Bitcoin Redux

I touched on bitcoins in the last post several months ago and had no idea even then that they would take the world by storm as much as they have now. Nearly all the blogs that I’ve read have posted about it multiple times, from tech sites like Wired and TechCrunch to economics ones like the Mises Institute’s blog. It has even come up in mainstream media sources like CNN. You’ve undoubtedly read about them either in my previous post or elsewhere so the exposé is not needed here.

Observe the bitcoin exchange rate in US dollars for the past six months and compare the scales to the chart in my previous post from only a few months ago, when the exchange rate sat around $100/BTC. As I write today, it is over $1050/BTC. It doesn’t take a genus to see that speculators have brought some serious skin to the game as an appreciation of over a thousand percent has taken place in such a short time. Once the playground of computer geeks and contraband smugglers, this digital currency has become the talk of everyone from Wall Street to Main Street. Even the second most powerful man in the world, Ben Bernanke, gave bitcoins a veiled compliment during one speech.

In the past couple months, speculation has become a dangerous game as the exchange rate fluctuates several percent every day, the most dramatic dates being an appreciation of what looks like around 69% on November 17th and a depreciation of 17% on November 30th. The preposterous volatility continues, trending perilously upward while the world sits and watches as the best laid schemes of mice and men succeed…or go awry.

It is important to note that the value of other currencies do not fluctuate this much. Nor it is an exaggeration to say that the world would simply self-destruct from instability if it did. For comparison, the US dollar has been able to purchase .83 euros at its absolute strongest and .67 euros at its absolute weakest, a band of about 24 percentage points, in the past five years.

It is surprising, then, that no one has tackled the issue of why the bitcoin’s exchange rate is so volatile but I will attempt a conjecture today. Take the world of foreign exchange, where currencies like the dollar, euro, yen, and all others are bought and sold for each other. Transactions happen continuously and at the speed of light as perfect information distribution and access to all markets simultaneously keep exchange rates in viciously tight equilibrium. The world’s markets spin on with astonishing stability considering that four trillion dollars worth of currency cross the planet every single day.

I believe that the reason bitcoin has not enjoyed similar stability is that none of the main exchanges offer built-in stability mechanisms. They are only spot markets. In a spot market, one may buy or sell bitcoins in whatever currency he pleases at the prevailing market price. In regular foreign exchange markets, there is not only a spot market, but also a forward market, which allows buyers and sellers to enter a contractual agreement to pay a certain exchange rate at some point in the future. There are also options, swaps, and currency pairs, which are entirely outside the scope of this essay and likely the topic of another. The point is, the existence of derivatives and the forward market self-enforces stability and that “viciously tight equilibrium” from above. Without those checks in the bitcoin market, mutability is the law of the land.

I daresay that the world is witnessing the growing pains of bitcoin, that it has become more popular than existing institutions can handle. Yet when someone has the volition to make a robust market with the same features other currencies enjoy, and if it becomes popular enough, the exchange rate instability will largely end. Bitcoins will be, from an investment standpoint, rather indistinguishable from their government-backed peers.

By the way, if you're a bitcoin user and would like to make a donation to my site, my wallet's address is  1GSCJTsYLEaBF2HX6WmnXDF9QuNezGo4v1 and it'd make my day to see something show up.

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What's the Big Deal with Bitcoins?

            Bitcoins…bitcoins...bitcoins!  It seems like the world has all of the sudden, or at least as of early this year, become entirely enamored with bitcoins as evidenced by the overwhelming press coverage they have been getting recently.  I don’t know how I managed to get this far in the year without writing about it because it has been a fascinating phenomenon to watch unfold.

            Recall from the end of my last post that bitcoins are an open-source fiat money that is backed by no government or bank, but rather the citizens of the internet.  It is the most fiat of money for that very reason.  Bitcoins have been around for several years, beginning in 2009 and growing slowly in popularity since then.  The exchange rate of dollars to bitcoins began 2013 at around $13 and rose to an all-time high of $230 by April and then dramatically crashed before leveling off around the hundred dollar mark where it sits now, several months later.  What happened in those months that caused the sudden bubble and bust?  I have a theory: an educated guess, if you will based on a little reading and some mental puzzle-solving.

            Bitcoins have been used primarily for ecommerce transactions of illegal goods because they are, by design, international and anonymous (or at least very difficult to track).  Drugs, firearms, fake IDs, and rather significantly more unsavory goods are dealt through illicit marketplaces with bitcoins being used as the medium of exchange, internationally and anonymously like the buyers and sellers themselves.  Hold that thought in the back of your mind.

            What was going on in the world in early 2013, culminating in March?  The European financial crisis had hit Cyprus pretty hard.  I even wrote a post about the whole incident when it was happening.  Cyprus is a tax haven for Russian business magnates and so one of the things that was suggested by the ECB/IMF/European Commission during the early weeks of March (March 16^th to be exact) was to confiscate 40% of the bank deposits of uninsured accounts with a value over 100,000 Euros: essentially targeting the Russian businessmen.  This idea was eventually dropped on March 25^th, but during the days between the 16^th and 25^th, the fate of those deposits were up in the air.  

            Before looking at the exchange rate graph below, take a wild guess as to when the bitcoin boom started, recalling that bitcoins are the de facto underground market currency and that a substantial portion of Russia’s economy is built on the dealings in such markets…and that Cyprus was a tax haven.

            If you guessed that the dramatic boom started in the third week of March, you’d be correct!  Bitcoins had been increasingly in the public eye since the beginning of the year but the major step up began when the deposits were threatened by seizure.  I suspect that the rest of the world noticed the inflation and speculators carried the bitcoin’s value to its highest point even after the deposits’ threat had gone away.  Examine the graph for a while and see if you can’t extract more insight from it.  The events of the past few months on the web and in the rest of the world are more interesting than ever and I suspect we can learn about how humans deal with booms and busts by seeing the bitcoin crisis as a microcosm of what has happened, and maybe will again, for other securities and currencies in the rest of the world.

By the way, the exchange rate chart can be made here where you can manipulate the time frame as well as several technical indicators.

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The Story of Money Part 2

            As promised, I am back with a sequel to the last piece about the story of money.  I mentioned that the main features of money are durability, divisibility, and wide acceptance as having value.  I also mentioned that these have not always been the case and that there is at least one notable exception that comes to mind, in the area of divisibility.  But this story in turn will take us to the more valuable insight about the nature of money in modern times, the concept of fiat money.    

"I'll need some help with getting this to the grocery store."

              There is an island in the South Pacific called Yap which until recent times has used large round blocks of stone as their currency, called Rai.  The origin of this money is unknown but essentially the scarcity of these stones (quarried and milled on another island), the difficulty associated with transportation (20+ men were required to move the largest ones), and the propensity for the movers to die with stones in tow when storms struck on the open sea made them sufficiently valuable to use as currency.

              While not all stone money items were gargantuan, it does not take much imagination to realize that having stone money of any size is not conducive to easy commerce between citizens.  This is where the story becomes even more interesting.  Once people realized that moving the Rai around was not practical, they started writing promissory notes that entitled the bearer to a particular stone stored in some location on the island.  Tangentially, the parallel between this kind of money and gold or silver certificates is easily seen.  This allowed easy transactions between people since a stone could be retrieved by anyone bearing the certificate.  Theft was out of the question because of the level of trust on the island and the fact that stealing boulders is no mean feat.

               On one fateful voyage, a very large and accordingly valuable stone was lost to the sea.  But as the inhabitants had grown accustomed to dealing in paper that represented stones, and the representative paper was still in existence, the populace agreed that the stone was out there somewhere and that its document was still valid money.  Thus fiat money was born for the island of Yap.

                “Fiat” is the Latin word for “it shall be” or “let it be done” and fiat money is money whose value is not derived from an underlying asset like gold, silver, or stone.  Rather its legitimacy comes entirely from the faith of the people who use it and, more often that not, the government that decrees it as the legitimate currency of the land.

                In modern times, the rise of Bitcoins has been an endlessly fascinating form of currency because it is backed by no government at all.  I recommend reading up on it because it is much too involved to deal with sufficiently here.  Yet even though there is no ruling authority that mandates it as having value, the faith and trust of those who deal in it online has elevated it to the status of money that is widely accepted in many stores (mostly online) across the globe.  But what makes it even more spectacular is the fact that it does not even have a physical presence.  In truth, it is the most fiat of money of all. 

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The Story of Money

What is money and why do we need it?  How did it come about in the first place?  This is a question that I addressed in conversation recently with a friend after visiting the Hong Kong Monetary Authority, its equivalent of the Federal Reserve.

Everyone knows intuitively what money is: a medium of exchange and permanent store of value.  In other words, one person has coins and bills and another person has coffee beans, guitars, or microscopes.  They trade one for the other and everyone goes on his way.  The permanence of money is also an important characteristic.  It would not do to have currency that decays over the course of time!

Where did money come from and why do people use it rather than just bartering like our ancestors used to, and why do we use paper or metal which have no intrinsic value rather than something that does have value?

The need for money is shown in the following story, as related to our class by my first economics professor.  Imagine that you are a maker of guitars and that you want to get coffee.  So you take your guitar to a coffee farmer and try to work out an agreement on a trade.  The problem arises: what if the coffee farmer does not want a guitar?  Or what if he does not have enough beans on hand to pay you for that guitar?  In modern terms, for example, 45.4 pounds of Starbucks coffee costs the same as a Fender Stratocaster, (if our ancestors had the benefit of price shopping on Amazon.com)! The problem with a pure bartering system is that not everyone wants what you have or perhaps they do but cannot accommodate your requirements for the trade. 

This is where money comes in: a society agrees on something that will be used to facilitate exchange whether it is coins, stones, shells, salt, metal ingots, or any number of other items used by civilizations in the past.  Besides society-wide acceptance of their value, money possesses at least one other advantage over trading goods for goods: it is easily divisible.  You will notice that half of a guitar, a third of a cart, and the base of a microscope are no good to anyone.  In other words, if our farmer from above didn’t have 45.4 pounds of coffee on hand, the trade would not go through.  But with money, the trade can happen between anyone who has money and anyone who is selling something. To recap, these features can be seen in money all over the world: easy divisibility, society-wide or universal acceptance in a country, and usually permanence in the material used to make it.  There are few exceptions but one or two of the most prominent ones deserve to be the subject of the next post. 

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China Seminar Post 3: The Real Wealth of Nations

            During one of our several university visits the lecturing professor gave us a particularly unique and memorable talk.  The typical speech we’d receive in these lectures tended to involve an economic lesson about some area that was growing such as how the city was planning to develop their infrastructure in this or that industry, or how 300 million people had migrated from rural areas to the cities, or how income has risen dramatically in the past several decades since the late 1970s.  This one, in particular, took a much more philosophical slant. 

            Professor Zhang Yu from Shanghai University spoke to us his philosophy about the reason that a country develops or does not develop.  Having grown up and been educated in an overtly Communist state, he learned that there was strength in unity of thought and belief.  He learned that the government was the benevolent institution to pass down those thoughts and beliefs for the good of the people.  But as he grew older and began to read independently (philosophers like David Hume), he came to a different conclusion.  He began to realize, as he told us, that the government cannot be the entity to oversee all aspects of life.  He told us that if the government controls thought and belief, then creativity and dynamism of the populace will be squelched, and a nation will be cursed with an inability to move forward.  As he said progress cannot be legislated, so he said that the power to transform a nation lies in the minds of its people.  Free thought emanating from the minds of free people is how society can evolve and change for the better.  So this brought him to his terminal point.  These days, those in governance over China’s cities and provinces put so much emphasis on how much is being exported, or how big the country’s GDP is from year to year.  This results in a measure of success being confused for success itself.  In reality, however, the true wealth of a nation is its people.  That country is rich which is blessed with free thinkers, tinkerers, and an environment conducive to the germination and sharing of ideas. 

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China Seminar Post 2: IBM

            In my last post, I recalled a visit to Baosteel, a symbol of the massive manufacturing capacity China has.  The following day, we visited IBM’s flagship office in Shanghai.  Not coincidentally, IBM ought to be taken as a symbol of China’s massive service-industry capacity.  For those who are unfamiliar, as I was to a large extent, International Business Machines provides custom programming services to business in need of software solutions, among many other things.  It is also a major player in the Big Data revolution, which I have written about before, competing with the likes of EMC and Google to meet the world’s growing data needs.  IBM has many branches beyond data processing and programming which makes it a major player and competitor in separate but complimentary industries such as financial management services and business operation planning.

            IBM is aware that the world is changing, sometimes for the better and sometimes for the worse.  But their overall mandate, as we learned in a lecture and saw on public service announcement posters hung around the office, is to build a smarter planet.  By “smarter”, they mean more connected, more responsive, and more efficient.  As we see, the world is a system of systems which exist not in isolation of each other, but rather as an ecosystem of its inhabitants.  In the broadest sense, IBM tries to measure the heartbeat of a city: its traffic, utilities usage, weather, and anything else one could possibly be imagine are all compiled and used to make a city run better.  Traffic is regulated more efficiently depending on the time of day, electricity is conserved in times of low demand, etc.  Weather readings are used to model climate patterns and make predictions for the future.  Even the pharmaceutical and medical research industries are being transformed as huge amounts of information is created from the processing of data at an The value of this kind of data compilation and processing can be seen at the individual user’s level as well when smart alarm clocks know poor weather conditions will exacerbate traffic and wake up their owners earlier.  The applications for this kind of technology are endless and as a doctor accesses and make decisions for his patient by measuring vital signs, so humanity can build a better world.

            IBM has been a particular boon to a developing nation like China because it is able to bring high technology to rural areas that are just beginning to modernize.  Without infrastructure like sewage systems, running water, power grids, public transportation, and the like, small towns are able to adopt the bleeding edge technology of city planning with the benefit of hindsight that is just one piece of the expertise IBM brings to its municipal clients.  By using IBM’s services, and the services of companies that offer the cutting edge of technology immediately, a town can make decades of regular development in one swoop of upgrade and join the 21^st century efficiently and quickly.  This means dramatic increases in the living standards for the populace touched by these improvements.  

  

                                                                                                                         IBM Logo

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China Seminar Post 1: Baosteel

I was in Shanghai recently with a school fieldtrip and we had a visit to one of the manufacturing facilities of China’s largest state-owned steel manufacturing company, Baosteel.  It is the second largest steel producing in the world after a Luxemburg company called ArcelorMittal.  With an area larger than the city of Macau (itself 11.39 square miles), the whole complex was an astonishing and breathtaking sight to behold.  One of my initial impressions was the fact that despite being a massive manufacturing area, the place did not give off the odor of pollution one would expect in a place where heavy machinery and metal smelting is in operation.  It turns out, and quite contrary to the popular culture belief of Western nations, China is quite environmentally conscious and has taken steps to offset the pollution created by Baosteel by covering 45% of the factory grounds with trees and foliage.  In reality, we learned that Baosteel is a small city with a zoo, pool, and other amenities that serve the employees and their families who live on-site.  I could not imagine an American company doing so much to take care of their people, and remember that this plant is in a country that often has a reputation for being a “pollution haven” by its detractors in the rest of the world.  Personally, I did not smell much pollution in the area and regardless of how effective their efforts are, one ought to give them credit for trying.

We witnessed the miracle of steel processing from the safety of a catwalk above the fray of the factory floor.  As we stepped into the room, it seemed as though we had been transported to a scene in Atlas Shrugged.  The heaviest of heavy industry came together in a shower of sparks emanating from fiery red steel ingots and measuring initially about three feet wide, by 50 feet long, and a few inches tall.  Over the course of a quarter mile of machinery, rollers pressed it down until it was much thinner and several times as long.  Before the metal was completely cooled, it was rolled into a coil.  Having finished, it was shipped off as the raw material for the next producer to use in his manufacturing.  Not only does the product from Baosteel go around the world but is used in a wide variety of applications from weapons to automotive, marine components to soda cans, and many more.  As a matter of fact, the 1 Yuan coin is stamped from their alloy.

As we drove around the city-factory, I was struck by many things.  The scale of the machinery was beyond anything I had seen before.  The blast furnace was actually several buildings because one could not contain it, for example.  Baosteel has three port harbors.  One is for receiving iron ore from Australia and Brazil.  A second is for shipping the finished product all over the world.  A final one is for the removal of slag, the impurities taken out of the ore in the smelting process.  It is common practice to recycle this slag and our tour guide was proud to inform us that many buildings are constructed of concrete made from Baosteel’s unusable materials. 

Despite the rather sun-shiny view we were given by the Baosteel executive/tour guide, I did hear from other sources that it is plagued with some large, but not unsurprising in light of the fact that it is a government-owned institution, problems.  First and foremost, and as one might expect, it is a highly corrupt institution.  It turns out that the monsters of patronage politics and its twin crony capitalism are alive and well all over the world when business and government are mixed. 

Overall, however, the tour was an eye-opening experience by any account and I came away with a more complete appreciation of the Far East’s progress.  So often in economics classes we will hear that the Chinese are building towers and buildings at unprecedented rates.  But this comes alive when we are greeted by a forest of cranes upon arrival in Shanghai.  In the same way, we hear that manufacturing is booming.  But I can say with some confidence that one starts to leave the realm of knowing and enter that of understanding while walking through in a room heated and illuminated by glowing steel. 

I didn't take this picture, but this is the room we saw. The line of fire is a steel ingot being rolled.

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The Enjoyment of Life and Liberty, the Means of Acquiring Property

I was reading recently that the famous line from the Declaration of Independence that calls “life, liberty, and the pursuit of happiness” inalienable rights is a paraphrasing of an idea that was expressed somewhat earlier that year by the writer of Virginia’s Declaration of Rights, George Mason.  See if you can find the similarity.

            “That all men are by nature equally free and independent, and have certain inalienable rights, of which, when they enter into a state of society, they cannot, by any compact, deprive or divest their posterity; namely, the enjoyment of life and liberty, with the means of acquiring and possessing property, and pursuing and obtaining happiness and safety.”

            That is Section One and clearly inspired Thomas Jefferson to start the US’s own Declaration with a somewhat more concise statement.  Mason hit upon a very important point in writing this bit, that the possibility of private ownership is part of the package of rights endowed to humans by the “Law of Nature and of Nature’s God” (to borrow from Jefferson).

            The idea of property is something that people often take for granted because it just seems so natural.  Yet a large issue arises when a government or some other authoritative entity encroaches on the property of others.  Often times, some will take the ideological stance that private property should be abolished and everything be shared equally.  Thankfully this is an antiquated view.  But a more common view, even today, is that the resources of those who possess more than the average citizen should be taken and redistributed to those who have less.  This broad concept is used, in part, for the justification of progressive taxes, entitlement programs, and the like.  But I digress.

            The ability to have and securely hold property is not only a human right necessary for the individual, but also for the smooth functioning of society as a whole.  Imagine what the world would be like if there was no property or only limited ownership! At the personal level, the need for ownership is easy to see.  After all, knowing that you have a bed, toothbrush, and cereal that will not be appropriated by others at their discretion is an important part of a smoothly operating life.  But at the level of society as a whole, things become more abstract.  Bur private ownership is crucial here too.  For example, patents, trademarks, and copyrights exist so that the creator of a medicine, the engineer of a car, the author of a book, or the scientist of some new groundbreaking material can reap the reward of his labor.  Without that, there would be no incentive to create.  Even for people who are motivated purely for the betterment of humanity must at the very least draw in the resources to pay for outlays made in the development process.

            In a different vein, think of the owners of businesses.  If they cannot operate in a legal environment which protects them from theft, then they will have very little incentive to do business in the first place.  One would rightly wish to reap the benefits and profits of his business if he must incur the costs and risks associated with it as well.  The benefit for society is the fruits of his labor.  Boeing makes airplanes, AstraZeneca makes medicine, and Archer Daniels Midland makes food.  Taken as a whole, the product of everyone’s labor is for the benefit of all a country’s inhabitants.  This well-functioning economy is made possible by many things, not the least of which being private ownership of the means of production, both physical and abstract.  Without property, a nation would function no less if it deprived its citizens of their liberty and even their lives. 

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Poster of the Year

Sometimes you see something that just has to be shared on an economics blog. Today's piece is a poster I saw hanging in my friend's room, which was originally painted by Glenn Beck and can be found here. More original content is coming soon. I've just been so busy with school work. Summer is coming soon and that should allow me to spend more time writing here.

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Margaret Thatcher: A Legacy of Principle

                Today the world mourns the death of Baroness Margaret Thatcher, the longest serving and only woman to be Prime Minister of England in the 20^th century.  Born in Lincolnshire, England in 1925, she began her career as a chemist and later joined politics in 1959 as a member of parliament.  She was most notably influenced by The Road to Serfdom, a book by everyone’s favorite: FA Hayek.  This piece talked about the evils of government intervention and why a more hands on central government was sure to expedite the downfall of a nation.

                Elected as Prime Minister in 1979, she carried the worldview set out in Hayek’s works and set about the enormous task of privatizing government-owned companies like British Steel as well as utility companies and others.  She was also famous for fighting labor unions and increasing interest rates to encourage saving.  This had the effect of slowing the growth rate of money supply and brought the rate of inflation down from 18% to 8.6% over the course of her tenure. 

As is typical of a disciple of classical and neoclassical economics, she slashed government spending ruthlessly in many areas including a 3.3 percent cut in defense, 67 percent cut in housing, and 5.8 percent cut in transport.  She did increase government spending in absolute terms between 1979 and 1990 by 12.9 percent by choosing to allocate resources to employment and training (+33.3%), health and social security (+31.8% each), and law and order (+53.3%), among others.  She was also instrumental in the skirmishes around the Falkland Islands when it was invaded by Argentina, preserving that territory for the Crown.

She acquired many detractors over the course of time, most notably in the Soviet Union who christened her the “Iron Lady”, a moniker that she embraced.  She was known for bold words that were often well received, but had a tendency to offend some who could not stomach disagreement with their own beliefs.  The people that tend to leave an impression on society are rarely known to be soft spoken.

                When I heard about her passing, I recalled a U2 lyric and thought, “’the last of the rock stars’ is gone”.  She belonged to a different era, an era where political correctness had not yet been contrived and a person was willing to be 100 percent transparent regardless of the ramifications for popularity.  She was from an era when a person’s beliefs guided his actions throughout time and not just conformed to the circumstances of the moment and disposition of the crowd around him.  The Iron Lady was well-beloved by some and well-hated by others.  But even her detractors would have to acknowledge that behind all the things she did and what she said was a strong human being that always had the best intentions of the British Isles at heart and would sacrifice anything, even her own interests, to do what she believed was right.  That is a lesson I think we should take to heart for our own integrity and the welfare of those around us.

                MSN has a page of her best quotes which I found to be an enjoyable read but there is a quote in particular I wanted to share from the 2011 movie “The Iron Lady”, a dramatization of her life, which sums up her character quite well.

“We will stand on principle, or we will not stand at all.”

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What's the Big Deal with Cyprus?

Trouble in paradise?

            To be perfectly honest with you, when I first saw Cyprus making headlines I thought to myself, “is this becoming news because the Wall Street Journal is tired of making front page stories about the Federal Reserve’s endless announcements to continue its quantitative easing program until 20xx?”  I’m telling you, this shows up on the front page of the WSJ at least once or twice every week and I think that Bernanke needs to realize that the world has caught on to his game.  I digress.  What is the big deal with Cyprus?  That’s the question that’s been in the back of my mind ever since the crisis popped up.  I’m sure that a big chunk of the issue is hype related to the fact that the Eurozone crisis isn’t really selling news anymore.  At the same time, a few things have happened differently with this crisis that make it noteworthy and not just another country experiencing hard times.  So the rest of this post is divided into three sections: an overview of the crisis itself, then a part on why this crisis is a big deal and one on why it is not a big deal. 

            The financial crisis in America had pretty far reaching consequences as we’ve seen.  For Cyprus, which is so dependent on tourism and shipping, those consequences hit quite close to home.  As a result of those tough times, it has been in a recession since 2009.  Government debt, in a manner similar to most of the rest of the world’s countries, has increased significantly since then.  Things got much worse recently when credit agencies downgraded its governmentally issued debt in 2011.  As we’ll see in the next section, most of Cyprus’ economy is involved in the tourism industries but there is a large banking industry for off-shore accounts, particularly Russian business magnates.  Allegedly 60 billion Euros worth of Russian assets are in Cyprus.  Cyprus banks are also very closely tied to the Greek economy as it had accrued 22 billion Euros of Greek private debt.  The wave of financial upheaval in Greece did not have very far to travel to drown its island cousin.  Still struggling from that issue, the credit downgrade was the spark that set the powder keg off and everything began to fall apart.

            Not one to let a comrade go to pieces, especially when it is so heavily invested, Russia loaned 2.5 billion Euros to Cyprus to be able to cover spending and refinance its debt.  This was a bandage solution, but a help nevertheless, until the European Financial Stability Facility gave them a bailout at the end of November, 2012.  The particulars of the bailout are fairly typical of any given one so I’ll spare the details.  The notable activity was the bailout from the European Central Bank and the IMF, which was in the amount of 10 billion Euros and, as part of the deal, took 6.7% of the amount in Cyprus bank accounts up to 100,000 Euros and 9.9% in accounts over 100,000 Euros. 

            What do you think when you think of Cyprus?  I always thought of fishing and I imagine most people do.  It may have been the national pastime back in the day, but I was surprised to learn that the populace is predominantly employed in service sectors related to tourism.  It is, after all, one gorgeous island nation.  Let me give you some particulars though.  Pulling numbers from the CIA’s World Factbook, I see that the country’s GDP is $23.57 billion (PPP) and the average gross salary is $2,636 per month.  Per capita GDP, also in purchasing power parity terms, is $26,900/year.  It has a population of 1,155,403, making it rank 160^th in the world.  It is considered a developed nation.  All in all, this is a small country and it’s crisis, while a big deal to them, does not really have repercussions in most of the rest of the world.  Remember the amount of the bailout?  I would venture a guess that 10 billion Euros is not a whole heck of a lot of money for the IMF considering that it holds claim to almost 11 trillion dollars worth of currency.  The biggest non-Cypriot consequences will likely be in Greece and Russia and any other folks they do major trading with, but the vast majority of the world goes on unaffected. 

            That is not to say that we in America should overlook this crisis because of the “creative” measures Cyprus has taken to make the bailout happen.  Recall the levy on bank accounts from above.  When I first heard about it I was first stunned beyond belief and then dreadfully (and hopefully irrationally) scared that this could become a common tactic.  Imagine a government reaching into its citizens’ bank accounts and taking their money!  Then I realized that… governments already steal their citizens’ money through taxes.  That is a whole other can of worms that will have to be opened some other time.  But for now, let us say that taxes are probably a necessary evil that we’ve all come to live with, but the idea of taking money right out of a bank account is just astonishing.  It’s really quite unheard of, quite an infraction of property rights, and sets a scary precedence now that this is on the table as a feasible option for ailing countries to solve their monetary crises.  That is not to mention the fact that they are taking foreigners’ deposits as well! 

            The Sicilian, from The Princess Bride, told us that the classic blunder is going into a land war with Asia.  We shall see now if Sicily’s neighbor on the other side of the Mediterranean accidentally started one by taking Russians’ money.  Perhaps desperate times require desperate measures, and I certainly won’t claim to know what will happen next, but it takes some level of desperateness to steal peoples’ money right out from their bank accounts and I suspect that a financial crisis is only the beginning of their troubles. 

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The Price of Money

           Anyone with any level of familiarity with economics knows the saying that there is “no such thing as a free lunch”.  This is the easy way of summing up the concept of opportunity costs: that when you do something with your time, money, or other resources, that you forego doing the next best thing that you could have done with that time, money, or other resource.  If I buy a movie ticket, I cannot use those 10 dollars to buy two five-dollar foot-longs from Subway.  It’s a pretty straightforward concept.  Now if instead of two hours of entertainment or a sandwich, you wanted to buy money, you could take what we know is called a “loan”.  While it might seem counterintuitive to buy money with money in the future, loans are created with interest added onto them to compensate the lender for his initial outlay and to charge the borrower for taking money that was previously not his.  In this arrangement, both parties are better off because he is able to fund something right away that might not have been attainable and the lender is able to make money by selling his money.  Loans make up a massive industry between mortgages on the personal level, commercial paper on the corporate level, and interbank loans between commercial and investment banks and the central bank.  These loans make up transactions worth trillions of dollars every year and the interest rate is the driver that allows all of them to happen. The interest rate is what a borrower has to pay to be able to use the money they take now, as opposed to their own money later.     

            At all levels, from individuals to the largest banks, the interest rate also encourages people to save or spend their money.  For example, if you could get 5% on money saved in a bank account (besides living in a land of unicorns), you’d be much more likely to save it than if the interest rate was only .05%.  This is because you get more value from the former situation than the latter.  Plus, your “next best thing” might be more valuable to you than .05% and less valuable than 5% interest, prompting your ever-rational self to spend money in the case of the .05% and save it in the case of the 5%. 

            The Federal Reserve understands this incentive structure and influences the interest rate that banks use as a benchmark for the rest of their interest rates in such a way that they deem best for the economy.  They need to be careful though, because the interest rate has such massive and far-reaching consequences.  These days, since the United States is in an economic slump, the Reserve has been trying to stimulate the economy by trying to get people to spend.  As we know, the way to encourage spending is to lower the interest rate and so that’s what they have been doing. Unfortunately for the Fed, the nation as a whole is spending less and saving more anyways because it is scared of what’s coming in the future.  What’s worse for them is that the nation seems to have reached something my professor would call a “zero lower bound” where the interest rate can’t be lowered much more.  So the Reserve has gotten creative in its economy-manipulating tactics and is introducing money into the economy in unprecedented amounts.  That’s a whole other can of worms to let out and untangle in a different post.

            The economy runs on expectations and right now the Fed, one could argue out of necessity, has dedicated itself to keeping interest rates low for years.  Fed watchers much have a really boring job these days because I can summarize their past few and certainly next few press releases in one sentence, “We will keep interest rates low until 2014 and continue with our program to buy Treasuries.”  2014 will roll around and they’re singing a different tune, or at least replacing “2014” with “2016”, that is.

            The glimmer of hope in this low-interest-rate situation is for those in need of loans, whether it be a home mortgage, student loan, business loan, etc.  Buying money is cheaper than ever and the Reserve’s hope is that people will start to again have the confidence to invest in new projects that will bring our economy out of the soup it’s been in for the past few years. 

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Broken Actions in Broken Systems

            There are a very few broad concepts that economists have identified as being problems that are quite difficult to solve.  They go by dramatic and ominous names like “adverse selection”, “moral hazard”, and most difficultly, “tragedy of the commons”.  One such problem that I’ve encountered recently is the principal-agent problem, the idea that non-optimal outcomes will result when the person acting is different than the one who will take the consequences of the action.

            In economics, we often solve problems by creating incentive structures that will make it in the best interest of a person to alter his behavior.  Too much pollution? Carbon tax.  This makes it more costly to pollute (the new incentive structure) and so incents companies to find greener practices (the altered behavior) that are cheaper than paying the tax.  These kinds of schemes work in the business world too as we see compensation tied to performance.  If a salesman doesn’t sell, he makes very little money, and vice versa, thus incenting hard work.  These solutions work because people are self-interested and will do what is best for themselves.  Ideally, incentive schemes are constructed in such a way that those self-interests are aligned with socially beneficial ones as well, lower pollution and more sales for the company in the former cases.

            A problem, which we say is the “Principal-Agent Problem”, arises when the consequences of actions are divorced from the ones doing them.  While the name may conjure up an image of school headmasters conferring with CIA members, we use these words in a different sense. So what are principals and agents?  A principal is one who enlists the services of an agent to act on his behalf.  So by extension, an agent is one who acts on behalf of a principal.  People buying and selling houses are principals and the ones who broker the transactions are called “real estate agents”.  Take this following story as an example.  One of my friends works in the Air Force as a bomb technician and he said that the screws that they use on a particular bomb cost over 100 dollars each and that the only way that they are different than the screws at Home Depot, besides the fact that they only cost 10 cents there, is that they are stamped with a serial number. 

The problem arises when there is a mismatch between the consequences of the principal (the general public who enlists and funds the defense services of the military by paying taxes) and the agent (the military, which can use all the money its collective heart desires without any regard to future stability or practicality of its methods).  The military can spend indiscriminately because it knows that the tax payers will always be around to foot the bill and so they have no incentive to change their ways.  Tax payers end up buying screws for a thousand times as much than if they were a private contractors getting those screws from a hardware store.  See the problem?  Luckily the government doesn’t yet have monopolies in too many industries besides defense (for good reason, I suppose) and free market competition is allowed to prevail.  The average contractor will get his screws at Home Depot because the cheaper he can get them, the cheaper he can pass his services on to customers.  There is no principal-agent problem here because the contractor’s actions affect him only.  The same applies to practitioners in other industries as well. 

But I ask you this, that as we come to a time of eventual governmental dominance of the health care system, what new principal-agent problems will be created?  If divorced incentives allow an entity to thrive even when it spends a thousand times as much as it could on a screw, what does that tell you about the people, incentive structures, practices, policies, etc. of the rest of that entity?  You must extrapolate because I don’t have the words to express it all.  In light of this, imagine that we’re talking about peoples’ lives and not metal fasteners: who’s screwed then?  

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Why Data Matters

The final frontier of the human race is proving to be less intergalactic than Star Trek would suggest and much closer to home.  Advances in the physical sciences have taught us great and marvelous things about the world we live in and about worlds beyond our own.  In the place where science and business collide, a new “space” has emerged that has already begun to revolutionize the way we work, play, stay healthy and safe, and innovate in science and technology. 

            The idea of “Big Data”, which is the up and coming game changer, will seem foreign without looking at what data is on a small scale and why it matters.  Data is collected and organized bits of attributes for the subject being studied.  People collect data about where, how fast, and how far they walk when they wear a GPS pedometer.  One of my friends keeps a log of the money he spends on gas, etc.  All these data collections are good, but are not the end to themselves.  Here’s what I mean.  If I said that the average tariff rate for a given product in a given country in a given year is 5%, that would be an interesting fact to know, but would probably be a useless fact unless you were in the habit of learning tariff data for countries.  Data, when correctly used, can be used to create information.  Take tariff data for this country over the course of time and you can make a trend line to support your informative claim that “tariffs in Indonesia have been falling for the past several decades”.  If you pool that information with other information learned from other places, you can arrive at the end goal of data: insight.  We’ve established that tariffs have been falling, and say that we learned from other data that exports have been on the rise.  Then we can turn the information into insight when we compare them and find through analysis that tariff rates and export levels are inversely correlated or when we apply that information and suggest that a country should lower its tariffs if it wants to encourage international business in a given industry.

            So data is a precious commodity because it turns to information and information turns into insight.  It has the potential to change the way we live and work and, as I said, has started to do so already.  Retail businesses have been using data to track inventories and shipments for decades, but now a new level of insight has been made possible through the advent of Big Data science.  Companies can now track a particular customer’s purchases and then send targeted marketing materials that are relevant to them.  Some might find this invasive, but whether it is or is for the sophists to decide.  The advantages of a business knowing itself and its customers are inestimably and undeniably valuable.

            Sun Tzu famously said in his book, The Art of War, “If you know the enemy and know yourself, you need not fear the result of a hundred battles.  If you know yourself but not the enemy, for every victory gained you will also suffer a defeat.  If you know neither the enemy nor yourself, you will succumb in every battle.”  Data and its interpretation unlock the potential for knowing yourself on a business level and a personal level. 

            Let me use an example that is close to home.  This year, I started a used clothing store with some friends.  We have a database that records each item that is taken, where the customer is from, and other attributes.  At the end of the day, we can look back and know what items are popular, women’s shirts for example, that we’ve served people from nearly 30 states and countries all over the world.  We get comments and suggestions for improvements that we can take into account for future operation.  Now imagine that we have a massive customer base, huge resources, and are a multinational corporation.  Say we’re Target or Wal Mart with access to talented people in all industries.  I can attest to the benefit data has had for our operation, small as it is.  So I can imagine how it must be driving business elsewhere.  Business is not the other place where the Data revolution has been happening.  Medical research has grown by leaps and strides with the invention of new data collection technologies and the advent of distributed computing/crowdsourcing has allowed for dramatic cuts in processing time and costs.  The benefits of these new technologies have helped in counterterrorism operations and other law enforcement and more sectors than one could even name.

            Exabytes of new data are made at an increasingly growing rate and the full potential has yet to be seen.  But I suspect that as humanity explorers this new frontier, our newly gained level of self-knowledge gained will allow us to win victories in efficiency and quality of life that are an important par of building a better future. 

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A Broken Parachute for Fiscal Cliff Jumping

            We have some great news from Congress that the fiscal cliff has been averted, apparently.  The legislation that is estimated to raise $600,000,000,000 over the course of the next decade will raise taxes on individuals making more than $400,000 per year and couples making more than $450,000 per year.  It raises the estate tax from 35% to 40%.  It changes the alternative minimum tax to be adjusted for inflation every year (which was something that should have been written into the original AMT legislation, but better late than never). Other highlights that CNN points out are an extension of unemployment insurance for 2 million people and renewed tax credits for research and development, child care, and tuition.  Break open the champagne, folks, we wiggled out of that pickle!

            Or did we?  I would submit that America has been off a “fiscal cliff” since some time during the Bush Administration and that Obama has only tied an anchor to the country’s feet.  I submit also that this “fiscal cliff” of late 2012 was a paper tiger in light of the country’s real financial issues.  Would you care for me to back those claims up?  Here we go! When Clinton left office, the government enjoyed a “budget surplus”: tax revenue was greater than expenses so extra money could be used to chip away at the national debt.  Bush reversed this trend and the national debt has been growing ever since.  By the time he left office that debt had grown from $5,727,776,738,304.64 to $10,626,877,048,913.08.  That is no small amount of money, and I’m purposely writing the numbers out in their fully extended version because I think that the impact of these mind-blowingly large numbers is lost when using words like “billion” and “trillion”.  Now when Obama took office, the national debt was $10,626,877,048,913.08, as we see from above, and as of December 28th, 2012, the national debt was $16,336,461,552,606.35 (statistics from treasurydirect.org). So we’ve had two presidents in a row who have spent vast amounts of money and Obama has added even more to the national debt in one term of office than Bush did during his eight years combined.  It is no secret that spending more than you make is unwise on a personal level or company-level so it is kind of appalling that a country can get away with it.  There are obviously quite important differences that allow a country to continue in this bad behavior but the real consequences of borrowing money and accruing debt is the same for any level of entity.  

            If a bank calls the debt of someone with a home mortgage and the person can’t pay, the house is taken by the bank.  If a government’s debt is called by the entity that owns its debt, what happens?  I shudder to think considering that a lot of US debt is owned by foreign nations.  Luckily America doesn’t owe any single nation so much that it couldn’t be repaid through some difficult maneuvers, at least not yet.  As time goes on, this will not be the case and, as one Chinese professor told our class one day, “The Chinese know they’ll never be paid back”.  Infer as you will. 

            But back to the Fiscal Cliff: I said it was a paper tiger and so I hope you see that this scrambling and ballyhooing for an extra 4.6% of income tax revenue from less than one percent of the population is miniscule in light of the massive financial trouble we’re in already.  I grant that the insidious tax increases in Social Security will help in some way with that chunk of government spending, by impoverishing the rest of us to a 2% greater extent (the amount of the temporary reduction that expired).  What can be done though?  Surely we don’t expect the government to solve its financial woes like regular folks do: by spending less and saving more.  After all, it is much easier to raise taxes than to scrutinize spending and eliminate waste or inefficiency.  Why go through the trouble of becoming responsible when you can rob your populace of their money?  This is exactly what we saw in the 11th hour of congressional negotiations when all we heard from Washington was hateful rhetoric and the news that no spending would be cut, only that taxes would increase.  This was a huge political victory for the President who has always been clear that he wanted to tax the rich more.  Good for him!  I wish there was a silver lining here, folks, but this extra money raised through new tax revenue does little more than open a broken parachute as our government plummets ever closer to financial doom.    

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