Jun 282013

Much talk about Bitcoin centers on the claim that it represents some kind of existential threat to the US dollar (USD) specifically, fiat currency generally, and maybe even the nation-state as a social institution and organizational structure. Considering that the total value of Bitcoin in circulation today, in June 2013, is approximately USD 1.25 billion, or 2% of Carlos Slim’s personal portfolio, one might easily conclude that Bitcoin fanboys are drunk on their own fumes and perhaps getting just a little bit ahead of themselves.

Deflating Inflation Fears

As I have pointed out before:

In general, and all other things held constant (or, as we say in the business, ceteris paribus), prices can rise for three reasons: demand increases (e.g., an auction or a popular restaurant), supply decreases (e.g., lower efficiency, war, or natural disaster), or the number of units of currency increases faster than the rate of increase of goods and services (inflation).”

If it fulfills even some of its potential, then Bitcoin could mitigate USD inflation, by increasing the economically relevant supply of available goods and services via the reduction of transactional friction, especially across borders and among the unbanked.

As things stand, a consumer in Suburbia is restricted to local merchants who will accept fiat cash and equivalents, stored-value cards, or cards tied to the banking system, on the one hand, and to online merchants who will accept stored-value cards, or cards and online derivative services tied to the banking system, on the other hand. That’s pretty much it.

Many of the payment systems that are tied to the banking system are either expensive or impossible to use across borders. This means that the supply of goods and services available to the Suburbian consumer is constrained by legacy and political inefficiencies in the international banking system.

The World’s Second-Largest Economy

With virtual currencies generally and Bitcoin specifically, consumers in Suburbia can buy goods and services from suppliers in Outland that hitherto have been out of reach, meaning that they effectively do not exist from the Suburbian perspective. While this might seem trivial to a Suburbian whose entire economic life is spent, as it were, in Suburbia, it is a daily headache for Outlandish suppliers and consumers, who comprise a rather significant economic force.

G’won… Click on the video!

For example, it is very difficult for local hotel operators in much of Latin America and the Caribbean to accept credit card payments directly from foreign guests as deposits prior to travel. This means that the foreign guests will tend to stay at hotels run by large international chains, putting the local hotels at a severe disadvantage. If a hotel operator in Latin America or the Caribbean accepted Bitcoin, even if only for the initial deposit, then anyone in the world could make reservations easily, and the effective worldwide supply of hotel rooms would increase.

This same story can be told for as many goods and services as one can imagine: coffee from small-scale roasters in Central America, small-label hot sauces from sub-Saharan Africa, local distilled spirits from the Caribbean, textiles from Southeast Asia, crafts from pretty much everywhere, personal services, software development, graphic design, world music, etc.

Before one dismisses the total value of small-scale global trade, one should consider that during the 2012 presidential campaign, Pres. Obama raised tens of millions of dollars in small-sized contributions, and that 83% of the world’s population lives outside the OECD. This same e pluribus magnum power of large quantities of small transactions is the driving force behind crowdfunding, which also can be facilitated globally much more easily with Bitcoin than with legacy options.

In the video above, Robert Neuwirth refers to the worldwide informal economy as the world’s second-largest economy. And, they don’t have bank accounts, credit cards, or access to capital markets, but they do have mobile phones, many of which can run Kipochi, even if they do not have smartphones that can run a Bitcoin wallet.

Ponder that for a moment, before reading further.

Somewhere in Nairobi, some street vendors are carrying more powerful financial technology in their pockets than 90% of the Suburbians reading this have in their whole houses.

Fear, Uncertainty, and Doubt

Bitcoin could essentially conjure into existence for Suburbians the goods and services produced by 5.75 billion potential trading partners in Outland that currently might as well be in some parallel universe. In so doing, the USD/stuff ratio (i.e., price level) could fall, even if the numerator (USD money supply) continued to grow at historically unprecedented rates, so long as the denominator (cool stuff from Outland) were allowed to grow even faster.

That’s right, widespread Bitcoin adoption could mitigate inflation! Those who claim the opposite assume that Bitcoin will supplant the USD for existing transactions, and that the two payment media will vie for shares of a fixed-sized pie, like two dogs fighting over a bone, which is silly. Chinese refinery operators are not going to buy Saudi Arabian oil with Bitcoin any time soon, as the percentage savings would be less than trivial. The USD will continue to function where legacy systems work well, and Bitcoin could open markets that have never existed before, if allowed to.

One concern that one comes across with distressing frequency is that tax collection might be made more difficult, if large numbers of Suburbians started transacting in Bitcoin, but there are alternatives to income taxes that can be as progressive as policy makers want them to be, including a national land tax based on assessed value, luxury goods taxes, automobile taxes based on sale price, etc., and tax collectors still can demand that all taxes be paid in local fiat and charge a conversion tax on Bitcion exchanges into the local currency. These suggestions should not be mistaken for a paean to the social welfare state, but merely as evidence that the taxation critique of virtual currencies is a red herring. Similarly, concerns about money laundering and terrorist financing are overblown, especially given the existence of Bitcoin’s publicly available blockchain, which records every Bitcoin transaction that has every been cleared and every Bitcoin user—including law enforcement and taxation agents— has access to.

Setting aside the red herrings, straw men, and other knee-jerk overreactions from luddites, the real issue is how Bitcoin can grease the wheels of small-scale global commerce, thereby removing the vast amount of friction from transactions across borders… which could ease inflationary pressure on the USD.

There’s Nothing to Fear but Fear, Itself

Should bankers be afraid of Bitcoin? Absolutely not! They can earn from the exchange into and out of Bitcoin, serve as escrow agents for Bitcoin users who prefer not to keep their holdings under a proverbial mattress, they can facilitate Bitcoin loans, use Bitcoin as a reserve asset, etc.

Should regulators be afraid of Bitcoin? No more so than any other commodity. In fact, perhaps even less so, seeing as how commodity markets are largely unregulated; it is the commodity derivatives markets that are regulated, and Bitcoin is a commodity, like gold, oil, or wheat, and not a derivative, like an option or a future. Now, if people start issuing options and futures contracts on Bitcoin, the of course regulators will have quite a lot to say.

Should law enforcement agents be afraid of Bitcoin? Hardly! The blockchain that memorializes every Bitcoin transaction for posterity can be read into a database and sifted every way imaginable using Big Data techniques. Also, it is remarkably easy to set up a sting operation with Bitcoin, which already seems to be happening.

Should tax collectors be afraid of Bitcoin? Perhaps, if their goal is to tax Bitcoin-denominated transactions that do not intersect with the banking system. However, anything that touches the banking system directly is recorded in accordance with banking regulations, and anything that touches the banking system indirectly is likely to drag the tax evader’s fingerprints through the blockchain, which is available to all without a subpoena.

Welcome to the 21st Century

Bitcoin is part of a larger transition away from the capital/labor economy to the service/knowledge economy. Welcome to the Age of Decadence, where disruptive innovations in engineering, entrepreneurship, and entertainment are announced with mind-boggling frequency. If government legislators and regulators clamp down on the work of frighteningly intelligent and disobedient young men and women, then that work will go to where it is tolerated, even if not embraced, per se, thereby impoverishing the populations that the governments are supposed to serve, protect, and represent.

Skype and Twitter are making a joke of national telephone monopolies. Remote collaboration tools are making a joke of immigration restrictions, and thus labor regulations. Free and open source software and hardware development tools are making a joke of patent and copyright regimes. The only way to stop or even slow this process would be to disconnect your country from the Internet, and, seriously, do you really want to do that?

Some legislators and regulators will try to shovel back the tide, and their people will be held back, as were the people of the USSR, Ghaddafi’s Libya, the military dictatorships that once reigned in Latin America, and Burma, Cuba, and North Korea today. Other legislators and regulators either will embrace or at least tolerate the inevitable change, and their people should fare well. Yet others will strike some middle path, with varying results.

What US officials in the Federal Reserve, the US Treasury, the Department of Homeland Security, the Internal Revenue Service, etc. do is anyone’s guess. It is obvious from my comments here what my hope is, and I continue to live in the USA.

If there are any Hortons in Congress… yop.

Invest accordingly.

Prof. Evans

May 062013

As Mark Knopfler of Dire Straits put it in “Telegraph Road“, after the homesteaders settle, then come the churches, then come the schools, then come the lawyers, then come the rules. And, as Danny Elfman of Oingo Boingo put it in “No Spill Blood“:

Who makes the the rules?
Someone else.”

So, what are we to make of this latest announcement that US regulators at the Commodities & Futures Trading Commission (CFTC)—the people allegedly responsible for the demise of Intrade—are not going to sit passively by and watch Bitcoin, that furry woodland creature that is giving status quo dinosaurs the fits, rise in prominence?

Bear with me, while I do that glass-half-full thing that I have done so well, to the great irritation of doom-&-gloomers, for more than a quarter-century.

This is FANTASTIC news! [Gads, how I miss the <blink> tag right now!]

If the CFTC regulated Bitcoin, or more likely Bitcoin derivatives, then this would officially legitimize Bitcoin and maybe even make it possible to buy it through a licensed derivatives broker, like OptionsXpress.

Yes, pipsqueak mom-&-pop operations would not be able to experiment with disruptive financial innovations, but Bitcoin is not the only unbacked token out there. Go experiment with something that is still off regulators’ radar.

Yes, the US financial system is run by and for the benefit of plutocratic oligarchs. Go live in Chile or Panama, if that sort of thing bothers you.

The point is that people with real money to spend have shown keen interest in Bitcoin, and regulators are lining up at the front of the parade and pretending like they are in charge, rather than trying to shut it down. As long as Americans continue to elect rulers who see their role as the wielding of power over everyone else, these are the only two realistic options.

The world would be a wonderful place, if it were governed by the principle, “No Victim, No Crime,” but until that day arrives count your blessings, however meager they might be.

What would CFTC regulation mean in practical terms? No one knows, and anyone who prophesies the future is a fool, a liar, or both. The main thing to bear in mind here is that, just as there is a cost for every benefit, there also is a benefit hiding within every cost.

That, and the market always wins.

Invest accordingly.

Prof. Evans

Dec 192012

17 December 2012, the San Francisco Chronicle had a story—”Solar Power Adds to Non-Users’ Costs“—that provides background for a very good Microeconomics test question:

Q: Under what circumstances can the combination of a decrease in demand and an increase in supply lead to an increase in prices?

The short answer, of course, is, “When government interferes with the market process.”

If you are required to show your work, here’s what you do:

First, note that the own-price demand elasticity for electricity tends to be low for most consumers, meaning that one tends to consume the same quantity, seemingly regardless of the price. For example, one would not expect someone to throw open the windows in the middle of summer, with the air conditioner turned to its lowest setting, if the price of electricity fell substantially. More likely one would continue to consume electricity at approximately the same rate and use the cost savings on something that had a higher own-price elasticity of demand, like those things that collect in one’s shopping cart at Amazon.com, but one rarely gets around to ordering for delivery.

You can illustrate it this way:

Vertical Demand Curve in Equilibrium

Fig. 1 : Vertical Demand Curve in Equilibrium

This is very similar to the textbook Supply & Demand graph, but with the Demand curve at the same quantity demanded for every price. (Of course, this is not realistic for all prices, and the real world is not so well-behaved. Such is the nature of economic models.)

As indicated in the article above, the increase in solar panels being installed on the roofs of residential and commercial buildings in California is causing a decrease in overall demand for conventional electricity.

In an unregulated market, we might illustrate it this way:

Vertical Demand Curve with Shift in Demand

Fig. 2 : Vertical Demand Curve with Shift in Demand

As the demand decreases, due to the existence of solar-powered substitutes, price tends to fall.  In an unregulated market, executives and shareholders in waning industries receive signals in the form of accumulating inventories—unsold output—that they either should reduce their prices, reduce their output, or both.  If the trend continues—as happened with sailing ships, tools for making whale oil, steam locomotives, buggy whips, etc. in earlier generations—the executives and shareholders receive signals that they should consider whether liquidating and reallocating their existing resources might be more profitable than clinging to a dying firm or industry.  (Schumpeter referred to this as ‘creative destruction‘.)

However, in a regulated market, suppliers and regulators agree on a price and fix it ex ante.  Typically, the price is below the equilibrium, at least in the first iteration, so that consumers will be happy and express their gratitude to the politicians who oversee the regulators.  (This sometimes is referred to as ‘the iron triangle‘ of regulation, and it is related to the concept of ‘regulatory capture‘.)

We can illustrate it this way:

Vertical Demand Curve with Regulated Price

Fig. 3 : Vertical Demand Curve with Regulated Price

Here, the regulated price (Pr) is below the equilibrium price that would clear the market, but is at least as high as is needed to generate sufficient revenues to cover the costs of production.  The executives and shareholders of regulated firms generally are rewarded for their cooperation with monopoly rights in the form of franchises that grant them the exclusive right to serve a particular geographic region.

The firm’s total revenue is illustrated as area of the pink rectangle below, which is price * quantity.  It is possible that a firm’s executives and shareholders might want to increase output, so that the firm could sell the excess into neighboring markets, but the jurisdictions of most regulated industries do not adjoin jurisdictions where competitors are unregulated.  Most likely, every neighboring territory is served by a different monopolist franchisee.

Vertical Demand Curve with Regulated Price / Total Revenue

Fig. 4 : Vertical Demand Curve with Regulated Price / Total Revenue

Returning to Fig. 2, as solar panels reduce demand for conventional electricity, the demand curve shifts to the left.

Vertical Demand Curve with Regulated Price and Demand Shift

Fig. 5 : Vertical Demand Curve with Regulated Price and Demand Shift

Because the electricity providers’ prices are fixed by regulation, and they have very high fixed costs, they are loath to lower their prices.  In fact, the fixed costs of maintaining a capital base that consists of indivisible centralized facilities, power lines, poles and waterproof underground conduits, substations, and other large and expensive infrastructure can vastly exceed the variable costs of fuel and peak-time labor, and these large fixed costs are the primary drivers of the price that suppliers and regulators agreed to previously.

Now, with a smaller consumer base, the utility operators have fewer customers to divide their fixed costs among.  In order to arrive at a rectangle with the same area as the pink one in Fig. 4, given that the utility operators not only cannot force consumers to buy conventional electricity, but are required to buy the excess electricity produced by the owners of the solar panels.  In other words, the suppliers are doubly pinched, and their only savings are in the form of electricity purchased at full retail from their customers, accompanied by a relatively slight decrease in variable fuel costs.

The only viable alternative in this situation is for the operators of the regulated conventional electricity utilities to petition the regulators for a price increase to be passed along to the remaining conventional electricity consumers.

Vertical Demand Curve with Regulated Price / Price Increase

Fig. 6 : Vertical Demand Curve with Regulated Price / Price Increase

Considering that solar energy becomes more economically viable, when its primary competitor—conventional electricity—becomes more expensive, the rising prices in this scenario create an incentive for even more consumers to adopt solar energy, thereby shifting the demand curve even further leftward toward zero… creating yet more upward price pressure.

And, in this way, regulation creates an environment, in which a decrease in demand can lead to an increase in price.

Invest accordingly.

Prof. Evans

Nov 042012

We examine the effect of securities laws on stock market development in 49 countries. We find little evidence that public enforcement benefits stock markets, but strong evidence that laws mandating disclosure and facilitating private enforcement through liability rules benefit stock markets.”
(La Porta, Lopez-de-Silanes & Shleifer 2006)

In general—and vastly oversimplified—regulatory regimes fall into three categories: Authoritarianism, Anarchism, and Transparency.

The term authoritarianism here refers to what one might think of as over-regulation, as when entrepreneurs in a particular country must seek permission—perhaps even an act of parliament or specific permission from the ruling junta—before being allowed to register a new firm.

The term anarchism here refers to a de facto, even if not a de jure lack of government oversight, where regulations either do not exist or exist but are not enforced.

The term transparency here refers to a regime, in which individuals are more or less free to do as they want, but must make public disclosures of actions or decisions of material importance.

Markets that could be described as ‘authoritarian’ tend not to attract much capital from investors outside those jurisdictions, and investors within those jurisdiction—particularly those who are not politically connected—often tend to prefer to invest abroad. This is in large measure, because they are highly constrained in how they can respond to new information, changing supply conditions for inputs, and evolving demand conditions among consumers.

For example, if one were required to declare the precise nature of one’s enterprise as a condition of registration and permission to operate, and one were forbidden to deviate in the future from this stated purpose in response to changing expectations, regulatory inflexibility might create an incentive for one to take one’s business to a jurisdiction less plagued by bureaucratic micro-management.

At the other extreme, ‘anarchic’ markets tend not attract much capital from outside those jurisdictions, and investors within those jurisdictions—particularly those who are not politically connected—often tend to prefer to invest abroad. This is in large measure, because they have little recourse to dispassionate enforcement institutions, like unbiased judges, neutral regulators, and incorrupt police.

For example, if one were subject to routine breach of contract, expropriation of property, or threat of violence, regulatory apathy might create an incentive for one to take one’s business to a jurisdiction less plagued by uncertainty.

Between these two extremes are ‘transparent’ markets, which one tends to find in English-speaking countries and non-English-speaking countries where the legal systems have been based on or even borrowed from England or the USA (and possibly the commercial code from Germany). In these countries, one has a relatively free hand to organize one’s affairs as one sees fit and to change plans as needed.

For example, in Australia, Canada, the UK, the USA, etc., one can incorporate, regardless of one’s standing in the community, family membership, political affiliation, or even criminal background. One does not need to declare the specific purpose of one’s firm—the boilerplate ‘purpose’ being “to engage in any lawful activity”—seek sponsorship or permission to incorporate, or submit to a background check. One submits articles of incorporation, pays a fee, and stays current with one’s filing requirements.

The executives of privately held firms must communicate all decisions and actions that have a material impact on the firm to their shareholders, or risk civil or even criminal complaint. The executives of publicly traded firms must file public disclosures for seemingly trivial matters, or risk regulatory penalties.

Jurisdictions where transparency is the order of the day tend to attract both domestic and global investment, have efficient and liquid markets, and recover from crises robustly.

The optimal level of regulation lies somewhere between authoritarianism and anarchism, in which executives are free to form expectations, make plans, take action, and to modify their plans in light of new information—including rumor, superstition, and noise—changing supply conditions for inputs, and evolving demand conditions among consumers.

Invest accordingly.

Prof. Evans

La Porta, Rafael, Florencio Lopez-de-Silanes, and Andrei Shleifer, 2006. “What Works In Securities Laws?” Journal of Finance 61(1), 1-32.

[possibly available at: http://works.bepress.com/cgi/viewcontent.cgi?article=1000&context=florencio_lopez_de_silanes]

[2003 Working Paper available at: http://www.nber.org/papers/w9882]

Oct 162011

In business, economies of scale means that it is less expensive, per unit of output, to produce goods, if one produces a lot rather than a few. For example, one would not build a factory, buy raw materials, and hire workers to make only one car. Similarly, one would not set up a restaurant to make only one meal.

Once the oven is hot, the freezer cold, and the employees on-site, the additional cost (what economists call the ‘marginal cost’) of producing a second meal is substantially less than the cost of going from zero to one meal. Likewise, the cost of producing the third, fourth, and subsequent meals can fall even further, as the employees get into the rhythm of the job, several items bake in the oven at a time, and the freezer is cooling more than air and empty shelves.

The larger the operation, the greater the output relative to the costto a point.

However, as with plants, animals, and essentially everything else, there is a limit to how much a firm can grow, before costs begin to rise faster than income.

Sticking with the restaurant example, let us assume that a good day’s gross income is $10,000, and that the pre-tax profit is about 15% of that, after paying for groceries, utilities, maintenance, payroll, insurance, etc. [Feel free to substitute an appropriate amount of your local currency, if you reuse this text.]

Now, imagine that the owners have hired a new general manager — we’ll call him Skippy [Feel free to substitute a culturally appropriate derogatory name here.] — who wants to double the gross revenue to $20,000 per day, even on historically slow days.

Skippy holds ‘motivational’ meetings and exhorts the employees to “work smarter” and to be “dedicated” to the “mission” and “vision” of the organization. He wants to run three eight-hour shifts per day, seven days per week including holidays, and to minimize costs.

One young man at a meeting asked, “Um… If we wanted to minimize costs, shouldn’t we just shut down? That way, costs would be reduced to zero.”

Skippy replied, “You have a bad attitude. Ask not what this firm can do for you; ask, rather, what you can do for this firm.”

One problem with selling more meals than is optimal is that one has to provide incentives for potential customers to become actual customers. One option is to offer larger servings, but customers typically eat only so much at each meal. Another option is to reduce prices, either across the board, during times that the restaurant is usually closed or business is slow, for individuals who are members of a favored category — females, a particular ethnicity, a profession, etc. — or some other form of discrimination against those who are not members of the favored category.

By doing so, the restaurant operator reduces the income from each meal sold, even though the costs of producing those meals do not fall. Quite the contrary, by running the equipment without break, one is unable to clean, maintain, or repair it, and by working one’s employees harder, they get tired, make mistakes, and become resentful; beyond the optimal scale, costs per unit of output rise.

It does not matter if it is a restaurant, factory, bank, or whatever, each firm has its optimal size, and anything larger or smaller than that optimal size is less efficient than it would be if it were operating at the optimal scale.

If Goldilocks were a management consultant, one might hear her say, “This firm is tooo small. This firm is tooo big. And, this firm…? This firm is juuust right.”

In general, two things systematically prevent firms from operating at their optimal scales: hubris and regulation.  Things that unsystematically prevent firms from operating at their optimal scales stem from the unknowability of the future: uncertainty, surprise changes in market conditions, natural disaster, and other things that one cannot foresee.

Hubris is the kind of overconfidence that leads one to believe that one knows more than one knows, and thus can do more than one can do. It is one of the qualities of the kind of narcissist that is expert at climbing to the top of an organization, in spite of a lack of actual knowledge, talent, or skill.  Such individuals often conflate speculative hypotheses with proven conclusions, confuse ‘could’ with ‘must’, and are loath to admit when they are in error.  They speak with great bombast, demean those who ask for clarification, and typically refer to their track records when pressed for details.

In positions of power, hubris can lead to doublethink, especially a desire to minimize costs and to maximize gross sales simultaneously, in spite of the fact that there is a cost for every benefit.

Granted, one can try to minimize fraud, abuse, and waste, but any more than this implies fewer raw materials, fewer fixed assets, and less available labor, and thus reduced output; decrease costs, decrease revenue.  Similarly, if one wants to increase output, this implies more raw materials, fixed assets, and available labor, and thus increased cost; increase revenue, increase costs.

Hubris tends to result in firms that operate above their optimal scales, based on the notion that bigger is better.

Regulation leads to inefficiency most commonly through the misapplication of the observation that price tends to approximate the marginal cost of production in a competitive market.  Only in a monopolistic market can one charge a price higher than the marginal cost of production, because in a competitive market – i.e., a market that has a very large number of relatively small suppliers – if one tried to charge a higher price, a competitor would undercut the price.  This process would continue, until no one were willing to charge a lower price.

In monopoly markets with only one supplier or in oligopoly markets with a small number of relatively large suppliers, sellers can charge prices that are substantially above marginal cost, because buyers have nowhere else to go.  The choice is between paying the high price or going without.

This reasoning underlies antitrust statutes.  The idea is that, since perfectly competitive markets have the lowest profit margins, and thus the lowest prices to consumers, a small number of large suppliers is de facto bad.

This ignores economies of scale.

Some productive processes have very high barriers to entry, typically in the form of expensive equipment, as is the case with airlines, cruise ships, railroads, electrical utilities, etc.  If it makes economic sense for suppliers in these industries to be large and highly concentrated, then the tendency will be for the successful to acquire the unsuccessful.

Some suppliers operate in a ‘winner-take-all’ environment, as is the case with search engines, social network websites, operating systems, etc.  If consumers tend to favor a particular supplier to the exclusion of essentially all other competitors, then the optimal supplier will tend to be a monopoly.

Regulations that hinder concentration where it results from economies of scale serve only to force suppliers to be inefficient.

The main thing to bear in mind is that hubris is ultimately its own undoing, and, in an increasingly integrated global community, regulation at the national level is increasingly anachronistic.

BEARING THE DISCLAIMER AT THE BOTTOM OF THIS PAGE IN MIND, a contrarian speculative strategy might be to sell short assets that are darlings in the popular media (i.e., subject to hubris) and buy long assets that are under intense government scrutiny (i.e., likely to migrate from unfriendly jurisdictions to friendly jurisdictions).

Invest accordingly.

Prof. Evans