A straightforward explanation of the present financial crisis
(part 1)
Perhaps you've noticed that some funky stuff is going down in the financial markets.
Most normal people seem to understand finance the way I understand physics. I
understand that, if you're holding a brick of lead and you drop it, it will hit your foot.
I seem to recall that the brick will accelerate at 9.8 meters per second squared.
Apparently this has something to do with general relativity. Perhaps if I boned up on
it for a year or two, I could gain some vague understanding of GR. But I am happy to
leave it to the physicists.
If you think of finance this way, I'm afraid you have been misinformed. First, finance
is not a science. Secondly, finance is not intrinsically complicated. And third, unless
you are a physicist, your life will be pretty much the same whether you understand
relativity or not. "You may not be interested in war," Trotsky once said, "but war is
interested in you." The same is surely true of finance.
A better way to think of our present financial system is to compare it to Microsoft
Windows. Windows is indeed complicated. It is astoundingly, brilliantly, profoundly
complicated. If there is anyone in the world, even at Microsoft, who understands all
of Windows, he or she must have a brain the size of a basketball. (One would think
this individual would have at least been photographed at some point.) It took them
six years to ship Windows Vista, and I really have no idea how the hell they did it.
But Windows is not intrinsically complicated. It is a time-sharing kernel with a
graphical user interface. A smart undergraduate can write an time-sharing kernel,
with basically the same functionality as Windows, as homework in a semester. The
same can be said of the GUI, which is perhaps a bit more code but is certainly less
complex. (I wouldn't have the same student write both. I do feel this would be a little
much.)
Windows is complicated because it is both ancient and mature. It has been around
for a long time (20 years), and it has been used to solve just about any problem an OS
could conceivably solve. Including quite a few that it has no business at all in solving.
Exactly the same can be said of the modern financial system. The difference is that
Western finance is ten times as old as Windows. If not twenty or thirty. The result is
that, as with Windows, people can spend their entire lives trying to understand a
single small corner of it - say, real estate, or commodities, or bonds, or whatever. To
actually understand all of modern finance, you would need a brain the size of a
beachball. This would certainly attract notice, and you might have some trouble
getting laid.
Learning Windows (or Linux, or OS X, or whatever - they are all humongous) is an
awful way to understand operating systems. You can put as much work into it as you
want, and all you will learn is a tiny scrap of the basketball. So even the people at
Microsoft who work on Windows all day do not have degrees in Windowsology. They
learned OS the same way I did: by studying the principles, which are not at all
complex, and then writing a toy OS.
Unfortunately, if there is any equivalent of the toy-OS approach in finance or
economics, I have not run into it. But this is UR, and we never let a small problem
like this stop us.
Certainly the closest thing to a toy economics is the Austrian School. But when you
read the Austrians, you are still getting a good dose of Windowsology. Even a very
thorough Austrian treatment, like Rothbard's, exists to describe the financial system
as it is, not as an undergrad would build it. Worse, the founding treatise of the
modern (Misesian) Austrian school dates to 1912, and the Austrians have spent most
of the century since just fending off their many enemies. So you are actually getting a
sort of Hapsburg Windowsology. It is an entertaining task to try to map Mises' terms
to the contents of today's WSJ, but I can't say it's especially easy or productive.
So I thought I'd give the toy-OS method, which (thanks to Conrad Roth) I call
nitroeconomics, a spin in explaining what's up with all these SIVs, CDOs, and of
course those famous subprime loans. Ideally, the less you know about finance,
economics or accounting, the better. If you do have some understanding of this area,
please try to suppress it.
Of course our toy financial system will exist only in our shared imaginations.
However, we do need to imagine building it, because we are assigning the task to our
imaginary undergraduate. One easy way to do so is to set our actors not in the real
world, but in a virtual world.
This is kind of cool, because as everyone who hasn't been living in a cave for the last
ten years knows, virtual worlds really do have real economies. (Here is one blog,
unfortunately quite Windowsological, devoted to virtual economics.)
Unfortunately, the virtual worlds that exist today tend to have very primitive
financial systems (think Windows 1.0). They are more focused on killing orcs or
chatting with giant inflatable penises or whatever, than options and equities and
mortgage-backed securities. And what they do have tends to be copied from the "big
room," which gives us more Windowsology.
Nitroeconomics (if you want to sound more scientific you can call it synthetic
economics) is different. It is set in the virtual world of Nitropia, which doesn't exist
but easily could. Orcs and inflatable penises are no strangers to Nitropia - there is no
economics without fun - but the main point of the place is that it has a financial
system which is simple and makes sense.
We can use nitroeconomics to understand real situations in the real world, such as
the subprime crisis, with a simple three-step process. First, we set up a scenario in
Nitropia which (we claim) is analogous to the real-world scenario we're trying to
understand. Second, we figure out what would happen in Nitropia. Third, we connect
this back to the real-world result. While the process is certainly nontrivial and offers
great latitude for error, it is also a lot easier than Windowsology. Especially if you
know nothing about Windows.
The first cool thing about Nitropia is that it has no financial system at all. Unlike
other, inferior virtual economies, it does not distinguish between "money" and other
virtual objects. A monetary token in Nitropia is an object like any other - a magic
sword, an inflatable penis, or whatever. A player in Nitropia who has a lot of money
just owns a lot of these tokens. There is no special, separate "bank balance."
Today I am going to carefully skip over the issue of what "money" is, and why some
goods are "money" and others are not. This is a fascinating question and we will
return to it. However, the answer does not help us understand the subprime crisis.
Rather, I will just declare by personal ukase that the monetary token in Nitropia is
the cowrie. Cowries have the following properties:

Every cowrie is identical to every other cowrie.

Any number of cowries can be trivially stored or carried.

To remain alive, a Nitropian must eat one cowrie a day.

Cowries are not (directly) useful for any other purpose.

Nitropia contains a fixed number of cowries - 2^32 or 4,294,967,296.

Eaten cowries reappear at a random point in Nitropia.
In other words, the cowrie system is a closed-loop financial system. You probably
understand intuitively why this is ideal. But we'll certainly return to the subject.
Nitropia is divided into two parts: Nitro City, where Nitropians hang out and chat
with their inflatable penises, and the Dungeon of Yendor, which is infested with orcs
and other monsters, but also contains magic swords and other useful trinkets. At the
beginning of time, all cowries are in Yendor, so Nitropians need to kill if they want to
eat. A small, monsterproof door in Nitro City leads down into Yendor.
The second cool feature of Nitropia is a frictionless market. The market only works
in Nitro City - there is no coverage in Yendor, so to speak. In Nitro City, any
Nitropian can teleport any object (cowries, magic swords, inflatable penises, etc)
instantly to any other Nitropian. There are no delivery or other transaction costs.
Moreover, Nitropians can solve the ancient who-gives-first problem by conducting
specified exchanges, in which all goods are as described or no trade takes place. And
Nitropians of an especially geeky bent can upload trading bots which make
automatic trades, allowing them to design any market mechanism whatsoever.
So we'll assume that for every object O, there are market bid and ask prices in
cowries. The ask price is the minimum number of cowries that anyone who has an O
will accept in exchange. The bid price is the maximum number of cowries that
anyone who wants an O will pay. For common objects, ask and bid will probably be
close. Of course, prices change all the time with the rich, complex and constantlychanging lives of Nitropians.
The third cool feature of Nitropia is a system of formal promises, in which
Nitropians can promise to perform some action in future. Promises in Nitropia are
transferrable objects, just like cowries or magic swords. The beneficiary of the
promise is the holder of the object. Thus for any promise there is a promisewriter
and a promiseholder.
A common standard promise is a promise to deliver some quantity of cowries Q, at
some maturity time M. We call one of these promises a ticket. The difference
between the present time N and the maturity time M is the term of the ticket.
Promises in Nitropia are automatically enforced. If a Nitropian writes some promise
and fails to deliver, she is said to choke. When a Nitropian chokes, her account is
liquidated. All goods in it are sold on the open market. All promises written by the
liquidated Nitropian are cancelled, prorated by the current ask price of the promised
good, and refunded to the promiseholder from the proceeds of the liquidation sale.
Nitropians who write promises can also accept restrictions. A restriction, also
automatically enforced, is a promise with no beneficiary. For example, a
promisewriter may promise to stay out of Yendor (for obvious reasons). Restrictions
may also include disclosure of any and all information about the promisewriter,
including objects possessed and other promises written. In general, restrictions are
useful because a promise from a Nitropian who accepts certain kinds of restrictions
may well sell for more cowries. More on this subject later.
Okay. We now know enough about Nitropia to understand the subprime mortgage
crisis, or at least its simplified Nitropian equivalent.
The cause of the crisis is a pernicious bit of financial engineering called term
transformation. If Nitropians are behaving sensibly, they will avoid term
transformation. Nitropians are just people, however - fat, lonely, pasty-faced people
with no life outside their computers - and we can't be too surprised when they do
non-sensible things. Why high-powered jock traders on Wall Street were playing the
term-transformation game is another question entirely, and we'll save it for another
day.
To understand term transformation, we first need to understand the market for
tickets.
To understand a market for any good is to understand why it costs what it does.
Since all prices are set by supply and demand, we need to know the motivations of
the buyers and sellers. Of course, the seller of a ticket can be its original writer, or
someone else who bought the ticket and now wants to sell it again. But for simplicity,
we'll start by assuming the only participants are the ticketwriter and the initial
ticketholder.
We've defined a ticket so that there are only three variables: the term to maturity, the
quantity of cowries to deliver, and the identity of the ticketwriter. The identity of the
ticketwriter determines the probability that the ticketwriter will choke before
delivering the cowries.
Assume for the moment (we'll un-assume it in a minute) that no ticketwriters choke.
For these magical risk-free tickets, which cannot exist in nature (unless Nitropia's
sysadmin changes the rules), we have only two variables: quantity and maturity.
We can eliminate the quantity by dividing the current market price P of the ticket (in
cowries) by the delivery quantity Q of the ticket (in cowries). This gives us a nice
unitless number, P/Q. What can we say about this number?
I assert that for any ticket of any nonzero term, P/Q will be less than 1.
Suppose P/Q is greater than 1. Then the ticket buyer will be exchanging P cowries at
time N for Q cowries at time M, where P>Q and M>N. But, since cowrie storage is
free, she would do better by just holding onto her P cowries until M. If P/Q is 1, she
won't lose, but she won't gain either. Why bother? Since all exchanges require both
buyer and seller, none will happen.
We can define P/Q as the discount of the ticket. Then we can use the continuous
interest formula to normalize this to an interest rate or yield, which by Nitropian
convention is specified not per year, but per day. (Life is fast in Nitropia.)
For any ticket, if we know any two of discount, yield and term, we can compute the
third. Thinking in terms of yields rather than discounts does not eliminate the term
variable. But it lets us ask a very interesting question: in the Nitropian ticket market,
how will the yields of tickets with different terms compare? (Remember, we are still
assuming that no ticketwriters choke.)
The answer is that yields at longer terms will be higher. This is not as easy to show as
the fact that there will be no negative yields. But it's worth working through.
To understand why longer terms mean higher yields, we have to consider the reason
that Nitropians buy and sell tickets in the first place. We are assuming that these
instruments will even exist. But why should they? Why is there a market for tickets?
A ticketwriter is promising to deliver Q = (P + X) cowries later, in exchange for P
cowries now. She cannot fulfill this promise without engaging in some activity which
is profitable. Please note that this is not a value judgment. It does not make the
activity good or bad. It just means that it takes in P cowries now, and produces P+X
cowries at M = (now + T).
(In fact, the ticketwriter will only write the ticket if she expects her activity to
produce (Q + Y) cowries, because otherwise she makes nothing at all on the deal.
Everyone's gotta eat.)
The ticketbuyer is exchanging P cowries now for Q = (P + X) cowries at M. His
motivations are simpler. He always has the alternative of just storing the P cowries
until M. But, if he uses the ticket instead, he will get X more cowries.
So we have both buyer and seller, and the transaction happens. But what yield does it
happen at? The yield is defined by the discount, which is defined by the price of the
ticket, which is set by supply and demand among buyers and sellers. Contra most
medieval thinkers, there is no just or righteous interest rate, derived from the Bible
and the eternal laws of God. If we want to know what the cowrie yield is, we have to
actually instantiate Nitropia. And, like any price, this yield may change over time.
And even at any one time in the Nitro City market, there is not just one yield. There
may be different yields for different terms. In other words, there is a yield curve. We
are now ready to see why this curve slopes upward - ie, yields at longer terms are
higher.
How do you actually turn a profit in Nitropia, anyway? Not that the ticketbuyer cares
at all how this feat is accomplished - but there is one obvious productive process.
Nitropians can descend into Yendor, kill monsters, and relieve them of their cowries
and other good stuff. Of course, the monsters fight back, so there is no sure thing.
And in order to fight monsters, you need weapons - magic swords, inflatable penises,
or whatever.
So the ticketseller might use P, the cowries she gets for selling a ticket, to rent a
magic sword, with which she descends to level 15 of Yendor, clears out a nest of foul
orcs, confiscates their cowrie stash, and returns to Nitro City, where she returns the
sword and pays off her ticket.
The trick is that all this takes time. Unless you find a way to hack the Nitropia
servers, there is no such thing as an instantaneous profitable process.
So we can ask: in Nitropia, what will the yield be for a one-second ticket? Unless
someone can figure out a way to turn P cowries into P+X cowries in one second, the
yield will be zero. Thus (as we saw) no one will write any such tickets. And if there is
some way to profit in one second, we can always imagine an epsilon term which is
shorter. Thus, the Nitropian yield curve intercepts zero term at zero yield - regardless
of the details of Nitropia.
We can generalize this observation by noting that there are always more kinds of
longer productive processes than shorter ones. If you want to descend to level 417 of
Yendor and take on the evil dragon Angstrom, it will take you three weeks roundtrip. Whereas if all you are doing is heading down to 113 to knock off some random
ogre, you can do it in a week.
But a ticketseller can construct the equivalent of one three-week dragonslaying
expedition by stringing three one-week ogre-whacking trips back to back. Because it
takes three weeks to slay a dragon, there is no way for the profitable process of
dragonslaying to affect the market for one-week tickets. The converse, however, is
not the case.
There is no law that says that dragonslaying has to be more profitable than ogre-
whacking. However, if it is not at least as profitable as ogre-whacking, no one will
slay dragons. If ticketbuyers still want three-week tickets, ogre-slayers will sell them
three-ogre tickets. The short-term yield is a floor for the long-term yield. The
Nitropian yield curve can be flat, but it cannot invert.
In theory, there might be no profitable processes at all in Nitropia. For example,
suppose there are no cowries or goodies at all in Yendor. The yield curve will start at
the origin and remain there. In practice, any world complex enough to be any fun at
all, virtual or real, will have long-term processes that are more profitable than their
short-term counterparts. Because any short-term process can produce long-term
tickets but the converse is not the case, there will be more sellers at later maturities,
and the extra competition will push up yields.
Now it's time to relax the unrealistic assumption that killing monsters is risk-free.
Obviously, it is anything but. Monsters have teeth and claws, they bite and scratch,
they shoot fireballs and crush your bones in their huge armored pincers. If you never
return from Yendor, not only do you not fulfill your promises, you have no assets to
liquidate. The monsters keep it all.
This is tricky because, suddenly, comparing tickets written by different monsterhunters is comparing apples to oranges. Wall Street seems to have real trouble with
this concept, but assessing risk is always a matter of subjective opinion. How do you
know whether a hunter will return? You don't. How do you know her probability of
returning? You, um, guess.
So you guess. Let's say you think your ticketseller has a 97% chance of coming back.
Then, the expected value of her ticket is not Q, but (Q * 0.97). This simply lowers the
price P that you are willing to pay for the ticket. So that we can calculate objectively,
we still define the discount as P/Q. The risk of choking simply appears as a higher
yield.
But wait. For most of us, a 97% chance of Q is not at all the same thing as a 100%
chance of (Q * 0.97). Risk tolerance is subjective and nonlinear. This creates a
market for risk dispersal.
If you, the ticketbuyer, want a 100% chance of (Q * 0.97), there is no way to achieve
it. Uncertainty cannot be converted into certainty. However, you can produce a much
more desirable probability distribution by buying not one ticket from one hunter
with a 97% chance of returning, but 100 slices of 1/100th of a ticket from each of 100
hunters, each of whom has a 97% chance.
A tricky transaction! At this point you, the ticketbuyer, are tempted to just let your
cowries sit around "under the mattress." But there is an alternative. You can buy one
ticket from a ticket balancer, who in turn deals with 100 ticketbuyers and 100
ticketselling hunters.
The balancer does not hunt herself. She does not go anywhere near Yendor. She buys
100 tickets of Q cowries with one-week terms from hunters who she estimates have a
97% chance of returning. She then sells 100 tickets of (0.97 * Q) cowries to riskaverse buyers. Since the buyers are risk-averse, by definition they accept lower yields
than she pays the hunters, and she profits. As described the balancer's risk of choking
is quite high, but maintaining a small buffer of, say, (10 * Q) cowries will make it very
low, due to the law of large numbers.
What does a ticketbuyer need to know in order to buy a ticket written by a balancer?
He needs to know that (a) the balancer will not wander into Yendor and get knocked
off by an orc herself, and (b) the balancer holds enough tickets with sufficient
expected value, plus some buffer, to have a high probability of delivering on the
tickets she has written. There are no risk-free tickets in Nitropia, but a balancer can
reduce risk to an arbitrarily low epsilon, of course at the price of lower yield.
Thus, the balancer must submit to restrictions and disclosures in order to write
tickets which are perceived as low-risk. Rather than forcing every buyer of her tickets
to do his own "due diligence," she will probably hire an auditor who will inspect her
restrictions and disclosures, and testify to her credibility. The auditor is then
responsible for maintaining its own credibility in the eye of the public ticketbuyer.
Okay. This concludes our discussion of normal, healthy finance in Nitropia. (Note
that we have not mentioned equity, ie, stock. Our "tickets" are bonds, zero-coupon
bonds to be exact. Briefly, a more sophisticated financial system would replace our
one-size-fits-all liquidation procedure with different priorities of tickets, where highpriority tickets are paid off early if the ticketwriter chokes, and thus earn lower yield.
Stock is a sort of zero-priority ticket for especially funky hunting expeditions whose
return is wildly unpredictable. Its holders get no fixed payment at all, just whatever's
left over after everyone else is paid. Which could be huge, or it could be nothing at
all.)
Now it's time to transform some terms. Term transformation (this vice goes by other
names which are easier to Google, but let's keep the suspense for a little while)
happens when a ticket balancer buys tickets which mature later than the tickets she
writes.
At first, term transformation seems to make no sense at all. Then it makes perfect
sense. Then you see what a truly awful idea it is.
Recall that in our explanation of ticket balancing, our balancer bought 1-week tickets
from hunters who were going on 1-week expeditions, ie, whacking ogres. She then
sold 1-week tickets to her buyers, and the whole thing worked out perfectly. Her
hunters, or at least most of them, came back with the cowries, which she promptly
delivered. No sweat.
Suppose that instead of ogre-whackers, our balancer dealt with 3-week
dragonslayers. Remember, since the Nitropian yield curve slopes upward, the yield
on dragonslaying is higher than the yield on ogre-whacking. In other words,
dragonslaying is more profitable per week than ogre-whacking. Not because dragons
are wealthier than ogres, though they are. But just because if it wasn't, no one would
bother slaying dragons.
Thus, term transformation is an obvious way for the balancer to pocket a little extra
scratch. She is still paying 1-week yields, but she is earning 3-week yields. But, um,
there's a problem - when her ticketholders come back in a week, what does she say?
"Um, we've had, some, um, bad weather. Also the ogres are unexpectedly
recalcitrant. Also, um, actually, I was just heading out. Can I call you tomorrow? I'm
sure we'll get this whole thing cleared up."
This might fly in the real world. But not in Nitropia, whose ice-cold, iron-hard law is
enforced not by mere flesh, but merciless and inexorable software. As soon as the
balancer breaks her first promise, she is locked out of her account and her assets go
straight to the block. Ouch.
So how can term transformation happen? It seems that we are trying to teleport
cowries not through space, but backward through time. Even in Nitropia, there is just
no way to convert tomorrow cowries into today cowries. Besides, as we've seen,
balancers need to be audited, and even if our balancer is so foolish as to think she can
pull cowries magically out of the future, no auditor could conceivably agree.
We cannot understand term transformation without looking at the motives of the
buyer. After all, the auditor exists only because the buyer demands this service. If the
buyer accepts that term transformation is good and sweet and true, surely the
auditor will agree.
First, we notice that, since the balancer is after all earning a higher yield from her
dragonslayers, she can pay a higher yield to her customers. What will probably
happen in practice is that she will split the profit with them. So the balancer wins and
the ticketbuyers win. In fact, since term transformation creates a higher demand for
long-term tickets, thus driving down the yield (if not quite to ogre-whacking levels),
the dragonslayers win, too. Everyone wins. It's a win-win-win situation. At least if we
can solve this pesky liquidation problem.
Second, we notice that liquidation is not as bad as it seems. Especially in Nitropia,
where the process is fully automated and demands no ridiculous, periwigged judicial
official. What matters to the ticketbuyers - and hence to the auditors - is that they get
their cowries. And, since the liquidation process has plenty of assets (the
dragonslayer tickets) to sell, there is no reason at all to think that the ticketbuyers
will take a haircut.
Quite the contrary, in fact. Remember that, to deal with the vagaries of monsterhunting, any balancer must maintain a small cowrie buffer to get on the good side of
the law of large numbers. With this buffer, plus the proceeds from selling the
dragonslayer tickets on the open market, the ticketbuyers may even profit when the
balancer chokes.
Of course this makes no sense. Liquidation cannot be profitable. If liquidation is
profitable, there is no need to liquidate. Ergo, the balancer herself can just sell the
dragonslayer tickets, using the proceeds to redeem the tickets she has written. She
has thus earned a week of dragonslayer yield, not ogre-whacker yield, and has still
come out ahead. Everyone still wins.
Thus, the auditor doesn't need to worry at all about the term of the balancer's assets.
The auditor can just verify that the total present market price (in cowries, of course),
of these assets meets or exceeds the number of cowries that the balancer is obligated
to deliver. As long as this criterion, which we can call scalar solvency, is met, there is
no problem.
Furthermore, this idea that the balancer's customers all show up after a week and
start pounding on the doors, demanding their cowries, is not at all realistic. We have
spent a considerable amount of effort in understanding the motives of ticketwriters.
We need to think more about the end buyers.
Why do buyers buy one-week tickets, rather than three-week tickets, even though the
latter produce a higher yield? It can only be because they feel they might need their
cowries in one week, rather than three.
Perhaps they will. But perhaps they won't. The future is full of uncertainty. If buyers
knew what they would exchange their cowries for next week, it's very likely that they
would just exchange them now. They lose a week's yield, they gain a week's use of an
inflatable penis. But Nitropians hold cowries and/or cowrie tickets, rather than
magic swords or inflatable penises, because they are not sure what they want to buy
in the future, or when they want to buy it. And because cowries cost nothing to store,
they are a good choice for a rainy-day fund.
So it's very likely that the balancer's ticketholders, when they get their cowries back
in a week, will simply want to buy another week's ticket. The rainy day has not
arrived. The cowries go back in the kitty. We call this rolling over the ticket.
Rolling over is really quite convenient for everyone concerned. If all her buyers roll
over, as they may well, the balancer does not have to sell any dragonslayer tickets
before their time. She can make this even easier by stipulating that, by default, her
tickets roll over. If one of her customers really wants his cowries after only a week,
the request will of course be satisfied promptly and courteously. If all the customers
demand redemption, there will perhaps be a little more of a Chinese firedrill as
dragonslayer tickets are sold, but the balancer maintains a comfortable margin of
scalar solvency, so again, everyone's ticket is redeemed.
Furthermore, now that we've made term transformation work so well, what is this
whole week thing about? The number no longer bears any resemblance to anything.
We have long since given up on the ogre-whacking. The ogre-axes have been beaten
into dragonswords. Surely, rather than insisting that her customers wait a whole
week whenever they want their cowries, she can shorten the term - say, to a day. Or
an hour. Or...
In fact, the magic of term transformation has solved a problem that we didn't think
was solvable at all. It has produced a yield on a zero-term ticket. As we adopt
automatic rollover and we adjust the term of the balancer's tickets down to epsilon,
term transformation creates a fabulous new construct, the demand ticket.
A demand ticket is an instrument that pays the bearer a quantity Q of cowries on
demand. It is just like holding cowries, only better. Because until you actually
demand your cowries, your demand ticket produces a yield. And no mere in-and-out
orc-mugging yield, either. But the maximum, bona fide, long-term, dragonslaying
yield.
Sometimes the dragon wins, of course, and we do have to subtract that. And the
balancer, like everyone, needs to eat. But overall, term transformation produces a
win for everyone. The end buyer gets maximum yield and total flexibility, the
balancer gets more of a taste, the auditor still has to audit, and the dragonslayers get
more investment at better rates. Perhaps the ogre-whackers aren't too happy, but
they just have to bring their game up to the point where it's as profitable as dragonslaying. If that can't be done, perhaps the ogre ecosystem could use a bit of a rest,
anyway. And aren't we, the brave hunters of Nitropia, stronger and better men and
women if we pit all our sinews against that noblest of beasts, the dragon?
Alas. If only it was true. If term transformation really did work, not just Nitropia but
indeed the real world would be a cleaner, shinier, happier place. (I'm afraid it's quite
inarguable that if the Americans and Europeans of 1908 could see their countries
now, they would be both amazed at the achievements of science and engineering, and
appalled at how shabby, filthy, ugly and dangerous their great cities had become. If
you can't imagine what this could possibly have to do with term transformation, I
understand. But I will get there.)
So what is the problem? What could possibly be the problem?
In the above defense of term transformation, which I do hope is not a strawman - I
really did throw in every argument I have heard or can think of, and if readers know
of others they should feel free to append - there are a few subtle, but extremely fatal,
holes.
First, let's introduce the concept of financial hygiene. Financial hygiene is a lot like
regular hygiene. If you are the only one who goes around licking doorknobs, you are
unlikely to catch diseases from doorknobs. But if you find yourself licking doorknobs,
it's probably not an idea you (being a sensible person) came up with yourself. Which
means that other people are probably doing it too. Sooo...
Financial hygiene is a criterion for prudent herd behavior. A strategy is financially
hygienic if the strategy works just as well whether a whole herd adopts it, or just a
maverick individual. As we'll see, term transformation is to hygienic finance as a pile
of oil-soaked rags is to a sanitary napkin. Term transformation is a great idea - so
long as no one else is doing it.
We'll start by going back to our magical risk-free tickets. What's truly amazing is that
term transformation is so dangerous that even when all tickets are risk-free, it can
detonate instantly and without warning. Mind you, risk does not make the problem
any better. In fact, it makes it much worse. But first things first.
With risk-free tickets, we no longer need the services of our balancer. Instead,
ordinary ticketbuyers can transform their own terms. This does not make the
problem worse, but it makes it easier to see.
In Nitro City, where all transactions are frictionless, why in the world would anyone
hold cowries? If long-term tickets are risk-free, keeping your cowries "under the
mattress" - even for a millisecond - is just throwing away cowries. Just hold the
longest-term tickets, with the highest yield, until you are ready to spend your
cowries. Then, instead of exchanging cowries for an inflatable penis, exchange your
long-term tickets for cowries, and immediately exchange the cowries for the penis.
With this strategy, you are always earning maximum yield.
Or will it? It's not clear that the yield will be all that great. After all, when everyone is
buying long-term tickets, how much can they yield? And let's not even start on the
consequences for the dragon ecology. Presumably the beasts are apex predators, after
all.
But there is a worse problem. The problem is that when you buy a ticket of term T,
you are signalling the market that you intend to exchange cowries now for cowries at
now + T. This demand is naturally satisfied by a dragonslayer who commits to the
opposite exchange.
If this is not really the transaction you intended to perform, you are sending a false
signal. When you send a false signal, you should not be surprised to get an ugly
result. When you send a false signal as part of an entire herd which is sending the
same false signal, you should be surprised not to get an ugly result.
Our fallacy in designing this wonderful edifice of term transformation was to assume
that it is possible for an unlimited number of parties to signal a market in one
direction, without affecting the market price. In other words, we were committing
the most common error in economics, by assuming an objective or absolute price. Of
course there is no such thing. All prices are set by supply and demand, and if you add
sellers to a market without adding buyers, the price will go down.
Let me slip briefly into the language of normal, Windowsological finance. To buy a
ticket of term T is to lend for a period of term T. To sell a ticket of term T is to borrow
for that period. And these same terms apply whether or not you are the original
buyer or seller of the ticket.
So, when you buy a ticket of term T, but you really intend to be able to use your
money at T/2, or T/6, or whenever the heck you feel like it or need to, you are
assuming that you will be able to find another lender at T/2, or T/6, or whenever,
who will acquire your loan. For example, an equivalent transaction is to write your
own ticket at T/6, with a term of 5T/6, and sell it. You keep the original ticket, and
use its proceeds at T to pay off the ticket you wrote. (Don't try this at home, kids.)
If everyone who lends at term T really intends to lend at term T, then a few
individuals whose plans turn out differently will have no problem in correcting their
mistake. Peoples' actions may differ from their plans, but they are likely to at least
cluster symmetrically around them.
However, if every single Nitropian who lent at N for term T really intended to lend
(for an extreme and unrealistic example) at T/6 - when N + T/6 rolls around, the
market for 5T/6 tickets will become um, well, kind of nasty. There will be quite a few
sellers, and no buyers at all. In the Nitro City ticket market on N + T/6, for tickets
maturing at T, the yield will be immense. And the price will be derisory.
This is the opposite of financial hygiene: financial contagion. Our herd of Nitropians
all thought they could earn a dragonslayer yield on an orc-hunter schedule. Well,
they did earn a dragonslayer yield - until the market opened at N + T/6. Then they
saw a picture that looked rather like this. And they suddenly realized that they had
no yield at all, but massive losses. And all this with 100% risk-free tickets.
The example of everyone selling at N + T/6 is slightly exaggerated. But it's less
exaggerated than you might think, for a couple of reasons. First, the whole point of a
rainy-day fund is to have a stash of cowries for a rainy day. And a rainy day, by
definition, rains on everyone. Second, when the curve starts to head for Antarctica,
everyone who has those N + T tickets sees the light and wants out ASAP.
This is called a panic. Historically speaking, the association between financial panics
and term transformation is about as solid as the association between smallpox and
the smallpox virus. Although I suppose you do have to have the smallpox virus to get
smallpox, whereas panics can in theory be caused by any widespread error in
planning that mimics term transformation. For example, the sudden discovery of an
asteroid that was about to hit Nitropia at N + T/2 would certainly have a rather
dramatic effect on the yield curve. On the other hand, if there are any cases of
financial panics in history that were not associated with term transformation, I am
not aware of them. Perhaps readers will be so kind as to enlighten me.
Now let's put the risk and the balancer back in, and see how it changes the game. Not
for the better, as you can imagine.
If you scroll back up to our rosy explanation of how well term transformation works,
you can see how the same error infects the case with risk and balancer. At every step
of the process, we were assuming that another buyer can be found for the ticket, at
the same pleasant prices.
Of course this is not so at all. The balancer just adds a layer of indirection to the same
basic process of breakdown and panic. The result is an even more spectacular
trainwreck. In a way it's almost beautiful, unless of course you're in it.
Using the familiar logic of financial hygiene, we can assume that in a market where
term transformation is active, our one poor balancer will not be the only agent
performing risk dispersal for the dragonslayer market. Rather, we need to consider
the entire category of balancers in this space as the herd.
The panic can start in many ways, but the simplest is a wave of redemption in
demand tickets. There is no way to predict this wave, because by replacing true
tickets with demand tickets, the term-transforming balancers have essentially
jammed a price signal. They have no idea what the future pattern of demand ticket
redemption will look like, either within their own customer base or across Nitropia as
a whole.
To redeem the demand tickets they have written, the balancers must in turn sell
dragonslayer tickets. Of course this drives the dragonslayer yield up and the price
down.
The result is that the balancers enter scalar insolvency. The total market price (in
present cowries) of the tickets they own, plus their cowrie buffers, no longer exceeds
the sum (in present cowries) of their current obligations. So the owners of their
demand tickets will take a haircut. They strive to avoid this in the usual way, by
withdrawing ASAP. The early bird gets the worm. Flap, bird, flap!
But to even calculate this haircut, to liquidate the balancers and pay their creditors,
more dragonslayer tickets need to be sold. So the price drops even further.
Eventually, someone realizes that ordinary, vanilla, untransformed, financially
hygienic demand for cowries at N + T continues to exist and puts a floor under the
market, and there are buyers again. If there is still a Nitropia to buy them in.
This nasty, nasty process is a feedback loop between the dragonslayer tickets, the
institutions that own them, and the customers to whom they are obligated. It can be
triggered by any unexpected pattern of selling, anywhere in the circle. For example, if
dragonslayer attrition rates start going up from 3% to 5% to 7% to 15% to 20% perhaps because demand for dragonslayer tickets has been so high that all kinds of
completely unqualified warriors decide to rent a sword and descend into Yendor in
search of dragons - the same thing will happen.
Next week, we'll look at how unhygienic finance in the real world, and just how and
when it got to be so popular. Clearly, what we have here is a case of regulatory failure.
Is this another piece of Reagan-era napkin economics, coming back up to haunt us
like a bad burrito? Did Hillary do it, with her cattle futures? Or is it one of those New
Deal things? When will it not be all FDR, all the time, here at UR? If you don't know,
please take a ticket and come back next Thursday. (And do avoid the comments if
you truly cherish your suspense, because I assume someone will spill the beans.)
How to actually restore the gold standard (or not)
I know I promised to give UR readers a break this week, but the ongoing
degringolade of our financial system is just too exciting to ignore.
This post is about the mechanics of returning to what people used to call hard
money. This is a very difficult problem for which there is no good solution. However,
as we'll see, some solutions are worse than others. If you need a celebrity
endorsement, or quasi-endorsement, Brad Setser says: "if nothing else, your plan is
creative." Indeed.
I will not be discussing the question of why the gold standard should be restored. I
assume you either believe this is a good idea, or you don't. If you don't, perhaps you
don't care. (Perhaps you haven't looked at the news lately?) Please feel free to come
back next week.
First, let's face it: the dollar is about as far from being "as good as gold" as Hillary
Clinton is from being "a major-league hottie." She needs a lot of work, and I mean a
lot. Restoring the gold standard is about as easy as restoring a '57 Chevy that has
been in the same barn since '68. Assuming of course that the world has been taken
over by zombies, and your only tools are a chainsaw, a hammer, and a case of cheap
brandy.
On the other hand, just pushing the Chevy down the road into zombie land isn't
going to work too well, either. So why not at least think about trying it? And that, I
promise, is the last I will say on the subject. At least for now.
First: there is a simple plan for successfully restoring the gold standard, which any
sovereign can apply at any time for any reason, and which will always succeed.
Let's call it "Plan X." To restore the gold standard via Plan X, you need exactly two
facts: the face value of valid fiat currency you have outstanding, and the grams of
gold in your treasury. (If you do not have this information, you are beyond the reach
of accounting. Your country is probably about to be overrun by savage tribes. You
should be looking for a seaworthy vessel, not trying to fix your monetary system.)
Let's call the first quantity F and the second quantity G. The new gold price, Pnew,
the price of a gram of gold, in cowries or strips of leather or wood chips or whatever
your people are putting out these days, is F/G. At least, it is at least F/G. At your
discretion, Sublime Pasha, it may be greater. I don't think I have to point out the
advantages of this option.
What makes a Plan X restoration slightly tricky is that whatever Pnew is, there is also
a Pold - the present price of a gram of gold. Since Pnew has to exceed Pold or no one
can possibly care, and since it offends the Pasha's dignity for the Armenians to frontrun his ass down in the bazaar, Plan X depends on the element of surprise. While it
shares this with all monetary policy, the amount of loot a leak can extract in a Plan X
gold restoration is effectively infinite and untraceable. Problem.
Thus it is very difficult for an inefficient bureaucratic state, which is indiscreet by
definition, to even consider Plan X as a viable policy option. Since an efficiently
managed state would never have left the gold standard in the first place, this problem
is unsolvable. Moreover, the same problem holds for all feasible restoration plans.
The option of just letting Pnew equal Pold is not physically tractable without some
serious alien technology. There is not enough gold on Planet Three. You would need
to go in for asteroid mining, or something.
Since this problem is not solvable, we will ignore it. Often people are faced with
multiple contradictory problems. I'll bet a lot of them are working 100-hour weeks
right now. To even start to deal with a situation like the present financial crisis, you
have to at least know why all your impossible courses of action are just as impossible
as they seem.
But there is a second problem with Plan X, which is that it is not politically feasible.
Ie, if you just apply Plan X, it will leave a very large number of people hatin' life, and
hating you as well. This is not conducive to a successful career in public service. And
this is why, I think, people shrink so instinctively from the very thought of restoring
the gold standard. They associate it with Plan X, which is too hateful even to
mention. In fact, while moral judgments are not my specialty, I don't think it's going
too far to describe Plan X as outright unethical.
Here is the problem with Plan X.
The monetary base of the United States today - the number of dollars outstanding in
the strict legal sense of the word dollar - is about $800 billion. The monetary base is
physical currency, plus the balances of member banks at the Fed. (In case you are
unfamiliar with the actual structure of the Fed, think of it as a secret uber-bank at
which only banks have bank accounts.)
US gold reserves are about 8000 metric tons. Ergo, F/G is about $100 million per
metric ton, or $100K per kilogram, or $100 per gram. Since gold today is around $30
a gram, this represents a Pnew/Pold ratio of about 3. (Obviously, all these values are
constantly changing.)
So Plan X, if applied to the dollar, would triple the gold price overnight. This seems
rather extreme. It suggests that Pnew is way too high. Perhaps, but it's also way too
low. Did I say this would be easy? If restoring the gold standard was easy, someone
would have done it already.
The problem is that the monetary base (M0, or F above) is not a particularly
important or useful number. It is not in fact a good representation of "the number of
dollars in the world." This is well-known. And there are a variety of other monetary
indicators, with snappy little numbers attached, like M1, M2, etc. In Britain they even
have M4, which I was sure was a motorway. In any case, none of these numbers is of
much interest either. They are all the result of subjective decisions, littered with
constants pulled out of thin air, etc, etc. This again is quite well known. No one has
done anything about it, because no one can do anything about it.
(The idea that monetary policy can be managed by mathematical models is, in fact,
madness. The experiment is neither deductively understood nor scientifically
controlled. Fitting models to the past is no substitute: it will always produce a "data
mining" effect. If one of these models somehow turned out to be correct, you would
have no way of knowing which one it was.)
Why is it impossible to measure the quantity of dollars in the world? Especially in a
modern country which is not about to be overrun by savage tribes, and really does
keep a handle on its monetary base? A fascinating question, folks.
We can start to see the answer by looking, within the monetary base, at the difference
between electronic dollars at the Fed and actual physical bills. These objects could
not be more different - one is a magnetic mark on a hard disk, the other is a piece of
paper. Why do we lump them together and treat them as the same thing?
They are equivalent because either form is convertible to the other. Any bank can
take a bundle of bills to the Fed and exchange it for electronic credits. Any bank can
also draw down its electronic balance in the form of print jobs. Both these rights are
protected by law, and there is no conceivable scenario on which the Fed runs out of
either disk space or paper.
You'll sometimes hear dollars in the monetary base called "high-powered," an
incredibly weird and confusing locution. Let's just call them formal dollars. Since
these dollars are all valid at present, they are formal current dollars.
The reason it's impossible to measure the quantity of dollars in the world is that a
formal current dollar is only one point in a vector space. Formality and maturity are
both variables. Worse, the latter is quantifiable but the former is not. So we are trying
to describe an unquantifiable two-dimensional vector as a precise scalar (our F). If
this isn't mathematical malpractice, I don't know what is.
How do we solve this problem? As usual, by trying to understand it.
Let's deal with maturity first. Imagine that every dollar bill had a "not valid before"
date on it, like a postdated check. Maturity is simply the difference between now and
that time. For example, a zero-coupon Treasury bond which matures in 10 years
could be defined as a dollar bill which is not valid until 2018. We can call these
dollars not current but latent.
Formality is the extent to which an instrument is guaranteed, in practice, by the Fed.
A Federal Reserve Note ("dollar bill") is perfectly formal. A piece of paper which says
"Mencius Moldbug promises to pay the bearer one (1) dollar" is perfectly informal.
Between these lies a wide range, which cannot be measured or quantified, but is no
less important for that.
A Treasury bond is almost perfectly formal - but not quite, since the Fed and
Treasury are at least in different buildings. In practice, the financial markets treat
Treasury obligations as perfectly formal or "risk-free." It is probably best to describe
them as negligibly informal.
"Agency" bonds - those written not by Treasury, but nominally private companies
(GSEs) such as the infamous Fannie and Freddie - are mildly, but not negligibly,
informal. The bond market puts a small premium on agency bonds over T-bonds
(typically a quarter point or so), showing that they have a small chance of defaulting.
This is essentially a political calculation, and financial markets do not hesitate before
making political guesses - which is not to say that they are always right. (Note that we
cannot use the GSE spreads as quantifications of formality, because there is another
variable in the equation - the actual default risk.)
But the most famous kind of informal dollars are the negligibly-informal current
dollars we call "checking deposits." While checking accounts are not as financially
important as they once were, most people have one and most everyone understands
them.
A checking deposit is actually a loan from you to your bank. This loan has a zero
maturity and is continuously rolled over. If you find this hard to grasp, imagine the
loan term was one minute. Every minute, the bank automatically returns your money
to you, and you automatically lend it back to the bank. If you show up at the ATM
and want to withdraw it, you have to wait until the minute is over. Replace a minute
with zero, and you have the "demand deposit."
It would sort of defeat the purpose, but imagine that your checking-account dollars
were not electronic entries, but physical bills. They look just like regular dollar bills,
except that they are blue, not green, and they have your bank's name instead of the
Fed's - eg, "Wells Fargo Note."
A dollar in a checking account is informal because it is a debt, and the debtor is not
the mighty Fed but a sordid, corporate bank. The Fed will not just take a blue dollar
and convert it to a green dollar. Your bank has to do that, and your bank has to have
its own green dollar to exchange for your blue dollar. If it's out, the Fed will not just
give it more.
However, like the Treasury bonds, blue dollars are negligibly informal. Your bank is
"insured" by something called the FDIC. This so-called "deposit insurance" is in fact
a sham, because the risk of a bank run is not in any way, shape or form an insurable
risk. Nor does the FDIC have anywhere near enough green dollars to exchange for all
the blue ones. However, although the Fed is not legally obligated to back up the FDIC
- just as it is not legally obligated to back up the Treasury - it is a political certainty
that it will do so.
We can think of informal instruments, like agency bonds or blue dollars, as an
inseparable combination of two instruments: a private debt (eg, your bank's debt to
you, as represented by the blue dollar), and an option written by the Fed. The option
pays off if the debt does not - unless, of course, the Fed's informal loan guarantee
turns out to be not just informal, but actually nonexistent.
We are now in a position to understand the horrendous destruction that Plan X
would unleash upon society. Since Plan X does not recognize the existence of
informal dollars, applying it is equivalent to destroying them, or more precisely
destroying their informal Fed option halves. The debt from the bank to you still
exists. But will it be paid? Um...
Plan X is easier if we think of it in two phases. In the first phase, we destroy the
informal options and set F to the monetary base M0. In the second phase, we
exchange every formal current dollar for F/G grams of gold, courtesy of Fort Knox.
(There are no formal latent dollars - the Fed issues no such thing.) After we perform
the first phase, we can perform the second at any time, so we can analyze them
separately.
All the destruction in Plan X comes from the first phase. Call it Plan X(1). Another
way to think of Plan X(1) is that (after printing the entire monetary base), we destroy
the Fed's printing press. No new dollars can be created, ever. If this reminds you of
the breaking of the assignat plates, you're not alone:
This system in finance was accompanied by a system in politics no less startling, and
each system tended to aggravate the other. The wild radicals, having sent to the
guillotine first all the Royalists and next all the leading Republicans they could
entrap, the various factions began sending each other to the same destination:
Hébertists, Dantonists, with various other factions and groups, and, finally, the
Robespierrists, followed each other in rapid succession. After these declaimers and
phrase-mongers had thus disappeared there came to power, in October, 1795, a new
government, - mainly a survival of the more scoundrelly, - the Directory. It found the
country utterly impoverished and its only resource at first was to print more paper
and to issue even while wet from the press. These new issues were made at last by the
two great committees, with or without warrant of law, and in greater sums than ever.
Complaints were made that the army of engravers and printers at the mint could not
meet the demand for assignats - that they could produce only from sixty to seventy
millions per day and that the government was spending daily from eighty to ninety
millions. Four thousand millions of francs were issued during one month, a little
later three thousand millions, a little later four thousand millions, until there had
been put forth over thirty-five thousand millions. The purchasing power of this paper
having now become almost nothing, it was decreed, on the 22nd of December, 1795,
that the whole amount issued should be limited to forty thousand millions, including
all that had previously been put forth and that when this had been done the copper
plates should be broken. Even in spite of this, additional issues were made
amounting to about ten thousand millions. But on the 18th of February, 1796, at nine
o'clock in the morning, in the presence of a great crowd, the machinery, plates and
paper for printing assignats were brought to the Place Vendome and there, on the
spot where the Napoleon Column now stands, these were solemnly broken and
burned.
Well, it certainly sounds like the right move at the right time. And who can't resist
the idea of sending a few phrase-mongers, not to mention Republicans, to the
guillotine?
But the good news is that we are not in a state of revolutionary hyperinflation. At
least, not yet. The bad news is that the result of Plan X(1) would be an episode of
economic destruction that would make the Great Depression look like a panty raid.
The informal loan guarantees we destroyed may have been informal. But they
existed. And people relied on them - just as if they were formal.
For example, by breaking the plates, we eliminated the Fed's informal guarantee of
Treasury debt. Surprise! Over the next 30 years, Treasury is now obligated to fork
over ten times as much gold as now exists in the United States - since the Treasury's
debt is about ten times the monetary base.
What do you think is the chance that this will actually happen? Fairly small, I would
say. I suspect long-term interest rates, at least as measured by Treasury bonds
(which is how they're measured now) would go from about 5% to more like 50%. If
not 500%. The good news is that you could actually buy that house you've been
saving for.
The bad news is that your savings probably won't be there. Because they are probably
in blue dollars, or something like them. Those debts from various financial entities to
you still exist. But the various financial entities don't. They will instantly face the
mother of all bank runs as people with blue dollars rush to exchange them for green.
The Fed's loan guarantees, it turns out, have been serving an essential structural
purpose in our economy. They have been making term transformation stable. The
interaction between term transformation and fiat loan guarantees deserves its own
Nitropian analogy, but what we do know is that term transformation is not stable
without them. Ergo, since it is not stable, it will collapse. The good news is that you
might be able to buy a hamburger for ten cents again. The bad news is that you might
not have ten cents.
So our definition of F as the monetary base has a great flaw, which is that it does not
account for the informal loan guarantees, which are legally meaningless but
economically important. As a result, we are simply destroying a large quantity of
money - the monetary equivalent of filling your gas tank with molasses. Woops.
There is only one way fix this. Our new plan, Plan Y, has to include informally
guaranteed instruments as well. Furthermore, because it includes informal
instruments, it has to deal not just with current dollars but with latent dollars (such
as Treasury bonds).
How does Plan Y deal with informal dollars? Very simply. It creates formal dollars,
and exchanges them for the informal dollars. So, for example, the Fed can buy all the
checking deposits that it has guaranteed. Your checking account becomes a greendollar account at the Fed. The debt from your bank to you is now a debt from your
bank to the Fed.
Alternatively, the Fed could just buy your bank at the present market value - ie,
nationalize it. This is less financially elegant, but it may be simpler in practice. It also
has another advantage, which is that it wraps up the maturity mismatch on the
bank's books. Your bank is almost certainly backing its short-term obligations with
long-term receivables. If the Fed refuses to renew the rolling loans that used to be
everyone's checking deposits, the banks will fail. If it lets them roll on for ever, it
might as well cancel them. Either way the result is ugly.
There are two ways for Plan Y to deal with latent informal dollars. One is to exchange
them for latent formal dollars. The other is to exchange them for current formal
dollars.
Perhaps the former could be made to work, but the latter is probably superior. The
trouble is that in a world with protected term transformation, we really have no idea
what the maturity preferences of investors are. If we assume that they correspond to
their current holdings, we run the risk of considerable economic disruption.
The people who have been buying 30-year T-bonds are not, in general, people who
are genuinely willing to exchange current dollars for dollars which are not valid
before 2038. In fact, considering that we have a system in which maturity
transformation is ubiquitous, there are probably a lot of financial players who own
dollars which are not valid before 2038, but have contracted to deliver valid dollars
in, say, March.
We do not actually know where supply and demand would set the 30-year interest
rate. It could be anything. If we assume that it has any relation to the present rate, we
will, again, create disruption. If we wanted disruption, Plan X would do just fine.
What we see is that Plan Y is essentially a bailout of the entire dollar financial
system. The informal guarantees have spread very far and wide. Our goal, in the first
(formalization) phase of the plan, is to find them all and use formal dollars to buy
them all out at the present market price. One of the largest sets of informal
guarantees is the set of promises the US government has made to itself in the form of
Medicare and Social Security, which may give you some idea of the kind of numbers
we're looking at. (Fortunately, entitlement payments are not securitized and thus are
not on the balance sheets of term transformers, which means they can be exchanged
for latent dollars.)
When Plan Y(1) is complete, everyone's monthly portfolio statement should show
more or less the same number that it did before, and the Fed will enjoy managing
many fascinating new assets. F, the final monetary base, will be a precise measure of
the number of dollars in the world. And we are free to go through with Plan Y(2),
which is precisely the same as Plan X(2): redeeming all dollars for gold.
However, we are no longer increasing the gold price by a factor of 3. The factor is
now more like 300. This does not require any more or less secrecy or surprise than
increasing it by 3 - in both cases, discipline must be absolute. But it does make us
think a little.
Not all the gold in the world is in Fort Knox. If you increase the gold price by two
orders of magnitude, you are making anyone who now owns gold extremely wealthy.
This happens - people make money, and they make money by being right when
everyone else is wrong. Predicting that paper money was unsustainable and the gold
standard would live again was not exactly a conformist investment. If you restore the
gold standard, you have validated it.
Also, you can tax the hell out of these people. Any restoration of the gold standard
should be associated with a high direct tax on gold ownership. If the tax is too high, it
will pass the Laffer peak and favor the really crazy antigovernment types who keep
their Krugerrands in their flowerpots. 80 or 90%, for example, is probably too high.
But 60% probably isn't.
The new gold zillionaires will certainly compete in some markets and drive up some
prices, but it is hard to see how they will much inflate the price of, say, crude oil, or
wheat. It's also worth noting that a lot of the world's gold, especially the gold that
hasn't been mined yet, is in places like India and Africa, which could sure use a little
money. And while no increase in the gold price will produce a giant flood of newly
mined gold - people have been trying very hard for a very long time to get gold out of
the Earth's crust - two orders of magnitude will certainly create a lot of jobs, not all of
which are menial. Perhaps some of our financial engineers could go back to school
and study geology.
On the other hand: once we have executed Plan Y(1), do we really need Plan Y(2)?
After all, our goal in restoring the gold standard is hard money: a completely neutral
monetary system, which is not subject to manias and panics, and does not bollix
economic prediction by exerting a chaotic, exogeneous, politically charged effect on
price levels or business activity. In other words, our goal is to never have to deal with
this kind of BS again. Condy Raguet put it well when he said:
Such being the theory of this branch of my subject, I have the satisfaction to state in
regard of the practice under it, upon the testimony of a respectable American
merchant, who resided and carried on extensive operations for near twenty years at
Gibraltar, where there has never been any but a metallic currency, that he never
knew during that whole period, such a thing as a general pressure for money. He has
known individuals to fail from incautious speculation, or indiscreet advances, or
expensive living; but he never saw a time that money was not readily available, at the
ordinary rate of interest, by any merchant in good credit. He assured me, that no
such thing as a general rise or fall in the prices of commodities, or property was
known there; and that so satisfied were the inhabitants of the advantages they
enjoyed from a metallic currency, although attended by the inconvenience of keeping
in iron chests, and of counting large sums in Spanish dollars and doubloons, that
several attempts to establish a bank there were put down by almost common
consent.
This is not the only historical example of the delights of monetary predictability. And
there is nothing more predictable than a constant. Suppose that, after formalizing the
dollar base, we just leave it at that? Why do we need the gold standard? Can't we just
fix the number of dollars in the world, and call it a day?
We can. But we may not want to.
Gold makes a good currency for several reasons. First, because it has some intrinsic
uses, it is self-bootstrapping in the classic Mengerian sense. But the dollar is already
a currency, so bootstrapping is not a concern. From an economic perspective, fiat
currencies work fine. Second, after a few millennia of mining, new gold is extremely
hard to come by, so the supply is quite inelastic. (The present gold supply dilutes at
well under 2% per year.) Inelastic is almost constant. But constant is even more
constant.
So a fixed, formalized dollar supply would create a currency that was actually harder
than gold - at least, in a strictly economic sense. The dollar would not be "as good as
gold." It would be better. (If only we could do the same for Hillary.)
This course of action would also have the effect, surely delicious in some peoples'
minds, of sending the gold price back down into double digits. People who hold gold
(such as myself) are, in general, holding it as money. If you fix the fiat currency
system permanently, you destroy the entire monetary premium on gold. If this
course is taken, perhaps its architects could have some pity on us poor economic
royalists, and print a little extra to buy back our Krugerrands.
The only problem with a fixed-supply fiat currency is that it has been tried before. It's
one thing to limit the number of dollars in the world. It is quite another to enforce
that limit. Congress can pass a law prohibiting the Fed from printing new money. But
will it? And next time there is a war, a flood, an indoor rainforest in Iowa, or some
other budgetary emergency, won't it just unpass it? Our F might quite easily become
like the Federal debt limit, which is routinely increased. A better idea might be to put
it in a Constitutional amendment. But even these can be repealed, or still worse
judicially ignored.
As Alan Greenspan once explained, gold as a monetary standard succeeds because it
is self-enforcing. The Fed cannot print gold. Congress cannot pass a law which
creates it. If the gold standard is really brutally abused, as it was in the 1920s and
'30s, it will turn on its abusers with a vengeance. This is not a bug, but a feature. Gold
works because it keeps the government honest. And surely anyone of any political
persuasion can agree that honest government beats the converse.
Of course, the main problem with Plan Y, gold or no gold, is that it can't possibly
happen. It is impossible to imagine Washington executing any plan anywhere near
this unusual and aggressive. Moreover, the first step is always to admit that you have
a problem. Picture that press conference! I can't, which is why I can't see this
happening.
Return to Castle Goldenstein: the gold market in a nutshell
With the Fed sounding like they share an office with the Hillary campaign - any
minute now, I fear, Dr. Bernanke is going to crack and accuse Greg Ip of fluffing the
euro's pillow - and the metals markets bubbling over like a bad quesadilla, perhaps
it's time for me to share some of my eccentric thoughts on the old yellow fellow.
Our goal today is to understand the gold market, from King Tut till now. We'll start
with abstract economics, whip through some financial history, and wind up in the
weird world of ETFs, DGCs, the CBGA, Comex and the IMF. If these letters mean
nothing to you, all the better. Most of what most people know about gold is, in my
humble opinion, wrong.
Of course, my opinions about gold are just that. I am neither an economist nor a
financial professional. I am certainly not a registered investment advisor! Everything
I know about precious metals, I taught myself. If any aspect of my presentation
inspires any confidence or respect, I am probably doing something wrong.
At the very least, please do not make financial decisions with reference to my
eccentric economic theories, which are probably also fascist, sexist and anti-Semitic,
unless you are at least sure you understand them and could defend them in a fair
argument with an intelligent and well-informed paperhead. I should also mention
that my own derisory savings are all in cash, ie, gold and silver bullion - not, in case
anyone plans a raid on Castle Moldenstein, retained therein. (Can you say "Zurich,"
boys and girls? I knew you could!)
First, the fundamental fact about gold is that it is a natural currency. James Turk
(whose satisfied customer I am) is by no means infallible, but this brief post of his
makes as good an introduction as any. This lovely freelance piece in the SF Chronicle,
by local comedy man Rob Baedeker, is the first sympathetic treatment of a goldbug I
have ever seen in any newspaper. When gold is hip, governments wake up in a stonecold sweat.
However, the starting point for my amateur aurology is a mysterious essay that
appeared in 2006 on the notorious doom-mongering financial aggregator Safehaven.
Its author, the blatantly pseudonymous John Law, has not reappeared and does not
appear to be answering his email. I think it's pretty safe to assume he was run over by
a bus. While I certainly don't agree with all of Mr. Law's opinions (and it should be
noted that the financial crisis he predicts, a currency run, is not at all the same thing
as the financial crisis which is happening now, a bank run), I think his basic theory of
money is more or less right. If gold is money, there's no way to explain gold without
explaining money. So let me give it a whack.
To make a long story short, Law's theory of money is that currency selection is a
coordination game, driven by appreciation effects rather than coincidence of wants.
As we'll see, this is not quite the same as the Menger-Mises Austrian theory of
money, but it could be seen as a variant - "neo-Austrian," perhaps. The classical
Austrians had many advantages. Game theory was not among them. But if you think
of Mises' "regression theorem" as a sort of proto-game theory avant la lettre, you
may be on the right page.
Perhaps this is all gobbledegook to you. What is money? In our usual UR style, try
and forget everything you know about the stuff. Imagine you are an incredibly
advanced alien, and your spaceship has developed some kind of awful navigation
defect that misrouted it to Planet Three. While you're waiting for the natives to
advance their crude technology far enough to at least patch your quantum warp belt,
you have nothing better to do than to study their barbaric economic habits, past and
present.
You notice an weird pattern of trade that seems to hold across a variety of civilized
societies. I'll let Carl Menger describe it, in his On the Origins of Money (1890):
There is a phenomenon which has from of old and in a peculiar degree attracted the
attention of social philosophers and practical economists, the fact of certain
commodities (these being in advanced civilizations coined pieces of gold and silver,
together subsequently with documents representing those coins) becoming
universally acceptable media of exchange. It is obvious even to the most ordinary
intelligence, that a commodity should be given up by its owner in exchange for
another more useful to him. But that every economic unit in a nation should be ready
to exchange his goods for little metal disks apparently useless as such, or for
documents representing the latter, is a procedure so opposed to the ordinary course
of things, that we cannot well wonder if even a distinguished thinker like Savigny
finds it downright 'mysterious.'
In other words, Menger - writing of course in the heyday of the classical gold
standard - observes the following mystery: a strange good which appears to be of
very little use at all, and yet is fervently desired by everyone.
First, note the contrast with modern goldbug twaddle of gold's "intrinsic value."
While gold is certainly more useful than green slips of paper, the difference is minor
in perspective. Pretty much anything you can get in exchange for a Krugerrand is
much, much handier around the house than the Krugerrand. While it is not obvious
that the same logic explains the anomalous valuation of Krugerrands and benjamins,
Occam's razor suggests that we should at least give it a shot.
There is a second strange observation, which Menger doesn't make but I will. This is
that, in addition to being anomalously overvalued, the good in question is
anomalously stockpiled. For example, there are about 150,000 tons of gold in the
world today, most of which is being used for nothing at all. Obviously the same
observation holds for paper currencies.
This is a very different pattern than we see for other commodities in the Wall Street
sense of the term - say, wheat, or zinc, or frozen concentrated orange juice. While
there are warehouses full of all of the above, the stock-to-production ratio of gold is
orders of magnitude higher than for any other good (even other precious metals).
Since annual gold production is about 2500 tons, the gold industry keeps 60 years of
inventory on hand. Imagine if this was the case for, say, iPods. Or even zinc. Its
bizarre stock-to-flow ratio is the easiest way to see that, even in the futuristic technoworld of 2008, gold remains a monetary commodity.
(It is very difficult to distinguish "monetary" from "industrial" users of gold, largely
because a large percentage of today's gold stockpile is held in South Asia as
investment jewelry. The linked Daniel Gross essay, sourced from the egregious
Virtual Metals, is a classic example of how analyzing a monetary good using ordinary
commodity-market tools produces gross systematic errors. Except for psychological
reasons, it matters very little how much gold is extracted every year. The number
could go up to 5000 tons or down to 0. Either is a small addition to the stockpile.
There is no reason to assume that these small annual deltas have any large direct
effect on the gold-dollar exchange rate. Gold is gold, new or old.)
So, putting our alien hat back on, we have a rough general picture of this strange
phenomenon, "money." It is a good that is either not very useful or downright
useless, but still is considered very desirable, and is stockpiled in large quantities.
Why would this be? Is it some quirk of hominid psychology, an irrational, instinctive
attraction which leads the violent hairy biped to crave shiny metals and pictures of
dead presidents? Is this why every advanced society seems to have at least one such
good?
We certainly can't rule it out. However, a simpler answer presents itself.
Suppose our hominids are engaging in the following pattern of trade, which we'll call
the monetary transaction pattern. At time T0, our hominid produces some original
good or service, O, and exchanges it for some intermediate good, I. He holds I until
time T1, when he exchanges it for some final good or service, F, which he consumes.
Between T0 and T1, the subject thus holds a stockpile of I, a good which he has no
plan to use. Does this ring a bell? Perhaps the phenomenon we call "money" is the
result of a whole society of hominids who, for whatever bizarre bipedal reason, have
all chosen the same I.
This explains the anomalous stockpile. It does not explain the anomalous valuation.
And it tells us nothing about why hominids might engage in this odd behavior. Why,
for example, doesn't our hominid just keep O until T1, and exchange it directly for F?
Here's a simple example of the MTP. Our subject, Sven, is a fisherman. His original
good, O, is fish. Salmon, perhaps. His final good is a white Cadillac convertible, with
wire wheels. His plan is to net salmon for 20 or 30 years, then buy the Caddy.
If Sven just keeps O until T1, he will have a huge pile of rotten salmon in his
backyard. Frankly, this is no way to retire. Hope is not a retirement strategy,
especially when all your assets are in fish. At least it's liquid - sort of. But it won't get
you any Cadillacs.
So Sven exchanges O for a storable good, I, such as palladium, and he is happy. In
other words, the MTP exists because the Svens of the world want to exchange present
goods for future goods, O at T0 for F at T1, fish now for Cadillacs later, and because
not all O are storable. Therefore, Sven has to select some good which is easy to store,
I - palladium.
One way to understand the MTP is to create a strange world in which it does not
exist. Imagine if we modify Nitropia so that anyone can trade with anyone, anywhere,
by teleporting goods. In addition, we'll assume that all goods can be stored perfectly
without any overhead. Is the result a premonetary equilibrium, in which no one has
any reason to stockpile an item he has no plans to use? I believe it is, but it is also
about as unrealistic as it gets. With all the monsters in the world, a Nitropia with
these rules would be pretty boring.
We can break this premonetary equilibrium in a number of ways. And herein lies the
rub.
Menger's classical Austrian theory of the origin of money relies on the coincidence of
wants. (The same is true for the latest neoclassical theory, that of Kiyotaki and
Wright, which may interest you if you're behind the firewall and have some kind of
pathological, Aspergery obsession with mathematical pseudocode. Otherwise, stick
with Menger, or his successor Mises, or later Rothbard. The classical Austrians may
not have been right about everything, but at least they knew how to explain
economics in English. Or German, anyway.)
In Menger's world, Sven selects palladium for a very simple reason. He has salmon
and nothing else. At T0, he trades with someone who has palladium, and wants
salmon. At T1, he trades with someone who has a Cadillac, and wants palladium.
Why palladium? Why do we use TCP/IP, rather than DecNET or Appletalk? Because
it's the standard. Translating between standards is a pain in the butt. When
standards compete, one tends to win and the others go away. Sayonara, HD-DVD. In
Sven's world, money is palladium. Gold is an exotic industrial metal, sometimes used
for plating speaker cables. There is no one who wants to trade gold for salmon or
Cadillacs for gold.
The basic problem with Menger's approach, from my perspective, is that he's
concerned with the historical origin of money, whereas I am concerned with its
logical origin. What Menger wanted to know is how money actually happened. What
I want to know is how it can happen.
So: clearly, in the actual historical context in which money originated, the
coincidence of wants was a serious problem, and Mengerian effects would no doubt
appear. On the other hand, in Nitropia, with its advanced teleportation technology,
barter is a trivial problem. If Sven wants to use gold as his I, and he finds a salmon
buyer who has nothing but palladium, no problem. He trades salmon for palladium
and palladium for gold, and he is there.
Wall Street is not Nitropia. Financial engineering is nifty, but it can't teleport bullion.
But Wall Street looks a lot more like Nitropia than either looks like, say, ancient
Greece. If we are concerned with the gold market today - and why shouldn't we be?
What is economics, touch football? - Nitropia is probably a better model.
And it is a fact that even in Nitropia, as long as there are fish which don't keep and
fishermen who want to retire, the MTP makes sense. Which means any Nitropians
who practice the MTP must select some intermediate good I. And since the
coincidence of wants is not a problem in Nitropia, Menger's analysis cannot apply.
Thus we see that Menger did not find the origin of money. He found an origin of
money. That is, he found one way of breaking the premonetary equilibrium -
eliminating teleportation - which could trigger one process of monetary
standardization. Menger's analysis does not and cannot show that the coincidenceof-wants effect is the only force that can result in standardized money. Perhaps there
is another? Indeed there is.
Back to Sven. Suppose that Sven can select any intermediate good I he wants - for
any I, the transaction cost of exchanging salmon for I, or I for a Cadillac, is
comparable. He is not bound in any way by the monetary preferences of salmoneaters or Cadillac-makers. His choice is truly his own - or so it seems. So how does he
choose?
The question is a little open-ended. Let's narrow it down. Suppose Sven is choosing
between only two possible intermediate goods - Ia or Ib. Say Ia is palladium, and Ib
is rhodium. What is Sven's algorithm?
It's actually quite simple. All Sven cares about is the change in the exchange rate
between palladium and rhodium, across the time window T1 - T0 of the transaction.
If (Ia/Ib)@T1 is greater than (Ia/Ib)@T0, he prefers palladium. If it is smaller, he
prefers rhodium. In other words, he will prefer the I which will appreciate more
across his monetary time window.
Of course, this has to be adjusted for storage costs and financial returns. If there is a
financial market denominated in rhodium, and rather than keeping his rhodium
under the mattress Sven can lend it out for a secure 3% rhodium-on-rhodium return,
this is part of appreciation. If palladium is radioactive and needs to be stored in an
expensive lead-lined chamber, effectively consuming 2% of its weight every year, the
same applies. But even with this 5% difference, if the palladium-rhodium exchange
rate is rising at 10%, Sven goes with palladium.
But how does he know what the exchange rate will do? He doesn't.
(Even a futures market cannot solve Sven's problem for him. Futures markets are
notoriously bad at predicting exchange-rate fluctuations, because loan markets
simply transpose future price fluctuations into the present. The gold futures market,
for example, cannot predict rises in the gold price higher than the cost of borrowing
dollars: otherwise, arbitrageurs can borrow money, buy gold, sell it in future, and
collect the differential between the predicted price rise and the dollar interest rate. In
fact, this would be a beautiful way to suppress the gold price, if not for that "buy
gold" step.)
All Sven can do is think. And this is where the game theory comes in.
If Sven is thinking rationally, which admittedly is a big if for anyone named "Sven,"
he will realize that he is not the only Sven in the world. Whatever intermediate good
he chooses, someone else will choose it as well. If there's one Sven, there's a herd of
Svens.
And since buying and selling any good cannot fail to affect its price - ie, its exchange
rate against other goods - we have a feedback loop. The herd selects an intermediate
good based on its predicted exchange rate. But the exchange rate cannot be predicted
without knowing the herd's selection. Problem!
Imagine the market for palladium, before the entry of this herd. Since palladium is
not being used as an intermediate good, everyone who owns palladium has some
actual use for it. Suppose, for simplicity, that this use is destructive - perhaps
palladium is eaten, like wheat.
It is very easy to describe the pricing of wheat. Wheat is correctly priced when the
price is such that wheat demand equals wheat supply, and wheat stockpiles neither
grow nor shrink. Perhaps you've seen Wall Street stories about commodities markets
in which inventories are said to be rising or falling. Commodities traders use these
reports to guess whether the price at present is too high or too low. If they're right,
they profit, if they're wrong they lose.
But why should wheat stockpiles neither grow nor shrink? Because no one wants to
stockpile wheat. In other words, because wheat is not a monetary good (for one
thing, it doesn't keep). In fact, if wheat was not a seasonal crop, it would probably be
produced under modern just-in-time supply chain discipline, with almost no
stockpile at all. Since it is a seasonal crop, it has some optimal stockpile. But it's
certainly not 60 years of production.
This is why the normal techniques of commodities valuation strike out when applied
to monetary goods. They are relying on an assumption that just isn't true. If the size
of the stockpile is not controlled, there is no point at which "supply equals demand."
Jessica Cross and her ilk are trying to solve for one variable in a two-variable
equation. They might as well be reading tea leaves.
A fellow named Shayne McGuire, whose main claim to fame is that he's not a
traditional goldbug at all but actually a state pension fund manager, has just put out
a new book with the charmingly blunt title Buy Gold Now. I haven't read it, but I
skimmed it a little on Amazon and it looks pretty good. In this interview, he
expresses the difficulty well:
Any MBA holder, who has been taught to value almost any asset, hits a stone wall
when faced with gold: it pays no dividend or coupon, and without deriving a cash
flow, the basis of most assets defined as being financial, there is no conventional way
to determine its dollar value.
Indeed (except that I would say "there is no conventional way to predict the exchange
rate between gold and dollars.") You cannot calculate it as if gold was a stream of
future dollar payments, because it isn't. You cannot calculate it assuming that the
gold stockpile needs to converge on a constant, because it doesn't.
But Sven - if his Ia and Ib are not platinum and rhodium, but gold and dollars - has
to compute exactly this number. How in the heck does he do it? Or does he just close
his eyes and guess? Let's go back and look at the feedback loop again.
First, we need to establish that Sven's problem is indeed (as I claimed earlier) a
coordination game. In other words, Sven's goal is to pick the same intermediate good
that everyone else picks. Why?
Because of herd effects. There are two cases to consider. In case A, Nitropia has not
yet chosen a standardized currency. In case B, it already has.
First, case A. Nitropia is just emerging from the premonetary equilibrium. All goods
in Nitropia, including both palladium and rhodium, are priced as industrial
commodities - ie, they are demanded only by direct users. Suddenly, a software
upgrade introduces fish, thus motivating the MTP, thus generating a herd of Svens.
Let's separate this herd into two strategies, by eye color. If Svens have blue eyes, they
follow their proper MBA reflexes and diversify, buying equally priced lots of
palladium and rhodium. But if they have brown eyes, they buy only rhodium.
Who does better? The brown-eyed Svens. Why? Because the MTP has created new
demand for both palladium and rhodium. There was no monetary demand before we
broke the equilibrium - now there is. Ceteris paribus, the price must go up.
But we've created more demand for rhodium than for palladium. Thus, ceteris
paribus, rhodium will appreciate against palladium. And thus the brown-eyed,
undiversified Svens will wind up with more pimped-out Caddies.
In fact, it is even uglier than this. Because if we then relax the eye-color constraint, a
substantial percentage of blue-eyed Svens are liable to say the hell with it, and ditch
their palladium. To buy rhodium. Thus shoving the palladium-rhodium ratio even
deeper into the dumps. There is only one end to this game.
Nor is this the worst. The worst is that, before the palladium-rhodium wars end, with
the victory of the rhodium bugs and the obliteration of the palladiumheads,
palladium had its little moment in the sun. Its price, too, rose above the level at
which supply equalled demand. It built a monetary stockpile.
And now that palladium has been demonetized, there is no need for any such
stockpile. Which means that it needs to be worked off. Which means the palladium
price will actually fall below its original industrial-commodity level. Ouch! Taste the
pain, palladium lovers.
Monetary competition is definitely not for sissies. At least in terms of the abstract
economics - we'll get to the reality in a little bit - there is no stable inhomogeneous
strategy. All the Nash equilibria are Highlander outcomes: there can be only one. But
which one? Ah, that's the fun.
Case B, in which rhodium has already won, confirms our suspicions. Essentially,
once there is one monetary standard, there is no need for another.
Once Nitropia is on rhodium, anyone who buys palladium is no different from
anyone who is trying to manipulate any commodities market. In a free market, if you
want to buy up a bunch of palladium - or wheat or oil or FCOJ - and by so doing raise
the price, you may do so. But if you want to actually realize your profits, you have to
sell at some point, and there is no reason to think you'll have any luck getting out at a
higher price than you got in at. This is called the "burying the corpse" problem, and a
thing of beauty it is.
In other words, money is the bubble that doesn't pop. Once rhodium feels the
Quickening, any other potential monetary standard is at an incurable disadvantage,
because its adherents are mere manipulators. Sooner or later they will get tired and
let their guard down, and rhodium will take their heads. But rhodium itself cannot
pop - there can be only one, but there has to be at least one. And that's money.
I am not an expert on monetary history, but my general impression is that, while
until the late 19th century both gold and silver were monetary metals, places and
times in which both gold and silver circulated amicably were rare. For example,
China and India were generally silver areas, whereas patches of Europe fluctuated
between silver and gold. Since Gresham's law will drive one of the two out if a ratio is
fixed, since distributing floating exchange-rate quotes to every cash register was not
exactly a practical technology, and since the noncirculating "good money" was
generally exported to a region where it was a current medium of exchange, it was
hard to avoid any other result.
In the Victorian era, however, the financial system became global, and gold crushed
silver much as described above, leading to a worldwide (if very imperfect) gold
standard. Silver holders got the shaft. Ouch. (In retrospect, if the US had gone to free
coinage of silver, instead of walking the yellow brick road to the cross of gold, we
might not have some of the troubles we have today.)
But wait - we have imported an implicit assumption. Why does Sven have to pick a
"precious metal?" What makes gold, silver, platinum, palladium and rhodium
"precious?" And why does his medium of intertemporal exchange have to be a metal
at all?
Well, obviously, it doesn't. Most of us store most of our assets in artificial currencies,
or assets producing flows of same (stocks, bonds, subprime AAA CDOs, etc). Clearly,
defining Sven's problem as the choice of one of the five major precious metals makes
it far too easy. Nor have we described the factors that govern competition between
the metals.
We know that I has to be storable. Salmon are out. Definitely out. So let's start from
there. Suppose our herd of Svens chooses some other common industrial product
which is storable - let's say, axes. How will axes do against rhodium? Can Nitropia
somehow get onto the axe standard, and if so will it last?
In fact, axes cannot be used stably as money. The problem is that an axe, as an
industrial product, cannot be stably priced above the cost of making an axe.
Probably, as our herd of Svens swarms into the axe market, there will be some
hysteresis as the existing axe makers struggle to catch up with the new demand. But
catch up they will. After the shock is absorbed, axes will experience no appreciation
whatsoever. Moreover, when the Svens flood out of axes into some good that actually
can sustain monetary appreciation, such as rhodium, the affair will go down in
history as a horrifying "axe bubble." As with palladium, but much worse. The
landscape will be littered with rusted-out axe factories, and people will be using axes
as doorstops, tire irons, etc, etc.
What is the difference between mining rhodium and making an axe? The difference
is that you can make as many axes as you want, and it is still just as easy to make
more.
Rhodium, or any precious metal, can sustain monetary appreciation because its
supply is restricted by diminishing returns. Appreciation causes the stockpile to
increase. But as the stockpile increases, the easily mined deposits are mined out.
There is no reason to think that the price will ever go high enough to preclude all new
production, but there is no reason to think it can't, either.
Imagine if today's gold price increased by a factor of 10. Would it increase gold
production? It certainly would. Perhaps the gold dilution rate might even get up to
5%, meaning 7500 tons produced per year, although if you know the gold industry
this is hard to imagine. Higher prices would also stimulate new gold discovery, and
gold underground is future gold. It is priced into the gold market through the stocks
of companies that own mining rights, and this certainly must affect any dilution rate.
Still, however, gold at $10K/oz or even $100K/oz would not come even close to
looking like an axe bubble.
In fact, I doubt that either of these astronomical prices could get gold to the present
dilution rate of the dollar. As I discussed here, there is no precise way to measure the
number of dollars in the world, but perhaps 15% a year is a good rough estimate of
the dilution rate. This number is very, very, very high for a currency. Imagine if
20,000 tons of gold could be mined every year. It would basically have to involve
some kind of alien earth-moving technology. And how many years could you sustain
it for?
Our first-order criterion for Sven is: do what everyone else is doing. Dilution rates
are our best second-order criterion for figuring out what everyone else is going to do.
When predicting future exchange rates between rhodium and palladium, with the
ceteris paribus assumption that industrial criteria will not affect the price ratio, our
first-order concern is the quantity of savings that will flow into each metal. Since
monetary demanders are not interested in the good itself - they purchase by value,
not by weight, volume, etc - we can think of their bars of rhodium as shares in
Rhodium, Inc.
In other words, what they have bought is a fraction of the global rhodium stockpile.
New mining increases that stockpile. It obviously does not increase the size of your
bars. Thus, if we discount industrial demand entirely, dilution is equivalent to
evaporation. If the rhodium stockpile grows by 10%, ceteris paribus, it's as if 10% of
your rhodium evaporated into thin air. Or as if storage expenses consumed 10% of its
weight.
These second-order factors, like positive investment returns, help drive the herd's
choice of currency. Is a 10% dilution rate sufficient to convince a herd to abandon an
existing, successful currency? What about 15%? I don't know. Ask Dr. Bernanke. If
there is any numerical procedure for predicting monetary herd behavior, I'm
certainly unaware of it.
However, factors such as dilution rate need to be evaluated not just in the present,
but all along the path that leads to currency fixation. For example, if it really would
be practical to extract gold from seawater at $10K an ounce (which it wouldn't), gold
would not be a viable global currency. If the entire global financial system migrated
into gold, prices would certainly exceed $10K/oz. Therefore, gold would have no
possibility of winning the currency competition. It would have no endgame, and
anyone holding it now should probably sell.
On the other hand, gold's enormous stockpile makes it far more viable as a global
currency than any other precious metal. Stockpiles of the platinum-group metals
(platinum, palladium, rhodium, and the minor metals osmium, iridium and
ruthenium) are much lower, as are silver inventories. This implies a much more
dramatic price response to an influx of savings - but it also implies a much higher
dilution rate produced by the influx. I doubt any mineable metal can exhibit any
predictable response to a price increase of four or five orders of magnitude. Thus the
PGMs, and probably silver as well, do not have a clear path to currency domination.
Not that gold's path is in any way, shape, or form clear! But it is much clearer than
anything platinum has to offer. And since there can be only one, clarity counts.
At this point we have reached a level of abstract precious-metals theorizing that is
certainly well beyond anything any market is likely to assimilate any time soon. Herd
strategies only work if the herd actually understands and applies them. Especially
considering Wall Street's almost tribal antipathy to gold and goldbugs - perhaps
Shayne McGuire is the harbinger of a trend, but if so he is very, very early - we are
simply getting ahead of ourselves.
Despite the Highlander logic, I own both gold and silver, and if I had a convenient
way to buy it I'd pick up some platinum as well. At present, Wall Street is
experiencing a generalized surge of savings into commodities. As investors become
more educated on the subject, this may sharpen into a generalized precious-metals
surge. By the time you see any kind of game-theoretic decoupling between metals, it
will be quite late in the game. Also, gold has a significant disadvantage, which
McGuire mentions in his interview: it is the only metal which governments have
substantial stocks of. More on this in a minute.
It's time to consider the metals' great competitors, the national or "fiat" currencies.
("Fiat" is in fact the correct technical word, but as a result of repetition by Ron Paul
and the like it is starting to acquire pejorative connotations. Unfortunately, this will
rub off on the complainers rather than the currencies. Power hath its privileges.
"National" and "artificial" are both good words without any strong connotations. You
can also just say "paper," which is no more than the truth. And if you like to wax
nostalgic for the old Constitution, this essay by George Bancroft may put some fire in
your belly.)
Now that we understand what money is, it's easy to see what the national currencies
are. They are artificial precious-metal substitutes. Governments always dreamed of
alchemy, and now they have it. Like so many youthful fantasies, the reality is not as
once imagined, but it is reality nonetheless, and we have to live with it.
Probably the most interesting fact about paper money, and certainly the least
understood, is the gradual nature of the transition from metal to paper. Not since the
18th century, in the heyday of the Amsterdamsche Wisselbank, has there been any
major financial system on an undiluted metal currency. The so-called "classical gold
standard" of the 19C, really the Bank of England standard, was at all times heavily
stretched with paper, like bread in a meatloaf. The reason we no longer have
anything called a "gold standard" is that, by 1971 when Nixon closed the "gold
window," the connection had become so attenuated as to be absurd. It was less a
meatloaf than a sort of meat-flavored Wonderbread.
How do you stretch a gold standard? Easily. Print pieces of paper that say "one (1)
gram of gold." Compel your subjects to treat them as equivalent to gold. This is the
original meaning of legal tender, a concept which is quite confusing without the
historical background. If you like, you can back these notes with something, typically
debts due in the future, perhaps with a small amount of actual gold to permit
"redemption." Or you can just accept them in payment of taxes. The combination of
term transformation and legal tender power effectively allows an infinite amount of
virtual gold to import itself from the future, via a Rube Goldberg machine so complex
that not one out of twenty of your subjects has any hope of understanding it.
Pure paper, without any fond memories of the barbaric relic, is a considerable
improvement on the old Bagehotian trickery. It is actually the first step back toward
gold. It is very hard to turn a meatloaf back into a steak. It is much easier to restore a
true gold standard, with no musical chairs, financial time travel or other wacky
hanky-panky, simply by migrating away from paper to gold. Throughout history,
paper money has been a cyclical phenomenon, and simple irredeemable paper is the
unskippable last step in the cycle.
As Wikipedia puts it:
The history of money consists of three phases: commodity money, in which actual
valuable objects are bartered; then representative money, in which paper notes
(often called 'certificates') are used to represent real commodities stored elsewhere;
and finally fiat money, in which paper notes are backed only by the traders' "full faith
and credit" in the government, in particular by its acceptability for payments of debts
to the government (usually taxes).
This is Whig history in one sentence. In real history, phase three wraps back around.
Clearly, the fact that paper money has no intrinsic utility is no barrier to its success
or stability. In any model of spontaneous currency standardization, whether Law's or
Menger's, there must be some original demand for the currency. But any government
worthy of the name can create demand where there is no utility. Simply order your
subjects to pay their taxes in your national currency. If they don't, arrest them.
I think it's very clear that if there was a fixed stockpile of dollars in the world, as I
proposed in this post, the unbacked paper dollar would outcompete all other
currencies, natural or artificial, in very short order. Even holders of euros and yen
would move their savings into the dollar. These currencies would depreciate rapidly
and collapse. So would gold, which would become an industrial metal, and quite a
cheap one thanks to its enormous stockpile.
In theory, the dollar is certainly capable of reversing its present losing trend against
gold. In fact it pulled off just this trick in 1980, under the leadership of the brilliant
Paul Volcker. Mr. Volcker is still with us, and if you start hearing noises about
bringing him back, worry. Gold prices declined almost continuously for two decades
after his victory.
But don't worry too much, because the Fed does not have the weapons it had in 1980.
The main one being 20% interest rates, which went quite a ways toward both ending
the monetary dilution of the '70s, and compensating dollar holders for what was left
of it. Unbelievable as it may sound, the US economy today is a shadow of what it was
in the '70s. As we saw in this latest cycle, it is so debt-laden that it cannot stand 5%
rates, even though these are at least -5% when you adjust for dilution. 20% was bad
enough in the early '80s. Today, you'd see feral children gnawing each others' bones
in the streets.
In theory, if a government cannot control a coordination game (such as currency
selection), it is not much of a government. Indeed, when you buy gold, this is
precisely the proposition in which you are investing. The Western governments of
2008 are red-giant states: they are as large as they have ever been, but also as weak
as they have ever been.
Why is the dollar weak? Why, when the US is running epic trade deficits, are interest
rates going down rather than up? Why is the suggestion of a note supply limited by
statute, a policy once followed quite effectively by this very same government, an
impractical curiosity which does not represent any real threat to gold holders? Why,
for that matter, in a time of currency crisis, are Americans allowed to hold gold and
silver at all - especially through incredibly convenient instruments such as the
precious-metals ETFs, GLD and SLV, which anyone with a portfolio account can use
to switch their savings into fully-backed bullion? Why is a senior fellow at what
Murray Rothbard used to call the "Rockefeller World Empire" appearing on NPR and
touting digital gold currencies?
This, I feel, is the most important question for anyone considering buying gold. Why
moon the bull? Why taunt the tiger? FDR faced a combined currency and banking
run in 1933. He leaped the fence, broke half the financial contracts in the country,
and took the metal back. It was illegal for Americans to own monetary metals for the
next forty years. A very simple case of attack and counterattack. Normal politics at its
finest. Could it happen again? Legally, sure. And yet something feels different.
The answer is just that FDR is no longer in charge. In fact, no one is.
No one observing the Western governments today can fail to be struck by a massive
sense of sleepwalking. There is no unified consciousness or purpose behind their
actions. Each of their decisions is an atom unto itself, made through an almost
ritualized process by a large number of very intelligent, talented and ambitious
people, whose abilities tend to cancel each other almost perfectly, leaving nothing but
a chilling bureaucratic continuity.
The modern regime is unable to take basic defensive actions against an impending
currency collapse, because it is unable to take any kind of thoughtful action at all. It
is certainly unable to admit that it has made any kind of systematic mistake. Because
it decided in the 1970s that gold and silver were industrial commodities, it legalized
their holding as a kind of gesture of power. There were those in 1971 who thought the
gold price would actually decline when Nixon closed the gold window, because now
the demonetization was official.
But in the '70s Washington still had men like Paul Volcker, a financial Aetius, with
true gravitas and real personal authority. Volcker's austerity measures were
something now unthinkable in Washington - a judgment call. He decided to restrict
the quantity of dollars and let rates do what they had to do. They did, and it worked.
A kind of last gasp of Carlylean government, a Roman ambush of the Huns, doomed
perhaps, but still brilliant.
Professor Bernanke is just that - a professor. He is a specialist in a framework
invented to employ specialists. Computer science is full of these research empires,
full of sound and fury, signifying nothing. Detaching your little subfield from reality
is the easiest thing in the world. Reconnecting is almost impossible. First, you'd have
to admit on your grant application that you'd been studying something other than
reality. If that's hard in Berkeley, try Washington.
Google News does not show me a single recent mention of the word austerity, at least
not used by an American with reference to American politics. Imagine if Barack
Obama went around the country talking not of "change," but "austerity." "Yes, we can
- tighten our belts." Impossible. He's more likely to invade France. So much for the
Washington consensus!
The custodians of the post-1945 financial architecture, such as they are, have one
weapon which they may still be able to deploy. This is their gold reserves, officially
about 30,000 tons. Central banks hold gold so that they can exchange it for their
artificial currencies, changing the exchange rate in their favor. Ie, so that they can
dump it on the market and trash the price. This is simply a generalization of
redeemable currency, in which all discretion is transferred to the bank. It is not a
conspiracy. It is normal.
However, it is not at all clear that official gold reserve figures are anywhere near
accurate. IMF guidelines have long encouraged central banks to report gold that is
"loaned" or "deposited" on a single line with actual monetary gold. In other words,
what the bank actually owns is not gold, but an obligation from another party to
deliver gold. The real gold has almost certainly been sold, and the counterparty
(typically a large domestic bank or foreign central bank) is - at least in theory "naked short." And not feeling too good about it, at least not these days. This practice
was a great way to make money in the '90s when the gold price was declining, and in
fact may have been a major cause of that decline. At this point it is somewhat
embarrassing. James Turk recently discovered that USG is in on this game, which
doesn't look good at all.
The gold lending situation, for no reason I can discern besides basic accounting
honesty (something USG is actually quite good at, as it plays into the natural CYA
response) appears to be heading slowly toward a correction. If this actually happens,
it will be very interesting to see how much gold is actually left. However, there is also
a large market in gold options and other derivatives. A central bank has many
weapons.
However, we keep running into the same problem: the red-giant state. If you assume
that USG and its allies are ruthless and Machiavellian, they have many ways to
defend their currencies. But if USG and its allies were ruthless and Machiavellian,
they would not have a problem in the first place.
Take the recently proposed IMF gold sales. The gold to be (possibly) sold will not
simply be dumped on the market with an auction, a la Gordon Brown. No, it will be
shoehorned into the existing Central Bank Gold Agreement, under which European
central banks sell 500 tons a year. Nominally, this is a restriction to avoid massive
sales that would depress the gold price. Perhaps this was even the original point. At
present, however, it appears to be an obligation to prevent the price from reaching
escape velocity, an obligation onerous enough that the Europeans would not mind
shuffling some of it off on the IMF.
And of course, no one even begins to admit that managing the gold price is the point.
Perhaps they are even sincere about this. Why shouldn't they be? Why shouldn't the
policies that once were ruthless and Machiavellian have become, after decades of the
system believing its own PR, mere force of habit? If the central banks were really
managing the gold price, don't you think they'd be doing a better job of it?
As I recently suggested on this RGE thread, there's a simple way to understand the
gold market. Think of gold as an artificial currency. Imagine that it's the currency of a
small European country, which we can call Goldenstein.
Every year for the last five years, the Goldenstein auro has appreciated by about 20%
against the dollar. And that was before the crisis. If we annualize 2008 so far, it's
more like a million trillion percent. I exaggerate. Slightly.
This means, of course, that the dollar has lost 20% a year against the auro. Now
imagine that you are doing customer outreach for some Wall Street firm that is trying
to appeal to Goldensteiners. Specifically, you are trying to persuade them to invest in
dollars. Or stocks, or bonds, or any financial asset which produces revenue in dollars.
How would you pitch that?
Now imagine that you're a bank in Goldenstein, and you're trying to persuade
foreigners to invest in your small but happy country. How would you advertise this
service? Would you even have to? Where would it stop? Why would it stop? How
would it stop?
Of course, there is no Goldenstein. That is, there is no sovereign country whose goal
it is to defend and promote the gold standard. There is no auro, just gold itself. The
economics are all the same - but there is no army, navy or air force. Goldenstein may
be small, but at least it has a police force with a couple of Glocks and some old
bulletproof vests. Gold has nothing at all.
And yet gold, as we've seen, is an existential threat to the greatest military power in
the history of the world, one whose legal and financial arms reach everywhere. No
corporation can even think about making USG its enemy. What can it do about gold?
Anything, if it wants. What should it be doing? Something, definitely. What is it
doing? Pretty much squat, as far as I can tell. Perhaps the god has abandoned
Antony.
De gustibus non computandum: or, economics needs a
divorce
Most people believe that there is something called "economics." But this is just not
so.
When we use the word "economics," we are conflating two completely distinct
disciplines. Worse, at most one of these disciplines is right - each despises and
condemns the other. It's as if English had one word stellatry, which meant both
astronomy and astrology.
Our first discipline is literary economics. Literary economics is what the word
economics meant in English until the 1870s or so. It is Carlyle's dismal science. It
was also practiced in the 20th century, under the name Austrian economics, by
figures such as Mises, Rothbard and Hazlitt. Our second is quantitative economics.
Quantitative economics was invented in the late 19th century and early 20th century,
by figures such as Walras, Marshall, Fisher, Keynes and Friedman. It is also practiced
today, under the name economics.
Observe, for a moment, the suspicious evolution of this terminology. Astrology and
astronomy have a similar temporal relationship - as do alchemy and chemistry. Ie:
astronomy replaced astrology, and made it clear that its predecessor was nonsense.
Chemistry replaced alchemy, and made it clear that its predecessor was nonsense.
But when Robert Boyle replaced alchemy with chemistry, he chose a new name to
make it clear that he was separating the sheep from the goats and classifying himself
among the former. Astronomy is separate from astrology for much the same reason,
and in much the same way.
Whereas in economics it's the other way around. The new name has replaced the old
one in situ, forcing its predecessor to decamp to a label which, like all labels, was
originally pejorative. It's as if chemistry had decided that it was the only true
alchemy, and forced the original alchemists to rebrand their field as, I don't know,
Swedish alchemy.
Of course, this doesn't prove anything at all. But isn't it slightly weird? You'd think
that if you discover that Field A, which has been taught in all the best schools and
universities since Jesus was a little boy, was so misguided in its methodology that it
is useless to continue its work, and instead people should study the far superior Field
B, you'd call your glorious new B a B, rather than insisting that you had discovered
the one true A.
I'd say this anomaly is, if nothing else, a reason to investigate the obvious alternative
that this question suggests. Which is that it's actually the new field, Field B, which is
a crock. And which has chosen to hitch a ride on the good name of Field A, devouring
it in classic parasitic style. In other words, it is actually the Swedish alchemists who
are the real chemists, and whose field has been invaded and annexed by a horde of
canting, zodiac-wielding transmutationists. Oops.
You may or may not agree with this proposition. But it is surely prudent to consider
it fairly. And the only way to do so is to hold the disputed marital property,
economics, in escrow, leaving the respondents with their own separate and equal
names. Ideally, the noun would be estopped from both parties, giving us not literary
economics but something like econography, and not quantitative economics but
something like economodeling. (Or perhaps, if you want to be nasty, econogy practitioners, econogers.) However, some may be too conservative for these bold
linguistic innovations.
Let's briefly establish the distinction between these fields. It should be obvious that
whatever their respective merits, they are different things and should not be
conflated under one name. To indulge in a little Procrustean generalization:
The method of quantitative economics - including both econometrics and
neoclassical macroeconomics - is to construct mathematical models of economic
systems, ie, systems of independent, utility-maximizing agents. The purpose of
quantitative economics is to predict the behavior of these systems, so that central
planners can manage them intelligently.
The method of literary economics is to reason clearly and deductively in English
about the behavior of economic agents. The purpose of literary economics is to
construct and convey an intuitive understanding of causal relationships in economic
systems.
Clearly, these fields have nothing in common, either in methodology or purpose. It is
true that some quantitative models can be explained in literary terms. However, they
cannot be justified in literary terms. And if they can, no quantitative methods are
necessary. Indeed, successful quantitative methods often hold up quite poorly when
judged by literary standards. Two good examples of this phenomenon are Henry
Hazlitt's Failure of the New Economics - a line-by-line response to Keynes' General
Theory - or Murray Rothbard's abusive treatment of Irving Fisher's equation of
exchange.
And by the standards of quantitative economics, which considers itself a predictive,
falsifiable, inductive science, literary economics is simply a nothing. At best, a
popularization. It makes no testable predictions. Why anyone would study it in the
21st century is a mystery.
Ergo: there is no possibility of reconciliation. Papers should issue. Custody of that
little brat, economics, should be delayed for further consideration. Perhaps he can be
sent to Antartica and eaten by a leopard seal.
Consideration of the merits and demerits of contemporary literary, or Austrian,
economics is off-topic for this brief, off-week UR. (I know I promised not to post
again until the 28th. But your host is not really known for keeping his promises.)
Rather, I want to use the tools of literary economics to explain why quantitative
macroeconomics is, to put it quite bluntly, fraudulent. The argument that economics
needs a divorce is not dependent on this point, but it certainly ought to help seal the
deal.
The point is unusually accessible because of an article this week in the NYT
Magazine, on the economist Nouriel Roubini. Brad Setser, Roubini's old sidekick and
now at the CFR, expands. (I used to post a lot of comments on Setser's blog, but that
was before little Sibyl showed up.)
Roubini and Setser are certainly not Austrians. Which makes their reinvention of
literary economics all the more interesting. The great lie, after all, is always one
cohesive monolith, whereas great truths seep in from every pore. Roubini is trained
in modeling, whereas Setser is not. Personally, I prefer Setser. But Roubini is more
flamboyant and more credentialed, and he gets the press. As the Times flack puts it:
Roubini’s work was distinguished not only by his conclusions but also by his
approach. By making extensive use of transnational comparisons and historical
analogies, he was employing a subjective, nontechnical framework, the sort
embraced by popular economists like the Times Op-Ed columnist Paul Krugman and
Joseph Stiglitz in order to reach a nonacademic audience. Roubini takes pains to
note that he remains a rigorous scholarly economist — ―When I weigh evidence,‖ he
told me, ―I’m drawing on 20 years of accumulated experience using models‖ — but
his approach is not the contemporary scholarly ideal in which an economist builds a
model in order to constrain his subjective impressions and abide by a discrete set of
data.
Indeed. Setser puts it this way:
But the outcome of most such models seem determined by the assumptions used to
create the model more than anything else. [...] I am biased, but I think it is possible
to be analytically rigorous (and to use real data to inform your conclusions) even in
the absence of a formal model.
And the commenters, as usual, repeat and reinforce the point in various interesting
ways. (If you want to participate in a productive discussion about international
monetary economics, Setser's blog is still the place to go.)
Moreover, even leading quantitative economists are happy to admit that in the
century or so of its existence, quantitative economics has displayed little if any
predictive power. For example, consider this cri de coeur from Greg Mankiw, or this
European reminder that none of the DSGE models in use every day at the highest
policy level includes anything like a plausible theory of what is surely the most salient
issue in economic prediction - the business cycle. And Axel Leijonhufvud is brutally
direct:
I conclude that dynamic stochastic general equilibrium theory has proven itself an
intellectually bankrupt enterprise.
Of course, I'm sure many other economodelers disagree with this epitaph. If nothing
else, few scholars display such Diogenesian honesty as to pronounce the death of
their own field. Nor are Mankiw and Leijonhufvud really saying that it's time for all
the economists in the world to clean out their cubicles and consider new careers in
the lawn-care industry. I'm sure they are quite confident that, with redoubled effort,
the profession can redeem itself. But, considering the age of the endeavor, the rest of
us should feel free to be skeptical.
One of the most interesting intellectual phenomena of today is the fact that we can
read the words of professionals whose jobs it is to actually predict macroeconomic
systems. Ie: fund managers. My favorites are three blogs I've mentioned before Macro Man, Cassandra Does Tokyo, and CT Oysters. Frankly, these guys are just
mensches, anyone who reads their blogs for five minutes can see it, and if I had any
money I would find a way to give it to them.
The first thing you notice about financial professionals is that they have almost no
interest in the work of academic quantitative economists. (In fact there is a species of
fund manager called a quant, but quantitative financial engineering has essentially
nothing to do with the quantitative economics of Marshall, Keynes, Fisher and the
like.) I discovered this world through Brad Setser's blog, and the likes of Setser and
Roubini do interact with the pros - giving them considerable respect, indeed, which
says a lot for Setser and Roubini.
But as we've seen, they are exceptions. In general, the relationship between the
financial industry and the academic field of quantitative economics strikes me as
quite comparable to the relationship between the software industry and the academic
field of computer science. Ie: what relationship?
When you look at the methodology of the world's Macro Men - this post is a fine
example - they seem to operate mainly on the basis of their noses. Their specialty is
integrating a wide variety of perspectives and arguments and judging the soup by
intuitive gut feel. Nothing farther from the work of Keynes and Fisher, or even from
the methodology of the 21st-century central banker (who is often looking at the same
problem from the other side) could be imagined. They are not practicing strict
Austrian economics, although they are often influenced by it. But their approach is
certainly in the literary category. Yet another strikeout for the econogers.
What I want to explain today is why quantitative economics doesn't work. My
refutation is certainly not the only possible one - you can find a whole bushel full
here. However, since only one refutation is required to refute anything, I have chosen
one I find particularly ripe.
The task of econogy is actually remarkably similar to that of astrology. The astrologer
maintains a model whose inputs are past measurements (star and planet positions,
comets, eclipses), and whose outputs are future events (the death of a prince, the
winner of a battle, the sex of a baby). Using signs, symbols and simulations, he maps
the one to the other. His results are dispatched directly to the king, who uses them to
set monetary policy.
Why do we know astrology doesn't work? We know it in two ways: inductively and
deductively. Inductively, we see no past track record of successful astrological
prediction - just as Professor Mankiw sees no past track record of successful
econogical prediction. But this tells us very little, really. It could just mean that past
astrologers were bad astrologers. However, radical new theories of astrology may
indeed allow us to predict the deaths of princes, etc.
The deductive argument is far more brutal. We know that astrology doesn't work
because we know that astrology cannot work. We know that astrology cannot work
because we know physics, and we know that there is no plausible mechanism by
which comets, planets, etc, can cause the deaths of princes. (Unless the comet
actually hits the prince - a contingency which boring, zodiacless astronomers are
perfectly competent to predict.)
Similarly, if you are an American, you've probably had the experience of watching a
baseball game and hearing the commentator produce some egregious abuse of
statistics, such as "Rodriguez bats .586 against Clemens on prime-numbered
Tuesdays." You know that this number is (a) not statistically significant, and even if it
was it would still be (b) a product of data dredging, ie, overfitting. And you know this
not just because sports commentators are nincompoops, but because you know that
the numerical properties of the calendar cannot possibly affect the batting of
Rodriguez.
Is there an equivalent for econogy? As it so happens, there is.
Here is a question: how much better a car is a (new) 2008 Mustang than a (new)
1988 Mustang? Is it twice as good? Three times as good? 5.7 times as good? 1.32
times as good? How much better a computer is the MacBook Pro than the Mac Plus?
75 times as good? 1082.1 times as good? And who was a better Bond, Sean Connery
or Daniel Craig?
Surely the form of the question is nonsensical. There is no objective way to quantify
the quality of a car, or a computer, or a Bond. We might as well ask: what
temperature is love? What is the weight of March? Which is better, a cat or a dog?
We can express all of these as numbers. We can even produce formulas which output
these numbers. But we cannot describe them as measurements.
Actually, however, econogers (econometricians, to be precise) solve these problems
on a regular basis. They do so when computing the mysterious quantity known to
econogers - and to readers of fine newspapers everywhere - as inflation.
The implicit proposition assumed by the word inflation, at least in its 20th-century
meaning, is that changes in the value of money over time can be measured
quantitatively. The 20th-century concept of inflation is largely due to one Irving
Fisher, who is surely one of the century's most distinguished charlatans. Professor
Fisher's work is online, and certainly worth reading, if only from a forensic point of
view.
Consider the phrase "value of money." What is the "value" of money? Money, at least
your modern fiat currency, has no particular direct utility, unless you need to snort a
line of coke or find yourself "caught short." We desire money because we desire the
things that money can be exchanged for, such as 2008 Mustangs, plasma TVs, crude
oil, etc. Thus we speak of the "purchasing power" of money.
To be more concrete, let's look at a specific currency - the dollar. At any moment, we
observe a vast set of prices, which are exchange rates between the dollar and other
goods - 2008 Mustangs, euros, tickets to Bond films, and so on.
These prices are measurements - hard numbers. For any time T at which the market
is open, we have a precise measurement of the dollar-to-euro ratio. We also have a
precise measurement of the dollar-to-crude-oil ratio, and even a fairly precise one of
the dollar-to-2008-Mustang ratio. (Though the bid-ask spread on this last is quite
wide.)
If we want to speak clearly, however, we cannot speak of the "value of the dollar." We
cannot say "the dollar is strong" or "the dollar is weak" or even "the dollar rose
today." We can say all these things about the US Dollar Index. But we could construct
another index which was a weighted average of the exchange rate from dollars to
zinc, dollars to Malaysian ringgit, and dollars to Bond-film tickets, and this number
would have just as much (and just as little) right to be described as "the dollar" as
does the aforementioned index (which is usually what people mean). But our two
numbers might well be quite different.
When we speak of the dollar, we have surrendered our souls to the fallacy of
objective value. We have constructed a unitless number out of a set of measurements
in incompatible units. The result is a mathematical solecism, like saying "my car is
60 miles fast." There is no such thing as value, only price, and every price has both
numerator and denominator units.
But saying "the dollar is strong" is a peccadillo next to the flagitious concept of
inflation. The Irving Fishers of the world claim, quite seriously, to be able to measure
the "value" of 2008 dollars in 1988 dollars. Let's look a little more closely at how this
feat is accomplished.
Clearly, this number is not a price. There is no exchange rate between 1988 dollars
and 2008 dollars, as there is between 2008 dollars and 2008 euros. Due to our lack
of reliable and effective time machines, there is no market on which 1988 dollars and
2008 dollars can be exchanged. (We can measure the 20-year interest rate in 1988,
but by definition this cannot be affected by any events after 1988, unless 1988 has a
time machine which can observe the future.)
Time is confusing, so we can think of the problem in another way. Suppose we build
a powerful telescope by which we observe economic activity on Alpha Centauri. It so
happens that the Centaurians call their currency the "dollar." What is the exchange
rate between Earth dollars and Centauri dollars? There is none, because Earth and
Centauri cannot exchange any goods, monetary or otherwise.
However, we note that some goods are exactly the same on Earth and on Centauri the laws of physics being equal. Earth zinc and Centauri zinc, for example, are both
zinc. Earth water and Centauri water are both water. So if we measure the prices of
these invariant goods in Earth dollars and Centauri dollars, we obtain - presto Professor Fisher's "commodity dollar."
But there are two problems with this approach. One, we have no reason to expect the
Earth-Centauri price ratio in zinc to be the same as the ratio in water, or methanol,
or gold, or any other intergalactic commodity standard. Two, while we can average
them, but we have no objective procedure with which to define the weight of each
commodity in our average. By mass? By energy content? By number of protons? By
total price of annual product on Earth? By total price of annual product on Centauri?
Each method produces a different result.
And three, we have no reason at all to measure goods that are identical on both Earth
and Centauri ("commodities") and ignore items that vary, such as cars, movies, pizza,
etc. An Earth Mustang costs E$30,000; a Centauri Mustang costs C$10,000. This
suggests that 1 C$ equals 3 E$. On the other hand, Centaurians weigh 500 pounds
and have eight legs, which requires a much heavier grade of suspension and a
completely different style of seat...
Human anatomy in 1988 is quite similar to its descendant in 2008. Otherwise, the
relationship between 1988 and 2008, at least as far as prices are concerned, is
precisely identical to the relationship between Earth and Centauri: 1988 and 2008
cannot trade, and consumers in each have a completely different set of preferences
and a completely different set of goods they can purchase to satisfy those
preferences.
The diligent gnomes at the BLS, of course, have thought of all these things. For
example, they have no problem in telling you how much better a car a 2008 Mustang
is than a 1988 Mustang. Every year, for a month or two, both the new year's model
and the old's are on sale at the same time. In the fall of 1988, you could buy either a
1988 Mustang or a 1989 Mustang. The latter was more expensive - say, 5% more
expensive. Therefore, it must be 5% better, dollars to dollars. Compute this number
every year, multiply it out, and we have our ratio. Here is a fine illustration of the sort
of numerology involved. (Yes, "Fisher" is our dear old Irving, he of the "permanently
high plateau," the eugenics, the prohibition and the intestinal butchery.)
This gives us an objective procedure to calculate the quality improvement in
Mustangs. Here is another objective procedure: subtract 1900 from the year, and
divide. This tells us that the 2008 Mustang is 108/88 better than the 1988 Mustang,
ie, 22% better. Which of these procedures produces a number closer to the actual
ratio of the value of a 2008 Mustang to the value of a 1988 Mustang? Obviously, to
evaluate them, we would have to know said ratio. Back to square one.
Do you still believe that the ratio between 1988 Mustangs and 2008 Mustangs, or the
ratio between 1988 dollars and 2008 dollars, or the ratio between Earth dollars and
Centauri dollars can be calculated objectively, and should be assigned to the same
category as actual numerical measurements, such as the ratio between 2008 dollars
and 2008 euros?
If so, I recommend a visit to John Williams' Shadow Government Statistics. Williams
combines the formulas used in the Carter era with the data sets of 2008 to compute a
rather different set of numbers. A look at the graph tells all. As Williams puts it:
Inflation, as reported by the Consumer Price Index (CPI) is understated by roughly
7% per year. This is due to recent redefinitions of the series as well as to flawed
methodologies, particularly adjustments to price measures for quality changes.
Needless to say, 7% is a rather huge number in the world of inflation statistics.
Is Williams right? Is he wrong? I think it goes beyond this. The problem is that
Williams is operating under exactly the same assumption as those he criticizes: that
there is an objectively calculable number called inflation. No doubt for perfectly
justifiable reasons, he favors one (old) method of calculating this number, whereas
the government's experts (also for perfectly justifiable reasons) favor another (new)
method. Presumably there are many other methods which did not find favor either
with the 1978 gnomes or the 2008 gnomes.
All of these figures are stuffed to the gills with subjective fudge. Whether the gnomes
evaluate the products and weight the averages using their own personal taste (don't
forget the Bond films - entertainment is a significant percentage of consumer
spending), or whether their subjective taste is kept at the level of algorithmic choice,
the problem is the same: different gnomes, different numbers.
Of course, there is nothing wrong with subjective estimation for purposes of
illustration. If an auto reviewer says something like "the 2008 Mustang is three times
the car of its 1988 ancestor," one might find it a little odd. If the number is not three
but 3.47, a troubling Aspergery feel begins to emerge. But this is the reviewer's
judgment, and judgment is why we read reviews. As a reader one may prefer
adjectives to numbers, but the numbers are certainly no less expressive.
And this even holds true for "inflation." A historian may find it useful, in explaining
the economics of the Roman Empire, to postulate an exchange rate between modern
dollars and the denarius of Diocletian. Wheat prices, or labor costs, or precious
metals, or any commodity or basket thereof, so long as the same good is obtainable in
both 308 and 2008, may serve.
Illustrations, however, are one thing. Equations are another.
Quantitative economics can be refuted simply by observing that almost all its models
rely on inflation-adjusted numbers. Figures such as "real interest rates" - ie, actual
or "nominal" interest rates minus "inflation" - are everywhere. Other headline
statistics, such as "growth," are calculated using the same kinds of spurious pseudoprices. (And others, such as "unemployment," are consequences of different
subjective choices.) Needless to say, an inflation discrepancy on the order of 7% is
enough to throw most of your macroeconomic models into a completely different
galaxy.
The key observation is that the relationship between the identity of the gnomes who
produce the "inflation" number, and the prediction of the model (such as
"unemployment"), is in exactly the same class as the relationship between the
position of Saturn and the batting of Rodriguez. The latter cannot possibly depend on
the former.
In other words, there is no conceivable causal mechanism by which the subjective
taste of the gnomes can affect the variable which the model is designed to predict. It
is just as erroneous to introduce the BLS's opinion of antilock brakes - whether
produced by the judicious conclusion of grizzled auto reviewers, or by an algorithm
which is simply encoding the details of Ford's model-year transition strategy - into a
model designed to predict unemployment, as it would be to introduce the phase of
the moon. Neither the phase of the moon or the stopping power of antilock brakes
can either cause or cure unemployment, and any formula which implies otherwise
can be discarded without any empirical evidence whatsoever.
Thus we can say: de gustibus non computandum. In matters of taste there is no
computing. It is not necessary for us to examine the empirical results of models
which purport to predict future events from a mixture of price measurements and
subjective quality assessments. We know deductively that no such model can be
accurate. We cannot be surprised to learn inductively that they do not, in fact, appear
to work. Deduction trumps induction, though it's always reassuring when the two
agree.
This analysis leaves two questions open.
One, we have demonstrated the worthlessness of economodeling, but we have not
demonstrated the worth of econography. Perhaps both are worthless. In that case, do
they need a divorce? Maybe they're more like one of those couples which deserve
each other.
Two, we have failed to explain why, if economodeling is such obvious nonsense, it
became and has remained so popular.
Perhaps these questions call for a sequel. The next UR post will appear on August 28,
2008. It will probably be about something completely different.
A clean-slate accounting of the dollar (part 1)
There seems to be a bit of a commotion in the financial markets. As one mugwump
put it: "this would be extremely interesting from an analytic perspective, if it wasn't
happening to us."
And the yellow dog has barked. Woof! The Au/USD ratio or "gold price" rose about
10% on Wednesday. This may not sound like a lot, but it's basically unprecedented. A
Moldenstein moment? Possibly, but I wouldn't write off the global financial system
just quite yet.
Looking at the chart, what seems to have happened is that a little before 10 AM,
someone chose to either acquire a fat slice of the yellow dog, or relieve themselves of
a negative slice. I suspect the latter. "Actually, Brooke, we used to have our very own
place in the Hamptons. But then Daddy decided a massive financial crisis was the
perfect time to short precious metals."
If the details of this matter interest you, see my comments Monday at Macro Man's.
The subject was the decoupling of gold and oil, which moved in sharply opposite
directions Monday. Hopefully causing someone to lose a large amount of money. I
would like to think that the events of the last year - or at least the last day - convince
the wizards of Connecticut, or at least the wizards' little black boxes, that the
marginal market for gold is dominated by its role as a natural currency, and that it
does not form reliable correlations with industrial raw materials ("commodities") or
official currencies (the hidden denominator of "the dollar," as in "the dollar rose
today" - meaning, basically, USD/EUR).
(Not that I expect raw material/USD ratios to crater. The basic driver of rising
material/USD ratios is the US trade deficit, which ships large numbers of dollars to
large numbers of people with a large marginal propensity to demand raw materials
and products thereof. Eg, China. Since the basic cause of the trade deficit is
underpriced currencies in emerging markets, and since this underpricing is not an
accident but a policy, there is no reason to expect this trend to reverse. Of course
speculators can overshoot it, but they can also undershoot it.)
You can also read this thread at Brad Setser's, in which I explain my modified
Austrian theory of banking, and the rather extreme crisis medicine it implies, to
skeptical but friendly bankers. Here at UR we're never afraid to go head to head with
the heavy hitters.
But all of this is written for those with some pre-existing knowledge of the system.
The great thing about being a skeptical generalist is that you trust your own ability to
think about X, instead of trusting those with actual knowledge and experience in X. I
am certainly no opponent of knowledge or experience, but it should be plain to
everyone at this point that our financial system is, in at least one mysterious and
incomprehensible way, broken.
So those who know it, know the broken thing. Worse, they believe that the dollar
system is exactly what it purports itself to be - money is money, bonds are bonds,
banks are banks, etc. And they have built a large superstructure of models on these
understandings. Said models do not appear to be in perfect working order.
When we analyze the dollar with no assumptions about economics, finance, or
accounting, we may make our own mistakes, but they will be our own mistakes.
Think of it as rather like analyzing a Soviet nickel company in 1991. Does the
company even exist? Does it even produce nickel? Does it own any mineral rights of
any sort? If we buy it, do we really own it? Etc.
So think of our clean-slate dollar analysis as a sort of forensic accounting, on a very
special Soviet nickel company: USG, also known as "America."
First, let's start by looking at a dollar. You probably have one in your wallet. This
exercise may seem pointless. And to some extent it is. But it reminds us of the first
rule of accounting: always trust your own eyes.
On the back of my dollar, there are some trippy engravings with Latin text. I don't
know Latin, but the context seems purely decorative and contractually void.
Hopefully this is actually so. There is also the phrase "In God We Trust," which
sounds vaguely like a financial obligation. But we know not what liabilities are being
ascribed to God, whether He has actually agreed to any such contract, or what will
happen if He defaults on it. So we'll call this one void as well.
On the front, more decoration, but also what seems like actual content. We learn that
our dollar is a "Federal Reserve Note," issued by "The United States of America." The
latter is our Soviet nickel mine - USG. The "Federal Reserve" is apparently some unit
or subsidiary thereof. Perhaps it has some relationship to the "Federal Reserve Bank
of San Francisco." Also appearing is the "Department of the Treasury," apparently
some other unit, employing a "Treasurer of the United States" and a "Secretary of the
Treasury." Oddly, these are not the same person. Perhaps the latter is the former's
admin. Their signatures are reproduced - context, unclear. Are the Treasurer and her
secretary personally liable for any obligation? If USG tanks, must they step in and
make me whole? We'll take a wild stab and say no.
We do not understand the internal structure of USG. We don't want to understand it.
We will treat it as a single entity with a single balance sheet. Presumably if we decide
to do the deal, we'll bring in our own people and reorg everything. For now, if USG is
lending to itself, or whatever, these transactions will cancel out. Simplifying
everyone's life. Life is short. Accounting is boring. Or at least, it should be boring. If
it's not, something is probably up.
There is also what looks like a serial number. Mine is "L68082696L." This suggests
that there is a list of serial numbers somewhere. Probably on a crumbling, makhorkastained notebook filled out by hand in Cyrillic. But still, this is excellent. It suggests
that we may be able to know how many dollars are outstanding. As we'll see, this is
too optimistic, but one can hope.
It also suggests that the Cyrillic notebook might record that I, Mencius Moldbug, am
the owner of L68082696L. But this can't be so - I know that no one knows that I have
this note. This is useful information; it means the dollar is some sort of bearer
security.
Finally, there is a fascinating phrase. It reads: "this note is legal tender for all debts,
public and private." When we investigate this, we find it refers to a rule in the
operating handbook for USG's internal security forces - 31 USC 5103:
United States coins and currency (including Federal reserve notes and circulating
notes of Federal reserve banks and national banks) are legal tender for all debts,
public charges, taxes, and dues. Foreign gold or silver coins are not legal tender for
debts.
Does this actually mean anything? Or is it purely decorative? As we'll see, it is
decorative. Or more properly, historical. It doesn't mean anything now, but it once
did.
Today, if I sign a contract promising to deliver a hundred dollars, I need to deliver a
hundred dollars. If I sign a contract promising to deliver a barrel of oil, or a tenth of
an ounce of gold, or five shares of Cisco, I need to deliver a barrel of oil, or a tenth of
an ounce of gold, or five shares of Cisco. All of this would be true with or without "31
USC 5103."
So we have learned the following from our examination: the "dollar" is some sort of
bearer security, issued by USG, attractive and portable, conveying no rights
whatsoever. Well, it was worth a try.
But we know something else, which is not written on the note but is implicit in its
design. We know that every dollar is equivalent. Each dollar is a member of a
homogeneous class of goods, each of which confers the same rights as every other.
Moreover, bills of higher denominations obey the same rule. A five-dollar bill will
always be worth five dollars. It will never trade up to $5.23, or down to $4.65.
This minimal amount of information enables us to classify the dollar as a financial
instrument. The dollar is equity.
Compared to your average equity issue - say, a share of Cisco - the dollar is a highly
inferior class of stock. It never has paid any dividends and probably never will. It
conveys no voting rights. We have no idea how many shares are outstanding. And
we're not at all sure what you'd own, if you owned all of them - but it is definitely not
all of USG.
But this is par for the course for your Soviet nickel company. The forensic accountant
is trying to make some kind of structured sense out of half a century of Communist
nonsense. Is this a problem? It is. Does this mean you shouldn't buy the company, or
its shares? Well, nickel is nickel. Some of the world's richest men got that way by
buying Soviet nickel companies.
Any financial instrument is one of three things: a deed of ownership of some good (a
title), a liability to fulfill some obligation, possibly contingent (a debt or option), or
none of the above (equity). The dollar is equity because (a) it is definitely not a title
or a debt, and (b) every dollar is created equal; whatever benefits USG may choose to
shower on the holder of L68082696L, it will provide to the holder of any other
dollar. It's not much, but it's a start.
Perhaps you think of the dollar as "money" or "currency," and you are very confused
by all this. "Money" and "currency" are nice words, but they have no precise
accounting definition. They just refer to a good or security commonly held for the
purpose of savings and/or exchange. Historically, we can identify four classes of
currency:
(1) Direct goods, such as coins of a standardized weight of precious metal.
(2) Titles or warehouse receipts to (1).
(3) Obligations to pay (1) or (2), or redeemable currency.
(4) Mere equity, or fiat currency.
These are (excluding the common 4-to-1 transition) in order of historical evolution.
Explaining the evolution is not of direct assistance in analyzing the dollar, but it
helps us get our bearings - and it defines terms which will be useful later on.
Class 1 currency (standardized metal) evolves into class 2 currency (titles) because
titles are more portable, secure and convenient. Digital gold is a modern class 2
currency.
Class 2 currency (titles) evolves into class 3 currency (redeemable notes), because the
change is generally profitable for the currency issuer, and the marks are too dumb to
know the difference. A title or warehouse receipt is a title because the issuer holds
goods that match it; otherwise, he is a thief. A redeemable note is a mere debt, and
does not default until redemption fails. And even then, the issuer is only bankrupt,
not in jail.
Suppose I have 100 ounces of gold, and issue 100 titles against it, each title stating
that the bearer owns one ounce of gold. This makes me a respectable issuer of class 2
currency.
Suppose I have 100 ounces of gold, and issue 200 redeemable notes against it, each
note stating that I will issue the bearer one ounce of gold on demand. This makes me
a scoundrel.
However, it also makes me wealthier than I was before, at least until more than 100
bearers show up to claim their gold at the same time. Will my notes trade at par? Ie:
will people accept them as equivalent to the class 2 titles? Well, every time someone
starts to get suspicious and tries to redeem one, it works. So I don't see why they
shouldn't. We have just reinvented the wildcat bank - a staple of early American
finance.
There is a cure for wildcat banking: those who accept class 3 notes should ensure that
the issuer is solvent. A financial institution is solvent if and only if the sum of all the
payments it is obligated to make equals or exceeds the total price of all the assets it
holds. So our Scoundrel Bank above is not solvent, because it is obligated to pay 200
ounces and it only has 100 ounces.
One way to see a redeemable note is to see it as a very short-term loan from the
noteholder to the bank, which is automatically renewed or "rolled over" when the
noteholder does not redeem. If the term of the loan is an hour, a minute or even a
second, the effect is redeemability. And note that when making a loan, what you want
to know is whether the loan will be paid back. And collectively, what all loanholders
want to know is that they all can be paid back. First come, first served, is not
solvency.
Scoundrel Bank can redeem for some of its noteholders. But not all of them.
Therefore, all unfortunate holders of its notes can agree on a fair - or "equitable" bankruptcy restructuring: every holder of a Scoundrel ounce note should receive half
an ounce of gold. As for the scoundrel himself, trees abound, and perhaps the
noteholders can pitch in for a rope.
But there is a tricky intermediate case - call it Questionable Bank - between
Respectable Warehouse and Scoundrel Bank. Respectable Warehouse issued 100
one-ounce titles. It has 100 ounces. Verifying the quality of the titles is as easy as
verifying these facts. Scoundrel Bank issued 200 one-ounce notes. It does not have
200 ounces. Verifying its insolvency is just as easy.
Questionable Bank also issued 200 ounce notes. It also has only 100 ounces. But it
also has 100 old pianos. Each piano, it asserts, is worth an ounce of gold. "Easily.
Easily. No sweat, man. These are fine pianos. Here, play this one. Hear that sound?
That's a sweet tone. Check out the action on the keys. Totally smooth. You could
move this piano for an ounce fifty, no problem.")
Suddenly our noteholder, or at least the accountant he hires, is required to be a piano
appraiser. Should you trade a Respectable title to one ounce, for a Questionable note
paying one ounce? It depends on the quality of the pianos. Obviously, every piano is
different. You can't just play the one up front in Questionable's office. You need to go
into the back room and tinkle away.
Moreover, even if each piano could be sold on the piano market for an ounce or
more, it is hard to know that all the pianos could be sold at once. Since price is set by
supply and demand, the appearance of a large splodge of pianos, even fine pianos, on
the market all at once, is liable to depress the piano price. And "at once," let's not
forget, is the term of the Questionable notes.
In real life, of course, the good in question is typically not pianos but loans. Usually
long-term loans. Pricing a piano is difficult, but it is nothing on pricing a loan. And
the result of dropping a glut of loans on the market all at once is even more
astonishing and disastrous.
If you are interested in the details of this issue, see the discussion at bsetser's. But in
this case Questionable has an easy solution for its problem. Like most currency
issuers, it is sovereign. It is not just a bank. It is also the government. One, nobody
can go into its back room and tinkle its pianos. And two, if people don't want to
accept its one-ounce notes as equal to one ounce, it can make them.
This provides an interesting explanation for the mysterious "legal tender" phrase on
the front of our dollar. It is easy for a sovereign currency issuer to transition its units
from a class 1 or class 2 currency, to a class 3. The class 3 currency is still defined as
the same weight of metal. But it is no longer backed by enough metal to redeem the
entire currency issue (otherwise, it might as well be class 2, like the old Bank of
Amsterdam). Besides metal, the issuer holds pianos, loans, Honus Wagner baseball
cards, etc, all of whose total market price exceeds the sum of the notes. Or at least
allegedly exceeds them.
It is highly desirable for the class 3 currency to trade "at par," eg, be exchanged oneto-one for the metal or the title. And for a sovereign issuer, this is no problem. If the
subjects arrogantly persist in scorning the King's honor by discounting his perfectly
good notes, the King's sword will discount their necks. Even the flagrantly insolvent
Scoundrel Bank will do just fine as a sovereign issuer. If Jews and speculators try to
stop the King's loyal subjects from paying their debts with the King's good one-ounce
notes, which they maliciously insist are worth only half an ounce, their heads are
forfeit.
And it is easy to see that the King's notes are worth one ounce, because anyone can
take them to the Castle and exchange them for an ounce of pure gold. No tricks or
shenanigans. Of course, speculators and Jews may assert that King Scoundrel has
used his sword to perform what is essentially an act of alchemy, an art of interest to
all kings past, present and future. But swords speak louder than words.
However, when King Scoundrel pushes his alchemy too far, the seams begin to show.
Foreigners, for example, have a nasty tendency to redeem the notes and skip the
country with the gold. This won't do at all. And it can be repressed in various ways,
but it leaks. The domestic price of Scoundrel notes will always be one ounce, but the
foreign price might be a bit lower. There is a perennial incentive to redeem notes and
smuggle gold. Bad.
This problem can be solved in a very simple way. Cut the Gordian knot. Suspend
redemption. Even better, terminate it permanently. Just default on the loan. You're
the King, after all. Who's going to mess with you? Certainly not the Jews and
speculators.
The result is a class 4 currency - equity. Conversion of debt to equity is the normal
procedure in bankruptcy. Scoundrel Bank still has plenty of assets, after all, just not
enough to keep its pesky subjects from redeeming their notes and selling the gold to
speculators and Jews. The class 4 currency is not, by any means, worthless. Holders
of notes are treated equitably. In theory they may even collectively own all of
Scoundrel Bank, although the King is generous enough to manage it for them.
Is it possible that our present dollar evolved through this process? Today we are
practicing accounting, not history. We do not know how the dollar came to be what it
is. All we know is that it's a class 4 currency. This conclusion is produced solely by
our own eyes, above.
To regularize this equity structure, to retrieve it from the realm of Soviet nickel and
bring it back into the realm of sane accounting, we need to do two things. One: we
need to decide how many shares there are. Two: we need to decide what you own, if
you own all the shares. For example, in the case of Cisco, the answer to the first
question is "5.9 billion," the answer to the second is "Cisco." These answers may be
slightly blurry around the edges, but only slightly.
Let's start by declining to answer the second question. Clearly, if you own all the
dollars, you do not own USG, including the highly lucrative (and nickel-rich)
continent of North America. While it might be great fun to elect a CEO of USG with
one vote per dollar, it is not essential to a proper accounting of the instrument. We
would also like to avoid restructuring USG as a whole, at least in this blog post.
For the moment, let's say our goal is to construct and spin off a new entity, DollarCo,
whose shareholders are current dollarholders on a 1:1 basis - each dollar will become
one share in DollarCo. As for DollarCo's assets, this is a political question. But just to
get in the right ballpark, let's start by throwing in USG's gold reserves: 264 million
ounces.
The first question is all we have left. How many dollars are there in the world? There
is a nice official answer to this question. The figure is known as M0, the monetary
base, and its current value is about 825 billion. Thus, DollarCo will have 825 billion
shares.
One of the nicest things about modeling a dollar as a DollarCo share is that the
process of equity dilution - creating new shares - is extremely well-understood.
Whereas the process of creating new dollars is, in classic Soviet nickel-company style,
shrouded in deep mystery. Everyone has a sense that there are a lot more dollars
around than there used to be, but few are quite sure why.
It is immediately obvious that creating new DollarCo shares cannot add more gold to
Fort Knox. But the process of dilution is still useful for various events in the
corporate lifecycle. Dilution confiscates a pro rata percentage of each share from all
shareholders, collects it all together, and assigns it to whatever party is granted the
new shares - presumably in exchange for some consideration which benefits the old
shareholders, making the confiscation worthwhile for all. For instance, if DollarCo is
to acquire PesoCo, it can issue new shares in exchange for all the shares of PesoCo,
according to whatever ratio the dealmakers work out.
What we don't want to see happening, however, is covert dilution. The party
secretary of our Soviet nickel company may well be running off shares on his laser
printer, and handing them out to his vodka buddies. This is a no-no. And we are not
sure what's happening in this "Treasury" place - but the number is definitely
increasing. For now, we would like to not only ascertain, but also lock, the number of
dollars outstanding. PesoCo will have to wait for another day.
It's important to recognize that DollarCo is a product of the accounting process. It
does not exist yet. All we have is USG, which owns Fort Knox among many other
things, and has issued some number of dollars. Before we can form DollarCo,
converting dollars to DollarCo shares and transferring USG assets to make DollarCo
worth something, we need to ascertain and lock the dollar count - first.
A dollar need not be a physical object. It can be an electronic entry, as many dollars
are at present. However, we need to know exactly how many dollars are outstanding.
A foolproof way to do this is to assign every dollar, electronic or paper, a consecutive
serial number - or as we programmers put it, a sequence number. If there are n
dollars, the first dollar is sequence number 0 (we can frame this one), and the last is
(n - 1). Rocket science this is not. And, most importantly, n is final - it cannot be
increased.
But we already know n, right? Isn't it 825 billion - M0?
Wrong. The problem is that this assignment, n = M0, simply does not make sense. It
is not consistent with economic reality. Of course USG can enforce it, as it can
enforce anything, but the result will be social and economic disaster. North America
will become a burned-out Mad Max wasteland, patrolled by marauding gangs and
packs of radioactive mutant wolves.
To think about this, let's make sure we fully appreciate the ramifications of
permanently setting n = M0 by imagining that each dollar is not just a piece of paper,
but an alien artifact, roughly the size of a poker chip but made using alien technology
which cannot be duplicated. These alien poker chips are a strange, glowing purple
color that no Earth technology can imitate. There are 825 billion of them, and no
aliens are around to extend the supply.
Everything else about our world, however, remains the same. Including the fact that
USG has a national debt of roughly $10 trillion - not counting unfunded
entitlements. Moreover, this debt is not even discounted. Quite the contrary: it is
considered "risk-free."
Question: how, exactly, in a world that contains only 825 billion dollars, can a debt of
$10 trillion be risk-free?
Moreover, USG runs an annual trade deficit of $750 billion. Even if it started each
January 1 with all 825 billion of these dollars in the country, which it most certainly
didn't, its subjects should be feeling pretty impoverished by Christmas. But no. They
run the same trade deficit, year after year after year. Perhaps the dollars are being
lent back to them - but why?
There can only be one answer: this $825 billion number is just plain wrong.
825 billion is the number of formal dollars outstanding. It is not the droid we are
looking for, though. What we need, in order to set up DollarCo and properly account
for the dollar, is the number of fully diluted dollars. Somewhere out there in Soviet
nickel-company land, there are trillions and trillions of covert, informal, virtual,
contingent, or otherwise mysterious dollars.
The goal of any clean-slate accounting must be to (a) describe these virtual dollars,
(b) figure out who owns them, (c) understand the process that produces them, (d)
shut this process off, and (e) map the virtual dollars to sensible financial
instruments, ideally just regular dollars.
Come back next Thursday for part 2 of this exciting series, in which we'll solve these
problems, or at least pretend to. (If you want the solution to actually be
implemented, I'm afraid you'll have to call your Congressman.)
Maturity transformation considered harmful: an
unauthorized biography of the bank crisis
[Update: there is a good discussion of this post chez Arnold Kling.]
"You may not be interested in war," Trotsky once said, "but war is interested in you."
Finance, too.
Perhaps you are under the impression that banking, accounting and economics are
perfectly understood by the bankers, accountants and economists. Or did this week
cure you of that? If it didn't, next week might. Generals, too, deserve deference for
their understanding of war. But not unlimited deference.
I am not a banker, an accountant, or an economist. I am a computer programmer.
My approach to financial engineering is to analyze it from the outside, taking nothing
for granted, treating it as I would a new operating system or programming language.
Our financial system is not a new operating system. It is a very old operating system.
Worse, there is only one of them: the whole world runs the Anglo-American banking
system, more or less as described by Walter Bagehot in Lombard Street (1873).
Lombard Street is our Windows. There is no Mac. There is no Linux. Our experts in
finance are not experts in finance. They are experts in Lombard Street finance.
Asking them to imagine an alternative is like asking a Windows programmer to
imagine OS X - except that Windows isn't 314 years old.
(The closest alternative to Lombard Street finance is a relatively obscure branch of
economics called the Austrian School. The basic problem with Austrian economics is
that it has never been tried in practice, and it has not advanced much since Ludwig
von Mises wrote Theory of Money and Credit in 1912. (A more readable modern text
is Murray Rothbard's Mystery of Banking.) The discussion below is generally
Austrian in method and theory, but simplified and generalized - and my conclusions
are very different from, say, Ron Paul's.)
In any case, if you're running Windows and you suspect that you might want to
"switch," a Windows expert is the last expert you want to ask. What needs to happen
now, I feel, is that a very large number of very smart people who know nothing about
finance need to do what I did, and try to figure the issue out from scratch. Hopefully
they will not get the same results.
Because my results are... disturbing. If you suspect that they might be right, please
try thinking through the problem for yourself. Let's go straight to the disturbing
results, and then we'll try to justify them.
1. We do not have a free-market financial system.
2. We have never had a free-market financial system.
3. Leaving the financial system to "work things out on its own" will not produce a
free-market financial system. It will produce a smoking heap of rubble.
4. Paulson's bailout is, if anything, far too weak. Our financial system is part of the
government. The proper first step is to stop lying about this. This means
nationalizing the banks. This is not an expansion of government, but a recognition of
its actual size. It is not an expenditure, but a revision of accounting to reflect reality.
5. A free-market financial system would be way cool. More important, it would be
extremely stable. But the only way to create one is to build it right from the start. If
you have a car and you want a motorcycle, sell your car and buy a motorcycle. Don't
decide to call your car a "four-wheeled motorcycle," and don't think unscrewing two
of the wheels will solve the problem.
6. Therefore, the government should close down the financial system we have now
and replace it with one that doesn't suck. What is the probability that this will
happen? Zero. But at least you know.
These are the results. Now, the explanation.
When we ask: "what caused the bank crisis," we need to distinguish between
proximate and ultimate causes. Our focus today will be on the ultimate cause. But
first, let's get the proximate cause out of the way.
The proximate cause of the bank crisis is the gigantic vote-buying machine we know
and love as the "Democratic Party." This gave us something called the Community
Reinvestment Act, which compelled banks to steer over a trillion dollars in flagrantly
bogus loans to the Democrats' electoral base. The scam is described, and its outcome
predicted, in this article from 2000. Here is Barack Obama's lead economic advisor,
endorsing it - in 2007. Doh.
If the gigantic protection racket known as the "Republican Party" had obstructed
"diversity lending" in any way, that might be a reason to support them. They didn't,
and it isn't. Indeed, Steve Sailer has uncovered a hilarious, and apparently
improvised, W. speech endorsing the program:
All of us here in America should believe, and I think we do, that we should be, as I
mentioned, a nation of owners. Owning something is freedom, as far as I'm
concerned. It's part of a free society. And ownership of a home helps bring stability to
neighborhoods. You own your home in a neighborhood, you have more interest in
how your neighborhood feels, looks, whether it's safe or not. It brings pride to
people, it's a part of an asset-based to society. It helps people build up their own
individual portfolio, provides an opportunity, if need be, for a mom or a dad to leave
something to their child. It's a part of -- it's of being a -- it's a part of -- an important
part of America.
To open up the doors of homeownership there are some barriers, and I want to talk
about four that need to be overcome. First, down payments. A lot of folks can't make
a down payment. They may be qualified. They may desire to buy a home, but they
don't have the money to make a down payment. I think if you were to talk to a lot of
families that are desirous to have a home, they would tell you that the down payment
is the hurdle that they can't cross. And one way to address that is to have the federal
government participate.
Truer words were never spoken. The federal government is certainly participating
now! So, we have our proximate cause: the Dempublicans. Or possibly the
Republocrats. Do we care? Does anyone with any brains still believe in any of these
swine?
The ultimate cause, however, is a matter of financial engineering. It has nothing at all
to do with elections or politicians. Politics explains where the bad mortgages came
from. Politics does not explain why they caused our financial system to lock up like a
clogged fuel pump, or why no one can price or sell these instruments. Pricing
dubious and complicated securities is what a financial system does. So why isn't it
happening? What is the engineering mistake that caused the financial system to be so
sensitive to this relatively minor piece of graft?
The engineering mistake is an accounting practice called maturity transformation.
In the best CS tradition - I consider it harmful.
Maturity transformation might also be called monetary time travel. It is an
accounting structure which permits a financial institution to pretend that it can
teleport dinero from the future into the present. High-tech modern finance can do
many cool things, but this is not one of them.
The price we pay for this illusion is a fundamental instability in the lending market.
To most economists, this instability is a Diamond-Dybvig dual equilibrium. To
Austrian economists, it's the Misesian theory of the business cycle. And in plain
English, it's your common or garden bank run. The present crisis, which is by no
means over, has many fascinating and devilish modern characteristics - but old
Beelzebub is easily discerned beneath its raiment.
Modern computerized finance is especially susceptible to the bank-run bug, because
in the last twenty years it has adopted an awesome array of incredibly beautiful and
fragile modeling techniques. Unfortunately, all of these models assume a stable or
single-equilibrium pricing environment. They do not allow for a phase change
between dual equilibria. Doh!
Why has this mistake gone unrecognized? The basic problem with maturity
transformation (MT) is that, while it is a bad accounting practice, it is not a new bad
accounting practice. MT is not some horrendous monetary Guantanamo unleashed
upon us by the corrupt Bushocracy. Nor is it a form of financial Bolshevism devised
by the Mussulman Candidate, Barack Osama. Oh, no.
Maturity transformation is the heart and soul of the Anglo-American model of
banking. Our current round of MT dates to the founding of the Bank of England in
1694. Lombard Street (which is still a good read) describes it in a nutshell. MT is
inextricably woven into our political system, our accounting system, our profession
of economics, even our Wikipedia. Despite the fact that it has been causing booms,
busts, and crashes since Pennsylvania Avenue was a swamp.
Or so, at least, I assert. Obviously it's a somewhat dramatic assertion. But I think it's
possible for you to use your own brain cells to understand why MT is harmful. You
don't need to trust me, or anyone else. The problem is just not that hard to follow.
You may know maturity transformation as "fractional-reserve banking," which is one
common case of the practice. A financial institution practices MT whenever it
"borrows short and lends long," ie, promises to deliver money in the short term
based on the fact that it is owed money in the long term. For example, in a classic
fractional-reserve bank which takes checking deposits and uses them to fund
mortgages, the bank's promises have a term of zero (your money is available
whenever you want it), and its mortgages are repaid across, say, 30 years.
But few of us have operated a bank. I want to explain intuitively why maturity
transformation is a basically corrupt practice. And for that, we'll need a more downto-earth example.
Suppose you lend a friend of yours from work, Bobby, a thousand dollars. He agrees
to give you the money back, plus fifty for interest, next week. The week is the term or
maturity of the loan.
Bobby then lends your K to a friend of his, Dwight. Dwight is about to ride up to
Humboldt to spend three boring weeks with his loser parents. Which will suck, but
which will also enable him to score a pound of weed and hitch back with it. The weed
can be moved for $1500 - but the three weeks is non-negotiable.
So the glitch arises when you buttonhole Bobby by the water fountain and mention
that it's Monday. "Yeah, right," he says. "Man, hey, do you want to go in for another
week? I'll give you another fifty. That's a good rate, man." This is, you agree, totally
fine. You have just rolled over your loan to Bobby. Next week, you do it again. And
the week after that, Dwight gets in. He pays Bobby $1300. And Bobby comes to you
with $1150, still smelling faintly of Humboldt.
You have just had a successful customer experience with the Bank of Bobby and
Dwight. You profited. Bobby profited. Dwight profited.
But is what Bobby did cool? Is it right? Did it display probity? We'd have to say - no.
At least, we would have to say this intuitively. We have not yet applied our logical
faculties to the matter. We have just used the awful Bobby, and the still more
horrendous Dwight, as propaganda props. Can we smear the noble art of banking
with these dank characters?
The basic problem with this transaction is that when Bobby said he wanted to borrow
a grand for a week, he was lying to you. Bobby is a user. He knew he could get away
with stretching the loan from one week to three, and he did. If he'd just asked you for
a three-week loan, everything would have been fair and square. But you might have
said no.
What do you want to know when you lend someone money - whether it's Bobby, or
Citigroup? You want to know that they'll pay you back. Or at least, that the
probability of repayment is high enough to be justified by the interest rate on the
loan.
To standardize this decision, our ancestors developed the art of accounting. Bobby,
or Citigroup, opens the kimono and shows you two lists. One is the list of promises
Bobby, or Citigroup, has made. For instance, Bobby has promised to give you $1050
in a week. This is sometimes known as a liability. The second list is the list of things
Bobby, or Citigroup, owns - for instance, Dwight's promise to deliver $1300 in three
weeks. This is an asset.
As a lender, what you want to know about Bobby or Citigroup is that they are solvent.
In other words: Bobby has enough money to pay you back. Solvency is computed by
subtracting liabilities from assets, the result being equity. For instance, if these are
the only transactions on Bobby's balance sheet, and if we assume (a big if) that
Dwight's promise is actually worth $1300, then Bobby's equity is positive $250, and
he is solvent.
Note that when you consider solvency, you are not asking whether Bobby can pay
you back. You are asking whether Bobby can pay all his creditors back. For instance,
if Bobby has also borrowed $1000 from your officemate Dave, but lent it to his exgirlfriend Angelique, who spent it all on meth, his equity is negative $750, and he is
insolvent - or bankrupt. He can pay you or he can pay Dave, but he can't pay both of
you.
There are two keys thing to remember about insolvency. One, it is a sort of event
horizon; you cannot borrow yourself out of bankruptcy. No one has any good reason
to lend to an insolvent party. Two, it is a collective decision: Bobby is either insolvent
with respect to both you and Dave, or he is solvent with respect to both. He can either
make good on his promises, or he can't.
But absent Angelique, when we use the solvency test to evaluate Bobby's business, it
looks like a good one. Bobby is solvent. But he also had to lie to you to get the loan.
Something is not quite right here.
If Bobby shows his balance sheet to a trusted third party, perhaps an auditor or
regulator, the auditor will agree that Bobby is solvent. If you ask Bobby whether he
can be trusted, he refers you to the auditor, who tells you that Bobby is solvent. But if
you saw his actual balance sheet, you wouldn't do the deal. Our accounting model is
simply not doing its job. Or is it?
Enough with Bobby. Let's look at an actual bank. FooBank, a classic fractionalreserve bank, has a billion dollars in demand deposits - that is, liabilities of zero
maturity, which are continuously rolled over when its depositors fail to withdraw
them from the ATM. It has $50 million in the vault, and $1.1 billion in fixed-rate 30year mortgages, giving it equity of $150 million.
Note that $1.1 billion is not the total amount of money owed on FooBank's
mortgages. It is the current market price of the mortgages. Ie: if FooBank sold the
mortgages to some other financial institution, it could get $1.1 billion for them.
(Because interest rates are always positive, that means the total payments over 30
years will be much more - let's say, $1.5 billion.)
So our question is: should you put your money in FooBank? If you give FooBank a
demand deposit, can you be sure that it will be there when you demand it at the
ATM?
Our first answer is: yes. Whatever your deposit is, it's a lot less than $50 million.
Our second answer is: no. Because FooBank, like Bobby, is a maturity transformer.
It owes $1B, now. It expects to receive $1.5B - over the next thirty years. Dwight is
sure taking a long time up in Humboldt! FooBank has only $50 million in the vault to
pay its $1B in demand deposits. If more than 5% of its customers demand the
payments they are contractually owed, FooBank is screwed. If you are not among the
first 5%, you're screwed too. What's FooBank going to do? Will the ATM print out a
message telling you to go up to Humboldt, and find Dwight?
Remember, back when we were considering Bobby's solvency, we established what
you want to know as a lender: that the borrower (Bobby) will be able to fulfill all his
promises, not just yours. There is no such thing as selective default. And there is
absolutely no reason to assume that your fellow depositors won't all show up at the
same time.
When you don't turn up and withdraw your demand deposit, you are effectively
rolling over a loan to the bank. And from the bank's perspective, there is no
difference between rolling over a loan and finding a new lender. So FooBank is
staking its undefeated record in promise fulfillment, which might be impressive in a
Bobby but is pretty much required in a bank, on paying back its old loans by finding
new lenders. Um... where have I heard that before?
Our third answer is: yes. Because we've forgotten something, which is that FooBank
is solvent. It may not have $1 billion in the vault. But it can raise $1 billion - quite
easily, by selling its $1.1 billion worth of mortgages.
In a modern digital market, this can be accomplished on the spot. It is a simple
matter of software. As customers line up at FooBank's ATM, red flags go up,
mortgages are sold - presumably to FooBank's competitor, BarBank - and trucks full
of cash from BarBank arrive. At the end of the day, FooBank has no deposits, and
$150 million in assets. It returns these to its stockholders and closes down. Call it an
immaculate bank run.
This is a worst-case scenario. It won't happen. And the fact that, in this worst-case
scenario, everyone gets their money back, is what makes it not happen - because the
motivation for a bank run is that, in a bank run, not everyone will get their money
back. Problem solved.
Our fourth answer is: no. Because we've forgotten something else, which is that
maturity transformation doesn't actually work. At least not in a physical, literal
sense. You cannot actually teleport money from the future to the present. FooBank
can't - and BarBank can't.
To understand the problem here, let's think a little bit about what makes FooBank's
mortgages "worth" $1.1 billion. We tend to use words like "worth" and "value" as if
they represented absolute, objective, physical characteristics. A kilogram of iron will
always weigh a kilogram. But what makes a package of mortgages "worth" $1.1
billion? Merely the fact that if you put it on eBay, the high bid will be $1.1 billion.
This, obviously, depends on the bidders. Mortgages, like everything else, are priced
by supply and demand. Even if we hold the demand for mortgages constant, pushing
$1.1 billion of them onto the market in one day is likely to depress the market price.
And why should the demand be constant? We certainly have no basis for this
assumption. Let's poke a little harder on this one.
First, we need to think a little harder about interest rates. We are used to thinking of
interest rates from the customer's perspective, in which they are a return on
investment. From a banker's perspective, however, an interest rate is the price of
future money in present money. For example, a 10% annual interest rate means that
I can buy $110 of 2009 money for $100 in 2008 money. This is an exchange rate, just
like the exchange rate between dollars and euros.
To know the correct price of a future payment - such as the payments on FooBank's
mortgages - we need to know two variables: the probability of default, and the
interest rate. Let's assume (this assumption is not valid in reality, as we'll see, but
breaking it will only make the problem worse) that the bank run has no effect on the
probability of default. Let's assume, also, that FooBank's mortgages are perfectly
good and have a minimal default probability.
But the interest rate for our 30-year mortgages is set by supply and demand. Clearly,
because we are in a maturity-transforming banking system, a considerable quantity
of that demand comes from maturity transformers such as FooBank. And ultimately
from its depositors. Ie: maturity transformation in the mortgage market, by
magically transmuting demand for zero-term deposits (money right now) into
demand for mortgages (money 30 years from now), has vastly lowered 30-year
interest rates.
So when FooBank's depositors pull their money out, mortgages go on the market and
mortgage interest rates go up. This increases 30-year interest rates across the market
- lowering the price of mortgages. That $1.1 billion isn't $1.1 billion anymore.
Worse, we have arbitrarily assumed that the run does not extend to BarBank. In fact,
we have assumed that BarBank, in some way, pulls in $1.1 billion of new deposits because that cash in those trucks needs to come from somewhere. But, since our
bank run is not the result of any problem restricted to FooBank (whose mortgages
are good), it can only be a systemic run. That is, all depositors everywhere realize
that the banks simply do not have the present money to repay them - and their socalled "solvency" is a result of long-term interest rates that do not reflect the actual
supply and demand for 30-year money.
Thus, the entire banking system is certain to implode. And implode instantly. The
result: a landscape of shattered banks, people who have lost their deposits, and very,
very high (but perfectly market-determined) interest rates. Moreover, housing prices
will decline - because they, too, are set by supply and demand, and high interest rates
mean expensive mortgages.
Another way to think of this is to realize that the Diamond-Dybvig model (see the
original paper, here) is not quite right - there is no "good equilibrium." The so-called
equilibrium in which depositors leave their money in the bank is unstable. You can
see this by observing that the probability of a bank run is never 0, and the value of a
deposited dollar cannot exceed the value of a non-deposited dollar - ie, the exchange
rate between a dollar in the bank and a dollar under the mattress cannot exceed 1:1.
But since a bank run can occur, a dollar in the bank must be worth slightly less than a
dollar under the mattress - to compensate for the probability of a bank run. Eg, if the
probability of the run is 0.001, and the bank returns only 50 cents on the dollar after
a run, the value of a dollar in the bank is 0.9995 dollars in cash. This disparity creates
withdrawal pressure, which is a feedback loop, and the run happens.
If this hurts your head, just think of the maturity-transforming banking system FooBank, BarBank, MooBank, and all their competitors - as a single bank. This
system has, like Bobby, made promises that it cannot physically fulfill, because
physically fulfilling them would require actual, physical time travel. There's simply
no way this can be good accounting.
Essentially, what we're looking at is the collapse of a market-manipulation scheme.
The banks have been collaboratively bidding up 30-year money by buying it with 0year money that belongs to someone else. The situation would be no different if they
were bidding up, say, copper, or Honus Wagner baseball cards. They have created an
artificial pricing environment, based solely on the carelessness of their depositors in
rolling over loans. Once the scheme is exposed, the price of Honus Wagner cards
crashes, the banks have spent the depositors' money on goods whose price has
considerably declined, and massive insolvency is revealed.
It helps to understand the use and misuse of the word liquidity in this environment.
The proper and original meaning of liquidity is the existence of a market with instant
trading and small bid-ask spreads, such as the stock market. For example, a house is
not a liquid asset in this sense, because setting up a housing sale is very difficult and
expensive.
But liquidity has come to mean something else: the presence of maturitytransformed demand for long-term assets. As we've seen, the price of 30-year money
in a market where banks can balance 0-year liabilities with 30-year assets is one
thing. The price of 30-year money in a market in which all the demand for 30-year
mortgages comes from 30-year lenders (for example, a 30-year CD - an instrument
which does not even exist at present) is very different.
Thus, when a maturity transformation scheme breaks down, the market is said to be
illiquid. In fact it is perfectly liquid in the first, original sense of the word. It is just
revealing the actual market price of 30-year money as set by 30-year supply and
demand - an interest rate so horrifyingly high it makes any 30-year mortgage at 6%
more or less worthless. (Actually, the "fire-sale" market for mortgages today is still
well above this price - it is set more by speculation that the MT switch will flip back
on, I think.) This phenomenon appears to resemble genuine liquidity, because assets
are "hard to sell" - but they are hard to sell only because those who now hold them
have them on their books well above the market price, and don't want to sell for less.
Professor Bernanke's recent mention of "hold-to-maturity" price reflects this
intentional misunderstanding. Economist Willem Buiter clarifies:
The MMLR [lender of last resort] supports market prices when either there is no
market price or when there is a large gap between the actual market price of the
asset, which is a fire-sale price resulting from a systemic lack of cash in the market,
and the fair or fundamental value of the asset – the present discounted value of its
future expected cash flows, discounted at the discount rate that would be used by a
risk-neutral, non-liquidity-constrained economic agent (e.g. the government).
Ie: the long-term interest rate on Treasuries. Which is still set by maturitytransformed demand (especially, via the central banks of China and the Gulf states,
which back their currencies with Treasuries).
Professor Buiter's definition of this rate as "fair" reflects the institutional assumption
of the economics profession that MT is a good, clean, and healthy thing. In reality, it
is concealing the most important price signal in the world: the present demand for
future money. MT adds present demand for present money into this market, utterly
and irrevocably jamming the signal.
The basic problem with the toxic assets that are clogging up the banking system
today is that there is no market mechanism that can reveal Professor Buiter's "fair
value." Any such mechanism needs to solve for two variables at once: it needs to
create a market in toxic mortgages in which the players are banks paying with
maturity-transformed money. Otherwise, the default risk of the loans cannot be
calculated by comparing their price with the price of Treasuries. The risk-free
interest rate in a market in which MT has broken down is much higher than the riskfree Treasury rate. This rate is unknowable. And you can calculate default risk from
price only if you know it.
Moreover, banks have no incentive to buy these toxic mortgages, turning MT back on
in the market - at least not until the price hits its rock-bottom point, at which MT is
completely off and 30-year supply is met by 30-year demand. Nor is there any way to
see when this point has been hit, because there is no genuine maturity-matched
market, and there are plenty of speculators betting on some kind of intervention.
And the implied interest rate at this rock bottom is so high that the houses which
collateralize the mortgages may be almost worthless.
And our fifth - and final - answer is: yes. Because FooBank, BarBank, and MooBank
are all FDIC-insured.
Actually, this is not even quite right. At least according to this story, FDIC is basically
empty. It had only $45 billion last time it reported, and it surely has a lot less now.
This to "insure" something like $4 trillion in deposits. You might as well defuse a car
bomb by wrapping it in toilet paper. FDIC "works" because it is backed by the
Treasury, which of course has the Fed's "technology, called a printing press" - ie,
Ben's helicopters - behind it.
In other words, when you make a bank deposit, you have acquired not one but two
securities. One is a promise from FooBank to pay you on demand. The other is a
promise from USG to pay you if FooBank doesn't. Because the promise is
denominated in dollars, USG can print dollars, and USG has no reason to welsh on
this promise, the dollar on deposit is truly worth $1. Not $0.9997, $1.
Note that we have just discovered the missing dollars from last week's post - or some
of them, anyway. These dollars are contingent - they only come into existence in
special cases, such as a bank run - and they are informal. But as informal, contingent
dollars, they exist nonetheless. If the Fed prints money to bail out FDIC, it is a
bailout - just like Paulson's bailout, the Fannie and Freddie bailout, the AIG bailout,
etc. There is no law requiring bailouts. But they seem to happen anyway.
For that matter, Treasury obligations are risk-free for exactly the same reason. This is
how the US can run a $10 trillion risk-free debt in a world with only 825 billion
actual dollars. It is simply assumed that well before Treasury would default, the
"technology, called a printing press," would be used to bail it out. There is no formal
guarantee of this. There is simply every incentive to do it, and no incentive not to do
it.
This whole beast is an incredibly cumbersome and bizarre accounting structure. And
it simply cannot be understood without reference to these kinds of informal
obligations. In accounting, the word "informal" is essentially equivalent to
"criminal." Simply put: the whole thing stinks.
Moreover, we can construct a formalized equivalent that has the same outcome, uses
maturity-matched accounting, and is completely unacceptable from a political
standpoint. In fact, it's more than unacceptable. It's ridiculous.
Consider FooBank, with its FDIC guarantee in place. The infinite printing press
guarantees FooBank's liabilities to its depositors. This leaves FooBank free to use the
depositors' money to buy 30-year mortgages, while assuring them that they can
redeem at any time.
A much simpler approach is for FooBank to simply store the deposits in its vaults,
and have FDIC make the mortgage loans - in a quantity equalling FooBank's
deposits. This produces: exactly the same safety for FooBank's depositors; exactly the
same demand for mortgages; and exactly the same risks for FDIC (which is, of
course, exposed to the mortgage risk).
And it's also utterly ridiculous. Basically, it means that mortgages are cheap because
Uncle Sam is printing money and lending it. When you want a mortgage, you apply
to the government. Moreover, the connection to FooBank's deposits is utterly
unnecessary. There is no reason that FDIC has to restrict its mortgage issuance to
FooBank's deposit base, tying it to the irrelevant convenience question of whether
depositors prefer their money in a vault or under the mattress.
What this thought-experiment tells you is that, if you believe in maturity
transformation, you believe it's good public policy for the government to print money
and lend it. Homeownership, after all, is important! President Bush says so, so it
must be true. This raises the question of why, if it's good for Uncle Sam to engage in
this practice, it's not good for everyone. Why not license private entities to engage in
the essential public service of counterfeit lending? The counterfeit spender drives up
prices and is bad for everyone, but the counterfeit lender creates a liability for every
dollar emitted... anyway. We are in the realm of absurdity.
We are now in a position to understand the crisis as a whole. What happened is that
a shadow banking system appeared, which performed maturity transformation
without formal FDIC backing. Participants in this market assumed that large or "toobig-to-fail" institutions, such as Lehman, Bear, AIG, etc, were effectively recipients of
an informal Federal guarantee, just like FDIC itself, the traditional banks, Fannie and
Freddie, etc. But they had reached the edges of informality and walked off the cliff
into delusion.
Furthermore, the financial models that players in the shadow-banking market used
simply did not incorporate the possibility of a maturity-transformation crisis. They
lived in a world of Lombard Street accounting, in which MT was just normal. The fact
that MT only works with a lender of last resort who can print money (or, under the
"classical gold standard," compel market participants to accept paper at par with
gold, as the Bank of England did during the Napoleonic wars), did not exactly bring
itself to their attention. Nor did the fact that they were treating private corporations
as perfectly-insured counterparties.
Essentially, Wall Street (a) thought it was a free market, and (b) assumed that MT in
a free market just works. Both of these assumptions were wrong. The financial
system was both free and protected, but the part that was free was not protected, and
the part that was protected was not free. And the border between the two was
completely informal, and was set in an ad-hoc, after-the-fact way by panicked
bureaucrats in Washington.
We are now in a position to consider solutions.
Our first solution is a free-market solution. In the free-market solution, Washington
renounces all bailouts, guarantees, nationalizations, etc. There is an easy way to do
this: break the Fed's printing press. Pass a constitutional amendment limiting the
number of dollars extant to the number of actual dollars in the world: M0, 825
billion. That's about $2750 for every American - although not all of these dollars, of
course, are in America.
Result: the mother of all bank runs. All bank deposits are vaporized. The assets
backing them become nearly worthless. Have fun paying off that $300,000
mortgage, with your $2750. Even Treasury obligations trade at pennies on the dollar
- have fun paying off that $10T national debt, in a world with only 825 billion dollars.
The good news: hyperdeflation. If you have a dollar, an actual physical greenback,
you can eat for a day. If you have $20, you're set for the month. A benjamin is
unimaginable wealth. Gas? Five cents a gallon. Gold? Worthless. Ammo? Priceless.
Basically, we're looking at Mad Max Beyond Thunderdome, with 1915 prices. I'm sure
this would make some people very happy. I am not one of them.
Our second solution is the Paulson plan - with its wonderful acronym, TARP. TARP
is effectively a new bank with no liabilities, $700 billion of equity (owned by USG),
and a mission to buy mortgages.
I am not going to go out on a limb and say the Paulson plan won't work. But I will be
surprised if it works. Basically, its goal is to pump enough money into the market for
"troubled" assets - assets in which a bank run has occurred, and MT has broken
down - to pull them out of the "troubled" category.
My suspicion is that the result will be just one more bank which holds troubled
assets, held on the books above their market price. So what? Why should this price
be the "official" price? Add this to the fact that the troubled assets are wildly
heterogeneous - every mortgage-backed security is different. Just because TARP
overpays for one, doesn't mean everyone should overpay for any. And they won't.
And our third solution is Plan Moldbug - nationalize all banks and other maturity
transformers, exchanging their shares for cash at the present market price, acquiring
their assets and accepting their liabilities. Consolidate the entire financial system
onto USG's balance sheet.
While we're at it, merge the Fed, Treasury, Social Security and Medicare into one
financial entity. Clean up the whole maze of interlocking quasi-corporations. The US
Government is one operation. It should have one balance sheet.
And yes, the banking system is part of it. Under the pretext of "regulation," the
banking system is already federally managed. Even its executive pay is apparently
about to be set by Congress. But most important, the banking system is part of USG
because USG has already chosen to accept its liabilities - by guaranteeing them.
When A guarantees B's liabilities, B needs to be on A's balance sheet. This is
accounting 101, folks.
This unity is even recognized in the conventional nomenclature for money supplies;
M0 is the supply of zero-term Fed liabilities (ie, Federal Reserve Notes, ie, dollars);
M1 is the supply of zero-term bank liabilities. The exchange rate between an M0
dollar and an M1 dollar is 1:1 and guaranteed to stay that way. So in what way are
they different things?
As we discussed last week, FRNs are more like equity than debt - they are not
promises to pay anything. And if an FRN is a share, a Treasury bill is a restricted
share. Thus, under Plan Moldbug, USG has a single balance sheet with no debt. It
can, of course, continue its present practice of diluting its equity (selling Treasuries,
printing FRNs, etc) to pay off its operating deficits. But it would be better advised to
issue a large pool of shares to itself, to assist it in phasing out this pernicious habit.
Also, Plan Moldbug has a critical fairness advantage: it is portfolio-neutral. The day
after this action, everyone's portfolio statement will show exactly the same number.
If (God forbid) you hold bank shares, those shares will be converted to cash, just as if
the bank had been acquired by another bank. If you hold mortgage-backed securities
- but who holds mortgage-backed securities? Not anyone I know. And if you pay a
mortgage, in all probability you are now paying it to the government. Do you care?
This is an important point, because Plan Moldbug involves a gigantic increase in M0.
M0 is the sum of Fed liabilities. By consolidating the balance sheet, we are moving
bank liabilities - the rest of the M's, and beyond - into this category. In any naive
analysis, this seems "inflationary." But naive analysis neglects the actual relationship
between money supply and prices. Prices increase when people have more money,
ceteris paribus, to spend on the same goods. If the change is portfolio-neutral, by
definition it cannot affect prices. In reality, all we are doing is recognizing the actual
supply of dollars, which is much greater than $2750 per American.
Naturally, the point of any such nationalization is not to have to do it again. Applying
to the government for loans is a little Soviet for my taste. Our present system, in
which Fannie and Freddie more or less are the government, is already a little Soviet.
The end goal is to phase out this lending-counterfeiter business, and construct a new
financial system - the motorcycle - in which lending is really, truly private, and
financial intermediaries match their maturities. If Bobby needs money for three
weeks, he asks you for a three-week loan. He does not ask you for a one-week loan
and then get a surreptitious, covert, informal three-week loan from the Fed's
"technology, called a printing press."
In any such financial system, we would see the true yield curve, the graph of interest
rates at every maturity, uncontaminated by maturity mismatching. My suspicion is
that at least at first, long-term rates would be quite high. Which means lower house
prices. In the spirit of portfolio neutrality, USG might want to print some more
money and kick it back to homeowners, such as, of course, myself...
But at this point we are just fantasizing, because none of this is going to happen. If
the American public balks at "King Henry" (I believe one poll showed 7% support for
the feeble TARP) - they'll have none of Emperor Moldbug. If printing a mere $700B
turns their stomach (the "cost to the taxpayer" - of course, no one will raise taxes to
"pay" for this use of the "technology, called a printing press"), moving a few T from
M1, M2 and M3 to M0 is a nonstarter.
What we're seeing here is a failure of democracy. Americans have a certain picture of
their financial system. They believe that a dollar is, in some way, an asset like gold
that cannot be printed at will. They believe that banks are free-market corporations,
not branded branches of the State. They believe in regulation, but they don't believe
in socialism. And so on.
Any politically realistic policy has to be framed in these terms, which are not realistic.
The result: stalemate, ineffectuality, drift, and disaster. In other words: EP1C FA1L. I
don't know what's going to happen, but I know it's not going to be good.
A regime-change signal: maturity crisis in gold?
As I said the other day, I support Barack Obama in the upcoming election. (In fact, at
this point I'd like to see John McCain suspend his campaign in the name of national
unity.) This means that, like many Americans today, I hope for change. And there's
no change like regime change.
I mean financial regime change, of course. A financial regime change is a phase
change in the markets for money - the end of an old era, and the beginning of a new.
As I recall, they even had money in Mad Max II: Beyond Thunderdome, so there is
always a new regime.
Many eras are ending in the financial industry, but there is one big one which hasn't
happened yet: a regime change in the global currency market. Our current global
currency regime is sometimes known as Bretton Woods II, or BWII. Perhaps if the
new regime represented only a moderate change from the present one, it might be
called BWIII. For policymakers at present, this outcome would probably represent
success. In the event of failure, the phrase "Bretton Woods" is unlikely to convey
positive brand equity.
No one really loves BWII. Since the term was coined, economists have made a parlor
game of predicting its demise. BWII is not an architecture, it's a system of stable
disequilibria. Saying "BWII is coming to an end" is like saying that in the future,
California will experience a large earthquake.
A more interesting question is: if there is a market signal - ie, a price series, a
number, a chart - that looks like the end of BWII, what might it look like? By
definition, the end of BWII is the end of the world as we know it. So we are,
essentially, looking for an end-of-the-world signal.
I am not an economic determinist, so I cannot go so far as to actually predict the end
of the world. For one thing, all outcomes are contingent on official action. There are
plenty of ways to stop this crisis instantly in its tracks - although most of them are
not politically conceivable. At present. Politics is not in any sense predictable.
(Did anyone watch Hank Paulson's speech on Wednesday? Including the Q&A? You
can see it here. Frankly, Bruno Ganz in Downfall is mostly more self-possessed. The
kindest thing you can say about Secretary Paulson is that he came across as if he
hadn't slept in three days, and at worst I was reminded of Ed Muskie and his
notorious Ibogaine moment. Does Fort Knox come with an an "evidence locker"?
Even the frame rate on the WMV clip is weird and twitchy, as if Treasury's IT farm is
feeling the heat.)
However, we are now seeing a signal in the wild that, if it means what I think it
means, could well be a predictor of global financial regime change. This signal is not
one of your common or "headline" statistics. It is not a first-line number or a secondline number or even a third-line number. It is not printed in any newspaper.
Nonetheless, you can find it with one click.
But before we say what the signal is, let's say what it should look like. What we are
looking for is a phase change between one equilibrium, which is the equilibrium we
have now, and another equilibrium, which is the equilibrium which has Tina Turner,
bad hair, and lots of crossbows. From the standpoint of a modeling philosophy which
assumes a single equilibrium, such a phase change looks like an indefinite-sigma
departure from the original price regime.
There are all kinds of such departures in the markets today. Perhaps the most
notorious is the TED spread, whose recent history looks like this:
Although this signal is very ominous, it is not our candidate. Note that if you graph
the inverse of one of these she's-gonna-blow signals, it assumes the other appearance
of an equilibrium-transition signal - the plateau that suddenly turns into a cliff. A lot
of the prices of mortgage securities have this plateau-cliff shape.
Nassim Taleb has described these indefinite-sigma departures as black swans. This
essay of Taleb's is required reading. While an equilibrium transition is not the only
kind of black swan in the world, it is the bird that seems to be causing the problems
we have now.
Here at UR, we think we know what this latest black swan is: a maturitytransformation crisis. Aka, a bank run. The previous essay is required reading to
understand the rest of this one. If you're skeptical or even if you aren't, please also
read the discussion at Arnold Kling's.
Here is the scary signal:
Again, if this isn't an indefinite-sigma departure, I don't know what is. But what is
this signal? What are these funny lines, anyway?
This is a gold lease rate - basically, an interest rate for borrowing gold. The source is
here. Note that if you scroll down to the long-term chart, you see two other spikes: in
1999 and 2001. The 2001 event is 9/11. The 1999 event was the Central Bank Gold
Agreement. These events turned out to be transient, and they are qualitatively
different from the current spike - as we'll see.
The current spike is explained, sort of, in this Financial Times story (also syndicated
here). What is not explained is the context and the implications. Let me try to fill in
the gaps.
The world's central banks have about 30,000 tons of official gold reserves. This does
not mean they have 30,000 tons of gold in their vaults. No one knows exactly how
much gold they have in their vaults. Estimates vary as to the discrepancy, but it is
probably somewhere between 2,000 and 10,000 tons. For perspective, annual
mining production is about 2500 tons.
The difference is in the form of "deposits," "loans," "swaps," etc: in a word,
receivables. Where X is some number between 2000 and 10000, the CBs have
(30,000 - X) tons of gold, and (X) little pieces of paper on which is scribbled "HAY
CB, ITS OK - I PAY U GOLD."
The signatures on said pieces of paper are names of "bullion banks." A bullion bank
is just like a regular bank, except that it does business in precious metals, not
government currencies. In particular, bullion banks profit the same way regular
banks do: maturity transformation.
In a typical transaction, the "deposited" gold is sold on the spot market, and the
resulting cash is used to finance a long-term investment, typically gold mining, that
produces gold. The result is that the bullion bank has short-term liabilities balanced
by long-term receivables, both in gold. In particular, bullion banks generally do not
expose themselves to fluctuations in the gold price, as they would if they used their
deposits to finance dollar-yielding investments. When the ratio of gold to dollars
changes, the bank's liabilities and assets change in unison.
A similar source of financing is the sale of near-term contracts in the futures market.
These contracts promise delivery of gold in a matter of months. The proceeds from
their sale can be used to finance production of gold over the course of years. Again,
the resulting structure has gold on both sides, and so is balanced against changes in
the gold price.
If you have read the essay on MT, all this will seem familiar to you. The bullion banks
are maturity transformers. Moreover, they are unprotected maturity transformers while the gold market is notoriously opaque, there is certainly no one who can print
and lend an infinite amount. This being kind of the point of gold.
Note that at least until recently, gold lease rates have been well under 1%, often
under 0.1%. Why do central banks participate in this market? The official
interpretation is that they want to earn a yield, however small, on their assets. The
conspiracy interpretation is that they want to suppress the gold price. In 1998, Alan
Greenspan told us that "central banks stand ready to lease gold in increasing
quantities should the price rise," which strikes me as fairly clear-cut. On the other
hand, since 1998 the gold price has risen considerably, and gold lending has not.
Most gold enthusiasts, and especially most gold conspiracy theorists (there is no
sharp line between the two, especially since gold-market intervention is one of the
world's few practical conspiracies; the whole point of a central bank is to intervene in
monetary markets) would have expected that a substantial spike in the gold price,
especially one accompanied by general financial chaos, would have resulted in some
kind of counter-intervention. Either this has not happened, or it has not been
effective.
My bet would be on the former. There is no doubt that central banks once managed
gold prices, and very aggressively indeed. But my impression is that the current
generation of central bankers has - or had - come to believe its own story, that gold is
an industrial commodity whose remaining place in the monetary system is a quirk of
history.
As Google Trends suggests, this perception is changing - if nothing else, because
BWII is obviously a sick puppy, and the obvious replacement for the dollar as
international standard of account would be the material which preceded it. In the
very short term, however, I think there are two forces which are causing the stress in
the gold market which the curve displays.
One, due to the general financial crisis, there is an enormous increase in Western
investment demand for gold, as seen in the now widespread retail shortages. This is
sucking present or "physical" gold out of the general bullion-banking complex. While
a shortage of coins, small bars, and other refinery products is distinct from a
shortage of metal proper, it certainly can't be said to help.
Two, and much more seriously: as the FT article described, the major gold lenders,
central banks, are refusing to roll over their loans. They are certainly not "ready to
lease gold in increasing quantities." If the article is to be believed (and other sources
confirm it), they are doing just the opposite.
In other words, they are behaving like rational lenders at the beginning of a maturity
crisis. Think about this for a moment from the position of a central banker. You work
at the Bank of Elbonia, let's say, in the gold department. Elbonia has 100 tons of gold
left over from its days as a great colonial power, but these days it is pretty much an
external province of the United States. For the last ten years, your goal has been to
earn a maximum rate of return for the Elbonian people, be it only 0.1%, on these
"unproductive assets." You have operated in an environment where it is essentially
assumed that major banks, especially major American banks, simply don't fail.
Suddenly you realize that major banks, even major American banks, do fail.
Moreover, you realize that your vault contains 50 tons of gold, and 50 non-tons of
paper reading "HAY CB, ITS OK" etc. (If you don't understand, see this.) Moreover,
you realize that you have not disclosed this ratio, making its disclosure, by definition,
news - especially if the disclosure involves informing the public that the non-tons are
non-tons. Moreover, you realize that, being a bureaucrat, your prime directive in life
is to not get caught with your pants down, and especially not to go to jail, and really
especially not to be torn to pieces by a mob in the street. And kind of the last thing
the people of Elbonia want to hear right now is that half their gold reserves have gone
up in smoke - thanks to you.
Moreover, even if you are not thinking these thoughts, your colleagues around the
world are thinking these thoughts. And the logic of the bank run is inescapable: if
everyone else is checking out, you want to check out too, and first. Thus, central
banks around the world are not "leasing gold in increasing quantities." They are
hoarding it in increasing quantities.
If this maturity crisis continues to develop - there is no guarantee that it either will,
or won't - the inevitable result is what a Mr. Juerg Kiener describes in this helpful
CNBC video: a bullion-bank default. Mr. Kiener appears to be what is generally
known as a gnome of Zurich. I am confident that he knows much more about gold
than I do, so I will take his guess that a delivery default implies a doubling of price as
sound. It sounds conservative to me, though.
In a gold maturity crisis, any paper instrument with counterparty risk is unsafe. For
example, the price of gold ETF shares, which are backed by 100% metal and have no
counterparty risk, may diverge from the price of gold futures, which are essentially
claims against bullion banks. It is not possible to predict whether or when this
divergence will happen, but it is easy to predict which of the two will go up and which
will go down.
From the perspective of BWII, the basic problem with a maturity crisis in the gold
market is that it has the capacity to produce a substantial spike in the price of gold in
dollars - doubling, etc. Any such spike attracts attention to the possibility of a return
to gold as a currency. Because any return to gold as a currency involves an increase in
the gold price of at least an order of magnitude, any such attention attracts a shift of
dollars into gold. Which increases the price, etc, and so on. I believe this is what Mr.
Soros calls reflexivity.
Moreover, the only way to damp a gold maturity crisis is to either find a gold lender
of last resort - who would have to be remarkably public-spirited, and display a high
level of sang-froid at the possibility of being torn to pieces in the street - or act
coercively, confiscating or banning gold. It is not 1933, and present Western
governments simply do not have the energy or popularity for this type of action.
So my guess is that unless the lease-rate signal is some kind of fluke (which it might
well be), the gold market is likely to default and deflate, the gold price is likely to
increase to a level which would at present appear absurd, and the BWII dollar
standard will be pushed toward failure and a return to the gold standard.
How this pressure will be resolved depends on the actions of governments. Ideally,
they would go with it rather than fighting it. But they certainly have the power to
fight it - having, after all, thousands and thousands of tons of gold to sell. However
the game plays out, hopefully it will at least play out quickly.
The Misesian explanation of the bank crisis
I've addressed this subject before at greater length, but I want to put it in one post
that people can easily link to and pass around.
Briefly: the fundamental cause of the bank crisis is not evil Republicans, lying
Democrats, "deregulation," "affirmative-action lending," or even "ludicrous levels of
leverage." A banking system is like a nuclear reactor: a complicated piece of
engineering. If it's engineered right, it works 100% of the time. If it's engineered
wrong, it works 99.99% of the time, and the other 0.01% it coats the entire tri-state
area in radioactive strontium.
The bank crisis is an engineering failure. Its fundamental cause is a humble bug.
Once we find the bug, we can start to ask: who is responsible for this bug? Who wrote
the code? Who rolled back the fix? That discussion, though fascinating, is out of
scope here.
Another analogy is the Space Shuttle disasters. Challenger had a bad booster O-ring;
Columbia's wing was hit by falling foam. The level of discourse we're hearing now on
the crisis tends to be "the Space Shuttle was Nixon's idea" or, at best, "Columbia's
wing melted through and fell off." This is not an engineering analysis. It is pointscoring at best, anti-information at worst.
I believe I know what the bug is. It was first identified by the 20th-century economist
Ludwig von Mises, capo of the Austrian School. Mises was an excellent writer, as
eloquent as Marx and far more sensible, and it's unsurprising that there is a large
Internet cult devoted to his work.
I am going to assume you are not a member of this cult. If there was a video of Mises
walking on water, I might be tempted to take his pronouncements for granted. Since
no such tape exists, they have to be explained and justified.
But we do need to start with Mises, because he was the first to solve the problem.
Almost a hundred years ago, in his Theory of Money and Credit, he wrote:
For the activity of the banks as negotiators of credit the golden rule holds, that an
organic connection must be created between the credit transactions and the debit
transactions. The credit that the bank grants must correspond quantitatively and
qualitatively to the credit that it takes up. More exactly expressed, "The date on
which the bank's obligations fall due must not precede the date on which its
corresponding claims can be realized." Only thus can the danger of insolvency be
avoided.
Let's call the sentence in quotes Mises' rule. A banking system which obeys it is
Misesian. We do not have a Misesian banking system - and that's the bug.
Basically, imagine that there were two kinds of nuclear reactors - fission and fusion,
perhaps. Fission reactors work 99.99% of the time. Fusion reactors work 100% of the
time. The reason our society gets its power from fission reactors is that our reactor
experts are fission experts. Therefore, we have resigned ourselves to having fission
reactors, plus a large fleet of mobile power-washers to clean up the radioactive
strontium every ten or twenty years. If you ask either the reactor engineers or the
cleanup crews about the possibility of switching to fusion, the best answer you'll get
will be something like "waah?" There are many worse.
Let's consider the sentence again. "The date on which the bank's obligations fall due
must not precede the date on which its corresponding claims can be realized."
Mises' rule of banking. Let's explain these terms and the reasoning behind them.
A "bank" is a financial middleman. It borrows from you and lends to someone else.
When you "deposit" money "in" a bank, you are actually lending money to the bank.
The bank does not keep this money in a big cardboard box. (I really hope this is not
news to you.) It lends it to someone else - call him Dwight.
The bank's "obligation" is its agreement to repay you your loan. Its "claim" is
Dwight's agreement to pay back his loan. (And your claim is the bank's obligation.)
So what Mises is saying is that the bank must not agree to return your money (plus
interest) before Dwight returns his money (plus interest).
Because, duh, it doesn't have it yet. Sounds obvious, right?
Of course, banks do not match individual claims and obligations in this way. If this is
the way it worked, you and Dwight could save time and money by cutting the bank
out of the loop. In reality, a bank borrows from and lends to thousands if not millions
of people, which allows it to meet its obligation to you even if a few Dwights turn out
to be deadbeats. Nonetheless, we can make the same obvious statement: by the time
the bank needs to pay you, it needs to have collected from enough Dwights in order
to have the money to pay you. Duh.
A more general way to describe Misesian banking is that the bank's plan to fulfill its
obligations must not involve any implicit transactions. For example, if the bank
promises to give you your money back in a week, and Dwight promises to give the
bank its money back in two weeks, the bank has an implicit transaction. At the end of
the first week, it needs to borrow money from someone else in order to repay you.
That someone else might just be you, in which case you are rolling over - that is,
renewing - the loan. But this is your decision, and the bank cannot know that you will
roll over. After all, presumably there is a reason you selected a one-week loan.
We observe that in Misesian banking, the duration of a loan is as important as its
amount. To balance a one-week obligation with a two-week claim is to balance an
apple with an orange. It is just, not, done. Recall Mises' statement: the credit that the
bank grants must correspond quantitatively and qualitatively to the credit that it
takes up. That means it can't have an apple on the right and an orange on the left.
(And what happens if it breaks this rule? Ha. We'll find out.)
A more naive approach to banking might just add up the claims on the left side of the
page, add up the obligations on the right side, note that the sum on the left exceeds
the sum on the right, and be satisfied. This would be "corresponding quantitatively" but not "qualitatively." In Misesian banking, the bank makes sure its structure of
claims allows it to satisfy its structure of obligations, as is, without implicit
transactions. (Another kind of implicit transaction might be a currency conversion.)
Let's look slightly more closely at the loan market. We'll start with the obvious and
segue into the not so obvious.
When you lend, you are exchanging present money for a claim to future money. Even
if you know that this claim is perfectly good, you have no reason to make the trade
unless you are getting more money in future than you give up in present - otherwise,
you would just keep the money in your big cardboard box. So, for example, you might
trade $100 in 2008 dollars for $110 in 2009 dollars.
The $10, obviously, is your interest rate, or yield - 10%. If you thought the loan had a
10% chance of not being paid back - the default risk - you might add another $10 or
so, to get the same expected return. And the year (from 2008 to 2009) is the
maturity of the loan.
We are now in a position to ask a very interesting question: in a healthy lending
market, assuming Misesian banking, and forgetting about default risk for a moment,
how should yield vary by maturity? Should a longer-term loan carry (a) a higher
interest rate, (b) a lower interest rate, or (c) the same interest rate?
I suspect that, just intuitively, you said (a). This is indeed the right answer. Let's see
why.
The market for loans is set, like everything else, by supply and demand. Every loan
has a lender and a borrower. The lender always prefers a higher rate. The borrower
always prefers a lower rate. At any maturity, the market rate is that rate at which the
number of dollars which lenders are willing to lend is exactly equal to the number of
dollars borrowers are willing to borrow.
We can make a little graph of this market, putting maturity on the x-axis and yield on
the y. The result is called the yield curve. At least in a free market, the yield curve will
always slope upward - higher maturities will command higher interest rates. This is
true for any set of lenders and borrowers, anywhere in the known universe. If they
have Misesian banks in the Lesser Magellanic Cloud, their yield curves slope upward.
How can we possibly know any such thing? We know only one thing: interest rates
are set by supply and demand. But we can make some elementary observations about
lenders and borrowers, which are true by definition.
The first is that at the same rate, any lender will prefer a shorter maturity. Consider
the choice between one-week and two-week lending. If both transactions had the
same rate, you could just lend for one week, get the money back and lend it again.
This gives you the option to use the cash at the end of the first week, an option that
the two-week maturity does not provide. An option can never have negative value, so
why not: you'll pick the one-week maturity.
The second is that at the same rate, any borrower will prefer a longer maturity. For a
borrowing transaction to be profitable, some productive process must use the money
and generate a return. The set of productive processes that can produce round-trip
return at a maturity of one second is empty. Therefore, in Misesian banking, no one
should want to borrow at a one-second maturity, because there is no lending at a zero
rate and no way to finance a productive enterprise at any nonzero rate - however
small.
As the maturity of the loan increases, so does the set of productive processes, and so
does the demand to borrow. Without violating Mises' rule, you cannot finance a ninemonth pregnancy with a one-month loan. You need a nine-month loan. Nine one-
month loans in a row will not suffice, because the last eight are implicit transactions.
Thus, for a higher maturity there is less supply of lending, and more demand for
borrowing. Less supply and more demand means higher price, which means a higher
yield. Which means the yield curve slopes upward.
This concludes our explanation of Misesian banking. Now let's explain the crisis.
Again, we don't have a Misesian banking system. We have what might be called a
Bagehotian banking system - after Walter Bagehot (pronounced "badget"), who
wrote Lombard Street, the first description of how this system works.
Here is a nice, concise explanation of the Bagehotian system:
The essence of what banks do in normal times is to borrow short and to lend long. In
doing so, they transform short-term assets into long ones, thereby creating credit and
liquidity. Put differently, by borrowing short and lending long, banks become less
liquid, thereby making it possible for the non-banking sector to become more liquid;
that is, have assets that are shorter than their liabilities. This is essential for the nonbank sector to run smoothly.
This appeared in the Financial Times on October 9, 2008. The author is one
Professor Paul de Grauwe, who like Professor Mises, and unlike me, got paid to
understand this matter.
Note the perfect inversion between the Misesian and Bagehotian theories. Mises,
writing almost a hundred years ago, describing a banking system that did not exist in
his time any more than it exists in ours, says: "Only thus can the danger of insolvency
be avoided." De Grauwe, writing now, says: "This is essential for the non-bank sector
to run smoothly."
Hm. We may not be sure whom to trust here, but we do know that neither of these
gentlemen is stupid. So what gives?
First, let's decode what Professor de Grauwe is saying. He's saying that banks
routinely violate Mises' rule - they borrow "short" (ie, with short-term maturities),
and lend "long" (ie, with long-term maturities). In other words, they engage in what
we call maturity transformation.
Because we know the shape of the yield curve, we know why MT is profitable. Short
interest rates are lower than long interest rates. So if the rest of the world is
practicing Misesian banking and you're practicing Bagehotian banking, you make a
mint.
In fact, we can say even more than this: we can say that MT lowers long-term interest
rates. In our stodgy, Teutonic Misesian bank, if someone wanted to borrow money
for 30 years, we had to match him with a lender who wanted to lend money for 30
years. In our fast-paced, Anglo-Saxon Bagehotian bank, we don't care - we balance
our balance sheet quantitatively, not qualitatively. We can match the borrower with
any lender, and get a better rate.
This is how a classic, Wonderful Life-style deposit bank works. A so-called "deposit"
is really a loan of instantaneous maturity, continuously rolled over - by not
"withdrawing" the cash, you are really renewing the loan. In the classical Bagehotian
model, this might be used to finance, say, a 30-year mortgage.
Bagehotian banking seems like a just plain better idea. Its profits can be distributed
to lender and borrower alike, producing higher rates for the former and lower rates
for the latter.
Unfortunately, there is a slight downside. As we said earlier: "duh, the bank just
doesn't have the money yet." When a bank borrows for a month and lends for a year,
how exactly does it complete the transaction? Is there a little time machine inside the
vault?
By violating Mises' rule, the Bagehotian bank makes itself dependent on an implicit
transaction: viz., finding someone to loan it money for eleven months. Let's look at
the ways in which it can implement that transaction.
The easiest way is just by inducing you to roll over your loan. It finds someone, and
that someone is you. The reason Bagehotian banks work 99.99% of the time is that
lenders, especially individual lenders, tend to roll over their loans a lot. You make a
bank deposit rather than buying a six-month CD, even though the CD pays a higher
rate, because you are not sure you won't need the money before the six months is up.
Often you find you didn't. In retrospect you should have bought the CD, but you had
no way of knowing this at the time.
The bank can also sell the 1-year loan. But selling a loan is equivalent to finding a
new lender. Again, it cannot be known on what terms this implicit transaction can be
executed.
What we've identified here is the wad of duct tape in the nuclear reactor. A
Bagehotian bank is not contractually sound, because it does not have a complete plan
to carry out its obligations. It relies on implicit transactions. And when these
transactions cannot be executed on the terms expected - poof. The duct tape catches
fire. The reactor melts down. The bank has a run.
In a bank run, the lenders start to doubt collectively that the bank will not be able to
execute on its obligations to all of them. The origin of the doubt could be concern
about the bank's quantitative solvency - eg, its 30-year claims are subprime
mortgages. Or it could just be a suspicion that the bank will experience a run. If there
is a run, you want to be the first out.
What happens as a Bagehotian bank experiences a run? Let's assume that, before the
run, the bank was still quantitatively solvent - the current market price of its claims
exceeds the sum of its obligations. The only problem is that the claims mature far
later than the obligations.
So the bank sells the claims on the open market. If it can sell them all at the market
price before the run, it is fine - it can raise enough cash to pay off all its depositors.
But a market price is a market price. It is not magic. Introduce new supply into the
market, or withdraw demand - and the price drops like a stone. The bank run
changes the price of the claims that are being sold. It has to find a lot of new lenders but the market price of everyone's claims is dropping. So all banks which hold claims
in this market are becoming quantitatively insolvent. The bank run spreads to the
entire market. Lenders run in the other direction. And so on.
The idea of the yield curve lets us visualize this in a particularly elegant way. Recall
that Bagehotian banking, by transforming maturities, lowers long-term interest
rates. It flattens the curve. At least as compared to the Misesian yield curve.
Think of this curve flattening as putting pressure on a spring. A Bagehotian banking
system is, at all times, a bank run waiting to happen. And when the run happens, the
spring explodes in the other direction - well past where the Misesian yield curve
would have been. It will not stop at the Misesian level, because a Misesian banking
system would never have made so many long-term loans. It will produce
astronomical long-term rates.
(This is exactly what we see now in the mortgage-backed securities market. It is
impossible to get a read on exactly what the risk-free interest rate is in this market,
because by definition there are no risk-free securities in it. Maturity-transformed
demand is (at present) no longer buying mortgage securities, but not all the holdings
have been liquidated, and there is no maturity-matched banking system to provide
baseline demand. So neither interest rate nor default risk can be computed from
asset price - you are trying to solve one equation for two variables.)
This metaphor of the spring lets us understand Professor de Grauwe's perspective.
He believes "[maturity transformation] is essential for the non-bank sector to run
smoothly" because he is thinking empirically, rather than deductively. He simply
notes that every time MT stops, the reactor fails and melts down, and the tri-state
area receives its coating of strontium. His thought is not intended as a comment on a
Misesian banking system which never initiates MT to begin with, an idea that has
probably never come to his attention. He is a fission expert, after all.
The difficulty in transitioning from Bagehotian to Misesian finance is immense,
which is probably a big part of why it's never been tried. The Misesian sees an
enormous set of financial structures which violate Mises' rule. He sees no way to
unwind them. Other than massive liquidation - the bank run as a virtuous purge of
"malinvestments" (pretty much any investment is a loss if it has to be financed at
80% interest) - there is no obvious way to get from here to there. The reactor just has
to blow, and the strontium has to be swept up. Or so at least is the conventional
wisdom, and no one is really working on the problem.
Moreover, there is another way to save a Bagehotian banking system: find a new
lender who can print infinite amounts of money. (Or, in a metallic standard, compel
the acceptance of paper as equivalent to metal.) This friendly fellow is generally
known as "the government," or more formally as a "lender of last resort."
The end result of Bagehotian banking is that, without any government protection, it
is incredibly unstable and will melt down at a drop of the hat. With full government
protection, it is stable, and it drives down long-term interest rates - just as if the
government itself had been making the loans itself. The lender of last resort might as
well be a lender of first resort. (There are no modern schools of economics which
believe, as far as I know, that governments should print money and lend it.) And with
wishy-washy, informal, wink-and-a-nod protection - which is what we had until the
other day - these toxic qualities are combined.
And this is how we continually stumble forward with a broken, Victorian-era banking
system, suffering the slings and arrows of bad financial engineering. The whole thing
needs to be rebooted, if not reinstalled, and we simply don't have a political system or an intellectual system - which is capable of this. But I digress.
A quick explanation of "fractional-reserve banking"
Elsewhere, Eric Posner, Walter Block, and Bryan Caplan debate "fractional-reserve
banking." Aren't you glad you read UR, rather than these other blogs, with their little
premasticated spoonfuls of brain? Here at UR we don't send you away hungry, that's
for sure.
It pains me to have to say that all three participants in this debate are out to lunch.
Posner and Caplan get the wrong answer for the right reason. Block, and the
Rothbardians generally, get the right answer for the wrong reason.
The critical fact about FRB is that it's a special case of our favorite financial solecism,
maturity transformation. As I explain in more detail here, MT is the cause of the
credit cycle, including of course our current unpleasantness. It is a source of grim
hilarity to me that, almost a century after Mises first discovered this, most people still
don't get it.
100%-reserve banking, as Block proposes, is of course MT-free and thus not a cause
of credit oscillation. So, again, he gets the right answer. But I suspect what strikes
most readers about the dialogue is that Posner and Caplan seem more or less
sensible, while Block seems to have some weird abstraction he can't let go of. So let
me provide a brief overview and try to straighten everyone out.
In classical "fractional-reserve banking," a bank balances liabilities which are
demand deposits with assets which are loans of nontrivial maturity. Let's assume for
simplicity that our currency is gold. So a fractional-reserve bank might issue notes
redeemable for 100kg of gold, while having only 10kg of gold in the vault, plus bonds
whose net present market price is 95 kg. Our bank's "reserve ratio" is thus 10%, and
its "leverage ratio" is 20 to 1 (because it has liabilities of 100kg and capital of 5kg).
Rocket science, this ain't.
Block asserts: the bank is fraudulent, because it does not have the gold to redeem its
notes. Posner and Caplan assert: the bank is solvent, because it can sell its bonds for
95kg of gold. In a frictionless market, this transaction can happen as fast as
customers can redeem.
Posner and Caplan are hereby directed to Arnold Kling, who seems to have finally
understood the problem with MT. In short, the assumption that mark-to-market
accounting and frictionless transactions imply that term loans can be liquidated at
market price is wrong. It ignores the collective game theory of the bank-run problem.
Briefly: the price of a bond or loan is a function of its interest rate. Interest rates in a
free market are set by supply and demand. In a bank run, all banks must sell future
money for present money, driving yields arbitrarily high and loan prices arbitrarily
low. An obvious, extreme, but historically common absurdity occurs when the
financial system as a whole has issued more demand notes for present gold than the
amount of monetary gold in the world. (Believe it or not, this was the case even for
the 19th-century "classical gold standard.") There's simply no way it can redeem.
Time travel is impossible; transmutation is impractical; matter is conserved.
So Block is right. In general. However, Block's argument (not his, but originally due
to Rothbard) is awfully strange, and bears only a remote resemblance to either logic
or reality. I suspect that this confuses a lot of people into thinking that there's no
there there, FRB is fine, these are not the droids we're looking for and the financial
system may go about its business. Let me try to untangle Rothbard's twisted
libertarian reasoning for you.
Rothbard, certainly one of the 20th century's top five philosophers, was a generalist
and synthesizer of incredible breadth and power. What strikes the reader of
Rothbard immediately is his razor-sharp consistency: hardly a piece is out of place. It
is almost impossible to find a crack in his edifice.
So how does he get to this weird view of FRB? He starts with an ethical premise:
slavery is wrong. If slavery is wrong, it must be unethical to sell myself into slavery.
In the world of Rothbardian ethics, this is because I have inalienable rights which I
cannot alienate (sell), namely, the control over my own body, which will always be
mine no matter what I do.
(I part ways with Rothbard here. While hereditary slavery is more debatable, I don't
have a problem at all with selling yourself into slavery. For me, a contract is an
enforceable promise; removing my option to make enforceable promises cannot
benefit me. If you don't want to make the promise, don't sign the contract. And
promising to be your faithful servant so long as you and I shall live is a perfectly
normal, legitimate, and (in a sane world) common sort of promise.)
In order to keep slavery illegal, Rothbard has to reach for what I consider a very odd
definition of a contract. To Rothbard, a contract is always a transfer of goods. So, for
example, if you pay me $1000 in exchange for painting your house, I have not
entered into a slave-like bond to faithfully paint your house. Rather, I have
transferred to you the shadowy, metaphysical, and thoroughly virtual object of a
paint job on your house. If I then fail to paint your house, I have in a sense stolen
your paint job, and thus am a thief.
This is why the idea of a bank deposit as a bailment contract is so appealing to
Rothbard. It fits his definition of a contract perfectly. It is also perfectly clear that if
the bank and its customers agree that the contract is a bailment, and notes are
warehouse receipts, a fractional-reserve bank is fraudulent. Historically this is a very
common case, and Rothbard knew his history.
However, the suggestion that openly-agreed fractional-reserve banking is fraudulent
is - as Posner and Caplan point out - untenable. (Remember, Posner and Caplan
follow their correct argument to the wrong answer because, while open FRB is not
fraudulent, as a case of MT it remains imprudent - for the depositor. Unless of course
it is insured by a fiat issuer acting as a lender of last resort. Which is equivalent to the
case in which the LLR is an LFR and just makes the loans itself. As it seems to be
doing these days. But I digress.)
Moreover, Rothbard slips here. His argument is untenable even in terms of
Rothbardian ethics. There is a crack in the great edifice.
Rothbard approves of the normal financial practice of term loans, or as he calls them
"time deposits." In a time deposit, A gives B $(X) at time (T), in exchange for the
promise to return $(X+k) at time (T+u). Of course, as a Rothbardian contract, this
promise becomes the shadowy construct of virtual future money.
The problem is that a demand deposit is an extreme, but qualitatively
indistinguishable, case of a time deposit. A demand deposit is the limit of a time
deposit as (u) approaches 0. For example, one might imagine a time deposit in which
case (u) equals one second. When the loan times out, it is automatically renewed
(rolled over), unless of course you are standing at the ATM and you want your money
back. In which case you have to wait one second for your latest loan contract with the
bank to time out, and the bank to return your money.
This clearly has exactly the same practical effect as a demand deposit. If a second is
too long to wait at the ATM, we can make it a tenth of a second, etc. And it is clearly a
time deposit. And there is certainly no way we can draw a line at any interval of time,
and say that if the term of the loan is more than five minutes it is nonfraudulent, and
if it is less it is fraudulent.
Thus, Rothbard and Block are just plain wrong. But they get the right answer
anyway, because FRB is a special case of MT and MT is harmful. The real reason that
100%-reserve banking will defeat FRB in the free market is that depositors will avoid
financial institutions that practice MT, and absent MT the natural rate of interest at a
term of 0 is 0 - because there are no productive investments that can produce an
instant return on capital.
Puffs of smoke from the gold volcano
I thought it would be nice to take a break from sounding like one of Plato's lesserknown, even-more-evil competitors, and note the latest in the eternally fascinating
and bizarre gold-dollar system.
In the dollar's favor, gold lease rates appear to have stabilized. (Ie: either this signal
was only a glitch, perhaps due to LIBOR weirdness, or it was countered effectively by
policymakers). Moreover, as expected in a recession, true jewelry consumption has
crashed.
In the East, at least, it is hard to separate luxury from investment jewelry, but even
gold investors of the Oriental persuasion seem to operate on an intrinsic-value
theory: they feel that the stuff has some natural price as a commodity, and they tend
to buy when it is cheap and not when it is not. As we have seen, this is not rational the rational gold investor is a momentum investor. However, this demand pattern is
real and unlikely to change any time soon.
And "Western investment demand" is keeping the gold price in dollars relatively
high. Perhaps a more accurate description is perhaps capital flight to gold - or, here
at UR, moving to Moldenstein. To paraphrase Milton Friedman, perhaps it's just
obvious that you can't have a heavily-bleeding global reserve currency and a free
market in the precious metals.
Of course, as per the paradoxical logic of monetary commodities, this is true only if
everyone knows it. Perhaps you are familiar with the paradox (familiar to every CTY
veteran) of the blue-eyed islanders. As we enter 2009 there is a simple, mechanical
trigger analogous to the stranger's arrival: any dumb, statistical screen for financial
assets that outperformed in 2006, 2007 and 2008 will put gold somewhere near the
top of the page. Moreover, it is obvious that the market for monetary gold is anything
but saturated - even most rich people still have none. Doh.
So, while it appears to me from my cursory perusal of the mainstream press, that
more people are beginning to understand gold, readers should bear in mind that (a)
this too might be a glitch; (b) the debt market is a Rube Goldberg machine which
may suddenly, if enough gasoline is poured into it and a sufficiently large blowtorch
is applied, restart for no obvious reason; (c) even if people understand things, they
can subsequently be made to un-understand them; and (d) the fact we continue to
have a free market in said precious metals is a function not of USG's wisdom, but of
its weakness - a quality never to be relied upon in one's enemies.
That said, the statistics for early 2009 are fairly impressive. Gold flow into the SPDR
trust alone, for example, is at almost 200 tons for the last month. Ie: six billion
dollars. Ie: roughly equal to planetary gold production. On February 11th and 12th,
the flows were 40 and 35 tons - a billion dollars a day. This is almost real money.
(Briefly: gold flows into to the trust when, if gold did not flow into the trust, the price
of SPDR gold would exceed the futures-market price.) Furthermore, while God only
knows what they are backed with, precious-metals bank accounts are reportedly
proliferating in Russia.
This trend is not sustainable at its present level. It must either accelerate, or
terminate. In retrospect, it will look like either a real signal, or a real glitch.
If the latter, the gold price carries a heavier monetary premium than at any time
since 1980 - at least. It has more monetary support and less support from the
traditional market, ie Hindu brides, and it will collapse more sharply. Gold can flow
out of monetary caches, as well as in. Just so ya know. (And besides, it is always a
contrary indicator when UR mentions gold.) In retrospect, it will look as if gold has
experienced another 1980 bubble and collapsed.
If the former, it will look like Exter's pyramid has finally rolled tip down. This, like
everything, will appear obvious and inevitable in retrospect. (There is probably no
one at the New York Fed who remembers John Exter, but I'm sure his collected
memos remain in the files.) I would not be surprised to see some political changes
accompany any such monetary earthquake.
Computing any level for a fully-monetized gold price is number abuse. Gold price in
what? By definition, your denominator has gone AWOL. However, perhaps a
ballpark guess can be constructed by comparing annual global gold production,
which while elastic is not as elastic as one might think, to annual global savings.
Certainly, until incremental monetary demand is consistently absorbing all new
production, the gold rocket is still, in some sense, sitting on the launch pad. And so it
is. There is some steam or something, however, emerging from the base. Either this
is nothing, or it means the rocket is about to take off, or it means the rocket is about
to fall over and blow up. It's your call, dude.
The Geithner plan, slightly demystified
Sometimes homeless guys come up to me on the street and ask: "what is this PPIP
thing, anyway? One: does it have anything to do with PPP, IP, or PPTP? And two: will
it work?"
One: no. But as one who once designed a C++ class called "PPTPPPPLink" - a choice
from which my programming career has never quite recovered - I feel Secretary
Geithner's pain. At least his latest acronyms no longer include words like "Troubled"
or remind us of Star Wars villains.
And two: no. At least, not if by "work" you mean "convert our rapidly-disintegrating
Rube Goldberg machine into a healthy, stable and productive financial system."
Perhaps this comes as a surprise to you. But probably not.
But a more interesting question is: will the Geithner plan achieve its intended
results?
Obviously, the PPIP is a bandaid, not a reboot. Its goal is not to create perfection. Its
goal is to stop the hemorrhage. Will the artery finally clot, this time? If you know the
answer, you can either make a lot of money, or at least avoid losing one. At least if
you're the sort of fellow who can raise $500 million from your friends at the Palm
Beach Country Club. I'm afraid the truth will not help the skells raise any quarters,
though. Ah, change.
Unfortunately, my answer is: I don't know. I can guess, though, and I will.
Let's start by looking at one common misconception about the Geithner plan.
Perhaps by clearing it up we can take our first step toward some small
enlightenment.
The misconception I have is that the Geithner plan (and its predecessors in the
department of liquidity-enhancing Star Wars villains, from MLEC to TALF)
represents a subsidy to the hedge funds and other fat cats who may, or may not,
participate in it. The essential Steve Waldman has battered this issue much, most
recently here.
One can argue this point, if one is willing to finesse the word subsidy. But for me, a
program is not a subsidy unless it can turn loss into profit. This the PPIP cannot do.
If the word subsidy attracts you solely on the basis of its negative connotations, fine.
I am happy to admit that the PPIP is a black, reeking horror. And I wouldn't be
surprised if its designers agree. Surely at least they consider it the least of many
possible evils.
But, at its bottom, the PPIP is a government loan facility. By definition, no loan can
render an insolvent balance sheet solvent. You cannot borrow your way to
profitability.
So, as a fairly typical example of the misconception, the New Yorker's Surowiecki
writes:
In fact, it’s essentially the same kind of subsidy that the entire U.S. banking system
has depended on for the last seventy-five years. What are FDIC-insured bank
deposits, after all? They’re non-recourse loans to banks. You deposit money with a
bank—that is, you lend it your money. The bank can then take that money, and
leverage it up nine-to-one to make loans or acquire assets. If the loans are good,
they keep all the profits. If the loans go bad, the most the bank can lose is the capital
it’s invested.
First, Surowiecki seems confused about the difference between a non-recourse loan
and a loan guarantee. The FDIC's loan guarantee can be seen as a free option, but
this option is a gift not to the bank, but to the "depositor." (I find "deposit," an
English word which connotes the act of putting something somewhere and leaving it
there, a dubious euphemism for a zero-term loan - hence the quotes.) The same is
true for the PPIP loan guarantee.
A simpler way to model this transaction is that the "depositor" or PPIP bondholder
lends to USG, whose credit rating is perfect thanks to its ability to print dollars, and
USG then lends to the bank. If the bank fails, USG eats the loss and takes the assets like any financial intermediary. This accounting interpretation produces exactly the
same results. And it involves no funky instruments, just bog-standard vanilla loans.
Again: the PPIP is a loan from USG. Since USG can print infinite dollars, it can loan
infinite dollars. But since a loan is neutral on the balance sheet, it is not a subsidy in
my doxology.
So - second - consider Surowiecki's phrasing:
The bank can then take that money, and leverage it up nine-to-one to make loans or
acquire assets. If the loans are good, they keep all the profits. If the loans go bad,
the most the bank can lose is the capital it’s invested.
I have seen this explanation a million times. The usual implication is that this
represents a one-way bet - a typical case of Wall Street's practice of "socializing loss,
privatizing profit." And perhaps it does, but not in the obvious sense.
In the obvious sense, the outcomes for the PPIP playa are exactly the same as in any
leveraged investment. The most our playa can lose is everything he puts in. Duh. If
you make an investment leveraged at 10 to 1, and that investment goes down by 10%,
you lose all your money. If it goes up by 10%, you double your money.
This is not a subsidy. It is normal finance. It is true whoever is providing your
leverage financing - Goldman Sachs, USG, or your Uncle Ernie. It is true whatever
your asset is - Florida swampland, gold, or frozen-concentrated orange juice. The
most you can lose is all your money. Again: duh. For what investment is this not
true?
While I am not a fund manager, I am quite confident that there is no shortage of
leverage for collateralized loans, whatever the asset, on Wall Street today. The cause
of deleveraging is not a shortage of leverage, ie, of prime brokers willing to lend
against collateral. While it's true that many of the "toxic assets" are one-off securities
for which establishing a market price is not just a matter of a ticker query, this is why
the big boys make the big bucks. Moreover, the spiral of deleveraging has affected
quite a few assets which are continuously quoted.
The cause of deleveraging, and of course its result as well, is falling asset prices.
More on this in a moment. But suffice it to say: no one at Treasury is stupid. They
know this.
So what were the designers of the PPIP thinking? How is this machine intended to
work? I was not, of course, in the room, but I am no dummy myself and I think I have
it figured out. While my guess is that the PPIP, like its predecessors, will not operate
correctly as designed, (a) I could be wrong; and (b) it could produce the desired
result through unintended means.
First, let's review what makes a "toxic asset" toxic.
The prices of any asset X, whether stock, bond or Kewpie doll, is set by supply and
demand. But in the Anglo-American financial system, which was invented by God
and is so perfect that it has worked the same for over 300 years, banks practice a
practice called maturity transformation. MT lets lenders who want to lend at a short
or even zero term (such as bank "depositors") fund loans of a long term (such as
mortgages). ("Fractional-reserve banking" is a special case of MT.) Thus, demand for
X is magically transmuted into demand for Y.
Ie: MT creates demand for long-term loans. Ie: MT raises the price of long-term
loans. Ie: MT lowers the interest rate on long-term loans. Ie: if MT breaks for any
reason, the price of long-term loans falls sharply, and the interest rate rises. This is a
"bank run," "liquidity crisis," etc, etc, etc.
In a world without MT - ie, one in which 30-year borrowers are funded by 30-year
lenders - a cluster of bad loans (such as NINJA loans to impecunious strippers)
would simply result in proportional haircuts to the original lenders.
But when 30-year borrowers are funded by zero-term lenders, falling loan prices
force the maturity-transforming bank to sell more loans, receiving present cash with
which to meet its zero-term commitments. This lowers the price of these loans, and
so on - creating the feedback loop that is the basis of the bank run.
"Toxic assets" are toxic because they are at the business end of a bank run. In a
"normal" market, the default risk of a loan can be calculated by comparing its yield to
the yield of a risk-free security, such as a Treasury bond, of the same term. The
spread between these yields can be assumed to represent the market's estimate of the
probability that the loan will default.
In a bank run, this formula produces nonsense, because it is comparing apples to
oranges. The market for toxic assets is simply a different market than the market for
Treasuries. The latter contains new demand from maturity-transforming banks. The
former does not.
Thus the yield on Treasuries is around 3%, whereas the yield on "toxic assets"
excluding default risk (ie, the yield on an imaginary risk-free toxic asset) is probably
something like 20%. The only buyers of toxic waste at the moment are the most
patient "vulture" investors. The carcass-to-vulture ratio is quite high, and getting
higher. Ergo: supply and demand, baby.
The goal of the various liquidity restoration plans, including PPIP, is to break down
the partition between these markets, creating a flood of gigantic profits as sea levels
equalize. We are now ready to look at how PPIP is supposed to work.
PPIP is essentially a bank-run-proof leverage facility. The key to PPIP is the
difference between PPIP and an ordinary margin loan. As we've seen already, the
risk-return profile of a PPIP investment is generally no different from that of an
ordinary leveraged investment. There is a difference, though, and the difference is in
the details.
An ordinary margin loan is a zero-term loan, like a bank "deposit." Unlike a bank
"deposit," it is completely safe for the lender, even without an FDIC guarantee,
because it is continuously marked to market. If you lever up at 10 to 1 to buy an asset
on Tuesday, and that asset falls 10% on Wednesday, your broker will instantly and
automatically sell the asset to repay the loan. The lender is left with all his money.
You are left with squat. (If bank "deposits" worked this way, there would be no such
thing as a zombie bank - Citi would be rotting peacefully in the grave.)
So, if you use an ordinary margin loan to lever up and buy toxic assets, and the asset
price continues to dive, two things happen. One: you lose all your money, instantly.
Two: the asset is sold, putting it back on the market and further depressing the price.
PPIP attacks this in two ways.
First, the PPIP loans are long-term. When you use a normal, zero-maturity margin
loan to leverage collateral, say at 10 to 1, you are betting that the price of your asset
will never drop by 10%. When you use a PPIP loan, say of 10-year maturity, to
leverage collateral, you are betting that the price of the asset will not have dropped by
10% at the end of 10 years. Big difference!
The PPIP leverage can withstand short-term fluctuations; the standard margin loan
cannot. Thus, it is not at all unreasonable for Treasury to hope that PPIP will attract
buyers who are not, at present, ready to make leveraged bets on dodgy mortgagebacked securities.
Second, if the worst comes to worst and the toxic assets have not recovered even after
10 years, PPIP does not dump them back onto the market. It sells them to Uncle
Sam, who buys them with his magic printing press. Thus, there is no feedback-loop
spiral of asset dumping, as in the classic bank run.
(By the way, using the phrase "taxpayer dollars" to describe expansion of the Fed's
balance sheet is a horrific abuse of both good English and good accounting. Sorry,
Americans: USG does not need your dollars. It can print its own without any trouble
at all. It taxes you simply because otherwise, everyone would be too rich, and prices
would go up. In other words, the purpose of taxation under a fiat-currency regime is
not to finance government expenditures, but to minimize monetary dilution, thus
defending the currency as an effective medium of saving.)
So: do I think PPIP will work - as in, achieve its goal of taking the toxic assets off the
bank balance sheets and restoring them to ruddy good health? Well, it is certainly
not impossible. But no, I don't think it will work. There are three big problems.
One, PPIP has a long row to hoe in generating enough demand for the toxic waste for
the banks to be willing to sell. Banks do not want to sell their toxic assets at the
vulture-investor bid, because holding these assets at non-market prices allows them
to pretend to be solvent. If the market price is 30 and PPIP demand can get that up
to 50, a zombie bank that needs 85 for any kind of solvency will not sell.
Now, one way in which PPIP could work is if banks find a way to use it to buy assets
from themselves. If they can bid 90 for their own assets held at 95, PPIP is simply a
cover for the obvious solution, which is for the Fed to just buy all the toxic assets
from the banks, at prices congenial to the latter. However, I don't expect this to
happen, because this type of Enron scammery normally happens in the absence of
public scrutiny. The PPIP could easily work by turning into a fraud, but USG winks at
fraud only when no one is looking. Now and for the foreseeable future, the stadium
lights are on. I'd be quite surprised if anyone major tries anything funny.
Two, remember our original point: leverage cannot turn losses into profits. If asset
prices rise, PPIP investors will make money hand over fist. If they remain durably
depressed, as in Japan, PPIP investors will lose their entire investment. If investors
anticipate this result, they will not participate in PPIP. If investors do not participate
in PPIP, asset prices will remain depressed - absent some more generous program.
Toxic assets tend to be collateralized loans themselves, and the collateral is generally
real estate. Falling real-estate prices create defaulting loans. But since all real-estate
is bought with loans, we see the vicious circle again. Asset-price deflation has its own
momentum.
As the suction of deleveraging feeds through the economy, more and more assets
enter the toxic category. Thus: expanding supply. Thus: falling price. PPIP must push
uphill against this brutal, unrelenting gravitational suckage. Not an easy task.
Three, the vicious circle is not at all irrational. It is actually quite sensible.
Doug Noland, whose Credit Bubble Bulletin has been reporting on the impending
disaster since Jesus was a little boy, calculates that the US economy needs about $2
trillion a year of new lending just to stay in the same place. This is obviously a seatof-the-pants guess, but it sounds about right to me. Thus all the noise from the great
and the good about "restarting the flow of credit," etc, etc, etc.
If we separate the economy into two consolidated balance sheets - A, the balance
sheet of the government and the banking industry; B, the balance sheet of all other
industries and households - we feel it is perfectly normal for B to borrow more and
more money, every year, from A. But is it?
In fact, when this "flow of credit" ceases, the result is described as a "recession." And
it is certainly quite painful. And when the flow reverses - that's real pain.
Now: imagine you were considering investment in a business, and that business had
borrowed two trillion dollars last year. Or two billion dollars. Or two million dollars.
There are two possibilities. One, the business is in an expansion stage, and is creating
equity with negative cashflow. It has a "burn rate." But it is using this money to make
productive long-term investments which will, in time, reverse this and produce a
profit.
Two: the business is a dog. It is losing money. It needs to be liquidated or at least
restructured. Woof! Sorry, Old Yeller. The time has come to say hello to Mr. Smith
and Mr. Wesson.
Which is it? There is no way to know. However, if we discover that the same business
has been borrowing money every year, in the same way, for the past decade, we
probably have our answer. If it has been bleeding for the past quarter-century...
behold: Exhibit A.
In this interpretation, the United States, as a whole, is a money-losing operation.
The fact that the dollar is a fiat currency has allowed us to disguise this, because fiat
currency is essentially equity, and equity can always be diluted. So our losses are
funneled into a hemorrhage of new shares, in the classic equity death spiral of the
dying corporation. But since USG, unlike most dying corporations, is sovereign, the
game can continue indefinitely.
The difference between capitalism and socialism is the difference between profit and
loss. It's not just that money-losing businesses lose money. They also produce crappy
goods and services. Once disconnected from the need to make a profit, they lose the
tension that makes them perform. There is only one way for a string to be taut, but all
kinds of crazy ways for it to be slack.
Nor is the US unique. If there is an economy in the world that does not run a trade
deficit with the future, so to speak, I do not know of it. The fact that we think of
continuously increasing debt levels as normal is a measure of the 20th-century
detachment from reality. Reality just called - it wants its money back.
This structure is especially interesting when juxtaposed with the fact that there are
less than 2 trillion actual dollars in the world (M0). How can a company be
capitalized at $50 trillion, when its customers have less than $2 trillion to spend?
Because the Fed can create new dollars, both explicitly by expanding its balance
sheet, and implicitly by issuing formal or informal loan guarantees.
And it does. At least in normal times. But these are not normal times. Owen
Glendower could call spirits from the vasty deep. Did they come, when he called? Not
as I recall.
The Fed can create new dollars, by the quadrillion. It could buy every slice of pizza on
the planet for a hundred dollars each, and abolish the IRS in the bargain. But will it?
As we see above, the Fed's mission is to lend, not buy. And it seems to be having a bit
of trouble in doing that. If PPIP fails, does it have the political power to take the next
step and straight-out buy toxic waste? With "taxpayer dollars?" I am not sure - not
sure at all.
USG can also emit dollars via deficit spending. At present, via the wonders of
"quantitative easing," it is selling bonds for dollars to fund its deficit, then buying
those bonds with printed dollars. Net effect: spending printed money. But how much
money is USG really capable of injecting into the economy, via all its lightbulbchangers, roof-caulkers and Iowa piglet museums? It'll take a lot of lightbulbs, even
the most sophisticated and environmentally pure, to replace all those home-equity
cashouts from 2006.
USG is simply an senescent state. It is so vast, ancient and sclerotic that it has great
difficulty in accomplishing the most basic function of government: wasting money. If
it cannot continue to produce dollars and spread them around broadly, the spiral of
deleveraging continues. Asset valuations that look reasonable in the light of M0 are
the only possible backstop.
And if USG can muster the energy to hemorrhage money, it diverts more and more of
its productive resources toward the point of the bleeding, and gradually turns into
the Brezhnev-era Soviet Union. In case you have difficulty translating "Brezhnev"
into English, the word you are looking for is "Dilbert." Non-profitable businesses
become process-oriented, ineffective, and generally insufferable for employees and
customers alike. To say nothing of shareholders!
If both these outcomes seem unattractive, perhaps it's time to consider Plan M. (M for Moldbug.) I feel it's essential to accompany all such destructive criticism with a
positive proposal, even just a summary. It's always nice to end on an up note.
The goal of Plan M is to shut down our present financial system and replace it with
one that is healthy and stable, preserving relative valuations in a way that is fair to
everyone and doesn't interfere with anyone's life or work.
A healthy, stable financial system has two main characteristics.
One, it uses a hard currency - one with a fixed or naturally restricted supply. An
example of the latter: gold. An example of the former: the numbers from 0 to (2^64 1).
Two, it exhibits balanced lending - maturity-matched banking. For every privatesector borrower of $X at term T, there is a private-sector lender of $X dollars at term
T. I believe this is what is known as a "free market." Financial intermediaries
diversify risk by aggregating loans, but do not systematically violate this constraint.
Interest rates at every term are set by this equilibrium, producing a stable yield curve
which shifts only with real supply and demand.
The catch is that to convert our present 300-year-old Anglo-American Frankenstein
into a healthy, stable financial system, a complete shutdown and reset is required.
USG is no more capable of this procedure than I am of jumping to the moon, but we
can still talk about it, I hope.
To reset: consolidate all financial securities and their collateral, including real estate,
onto the Fed's balance sheet, at the present market price. The Fed buys all stocks, all
bonds, all houses, all commercial real-estate, etc. Automated appraisal tools, a la
Zillow, can be used for unique assets. If you own a home, your mortgage becomes
rent and your equity becomes cash.
The result is a 14- or 15-figure M0 that includes all former financial assets. Corporate
debt disappears, because it becomes debt from the Fed to itself. Same with mortgage
debt. If it is necessary to buy votes, unsecured personal loans can be forgiven.
Otherwise, they are debts to the government - tax liabilities, essentially.
And all the toxic assets cancel, because they were held by banks whose stock is
acquired, and owed by homeowners whose home has been acquired. Again, the Fed
owes itself nothing.
Outcome: the citizens of America are sitting on a giant buttload of cash. The Fed is
sitting on a giant buttload of real assets. A giant auction is held. Eternal Bolshevism
is averted, and life returns to normal. Only better, I suspect.
This dollar pool can either be fixed, producing an ultra-hard fiat currency, or mapped
to the nation's gold reserve. While the former is economically optimal, the latter has
numerous political advantages.
Mapping 10^15 dollars to Fort Knox will produce a much higher gold price than the
current value. This is a feature, not a bug. It has the usual effect of currency
devaluation, ie, stimulating economic activity. But the stimulus does not become
addictive, because the currency is now hard and will stay that way. There is also a
Keynesian effect in which gold mining absorbs a large number of now-unemployed
workers. While the production of currency does not create goods and services, from a
political perspective it never hurts to get disgruntled people off the street. Gold
holders also win big, but they win big in the right way: by being right.
And, of course, a hard gold standard is self-enforcing, whereas a fixed money supply
is not that hard to un-fix. Given the 20th-century experience with virtual money, I
suspect that it may be another century or two before the snake can tempt Eve again.
As Mark Twain said, a cat who sits on a hot stove will never sit on a hot stove again or a cold stove, either.
While Plan M (which I've been proposing for, oh, about the last year and a half) is
politically inconceivable, it is an economic no-brainer. At least to me. If you agree,
perhaps you should consider what can be done about the political obstacles. America
certainly has no shortage of lampposts.
America: zombie nation
If you read the newspaper these days, which is probably a mistake, you cannot help
but be struck by the increasing verbal intimacy between the business section and the
Kingdom of Night. Is this just an accident of terminology, do you think? Or does it
indicate something more sinister?
For example, everyone knows what a zombie bank is these days. They have also
heard of the shadow banking system, which the Obama administration is doing its
best to resurrect. And speaking of the Obama administration, UR readers will recall
that our dear President got his start as an acolyte of a philosopher who dedicated his
most famous book to Lucifer, Prince of Night - which by my calculations gives us two
degrees of separation between Barack Hussein Obama and Satan himself. Not that
any of this bothers anyone, of course. Why should it?
And are we dealing with one dark force, or many? For example, is a zombie bank the
same thing as a shadow bank? Not at all. They are entirely different species of
monster - no more alike than an orc and a troll. Indeed, we certainly have or at least
had a shadow banking system, but it is not even clear that there was every any such
thing as a shadow bank. Such deviltry will shock no student of the Hadean realms.
For today, let us confine ourselves to the subject of zombie finance. It may not be the
only dark force in the underworld, but there is certainly enough to go around.
To put it succinctly, America is a zombie nation because it is no longer possible to
imagine her without zombie finance. It was quite some time ago that we stepped
across that black stream, from whose far bank none return. No, landscaping did not
just put those asphodels in.
What is zombie finance? Zombie finance is the financing of zombies. To be more
exact: you commit an act of zombie finance when you lend money to a zombie.
A zombie is an insolvent institution that continues to operate. An institution is
insolvent if it is clearly unable to meet its present or future obligations. This
definition is slightly trickier than it looks. The devil is seldom absent from the details,
and we will indeed grapple with him there. But basically, the analogy of the living
dead is quite accurate.
For example, a zombie bank is a zombie because the total market price of its assets is
less than the sum of its promises to pay. Thus, it has no way to meet its obligations,
even by selling all the things it owns. The zombie's creditors must therefore meet,
divide up its assets pro rata, and sell its executives as white slaves to the salt-pans of
Tangier.
The law of bankruptcy, as handed down by sages of old, abhors the zombie. If the
obligations of a zombie can be restructured, handing its bondholders a haircut but
converting the result into a profitable operation, the majesty of the law is there with
its machete. If the zombie is an inherently unprofitable institution, the majesty
brings its axe instead, and has a grave handy.
I think most intelligent people understand this. They understand, generally, that this
state of affairs is right and true, that it will hold in America in 2500 AD as it held in
Sumer in 2500 BC, that not merely the whims of random, dead white men, but
nature herself, abhors the zombie. The principles of accounting are not arbitrary.
They are natural law.
But what I don't think most people understand is what happens when we break this
law. Opening a direct shaft between the vaults of the Federal Reserve Bank of New
York and the Balrog-ridden mines of Moria. Which skip day and night with lithe,
spidery orcs.
So let me explain what happens. But first, here is the main thing: your awareness of
this issue may date to 2007 or 2008, but the black tunnel itself is far older. Zombies
have walked the streets of Manhattan, rotting and unashamed, for decades at least possibly even centuries. There is no past golden age in which our financial system
was good and sweet and true, although this does not mean no financial system can
ever be good and sweet and true.
The Anglo-American financial system is a lot like a New York State cabernet. I was
once caught in NY on a Sunday before the laws changed and was compelled, quite
unconstitutionally, to purchase a bottle of this material. So far as I can tell, a $20
North Fork claret has all the flavors that a ten-dollar red should have. It also has a
number of other flavors, that it shouldn't. Similarly, Anglo-American finance (which
is far older than the 20th century) provides all the services that a financial system
should provide, and more. Namely: it feeds the zombies.
Let's take a closer look at these zombie loans.
Again, a zombie loan is a loan to an institution which is unable to pay its obligations.
Because, after the loan, the zombie's equity (assets minus liabilities) is exactly as
negative as it was before the loan, no loan can restore the true warmth of life to the
dead flesh of a zombie. Moreover, since a loan to a zombie cannot trade at par
(someone has to take the haircut), the lender has lost money as soon as the loan is
made.
So who would make a zombie loan? The answer is simple: only another zombie. But
why would even a zombie loan money to a zombie?
Fool! The dead are beyond reason. This is what makes them zombies. Zombie finance
is a money-losing proposition; zombies are money-losing institutions. The symmetry
is striking and perfect. Of course zombies lend to zombies. This is one of the best
ways to lose money.
The essential question about zombies is: what makes zombies so evil? The essential
answer is: everything. But let's pick a couple of salient points.
The first fact to understand about zombies is that zombies lie. There is no such thing
as a truthful zombie. No zombie will come up to you and tell you that it's a zombie. In
the zombie's opinion, its balance sheet is perfectly sound. After all, who knows what
those assets are worth, until we sell them? A liability is a fact. An asset price is an
opinion.
And therefore, in the view of both the zombie borrower and the zombie lender - both
of whom are zombies - the borrower is just engaging in the natural practice of
refinancing its debt. Of course, refinancing is indistinguishable from taking out a new
loan to pay off an old loan. But if the zombie was not a zombie, it might have a
perfectly good reason for doing this.
More generally, zombies act with ulterior motives. In reality, a zombie lender may
have a perfectly good reason for lending to a zombie borrower. It's just that this
cannot be a financial reason. It must be some other kind of reason - generally an
aromatic one.
For example, a common zombie structure is that of patronage. In a patronage
hierarchy, money flows downward and power flows upward. A stream of uneconomic
loans is an excellent way to cement a patronage structure, perhaps the best there is.
While it is going too far to say that all zombies represent cases of patronage, it is
certainly the structure to expect.
To count the mass of the client as part of his pyramid of power, the patron must own
him body and soul, heart and mind. Gifts will win your client's heart, but loans will
win his mind as well. In a word, uneconomic loans create systematic dependency.
When the client is an individual, this relationship is sometimes described as debt
slavery. While one may disapprove of debt slavery for moral reasons (I do), there is
no denying that it works like a charm.
Another common zombie structure is that of bureaucracy. Bureaucracy can be seen
as a form of patronage in which the commodity distributed is not money, but power personal importance. A bureaucracy adapts to maximize the number of
"stakeholders" who influence each decision. Typically, it does so by eliminating
formal personal authority, and replacing it with a structure of rules to which all may
contribute. This approach of process-oriented decision-making is the best that
bureaucracy can do; in a more degraded bureaucracy, power is also distributed
through cliques and mafias which make decisions informally, using the process as
camouflage.
But we have followed the chain of zombie finance only one step. Zombie X may lend
to zombie Y, but who is lending to zombie X? If the answer is "no one," zombie X will
dry up and fail to meet its payments. And zombie Y will follow it.
You probably know the answer to this question. However, let us postpone it for a
minute. We will ask it again when the awful consequences of the answer are fully
clear.
The truth about zombies is that zombies act differently. Again, they have ulterior
motives, and they are fundamentally dishonest. These corruptions originate in the
financial structure of the zombie. However, they do not stay there. We are now in a
position to see how zombie finance eats away at the structure of society.
Suppose A pays B. There are three good reasons for A to pay B. All others are zombie
reasons, and the payment can be classified as a zombie payment. Otherwise, it is a
live payment.
The first good reason for a live payment is that A owes the money to B. B is receiving
the payment as part of a right. This is very well and good; we note, however, that this
right itself is an asset, and must have been acquired through some means itself. Even
if the right is ancient and the means was unwholesome, the unwholesomeness is in
the past and not the present. Moreover, since this transaction is not voluntary, it is in
a sense not a transaction at all.
The second good reason for a live payment is that A is purchasing some good from B.
In the special case in which the good is B's promise of a future payment, this is a
loan. But whether the good is a loan, a house or a goose, A is giving up good money.
If he did not prefer the good received to the money relinquished, he would not have
made the exchange. While time may prove him incorrect in his appraisal, we know at
least that he tried - and tried hard. We can thus describe this as a profitable
transaction.
The third good reason for a live payment is that A is the benefactor of B. A intends
the payment to benefit B, not to benefit A. This implies that A has some personal
relationship with B, and gains emotionally from the act of improving B's lot - a
charitable transaction.
What we observe about the two voluntary forms of live transaction, profitable and
charitable, is that both impose some discipline on B. It is this discipline that zombie
finance destroys.
Profitability is a cold master. If B is a vendor of goods - loans to himself included - he
must produce goods that appeal to A. He is presumably competing with many other
such vendors. If he becomes ineffective or inefficient, he will not survive.
As a reactionary, this discipline is rose-sweet to me. For every productive activity in
which humans engage, for every good way in which to get the job done, there are a
thousand incompetent, wasteful, or otherwise dunderheaded ways. Like happy
families, effective businesses are all alike. Every incompetent business is its own
unique, special snowflake.
Consider a restaurant. I will grant that there are a million ways to run a good
restaurant. Nonetheless, every good restaurant has good food and good service at a
good price. For each such restaurant, there are a thousand ways in which, if its good
management were replaced by bad management, it could be converted into a bad
restaurant.
Order is order because it is easier to be disorderly than orderly. The tension of
profitability is a divine weapon for the reactionary ideal of order. The reactionary
state is orderly at the sovereign level, of course, but it is happy to maintain private
corporations within itself - each of which must be profitable or at least solvent. And
each of which therefore creates its own internal order, typically with an effective
hierarchical command structure and a single leader who governs by personal
authority.
It is not at all surprising that progressives hate corporations and the profit system. It
is a natural consequence of the antipathy to order, the anarchism, the lust for
entropic destruction, which is the foundation of their creed.
Moreover, where the discipline of profit leaves off, the discipline of charity takes
over. Charity is the principle of the family and the church, both ancient pillars of
order. Charity - true charity - produces discipline because true charity is in all cases a
paternal relationship. In exchange for the gift of charity, the recipient surrenders his
independence to the benefactor.
Charity is an asymmetric relationship of dependence, but it is not at all without
structure. In true charity, affection is always matched by obedience. If B surrenders
himself to the care of A, he becomes a ward of A. A, his sponsor, assumes the
obligation to support him, and also takes responsibility for any misdeeds B may
commit while under his sponsorship. In return, B gives up his freedom, or at least his
freedom to disregard the wishes of A.
So in both cases, the cords of finance are taut. The stiff cytoskeleton of society is
intact. The strong are disciplined by profit, the weak by charity. And money itself
produces this discipline - no Order Castles, Spartan crypteia or Eton fagging are
required, just the cold weight of gold in a man's hand. (Have you ever held a gold
coin? Bounced it off a table? It rings like a bell.)
Zombie finance enters this elegant structure of spontaneous order as sulfuric acid
enters a coral reef. The beautiful creatures of the reef, exquisitely adapted, are also
exquisitely sensitive. They are not exquisitely adapted to sulfuric acid, anyway. They
die, and their bleached bones remain, perhaps with a coat of brown slime.
While there are only two types of voluntary transaction - profitable and charitable the profitable transaction of lending, ie, the purchase of a promise of future money,
almost deserves its own category. The loan is a ballet of such exquisite natural beauty
that the mating fights of the Hawaiian monk seal, the stately, swirling parade of the
hammerhead school, and the love song of the trilobite pale in comparison.
Consider the trust it takes, for instance, for A to say to B: I will give you money now,
in exchange for your promise to pay me ten years from now. A ten-year loan! We
think of this as an entirely normal transaction; in fact, it is remarkable. Think of how
much order, sanity, and decency must exist in a society for A to have any confidence
that ten years later, B will be good for it.
Indeed this transaction is remarkable in our society - for it is practically nonexistent.
We do not have true ten-year loans. We have ten-year (nay, thirty-year) zombie
loans.
From the borrower's point of view, a loan is a loan. But a zombie loan is a zombie
loan because no one, other than a zombie, would make it. It is made not for
profitable or charitable reasons, but for zombie reasons. Instead of the discipline of
the real world, it imbues the borrower with the dark ulterior motives of the zombie
world.
To finance anything is to control it, and to accept zombie finance is to dip at least one
toe in the waters of the Styx. Freed from the discipline of profit or charity, the zombie
lender becomes a free radical, an agent of destruction. There is no bound on the
strangeness of the motives under which the lender may be operating, or the hoops
through which the borrower must jump.
We see this most clearly when we look at the ultimate zombie nation: the Soviet
Union.
Obviously, Russia has not come close to recovering from the Soviet period. Russia
was a cultural paradise; it became a tomb; it remains a graveyard. But I mean Russia
in the late Brezhnev period, not Russia today (kleptocracy is no great improvement
on bureaucracy).
When most people think of the difficulty of life in the Brezhnev era, I think they tend
to think of either poverty in a strictly material sense - eg, sawdust in the bogroll - or,
of course, the travails of the dissidents. However, as a student of history, the point
that impresses me most is the great pointlessness of most peoples' lives. (And no,
most people were not dissidents.)
There exists a great film portrait of life in Poland in the '80s, a primary source in
some sense because it was actually filmed in Communist Poland - Krystof
Kieślowski's Blind Chance. The common thread in all three episodes is a feeling of
general personal futility. The late Communist world was a world in which it was often
your job to do strange, useless things badly, all day, for no good reason at all.
There is another world in which it is often your job to do strange, useless things
badly, all day, for no good reason at all. This is the world of Dilbert. Many of us have
experienced it.
My theory is that Dilbert and Brezhnev are the same thing. I call it Dilbert-Brezhnev
syndrome, or DBS. While we are certainly not the Soviet Union, my theory is that
America has contracted a rather serious case of DBS.
The Soviet Union was a world in which business bore no relation to profit. People did
strange, useless things badly because, lacking the discipline of profit that enforces
efficiency, they succumbed to ulterior motives. Their unprofitable enterprises,
purportedly businesses, were in fact patronage structures.
America is a much more interesting case, because (aside from its endlessly
burgeoning political system, including its grant-funded "nongovernmental"
periphery), the industries in which we see Dilbert syndrome are private, profitable.
Nothing in America today is Brezhnev bad, but it is getting there. Furthermore, we
cannot compare the America of 2009 to itself - we must compare it to the America of
2009 that should exist. Where is the iron broom of competitive discipline? How can
pointy-haired managers, HR red tape and sensitivity seminars survive it?
The answer, I think, is our friend zombie finance. We do not have Gosplan, but we
have Wall Street. America is Dilbertized to the extent that Wall Street is zombified.
Let's take the loans that created the housing bubble. These were zombie loans to a T.
So, for example, Steve Sailer asks: where was capitalism? Why wasn't anyone betting
against these loans, and driving them down to their true value?
The answer is that the free market bears very little relationship to the process that
distributed these loans. The loans were made because they could be securitized and
given AAA ratings. Their AAA ratings were assigned by Moody's, S&P, and Fitch, the
three major NRSROs, which are not in any sense private corporations. They might as
well be a Department of Ratings. Their operation is entirely bureaucratic. "It could be
structured by cows and we would rate it."
This bureaucratic seal of approval was created for the banking industry, in which
these ratings were presumed to correspond to default rates - not through anyone's
wise judgment, but as a matter of regulatory fiat. They were also adopted by the
unregulated shadow-banking industry (which incurred short-term liabilities to buy
long-term loans, without the formal protection of official banking status) again not as
a matter of prudence but a bureaucratic assumption. The shadow bankers saw
themselves as living in a world in which the banks would not be permitted to fail.
Besides, if they had any doubts, they could buy insurance from AAA-rated AIG.
And look at the houses these loans created! Millions of soulless, cookie-cutter, jerrybuilt McMansions in the middle of nowhere. If this isn't the residential-construction
version of the Virgin Lands Campaign, what is?
The Soviet system is sometimes described as state capitalism. But it was not the
sovereign nature of the Soviet state that made its apartments ugly and its waitresses
surly. Nor, I think, was it even the size of this gigantic, unicellular organism - plenty
of large private companies (don't miss this look inside Wal-Mart) can delegate
considerable decision-making power, and even financial independence, to their
lowest layers.
Rather, the Soviet system is an example of zombie capitalism. When resource
allocation is not subject to the discipline of profitable exchange, everything decays
and becomes foul. The coral bleaches, the slime burgeons.
My feeling is that American zombie finance is largely responsible for the appearance
of DBS in the New World. Why is the country covered with hideous developments,
strip-malls and chain stores? Because it has, or had, a financial system designed to
finance these things. Many of us would prefer a Ritual to a Starbucks and a Joe's
Diner to a Burger King, but the chains have an unbeatable advantage: it is much
easier for them to get a loan.
In the Soviet system, everything was one chain. You ate at Restaurant #26,719. You
will note that every Starbucks store has a number as well, although for some reason
they do not put it on the marquee. Starbucks is subject to the discipline of profit - but
it is not as subject as it should be, because its sheer size gives it access to zombie
money. Thus the generic can defeat the specific, blandness outcompetes character,
and we drink charred cat hair rather than coffee.
But we are attributing quite a few disasters to this phenomenon, which we have not
yet examined in detail. What is American zombie finance, anyway? Besides the late,
distressing intrusion of acronyms, how can the undead escape the discipline of profit
in our system?
First, let's assign credit where credit belongs: our old friend, USG. Since only a
zombie will lend to a zombie, and USG certainly lends to plenty of zombies, it must
be a zombie itself. And indeed, we are unsurprised to discover that USG operates
under neither the discipline of profit nor that of charity. (It does suffer the discipline
of democracy, or at least "right-wing populism." But this is an awfully frail thread
with which to leash so big a dog.)
Thus, all zombie loans are ultimately government loans. A profitable government
would make profitable loans; an unprofitable government is perfectly positioned to
be the root of a patronage tree, regulated by bureaucracy. Understandably,
Americans have a traditional dislike for the idea of government lending, so the
process must be disguised. Fortunately or unfortunately, depending on your point of
view, it is becoming less disguised.
The typical way in which government loans are disguised is to structure them as loan
guarantees. Consider, for instance, the 30-year zombie loan with which you buy a
house. This loan is a zombie loan because, in order to receive it, you did not have to
find a private party who was willing to lend you money for a 30-year term. Nor did
the bank who lent you the money. Nor did anyone.
The traditional banking structure which creates these loans works as follows:
someone lent a bank money with a continuously-revolving term of 0, ie, made a
"deposit." The bank took that money and lent it to you with a term of 30 years. This
is our old friend, maturity transformation.
Maturity transformation is zombie finance, plain and simple. If this transaction were
complete as described, it simply would not happen, because no one would "deposit"
in this bank. Reason: the bank cannot fulfill its present obligations without selling its
loan, which equates to finding a new lender. Recall that this meets our definition of
insolvency.
And this is true even if the market price of the bank's assets exceeds the sum of its
liabilities. Reason: an asset price is an opinion, a liability is a fact. If your bank is the
only bank practicing MT, it can sell its assets and is perfectly safe. If your pyramid
scheme is the only pyramid scheme in the world and you are at the top, you are just
as happy a camper.
Systemic maturity transformation is not a free-market phenomenon because, in a
free market, interest rates are not fixed. They are set by supply and demand at every
maturity. If you transform demand for 2009 money into demand for 2039 money,
you are driving the price of 2039 money in 2009 money up, and interest rates down.
But if those who demanded 2009 money had actually wanted 2039 money, they
would have said so. Since they demand 2009 money, they are apt to demand it back
in 2009. When they do, the price of the 2039 money that backs these loans will fall
back again, and banks that back 2009 obligations with 2039 assets will find
themselves insolvent.
Essentially, the depositor in a free-market maturity-transforming bank has bought
into the loan-market equivalent of a market-manipulation scheme. You can make the
price of anything go up by buying more of it, creating a paper profit in which your
assets are "worth" more than you paid for them. But in order to actually turn less
money into more money, you have to sell as well. This is the "burying the corpse"
problem. A bank run is the banking equivalent of burying the corpse.
Enter USG. USG, via FDIC, "insures" (another Orwellian misnomer, as there is no
insurable risk here) the "depositor's" loan to the bank. In return, it "regulates" the
bank by requiring it to follow its official lending criteria, NRSROs and all.
Any such loan guarantee is equivalent to a triangular structure of loans. Thus, what is
really happening is that the "depositor" is lending to USG, and USG is lending to the
bank. Because USG will not default to the depositor, the depositor does not care if
the bank defaults to USG. Moreover, since USG only loans to banks that follow its
lending practices, it might as well be USG making your home loan as well. (This, too,
has had several layers of veil stripped away.)
This entire structure is dependent on that wonderful modern innovation, fiat
currency. Fiat currency allows USG's guarantees to be watertight. USG can never
default, because all of its "liabilities" are defined in its own scrip. Thus it can loan as
much money as it wants, to anyone, for any reason. All of America's money in the old
sense of the word has fallen, somehow, into USG's vaults. Fancy that!
By the standards of 1909, Americans have no money at all. Rather, a dollar is a sort
of loyalty point, frequent-flier mile or stick-on gold star. Thus, behind the
increasingly threadbare Potemkin capitalism, we see much the same financial system
as in the Soviet Union. To get a loan is to ask the State for some of its brownie points,
which must be repaid not because the State needs the brownie points back, but
simply because it (a) wants to maintain some level of demand for its rubles, and (b)
would hate to forfeit the opportunity to compel you to serve it.
This is the basic problem with fiat currency. It can be used, in almost arbitrarily
subtle and fiendish ways, to fill holes in balance sheets, making insolvent institutions
look solvent and unprofitable ones look profitable. Paper money is embalming fluid zombie juice. It can raise the dead from their graves, but it cannot bring them back to
life.
Moreover, before the fiat age, governments performed the same trick, by protecting
their favorite banks (ie, all of them) from the rigors of bankruptcy. To suspend the
liquidation of a bank is to lend to it - effectively, to convert its liabilities into legal
tender. The so-called "classical gold standard" of the 19th century was not a true hard
currency, but a mixture of gold and paper. Gold convertibility provided some
discipline, but still allowed for considerable monetary dilution - and, hence, zombie
finance.
And note that our theory of the corrosive effects of monetary dilution is not at all
original:
There is no subtler, no surer means of overturning the existing basis of society than
to debauch the currency. The process engages all the hidden forces of economic law
on the side of destruction, and does it in a manner which not one man in a million is
able to diagnose.
You have probably heard this quote before. This is because the author is Darth
Keynes, albeit in his Anakin phase. He would later practice what he preached.
And, as usual here at UR, we have saved the worst for last. We are not just afflicted
by zombies. We are utterly in their hands. No mere twist of financial regulations can
save us. We cannot simply cut off the embalming fluid. Charon provides no reverse
commute across the Styx.
Think, for a moment, about balance sheets. A balance sheet lists what an institution
owns, and what it owes - assets on the left, promises on the right. The conventional
way to tell whether the institution is solvent or not is to total (A) the market's bid
price for the assets, and (B) the institution's cost of fulfilling all its promises. If (A >
B), the institution can trivially fulfill its promises by shutting down and selling its
assets. It is therefore solvent. Otherwise, it is not.
(As we've seen, this solvency logic can be gamed - it does not take into account the
effect of asset sales on market prices, instead effectively assuming a sort of just-price
theory for interest rates. However, the balance sheet itself contains all the
information we could want. For an accurate calculation of solvency that prevents
maturity transformation, we need only treat assets and liabilities of different
maturities as qualitatively distinct, like dollars and euros.)
Note that balance sheets display a pleasant associative quality. Acting purely in our
heads, we can combine two institutions, X and Y, by merging their balance sheets. All
promises from X to Y or Y to X are thus moot, and we can ask: is XY solvent?
We can use this property to theoretically consolidate an arbitrary number of balance
sheets. In this way, we can go from the microeconomic level to the macroeconomic
level. However, game-theoretic effects on asset prices become increasingly important
as we aggregate all possible buyers for an asset into one entity. Again, you cannot
make money by bidding up the price of a good which you sell only to yourself.
Often, when evaluating the solvency of an institution, no reliable accounting exists.
Opaque balance sheets and asset valuations are not a novelty to the intrepid financial
spelunker. Therefore, it is often useful to find other criteria. For example, one simple
criterion is to ask: is money flowing into this thing, or out of this thing? If money is
flowing out, it may be solvent and profitable. If money is flowing in, it may still be
solvent, but it is probably not profitable - and it may well be neither.
So let's consolidate America onto two separate balance sheets. Balance sheet A: USG
and the banks. Balance sheet B: households and all other businesses.
What we notice is that, in what are supposedly normal economic circumstances, we
see a continuous flow of money from A to B. In exchange, naturally, for promises of
future repayment. Except when the credit markets break down, B takes a couple
trillion dollars of A's money every year.
Now, again, there are multiple explanations for this. If we look at B's claimed balance
sheet, it appears to be solvent. On the other hand, it includes many assets for which
the only buyer is B itself. What can we say of these valuations? If B is insolvent, they
are probably bogus, and if they are bogus B may well be insolvent. Otherwise, not.
This tells us very little.
We note, however, the money flow. The money flow is negative. Money is flowing
into B. This is consistent with the hypothesis that B is an insolvent and unprofitable
operation. It is also consistent with the hypothesis that B is investing this money, ie
using it to produce capital - farms and factories and patents - which will or at least
could, in future, result in money flowing in the other direction. Sure. All I can say is:
I'll believe it when I see it.
So when you hear Obama or Geithner or any other luminary talk about "restoring the
flow of credit," you now know how to translate this. It translates as "restoring the
flow of embalming fluid." We are all zombies, and we must be fed.
The most plausible explanation of an economy that is continually borrowing more
money, and taking on more debt, is that the entire economy, as a whole, is a moneylosing operation.
Its addiction to borrowing is an addiction to zombie finance. A profitable lender
would not be sending good money after bad. A profitable lender would cut the whole
system off, cold turkey, and see which of its debts it can repay when it no longer has
new loans to repay them with.
And this is what I mean by a "zombie nation." It is not just the banks that need
restructuring. It is the entire economy, because the entire economy is dependent on
the continuous generation of new debt. This is the hallmark of the zombie. Beneath
this soothing curtain of formaldehyde, it is not just Citibank that is insolvent and
unprofitable; it is not even just GM; it may even be most American companies.
Nobody's profit margin is that wide.
America! Hail, chief of the dead. Alive you were the greatest, and death has barely
touched you. You strode the world; you stride it still. Rule it, even - for of all dead
things, you are the least dead. That furrowed brow is almost fresh. The frost upon it
might well be sweat. That tan and bony fist still clasps its notchless sword.
But the scent is unmistakable. The beetles are already at work. Grosser fauna lurk.
And what do we do? We do nothing. We serve a straw-packed corpse, nailed to a tall
and ancient throne. Dead, festering, and nowhere near ready for the grave. And we
smile as we go about our duties.
Statistical analysis moons the bull
There's an interesting article on statistical prediction in the FT this morning. The FT
firewalls articles after a day, so I suspect this link will break, unless you are an FT
subscriber.
I want to quote some chunks of the article, not because it's smart, but because it's one
of the most embarrassing essays to ever appear in print. The trouble is that the
author, Ian Ayres, is pimping a new book, and the FT article is adapted from that
book. Since the book was not written in the last month, it says things about the
financial markets that in the light of recent events are, at best, grimly hilarious.
Presumably if you were a national-security pundit, you had a book release scheduled
for October 2001, and your book observed that the threat of terrorism was
overheated propaganda churned out by a cabal of neoconservative wingnuts, your
publisher would have the sense to pull the book. Or at least hold it until 2005 or so.
You'd think the FT editor could at least have done a quick snip on this graf:
Since the 1950s, social scientists have been comparing the predictive accuracies of
number crunchers and traditional experts - and finding that statistical models
consistently outpredict experts. But now that revelation has become a revolution in
which companies, investors and policymakers use analysis of huge datasets to
discover empirical correlations between seemingly unrelated things. Want to hedge a
large purchase of euros? Turns out you should sell a carefully balanced portfolio of
26 other stocks and commodities that might include some shares in Wal-Mart.
Um, sure. Want your hedge fund to go tits-up and explode like a rotting whale,
raining putrid financial instruments all over Connecticut? Turns out you should
assume financial markets are stochastic systems in which the future mirrors the past.
Apparently some things that are "seemingly unrelated" are actually also actually
unrelated.
As one guest on Brad Setser's blog (the Mos Eisley of the macro finance geek - but see
also Macro Man, Nihon Cassandra, Winter, Plant, Waldman, and Hellasious) writes:
It seems like there are two points of view running through this blog:
(1) the securitization process was fundamentally flawed
(2) the process wasn’t flawed, but buyers weren’t prepared for predictable
downgrades.
Twofish: ―You have a CDO that's divided into three tranches. Let's call them high
risk, medium risk, and low risk. Everyone knows that the high risk CDO will lose
money, the question is how much. You do the calculation and it shows that the low
risk tranche has a 2% chance of losing money.‖
But the latter sentence is a prediction about the future. This prediction is based on
assumptions (e.g. x percent of the underlying loans will behave like this population of
loans on which we have historical data). The models only address correlations
between the different cash flows to the degree that their assumptions about the
behavior of the underlying mortgages are correct. The problem is times change,
behavior changes. It’s hard for some of us to believe that models that process
historical data can hope to give reliable predictions about future events.
If the models are only a little wrong – and the modelers would have taken this into
account – you have a good CDO. If the models are a lot wrong, you have a lemon.
It seems that the people who believe (1) think that the models are likely to be wildly
off the mark, while the people who believe (2) think the models are basically sound.
The problem I have with (2) is this: If in fact the process by which CDOs were created
is fundamentally sound, why aren’t people in the know making a killing buying CDOs
up right now?
Indeed. "Bueller? Bueller?"
Fortunately, at least the financial markets are not Professor Ayres' leading example.
But instead he opens his article with this precious ort of automatist idiocy:
As the men talked, they decided to run a horse race, to create "a friendly
interdisciplinary competition" to compare the accuracy of two different ways to
predict the outcome of Supreme Court cases. In one corner stood the predictions of
the political scientists and their flow charts, and in the other, the opinions of 83 legal
experts - esteemed law professors, practitioners and pundits who would be called
upon to predict the justices' votes for cases in their areas of expertise. The
assignment was to predict in advance the votes of the individual justices for every
case that was argued in the Supreme Court's 2002 term.
[...]
The experts lost. For every argued case during the 2002 term, the model predicted 75
per cent of the court's affirm/reverse results correctly, while the legal experts
collectively got only 59.1 per cent right. The computer was particularly effective at
predicting the crucial swing votes of Justices O'Connor and Anthony Kennedy. The
model predicted O'Connor's vote correctly 70 per cent of the time while the experts'
success rate was only 61 per cent.
Now, why is this not surprising?
It's not surprising because the good professor is testing a model against a survey. In
other news, Professor Ayres is a world-class marathoner: in a 26.2-mile race, he can
outperform my grandmother. Although considering the intellectual honesty that this
exercise demonstrates, he'd probably feel the need to kick her walker as he shambled
past.
If our esteemed professor were actually to establish a prediction market in which
people could make actual money by predicting Supreme Court decisions, he could
actually pit the best models against the best experts, as selected not by his secretary,
but by an adaptive system which rewards success and punishes failure. Heck, if he
has a good model, he could actually make some scratch in the game. Maybe he could
even detach himself from the Official Tit.
Now, why hasn't anyone done this? (At least, I get no useful hits when I google
"Supreme Court" and "prediction market.") Perhaps because, as I suspect, the
market would have error rates well under 10%? Perhaps because, if you have a career
as a crusader for "social justice," general-purpose media whore, and permanent
Fedco flack, constructing an experiment designed to demonstrate the essentially
comical nature of the rotary system's most revered agency - the Inspection Council isn't the idea that leaps instantly to mind? I'm just guessing, here.
If you need a pop-science book about modeling and prediction, try David Orrell's The
Future of Everything. Orrell, who actually is a mathematician, does not have a whole
lot to say except that it's a really bad idea to trust a model. As Orrell's near-namesake
once put it, "trust a snake before a Jew and a Jew before a Greek, but don't trust an
Armenian." Hopefully, by the end of Orrell's book, you will trust a whole clan of
snake-handling Greco-Jewish Armenians before you assume that "a carefullybalanced portfolio of 26 other stocks and commodities" will mirror the fluctuations
of the euro.
If you're more interested in the financial end of this, I haven't finished Rick
Bookstaber's book, but so far I like it. A little Austrian economics would do
Bookstaber a large passel of good, but his Blowing Up The Lab essay in Time is as
good an introduction to the CDO disaster as I've seen so far.
Gary Larson's first Far Side anthology has as its cover what I think is actually the best
Far Side cartoon ever. Note, however, that the idiot photographers are only sticking
their tongues out at the bull. They have not actually turned around and mooned it as Professor Ayres just has. Hopefully he's already consigned his royalties to
Goldman's Global Alpha fund, which, after "three 25-sigma events in three days,"
could certainly use the cash.
Who the heck is Benn Steil?
Readers ask: who the heck is Benn Steil? And why should I care?
Actually, everyone should care who Benn Steil is. At least, everyone who has more
than a couple hundred bucks in the bank.
Benn Steil is this person. He is also the author of this article. And if you prefer the
dulcet tones of his gentle yet masculine voice, you can listen to him here. I don't
mean to sound like a conspiracy theorist, but when the CFR and Ron Paul are singing
the same tune, you can be pretty sure the fat lady is at least in the building.
Most importantly, Benn Steil is singing. Which means he's not quacking.
The 20th century was the century of quack everything. Perhaps most infamous was
the great Soviet quack-geneticist, Trofim Lysenko. But quackery in its Eastern
edition was crude and unsubtle. Its associations with brute force were impossible to
conceal, and it seldom lasted long when that force was removed.
No, the postwar Western university is our true Valhalla of quack. Quackologists will
be studying this system for decades, and they will certainly not get bored. The sad
fact is that almost everything studied and taught in Western universities today is
quackery. The only exceptions are some areas of science and engineering. For
example, I'm pretty sure that chemistry and biochemistry are generally quack-free.
However, if Lee Smolin and Peter Woit are right (and Luboš Motl is wrong), we are
beset even by quack physics.
We certainly have quack poetry, quack computer science, and quack history.
"Journalism," for example, is quack history at its finest. And figures such as Freud,
Rothko, Mann (read the whole thread, or at least to the "Piltdown Mann" bit), Mead,
and Ashbery will have to appear on any list of history's great quacks. Their
achievements may be surpassed, but how can they ever be forgotten?
And then there's economics.
Pretty much everyone thinks of 20th-century economics as a seething nest of
quackery. Including most 20th-century economists. All they disagree on is who the
quacks are.
It is incontrovertible that quack economics is alive and well in the world today. It is
possible that the Austrian, Chicago, George Mason, New Keynesian, and "postautistic" schools of economics are all quack. It is certainly not possible that they are
all nonquack.
So how can you tell the difference between a real economist and a quack economist?
I'm afraid a bit more than $64,000 is riding on this question.
Here is my answer. Please feel free to refute it in the comments section. I have an
open mind, but it tends to close after a while when it doesn't hear any good
arguments.
My test is that a real economist is an economist who believes that any quantity of
money is adequate. A quack economist is an economist who believes that increasing
prosperity - or even continuing prosperity - demands a continuously increasing
quantity of money.
There is a word which means "an increasing quantity of money." The word starts
with an I. However, in the 20th century this word started to be used in a new way,
meaning "an aggregate increase in prices." While the two phenomena are certainly
related, using the same label for both doesn't strike me as the ideal way to elucidate
the relationship. And when you realize that the new meaning largely dominates in
modern English usage, leaving no word at all for the old meaning, the needle on your
quack detector may start to 'pop' a little.
For this reason, I prefer to borrow a term from a slightly different department of
finance, and describe an increasing quantity of money as dilution. If there is any
ambiguity, one can eliminate it by speaking of monetary dilution.
(As for an aggregate increase in prices, the obvious word is appreciation, which can
be further categorized as asset price appreciation and consumer price appreciation.
The general use of the I-word in newspapers today is the latter. No precise or
objective distinction between "assets" and "consumer goods" can be constructed, of
course, but the same can be said for the index baskets generally used to "measure"
consumer price appreciation. Any number produced by a subjective index is fudge - it
may still be useful, but it is useful only to the eye. Anyone who plugs any subjective
number into any mathematical formula or model is a quack, period. But I digress.)
So we can reframe our quack detector by declaring that there are two kinds of
economists: those who believe that monetary dilution is essential, and those who
believe it is inessential. Not only is this a boolean distinction, it is a very sharply
polarized one - as we'll see. In short, the conditions for a great quack hunt can only
be described as ideal.
Our razor is as simple as could be. Dilutionists are quacks. Nondilutionists are
nonquacks - unless of course they are peddling some other brand of quackery.
There is no ambiguity at all. This test applies to any economist, or supposed
economist, past or present, professional or amateur. If the voters of a democratic
nation are infected with quack economics, their government will hire quack
economists who peddle quack prescriptions. As Miguel Ferrer put it in RoboCop,
that's life in the big city.
For example, one common belief among amateur dilutionists is that if the economy
of some country "grows" (another fudge factor) by 3% a year, its currency should also
be diluted at 3% a year. Any professional economist, quack or nonquack, knows that
this makes no sense at all. No serious economist believes it in the exact numerical
form stated above. However, it's a common belief among the general public, and
dilutionists seldom seem to disabuse them of it.
Why is dilutionism quackery? This is actually quite easy to see.
Modern currencies, such as the dollar, are fiat currencies. In principle, there is
nothing at all wrong with a fiat currency. There is no valid economic objection to
paper money, and there is no economic connection between dilutionism and fiat
currency. In principle, it is perfectly easy to imagine a fiat currency system with a
fixed quantity of currency.
Whatever your monetary system, money is a good like any other. It is not a "measure
of value" or a "claim on wealth." It is a commodity, whether virtual, paper, or
metallic. (The reasons that people are willing to exchange so many nice things for
money, and the reasons they choose one form of money over another, are complex we'll save them for another day.)
What makes money money, however, is that most or all people who hold money hold
it not in order to use it directly, but in order to exchange it for other goods. True, you
can write a phone number on a twenty-dollar bill, and you can melt down a
Krugerrand and make it into a gold cokespoon. But neither of these uses are relevant
to 99.999% of the people who hold twenties or Krugerrands.
In other words, when most people make decisions about money, they are concerned
with the exchange rates between money and other goods - ie, the prices of
nonmonetary goods in money. Any change in their money that does not affect the
quantity of goods they can obtain in exchange for the quantity of money they own
will not affect their behavior.
Therefore, monetary systems can be redenominated neutrally, by rescaling a
currency so as to affect all moneyholders in exactly the same way.
For example, Turkey recently stripped six zeroes from its currency. Each million old
Turkish lira was converted to one new Turkish lira. All contracts denominated in old
Turkish lira were rewritten in new lira. And so on. This did not amount to a
99.9999% wealth tax. It did not change the behavior of Turks, or anyone else, in any
nontrivial way. Similarly, if Turkey had doubled its currency, so that every million
old lira was now 2 million new lira, there would have been no nontrivial effect.
On the other hand, if Turkey had converted every million old lira into one new lira,
except for lira held by Armenians, who received half a new lira, the effect would have
been a tax on Armenians. If it had doubled its currency, but not doubled debts to
Armenians, so that your million old lira became 2 million new lira, but if you owed 1
million old lira to an Armenian, you still owed 1 million new lira, the effect would
have been a partial repudiation of debts owed to Armenians. And so on.
There is no distinction between monetary dilution and redenomination. If you dilute
a monetary supply by 10%, you are exchanging 1 million old lira for 1.1 million new
lira, whether or not you choose to think of it this way.
However, the type of monetary dilution that we think of when we use the "I" word is
never, ever a neutral redenomination. There are many ways of creating new money counterfeiting in a fiat currency system, gold mining under a gold standard, etc.
None of them distribute an equal share of the new money across every unit of the old
money. None of them rewrite contracts or debts. If they did, they would be neutral,
and no one would bother.
One easy way to see this clearly is to imagine a monetary system in which money is
measured in fractions of the outstanding money supply. Instead of a number like
$1000, your bank statement would have a number like "one billionth," meaning that
you owned a billionth of all the dollars in the world.
Redenomination in this kind of fractional monetary system is so trivial that the
operation does not even exist. Moreover, we can redefine any monetary system in
these fractional terms - as long as we can define the quantity of currency in the
system. It is just a matter of changing our accounting convention.
So what would nonneutral dilution look like under fractional accounting? The answer
is simple - it looks like redistribution. When you dilute lira owned by Armenians but
not lira owned by Turks, the result is precisely the same as taking lira from
Armenians and giving it to Turks.
Every nonneutral dilution can be defined as the combination of a neutral
redenomination and a nonneutral redistribution.
And this is why dilutionists are quacks. Dilutionists are quacks because it is
impossible to imagine a way in which the systematic pilfering of wallets could
somehow be essential to commerce and industry.
We can categorize monetary systems as closed-loop (no new money is created) or
open-loop (new money is created). Even the gold standard is an open-loop financial
system, because new gold can be discovered and mined. 19th-century gold
discoveries in Australia, California and Canada had substantial global monetary
effects. But at least Mother Earth is in control of this particular loop.
Obviously, fiat currencies are all at least potentially open-loop. Typically the State, by
persecuting all counterfeiters other than itself, controls the loop. For example, the
most naive form of dilution is simply for the government to print money and spend
it.
This is not how dilution works in most Western countries today. Rather, modern
governments use their fiat currencies to issue perfect loan guarantees. For just one
example, a conventional bank "deposit" in the US is actually a zero-maturity loan
from you to your bank. This loan is nominally "insured" by a "corporation" called the
FDIC, but this risk is not an insurable risk, nor does the FDIC store the slightest
fraction of the funds it would need to make its guarantee 100% reliable. However, the
guarantee is indeed 100% reliable, because the FDIC is ultimately backed by the US's
power to create as many dollars as it wants, and the US has every political incentive
to exercise this power.
(Another way to understand dilution via loan guarantee is to realize that the US's
power to define a piece of paper as a "dollar" is no different from its ability to define a
slice of your checking account as a "dollar." The US can fix the price of any good
relative to its own fiat. If Congress wants to declare that every Honus Wagner
baseball card has a face value of one billion dollars, it has all the power it needs to do
so. But again, I digress.)
Why would anyone ever believe in dilution? Well, there is a very straightforward way
to use dilution to create apparent prosperity: use it to redistribute money from
people who are saving money, to people who are spending it. While typically the
savers and the spenders are not the same people, if you can imagine a government
program that would force anyone with a large nest egg to spend it all this year, you
can certainly imagine the resulting boom.
Again, however, we see that dilution can accomplish no objective which cannot also
be accomplished by redistribution. And what is the advantage of dilution over
redistribution? Simply that dilution is easier to hide, and harder to resist. In other
words, we will expect to see a state choose dilution over redistribution when that
state is either deceptive or weak. Or, of course, both.
And there is an even more troubling fact.
The fact is that all famous 20th-century economists - Fisher, Keynes, Friedman,
Samuelson, Galbraith, etc, etc - and 99.9% of working economists today are
dilutionists. In other words, they believe that a closed-loop monetary system, or even
a nearly-closed system such as the gold standard, is impractical or at least
suboptimal.
We can even link to bloggers. Cowen and Tabarrok: dilutionists. Kling and Caplan:
dilutionists. McArdle: dilutionist. Mankiw: dilutionist. Levitt: dilutionist. DeLong:
major dilutionist. Und so weiter. Pretty much your only nondilutionists are to be
found in the Austrian School, and even there you need to be careful.
Therefore, we are left with the conclusion that either (a) the above analysis is in some
way wrong, or (b) 20th-century economics was dominated by quacks, and mostly
remains so.
It's not at all clear why (b) should even start to be surprising. Didn't we already know
that the 20th century was the era of quack economics? What was the Soviet Union
but a giant outdoor experiment in economic quackery?
I say "20th century" because we observe an interesting fact: when we scroll back in
time, we see that dilutionism makes itself quite scarce.
Madison wrote in Federalist 10 of "a rage for paper money, for an abolition of debts,
for an equal division of property, or for any other improper or wicked project." Burke
is even more colorful:
When all the frauds, impostures, violences, rapines, burnings, murders,
confiscations, compulsory paper currencies, and every description of tyranny and
cruelty employed to bring about and to uphold this Revolution have their natural
effect, that is, to shock the moral sentiments of all virtuous and sober minds...
Ben Franklin was the leading colonial enthusiast of open-loop finance, a perspective
not at all inconsistent with his general harebrainedness. The fate of the Continental
dollar, not to mention the French assignat, did a reasonably good job of discrediting
dilutionism. Even Lincoln's greenbacks were formally limited in supply, and after the
war this limit held.
In general, anyone who openly proposed outright dilutionism in the 19th century was
treated as a monetary crank - much as Ron Paul is now for his espousal of the gold
standard. (Frum's arguments, if you can call them that, are quite typical of the canon.
At least he's in good company - not just with the 20th century's top economists, but
also one of its great poets.)
But even the classical gold standard of the 19th century was quite diluted. The 19thcentury banking system never had anything like enough gold to redeem all current
claims in metal. Frequent panics and cycles were the result, culminating in the events
of the early 1930s, in which a worldwide rush for redemption eliminated the last
vestiges of closed-loop finance.
To find what Austrian economists call a "100%-reserve" monetary system, you have
to look in more obscure corners of history - such as the Amsterdamsche Wisselbank.
Or, as Condy Raguet claimed in 1840, Gibraltar:
Such being the theory of this branch of my subject, I have the satisfaction to state in
regard to the practice under it, upon the testimony of a respectable American
merchant, who resided and carried on extensive operations for near twenty years at
Gibraltar, where there has never been any but a metallic currency, that he never
knew during that whole period, such a thing as a general pressure for money. He has
known individuals fail from incautious speculation, or indiscreet advances, or
expensive living; but he never saw a time that money was not readily obtainable, at
the ordinary rate of interest, by any merchant in good credit. He assured me, that no
such thing as a general rise or fall in the prices of commodities, or property was
known there; and that so satisfied were the inhabitants of the advantages they
enjoyed from a metallic currency, although attended by the inconvenience of keeping
in iron chests, and of counting large sums in Spanish dollars and doubloons, that
several attempts to establish a bank there were put down almost by common
consent.
I'm not sure on the details, but I'm afraid there are banks in Gibraltar now. However,
if you prefer to store your portfolio in doubloons, there is always Jersey. Yes - in fact,
this is exactly what Benn Steil is talking about.
See also Sebastian Mallaby, in Monday's Washington Post. Again, the CFR rears its
ugly head.
Basically, what we're looking at here is the harsh but necessary process of waking up
from the last century. There is a reason that quackery, in economics and poetry and
nutrition and painting and history and psychology and paleoclimatology and
computer science and just about any other department you can name, did so well in
the 20th-century university system. Reality knows no master, but quackery is useful.
Sometimes it's even profitable.
And will we end up back on the gold standard? Possibly. I really have no idea.
As Lech Walesa used to say, it's easy to turn an aquarium into fish soup. It's a lot
harder to turn fish soup into an aquarium. Likewise, it's easy to go from a closed-loop
currency to an open-loop currency. Going back, on the other hand...
In the '80s and '90s, governments found it not all that hard to reverse quack central
planning. Often the corporations nationalized in the '30s through the '60s were even
structurally intact, and could just be resold. Reprivatizing the monetary system is a
completely different level of difficulty. It involves revising not just decades, but
centuries, of Western financial practice.
Worse, any transition to a fully backed gold standard implies a preposterous
discontinuity in the gold price. If such a transition is officially planned, it would
demand a level of secrecy and coordinated execution that would make the CFR look
like MySpace. If it happens spontaneously in the market, as Steil suggests - the mind
boggles. I can imagine how this could happen on a purely economic level. I can't
imagine how it would interact with politics.
But history is out there. It has not been repealed. The present is not permanent. In
fact, to the future, it may look pretty strange.
[BTW: I know I promised to wrap up the Dawkins series this week. However, on
further reflection, I feel it may actually need to be not ended, but extended. Hopefully
this week's posts have provided UR readers with a wider window on the alternate
reality around us.]
UR's crash course in sound economics
Today we're going to achieve a basic understanding of economics in one UR post. No
previous knowledge of the subject is assumed.
UR can deliver this remarkable savings in both time and tuition because, and only
because, our "economics" is an entirely different product from the standard academic
sausage. We've considered changing the word - but this feels hokey. It also conceals
our feeling that (a) for most customers, UR's "economics" is a more than satisfying
replacement for 20th-century industrial numerology; and (b) our version is far closer
to the original artisanal craft.
Here at UR, "economics" is not the study of how real economies work. It is the study
of how economies should work - in other words, of how sound economies work.
Sound economies, as we'll see, are also stable economies. All the King's
mathematicians have had some trouble in reproducing this property.
Since there are no economies on the planet which are even remotely sound, nor is
there any prospect of any such thing appearing, this discipline cannot conceivably be
empirical, quantitative, or worst of all predictive. Its only tools are logic and sanity.
Sound "economics" can only be natural philosophy, not "science." (A brand in any
case increasingly overexposed - not least by its association with the King's
mathematicians.)
Moreover, since healthy economies are healthy by definition, there is no practical
reason to study them. No remedy is required for their ills, since they are not ill. Thus
UR's "economics" is not only nonscientific, but nontherapeutic.
It does not even offer a path for transforming a pathological economy into a sound
one. It prefers the old Irish directions: "don't start from here." If there is such a path,
it is certainly neither gradual nor gentle. Since real governments are about as capable
of following it as your grandmother of climbing K2, its existence is just as fantastic as
our sound economy, and it is not even worth mentioning.
So why bother? Well, two reasons. One, sound economies are simple. Or at least, they
operate on simple principles, which we can explain in one post.
Two, if you want to try to start to begin to consider understanding the giant bag of
cancer, graft and rust that is a 20th-century economy, you may find it helpful to
contemplate the imaginary sound economy inside it. Or not, of course. But at the end
of the post, we will look at a few of the pathological ways to corrupt a sound
economy. You may find them faintly familiar.
On to sound economics. Readers familiar with Austrian economics will find much to
skim, especially at the start, but should also watch out for nontrivial differences in
the origin of money and the structure of the loan market.
First: what is an economy? An economy is a network of conscious actors, who desire
goods they can produce and exchange. All real human societies are thus economic.
So are alien societies, if any exist, and if the aliens can think and plan. Virtual worlds
which meet this definition are also economic, and display the expected patterns.
The desires of a conscious actor are unknowable by definition. We observe only the
action. Moreover, the assumption of consciousness (which is rational by definition)
tells us extremely little about these desires, especially when we start to order the
desirability of goods. Which is more desirable: a one-carat diamond, or a six-pack of
Fiji Water? Depends whether or not you are lost in the desert.
But rationality does give us one rule: that a good always has positive (if negligible)
desirability. So it is always rational to prefer more goods to fewer goods. Eg, more
money to less money.
This might be objected to in the case of your brother-in-law's rusted-out 1981
conversion van. But the problem is one of semantics: his need to junk the van (which,
not unlike our real economy, only needs a transmission, a couple axles and a little
Bondo) is a liability or obligation, not a good. If he had a voucher for free vehicle
disposal, his ownership would again be a pure good - however negligible.
We can state the principle more precisely by observing that a conscious actor always
prefers more powers and fewer duties. A power cannot have negative value, because
one can always decline to use it; a duty cannot have positive value, because one can
always do it anyway. The classic form of economic power is ownership of some good;
the classic form of duty is a debt.
And this is about it for ol' "homo economicus." What rationality does not and cannot
tell us is anything else - specifically, what we really want to know, which is whether
any actor X should prefer good A to good B.
Again, only X can decide whether to prefer the diamond or the water. Moreover, if all
actors ordered all goods identically by desirability, we would have no economy by
definition - for we would have no exchanges.
And it gets worse. We cannot even know all of X's preferences - only those which are
revealed. The only way for an objective observer to observe that X prefers A to B is if
the observer actually sees X give A (or A, plus choices or minus duties) to some Y, in
exchange for B (or B, minus choices or plus duties).
Does all this seem obvious? You'd think it would be. However, a considerable thrust
of medieval pre-economic thought was the effort to determine just prices for goods,
derived from objective factors. The urge to just-price theory is by no means extinct.
We appeal to it, however vaguely, whenever we mention the "value" of a good, as if
"value" were an objective quality such as mass or energy.
(Indeed the entire apparatus of price-index terminology, from "inflation" to "real"
and "nominal" figures, "1980 dollars," and the like, is deeply if subtly rooted in the
fallacy of objective value. All this doxology is shunned by the sound. Indeed, the wise
man would rather drop the N-bomb than let "nominal interest rates" slip past his
lips.)
It would be an overstatement to say that all fallacies in economics proceed from the
error of attributing objective value. But it might not be much of one. Objective value
is the luminiferous ether of economics. There is no such thing as value (objective
desirability) - there is only price (exchange rate on a clearing market). For example:
consider your house.
But what are these markets? Perhaps it's time to define them.
First we need to simplify our sound economy beyond physical reality, and assume
that all goods are both perfectly fungible (each unit is identical, like a barrel of oil or
a bushel of wheat - not like a house) and perfectly divisible (it makes sense to speak
of 2/3 of a barrel of oil, but not of 2/3 of a Ford Explorer). Goods exhibiting these
qualities are sometimes described as commodities - a confusing term, not
consistently applied. In any real reality, most goods are not fungible commodities.
However, once we understand the commodity-only problem, it is trivial to extend its
principles to the ordinary sound economy.
For every pair of goods - say, oil or wheat - there is a market. This is some trading
mechanism by which actors exchange oil for wheat and wheat for oil. For example, A
may give B a barrel of oil, in exchange for six bushels of wheat. For this transaction,
the oil/wheat exchange rate is one barrel to six bushels.
In revealed-preference terms, what this exchange tells us is that A preferred six
bushels of wheat to a barrel of oil, and B preferred a barrel of oil to six bushels of
wheat. Otherwise, they would not have made the trade.
But the interesting question is: why six? Why this exchange rate, not another
exchange rate? For instance, we know that A would prefer seven bushels of wheat to
a barrel of oil (because he must prefer seven bushels to six bushels, and he prefers six
bushels to the barrel). We do not know if B would prefer a barrel of oil to seven
bushels of wheat - but we don't know he doesn't. He certainly might. If he does, the
same A and B could conduct the exchange at seven barrels to the bushel, and both
walk away satisfied. Instead, they trade at six. Why?
The answer is that A and B get the oil-wheat exchange rate by participating in a
market. Ideally, this market contains all players who wish to make this trade. The
market clears when no trades are desirable to both sides - at the market exchange
rate, no A and B can be found who want to exchange oil for wheat.
Of course, preferences and players are constantly changing, so the market never
actually stops trading, and the exchange rate never stops moving. However, we can
imagine the first day on which the market opens, with oil moguls on the left side of
the floor and wheat barons on the right, all looking to establish an exchange rate.
This is the famous model of supply and demand. I dislike this terminology, because
it implies some qualitative distinction between A and B - between trading wheat for
oil, and oil for wheat. Of course it is arbitrary who is A and who is B, who gets to be
the numerator and who has to be the denominator. But the terms are unavoidable.
For this example, therefore, we'll speak of oil-wheat supply and wheat-oil demand.
The oil-wheat supply is the number of barrels of oil that will be exchanged for wheat
at a given oil-wheat exchange rate. So, for instance, the oil moguls might be willing to
provide only 15 million barrels of oil for five bushels a barrel - but for seven, you will
pry 40 million out of their hands. This implies that 15 million barrels are held by
moguls who would take five bushels or less, and 25 million are held by moguls who
will take seven or less, but no less than five.
The wheat-oil demand is the number of bushels of wheat that will be exchanged for
oil at a given oil-wheat exchange rate. So, for instance, the wheat barons might be
willing to let 150 million bushels go for five bushels a barrel, but only 50 million
bushels at seven bushels a barrel. Again, this implies that 100 million bushels are
held by those who would give more than five bushels for a barrel, but not more than
seven.
Our assumption of rationality tells us that more wheat is preferred to less wheat, and
more oil to less oil - whether you are a mogul or a baron. Therefore, we know that the
supply curve slopes up (more wheat per oil, more oil supplied), and the demand
curve slopes down (more wheat per oil, less oil demanded).
And - in case it isn't obvious - we see that the market clears where the curves
intersect. There is a single oil-wheat ratio at which, after a single set of trades, all
barons and moguls are satisfied and no further exchanges will be made. (Except, of
course, as actors and preferences change.)
Pretty much everyone understands "supply and demand" in this sense. However, the
critical point is that the market reveals preferences only at the clearing rate. It can
tell us, for instance, that the market clears at six bushels a barrel - at which point the
moguls are collectively willing to trade 20 million barrels of oil for 120 million
bushels of wheat, and the barons collectively willing to trade 120 million bushels of
wheat for 20 million barrels of oil.
The market does not reveal the shape of either curve, except at the intersection of the
two. It does not reveal how many barrels the moguls would release at five bushels a
barrel, or four, or seven. It does not reveal how many barrels the barons would want
at five, or four, or seven. This is one of the most important insights of 19th-century
economics - now you know where this blog got its name.
Great. Now, we understand markets. So clearly, for every two commodities in our
economy - oil and wheat, or silver and wheat, or wheat and corn, or oil and silver there needs to be a market. Since obviously, anyone can want to trade anything for
anything else.
Actually, this is not true. If we have n commodities, we don't need O(n^2) markets.
We only need O(n) markets. Whew! What a relief. You'll note that in real life, there is
no oil-wheat market - even though farmers drive tractors, and roughnecks eat bread.
Imagine a square matrix in which our n commodities are rows and columns. How
much real information is there in this matrix? Obviously, the oil-oil exchange rate is
always 1, and the oil-wheat and wheat-oil rates are the same thing. So half our boxes,
plus n, become blank.
But this is by no means enough blanking. Because we note an interesting fact - if this
entire marketplace clears, it cannot be possible to construct a cycle of exchanges
through which one ends up with more wheat, or oil, or silver, or anything, than one
started with. This is obviously a desirable trade, and yet in a cleared market there are
no desirable trades.
So the matrix is quite degenerate. There are only n-1 meaningful values. For instance,
if we know the exchange rate of oil to wheat, silver to wheat, and corn to wheat, we
can trivially work out the exchange rate of corn to silver. Wheat, in this example, is
our numéraire. In theory, any commodity can serve this role.
You might say: well, in that case, why wheat? Why not silver? Indeed silver seems,
just intuitively, like a much better denominator than wheat. Of course the commodity
generally used as numéraire is that generally known as "money," and of course silver
has served many societies as "money." And an exchange rate for which "money" is
the denominator is known, of course, as a price.
Note how far we have drifted from our medieval urge to objective value. Before this
little indoctrination session, you might have said your house was worth $400,000.
Now, you say that you feel confident in finding some party B who would exchange
400,000 dollars for your house - but much less confident in finding a B who would
fork over, say, 450K.
This is, of course, a case of hypothetical and unrevealed preference, until you
actually sell the freakin' house. Then, if you actually get 400, you may feel justified
in describing this as its price. (But then it's no longer your house.) The word price is
dangerous - you can feel it wanting to drop its denominator, and become a unitless
objective value. But it is impossible to avoid. One can only exercise the utmost
caution in its presence.
We could easily be satisfied in this definition of "money" - the standard denominator
for transactions. But the scare quotes remain. Because this definition is quite
unsatisfactory.
Again, the standard denominator of exchange is arbitrary - the numéraire could just
as well be wheat as silver. But somehow, in reality, it is often silver, and almost never
wheat. Why is this?
Indeed the numéraire is arbitrary, especially with modern electronic accounting. It is
a cosmetic role. We could indeed all do our books in wheat. But the intuitive
assumption - that whatever is the standard denominator for transactions, the
numéraire, becomes "money" - is quite wrong. The causality goes the other way
around. Money becomes the numéraire. There's something going on here, Mr. Jones.
The cosmetic role hides a much more important phenomenon: the anomalous
demand for "money." Intuitively, the commodities historically used as "money," such
as gold and silver, are not particularly useful to anyone. Yet they are highly sought
after. Carl Menger, whose theories on the subject are almost but not quite right, put
it like this:
There is a phenomenon which has from of old and in a peculiar degree attracted the
attention of social philosophers and practical economists, the fact of certain
commodities (these being in advanced civilizations coined pieces of gold and silver,
together subsequently with documents representing those coins) becoming
universally acceptable media of exchange. It is obvious even to the most ordinary
intelligence, that a commodity should be given up by its owner in exchange for
another more useful to him. But that every economic unit in a nation should be ready
to exchange his goods for little metal disks apparently useless as such, or for
documents representing the latter, is a procedure so opposed to the ordinary course
of things, that we cannot well wonder if even a distinguished thinker like Savigny
finds it downright 'mysterious.'
(Prof. Dr. Menger declined to comment on the still more advanced civilizations of the
20th century - which managed to dispense with even the metal disks. "Progress," he
muttered, and slammed his portcullis on your correspondent's toe. Inside, someone
cocked an arquebus.)
This anomaly provides our definition of "money." By UR's house definition, any
commodity which experiences Menger's anomalous demand is "money." By this
definition, if there is anomalous demand for silver, but none for wheat, silver is
"money" and wheat is not. But we can still construct a marketplace in which silver is
money, and wheat is the numéraire. It would certainly be weird - but it would work
perfectly.
Of course one can define this big, vague word, "money," however one likes. If you
define it as the numéraire, wheat is "money." But this would leave Menger's anomaly
without a name.
First we must discard one plausible theory of the anomalous demand, which is that
money's use as numéraire causes the anomaly (rather than vice versa). In our
abstract marketplace, this hypothesis is easy to falsify.
If you wish to trade oil for corn in a wheat-priced market, you do indeed need to sell
oil to buy wheat, and buy corn with that wheat. So you need wheat. However, your
demand for wheat is entirely transient - it exists only for the time it takes your trade
to execute. Thus the total stockpile of wheat required to lubricate a wheat-priced
market is the maximum amount of wheat that concurrently executing trades will use
in parallel. On an efficient electronic market, this number will be negligible. On a
really efficient market, it will be zero.
Thus, the use of wheat pricing in a marketplace creates no significant demand for
wheat in that marketplace. Thus, it cannot possibly be the cause of any such
anomalous demand. Similarly, if there is anomalous demand for silver, we know it
cannot result from the use of silver as a numéraire. Thus the causality can only run
in the opposite direction. First, silver experiences anomalous demand; then, it
becomes the standard denominator.
The actual cause of the anomalous demand is no big mystery. It is the natural desire
of many actors to make exchanges across time.
Rather than exchanging present oil for present wheat, an actor may wish to exchange
present oil for future wheat - for instance, if he has oil now and wants to make sure
he has bread next year. (In some cases this demand can be satisfied by a commodity
futures market, but this requires the actor to know exactly what good he wants for his
oil, and when. Certainty about one's future demand schedule is certainly not an
implication of rationality.)
Therefore, actors engage in a behavior for which the natural English word is "saving."
But this word was abused to well past an inch of its life by the 20th-century
economist. To be precise, therefore, I will call it "caching."
In caching, actor X exchanges A at time T1, for B at time T2, with two exchanges. At
T1, he trades A for some caching medium M. He then stores M until T2. At T2, he
trades M for B. Rocket science, this is not.
Key point: the demand is anomalous because X does not actually consume M. For
instance, if M is silver, X does not make jewelry out of it, use it as a paperweight,
pour it down Crassus' throat, etc. Therefore, ceteris paribus, use in caching increases
demand for M. Hence the anomaly.
If T2 equals T1, caching degenerates into the transient transaction described above.
Transient transactions do not create anomalous demand. Non-transient transactions
do. At any time T, we can observe a stockpile Sm - yes, the "money supply" - of this
marketplace. This is simply the sum of all M stored by caching actors. It clearly
represents new demand for M - and the longer the caching period (T2 - T1) of a
cache, the longer it contributes to Sm.
So, for instance, if you are paid in silver and live paycheck-to-paycheck, you make
only a minimal contribution to Sm, because you never hold very much silver. The
boss gives you a little leather bag of it on Friday; you blow it over the weekend on
Colt 45, cheeba and Doritos; which run out by Thursday; and so on. You are
conducting exchanges across time - but not much time. It is your boss's boss's boss,
the fat Armenian, with the big barrel of thalers in his basement, who really makes
money money.
Thus in the case of the anomalous demand, we see one stabbed corpse and one
bloody knife. And thus we feel comfortable in calling any widely used caching
medium money. Moreover, since cachers of silver are inclined to do their accounts in
silver, it is not hard to see how silver becomes the standard denominator of
transactions - the numéraire.
This does not tell us why silver is a good caching medium, and wheat is not. But it
gives us the tools to at least ask the question.
We must ask it subjectively, of course. From the perspective of actor X, wishing to
exchange A at T1 for B at T2, choosing some good to serve as M, what makes some
Ma better than some other Mb? Does this depend on: the nature of A? The nature of
B? Or the subjective desires of X?
Surprisingly, the answer is "none of the above." X's choice depends only on Ma, Mb,
T1 and T2. It is objective; it depends on future information, but objective future
information. If the exchange rate Ma/Mb at T2 will exceed the exchange rate Ma/Mb
at T1, with any storage-cost differential factored in, Ma is a better caching medium
than Mb. Otherwise, Mb is better. In either case, one medium beats the other for any
A or B.
In plain English, if Ma is appreciating against Mb across T1-T2, Ma is a more
desirable money than Mb. Otherwise, vice versa. Of course, this calculation must
include the cost of securely storing Ma or Mb for T2-T1, which is prohibitive for
many goods - salmon, for instance.
Of course, this requires X to know the future of two commodity prices (Ma and Mb).
This is by no means a trivial feat of prophecy - highly profitable, indeed, if it can be
done. But prophecy is in fact the least of X's problems. He has a worse problem. He is
in the land of game theory.
The trouble is that X is just one actor in a world of many other actors. And because
any widespread use of any Mx as money increases the demand to exchange any A for
Mx, ceteris paribus, it will also increase the exchange rate between A and Mx.
Moreover, if many actors use Ma for money but not Mb, the exchange rate Ma/Mb
will increase.
But wait - this is the input to our calculation. Unfortunately, it also seems to be the
output. The computation is self-referential. X is looking for a Nash equilibrium - he
needs a strategy that works well for him, assuming everyone else is using the same
strategy. Ie: game theory.
Fortunately, good mathematics never conflicts with good sense. So let us confine
ourselves to the latter, and apply it to our silver example. Starting from an imaginary
prehistoric point in which there is no money at all, suppose every X who produces
anything - wheat, oil, salmon, frozen concentrated orange juice, any A - chooses to
cache in silver, exchanging these products for silver.
Ceteris paribus, this new demand decreases the exchange rate from wheat to silver,
oil to silver, and anything else to silver. Ie, it raises the price of silver in wheat, oil,
and anything else - including other potential Mx, such as gold. Silver, previously a
minor industrial metal of minimal utility - pace Menger - experiences a rush of
anomalous monetary demand which greatly exceeds its previous industrial demand.
Thus, silver's price in wheat, silver's price in oil, etc, etc, all skyrocket. But most
important to the cacher, silver's price in the alternative monetary good - gold skyrockets as well. Thus if Ma is silver and Mb is gold, Ma/Mb skyrockets - since
everyone is caching silver, and no one is caching gold. So, assuming that everyone is
caching silver, everyone should cache silver. And this is our Nash equilibrium.
On the other hand, this logic is not metal-specific. It works exactly the same way for
gold. If everyone is caching gold and no one is caching silver, everyone should cache
gold and no one should cache silver.
And in the worst case for X, at T1 everyone is caching silver. Therefore, at T1, X
trades his wheat for silver, buying silver at the stratospheric price created by all other
silver cachers. Sadly, for reasons unknown, somewhere between T1 and T2, everyone
decides to exchange their silver for gold. They shouldn't, but that doesn't mean they
won't. Sadly, X is the last to hear of this trend.
When all the formerly cached monetary silver returns to the industrial silver market,
we have the reverse of anomalous demand - anomalous supply. Thus, ceteris
paribus, we would expect the price of silver in anything to be depressed below its
normal equilibrium. Of course the price of silver in gold will suffer the worst, for gold
is going up as silver is going down. So X buys high, sells low, and then has to buy
high again. Yea, truly is he jobbed in every orifice.
So what M should you cache? Confused enough yet? Let's take a step back and try to
profit from this confusion.
First, we see that at least one good must experience anomalous demand and become
money, because the pattern of caching is a human universal.
Second, we see that the problem is path dependent. We have yet to establish the
exact criteria that make a good M, but obviously multiple goods (silver and gold, in
our example) can satisfy these criteria. Yet it is perfectly possible to construct an
economy in which actors cache in silver but not gold, or in gold but not silver.
Third, we see that coexisting monies are unstable. A natural question is: given the
uncertainty, why not cache in both gold and silver? Why doesn't everyone just
diversify their portfolio, so to speak? This seems much more stable than picking one
of the two. In fact, it is much less.
The problem is that anomalous demand is a positive feedback loop. Suppose both
gold and silver are monetized. But they are separate goods, each with its own supply
and demand, so the bimetallic ratio, Mg/Ms, cannot be fixed. And once it starts to
drift in favor of either, cachers will recognize that drift and convert their caches to
the money which is gaining. Causing it to gain even more - positive feedback.
Eventually, one of these goods will be monetized and the other will lose its
anomalous demand. After suffering from anomalous supply, of course, while
industry works off the monetary stockpile.
(This actually happened, against silver and in favor of gold, in the late 19th century.
Gold and silver had coexisted as money since classical times, largely because the
world was an inefficient patchwork of gold countries and silver countries - China and
India, for instance, were on silver. As trade became global and efficient under British
hegemony, Britain being on the gold standard, silver could no longer compete and
was effectively demonetized.)
No matter how many goods you try to diversify your anomalous demand across, in an
efficient market this "Highlander effect" will leap up and bite you in the butt. Since X
is seeking a Nash equilibrium, he must assume that if he is diversifying, others are
following exactly the same strategy. Thus they are smearing their anomalous demand
across a basket of goods, jacking up the price of each a little rather than one a lot.
Nonetheless, what can be jacked up a little can also fall back a little - and will, as
anomalous demand concentrates in a single good, with the first to buy that good
profiting the most. "There can be only one."
And thus the problem is revealed as not a problem at all - under normal
circumstances. Under normal circumstances, the good to cache is the good that
everyone else is caching, ie, money. Under normal circumstances, no one sees the
origin of money - money is already there. All the anomalous demand is concentrated
into a single good. That good is money, and no grasp of game theory is required to
tell what good it is. If a time machine transported you into any normal, sound
economy, it would be immediately obvious.
Under normal circumstances, it is extremely imprudent to cache in any other good
than the standard money of the economy - eg, to cache in gold, when the standard is
silver. Why? Because if you are doing it, other people are probably doing it, too. You
are probably not the first. Thus you are paying a monetary premium for your gold,
and thus caches already exist. If more people buy in after you, if more anomalous
demand appears, the premium will increase and you will profit. But if at any point
this trend reverses, it has nowhere to go but down, and you will get jobbed as
described above. You can only win if gold takes silver's head and emerges as the new
monetary standard.
This pattern may seem familiar to you. There is actually a word in English for an
abortive attempt to create stable anomalous demand. That word is "bubble."
Anything - a metal, a baseball card, a worthless Internet stock - will keep going up if
people keep buying in. Anomalous demand. Also referred to as the greater fool
theory.
But there only has to be one good which experiences stable anomalous demand. That
good is money. Money is the bubble that doesn't have to pop. Any good that tries to
replicate this stability alongside the current monetary standard will either (a) replace
that standard, or (b) pop. Probably the latter. If your Internet stock does not actually
have a chance of becoming the new global currency, therefore, you are well advised to
price it as if no anomalous demand existed - and avoid the greater fool theory.
Intuitively, you can think of a monetary system as a sort of battery. When actors
cache in silver, they are charging the silver battery - pressurizing the bubble that
doesn't have to pop. When they spend their caches, they are discharging the battery.
Naturally, the exchange rate between wheat and silver is set by the collective desire
to exchange silver for wheat - discharging the battery - and the collective desire to
exchange wheat for silver - charging the battery.
This analogy breaks down in one important place: there are no units with which we
can measure the "charge" of the battery. All we see is the set of exchange rates
between other goods and silver. Each of these exchange rates has the same
denominator - silver - and a different numerator - oil, wheat, etc. We can no more
mix them in calculation than we can add furlongs to bushels. Broadly, we can see that
silver must be money, because we observe Menger's anomaly - its desirability is
completely out of whack with its utility. But there is no precise means by which we
can quantify this anomaly.
In practice, however, we see that the anomalous demand for a standard monetary
good is so great that the normal, industrial demand appears negligible. It can even be
zero, although it cannot have always been zero - or no one would have cached the
good in the first place, worthless objects being worthless, and it would not have
become money. However, once the good is standardized as money, it is stable and
can be as useless as it likes.
If we assume for purposes of argument that anomalous demand is the only demand
for money, we observe an interesting phenomenon first noted by Hume. Since money
is not used by those who cache it, a supernatural force which replaces every gram of
silver with two grams - assuming said force rewrites all contracts which mention
silver accordingly - will leave the economy exactly the same. Everyone who,
yesterday, was willing to exchange a bushel of wheat for a gram of silver, will today
demand two grams of silver. The charge in the battery is unchanged; its size is
doubled and its density is halved.
But note that this assumes an identical distribution of the silver. If our supernatural
force doubles the amount of silver in the world by quadrupling the caches of
Americans, while leaving the caches of the unfortunate Europeans alone, we will see
increases in the exchange rate of pickup trucks to silver, but not in the exchange rate
of escargot to silver. As for goods that both desire, the Americans will get more and
the Europeans less. This is known as the Cantillon effect. Our simplistic battery
analogy has no room for it.
Likewise, our supernatural force can create a zillion tons of silver without affecting
prices at all, if those zillion tons are placed in the custody of an actor who does not
spend them (ie, whose demand for any good is zero at the present price). Again, our
battery analogy has no room for this weird corner case. The lesson: use the battery
analogy, but be aware of its limitations.
We are now in a position to understand the qualities of a stable monetary
commodity. First and foremost, money must hold a charge - it must respond to
anomalous demand with a stable increase in its price vector. It must not respond to
anomalous demand by a mere increase in production.
Thus we see the difference between silver and wheat as monetary candidates. Wheat
is a fungible and storable commodity - it has storage issues, but let us disregard these
for a moment. It is not transportable, but electronic warehouse receipts can
surmount this. The problem with wheat as money is that no amount of anomalous
demand can increase its price above the cost of farming, which can generate an
indefinite amount of wheat.
In the battery analogy, wheat leaks. Suppose that the world is on a silver standard,
when suddenly our supernatural force destroys all silver and removes the very
element from the periodic table. The market must choose some new money. If some
set of actors try to treat wheat as money and buy into a wheat bubble, they will not
send the price of wheat to the moon as they build up their caches. Rather, they will
generate an arbitrarily absurd stockpile of wheat. Meanwhile, those who bought gold
instead will be sitting on their profits. The wheat bubble will pop, the wheat stockpile
will be sold as food, the wheat cachers will get jobbed.
Compare this to a precious metal, such as gold or silver. These are monetary metals
precisely because of their restricted supply. Mining precious metals is an exercise in
diminishing returns - the more you extract, the more expensive it becomes to extract
more.
If our present accursed monetary system were to vanish from the earth, the ideal
monetary replacement would be gold rather than silver, simply because annual gold
production (leakage) is only about 3% of the global monetary stockpile (which is
large, because gold retains a nontrival monetary role.) This is very significant
leakage, but it is much less than the leakage in silver - in which annual production is
comparable to the global stockpile. Thus it is much harder to monetize silver,
because early buyers will be diluted by a much larger wave of new supply.
Since we understand supply and demand, we can see that any new money produced
satisfies and thus cancels our anomalous demand. Since we understand that the
anomalous demand for money is self-dependent, we see why people take leakage so
seriously. Indeed there is another name for monetary leakage - "counterfeiting." On a
natural metal standard, mining of metal is the precise equivalent of counterfeiting.
Leakage is extremely dangerous not just because it effectively equates to mass
confiscation, but also because it destabilizes the monetary standard itself. Assuming,
as in Hume's example, that leakage is uniformly distributed (which it won't be), we
would expect to see a natural upward drift in all prices as anomalous demand is
diluted. Note that this includes prices of potential competing moneys - Mb to the
present standard Ma. If silver leaks, wheat prices in silver will tend rise - but so will
gold prices in silver. (Assuming that gold does not have its own issues.)
And when Mb/Ma is increasing, we know what this tells us. It tells us that gold is a
better metal to cache than silver. If this trend can run to completion, replacing silver
with gold as a monetary standard, it may well do so. And there is no reason it has to
do so slowly. The result will be a monumental economic cataclysm in which wealth is
redistributed from the aforementioned argentiferous Armenians to a new generation
of aurophilic speculators - almost certainly Jewish. Few political systems can
withstand such an event, good for the Jews though it is.
In an ideal monetary standard, the stockpile of money would be fixed, and there
would be no mining or counterfeiting whatsoever - and thus no leakage. No natural
good satisfies this criterion, but artificial commodities can be constructed - ie, "fiat
currencies." Thus we see another counterintuitive truth: a fiat currency can in fact be
a better money than gold or silver. Unfortunately, it also lends itself much more
readily to pathological abuse. Paul Erdös became a world-class mathematician by
taking speed; you or I would just become speedfreaks.
We now understand money. Which means we're almost done! All we need to
understand is interest and the loan market.
Loans are extremely simple. A loan is a promise of future money. Specifically, it is
the promise, written by some party Y, to pay some quantity Q at some future date D.
The price of this loan is the price of future money in present money, modulo the
probability that Y is a scumbag or loser and will default on the loan.
Default risk is easy to factor out of this equation, so let's just deal with it now. How
does a market estimate the probability that a loan will default? This probability itself
can be isolated and sold, via an instrument such as the (unjustly) notorious creditdefault swap. Thus, the price of a risky loan is the price of a risk-free loan, minus the
price of a risk-free CDS on said loan.
A CDS market is a case of a prediction market. How do prediction markets predict
the future? Magic? No, supply and demand. If you think the price of a prediction
instrument does not match its actual probability of payout, and you are right, you
profit. If you are wrong, you lose. There is no magical law which requires the
intersection of supply and demand to equal the actual probability - in fact, defining
"actual probability" is itself an almost magical challenge.
Thus, the price of a prediction instrument is only as good as the collective
intelligence of its participants. Successful prediction markets, such as Vegas for
sports, are very hard to beat, because they have been active for a long time and
experienced a Darwinian effect - gamblers who know their sports win and keep
playing, gamblers who don't lose and drop out. Exactly the same effect is seen in any
non-dysfunctional financial market.
Even without these exotic instruments, loans are easy to standardize by estimating
default risk and constructing pools of diversified loans, thus putting the central limit
theorem on your side. One loan with a 5% chance of default is a very scary thing to
buy, but an equivalent share in a pool of 100 uncorrelated loans, each with the same
chance of default, is much easier to handle. Of course, the probability must still be
estimated, but this is a well-known profession - estimating the default probability of
loans is (in a sound economy) the job of "banking." Like any job, it's not easy but it
can be done.
With that said, let us analyze the loan market assuming zero default risk. Again, the
price of a loan is the price of future money in present money. This is always less than
1 - eg, a 2011 gram of silver might cost 900 milligrams in 2010 silver.
But what does this mean? Why does this market exist? Let's look at the demand and
supply sides separately.
Consider our cacher X again. Under what circumstances should X buy a loan?
Answer: X should buy a loan if, and only if, he knows his T2 - the date at which he
will spend his cache. If his T1 is 2010 and his T2 is 2011, he will have more silver in
2011 if he buys 2011 silver with his 2010 silver, rather than just caching his 2010
silver until it turns into 2011 silver.
But wait - is this leakage? Does the existence of a loan market decrease anomalous
demand? Not at all. The silver cache has just been transferred - instead of X holding
the silver, it is Y, the borrower. Neither anomalous demand nor the silver stockpile
has changed in the slightest.
A more interesting question is why X should not buy a loan if he does not know his
T2. He has a barrel of silver in the basement - he might want to spend it on
something in 2010, or he might want to spend it on something in 2011. Suppose he
just buys a 2011 loan, anyway? A loan is a negotiable instrument - anyone can resell
it. If X decides that he wants to spend his cache in 2010, he can just sell the loan on
the open market, get the money back, and spend it.
As it happens, we have already solved this problem. We solved it above in our
discussion of anomalous demand. X, when he performs this unnatural act, is caching
a good (the loan) which he may, or may not, use as money - buying and reselling, as
above. If he turns out to actually want 2011 money, he has correctly anticipated his
future desires and is not using the loan as money. Otherwise, his demand is
anomalous. If he is the only one doing it, fine - his actions will have a minimal effect
on the market. But he won't be.
Any societal pattern of such behavior will create exactly the same bubble
phenomenon that we see in any failed attempt to create an alternative money. When
the herd of Xs, who should simply be caching money, buy 2011 loans, they drive the
price of 2011 loans up (lowering interest rates). When they sell 2011 loans - because
they actually wanted 2010 money, not 2011 money - they drive the price of 2011
money back down. Therefore, unless they get into the bubble early and out early,
they get jobbed. Just as in any bubble. Lesson: don't buy any good you don't intend
to use, unless that good is money.
We also see that the longer the term of the loan, the lower the market demand for it.
For any X, two one-year loans, strung back to back, is an adequate substitute for one
two-year loan. But for an X whose T2 is in 2011, not 2012, only a one-year loan will
suffice. Thus the longer the loan, the fewer buyers who can use it.
In real societies, however, demand for long-term loans is quite nontrivial. If you
intend to retire 20 years from now, it is quite reasonable to buy a 20-year loan to
fund your retirement. As we'll see in a moment, you will get a better interest rate
than if you strung out 20 one-year loans in a row.
Now, let's consider the supply of loans. Who would sell a loan? There are many
reasons to borrow, of course, but generally the borrower is involved in some
productive endeavor. Your endeavor certainly has to be productive if you're getting
900 kilos of silver in 2010, and turning it into a metric ton in 2011.
On a precious-metal standard, the simplest form of productive enterprise is a mine.
You spend your 900 kilos digging the hole; you pull a metric ton out of the hole. A
business that earns its return through commerce, rather than monetary production,
looks no different to the lender.
The important point about productive enterprise is that production always takes
time. There is no possible enterprise that can turn 900 kilos of silver into a ton of
silver in one second. This dictates the term of the loan.
And again we see that the supply of 2-year loans will exceed the supply of 1-year
loans at any interest rate - because an enterprise that produces return after 1 year can
sell a 2-year loan by selling one loan after another, whereas one that actually takes 2
years is quite ill-advised to sell a 1-year loan. (The result being the inverse of the
bubble scenario described above.) If you ever see an Austrian economist talking
about "more roundabout means of production," all he means is this.
When we combine these supply and demand functions, we learn something very
important about the sound economy: that its yield curve (the market interest rate for
every term) slopes upward.
Interest rates at longer terms are higher than those at lower terms, because loan
prices are lower at longer terms; longer loan prices are lower because the demand is
lower, and the supply is higher. No ceteris or paribus is necessary. If you see an
inverted yield curve, you know that you are looking at a very, very sick loan market.
Don't walk away - run away.
Which brings us to our final subject: pathological economics.
Barring bizarre and unforeseen real-world phenomena, such as a zillion-ton asteroid
of silver landing in Brazil, a sound economy is stable. Supply is always equal to
demand, bubbles do not exist in commodities or financial instruments, and the
monetary standard suffers only negligible leakage from counterfeiting or mining.
Unfortunately, misgovernment is the fate of man. Misgoverned economies appear to
be an especially eternal fate. In fact, there are almost no historical cases of a sound
economy as described above. Someone is always screwing up something.
There are two basic patterns of economic misgovernment. One: the government fixes
prices. Two: the government tampers with the monetary system. The former is
heinous; the latter is diabolical.
Fortunately, just about everyone knows the effect of price-fixing: surplus or shortage.
Somehow, the principle of supply and demand has actually become part of
democratic folk wisdom, like multiplication tables, the names of the Greek gods, and
pressing "1" to get your voicemail. We must be thankful for this mercy, which surely
cannot last forever.
The simplest way to tamper with the monetary system, known since well before Jesus
was a little boy, is to debase a metallic currency. The state simply forces its subjects
to accept the debased currency at par with the old, good money - eg, to accept an
alloy of silver and nickel in payment for debts in pure silver. Thus it creates leakage,
without actually creating silver. It taps the battery.
In many cases, debasement is more convenient than taxation, to which it is obviously
equivalent. Some remarkably effective governments have employed it. For instance,
during the Seven Years' War, Frederick the Great (fighting for Prussia's life against a
coalition of all the surrounding countries) debased the currency. Of course, he also
restored it within a year after the war. That's because he was a king, not a professor.
But I digress.
Far nastier is the practice of debasing the currency with loans. Thus, rather than
being compelled to accept a silver-nickel alloy as silver, subjects are compelled to
accept a promise of future silver (typically written by the government or its closer
friends) as present silver. The output of this leakage is not silver, but lower interest
rates. The practice is especially insidious because its blessings are visible to all
borrowers, whereas the curse of monetary dilution is almost invisible.
Modern fiat currencies were not, like the optimal fixed-supply fiat currencies I would
like to see, created all at once by actual fiat. They were created by incremental loan
debasement. The 19th-century classical gold standard is quite misnamed, for
instance - it was not actually a gold standard, but a pound standard. Behind the
pound sterling was a certain amount of gold, and a certain amount of British national
debt - denominated in gold. Not at all the same thing.
The pound, of course, was "convertible" into gold. Similarly, shares in Bernie
Madoff's Ponzi scheme were convertible into dollars. Many people converted them
into dollars, and felt convinced as a result that they were "worth" dollars. Of course
they were simply shares in the underlying assets, and could be worth no more or no
less.
Thus a pound was a share in a pool of gold, and a pool of British debt - the latter
larger than the former. After WWI, the latter became grossly larger than the former;
the pretence could no longer be sustained; and Britain "went off gold." In reality it
had not been "on gold" since the 17th century. It had been running a hybrid currency
- part gold and part fiat. The fiat quality arose from the fact that Britain's national
debt, though denominated in gold, could not be paid in gold. Thus in gold terms
these were simply bad loans, ie, worthless paper - ie, fiat.
Normally, in a bankruptcy, debt becomes equity, and so the old gold-denominated
government debt morphed (without any formal process) into its modern state of
government equity. And thus we see the modern fiat currency, a unit of which is
essentially a share in the government. Without voting rights or dividends, alas, but a
share nonetheless. Equity is the lowest tier of debt. If a note confers no rights, it is
equity.
On an (open-ended) fiat currency the potential for pathological finance is almost
unlimited. For instance, perhaps the most pernicious practice of fiat finance is the
issuing of loan guarantees, which now in USD total in the tens of trillions. A loan
guarantee is simply a camouflaged loan, disguised for the usual corrupt reasons.
When the government guarantees A's loan to B, what is really happening is that A is
lending to the government and the government is lending to B. Thus, for instance,
when FDIC guarantees your loan to your bank (a "bank deposit"), you being A and
the bank being B, you are lending to USG (whose payment is sure, because the loan is
denominated in USG's own equity), and USG is lending to the bank. The latter is the
corrupt transaction; the former is the disguise.
But we could go on in this vein forever. Again, the point to repeat: there is no simple
or gradual way to unwind a pathological financial system. It must either collapse or
be destroyed. On the other hand, there is no reason it can't survive forever, like a
Cuban truck - stinking horribly, bellowing like a bear giving birth, and running no
faster than fifteen miles an hour. All we can hope is that, however it turns out, it will
be good for the Jews.
Gold and the central banks: the game theory
"About to" was definitely an overstatement! But since I first discussed the matter in
2006, the world has made remarkable strides towards understanding the monetary
role of gold. I doubt this has anything to do with "John Law," but you never know perhaps his post is responsible for a buck or two of the price. All kinds of people read
teh Internets.
In case anyone with a lot of dollars is reading today, my position on the gold price is
the same as in 2006. If gold will eventually be remonetized, gold is insanely cheap. If
gold will never be remonetized, gold is insanely expensive. It's one or the other.
Therefore, if you guess right about this question, you will make huge profits, and if
you guess wrong take huge losses.
Your guess is probably better than mine, so I will refrain from making one. I note,
however, that in 2006 the remonetization of gold was a decidedly fringe perspective.
Now it appears regularly in the headlines. It is still a long way from happening. So
there is plenty of time to hop on this bandwagon before it either rolls to glory, or off a
cliff.
My specific prediction for the future of the gold-dollar exchange rate is: if there are
more sellers than buyers, the gold price will go down. Otherwise, it will go up. You
can quote me on this.
Aside from the traditional jewelry markets, which remain quite important as a
demand contributor, what sets the gold price is the balance of buyers and sellers in
the market for monetary or "investment" gold. If money is moving into gold, gold
goes up. If money is moving out of gold, gold goes down. Given the existence of
involuntary sellers (such as gold miners), some money always has to be moving in.
(Actually, I've never really understood why gold miners sell gold, beyond recouping
the cost of mining. Why don't they just retain all profits, in gold, on their balance
sheets? Why resort to old-fashioned dividends? That's certainly the way we play it
here in Silicon Valley. All the more so for a gold miner which voluntarily sells gold,
and whose shareholders are thus betting both ways in the gold market. Ideally, of
course, the shares of a gold miner would be priced in gold, but this is really asking
too much of 21st-century financial innovation. The 22nd might get to it.)
There is some interesting news on the flow front, which is that central banks have
become net buyers, rather than sellers, of gold. Obviously, this trend changes the
flow and drives the price up. If it reverses, of course, the gold price will go back
down. Most industry observers believe that reserve-accumulating central banks will
continue diversifying into gold. I am not an industry observer, but I agree.
Now, here is the interesting part. The game-theoretic process which in the past has
selected gold and/or silver as monetary goods, which may just as easily operate in the
future, and which may even be starting to operate now, is a form of distributed
coordination. Previously, I have described this coordination game as a game
involving a large number of small players - retail investors, as Wall Street would put
it. However, the game theory works just as well for a small number of large players.
Such as the central banks.
Moreover, the game theory only works if the players understand it. This is the nature
of any Schelling point. Understanding can spread more easily among a small number
of large players, than a large number of small players. Therefore, it seems like a fun
exercise to restate the theory in these very different terms. After all - anyone can read
teh Internets.
The accumulating CBs (China, Russia, India, Japan, the Gulf, etc) face a simple
problem. Some good has to be the international reserve currency, and thus
experience price appreciation due to monetary demand. At present, this good is the
dollar (and dollar bonds).
The dollar, however, is diluting at a rapid pace, owing to the fiscal incontinence of
USG. If you consider the dollar as an sovereign equity instrument, which I do, USG is
in what looks a lot like an equity death spiral. USG is continuously issuing large
amounts of new equity to finance its operations. This could end well, but history does
not suggest that it will.
(Dollar as sovereign equity, Cliffs Notes version: the dollar is not a debt, since it is
not a promise of anything. It must therefore be equity. If the dollar is a share, a dollar
bond is a restricted share. For a fully-diluted valuation, restricted and contingent
liabilities must be included.)
Thus, central bankers (such as those in Beijing) feel their assets are performing
badly. This can easily be made a media issue. Which might involuntarily affect their
careers. Thus, they seek other currencies in which to park their cash. Preferably,
currencies which are not falling like a rock.
However, central bankers have a unique investment problem which you and I do not
face. They have so much money that, anywhere they put it, they will move the
market. For example, if reserve managers worldwide switch half their dollars into
GBP, the following events will occur - coefficients are entirely random:
1. The pound goes up to $8.
2. Britain's economy collapses.
3. The BNP seize power and print trillions of pounds to pay their skinhead armies.
4. The pound goes back down to 10 cents.
5. The central banker loses the people's money and is hanged in the street by mobs.
If you are anyone who has large amounts of money, central banker or no, your goal is
to spend that money in a way that does not move the market. Ideally, you would like
to buy at a price set by supply and demand (not including you). You would rather not
buy at a price set by supply and demand (including you). This is a tricky task in
which many are paid much to succeed.
Market-moving purchases - as we'll see later in the program - pose a special
challenge to accounting. They create what George Soros calls reflexivity. Standard
14th-century Italian double-entry accounting, while perfect if you are running a
bodega, is not capable of handling this matter. Because central bankers are not used
to thinking about monetary game theory, and have no idea how to integrate this with
their 14th-century accounting, they fail to see the optimal strategy.
The problem that breaks Florentine accounting is: if I drive the market up by buying,
how should I value what I just bought? Should I mark it to the market price? If so, I
am marking it to supply and demand (including me)? Or should I mark it to the price
I could sell it for? If so, I am marking it to supply and demand (not including me).
The larger the position, the larger the difference between demand (including me) and
demand (not including me).
Suppose, for example, that you have 50 billion dollars, and you use this stash to buy
the entire 2008 and 2009 peanut crops. You triple the price of peanut contracts.
Congratulations! Your position is now valued at $150 billion. You've made a 200%
profit. You've made money just by marking to market. You should be a spammer.
This is called "market manipulation," or more specifically "cornering the market,"
and it happens to be illegal. But even if it was not illegal, it would be unprofitable,
because you cannot generally profit with this strategy - as you sell, you are driving
the price back down. Your peanut contracts are valued at $150 billion - but can you
get $150 billion for them? You can't buy lunch with peanut contracts.
This is called the burying-the-corpse problem, the corpse being the vast quantity of
peanuts that you have bought but don't intend to eat. The accounting profit is indeed
a mirage. Unless of course you can bury the corpse - ie, get some other fool to take all
those peanuts off your hands, at anything like the inflated price you have created.
There is an easy way to avoid this entire weirdness. Spread it around. Diversify. Don't
make market-moving purchases. For the standard large investor, and doubly for the
standard central banker, distorting the market with a purchase is considered a rookie
mistake.
Thus the old-school CB answer to gold, now just beginning to fade. When asked why
a return to the gold standard is impossible, the standard answer is: "there isn't
enough gold."
What this means is that the stock of monetary gold is relatively small compared to
the number of dollars it would have to absorb, were gold to replace the dollar as the
international reserve currency. (Ie, not even considering the awful possibility that
ordinary citizens decide to redirect their savings into the yellow dog and 100%backed instruments, obviating the entire concept of a reserve currency.)
Thus, if CBs buy large quantities of gold, they drive the gold price up. Or more
precisely, if they exchange large numbers of dollars for gold, they drive the golddollar ratio up. Or at least, so theory predicts. And for once, practice seems to match
theory - at least, in China:
―Gold is definitely an alternative, but when we buy, the price goes up. We have to do
it carefully so as not stimulate the market,‖ he said.
Indeed. Hu Liaoxian is even trying to jawbone the gold market down:
―We must keep in mind the long-term effects when considering what to use as our
reserves,‖ she said. ―We must watch out for bubbles forming on certain assets and be
careful in those areas.‖
[...]
However, officials in Beijing are aware that China’s $2.3 trillion reserves are now so
enormous that the central bank cannot buy much gold without distorting the price,
so they have adopted a de facto policy of buying in a calibrated fashion each time
prices fall back to their rising trend line – ―buying the dips‖ in trading parlance.
Experts say that China is putting a floor under the gold price but does not chase
rallies once they are under way.
Either Mr. Cheng and Ms. Hu do not understand the game theory of monetary
formation - or they do and they are playing it close to the chests. If they - or their
colleagues - ever figure out the game, God help the dollar.
When a CB buys gold, four things happen. One: the CB insures itself against the
chance of gold remonetization. Two: the chance of gold remonetization increases.
Three: the gold price goes up. Four: the buyer looks good, because the assets he
bought went up.
How is this different from buying the pound, or buying peanuts? Because the price
increase in the pound, or in peanuts, is unsustainable. What goes up has to come
back down. For their own different reasons, the pound and peanuts are incapable of
absorbing total global monetary demand, and acting as a stable international
currency. Therefore, a sophisticated investor of large money avoids generating
phantom profits by distorting the market in pounds or peanuts.
With gold, it is different. What goes up can go back down, as it did in the '80s. (In
1980, it looked rather as if gold was to be remonetized. Then Volcker saved the dollar
with 20% interest rates. Of course, at the time America was also a net creditor.) But
because we know that gold is a viable monetary system, we know that when gold goes
up, it does not have to come down. If it doesn't come down, that means gold has been
(re-)monetized. Peanuts cannot be monetized - they cannot become arbitrarily
expensive. Gold can. Therefore, the decision calculi for gold and peanut purchases
are fundamentally different.
The gold price has been increasing at roughly 20% a year since 2001. Perhaps
coincidentally, the global dollar supply is diluting at rates not too different from this.
Betting on the continuation of this trend is not difficult - one the way to bet on it is to
buy gold. Which causes the trend to continue. Reflexivity! The dollar itself is a
bubble, held up by the monetary demand for dollars - and the dollar does not appear
to be an especially stable currency.
Thus there is an entirely different Nash equilibrium out there - one in which all the
central banks dump the dollar for gold. This causes the gold price to skyrocket,
creating permanent profits for all the reserve-accumulating central banks.
Don't believe me? Think about it. When remonetization is complete, by definition the
CBs will be computing their accounts in gold. Since the price of gold in dollars, under
this scenario, is much higher than it is today, it will look like the CB made an
enormous profit on the transaction: in exchange for green pieces of paper, now of
minimal value, it received good gold. Or it was foolish and held on to the green
paper, in which case its bankers are lynched in the street.
This is a self-reinforcing feedback loop. The more gold the CBs buy, the more
incentive they have to buy gold. Because if the game ends with gold winning, the
game will be scored by how much gold you got for your dollars. This will be a
consequence of how soon the CB exchanged its dollars for gold. Devil take the
hindmost! A classic panic scenario. A melt-up for gold; a melt-down for the dollar.
In other words, when gold is remonetized, the numerator and denominator on the
"gold price" are exchanged. The relevant price is now the "dollar price." What is a
dollar worth? How many milligrams of gold can you trade it for? This piece of paper
is a financial security, n'est ce pas? Does this security yield gold, own gold, redeem
itself for gold, etc? No? If you want it to be worth anything, you might want to change
that...
Here is the difference between gold and peanuts. No one will ever ask how many
peanuts a dollar is worth, because peanuts will never be a monetary good. For one
thing, it is too easy to grow them. Gold can be monetized, and peanuts cannot be
monetized, because of fundamental physical differences between gold and peanuts.
Every monetary system is a self-supporting market-manipulation scheme of this
type. As Willem Buiter points out, money is the bubble that doesn't pop. In a free
market, a currency is stable if and only if the currency is reasonably watertight and
does not dilute much. In this panic - the same panic "John Law" anticipated - we see
the "dollar bubble" popping, and a new "gold bubble" forming. If someone finds a
way to print gold, of course, the gold bubble will pop and some other good will accept
its monetary demand - rhodium, perhaps. Or baseball cards.
So, if Cheng Siwei and Hu Xiaolian understood the game theory, they might go ahead
and "stimulate the market." China cannot prevent her purchases from stimulating
the market. But she can ensure that when she stimulates the market, she stimulates it
first - thus getting the best price. And thus ending up with the most gold.
Collectively, the central bankers of the world might agree that they do not want gold
to be remonetized. Individually, it is in their interest to defect from this consensus.
As the American Century decays, individual motivations tend to become more
prominent. You and I are not in a free market - but the central banks are.
And there is another individual motivation that CBs might have for remonetizing.
Suppose a large exporter, such as China, which undervalues its currency and runs a
large trade surplus as a result, takes a huge radical step and goes all the way to a
100%-reserve gold currency. The ultimate hard currency. If this succeeds, China is
the new England - the financial capital of the world, forever. Everyone else's money?
In a word: pesos. Hard currency is Chinese currency. China's natural supremacy over
the barbarian kingdoms of the West is restored.
There is a practical problem with Chinese remonetization: China has very little gold.
Even after the PBoC converts all its dollars to gold - even at the gold price generated
by this conversion - it will not have enough gold to back all the yuan in circulation. At
least, not at the present yuan-dollar ratio.
When a CB fully remonetizes by converting its balance sheet to hard gold, a fiatcurrency note becomes an equity share in the central bank's gold pool and can be
valued as such. What is the share worth, in gold? What are the central bank's assets,
measured in gold? Same question. If the CB has 1000 tons of gold and has issued 1
trillion notes, each note is worth a milligram of gold. Gold accounting - not so hard.
In other words, to fully remonetize to gold, China (or any country, even the US with
Fort Knox), will have to devalue its currency. The entire event obviously devalues all
fiat currencies against gold, because it sends the price from $1000 an ounce to
something more like $20,000. But since the US has a huge hoard of gold, the dollar
needs to devalue less against gold than other currencies, such as the yuan. Thus, in
any full remonetization, China must devalue the yuan against the dollar.
Now: class, what is the economic effect of a devaluation? What are central bankers
around the world struggling desperately to accomplish? Same question! The answer
is: "stimulus." Devaluation is inflationary; inflation is a stimulant. Age-old economic
truths. China's low gold reserve is not a problem, but an opportunity. It is not a bug but a feature.
Of course, if you resort routinely to devaluation or any other stimulus, you become a
stimulus junkie. You get chronic inflation - fiscal needle-tracks. But this cannot
happen as the result of remonetizing to gold. Because - duh! At the end of the game,
your economy is on the gold standard. You are a healthy financial and industrial
power, not a strung-out inflation junkie. England in the 1870s, not Argentina in the
1970s.
And ideally a you've gone all the way to a 100%-reserve hard-money standard, which
means no more booms and busts. So, when I propose remonetization, what I'm
saying to central bankers is the equivalent of saying to a heroin addict: after a hit of
this junk, you'll feel so high for so long, you'll never want to shoot up again! If you
can find a junkie who wouldn't take this offer, your country has some very unusual
junkies.
In previous centuries, the phenomenon we know as a "recession" was sometimes
described as a "shortage of money." I too am experiencing a shortage of money - can
anyone give me some money? Doesn't everyone have a shortage of money? But the
term, which seems silly, is actually quite reasonable - a shortage of money is actually
an excess of debt. An economy experiences a shortage of money when it has run up
unsustainable debts. It is collectively bankrupt. Its actors tend to find themselves
individually bankrupt as well. Hence, recession.
For instance, the classical gold standard of the Bank of England era failed because,
after World War I, the gold cover (ratio of CB-guaranteed gold debts, to CB gold) was
just too high. This, too, was a shortage of money - a shortage of gold. The correct
answer would have been to share the pain equally all around, by devaluing the pound
and other currencies against gold - ie, making them reflect their actual gold value.
But this was too politically painful; so instead, the entire system was allowed to
collapse. Some consider this a good outcome.
But the global economy does not have a shortage of gold. It has a shortage of dollars.
It is not oppressed by unpayable gold debts. It is oppressed by unpayable dollar
debts. (If lending were restricted to self-interested market actors who need a dollar to
lend a dollar, ie not the Fed, you'd really see that shortage.) When you revalue gold,
carried on the balance sheet at $42 an ounce, to the post-remonetization price of tens
of thousands an ounce, what are you doing? Creating one heck of a lot of new dollars.
Therefore, if Cheng Siwei and Hu Xiaolian follow my advice, join the bubble instead
of fighting it, and unilaterally remonetize with devaluation, China should experience
the following results:
First: dramatic stimulus to the Chinese economy. Second: dramatic inflow of gold
into China. Third: dramatic, but temporary, inflation, in the context of boom
conditions and general prosperity. Fourth: eventual stabilization, with China a
wealthy First World country which is the world's financial and industrial leader.
Fifth: large gold-plated statues of Cheng Siwei and Hu Xiaolian are erected all over
China.
Of course, remonetization would also produce enormous profits for gold speculators.
Ie, anyone else who jumps on the bandwagon. Currency transitions are inherently
turbulent processes. Central banks, as they should, hate turbulence.
On the other hand, if there is no option but to make the transition, it may be better to
rip the band-aid off fast than slowly. It is certainly better to understand the situation
- and once you understand it, the outcome seems difficult to resist. As in many cases,
the CBs may just need to move faster and more decisively than the speculators.
The reason I still expect gold remonetization to happen - in the long term, not
tomorrow! - is that there's simply no other viable alternative. Everyone knows that
the global economy needs a new currency. Most can see that the dollar cannot be
saved or replaced by any other sovereign currency or basket thereof - because no
central bank could tolerate the economic effects of the upward revaluation that
would result if its currency replaced the dollar in CB portfolios. When the impossible
is eliminated, the improbable becomes a certainty.
Expiring liquidity facilities: bad plan, Stan
The Fed, ensuring a busy quarter ahead, tells us:
In light of ongoing improvements in the functioning of financial markets, the
committee and the board of governors anticipate that most of the Federal Reserve’s
special liquidity facilities will expire on Feb. 1, 2010, consistent with the Federal
Reserve’s announcement of June 25, 2009. These facilities include the Asset-Backed
Commercial Paper Money Market Mutual Fund Liquidity Facility, the Commercial
Paper Funding Facility, the Primary Dealer Credit Facility and the Term Securities
Lending Facility.
Thankfully, this date for a fully-loaded round of financial Russian roulette comes
with a caveat:
The Federal Reserve is prepared to modify these plans if necessary to support
financial stability and economic growth.
Ya think?
I am not, of course, any kind of financial analyst. My comments do not constitute
investment advice, never have, and never will. But sometimes a nigga just got to step
up to the plate, get his hand on tha mic and lay down some chronic prophecy. I
predict: serious financial disturbances will occur on or before February 1, 2010. Or
soon thereafter.
(And if you want to know more: consult my big nigga, Professor Sethi of Ba - I mean,
Columbia. He gots to get his mind off all them little ladies. Plus he says he got some
kind of model and shit. Sound like a stone-col' OG PhD nigga to me.)
Okay, stop laughing. I also have a serious - ie, verifiable - prediction. I predict that
before the end of 2010, probably well before the end of 2010, possibly even before
the beginning of 2010, the Fed will be forced to renew these facilities or others like
them. In other words, I predict that its attempt to kick the liquidity junk will not
succeed. In the end, I believe all these "temporary" facilities will become
substantively permanent - just like the original LF, deposit insurance.
Please bear in mind that this is a guess, rather than a deduction, and is based on
assumptions about rational crowd behavior that may simply turn out to be false. If
they are false, it is not my explanation of maturity transformation which is false; it is
just these assumptions, ie, the belief that humans are even remotely distinguishable
from remote-controlled sheep. Certainly if they were remote-controlled sheep, I
would expect no crisis.
With this caveat of my own, let me put it this way: the Fed simply does not
understand maturity transformation. It thinks it can just take these collapsed
markets, which it suspended by guaranteeing, and turn them back on again. And
they'll just work. This could be described as the therapeutic theory of financial
cryonics. If Alcor could freeze your brain and then warm it up, this would be a
tremendous achievement. It would not cure your brain tumor, though.
The Fed can freeze the money market, then thaw it back out. An achievement though hardly unprecedented. Let's look for a second at how it did this.
What are these temporary liquidity facilities? A "liquidity facility" is simply an openended guarantee that the Fed (or some other authorized authority) will issue an
arbitrary number of dollars to buy an arbitrary number of goods at a fixed price.
In principle this exact mechanism could be used to fix the price of corn. Or at least, to
support it. Although the Fed would wind up owning a lot of corn. What's neat,
though, is a trick that can be played in the securities markets. Through the miracle of
loan guarantees, an issuer of currency X can be used to support the price of any
debt, ie, promise of future payment. So long as every principle of good accounting is
disregarded, these contingent liabilities can easily be omitted from the sovereign
balance sheet.
To fix prices, the sovereign just issues an invisible, parallel, derivative security which
is invisibly bundled with the security whose price is to be fixed. (Or at least,
supported - I'm not sure whether infinite dollars can be used to suppress dollar
prices, though perhaps some trick can be played. It's always easier to intervene prices
upward than downward. Downward you are rationing; upward, you are just taxing.)
Thus, consider the case of FDIC deposit "insurance." When you make a "deposit," ie a
zero-term loan continuously renewed, to a "bank," ie a vampire whorehouse with
AIDS, in return you receive not one but two notional securities. For every green
dollar you deposit, you receive two dollar-sized instruments: the bank's promise to
repay you on demand (call it a yellow dollar), and FDIC's promise to pay you if the
bank can't (call it a blue dollar - precisely, a credit-default swap.)
Taped together, the yellow and blue dollars make green. Your loan to the bank is
risk-free. And indeed these instruments have to be taped together. Because if you
could separate the two, and create separate markets in which yellow and blue dollars
traded separately - coeds, what would happen? We'll return to this question in a
moment.
All the liquidity facilities mentioned in the press release are of this class. Your "yellow
dollar" in the case of the money-market funds, for instance, is a dollar which is "in" a
money-market fund. In reality, this yellow dollar is a zero-term debt (promise to pay
on demand) by a financial intermediary, which is backed by "commercial paper,"
which is a meaningless word for short-term loans issued by large corporations. These
corporations are typically performing maturity transformation in the sense Minsky
describes - that is, their financial structure has been designed so that they have to roll
over their loans, rather than repay them from cash flow.
What the Fed is doing, when it terminates these liquidity facilities, is canceling its
"blue dollars" - ie, its loan guarantees. Each blue dollar is marked: "not good after
February 1, 2010." My prediction boils down to the prediction that these securities
will not in reality be canceled. Rather, I believe they will ultimately remain good.
Bureaucratically, however, turning around on this plan - and effectively admitting
that these once-temporary programs have become permanent - represents a
significant defeat for the Fed. Therefore, the Fed will have to suffer some pain before
admitting this defeat. Thus, I expect market turbulence.
This time around, the market should be pretty sure the Fed will not actually let the
money market fail. It was pretty sure of that in 2008, or at least it should have been.
But it still had to test the Fed's intangible commitment to provide liquidity insurance
to the money market and the shadow banking system. Once that commitment is
withdrawn, it must be tested afresh.
(Those who can predict this turbulence accurately, as always, can make money off it.
But this is an exceptionally nontrivial task - you can't go to Ameritrade and click to
short "yellow dollars." Since my prediction is that any crisis will be ended by the Fed
restoring or extending its facilities, no persistent change in any price is implied. I'm
sure it is possible to make money off a correct prediction of turbulence - if you know
the prediction is correct, which I don't. But it can be done only by capable and welltrained professionals.)
Again, the backstops will hold. The blue dollars will survive. But after February 1,
2010, they go from being formal guarantees to informal ones - just the same position
they held before 2008. Note that the actual financial condition of the banking
industry, ie its actual balance sheet, has not particularly improved since 2008.
Therefore, the market will have to test the strength and reality of these backstops. It
will do so through that phenomenon we have learned to know well and love, here at
UR, the "liquidity" (or more correctly, maturity-transformation) crisis. More broadly,
the entire wave of temporary powers that were the original fruit of the first wave of
the crisis is expiring, dissipating, and vaporizing, as emergency powers do in
Washington. It is being sucked up by bureaucracies on all sides, restoring the normal
Beltway equilibrium of general administrative paralysis.
In a political context where the administration is weak, the Fed is weak, its chairman
is awaiting confirmation, and Congress is actively on the rampage - how easy is it for
the Fed to make this U-turn? I suspect the market will want to find out, especially at
a time when the first sovereign default crises of the New Depression (Greece, etc)
appear imminent.
One of the serious problems here is that, while the guys at the Fed may not be
geniuses, they are not dumb, either. They are, in fact, perfectly competent
economists. And they know perfectly well that this whole blue-dollar scheme is a
botch, because they have read their Hayek and know that it's a bad idea to conceal a
price signal. In this case, the price of yellow dollars.
Or prices, of course, because the price of a yellow dollar depends on the financial
condition of the issuing bank. If the bank is solvent, the yellow dollar is worth $1 - ie,
one green dollar. If the bank is insolvent, the yellow dollar is worth whatever it can
recover of the assets. Which could be nothing, in extremis, in which case the
corresponding blue dollar is worth $1.
Back in 2008, when everyone was pretending there was no such thing as a blue
dollar, there was something that looked like a free market for yellow dollars.
Unfortunately, this market had to be frozen. It started sending a signal that no one
wanted to hear: that the banks were insolvent. In money-market terms, the yellow
dollar "broke the buck."
Formal blue dollars, via the LFs, were hastily issued. As we've seen, the blue-andyellow dollar trades as a green dollar, period. In fact, this is the problem with blueand-yellow dollars, in the long term, and why the instinct to terminate the LFs and
return to a free market is quite sound. Yes, by all means: Washington should get out
of the banking business. Canceling the blue dollars on February 1, 2010 is not, I
believe, an effective way for it to do so.
With blue dollars, the solvency signal as well as the liquidity signal is laundered. The
bank (or corporation, etc) can borrow money from actors who will bear no loss if it
fails. In the medium term, this is a recipe for a lot of bad loans. In the long term, this
is a recipe for turning the country into the Soviet Union: a land in which all loans are
government loans. Command economics replaces financial sanity as the grounds for
evaluating capital investments. Frankly, in the present state of the real-estate market,
we are already most of the way there.
When Washington cancels the blue dollars - the loan guarantees of the various LFs it turns the market for yellow dollars back on. Now, note that this market, when it
was frozen, was in the throes of a maturity-transformation crisis. What would a
rational actor do when the market is turned back on? Redeem his yellow dollars for
good, old-fashioned green dollars - while he can still get the official 1:1 exchange rate.
Once enough people follow, the rate will no longer be 1:1. And so on. The bank run
begins all over again.
We can see this easily by solving the thought-experiment I posed earlier: split the
yellow and blue dollars. If holders of yellow dollars can be granted free blue dollars loan guarantees, credit-default swaps, call them what you like - these securities,
presently virtual, can be made tangible. Tangible, they can be made negotiable. In
principle, each of these steps is a Pareto optimization.
But look what happens when you have two separate markets! The bank run exhibits
reflexivity - in the absence of artificial stabilization, unprotected maturity
transformation is like a pencil standing on its point. However precisely it is
positioned, the pencil's state can at best be described as a stable disequilibrium. It
can be held standing either by a solid support (the liquidity facilities), or by duct tape
(opacity, inefficiency, irrationality, etc).
When the blue dollars were created, the pencil (really more like a telephone pole)
was falling over. The market for yellow-only dollars was frozen in this position. Turn
it back on, and what happens? With the solid support gone - what duct tape could
hold up this market, now? Anything equivalent to a yellow-dollar market (for
instance, actual CDS on banks) is a perfect feedback signal, and should instantly
revert to collapse mode.
Just like a falling pencil, a bank run is reflexive - the farther the yellow-dollar price
falls under $1, the greater the force pushing it down. If the Fed does not intervene at
all, all the banks fail, and so do all the corporations which issued short-term paper
for internal maturity transformation. Of course this will never be allowed to happen,
because it conflicts with the Fed's mission, and so on. However, this U-turn cannot
be not certain until it happens.
This logic predicts another wave of the crisis. If it is correct, a second tsunami could
hit at any time - even tomorrow morning. Again, UR does not provide financial
advice. All I'm saying is: make sure you are safe from this great, churning, angry wall
of water. Don't panic, though!
It's interesting to note the effect of these tsunamis on the gold-dollar exchange rate.
If you put a chart of the gold price next to a chart of UR posts which mention gold,
you will see immediately that the latter cause the former to drop sharply in the short
term, but rise smoothly in the long. Of course, I have no conceivable explanation for
this pattern, which I'm sure is just a coincidence. However, I do have some
observations regarding liquidity crises and gold.
Broadly, over the last few years, gold builds up a pool of money correlated with "risk
assets" which represent anti-dollar bets. When there is any hint of a liquidity crisis in
the dollar world, we see a "shortage of dollars" ("shortage of money" is a 19th-century
term for "liquidity crisis"), implying a kind of deflationary suction which tends to
raise the price of dollars in everything.
Including, for instance, gold. When gold has been going up for a while it always
accumulates a population of momentum traders who, not having read UR and not
understanding monetary formation, are weak hands. A shock takes the frothy air out
of the top of the bubble. Further down, though, gold buyers are notoriously strong
hands - quite committed to their decision to bail on paper and head for real metal.
And in the longer term, what the market sees is that the Fed cannot, because of its
economic mission, tolerate any sustained deflationary pressure within the dollar
economy. (For example, if the Fed canceled all its liquidity programs, we'd be back to
the five-cent hotdog, if anyone had any hotdogs - in short, Mad Max Beyond
Thunderdome, with Norman Rockwell prices.) Thus, in the longer term, the general
instability, stagnation and incontinence of the dollar system is revealed, driving
savers to the emerging hard currency outside it.
(The effect of a maturity crisis in the dollar on the dollar-gold exchange rate should
not be confused with the effect of a maturity crisis in gold, which (due to the
presumed fractional-reserve structure of the futures markets and other bullionbanking institutions) I still believe is possible. Bullion banks, the "commercial"
traders on Comex and other exchanges, have issued quite a large number of shortterm liabilities in gold and silver. Presumably these traders do not expose themselves
directly to price fluctuations - so these liabilities must be backed by other positions,
almost certainly not allocated bullion, almost certainly in gold and silver. There is not
enough bullion on the exchanges for it to be pure bullion. It cannot consist entirely of
mining hedges, ie long-term promises of gold and silver - because the positions
fluctuate too widely. So there must be something else, and I wonder what the hell it
is. My guess: synthetic baskets of mining stocks. Regardless, unprotected maturity
transformation is a dangerous game for lender and borrower alike, and no one
should be playing it.)
On sovereign financial reconciliation
When Necker published his Compte rendu in 1781, many have credited him with
causing the French Revolution. Before the Compte rendu, no one in France had
understood anything about Bourbon finance - possibly not even the Bourbons. As La
Wik puts it, in charming Wikipedese:
Before, the people had never considered governmental income and expenditure to be
their concern, but now armed with the Compte rendu, they became more proactive.
Indeed. Of course, in the subsequent decades, many thought twice about becoming
more proactive! But governmental income and expenditure had indeed become the
people's concern - then and forever. Alas, it remains our own.
According to modern historians, Necker's accounts were not entirely honest. I will go
with the modern historians on this one - sight unseen. I have not personally
inspected the Compte rendu, but my guess would be that Bourbon finance included a
lot of strange French holes in which strange amphibians things could hide. The
Bourbon administration, while great at many times and in many ways, is seldom
celebrated for either simplicity or transparency.
One of the most fundamental patterns of history is that good government is
responsible government. A corollary is easily deduced: good government is
financially responsible government. Since good government is indeed our concern,
we should become concerned indeed when our government does not appear to be
financially responsible.
An easy way to be financially irresponsible is to be financially opaque. If an
institution is responsible, it must be responsible to someone; to observe it, that
someone must be able to form a clear picture of its financial operations. There are
many ways to be financially opaque, while superficially appearing transparent.
Suffice it to say that I am not sure anyone has a really sound understanding of
America's sovereign balance sheet.
But regardless of the cause, if an institution is not financially responsible, it must be
reconciled. Reconciliation is simply a polite word for bankruptcy. What are we
reconciling with? Reality!
As Carlyle writes:
Great is Bankruptcy: the great bottomless gulf into which all Falsehoods, public and
private, do sink, disappearing; whither, from the first origin of them, they were all
doomed. For Nature is true and not a lie. No lie you can speak or act but it will come,
after longer or shorter circulation, like a Bill drawn on Nature's Reality, and be
presented there for payment, - with the answer, No effects.
Pity only that it often had so long a circulation: that the original forger were so
seldom he who bore the final smart of it! Lies, and the burden of evil they bring, are
passed on; shifted from back to back, and from rank to rank; and so land ultimately
on the dumb lowest rank, who with spade and mattock, with sore heart and empty
wallet, daily come in contact with reality, and can pass the cheat no further.
[...]
But with a Fortunatus' Purse in his pocket, through what length of time might not
almost any Falsehood last! Your Society, your Household, practical or spiritual
Arrangement, is untrue, unjust, offensive to the eye of God and man. Nevertheless its
hearth is warm, its larder well replenished: the innumerable Swiss of Heaven, with a
kind of Natural loyalty, gather round it; will prove, by pamphleteering, musketeering,
that it is a truth; or if not an unmixed (unearthly, impossible) Truth, then better, a
wholesomely attempered one, (as wind is to the shorn lamb), and works well.
Changed outlook, however, when purse and larder grow empty! Was your
Arrangement so true, so accordant to Nature's ways, then how, in the name of
wonder, has Nature, with her infinite bounty, come to leave it famishing there? To all
men, to all women and all children, it is now indubitable that your Arrangement was
false. Honour to Bankruptcy; ever righteous on the great scale, though in detail it is
so cruel! Under all Falsehoods it works, unweariedly mining. No Falsehood, did it
rise heaven-high and cover the world, but Bankruptcy, one day, will sweep it down,
and make us free of it.
There are many ways to define a sovereign bankruptcy, most of which convert one
falsehood into another. A true sovereign reconciliation produces a financially sound
and transparent sovereign balance sheet in one step, fair to all creditors. If your plan
matches this definition, whatever it is, it cannot possibly be wrong.
As I see it, any sovereign bankruptcy which is "true and not a lie" must recognize
three facts:
First, any real bankruptcy demands a change of management. What follows is
certainly not a plan that can be executed by the present management. What
restructuring plan is? But this is outside our scope today.
Second, precious metals are the only currencies to which a sovereign can be
accountable. Therefore, reconciliation must produce a sovereign whose books are
done in direct gold. A direct gold standard is 100% blue agave. A basket of gold and
gold loans is not gold. (Ie, the 19th-century Bank of England "gold standard" was not
a PGS.) The exact technical term is allocated gold.
Third, fiat currency is sovereign equity. Let me repeat that: fiat currency is sovereign
equity. Perhaps I could say it a little louder: FIAT CURRENCY IS SOVEREIGN
EQUITY. If the right twelve people ever understand this, the world as we know it will
come to an end.
Fiat currency has to be equity. It is (a) a financial security, and (b) not a debt. Ie, it is
not a promise of anything. If it was a promise of anything - regardless of the quality
of that promise - it would not be fiat currency! D'oh.
Therefore, we know exactly what a dollar is: a share of stock in USG. It is just one
class of stock, of course, conveying no voting rights. The dollar has never paid any
dividends, though perhaps this will change. In sufficient quantity it does convey one
very important benefit: the right not to be arrested by the IRS. It also conveys an
important right: the right to be treated equitably with all other dollars. My dollar is
worth just as much as your dollar or China's dollar.
If you disagree with these facts, you can stop reading this essay now. We are going to
reason as if they were true. If they are not true, all that follows is nonsense.
First, we see instantly why we cannot get a clear picture of the financial condition of
USG. It calculates its accounts in its own stock! Can you imagine a company which
paid all its vendors in its own corporate shares?
Any corporation can, of course, issue new shares to itself any time it likes. (This is
called dilution.) But how on earth can anyone assess whether this company is
profitable? How do you value a share? Actual companies which do crazy things like
this are generally not profitable, because otherwise they would not need to do crazy
things like this.
And that's not all. Not only does USG calculate its own accounts in terms of its own
shares - it compels its citizens to do likewise. It operates an entire economy in which
the medium of exchange is this scrip. Of course, we all know this and think of it as
normal, so it takes some effort to see how insane it is from an accounting perspective.
One metaphorical crutch that can help us with this is the new invention of virtual
worlds. Virtual worlds tend to have virtual currencies, whose economics differ not at
all from the economics of real currencies - except, of course, that they are virtual. But
virtual worlds are operated by real companies, which exist in the real world and do
their books in it.
The virtual world Second Life, operated by Linden Lab, is one such. Linden Lab is
not a publicly traded company, and perhaps it will never be. Suppose it was. We'll
call its stock ticker LLX.
Second Life has a currency called the Linden dollar. The Linden dollar is an
irredeemable fiat currency, though LL keeps it roughly pegged. But suppose it was
backed and redeemable - making it debt, not equity. What should it be backed by?
US dollars? Gold? Or...
Let's suppose Bernie Madoff, or some other unscrupulous person, were appointed
the CEO of Linden Lab. As CEO, he is responsible to his board. His board will love
him - everyone will love him - if he can only get the price of LLX up. Hm...
I know! Bernie will back Linden dollars with LLX shares. That way, when you buy
Linden dollars to play Second Life, you are actually investing in Linden Lab. Share
prices are set by supply and demand, of course - to issue a new wodge of L$, LL goes
to Nasdaq to buy an LLX share. Naturally, this drives the stock price up. Which is
what Bernie wants! Problem solved.
What Bernie has done is to redirect the monetary demand of Second Life residents
into the market for LLX shares. Since as long as Second Life exists and thrives, this
monetary demand will remain high and stable, what goes up need never come down.
By using his own shares as a fiat currency, Bernie has performed a rare successful act
of market manipulation.
The result is that LLX, as a stock on the Nasdaq, will not be priced like other Nasdaq
stocks as a function of its theoretical earnings. LLX may have no earnings
whatsoever, ever. A Linden dollar now certainly conveys no rights to any
distribution. The shares of an ordinary company would be worthless under this
condition, but not LLX. Were it not that Linden Lab's churlish, ungrateful vendors
demand payment in US dollars rather than Linden dollars, Linden could operate
forever under these conditions, however inefficient its operations.
Needless to say, Linden Lab's financial operations under this system would be
entirely impenetrable - probably even to Linden Lab itself, but certainly to any
external examination. But this is exactly the model under which USG operates: it
directs the monetary demand of its own subjects into its own equity, in which it also
does its own books. Small wonder no genuine Compte can be Rendu. There is
nothing in the books but madness. Madness!
So let's reconcile this madness. Let us not only render accounts - but pay them. The
ends of any design: (a) create a sound and viable financial structure; (b) treat all
creditors fairly. These goals are just as appropriate and essential at the sovereign
level as in any private bankruptcy.
No sovereign balance sheet can be reconciled without admitting and employing the
full set of sovereign powers. Frankly, the days when it made sense to talk about
property rights in the United States are over. Any such talk is babble - like talk of
restoring the Bourbons. God may once have granted France to the Bourbon family,
but he appears to have changed his mind.
If property rights must be preserved, USG's balance sheet cannot be reconciled. You
either do this thing or you don't. We are all creditors of USG, and none of us has any
special rights. After the reconciliation, of course, property rights can and should be
as rigorous as anything. During the reconciliation, they are all just pieces of paper signed by USG. USG is bankrupt. The pieces of paper remain important; the
bankruptcy process will treat them fairly.
During the reconciliation, the essential criterion is fairness. A bankruptcy process
creates no winners and no losers. At least, it creates no winners and losers among
those in the building. If you got out before the bankruptcy, there is no way you will
not be thanking yourself. Since USG is sovereign, to a limited extent it can perform
such clawbacks, but a sovereign must be careful not to test the physical limits of its
sovereignty.
What I'm trying to say here is that in any scenario in which any sovereign undergoes
this process, and converts its balance sheet back to gold, there will be one set of big
winners. These will be people who sold the sovereign shares, or assets denominated
in those shares, for gold - before the bankruptcy. A sovereign, to a limited extent, can
and should tax these moguls - just as it taxes people who bought Google at the IPO
price. If it taxes them too much, however, it must either create a large gap between
the price of natural gold and the price of monetary gold, or apply a tax rate which
creates a black market in old gold. Either is dangerous.
There are always rich people. A marginal dollar in the hands of the rich is much less
likely to be competing in any market with your dollar, than a marginal dollar in the
hands of the poor. In other words: it is less "inflationary." Therefore, enriching the
goldbugs is not a serious concern for policymakers. They were right; therefore, they
should profit. In a word, that's capitalism.
The brutal truth about USG's shares is that, due to the above (and other)
manipulations, they are overvalued in gold. If a dollar is a USG share, and USG
shares are repriced in gold, a dollar cannot be worth anywhere near 30mg. It might
be worth 1, or 2, or 3. For the dollar holder, the main pain is still to be felt. If 2008
and 2009 felt financially stormy, your barometer is overcalibrated. The market has
barely come under pressure.
Because even its currency is tied up in the strange machinations of its bizarre 18thcentury government, USG, America must experience bankruptcy as a whole. USG
was never designed to be a total state, but it is one now. If you would like it not to be
a total state, the only way to start is by acknowledging that it is a total state. Capisce?
Is this for some reason difficult?
The task of the new financial managers of this total state is to set a new price level
across the entire American economy. That price level must be one at which the
economy is (a) stable and (b) can generally pay its debts. At present, the economy is
artificially depressed by deflation; thus, the new price level should be set at a low,
stimulative point.
Devaluation is always and everywhere an economic stimulus. It rewards the poor at
the expense of the rich. This is bad policy on a continuing basis, but excellent policy
as part of any one-time event. Any reconciliation should include a strong dose of
stimulative inflation. Because the endpoint is a direct gold standard, this stimulus
will not last; in the long run, the economy must rearrange itself to a profitable
equilibrium with no fiscal, trade or monetary deficit. However, through devaluation
the transition can be made almost arbitrarily gentle.
This transition plan has six steps. First, we identify all of USG's liabilities - simple or
contingent, formal or informal - and securitize them, converting them to debt in
dollars. Second, we nationalize all financial assets at the present market price,
converting them all to dollars. Third, we cut each dollar in half: the left half is a share
in USG without its gold reserve, the right half an allocated claim to that gold reserve.
Fourth, we run a Dutch auction to set the price of left dollars in right dollars - an IPO
for USG, now highly profitable, owning the entire country, and debt-free. Fifth, we
convert all payment and accounting systems to right-dollars, treating left-dollars as
ordinary portfolio securities, and normalizing right-dollars into units of weight - ie,
grams Au. Sixth, we privatize all the nationalized assets
The first and second steps are the hard ones. The fifth is a lot of work, but it's a small
matter of programming. The first and second actually require thinking. Let's do that
thinking.
First: boys and girls, let's play a fun game - "find the liabilities!" USG has many
conventional debts; it also has many strange liabilities of an unconventional form.
We need to find and liquidate all of them, converting them into dollar securities.
In the second step, we convert all these liabilities to present dollars. We already did
this in the first step for financial securities: if you held T-bills or Agency bonds, USG
bought them at the present market price. However, many of USG's liabilities are (a)
contingent; (b) actuarial; or (c) informal. All of these must be discovered and
replaced with mere dollars.
First, USG has contingent liabilities. These are promises USG has made which may
force it to be liable for a debt. A good example is a loan guarantee. USG has made a
lot of loan guarantees. Most of them were made to institutions acquired in the first
step, and obviously a guarantee to oneself is void. But in case any are still floating
around, they need to be cleaned up.
To clean up a loan guarantee, assume the loan and pay it off. If A has loaned $X to B
and USG has guaranteed this loan, USG pays $X to A and is owed $X by B. Poof!
Reality is revealed. A loan guarantee is in reality a government loan. Better living
through bankruptcy.
Next, USG has actuarial liabilities. For instance, suppose you have been paying into
Social Security. You have therefore earned Social Security benefits. The payout will
vary depending on your age. The present actuarial value at present interest rates of
your benefits, however, is easily calculated. This sum is deposited into your Fed
account. Social Security can be entirely closed out in this way.
So can all entitlement programs, even those paid in benefits rather than cash. For
instance, what are your Medicare benefits worth? What would it cost you, in present
dollars, to buy your Medicare benefits from a profit-making insurance company?
That sum is deposited into your Fed account. In fact - why not give everyone
Medicare coverage while we're at it? If the people want national health care, this is a
perfect way to give them exactly that.
Essentially, we are cutting the strings of dependency that bind voters to Washington,
not by eliminating their benefits but by cashing them out. Once said voters
understand this model, it strikes me as unlikely that they will oppose it. If there is
some problem with this, just increase the allocations by 20 or 30 percent. The yelps
will rapidly subside.
These political buyouts should already be calculated in a generous and giving spirit.
Since the old management spent 75 years buying political power with USG's printing
press, surely the new management cannot be excused for doing so on a one-time
basis.
(Progressives are attracted to national health care because of the enormous number
of strings it will attach. Voters are attracted to national health care because they want
national health care. If you have a plan that provides national health care without
any strings attached, do not expect it to attract progressives.)
All recurring payments made by Washington should be investigated for conversion to
debt. They probably are debts - just informal debts. For instance, welfare payments
proper obviously cannot be monetized and transferred to the recipients. This
budgetary stream, however, can be monetized and converted into an endowment,
which endows a charity that looks after the recipients. Washington, which is a very
caring place, can get all its caring good works out of its hair and off its books in this
way. Even national defense can be endowed - a proposition that would certainly tend
to minimize unmotivated adventurism.
Even the most basic expenses can in fact conceal debts. For instance: consider a
government employee who cannot be fired. Well, new management is what it is! It
turns out: he can be fired. (In fact, I would be quite surprised if new management
keeps many of the old employees.)
But the old employees have a right: the right not to be fired. This is an entitlement.
Being sovereign, the new management cannot be compelled to employ them. Being
fair, and anxious to prove its fairness, it is compelled to respect this entitlement, as it
respects others. Thus it should compensate fired government employees with a
mammoth dollar severance, which repays them for their loss of tenure.
So there is a simple explanation for the first step. Formalizing and securitizing
entitlements is always and in every case a Pareto optimization - except in one case,
the case in which the entitlement is a mechanism of dependency through which the
provider asserts paternal guidance.
USG is particularly noted for the high quality of its paternal guidance. Not.
Moreover, since this objective (debatable in the first case) cannot be observed in
polite company, it cannot be the actual motivation for these policies. Otherwise, you
would be making the same argument for welfare that George Fitzhugh made for
slavery. I'm sure you wouldn't want to do that.
Second: nationalize all financial assets, at their present market price.
This is not hard to define. But why? What is the rationale for this unprecedented act?
The word "nationalize" is needlessly provocative. Rather, we are consolidating the
sovereign balance sheet. This is both righteous and essential for more reasons than I
can count. But let me just enumerate a few.
The basic moral reason is that since the dollar financial markets are so
fundamentally and thoroughly manipulated, the prices of financial assets cannot in
any way be regarded as market prices. The new management will create free
markets. The old management ran the book at a rigged casino. The new management
is closing that book - with its present entries. If you have a balance at the casino, you
get the balance back in cash. (Ideally at a premium, for your trouble.)
Perhaps you doubt that all securities prices are set by the government. Actually, this
can be trivially deduced from basic investment theory. The price of a loan is set by
the interest rate of that loan, the probability of default, and the risk-free market
interest rate. If the USG fixes or manipulates the last - as of course it does - in what
sense is this price a market price? Duh.
We can still compute the probability of default from the price of the loan; this market
information is still visible. We can compare relative prices of securities. The number
that appears next to the loan in the owner's portfolio window, however, is entirely
determined by USG. The absolute price, in dollars, is an administrative decision of
the government.
For instance, if the Fed ceased to lend or buy loans tomorrow, interest rates might
well go to 87%. I pick this number arbitrarily. It might also be 187%. Or 287%.
Question: if interest rates go to 87%, what is a 30-year zero-coupon T-bill paying 5%
worth? Can you even sell it? Or do you just recycle it? You do the math.
Moreover, this principle extends not just to financial instruments, but also to
financed assets. Consider a house. The house's owner is in the quaint habit of talking
about what her dwelling was "worth," as though this was some objective quality of
the physical object, like being brown. Between 2000 and 2006, her house "went up" before it was "worth" $300K, after it was "worth" 550K. The house, in fact,
deteriorated. It did not spontaneously remodel its kitchen. Perhaps its neighborhood
became more attractive - or perhaps the dollar market was being pumped full of
government loans.
The economic planner thus faces a dilemma. Any return to free-market economics
will have an extremely chaotic, and generally negative, effect on the price of financed
assets. This is because any return to free-market economics is likely to result in
higher interest rates, since there will be no government lending or loan guarantees.
This is why no realistic reconciliation plan can maintain property rights - at least, not
in the market for securities and securitized assets. It is essential to fall back on the
less rigorous, but more important, standard of fairness. What is fair in dealing with
this problem? What's fair is that whatever you own, be it stocks or bonds or houses,
you bought in dollars; if it "went up," you earned those dollars too; when it "went
down," you suffered with it; whatever you are "worth" is yours. All results of the
financial ancien-regime are permanent.
The present prices are not free-market prices. But they are market prices. They
represent genuine results of real life. A fair system would maintain these results.
Therefore, the only way to revert to market pricing, while preserving fairness, is for
USG to buy these assets at their present price, which USG itself has set; and sell them
again at market prices. Which will generally be lower, since any liquidation is bound
to be deflationary.
What is the difference? Who takes the loss? The "loss" is a liability that USG
assumed, when it decided to manipulate the freakin' market. It cannot just cancel
this debt. Rather, the debt must be paid. But the debt cannot even be calculated
without returning the asset to the market. Thus, temporary nationalization is
essential.
Nationalization can be quite involuntary. Financial assets are not, in general, of
sentimental value. Houses are an exception. There is no sense in kicking people out
of their houses. However, there is such a thing as a long-term lease. If the
government nationalizes your house, you will obviously get a long-term lease.
Therefore, we have our plan for the asset side of USG's balance sheet. Since USG is
sovereign, it is the final and ultimate owner of everything. It exercises that right. It
buys all market-traded securities at the market price. It grants all holders of all
financed assets, right down to cars, the right to sell the collateral to USG at the
present market or assessed price, whichever is higher. Cars and houses are leased
back to their owners. For financed assets, this is an option and you don't have to take
it - but if you don't take it, USG is not responsible for any pain you may taste.
Where does USG get the money for this? Remember, no one has any money. Fiat
currency is sovereign equity. Instead, we have shares of USG. The correct question
is: where does USG get the dollars? The answer is: it issues them. Any financial
reconciliation will see the creation of enormous numbers of shares. That's why they
call it a debt-to-equity conversion.
As for gold, USG demands that all citizens turn in half their gold. It's called a "tax,"
doofus. The new management is hardly about to abandon their right to tax! And the
tax includes jewelry - to keep it, pay the gold tax. More than this, and people will
cheat. Less, and USG would get more by asking for more. 50% should be somewhere
near the top of the Laffer curve.
Moreover, no such tax is a rational reason for present gold holders to oppose this
plan. Again, they will profit massively by it - as they should.
What have we done to USG's balance sheet? On the liability side, we have added 10
or 20 trillion dollars - at least. Almost all American debts are now owed to USG;
almost all American assets are now owned by USG. This is the nation-state as giant
totalitarian corporation. It is not a sustainable state of affairs, but we do not intend to
sustain it. On the asset side, we have added a large number of valuable assets - debts,
homes, corporations, etc.
We also must consider personal balance sheets. As a result of this operation, your net
worth in dollars is unchanged. Your net worth, however, consists entirely of dollars.
If you had $200K in home equity, you now have $200K in dollars. If you were in
debt, you are still in debt. (Except that underwater nonrecourse mortgages are wiped
out.) All that changes is that you now send your checks to Washington, instead of
"The Lakes, Nevada."
Moreover, since the Fed has acquired all banks, you don't have $200K "in the bank."
You have your own account at the Fed, a privilege previously reserved for actual
banks. This layer of indirection is entirely artificial and unnecessary - in short, a
historical legacy. In a world of electronic dollars, the Fed's state is simply a big
spreadsheet in which each row is a pair: your SSN, and the number of dollars you
own. Your number indicates how many brownie points Uncle Sam has assigned you,
so to speak. And if you prefer your brownie points on paper, all ATMs now have a
new logo: the Fed's.
Liquidation is the conversion of debt into equity. But when we find all the spending
that is actually debt, and convert it into actual debt, we don't just liquidate the debt.
What we are doing here is destroying USG's chronic deficit. All of its regular
expenditures which are not related to the production of revenue - revenue in gold are in fact debts of the old regime. Since the old regime was bankrupt, all its debts
are converted into equity - ie, present dollars. The result is a gazillion dollars - but all
those dollars are shares in USG. Which is now massively profitable. Bankruptcy in a
nutshell!
Financially, the continent has been converted into one immense gold farm. It costs
very little to administer, the Americans being docile, and produces enormous
returns. In short, it is more profitable than Jesus. This profits must be split, however,
across a gazillion shares - or dollars.
The new America has the simplest possible balance sheet. On the liability side, it has
no debt and a single class of equity. On the asset side, it has everything. An enormous
stream of gold, from both taxes and debts, pours into Washington's coffers.
Naturally, it must be distributed to the shareholders - and thus the shares have value.
Gold value.
But what, exactly, is their price? USG's profits are not yet an enormous stream of
gold. They are only an enormous stream of dollars. An entity cannot be financially
responsible if it pays dividends in its own shares. This would just be bizarre.
We now face our third problem: dividing the dollar. This is our automatic dollar-gold
devaluation figure.
Again, all dollars are cut in half. Quite literally - if you hold dollars as cash, you take a
pair of scissors and cut them right down the middle. Electronically, of course, no
scissors are required. Electronically, all dollars are in your Fed account. This will
simply change from one number to two. If yesterday you held 50K dollars, today you
hold 50K left-dollars and 50K right-dollars. These will not exchange at 1:1 exactly probably nowhere near. But their sum is no more, and no less, than what you had
before.
Left dollars are shares in USG's vast pile of assets, seized in the nationalization, and
of course in the future revenues of USG itself. Which are themselves vast. Rightdollars are claims to USG's gold reserve, fully allocated and redeemable. Essentially,
a left dollar is a share in the American Treuhand; a right dollar is a zilligram in
BullionVault.
A crucial question is whether Fort Knox accepts bail-ins - ie, you can deliver a right
dollar's worth of natural gold to Fort Knox, and get a right dollar for it. If so, the
monetary system is a direct gold standard. If not, the price of monetary gold may
float above the price of natural gold. There is no technical problem with this, but it is
probably imprudent. A hybrid gold standard with restricted bail-in is an interesting
design, but perhaps too experimental. After 75-plus years of New Deal economics,
the people will demand only the simplest and most classical of financial designs.
Floating super-gold is not in this class.
To divide the dollar, we need to (fourth) establish an exchange rate between left and
right dollars; and (fifth) convert the standard of payment to right dollars. (a) is the
same problem as the problem of valuing the East German Treuhand, except in gold of assigning a stable gold value to all financial assets. Basically, a left dollar becomes
an investment dollar; a right dollar a spending dollar.
In particular, all debts are converted to right-dollar debts, at the initial left-right rate.
If the market does not set a good exchange rate, debtors may be unfairly penalized or
rewarded. However, we cannot do better than this market.
In a single gigantic Dutch auction, a left-dollar price is set; all those who prefer left to
right dollars below this price receive left for their right, and vice versa. The result is
the Rate - best expressed as the price of a dollar in milligrams of gold. (My guess is:
somewhere around 2.) The old dollar is split into left dollars and right dollars; the
left is an investment, ie, a stream of future returns; the right is money.
To create a new capital market, we must value our investments in terms of money.
We must value the dollar in gold. We do this, in one step, by getting all the
investments into one pool, and valuing that pool in gold. We can then By centralizing
this decision, we ensure that its consequences are fair to everyone.
And, again, fifth: payments can then be switched to right dollars. Or rather, grams of
gold. Since right dollars are no more than claims to gold, going all the way to a
weight-based standard is trivial. And probably advisable. But the difference is not
substantive. Once we have valued left dollars in right dollars, we can value dollars in
right dollars. Or rather, grams of gold.
Let's say we go directly to milligrams. On the flag day, therefore, all prices become
milligrams Au, all payments gold payments. To set the gram price from the dollar
price, multiply by the Rate. To rewrite old contracts written in dollars, multiply by
the Rate. This change, like any redenomination of the currency, is mechanical.
Of course, these prices may fluctuate; all prices do. However, we have been extremely
careful throughout this entire exercise to preserve relative purchasing power. Asset
prices will have no choice but to change, because the entire financial market has been
rebooted. Consumer prices and labor prices should remain roughly the same,
because purchasing power (relative to the Rate) has remained roughly the same.
Or, for a slight stimulus, become slightly greater. At the expense, of course, of
stealing from the rich and giving to the poor, the economy can be arbitrarily
stimulated on a one-time basis in the course of this procedure. In the long run it will
have to become more productive or more austere, hopefully the former. In the short
run, the transitional management can print as many dollars as it wants. And
probably should - to grease the wheels. Inflation is not a concern.
Not continuing inflation, anyway. Because, again, the result is a direct gold standard.
A thing never before seen in history, at least not for the last three centuries. It will
run stably and indefinitely without serious market fluctuations. It will certainly not
exhibit persistent inflation, unless someone figures out how to extract gold from
seawater. (There actually isn't that much gold in seawater.)
Finally, in the sixth step, USG spins off the nationalized assets and becomes a lean,
mean 21st-century corporate government - extremely small and highly profitable.
When it sells (reprivatizes) the private assets it acquired in the second step, it sells
them of course for gold.
It will sell them into a market that can establish true, stable market prices for them.
This market will price them by measuring their expected yield in direct, 100%-
reserve gold, and setting a yield curve that reflects the balance between present and
future direct gold.
And this is the end state: a stable private economy on the gold standard. Moreover,
unlike most plans for returning to gold, this plan does not cause a reduction in
aggregate consumer demand by reducing aggregate purchasing power. Implemented
properly, it should perform a one-time inflation in which the purchasing power of the
rich is redistributed to the poor - stimulating demand, not contracting it. But this
inflation cannot be chronic, as it is one-time. It thus cannot produce the perverse
incentive structure we see under chronically-inflating economies.
So can we do it? Nah, we can't. No way. Nothing like this will ever happen. I
guarantee you.
Maturity transformation: cat, bag, out
The neo-Austrians have (re-)discovered it:
Even if we accept the case for a 100 percent reserve requirement, we see that the
maturity mismatching of liabilities and assets (borrowing short and lending long) is
itself perilous—and in the same sense that fractional reserves are perilous.
The matter also now seems understood in high places:
On the liquidity front, there are a host of initiatives underway. The Basel Committee
on Banking Supervision is working on establishing international standards for
liquidity requirements. There are two parts to this. [...] The second is a liquidity
standard that limits the degree of permissible maturity transformation—that is, the
amount of short-term borrowing allowed to be used in the funding of long-term
illiquid assets. Under these standards, a firm's holdings of illiquid long-term assets
would need to be funded mainly by equity or long-term debt.
Yeah, good luck with that, guys. I hope those 57% mortgage-interest rates don't
cramp your style. Can I offer you any pitons to go with that yield curve?
In any case, precious UR bandwidth need no longer be allocated to this matter. Just
remember - you heard it here first.
Our financial analysis can now address more fundamental concerns. For instance:
Ben Bernanke and Robert E. Lee - separated at birth! Again, you heard it here first.