premier but in the hierarchy of money that is lower than the cash it would previously have had, and it has to wait for Premier to sell the oil to pay it, and take credit risk and oil price risk in the meantime. Vendor financing is not the panacea for offshore because unlike banks vendors can create credit, but not money, and these are two fundamentally different things. There is a financial limit to how many customer Drilquip can serve like this. Collectively this lowers the universe of potential projects for E&P companies, and therefore the growth of the industry, that can be achieved. Credit creation is essential for an industry to grow beyond its ability to generate funds internally.

Another good example is the Pacific Radiance restructuring. Here the proposed solution, that I am enormously sceptical of, is that a new investor comes in allows the banks to restructure their loan contracts/ assets such that they can get paid SGD 100m in cash immediately while writing down the size of the loan. The equity and funds coming in are funds from the existing stock of money supply, they are not additional liquidity created by a belief in underlying asset values and represented by a paper loan contract and a growth in the loan book of the bank. While the new funds are adding to the total stock of money available to the offshore industry the bank involved is taking nearly as much off the table and you can be sure they won’t be lending it back to the sector. And thus the money stock and capital of the industry is reduced. Asset values remain low and the pain counter-cyclical process continues.

When you see companies announcing asset impairments and net losses that flow through to retained earnings this is often merely accounting of the banks withdrawing money from the sector and the economic cost of the asset base not being in tune with the amount of money available to the industry as a whole. It is also seen in share price reductions as the assets will never pay their owners the cash flows previously forecast.

In a modern economy this is normally the transmission mechanism from a credit bubble to a subsequent economic collapse: the ability of private sector banks, and only banks because of the system can create “money”, to amplify asset prices and cause sectoral booms on the way up and reduce the money stock and asset valuations on the way down. Why this happens is a complex topic and cannot be tackled in a blog, but it has clearly happened in offshore. Just as it has happened in housing booms, mining booms, ad infinitum previously. The dynamics are well known and are accentuated in industries which have had a lot of leverage. Much work was undertaken following the depression of agricultural prices in the 1930s, a commodity like oil which fluctuated wildly but the tangible backing of land allowed banks to supply significant leverage to the sector. Irving Fisher, quoted above, was famous for predicting that the US stock market had reached a “permanently high plateau” in 1929,  but his understanding of debt dyamics from studying banking and the US dustbowl depression transformed our understanding of the role of credit and banking.

[This explanation crucially differentiates between inside-money and outside-money. I am making a distinction between money generated inside the offshore sector and outside. By inside money I mean E&P company from expenditure, credit created amongst firms in the industry, and retained earnings. Outside money is primarily bank credit and private equity and debt funds. But whereas private equity and debt funds must raise money from the existing money stock only bank created money raises the volume of money].

In offshore the credit dynamics have been combined with the highly cyclical oil industry and allows optimists to believe a “recovery” is just possible. But a recovery scenario that is credible needs to differentiate between an industrial recovery, driven by the amount of E&P projects commissioned, and an asset price recovery, which is essentially a monetary phenomenon.

A limited industrial recovery is underway. It is limited by the availability of bank credit and the huge debts built up in the previous boom by the E&P companies, and their insistence that shareholders need dividends that reflect the volatility risk of the oil and gas industry. It is also limited because of the significant market share US shale has taken from offshore. But the volume of offshore project work is increasing. This is positive for those service firms who had limited asset exposure, and particularly for the Tier 1 offshore contractors, as much of the work being undertaken is deepwater projects that are large in scope.

But an asset recovery is still a long way off. There are too many assets for the volume of work in the short-run and in the long run it will be very hard to get banks to advance meaningful volumes of credit to the industry. Companies can write loan contracts with each other that represent a value, but banks monetise that immediately by providing liquid funds and therefore raising the animal spirits in the industry, whereas shipyards lending money to drilling companies need them to generate the funds before they can get paid. The velocity and quantity of money within the industry become much smaller. Patience and animal spirits make poor bedfellows.

Bank risk models for a long time will highlight offshore as a) volatile, and b) risky given that a bad deal can see even the senior lenders wiped out completely. Like all of us banks fight the last crisis as they understand it best. Until banks start lending again the flow of funds into the offshore industry will mean the stock of assets that were created in more meaningful times are worth less. In a modern economy credit creation is the sign that animal spirits are returning because it raises the return to equity (and high yield) providers.

In the boom days leading up to 2014 money and credit were plentiful. The net result was a vast amount of money being “created” for the offshore sector and a lot of deposits being created in accounts by virtue of the loans banks were creating to companies in the offshore sector based on their asset value. Now the animal spirits are no more and a feeling of caution prevails. The amount of money entering the sector via higher oil prices and private equity and debt firms is much smaller than was previously created by the banking sector. Over time this should lead to a more rational industry structure… but a repeat f 2014 days is likely to be so far away that the market at least has forgotten it…

As The Great Man said:

We should not conclude from this that everything depends on waves of irrational psychology. On the contrary, the state of long-term expectation is often steady…[but]…We are merely reminding ourselves that human decisions affecting the future, whether personal or political or economic, cannot depend on strict mathematical expectation, since the basis for making such calculations does not exist; and that it is our innate urge to activity which makes the wheels go round, our rational selves choosing between the alternatives as best we are able, calculating where we can, but often falling back for our motive on whim or sentiment or chance.

Zombie offshore companies… “Kill the zombie…”

“I’ve long said that capitalism without bankruptcy is like Christianity without Hell. But it’s hard to see any good news in this.”

Frank Borman

“In a business selling a commodity-type product, it’s impossible to be a lot smarter than your dumbest competitor”.

Warren Buffet

The Bank for International Settlements defines a Zombie Company as a “firm whose interest bill exceeds earnings before interest and taxes”. The reason is obvious: a firm who is making less in profits than it is paying in interest is likely to be able to eke out an existence, but not generate sufficient profits to invest and grow and adapt to industry changes. A firm in such a position will create no economic value and merely exist while destroying profit margins for those also remaining in the industry.

The BIS make clear that zombie companies are an important part of the economic make-up of many economies. I am sure sector level data in Europe would show offshore comfortably represented in the data.

Zombie Firms.png

Conversable Economist has an excellent post (from where I got the majority of my links for this post) on Zombie Companies and their economic effects, which timed with a post I have been  meaning to right about 2018 which I was going to call “year of the zombie”. Zombie companies have been shown to exist in a number of different contexts: in the US Savings and Loans Crisis zombie firms paid too much in interest and backed projects that were too risky, raising the overall costs for all market players. Another example is Japan, where post the 1990 meltdown Hoshi and Kashyap found (in a directly analogous situation to offshore currently):

that subsidies have not only kept many money-losing “zombie” firms in business, but also have depressed the creation of new businesses in the sectors where the subsidized firms are most prevalent. For instance, they show that in the construction industry, job creation has dropped sharply, while job destruction has remained relatively low. Thus, because of a lack of restructuring, the mix of firms in the economy has been distorted with inefficient firms crowding out new, more productive firms.

In China zombie firms have been linked to State Owned Enterprises, and have been shown to have an outsize share of corporate debt despite weak fundamental factors (sound familiar?). The solution is clear:

The empirical results in this paper would support the arguments that accelerating that progress requires a more holistic and coordinated strategy, which should include debt restructuring to recognize losses, fostering operational restructuring, reducing implicit support, and liquidating zombies.”

The subsidies in offshore at the moment keeping zombie firms alive don’t come from central banks but from private banks, and sometimes poorly timed investments from hedge funds. Private banks are unwilling to treat the current offshore market as anything more than a market cycle change, as opposed to a secular change, and are therefore allowing a host of companies to delay principal payments on loans, and in most cases dramatically reduce interest payments as well, until a point when they hope the market has recovered and these companies can start making payments that would keep the banks from having to make material writedowns in their offshore portfolios.

Now to be clear the banks are (arguably) being economically rational here. Given the scale of their exposure a reasonable position is to try and hold on as the delta on liquidating now, versus assuming even a mild recovery, is massive because of the quantity of leverage in most of the offshore companies.

But for the industry as a whole this is a disaster. The biggest zombie company in offshore in Europe is SolstadFarstad, it’s ambition to be a world leading OSV company is so far from reality it may as well be a line from Game of Thrones, and a company effectively controlled by the banks who are unwilling to face the obvious.

A little context on the financial position of SolstadFarstad makes clear how serious things are:

  • Current interest bearing debt is NOK 28bn/$3.6bn. A large amount of this debt is US$ denominated and the NOK has depreciated significantly since 2014, as have vessel values. SolstadFarstad also takes in less absolute dollar revenues to hedge against this;
  • Market value equity: ~NOK 1.73bn/$ 220m;
  • As part of the merger agreement payments to reduce bank loans were reduced significanlty from Q2 (Farstad)/Q3 (Solstad) 2017. YTD 2017 SOFF spent NOK ~1.5bn on interest and bank repayments which amounted to more than 3 x the net cash flow from actually operating all those vessels. While these payments should reduce going forward it highlights how unsustainable the current capital structure is.

The market capitalisation is significantly less than the cash SOF had on the balance sheet at the end of Q3 2017 (NOK 2.1bn). Supporting that enormous debt load are a huge number of vessels of dubious value in lay up: 28 AHTS, many built in Asia and likely to be worth significantly less than book value if sold now, 22 PSVs of the same hertiage and value and 6 ageing subsea vessels. The two vessels on charter to OI cannot be generating any real value and sooner or later their shareholders will have had as much fun as they can handle with a loss making contracting business.

But change is coming because at some point this year SolstadFarstad management are in for an awkward conversation with the banks about handing back DeepSea Supply (the banks worst nightmare), or forcing the shareholders to dilute their interest in the high-end CSV fleet in order to save the banks exposure to the DeepSea fleet (the shareholders worst nightmare and involves a degree of cognitive dissonance from their PSV exposure). Theoretically DeepSea is a separate “non-recourse” subsidiary, whether the banks who control the rest of the debt SolstadFarstad have see it quite that way is another question? It would also represent an enormous loss of face to management now to admit a failure of this magnitude having not prepared the market in advance for this?

Not that the market seems fooled:

SOFF 0202

(I don’t want to say I told you so).

SolstadFarstad is in a poor position anyway, the company was created because no one had a better idea than doing nothing, which is always poor strategic logic for a major merger. What logic there was involved putting together a mind numbingly complex financial merger and hoping it might lead to a positive industrial solution, which was always a little strained. But it suited all parties to pretend that they could delay things a little longer by creating a monstrous zombie: Aker got to pretend they hadn’t jumped too early and therefore got a bad deal, Hemen/Fredrikson got to put in less than they would have had to had DeepSea remained independent, the banks got to pretend their assets were worth more than they were (and that they weren’t going to have to kill the PSVs to save the Solstad), and the Solstad family got to pretend they still had a company that was a viable economic entity. A year later and the folly has been shown.

Clearly internally it is recongised this has become a disaster as well. In late December HugeStadSea announced they had doubled merger savings to 800mn NOK. The cynic in  me says this was done because financial markets capitalise these and management wanted to make some good news from nothing; it doesn’t speak volumes they were that badly miscalculated at that start given these were all vessel types and geographic regions Solstad management understood. But I think what it actually reflects is that utilisation has been signifcantly weaker than the base case they were working too. Now Sverre Farstad has resigned from the Solstad board apparently unhappy with merger progress. I am guessing he is still less unhappy though than having seen Farstad go bankrupt which was the only other alternative? I guess this reveals massive internal Board conflict and I also imagine the auditors are going to be get extremely uncomfortable signing vessel values off here, a 10% reduction in vessel value would be fatal in an accounting sense for the company.

The market is moving as well. In Asia companies like EMAS, Pacific Radiance, Mermaid, and a host of others have all come to a deal with the banks that they can delay interest and principal payments. Miclyn Express is in discussions to do the same. This is the very definition of zombie companies, existing precariously on operating cash flows but at a level that is not even close to economic profitability, while keeping supply in the market to ensure no one else can make money either. Individually logical in each situation but collectively ruinuous (a collective action problem). These companies have assets that directly compete with the SolstadFarstad supply fleet, with significantly deeper local infratsructure in Asia (not Brazil), and in some cases better assets; there is no chance of SolstadFarstad creating meaningful “world class OSV company” in their midst with the low grade PSV and AHTS fleet.

Even more worrying is the American situation where the Chapter 11 process (and psyche) recognises explicitly the danger of zombie companies. Gulfmark and others have led the way to have clean, debt free, balance sheets to cope in an era of reduced demand. These companies look certain to have a look at the high-end non-Norwegian market.

SolstadFarstad says it wants to be a world leading OSV company that takes part in industry consolidation but: a) it cannot afford to buy anyone because it shares are worthless and would therefore have to pay cash, and b) it has no cash and cannot raise equity while it owes the banks NOK 28bn, and c) no one is going to buy a company where they have to pay the banks back arguably more than the assets are worth. SOF is stuck in complete limbo at best. Not only that as part of the merger it agreed to start repaying the banks very quickly after 2021. 36 months doesn’t seem very far away now and without some sort of magic increase in day rates, out of all proportion to the amount of likely subsea work (see above), then all the accelerated payment terms from 2022 will do is force the event. But still is can continue its zombie like existence until then…

In contrast if you want to look at those doing smart deals look no further than Secor/COSCO deal. 8 new PSVs for under $3m per vessel and those don’t start delivering for at least another 18 months. Not only that they are only $20m new… start working out what your  10 year old PSV is really worth on a comparative basis. There is positivity in the market… just not if you are effectively owned by the bank.

One of my themes here, highlighted by the graph at the top, is that there has been a structural change in the market and not a temporary price driven change in demand. Sooner or later, and it looks likely to be later, the banks are going to have to kill off some of these companies for the industry as a whole to flourish, or even just to start to undertake a normal capital replacement cycle. Banks, stuffed full with offshore don’t want to back any replacement deals for all but the biggest players, and banks that don’t have any exposure don’t want to lend to the sector. In an economy driven by credit this is a major issue.

I don’t believe recent price rises in oil will do anything for this. E&P budgets are set once a year, the project cycle takes a long time to wind up, company managers are being bonused on dividends not production, short cycle production is being prioritised etc. So while price rises are good, and will lead to an increase in work, the scale of the oversupply will ensure the market will take an even longer time to remove the zombie companies. At the moment a large number of banks are pretending that if you make no payments on an asset with a working life of 20-25 years, for 5 years (i.e. 20-25% of the assets economic life), they will not lose a substantial amount of money on the loan or need to write the asset down more than a token level. It is just not real and one day auditors might even start asking questions…

I don’t have a magic solution here, just groundhog day for vessel owners for a lot longer to come. What will be interesting this year is watching to see the scale of the charges some of the banks will have to make, a sign of the vessel market at the bottom will be when they start to get rid of these loans or assets on a reasonable scale.

Kill the zombies for the good of the industry, however painful that may be.

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.”

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.