Wednesday, 24 August 2016

Maslow's hierarchy of money

A new study shows that the form of shadow "money" used in US prisons is changing. For many years it has been cigarettes (tobacco), and to a lesser extent stamps and envelopes. But now it seems the popularity of these in the prison black economy is declining - in favour of food. Specifically, Ramen noodles, a high-calorie, substantial foodstuff.

Without examining the reasons for this change, it would be easy to assume that this is a matter of relative scarcity. Perhaps Ramen noodles are cheaper and more widely available than cigarettes, so inmates are turning to them because they are easier to obtain. If so, then Gresham's Law tells us that Ramen noodles would eventually become the principal medium of exchange. Cigarettes would gradually disappear from circulation, becoming an increasingly expensive store of value.

Of course, rich prisoners might worry that lack of demand for cigarettes would reduce their value - after all, if you can't sell your ciggies, you might as well smoke them. So they might hoard Ramen noodles in order to restrict the amount in circulation, or they might try to force up the value of Ramen noodles by artificially pinning their price to cigarettes. We might end up with something akin to a bimetallic standard, with Ramen noodles being the "silver" used by the poor and cigarettes becoming rich prisoners' "gold".

This would create hardship for poorer prisoners, some of whom would be unable to obtain the noodles needed to buy other near-essential goods such as hygiene products. Perhaps there might be some enlightened prison officer who would deliver an inflammatory speech demanding the free circulation of Ramen noodles. "You shall not crucify prisoners on a cross of cigarettes"......

Alternatively, prisoners could be taking to Ramen noodles because they are all giving up smoking and want a new, healthier type of money. "Maybe Ramen noodles are the prison equivalent of Bitcoin", said one bright spark on Twitter.

Umm, no. The change is being driven by a fall in supply, not demand. And it is not the supply of cigarettes that is falling. According to Michael Gibson-Light, the author of the new study, the change is caused by deterioration in the supply of food:
"Prisoners are so unhappy with the quality and quantity of prison food that they receive that they have begun relying on ramen noodles -- a cheap, durable food product -- as a form of money in the underground economy," he said. "Because it is cheap, tasty, and rich in calories, ramen has become so valuable that it is used to exchange for other goods."
The US's prisons are overflowing with people, as politicians insist on more and longer prison sentences. But the funds to run the prisons are not keeping pace with the increase in inmates. Consequently, prisons are being forced to cut back on basic provisions, such as prisoners' food.

So the change in prisons' "shadow money" is being driven not by Gresham's Law, but by Maslow's hierarchy of needs. The lowest level on Maslow's hierarchy (see the image at the head of the post) is physiological needs - air, food, water, shelter, warmth, excretion.* Inadequate food within US prisons has financialised prisoners' physiological needs. It has turned food into money.

Tobacco addicts may claim that they have a physiological need for a smoke, but the widespread substitution of Ramen noodles for cigarettes suggests that for most prisoners, the need for tobacco is higher order. It is easy to see that stamps and envelopes belong in the "love and esteem" section, since they enable prisoners to communicate with family & friends. But where does tobacco fit in? Perhaps there is a hierarchy within a hierarchy, a relative ranking of physiological needs. Tobacco is only a driving physiological need until a greater need shows up.

There is of course a positive effect from this change. If cigarettes will no longer be so freely available, fewer prisoners will smoke them. But against that we must put the health effects of restricting food. What kind of society is it that will provide so little food to prisoners that a black market food supplement becomes money?

Food, of course, does not only feature at the physiological level. Few would argue that caviar and truffles are a physiological need: they belong in the "esteem" section, three levels higher. And in some forms of "self-actualisation", food intake can be severely restricted - ideological veganism, for example. Food features at every level of the hierarchy. And so does money, in one form or another. Money is the facilitator, the means by which people are able to meet their needs, including many of their higher-order needs: after all, self-actualisation is a bit irrelevant when you don't have food or shelter, and relationships can be broken beyond repair by failures at the physiological or safety level.

But Maslow's hierarchy applies to the individual, whereas what constitutes "money" is a collective decision. As Hyman Minsky said, anyone can create money, the problem is getting others to accept it. Money is a social construct. And yet - just as in Maslow's hierarchy, lower-order needs drive out higher-order ones, so when a whole community is distressed, lower forms of money drive out higher ones. Silver replaces gold, paper replaces silver....but when people are starving, gold, silver and paper become worthless, and food becomes money. We can, in a way, regard Gresham's Law as the social equivalent of Maslow's hierarchy.

This touches on fundamental questions about the nature of money. Food-as-money works for those who need food: inflation is benign, since it ensures that all those who want food can have it. Grain standard currencies are very good for agricultural communities, since they ensure that the price of food naturally adjusts to production and wide fluctuations in food prices are avoided. But for those who want to save for the future, food-as-money has serious downsides, including the fact that it can be eaten. When times are hard, the temptation to eat the money and leave nothing for the future can be very high. You can't eat metal or paper.

There is a vast ideological gulf between those who regard money as primarily a store of value, and wish to fix its supply to prevent the value falling, and those who regard money as primarily a medium of exchange, and wish its supply to respond flexibly to demand. In choosing Ramen noodles over cigarettes, it seems that prisoners prefer to regard shadow "money" as a medium of exchange.

But it is early days yet. There may still be a backlash from those rich in cigarettes. And you never know, they might even start using Bitcoin.

Related reading:

The nature of money
The golden calf
Ultra-liquidity - Pieria

Image from Wikipedia.

* The image at the head of the post shows sex as a physiological need, but this is disputed.

Sunday, 21 August 2016

The art of economics

Collected here are my posts about the changing nature of economics. Olivier Blanchard says "there is room for art as well as science". In these posts, I develop the concept of economics as art: vague, conceptual, imaginative, complex, and subjective. In other words - human.

I should make it clear that I am mainly talking about macroeconomics, although microeconomics is also changing for other reasons.

The problem of mathematics
When the Nile floods fail
The failure of macroeconomics
The necessary arrogance of elites
Spurious precision
No, please don't show me your model

Friday, 19 August 2016

No, please don't show me your model

Unsurprisingly, on my post "The Art of Economics", which attempted to put the mathematical models beloved of mainstream economics firmly in their place, is a comment defending mainstream mathematical models. Here it is, in part:
Secondly, you definitely don't need obscure heterodox models to predict a financial crisis. I've cited it before, but for instance Kiyotaki-Moore basically sketches out how a crisis like this can occur. There are actually plenty of examples of perfectly fine mainstream papers on this topic. And it wasn't just heterodox economists that predicted it. People like Dean Baker, Roubini or even Krugman didn't exactly rely on post-Keynesian or Minskyian economics, their logic was fairly straight forward. Stiglitz has some great models on bank failure, which are essentially mainstream info-asymmetry economics. I also think Minsky is useful but not that useful, and it's not especially scientific. He doesn't really have any kind of model, he just essentially asserts that banks will turn to speculators (and also made a lot of mistakes with regards to importance of credit cards, diminishing importance of large infrastructure loans etc..) The mechanisms aren't adequately explained. At least the Austrians, who I definitely oppose, have a mechanism for how banks turn to unstable speculators - aggressive monetary policy. 
This is bad science of the "show me your model" variety. A mathematical model may give apparently accurate results, but that does not mean it has the right theoretical foundations. Valuing the model over the theory was lampooned by the great physicist Richard Feynman, in this lovely metaphor:
[Feynman] imagines a Mayan astronomer who had a mathematical model that perfectly predicted full moons and eclipses, but with no concept of space, spheres or orbits. Feynman then supposes that a young man says to the astronomer, “I have an idea – maybe those things are going around and they’re balls of rock out there, and we can calculate how they move.” The astronomer asks the young man how accurately can his theory predict eclipses. The young man said his theory wasn’t developed sufficiently to predict that yet. The astronomer boasts, “we can calculate eclipses more accurately than you can with your model, so you must not pay any attention to your idea because obviously the mathematical scheme is better.”
In dismissing Hyman Minsky's hypothesis because the model was incomplete, my commenter has behaved like Feynman's Mayan astronomer. Never mind the theory, show me your model....

So, let's look at the mainstream model recommended by my commenter. Like all (yes, I mean all) pre-crisis economic models, Kiyotaki-Moore does not model the financial sector accurately - in fact it does not model it at all. And because of this, it models a financial crisis as starting with some kind of exogenous shock coming out of the blue, in this case a temporary shock to productivity. The model is a farming model, so a productivity shock of this kind might be an adverse weather event, perhaps.

Now, there may indeed be a shock that triggers a financial collapse, but it is not necessarily exogenous. In 2008, it was the fall of Lehman Brothers, which was by any reasonable standards an endogenous shock: similarly in 2007, BNP Paribas's announcement that it could not value subprime MBS, was an endogenous shock. Do endogenous shocks have different effects from exogenous ones? We do not know, and the model does not tell us.

But in the absence of any model explaining how debtors become fragile, we can have no reason to assume that ANY shock, exogenous or endogenous, would have destructive effects. Indeed Kiyotaki-Moore themselves say this is a weakness in their model:
A weakness of our model is that it provides no analysis of who becomes credit constrained, and when. We merely rely on the assumption that different agents have different technologies. 
"Different technologies". What a get-out line. But if you exclude the financial sector from your model, that's the kind of blanket excuse you end up with.

If your model cannot explain how people and corporations become over-leveraged and therefore fragile, it can have no predictive power whatsoever. All it can do is say "IF people/businesses are over-leveraged when a shock hits, THEN this is likely to be the effect". So Kiyotaki-Moore can neither explain nor predict a financial crisis. It merely describes how an (unexplained) shock propagates itself through an (unexplained) over-leveraged population, with long-lasting negative effects. That is useful, of course - in fact I think this model does a pretty good job of explaining the amplifying effect of collateral price falls in debt deflationary collapses. But that isn't what my commenter claimed it did.

Let me be clear. I don't have a problem with mathematical models, as long as they use appropriate mathematics and have a sound theoretical basis. But we have to respect their limitations. They don't necessarily adequately explain economic events, let alone reliably predict them. And they are never a substitute for logical thought. .

So I don't want you to show me your model. I want you to explain your thinking. What is your theory, and how have you defined it? What thought processes brought you to this point? What are your assumptions, and how have you justified them? If you cannot explain these in words, then however clever your mathematics, your model is devoid of substance. Throw away your Greek dictionary, and write me an essay in plain English.

Related reading

Photo of Richard Feynman from

Thursday, 18 August 2016

Spurious precision

Over at Bloomberg View, Noah Smith has a pop at what he calls “heterodox economics”. By this he means the new ideas in economic thinking that have sprung up since the 2008 financial crisis but so far haven’t made it into mainstream economic journals.

Noah starts by admitting that mainstream economics abjectly failed to predict the crisis and gave little or no guidance on how to deal with it. Because of this, according to Noah, “many people have looked around for an alternative paradigm -- a new way of thinking about macroeconomics that would have allowed us to avoid the pitfalls of the Great Recession.”

Indeed they have.  Though some of the ideas are not so new – Hyman Minsky’s “Financial Instability Hypothesis”, for example, dates back to 1992.

According to Noah, the search for alternative thinking inevitably attracted people who – for whatever reason – “felt shut out” of the mainstream. And as an example of one of these so-called “heterodox” economists, he cites me. Here’s Noah's quotation from my post “The necessary arrogance of elites”, together with his introduction to it:
Many among the heterodox would have us believe that their paradigm worked perfectly well in 2008 and after. As an example, take a recent blog post by British economics writer Frances Coppola. Coppola likens mainstream macro to classical music, which walled itself off from the innovations of rock and jazz. Like the musical innovators of the 20th century, she claims, the heterodox have found something that works better than the ossified old ways of the elite:
Heterodox economists working in the real economy –- many of them untrained in formal economics –- not only predicted it but correctly identified the causes …
The redefinition of the foundations of economics that is currently being done by heterodox economists will inevitably result in many of the models beloved of academic economists becoming obsolete.
(The post from which these quotations are taken was actually written in 2012. It was reprinted recently by Evonomics under the title “What UnpopularMusic Can Teach Us About The Future of Economics”.)

The paragraphs from which Noah has taken these quotations actually say the exact opposite of what he claims. Here they are, in full:
And as with “serious” music, when economics becomes so divorced from reality that it fails adequately to explain the real world in which people live, people reject it. People rightly ask why academic economists failed either to predict or adequately explain the financial crisis, whereas heterodox economists working in the real economy – many of them untrained in formal economics – not only predicted it but correctly identified the causes. There is a real danger that the anger people feel over what they see as the failure of mainstream economics leads to rejection of mainstream economics in its entirety and, importantly, withdrawal of funding for academic economic research. This, I feel, would be a mistake.
We may not see the relevance of dynamic stochastic general equilibrium models in a world which manifestly is not in equilibrium. But that doesn’t mean that these, and other mathematical models, have nothing to contribute. The redefinition of the foundations of economics that is currently being done by heterodox economists will inevitably result in many of the models beloved of academic economists becoming obsolete: as with much of the experimental serious” music of the 20th century, they will not survive the test of time. But there will be models that remain relevant, and there will be others that appear obsolete but that will in due course be redeveloped and find new life in the new economic paradigm. If we allow them to disappear, our economic understanding in the future will be the poorer.
Contrary to the impression Noah gave, I was defending mainstream economics and its beloved mathematical models. But not because they have done a good job – they have not. And not because economics does not need a different paradigm. It does, desperately. Noah’s arrogant defence of mainstream economics shows this more clearly than anything the heterodox community could say.

We who live through this paradigm shift have a blinkered and biased view, rendering us unable to see the true value of either the old or the new. We either defend the old and reject the new, because the old is all we know and the new has yet to prove itself; or we reject the old and defend the new, because the old has failed and we need something to believe. These are, of course, extremes. The eventual synthesis will include elements of both old and new. In what proportions, history will decide.

And this brings me to my fundamental objection to Noah's post.

Noah's core proposition is that economics has no validity unless it is expressed in mathematical terms. He says that economics without mathematics doesn’t add up. But economics consisting entirely of mathematics doesn’t add up either. Exclusive reliance on mathematics as language is highly problematic, and not just because it inevitably creates a protected elite. It is because of the impossibility of precision. To explain this, here is another musical analogy.

Anyone who has ever attempted to write down, in conventional musical notation, exactly what a jazz singer does knows how imprecise and inadequate musical notation is. Yet when it is removed from the source and viewed academically, it creates a kind of spurious precision. The original intention is demeaned and deformed to fit into the straitjacket of the notation, and the notation then “becomes” the music. Gifted performers, of course, interpret the music from the notation – but in bringing it to life, they re-create imprecision.

So too, relying on mathematical models to explain how our complex, ever-changing world works demeans and deforms it. The more precise a model is, the more unrealistic assumptions have to be made to make it work, and the less likely it is to be an adequate representation of reality. Reality is imprecise and transient.

The great economists of the past knew this - which is why we do not find pages of Greek symbols even in the writings of those who, like John Maynard Keynes, were fine mathematicians. And some members of the mainstream are beginning to realise that economics is much bigger than their beloved DSGE models. Olivier Blanchard, for example, recently called for a more diverse range of models, including "ad hoc" schematics that have little precision and much imagination. "There is room for both science and art", he said. Though he can't quite let go of the DSGE dream, not yet......

Noah's post unfortunately seems to have elicited some rather defensive responses from the heterodox community, along the lines of “But we DO like mathematics!” or even, “Actually our mathematics is better than yours”. But this is to buy into Noah's core proposition. The heterodox economics community should - and, to be fair, in most cases does - reject it outright. Economics is not, and cannot be, exclusively mathematical. This is the terrible mistake that the mainstream economists of our time have made.

The spurious precision of mathematics led "serious" music down the blind alley of serialism. And it has led mainstream economics down the blind alley of general equilibrium. I defend DSGE models, yes, but for their future possibilities, not for their current application.

There is no need for the heterodox economic community to be defensive about vagueness. Vagueness is creative, and imprecision and ad-hocery are the future. The art of economics is being reborn.

UPDATE: I have removed from this post five bullet points which were intended as a very brief summary of Noah's post, and reorganised the post to compensate. Noah says that they are not what he meant, and I respect that. And anyway, they are a distraction from the core argument of this post.

Related reading:

Where danger lurks - Olivier Blanchard
Colds, strokes and Brad Delong
The Slowly Changing Resistance of Economists To Change - Steve Keen (Forbes)

Image from Sibelius.

Tuesday, 9 August 2016

Birth of a bank

I have been following with some amusement the death and resurrection of the Bitfinex exchange. Bitfinex was forced to suspend trading after losing nearly 120,000 BTC in a hacking on 2nd August. But instead of going into liquidation, as we might expect, it reinvented itself - as a bank.

Bitfinex had been doing bank-like things ever since its creation in 2012. It accepted deposits from some of its customers, and lent out those deposits to other customers - with the depositors' permission, of course. However, as long as customers controlled their own wallets, and default by a borrower rebounded directly back to the lender, Bitfinex could simply call itself an exchange, or a peer-to-peer lending platform.

Bitfinex kept customer money in individual wallets under lock and key - three keys, to be precise. Two of the three keys were needed for funds to be moved from the account (or two of three digital signatures, if you prefer).

One key was held by Bitfinex, and a second was held by a trusted custodian and signatory, Bitgo. For wallets containing borrowed funds and belonging to a US resident, the third key was held by the customer. For all other wallets the third key was held in cold storage under Bitfinex's control.

Clearly, since they did not control the keys, the customers did not have control of their funds. They could only move them by giving instructions to Bitfinex or Bitgo. But Bitgo would only operate its key on the instruction of Bitfinex: it would not accept separate instruction from the customer. So in practice, customers could only move their funds if they instructed Bitfinex to do so. This is already looking much more bank-like, isn't it?

But wait. Bank deposits are loans to banks, and depositors are senior creditors. In the event of insolvency, senior creditors are only entitled to a share of the assets - they don't have an automatic right to recovery at par. This applies even for insured deposits, since insurance is separate from the liability itself. In insolvency, all depositors may take a haircut - but insured depositors are then made good by their insurance. In conventional banking systems, deposit insurance is a public good, though it may be limited to smaller deposits. It exists primarily to prevent bank runs, and secondarily to mitigate the damaging effects of bank failures on more vulnerable people.

In contrast, in a custodian system, customers have not lent their money - they have placed it in a safe deposit box. They have every right to expect that even in the event of insolvency, their money is safe. This is why regulators like the CFTC insist that client money must be segregated from the broker's or exchange's own money. Losses must be born by shareholders and creditors, not by customers.

Bitfinex's system was supposedly custodian. But the fact that customers did not have control of their own funds suggests that it was not. After all, who ever heard of a safe deposit box to which the customer can only gain access with custodian permission, but custodian staff can raid at will?

And raid it they did. No, I don't mean the hacker - though that was a raid on certain customer accounts. I mean Bitfinex management.

Following the theft, Bitfinex management decided unilaterally to "socialise losses". It imposed a 36.067% haircut on all customer balances. It also turned out that Bitgo, the custodian, had no insurance against customer losses. So all customers suffered a loss. In effect, Bitfinex management raided customer deposit boxes to cover the exchange's losses. Importantly, they did so WITHOUT customer agreement. They treated depositors as if they were lenders to the exchange itself, not lenders to other customers.

On the borrowing side, Bitfinex does not allow customers to withdraw funds from their wallets until all borrowings have been cleared. It does not allow them to borrow more than 70% of the value of a short sale. And it will forcibly liquidate balances in order to settle loan obligations.Yet even with such coercive provisions, it seems that Bitfinex was in the habit of absorbing loan defaults rather than passing them on to the lending customers. So it also treated borrowers as if they were borrowers from the exchange itself, not from other customers.

It's all looking highly bank-like, isn't it? But wait. We have credit intermediation and maturity transformation, true. But for Bitfinex to be a bank, not just a peer-to-peer lender, we need a third element. Fractional reserve lending - or as it should be called, money creation.

As long as Bitfinex was only trading existing currencies, there was no fractional reserve element. Deposits were lent out to borrowers, and no money was created. But that has all changed now. As part of the bail-in of depositors, Bitfinex created its own currency.

The haircut of customer balances exchanged existing currencies (which Bitfinex can't create, but needs in order to settle its debts) for newly created "tokens" called BFX. These bear no interest, are pegged at par to the US dollar, and will (hopefully) be tradable. They have no maturity date, but they can be redeemed by their originator. So they are zero-coupon, perpetual, callable debt securities. Possibly, in the future, they could be shares.

Now, let's remind ourselves of the characteristics of a fiat currency. Fiat currency consists of "tokens", which usually bear no interest* but are tradable. The tokens have no maturity date, but can be called in by the issuer at any time. So fiat currencies are zero-coupon, perpetual, callable - well, are they debt securities, or are they equity shares?

But, I hear you say, fiat currencies are produced by central banks out of thin air, aren't they?

No. They are created by banks. Any fractional reserve bank can create fiat currency. The vast majority of fiat currency in circulation is created by commercial banks in the course of lending. Most countries choose to restrict the issuance of notes and coins to central banks or government. But in Scotland and Northern Ireland, banks issue their own banknotes, which are pegged at par to sterling.

Bitfinex has been lending on its own account. I'm sorry, but it has. And now it is creating its own IOUs to cover the fact that it doesn't have enough reserves to meet its obligations. These IOUs are currently worthless, of course, since Bitfinex has currently no intention whatsoever of honouring the notional convertibility to US$. But the customers either have to accept them or force Bitfinex into liquidation - which would potentially leave them worse off. The best the customers can hope to do is create some value by sticking with Bitfinex and trying to create a market in BFX.

And of course, if they succeed, there will be absolutely nothing to prevent Bitfinex doing more own-account lending and issuing more BFX to fund it.

Bitfinex has become a bank.

Related reading:

You've been buttfinessed - BitMex Blog
I am a bank
The IMF proposes the death of banking
Of course Scotland can use the (Scottish) pound - Forbes

Image from Positive Money.  

* In fact many forms of fiat currency do bear interest. But of course Bitfinex could pay interest on its tokens. That wouldn't really make any difference to what is going on here.