COVID-19 economic reflection

Some thoughts of the economic crisis we’re currently going through, the likely ways out, and the shape of the economy and society in the aftermath.


It’s a relatively safe prediction that the economy after COVID-19 will end up more consolidated and the balance will shift from SMEs to corporations. As a result of the shutdown lots of small firms and their supply networks will be wiped out, while large global brands expand in their space. That will raise inequality within economies, and between economies. For example middle-income countries with lots of SMEs will lose domestic firms and substitute imports from the same multinationals.

In part that may explain stock prices, where tech stocks are having a V-shaped recovery out of touch with the real economy. Amazon is now above its pre-crisis valuation. Inevitably, these firms will see a few bad quarters because the wider public, if not the middle class, will have less money to spend. But they’ll spend it online or on gadgets instead of at the pub. Global firms will be better placed than small firms or other investments, and as such they may see flat profits but higher Price/Earnings ratio.


What’s less clear is whether the economy will recover to its pre-crisis state. Of course in the long run it will. But some sectors, notably oil and aviation, are seeing a sudden glut of resources where the operators have to pay to store their oil or maintain their grounded aircraft. With a slow recovery, and climate change round the corner, we may never see the current stock of aircraft, oil infrastructure, hotels, or cruise ships fully back in use. Companies like Airbus or BP will likely survive, but the more traditional products in their portfolio may be retired in favour of new technologies or greener offerings.

In theory, this is a perfect time to invest in green energy, as well as rethink the platform economy. The first phase of AirBnB or Deliveroo has been an inequality machine. But with lots of people out of work, less international travel, and probably less frivolous spending after the crisis, maybe the platform economy can find itself a democratizing role. Providing services to each other at a local level is not inherently exploitative. Perhaps as we look for a more local and more resilient way of life, both green investment and informal services could see an upsurge. Whether they will is another matter.


The crisis response to COVID-19 has been strikingly local, at the level of European countries, US states, or Chinese provinces. Roughly speaking people organized at the 10M to 100M population scale. Perhaps this tells us something about the natural scale of economic recovery also. After the crisis we may see less global trade but more domestic consumption and domestic tourism. Firms will obviously take advantage of national incentives. How nation-states pay for those incentives will be revealing.

People seem to have learnt a little, perhaps the minimum, from the Global Financial Crisis. This time round the stimulus was quick to come and relatively free of moral lecturing. It’s hard to blame a small business for failing when the government ordered it to close. But attitudes to dealing with the spike in public debt have not changed. The US and Japan are likely to load it on the central bank and deal with it painlessly. Europe is hampered by the Euro and likely headed for another round of austerity. The end result of austerity is the stronger financial capital buying up distressed assets of the periphery.


Much is said about whether, once we’re free to go anywhere and sit down in coffee shops, people will revert to their old consumer lifestyles or, thanks to this forced lesson in stoicism, our preferences and consumption patterns will change. It may not be philosophy that drives the change, but certain things that were politely obscured are now laid bare. As economist Marianna Mazzucatto points out, if the “essential” workers keep us alive, how did the “non essential” ones manage to extract so much value, and is that going to change?

The most benign way to deal with the obvious collective redundancy of the middle class is to consider more flexible work-life options, a different balance of formal employment and community work, or a four day week. Europe may deal with lean times this way. In more sink-or-swim economies like the US we may see a wave of forced entrepreneurship, where people are let go from companies and, if they’re above becoming Uber drivers, they start their own micro-brands offering who knows what products and services.

So on one hand consolidation of capital into fewer, bigger corporations that absorb the markets of smaller firms. On the other, depreciation of legacy sectors and investment in green technology likely sooner than iit would otherwise happen. Widely varying debt politics, and different ways to absorb the semi- and unemployed, either through collectivist work sharing or by somewhat desperate and improvised self employment.

Nine bad ways of thinking

Logic is the screwdriver of thought. It’s good for solving precise problems, of which there’s more lately, but human thinking through the centuries has developed a much wider set of tools.

Accordingly, here’s some common ways to think poorly. These are not logical fallacies, but broader ways of getting things wrong.

False shortcuts
A shortcut is when you have a large problem to solve, like evaluate many possibilities or consider many factors, and as you try to abstract it in your head you think “X has to have that relationship to Y so the answer can’t be over there”. For example you think two ways are equivalent, or one choice is no better than the other, so there’s no point exploring some part of the space. Well, when you get that abstraction wrong it’s a false shortcut and you make mistakes. Happens to me all the time.

Category arguments
Arguing that X is a Y, or questioning whether X is a real Y, is almost never a helpful philosophical method. There are well meaning situations when we’re trying to be inclusive, but more often than not it’s an attempt to exclude someone for not being a “real” member of a group. It also carries the suspicion of frame shifting. What is it about Y (the frame) that you want to pin on X (the individual) and is that helpful? Could you deal with the question at hand universally, or individually?

Baseline calibration
Making choices is hard. We’re used to ranking alternatives among each other, but do we consider how much difference the choice makes overall? When we scale the options with baseline importance, the difference may be tiny. Like this thing is better than that thing, but how much difference is a thing going to make to my life or my happiness? People make this mistake with money and buy things that are too cheap or too expensive. It’s also in business, politics, and everywhere.

Learnt constraints
A corollary to the false shortcut is when you have a real constraint, such as X isn’t practical, or person Y would never have it, and that used to be true but the constraint isn’t there any more; because you changed, the times changed, or something else. A learnt constraint is the miserable condition when you’ve excluded some possibilities without noticing the constraint isn’t actually there. It holds back people, and it’s also why innovation is difficult.

Taking people at face value
To take people at face value is to process what they say and not why they say it. For example “how is Claire?” means I want information about Claire but also signals that I care about her, or I may be trying to show that I’m a caring person, or feeling unease about something that happened with Claire in the past. Here it’s obvious that there’s a social subtext, but all speech carries subtext all the time. The proper way to parse statement S is to think “Person X is telling me S, and what may be going on in X’s brain to say that?”. Men are especially clumsy with subtext and women better at detecting it. I hope AI is female.

Apparently you’re supposed to take people at face value to avoid the ad hominem attack. That’s nonsense. Ad hominem is to say the witness is a slut. Face value is to ignore that the witness has material interests. An example where the question is irrelevant is to say the lawyer is defending the accused because they’re the lawyer. Of course in trusted situations we can take people at face value, but not all the time.

Toxic topics
One of the worst way to have moral arguments is to bring up examples that make people altogether uncomfortable or unwilling to defend a side. Think of the children, the Nazis, the latest atrocity. That’s obviously prone to manipulation. It also produces a toxic debate between thick-skinned people as those with higher levels of empathy, and often the victims, are driven out. To deal with these issues create a safe space, take good time, focus on patterns rather than specifics, and frequently affirm shared principles.

Wanting to be right
A great way to be wrong is to care about being right, in other words to be emotionally invested in the ideas you already have. You’re likely to think deeply to yourself, avoid sharing or exposing your true beliefs, and seek confirming evidence and like-minded people. In fact being wrong has almost the same symptoms as being intelligent, and there’s no shortage of smart but misguided people. The mistake is valuing thought over experiment.

The right way to be right is to test your ideas by convincing others, applying in practice, or comparing expectations with facts. Drop the ideas that don’t work, that’s the hard part. Then take in some new ideas, combine, and repeat. Intelligence is an evolutionary process, not a mathematical one. The price of being right is you have to face being wrong often, and you have no choice over what you’re right about.

Classical thinking
A less common error is to try to grasp the objective truth about some matter that’s inaccessible. Is this person guilty or good? What transpired behind closed doors? What’s in X’s mind? Well, you don’t know. It’s like quantum mechanics. You can’t probe the truth and all you can do is maintain your knowledge in a superposition of states consistent with the evidence. Person X could be trustworthy or not. The error is not to get a wrong outcome, it’s to think classically that they are one way. Western fiction is classical and Asian cultures understand superposition, it seems.

The unitary intelligence
People don’t interact with the world and with others rationally. We interact, first, emotionally: Do I like this person, these ideas, this situation? When we perceive a new thing we ask all the ideas in our head what they think of it. If our ideas mostly approve, we admit the new information or new argument. Otherwise we exclude it. If our existing ideas rebel, we exclude it violently. Wanting to value facts, question assumptions, or entertain something new are also ideas we might have. They play a big part in what we admit.

We’re not a unitary intelligence, we’re a forum of ideas. The reason your arguments with religious people don’t work is you present ideas that they (their other ideas) don’t like and they don’t carry the ideas of openness or objectivity as strongly as you do. Or they carry only openness and get seduced by quack theories. Once you see people as a forum of ideas it affects discourse and also ethics. Do you write off people or try to get their better ideas to prevail?


European conceptions

“The EU has brought peace to Europe”

The theory here is that rival Capitalism causes war, and that’s true but no longer relevant. Moral revulsion and nuclear weapons made a repeat of WW2 unpalatable, while rapidly advancing technology and the politics of the Cold War aligned all of Capitalism into one block. It’s more accurate to say that the EU was an adaptation to peace and technology than that it was a political nudge to stop the French and Germans from fighting. Yes the EU is an architecture for peace, but it’s more a consequence than a cause.

Also as an aside, the EUs anti-war credentials are disappointing. We’ve had war in Europe, in Yugoslavia and Ukraine, and the EUs misguided diplomacy did more to hasten these than to stop them. The EU did nothing to discourage American interventions that destroyed Iraq, Libya, and Syria and only dealt with the migration “problem” as if it was a natural disaster. Now that Capitalism is splitting into rival camps, a result of failing to accept Russia and China as equals, the EU is once again introspective and silent.

“The EU creates shared prosperity”

In many ways an open, peaceful, high technology environment can’t fail to do that, so we have to judge how the EU’s achieves better or worse outcomes than plain economics. Up until the 90s, Europe’s strong welfare states and “four freedoms” scored pretty well. It looked like the EU was set to emulate the Nordic ideal at a larger scale.

But since Maastricht the EU went neoliberal and focused on competition, inside societies and between regions. The Eurozone was set up as a structure that generates winners and losers. It’s a zone with free trade, a fixed gold-like currency, and no shared taxation or welfare systems. This benefits export economies that accumulate all the money, and punishes weker deficit regions that end up gradually stripped of their assets.

There are secondary effects too. A shared currency allows the winners to accumulate bigger surpluses and the losers bigger deficits than they could otherwise. The Euro is sort of guaranteed, but not entirely, leaving just enough risk to cause capital flight from poor to rich areas, and there’s a brain drain in the same direction. Although the rules don’t say “money shall flow from the periphery to the industrial core” the rules ensure that this happens.

“The EU safeguards democracy”

In the early days the EU was a strong modernizing force, especially for peripheral states like Ireland, Spain, or Greece that were struggling to reform their democratic institutions, civil, and family law. There’s a strong sense among their populations of never going back.

However look at the EU now: France has a severe exclusion problem and every few years all the other parties have to ally to prevent a fascist becoming president. Hungary and Poland have nationalist authoritarian leaders. Austria has a far right leader every other term. Italy has far right populist splinter groups. Greece had to choose between the neo-nazis and the idealistic far left, and thankfully we chose well. In Germany and Sweden the elites claim to be in control but hatred simmers underneath. The Brexit faction in the UK is a mere nuisance by comparison.

Nationalism and fascism aren’t like an infectious disease of bad ideology that you cure with an antibiotic of truth. They’re more like an unhealthy diet of inequality, austerity, and lack of prospects subdued by the liquor of a tabloid press. As long as the EU follows a neoliberal path of increasing inequality and “managing” dissent the forces of hatred will persist.

I’m fed up of hearing the liberal middle class, people like me, cry that politics is turning to the right, that the working class is seduced by hateful demagogues, or that people dared to vote Brexit, while that same middle class can’t stomach the left of Corbyn, Podemos, or Varoufakis (or Sanders, Warren, Ocasio-Cortez) claiming that they’re unelectable or too dangerous or indeed “populists” themselves. Well the writing’s on the wall. The longer the middle class clings to a vision of privileged centrism that collapsed in 2008, the more we’ll be handing victories to the merchants of chaos.


The GDPR is now the law across Europe. I don’t like it. I think it’s seriously misguided.

It gives me rights and freedoms that I don’t want or care about. Viscerally as a human I’m not concerned what data others have about me. I don’t presume to know or change it, any more than I could reach into their minds and change their thoughts. If some evil magician gave me that power, I would recoil in horror.

I’m now uselessly informed of every way businesses use data. I can’t read a privacy statement any more. Can you? I can withdraw consent, but the other side can withdraw the service or whatever is their side of the deal. The law doesn’t give me anonymity, or discretion, consumer rights, or anything that I care about.

CCTV is everywhere. The phone company tracks me and my calls are logged. My provider knows where I go on the internet. The law does nothing whatsoever to stop state surveillance. It’s privacy theater.

Abusing the law will be fun. Every time I buy something firms ask for my details. I can immediately serve them a notice to erase the data or face millions in fines. I’m sure it’ll be great for European businesses if everyone does that.

Global firms may decide it’s not worth the risk and cut their services from us. Suddenly I face discrimination because of my citizenship, and there’s nothing I can do about it. Good job!

It’s massive jurisdictional overreach and hugely intrusive to enforce. So is copyright and other “worthy” censorship laws, but we need fewer of these not more.

Terrible legislation. Misguided, and I think miss-sold. The GDPR is last century politics, fighting the STASI, or big bad Google whom citizens don’t want fought on their behalf.

The two sensible choices

There are two sensible and realistic choices for solving the Euro crisis. The sensible and realistic choices are:

  • Surplus areas like Germany give deficit areas like Greece free money, indefinitely, or,
  • Weak economies like Greece and Spain leave the Eurozone.

These really are the sensible and realistic choices. You need one of these if you want roughly equal purchasing power across the Eurozone. Otherwise, money will flow from unproductive deficit areas to productive surplus areas, people in surplus countries will get steadily richer, people in deficit countries will get continually poorer, and eventually this will come to a head by revolt or other radical means.

Free money recycles this flow, exchange rates stop it. Economically the first is better because more flow of goods and services and money turns the economy forward and makes everyone consume more in aggregate. The latter choice aims for fairness, sacrificing total volume of trade and industry in the process.

Right now we’re still discussing the free money idea. Free money could be given as tax-and-transfer grants like most states do internally, as endless monetary expansion like the US, or by recurrent debt default and restructuring. The only advantage of the third option is it makes a policy look like an accident.

If free money won’t fly, leaving the Eurozone is the choice. Greece should have left the Eurozone… any time from 2001 till tonight would be good. Cynics would say stay until 2011 while the free money vision of Europe looked ascendant, but certainly Greece should have dropped after that. Greece should leave now.

Dropping out of the currency union has only advantages for the weaker economy. The disadvantages for the stronger economy are that it stops the flow of funds from the poor to the rich and removes demand for their exports. Germany selfishly wants the Euro. Greeks are stupidly attached to it because they equate the Euro with the EU and three decades of progress.

There are also a couple of totally fantastical choices that people might believe would fix the Eurozone, but they won’t work.

  • Economies like Germany and Greece become similarly productive any time soon.
  • Regions fix trade imbalances through fiscal discipline and austerity.

These are myths. It would be great if Greece was a bit more prosperous like Germany and that would take a venture investment ethos, congenial labour relations, an orientation to global markets, nourishing a boutique economy, branding, IP rights, stability and democracy. Well, at least Greece has democracy.

Different economies may become more alike, but they won’t become the same. The Mississippi delta is less productive than Silicon Valley and that’s why the meagre social policies of the US transfer funds indefinitely from rich Californians to poor Louisianan’s. Convergence doesn’t remove the need for transfers, it makes them smaller.

As for austerity, austerity is the null policy. Austerity means to just accept the dynamic of unproductive regions being steadily poorer and productive regions being steadily richer without asking for free money to mitigate it. And fiscal discipline means don’t try the free money by monetary expansion or default routes.

Until 2011 it looked like Europe was going to work like a superstate using free money transfers. This would have been better for all, including Germans. This idea now looks dead. Weak economies should ditch the Eurozone, now.

What Grexit looks like

Now that Greece voted No in the referendum it’s likely the institutions will seek a quick compromise to avoid serious damage to themselves and the Euro. In that case we’re looking at a more reasonable bankruptcy negotiation between Greece and the creditors, within the Euro. There will be capital controls for a while, like Cyprus, but eventually they’d be lifted.

The alternative is the Grexit scenario. However Grexit doesn’t mean that Euro deposits get redenominated to drachmas overnight. There’s no legal basis to do that. Euro deposits are obligations of Greek banks to individual depositors. They’re supposed to be guaranteed by the ECB, except last week the ECB decided to stop honoring that obligation. That decision will bite them, but it’s another matter.

Anyway Euro deposits are not the business of the Greek state or the bank of Greece. They could not redenominate Euros to drachmas, except by seizure. Also, there’s no incentive to do so. When the ECB withdraws its guarantee, Euros in Greece are precious hard currency like gold coins. Whatever Euros Greeks have, they’ll want to keep. Why would you convert perfectly good Euros to less valuable drachmas?

So on Monday, after a no vote, we have a scenario where Greek banks have Euro liabilities (deposits) and outstanding Euro loans, and they’re not guaranteed. There’s no lender of last resort for Euros in Greece. Banks would have to be super-prudential about handling Euros in this scenario, with deposits equal to reserves or close. Any MFI creation of Euros through loans would be extremely risky.

Of course banks are much more exposed than this. Soon, because of bad loans or the ongoing bank run, Greek banks go insolvent in Euros. At that point, the Bank of Greece steps in and guarantees deposits, but in Drachmas. And that’s how the conversion happens.

There’s a haircut on deposits until the Euro accounts of banks drop to the super-prudential level they’d need to be to operate safely. That means deposits equal reserves plus really safe loans. Greek banks continue to operate Euro accounts in this way thereafter, to facilitate transactions in tourism, import/export, etc. Euro loans will be hard to make and they’d only be made to businesses with good short-term collateral such as outstanding invoices. Not mortgages. Euro will effectively stay in Greece as a business currency.

The remainder (the amount that was haircut) gets converted to drachmas. So if you had €1000 in the bank and after haircut you’re left with €600, you also get the equivalent of €400 in drachmas, courtesy of the Bank of Greece. People can’t really complain about this change, because it’s the big bad ECB that haircut your Euros and the Greek state (Bank of Greece) saved you by giving you drachmas in compensation.

Thereafter the two currencies exist in parallel. Banks operate both types of accounts. Euros are not guaranteed, hence super-prudential: hard to get Euro loans, no Euro credit cards. The Banks of Greece acts as lender of last resort for drachmas, like a normal central bank. Drachmas operate with all banking services immediately and eventually notes and coins are introduced. Businesses that deal with tourism or import/export will surely maintain both Euro and drachma accounts. Everyone will have to declare their Euro and their drachma income separately and pay taxes in each.

Ordinary people like pensioners and dentists will either run out of Euros eventually, or they’ll use them for savings (bad idea, not guaranteed), or they’ll accept some offer to close their Euro account and convert to drachma. Pensions, salaries, house purchases, utility bills, and other big domestic prices will be negotiated in drachmas. Shops will post two prices, at least for a few months.

Eventually anything that’s related to tourism or imports, like electronics, will post both prices. Everyday domestic trade like street markets for food, plumbers, English lessons, hairdressers etc. will transact pretty much only in Drachmas. The Drachma has to be the official currency and there’s enough need for money for it to be accepted. The Euro just has to be legal to circulate, it doesn’t need any encouragement.

And then life will be good!

Having your own currency does three things: It makes imports expensive relative to domestic goods; it lets you pursue monetary policy; and it lets you devalue to make your exports price-competitive. The first two are crucial for Greece. The third is moot.

Greece is in a mess with external Euro debt because individuals prefer to buy imports than to pay taxes and so Euros leave the country. After the switch, businesses that earn Euros will have Euros to spend and they’ll have to be responsible because Euro loans will be super hard to get. Everyone else will face a Euro/Drachma exchange rate when buying imported goods. It’ll make iPhones expensive if you’re not directly earning Euros, and that’s really the worst part of the whole transition to drachmas thing.

The macro effect is Greeks will be buying more basics such as food, housing, and services which are predominantly domestic. They’ll be buying fewer discretionaries such as cars or electronics which are imports. Some essentials such as oil, clothing, and medicines require imports but currently those imports are cheap and there’s some production capacity in Greece for these sectors. That’s a very fortunate configuration for Greece’s balance of trade.

More importantly, the Bank of Greece will finally be able to run monetary policy in a way that fits Greece and not the gold standard delusions of Germany. Obviously it’ll be an expansionary Keynesian policy and the drachma will drop, but not alarmingly. Greece’s economy isn’t a basket case because of inflationary tendencies, By now it’s in a hard currency straitjacket.

Greece has massive unemployment, it’s demand-side limited, and there’s a huge amount of informal debt because of lack of liquidity. The plumber owes the teacher, the teacher owes the dentist, etc. and no-one has any money. As soon as money of any kind flows into the economy people will start paying their bills and the economy will pick up be amenable to taxation. Even if the Greek state makes up a few percent of fiscal spending with monetary easing that’s unlikely to yield so much drachma inflation to be a problem.

The third aspect of having a weak floating currency is that Greece could devalue it, deliberately or by letting it slide, to make its exports more attractive. If only Greece had exports, that would be a great idea. Greece makes its Euros from tourism and in the Grexit scenario that income would be the same or slightly less. Tourism is price sensitive but it’s not that scalable. If you have capacity for a million visitors you can’t bring in two million by being slightly cheaper the way you can scale up industrial production.

Greece’s other exports are oil product (basically running a refinery, it has no wells) and things like ore and agricultural goods. Again, what is Greece going to do? Grow twice as many tomatoes? Greece’s competitiveness problem is not having industrial, not that they’re expensive. The idea of being more competitive by devaluing the currency is beside the point for Greece. Greece’s long term competitiveness needs to come from things like boutique exports and tech startups, and there’s nothing about Grexit that works against these. Sweden is not in the Euro and full of tech startups.

Overall the supposedly disastrous scenario of Greece leaving the Euro won’t be disastrous. For Greece. It may be disastrous for the Euro, or for the careers of some politicians and mainstream economists because Greece will be doing spectacularly better almost immediately and various parties will begin to question what benefits the Euro really delivers.

The ECB broke the Euro, already

Can we get something straight? Euro deposits in Eurozone banks are liabilities of Eurosystem to individual EU citizens. Euro deposits in Greek banks are liabilities of those banks, and indirectly of the ECB, to individual depositors who live in Greece. Not to the Greek state. The Greek state is not part of this contract. If Greek banks were drachma banks they’d be the responsibility of the Bank of Greece. Now that they’re Euro banks they’re the responsibility of the ECB.

This is a contract of trust between the ECB and individual residents of EU states, including the Greeks. The Greek state is another actor, in essence a very large bankrupt business. The ECB is justified to be angry that the Greek state is threatening non-payment of its debt to the ECB, but that’s a dispute between a bankrupt business called the Greek state and the ECB. Because the ECB is unhappy with the Greek state, it decided to breach its contract with individual Greek citizens and refuse to honor their deposits. Sure enough, Greek citizens have a say in what the Greek state does but in the supposedly professional world of banking and contracts the individuals and the state are not the same thing.

To put this in perspective it’s like JP Morgan, the US bank, seizing the deposits of its customers in Detroit because it is owed money by Ford, Chrysler, etc. where these same people work. JP Morgan would then say “Ford employees refused to waive their pension claims in order to give Ford money to pay us, so we’re grabbing the deposits of these same employees directly”. Americans, how does that sound? I thought so. You cannot seize one person’s private property to recover the debt of another entity, however related. Well, you can if you are a political sovereign, but not with any pretence of legality.

Spaniards, how would you like it if the ECB decided not to honour your deposits after September because you voted Podemos?

Scots, what if your country voted Yes on independence and a few months down the line the Sottish state had a falling out with England? Inconceivable, I know. What if then the Bank of England refused to honour the deposits of individual RBS customers?

Germans, your banks now have tens of billions of liabilities to Greeks, Cypriots, Spaniards, etc. who decided as individuals to transfer their deposits to Germany. In the world of banking every liability requires a corresponding asset and in the Euro system the asset is something called TARGET2 balance from Greek to German banks. The asset behind that is Euro loans of Greek citizens to Greek banks. If you let the ECB seize deposits in Greece, Euro loans in Greece will go bad, Greek banks will fail, and said TARGET2 balances would be worth nothing.

German banks will then have tens of billions of Euros of liability to individual people, many of whom happen to be Greeks and Cypriots, with no corresponding asset. What solution will you legislate for that? Will you let your banks honour individual deposits or not based on the passport of the account holder? Will you haircut all deposits in Germany? Will you bail the banks out?

The rules of the game are that he ECB is responsible for all Euro accounts. It has accounts more or less directly with states – states are treated like very large businesses. The faith of the ECB also stands behind private banks, so that the private banks can honour Euro accounts of individuals. With Cyprus, and now with Greece, the ECB has decided to price in default risk, country by country, by refusing to honour the full value of the accounts of individuals.

If that is so the Euro has already failed. It is not one currency, it is already three: Cypriot Euro, Greek Euro, and the rest. If this policy line continues soon there will be a fourth, fifth, and more currencies all called Euro but having different net present value depending on in which country they exist as bank deposits. This is not a single currency system, it is a failure.

How QE works

Various commentators are saying that Europe’s QE won’t work, or QE in general doesn’t work because it just boosts the value of assets. Increasing the reserves of banks, critics say, doesn’t cause banks to lend money to the real economy.

That’s irrelevant. QE is not supposed to make banks lend more money. Banks don’t need reserves to lend money, or rather it works the other way. Banks lend money if there’s demand for loans, and then ask for reserves which are always given.

What QE does is indeed to boost asset prices. Central banks buy bonds, people who sold the bonds buy stocks, stocks go up in value. Or people who sold the bonds spend money, money ends up in company profits, stocks go up in value.

And this how QE works. What happens when stocks go up in value? Companies expand and hire more people. What happens when stocks fall in value? They cut costs and lay off people. When stocks rise in value pension funds are wealthy. When they fall, poor.

In our imperfect system QE is a blunt instrument that makes rich people richer while boosting the economy. The problem, though, is with concentration of financial wealth, not with QE.

How to understand Greece’s negotiations with its creditors, part 1

Greece: We can’t pay the interest on our debt because the principal is high, the rate of interest is high, and our income is much too low thanks to the income-reducing austerity measures imposed by our creditors.

Creditors line so far: Prioritize paying creditors above anything else. We don’t care about the cumulative damage it does to your economy.

Greece with Syriza: We refuse to do that any more. Besides, can’t you see it’s pointless? We have less and less income to possibly pay you with.

Creditors after election: Well we can’t remove the debt principal from the books because debt is money and European nations’ money would have to disappear.

OK, these are good opening positions for negotiation. Greece is asserting you can’t collect from a business you’re running into the ground. Central bankers are asserting that “Europe’s money is our balance sheet” and you can’t remove debt from the assets side of the balance sheet without something bad happening to the liabilities (money) side.

What next? Compromise I expect. Either central bankers accept that balance sheets with liabilities exceeding assets are OK for central banks, or they’ll figure out a way to make old debt a token asset that generates little or no current account obligations. The first would be easiest, but the economic Zeitgeist is against it so I expect the latter. Some sort of indefinite near-zero real interest rollover as is the case with US or Japanese debt.

To clarify for the concerns of northern European folk:
No-one really expects a nation to pay back its debt. It’s not a project to build a highway, or little of national debt is like that. Nations borrow more or less indefinitely and the amount of debt may rise and fall but that’s an investment concern like the stock market rising and falling in valuation. Generally debt is supposed to rise slowly, and to pay it all back is a bad thing because it removes bonds from the investment market. Neither is Greece expected to pay back northern Europe nor are northern European taxpayers on the hook to pay Greece’s bill to someone. Sovereign debts are not like auto loans.

Rather, sovereign debts are like stocks or mortgages. They’re assets in the banking system. Greece essentially borrowed into a bubble and in 2010 was revealed to be a bad asset. Greece’s economy is worth less than it’s mortgage, so to speak. Bad call, maybe reckless, but it’s the truth. Since then the bad asset that’s Greece’s debt has been passed around until it ended up in Europe’s central banks, the way bad assets in the US ended un in the Fed. That’s OK, it’s partly what central banks are for. No one is going to liquidate a central bank because its liabilities exceed its assets. Except the ECB, if they decide to. But that would be dumb.

So what the negotiation is about is seeking one of two outcomes: Either agree in banking circles that having big holes in the balance sheets of central banks is OK, in which case they can write off a big chunk of debt and put the remaining amount back on the investment market on a sound footing, or figure out a clever way to keep the debt on the books so the books look neat but the debt generates no real interest or pressure on the real economy. The first is emotionally cleaner and revives the economy, and it’s what Syriza wants. The latter buries the problem until it dies of old age and is the Japanese approach. I like Japan…

Why is there an oil price?

Why is the oil price well-behaved? I mean why is it settling in a range around $50 a barrel instead of being stuck at a few dollars per barrel, the marginal cost of the cheapest producers? Or for that matter why isn’t it much higher, at several hundred or thousands of dollars? These questions are not as trivial as they appear.

I know that different producers face different costs of extraction and shipment, with Saudi Arabia bing the cheapest and US fracking the most costly. If producers also face scaling limits on production, that would create a sloping supply curve. But do they? What’s stopping Saudi Arabia from pumping the oil out of the ground much faster and meeting the entire world demand until its oil fields run out? It could then charge a price just below the amortised extraction cost of the next cheapest producer.

Is there a technical or geological limit on how fast you can drain an oil field? Faster extraction of course requires more rigs, but the capital requirement is moot. If one rig is profitable at a given oil price so are 100 rigs, assuming the oil field and the market last longer than the capital amortization period.

A fully competitive market with zero foresight, in other words concerned only with present returns and assuming oil reserves and world demand lasting indefinitely, would suggest an oil price close to the lower bound. That we’re not seeing that suggests producers are factoring some aspect of future or total expected returns into their supply decisions. In other words they set the NPV of future returns above zero. Hold that thought.

What’s at the other extreme? What if some really far-sighted people, say Norwegians, value future returns on par with the present? Then they should say “Hang on, this oil belongs not just to us but to our children and our children’s children. All future generations need to be compensated for losing their finite resource, so we’re keeping it in the ground until it’s the last oil in the World and prices are many times higher than thy are now”.

If a producer can wait, assuming oil stock is finite but world demand persists indefinitely, you’d expect them to sit on the oil until production collapses, there are acute shortages, and they can extract punitive prices. That’s the way to maximize total returns if you set the NPV multiplier of future income at 1, that is you value the future as much as the present. Nobody does that, not even the Norwegians.

So what determines the price of oil? Is it the intersection of a textbook competitive supply and demand curve, where supply means marginal production cost and capital amortization? Is Saudi Arabia simply trying to drive US shale (fracking) out of the business? That’s the theory that prevails in the business press. Or is there something more subtle going on?

If producers are basing their supply decisions not just on spot supply and demand but on some sort of future returns calculation, they have three factors to balance:

An NPV curve (Net Present Value) or how they value money today vs. money in the future. This is subjective. War or fear of losing power may make the current leadership of an oil producer unusually short-termist. Oh look, ISIL, Yemen, the Saudi king just died…

Finite stock considerations, in other words recognizing that the stock of oil that each producer has is not infinite. Neither is the world total. Peak oil looked like an overriding concern a few years ago, but with the exploitation of shale and other expensive reservoirs the concern has abated. Oil is still not infinite though, and it’s finite within one or two human lifetimes meaning that producers should care.

The uncertainly of future demand. Sure, demand fluctuates but it’s rising indefinitely or at last not falling, is it? Well that assumption may be dramatically wrong. Oil demand may well drop abruptly because of climate limitations, or because of a technology shift to a superior form of energy such as solar. If you’re an oil producer with foresight you might want to get your money now before that happens.

I find these price-influencing factors at least as plausible as the naive assumption that there’s a price war going on against shale. If they apply, low prices may persist much longer than analysts are expecting, or may revert quickly. Prices may also move much lower or much higher than the cutoff point for shale which appears to be near current levels. We’ll see. But if a lot of volatility happens, and price turns out not to be driven by shale costs, don’t be surprised.

Marginal contribution nonsense


Consider two imaginary artists, Jay and Ani. Jay raps about problems not caused by women and Ani sings ballads about problems created by men.

Unequivocally Jay is more popular. At almost any time and place more people want to listen to Jay than Ani. Of course popularity is not the only measure of worth. We could make qualitative arguments as to why Ani’s work should be more prominent, and these ultimately translate to predictions about hidden preferences: Maybe everyone will value her more in the future, or some people value her really strongly, or would value her if it weren’t for marketing. We’ll return to these concepts later.  But for now let us concede that the market has ranked Jay’s contribution higher than Ani’s.

How much higher is Jay’s contribution relative to Ani’s? Today, Jay is 50 times richer. Does this mean his contribution to the world through music is 50 times greater? Not so fast!

Suppose our wonderful artists started their careers in the 1900’s. There’s no amplification and no recording, so all they can do is acoustic concerts in relatively small halls. Jay is still more popular and manages to book 3 times as many gigs. In these circumstances where the artist’s product scales with their labor we can say that yes, Jay’s contribution is 3 times Ani’s or close enough.

Then it’s 1950 and we have amplification. Now people can gather to really big concerts in stadiums. Jay can pull in the big crowd and earns 10 times as much as Ani who’s still doing small gigs. Did Jay just expand his contribution, or did the work of engineers and athletes and builders do that?

Fast forward to 1980 and someone invents CDs. Imagine at first there’s only two CDs on the market, Jay’s work and Ani’s work, and they’re very expensive. Let’s say they’re $100 so consumers can only afford one. Forced to choose, the vast majority of people go for Jay’s CD and he ends up selling 100 times as much as Ani. Is his contribution now 100 times greater? Why? What changed since the acoustic days?

A few years later in the 1990s publishers have figured out how to make CDs cheaply and price them properly, so now they’re $10. Suddenly consumers can afford to buy both Jay’s and Ani’s work, and Jay is now making 50 times Ani’s sales. Did their relative contribution actually change?

Now it’s 2010 and some geeks invented streaming music. They charge $10 a month and let you listen to whatever you like, distributing money to artists according to how often each song is played. Now people have access to both Jay’s and Ani’s work and it turns out that Jay’s work gets played 200 times more than Ani’s. Wait, what happened? Jay now earns 200 times as much as Ani. Does that reflect his contribution, or is his music more everyday entertainment compared to Ani’s deep stuff?

Now let’s revisit the qualitative questions about worth that we parked at the start. Is it correct to reward artists according to how many times their songs get played? What if people value listening to Ani’s songs occasionally, or just having the option to listen? Remember people don’t pay per listen, they pay a flat fee. What if artists were rewarded progressively, say by the log or square root of play counts? What if the money was apportioned by listener ratings, or an even more direct listener choice to support specific artists? Changing the model of what’s essentially an interpretation of the subscriber’s preferences completely changes the valuation of each artist’s work.

The moral for economists is that marginal contribution is nonsense. A meritocratic market can rank contributions with plausible veracity but says nothing about the magnitude of contributions. Earnings are an emergent result of technology, ownership, legal structures, trust, marketing, and other factors. These factors determine the shape of the earnings curve – how much winners win and losers lose. A meritocracy, at best, defines who the winners are.

Income from capital is where the fun is

I’m half way through Piketty’s book but have a methodological criticism.In keeping with convention, Piketty classifies the income of top professionals such as managers as “income from labour” if it’s paid as salary. He classifies as “income form capital” only overtly financial income such as rents, dividends, capital gains on shares, etc. I agree in accounting terms but not in economic terms, and as such I feel Piketty’s conventional approach paints a more optimistic picture of the ratio of income from capital vs. income from labour than is actually pertinent.

Arguably it’s more correct in terms of economic analysis to treat upper middle class incomes, especially the incomes of managers and professionals in tech, pharma, banking, and other sectors with highly concentrated capital structures as deriving from capital, even if these people receive their income through salaries. The justification is twofold:

Firstly, if we also assume the conventional notion that salary for labour is compensation for one’s time, that implies the intrinsic worth of a top professional’s time is several times higher than that of an ordinary worker. That reveals an extremely discriminatory conception of human worth, which is also implausible. Much more likely, top professionals are highly compensated for something that they have, human capital, and not for yielding their Marxian capacity for labour. Arguments about diligence or laziness are about yielding a different capacity for labour, say 90 vs. 30 hours a week, and they may have some truth but however generously they don’t account for more than a 2x or 3x pay difference.

So the high pay of top managers and professionals must derive from a kind of human capital. What kind of capital would that be? I speculate it’s a mixture of skill and trust, with the major difference deriving from trust. Skill is things like being a good lawyer or a fabulous programmer, largely the result of practice and education. Trust is who you know and how you are perceived, and in particular the perception as to how faithfully you’ll serve the interests of capital. Trust, not skill, in my view is what distinguishes CEOs and VPs from mere mortals and what gets them invited and placed into these roles in the first place. But it is a resource. Trust is something that an elite enjoys and the multitude doesn’t automatically have, so it’s capital, not labour in the sense of capacity to do work.

The second justification is considering where the efforts of different kinds of waged employees go. The daily efforts of an ordinary worker, such a delivery driver, industrial worker, sales clerk, customer service attendant, and so on unequivocally go into production. That accords to the familiar production function of a firm, combining labour, capital, and other factors to achieve production. But crucially, the efforts of ordinary workers do not change the capital stock of the firm or the coefficients of the production function. In that sense labour is a dispensable commodity and its return scales linearly with the turnover of the firm all other things being equal. This activity, I argue, is correctly captured by the classical term “labour”.

The efforts of highly paid managers and professionals, in contrast, overwhelmingly go into capital formation. A Google employee who creates the company’s next innovation, a pharmaceutical researcher, or a financial deal maker are not contributing labour as an input into production. They work to increase the capital stock of the firm, and they do so qualitatively, so that the increase in the coefficients of the firm’s production function compounds exponentially. Top professionals are directly rewarded for their multiplicative effect on the production function, which arguably means their income should be properly classified as income from capital however the money is actually paid.

If we account for top professional incomes as incomes from capital as opposed to labour we will arrive, I think, at an even more alarming picture concerning the yield of capital vs. the yield of labour than Piketty already paints. And I think that truly reflects reality as we observe the relative bargaining powerlessness of capital (who cares if your strike if capacity to do work vastly outstrips demand) compared to the leverage enjoyed by the class of people who work in capital formation.

Beyond the economics, metaphysically it’s worth noting that all the good jobs, in the sense of initiative, sense of achievement, intrinsically rewarding activity, and so on today are in capital formation. Tech workers tend to have an optimistic view of the state of the world because, by and large, we work in capital formation, an experience that even at the lowest level is qualitatively different from those who truly work in production. All the fun jobs are in capital formation and that is a very serious problem in many dimensions.

Economies are graphs, study them as graphs

Economies are graphs. The workings of economies would be better illuminated if economics were developed as a study of graphs, the things with nodes and edges, instead of aggregate stocks and flows.

A person is a node in the graph. Real value (goods and services) flows from one person to the other in a direction that we label with an arrow, and sometimes money flows in the opposite direction. The purpose of money is to shortcut loops or debts of value reciprocity that would otherwise take too long to balance. When you want interdependence you don’t settle in cash, which is why you don’t pay for gifts or for the services of family members and co-workers.

An artisan is a person who delivers value directly to customers and gets paid immediately or soon along the same arc. In a market, like a Sunday fruit market, arcs are transient but in other situations arcs are long lived and capture trade relationships including trade debt. Customers can put up money at the end of arcs to motivate them, and we call this demand. The social function of money is largely to motivate value arcs that would otherwise be hard to negotiate. The fact that money sometimes accumulates is an aberration.

A market is a device for arc formation. A variety market such as a bazaar or department store serves to reveal and create the value arcs that meet demand, by rewarding certain links among the vast space of possible production. It’s a network phenomenon with persistence, like learning in the brain. The kind of commodity market much loved by economists is a much lesser creature. It aims to create and destroy arcs instantly, in atomic transactions, to avoid long term graph formation and only accumulate the money imbalance. At best it’s an inefficient method for optimising aggregates.

Companies and families are structurally the same, in that individuals send value to each other according to internal relationships without getting paid by the receivers. They’re explicitly not markets. Money arrives at some distinguished nodes and gets shared along different arcs than the value flow. People tend to identify and be invested with their outgoing value arc, not the incoming money arc – this is what I do, not that’s what I get paid – and when the opposite happens it’s a dysfunction.

People pass incoming value as well as add their own, such as when a leader or seller delivers a finished item, or when an academic synthesises the wisdom of others. Value creation is a graph process quite distinct from money capture. Everyone understands value creation by aggregating flow on their graph and most approach it with a well-developed moral sense, egalitarian or biased. Few people have the inclination or low morals to monopolise money capture in the opposite direction.

Value flows will in general be unbalanced, from the more to the less productive, in an economy or any meaningful subgraph or time period. They have to be unbalanced if they are optimally large. Debt will maintain unbalanced flows that may be desirable, but is not a device to achieve balance or fairness. We have to set up, as societies, the value flows that we want including unbalanced transfers for education, misfortune, or old age.

Money accumulates because the settlement of transactions is not perfect and economic graphs such as firms are set to aggregate this imbalance, though not as a direct mirror of value flow. Wealth aggregates to different people and more unequally than their value contribution, because graphs have evolved to make it so. There’s no guarantee or even tendency for wealth to mirror value creation in the long run; there are just emergent graph effects and motives to steer them.

Value flows matter. Money flows in the end should not, although today they do. In the short run and all other things being equal, money and finance serve to motivate and adjust value flows differentially. Beyond that, any large accumulation of wealth or debt is emergent and arbitrary. It should not be treated as power or bondage, but as a relative claim to future flows made self-limiting by inflation.

Someone who is unemployed has no outgoing arcs. No-one wants their value output, perhaps because they have no incoming arcs either: No training, no colleagues or equipment, etc. A menial service worker or someone in a predatory profession like a spammer recognises that they transmit zero or negative value. All are unhappy, in the psychological sense of lacking purpose or value, even if some money somehow flows in their direction by other means.

What about a person who cultivates themselves, through erudition or physical training? In graph theory that’s a node with an arc pointing to itself, and can be formalised the same as other value transfers. Perhaps value towards self will later join output for others, such as when studying before publishing. Leisure is then either a restorative value transfer, i.e. useful, or if it achieves nothing it’s the absence of value flow.

In either case, utility is a relatively transient attribute of the self. It’s things like energy, joy, hunger, tiredness, sleep, etc. People consume value including leisure to increase their utility and partly damage it by working, mostly in a daily or weekly cycle. Work is a disutility insofar as it damages us, and a utility when it makes us greater. In a graph theory of the economy utility is more of a temporary, limiting but also self-correcting, state of individuals than something that could be amassed, precisely calculated, or time shifted.

Incidentally a lazy person is someone who, for one reason or another, needs to consume more leisure to restore their utility. To be more productive, learn to rest more efficiently. Firms that emphasise the quality of the work experience recognise this. Grim dwellings for the poor destroy utility.

Most value flow is not in markets with transient arcs and immediate settlement but along economic relationships that have some permanence: Family, work, knowledge, reputation, trust, social contribution. People like to adjust their graph connections to gain higher status, but they don’t seek an extemporaneous, fully market disciplined existence.

Although utility and value transfers are in the here and now, people desire security for the future. The need for security is a preference for being included in the value graph of the future. People invest in their position in the graph of the present, by and large the outgoing value arcs, during their productive years, and expect some reciprocity i.e. to receive flows value in young and old age.

Ordinarily we treat these as social value-debts shared by the immediate graph neighbourhood: Family, professional guild, nation or other social group. Increasingly we’ve treated these time shift problems as money-debts: Student loans, private savings. Since the purpose of money is explicitly to avoid permanence or long-term reciprocity, this fails to engender security. Far too much money is amassed to achieve security for a few, creating a massive loss of utility. And that, too, is an aberration.

Economies are graphs. Study them as graphs.

On Bitcoin

My thoughts on Bitcoin, originally a comment here:

Bitcoins are virtual gold, or maybe palladium. The have low use value, high scarcity, can’t be forged, and aren’t controlled by any government. They’re clearly designed to facilitate payments and store value. People aren’t obliged to accept them, but they do so voluntarily. Very few real-world vendors accept Bitcoins, making their use value low and uncertain, but the speculation is that acceptance will grow making them valuable. Currently they’re like an obscure precious metal, say palladium. Proponents hope they’ll become mainstream like gold, silver, money.

So are they money? They’re clearly an attempt at commodity money, like gold. Let’s assume the proponents/speculators are correct and they achieve broader acceptance. What are the implications? Continue reading

How to price air travel properly

The current pricing model for air travel is nonsense stacked upon nonsense. Single fares, return fares, fees for changes, discounted and flexi fares, business fares, loyalty bonuses… all nonsense. It developed as an anti-competitive arms race between the airlines of the 70s and escalated from there. Nonsense. Here’s how to price air travel properly.

The cost of a seat has three components:

  • A fare, valid for a segment class, season, and class of service. For example “Between UK and East Coast US, standard service (economy), spring-summer 2014” £345.
  • An option to travel on a particular date, flight, and seat. For example “Option to travel on VS45, LHR-JFK, May 17, 2014, rows 28-37” £73.
  • An efficiency bonus. For example “Returning within a week, returning on the same weekday, checked baggage, full flight” -£65 (discount). Or another example “Short connection, Roll-on luggage, meal” £35 (surcharge).

To travel, you need to purchase a fare and at least one option for the flight you want. When you check in you may get money back as an efficiency bonus, or if you do certain things you may be asked to pay surcharges.

Continue reading

The Eurozone crisis is about taxation vs. inflation

This formidable crisis that we’re having is, still, about taxation vs. inflation as a means of surplus recycling. A handful of countries including Germany have managed to make taxation work sufficiently well for surplus recycling (sort of, given high surpluses and still rising inequality). The Germans have foolishly written that into the constitution. All other countries, including the US and Japan, find taxation politically or practically insufficient as a means of surplus recycling and make up with a measure of monetary expansion. We’ll call that inflation although it’s not the same thing.

Monetary expansion taxes all assets denominated in a currency and is thus a form of recycling. In the US the market rises when easing is expected. Why? Because investors know that firms will have an opportunity to capture the surplus that is so recycled. Otherwise surplus will be more and more concentrated in retained profits, it won’t return to the market, and investments will have diminishing yield.

Southern Europe and the so-called lazy Greeks have been especially bad at taxation and especially reliant on inflation, devaluation, and the like. All countries pay their way if inflation is allowed. Fiscal obligations are covered in nominal terms and purchasing power for imports diminishes. The Eurozone was created, foolishly, with a German-inspired “there shall be no inflation” clause, and foolishly Greece applied and was admitted knowing that making taxation work in the timescale was unrealistic (and it’s a tall order for any country ever). The Eurozone then persisted, foolishly, in denial. The Greeks will endure anything but make taxation work, and the Germans will contemplate any measure but admit that taxation is insufficient and monetary expansion is a necessary pillar.

So please, let’s not moralise about lazy this and cruel that. Let’s see how we can back out of past decisions that were foolish, and that means talking about the role of both taxation and inflation (monetary expansion) in the Eurozone.

Inspired from Yanis Varoufakis’s blog here

A short critique of the Efficient Market Hypothesis

The so-called Nobel prize in economics has been awarded to Gene Fama for his Efficient Market Hypothesis. EMH states that markets instantly price in all available information and so nobody would be able to outsmart or otherwise outperform the market consistently in the long run.

Here’s my short critique of the theory.

The EMH assumes there’s an event horizon. Events behind the horizon, be they unknown future events or insider secrets, have no bearing on prices. Then events pop up over the horizon and instantly the market computes new asset prices to fully reflect the new information. Ergo you can’t out-compute the market.

The assumption that the market computes prices instantly is idealistic but we’ll go with that. The market is pretty fast, down to seconds or less.

Real-world events don’t flip from fully unknown unbiased probability to fully known outcomes. There’s a bias i.e. any particular event is predicted as more likely to happen than not, or vice versa, and better confidence estimates of the event’s probability become available over time. But so long as we assume everyone has access to the same stream of predictions the EMH still makes sense.

Where the EMH falls down is that prices don’t change to reflect the final valuation of a future state as soon as that future is known. New information gets priced in over time, from when the information is revealed to the time when the new situation actually takes effect and directly bears on the fundamentals. People see the instant tick of the pricing and say “ha, EMH!” but there’s a lot more pricing yet to come, and that’s why prices change continuously even in the absence of important news.

The reason markets price in information over time is twofold:

  • Market participants have different trading time frames. If we know for certain that the US will default in one year that will cause stocks to drop instantly, but there’s still time to invest and get out during the year, so people do. If the time frame is uncertain there’s more scope for price change. Miscalculations about trader’s ability to enter and exit cause bubbles to inflate and then crash.
  • Since the market isn’t pressured to price in the impact of future events until the exit window of each type of trader closes, it doesn’t, and how it will eventually price the impact over time remains unknown. Market participants have to predict prices at specific times and and the analyst with the better prediction of the market’s reaction wins. For example if you and I predict that a default will cause a 5% or 30% drop in asset prices tomorrow (not eventually when the default happens) one of us will come out looking smarter.

So, even in a world where everyone has full access to information about events, including likelihood and confidence, there are still opportunities. Opportunities arise from being better or worse at estimating how the market will compute price changes over time given known inputs, which is a notoriously hard but valid computational problem.

How the 2013 US default will play out

Here’s what will happen with the US debt ceiling over the next few weeks.

Neither side will compromise to raise the debt ceiling. President Obama, who is in the right, won’t negotiate because caving in to blackmail will undermine his and every future president’s authority. Hardline Republicans won’t negotiate because they’re reckless and want to bring about a default and a fiscal collapse in order to implement libertarian utopia.

Wall Street, defence, and regular business leaders will call their republican senators and tell them in no uncertain terms that future campaign contributions will go to Democrats unless they back off. Most Republicans will be burned by this, but the Tea Party wont back down because they have grass roots and rich libertarian supporters.

The treasury will run out of money on October 15 or thereabouts, and then will hold back all payments equally until they can be covered by tax receipts. That will include Treasury bond payments, and the US will be in default. Rating agencies will downgrade US debt to hot potato status. The market will maintain the belief that the US will eventually pay the arrears after an unknown delay.

The Fed, being the only well-funded and well-run branch of government, will intervene massively. Mr Bernanke will generate trillions of reserves (Fed credit to US banks) and use it to buy Treasury bonds from the banks. This will keep Wall Street banks solvent and mitigate the fall of Treasury prices. They’ll fall by a few percent instead of crashing. The Fed may also elect to buy stocks to calm stock markets and later gain revenue. This intervention will be held tightly by banks and not generate consumer price inflation.

A fall in the value of US treasuries means a rise in the interest rate that the US has to pay for all its accumulated debt, not just new debt (although the new rate gets phased in over around five years as bonds mature). Something like a 2% rise is burdensome. At some level, be that 4% or 5% or similar the market starts to believe that the US will never pay some of the debt and interest rates spiral to 25% or more because of the risk. That makes it certain that the debt won’t be paid in full, and US debt changes form a safe asset to a speculator’s trade. That’s what happened to Greece. It’s not clear if the Fed will be able to avert the latter scenario.

Either way, if the debt limit isn’t raised and the US defaults the US will have to pay higher interest. It may be much higher or impossibly higher. If you’re concerned about lowering the US debt burden, default is not what you want!

Central banks outside the US, particularly in Japan, may elect to cover their own financial institutions’ exposure to Treasuries by generating reserves in Yen, Pounds, etc. This will keep the financial system from collapsing and convert immediate paper losses to long-term recession, as happened 2008. The ECB, because it’s in the grip of Teutonic myths about money and debt, will be the last to react and will do so in half-measures, putting several European financial institutions in peril and adding to the ongoing Eurozone crisis.

The collapse of demand for Treasuries doesn’t pose survival challenges to real economy firms. Successful US firms have large cash reserves. The abrupt fiscal tightening will significantly hurt firms in certain sectors. However the secondary effects are severe and they’ll come back to affect all US businesses through the world economy.

The largest foreign holders of US Treasuries, China and Japan, have these bonds because for years they maintained a trade surplus with the US. Every year Americans (the private sector) import more things from China than they sell to China, so that excess dollars pile up at the Chinese central bank. Then along comes Uncle Sam, takes back the dollars and spends them in the US economy, and gives China yellow debt certificates called Treasury bonds. The Chinese effectively subsidise American consumption (they work for less) in order to boost their own production, and Americans maintain unaffordable consumption by going into paper debt. To a lesser extent the same happens vis-a-vis Japan, Korea, Taiwan, and Germany. Outside of a crisis scenario, no-one expects the US to pay back accumulated debt. To creditors it’s a long-term safe investment that pays interest.

When the US defaults, this arrangement breaks down. Suddenly the Chinese will no longer accept Treasury bonds and will demand dollars to replace the amount they hold as they mature. The Fed may decide to fly plane loads of newly printed Benjamins ($100 bills) to China and take back expiring Treasuries to shred them. China won’t accumulate the dollars but will try to spend them immediately on asset purchases, in the US and abroad. This will have three major effects:

  • The value of the dollar will fall sharply compared to other currencies, as there will be a flood of dollars chasing assets worldwide. American wealth will be reduced significantly, and there will be inflation through imports.
  • Imports to the US, including things like industrial components and iPads, will be much more expensive for Americans or unaffordable to US firms. Demand, production, profits, and stocks will fall sharply around the world.
  • America’s creditors will pick up devalued stocks worldwide, making a long term shift of capital from American to Asian and a few European holders. Iconic US firms such as Apple may come under hostile takeover by foreign capital.

The US may instead refuse to pay cash for Treasuries that mature and no-one can force them because the US has aircraft carriers. However the economic effect will be the same or worse: If the US bluntly refuses to honour Treasuries the dollar will fall further and trade will halt as foreigners will trust neither Treasuries nor dollars.

Eventually, perhaps after a few weeks, the US will find a procedural way to end the debt ceiling stalemate. They’ll remove or convince recalcitrant congressmen to vote for a permanent increase. However, the damage done to the economy will be permanent. Markets will resume their upward trajectory but will not recover their lost value. Capital will have been permanently transferred from the US to its creditors. Global demand, income, and profits will be permanently lower than they were before the crisis. The US will not regain credibility with bond investors until they make a constitutional change to put debt under control of the executive.

In the medium term the default will hurt China, Germany, and other Asian countries harder than the US. They will lose a profligate customer who’s buying on credit and will have to substitute US demand with demand of their own. That may happen, if money flows liberally enough in the Asian middle and upper income classes, but most likely demand and the overall economies will be permanently depressed. In the long run world economies will move past their dependency on US demand and move on.

The US will be left a much more insular and backward economy than it is today. With the dollar sharply devalued and no foreign credit the US will have to produce and consume domestically, which it can do. Expect American cars, American PCs and smartphones actually made in the US, a resurgence of blue-collar workers, higher nominal incomes and much higher consumer prices. People will buy durable goods and not gadgets. Sort of how it was in the 60s. In a way this will be more balanced and robust and may appeal to conservative nostalgia. However, it’s not the path to a libertarian powerhouse. If anything, with capital severely weakened and a greater need for domestic labour, a stronger social contract or New Deal will be needed to see America through the aftermath.

How the US Federal Wealth Fund was created

Counterfactual fiction, showing what would be the ideal path through the crisis. Very unlikely though.

It all started with a rather childish standoff. It was late 2013. An increasingly recalcitrant Tea Party faction within the GOP was holding America hostage by refusing to vote on a budget unless president Obama took back his recently enacted health reform. With tempers frayed from the government shutdown, a mere nuisance in the great scheme of things, the ultra-right Republicans went on to blackmail over the debt ceiling. Do as we ask, they said, or in fifteen days America defaults.

Everyone warned this would not be pretty. In a rare alliance, Wall Street and the defence lobby, all major newspapers, and just about every economist and economic policy maker called on the Tea Partiers to end the nonsense. A default by the United States government would be unprecedented. US treasuries, held everywhere as collateral and reserve assets, would become uncertain in pricing. That would trigger a selloff and a paper collapse making every bank in the west technically insolvent (and China).

No-one blinked. President Obama correctly held his position, arguing that the threat of blackmail would become constant if one caves in today.

The days were running out. Markets jittered. Editorials proclaimed impending doom. Then the day when the Treasury said it would run out of money came. And passed. Nothing happened. Uncle Sam’s bills got paid. Markets started rising. Both parties proclaimed victory, although it would take a few more weeks to fully reveal what had taken place.

With other options exhausted, outgoing Fed chairman Bernanke and legendary chairwoman Yellen who was then the nominee hatched a plan. In the run up before day zero the Fed set about buying stock. Lots of stock. It was done quietly though the biggest Wall Street banks, and some 700 holding companies they set up to disguise the activity. Only the CEOs and a small group of traders at each bank knew. The Fed simply created cash and lent it to the banks, who then lent it to the shell companies that swept up every stock or fund on the US exchanges and many abroad. If it weren’t for the unprecedented scale of the operation markets would be crashing, aided by the front page articles (some of them politically pushed) predicting the crash. But the Fed took up shares as fast as scared investors were offloading them, no-one lost much money, and prices stayed almost table.

All in all, on the day the US government would supposedly default it was in possession of roughly 43.6% of US stocks.

When Uncle Sam needed money, the Fed started selling some of the stock at higher prices. It was also collecting massive dividends. The Fed returned these profits to the Treasury, as it ought to, and miraculously the Treasury was able to pay its bills. The Treasury refused to name where the money came from at first, and eventually issued a statement that money comes from “the profits from assets of the US government”. Newspapers took a few days to process what this meant. When they did, the Tea Party sank, for it had brought to America the nearest thing to Communism.

Over the next 18 months the numerous shell companies created to buy up the stock market were reorganized into the US Federal Wealth Fund, the largest economic actor in history. The fund expanded its holdings to its current mandate of 48-49.9% of US traded stock and since then has been generating 20-25% of annual revenues of the US government. The amount varies pro-cyclically, as the stocks owned by the Fund do better at times of boom. That in turn allows the government to build cash reserves and spend them in fiscal stimulus when the business cycle drops.

President Obama never asked for the debt ceiling to be raised, and it has not been raised since. No more borrowing has been necessary. To this day new Treasury bonds are issued to replace maturing ones, minus some, so that US debt declines at 0.05% a year in nominal terms. They’re kept mainly as an accounting device and an inflation-protected asset for investors. Inflation briefly rose to about 3% in the years after the Fed’s intervention and then fell back to a steady 1-2%. Since the massive monetary expansion by the Fed was held by investors, and was then pulled back in dividends and capital gains, it did not drive up consumer prices.

America is now, twenty years on, a much more egalitarian society, similar to the European nation of Norway. Counting the fund as representing all Americans, some 72% of wealth is owned by the lower 90% of the population. The bottom 50% own 63% of wealth roughly equally. Revenue from the fund has expanded Medicaid, Medicare, Social Security, and Obamacare (a slur that stuck) to cover all Americans with dignity. Taxes are actually higher than they were in 2013 by about 5%, or 11% for rich Americans, and no-one complains. Fuelled by broad middle-class incomes the economy has boomed, growing at 3-4% for two decades.

The ultra-conservatives of the Tea Party never intended to make the US a haven of egalitarian prosperity into the 21 century. They probably never heard of the ideas of Louis Kelso and other visionaries of egalitarian Capitalism. But we’re here today largely thanks to their misguided actions.

Either there’s parity between M0 and M1 or there isn’t

For a given currency such as the Euro, either there is 1:1 parity between M0 (central bank money) and M1 (commercial bank money) or there isn’t. Actualy many problems would be mitigated if there was no guaranteed parity, i.e. if bank deposits could fall in value when monetary-financial bubbles burst. If in 2008 there had been a haircut on all bank deposits to write off bad debts, that would have been much preferable to austerity as a means of rebalancing. At least it would be so in substance – selling it to the public would have been a challenge.

However, parity or not parity has to be uniform across a currency. If Euro-denominated bank deposits in some Cypriot banks are overvalued and must be cut then all Euro-denominated deposits in the zone must be cut equally, by a smaller amount. That is necessary for a single currency and banking system to work. Otherwise, Cypriot bank money, or Greek, or whoever’s is next is not actually trading 1:1 with German bank money due to risk perception and we don’t really have a single currency. Or more accurately we have single M0 (central bank money and printed notes) but M1 (bank deposits and nearly all inter-bank payments) is already fragmented and exposed to de-facto exchange rate risk. That risk premium is opaque and thus much higher than if it were a properly floating national currency. Greek businesses, and presumably soon Cypriot ones, are unable to pay for imports with Greek-bank M1 (bank money) at parity. Businesses in countries with stricken bank systems are de-facto thrown out of the single currency already.

The Bundesbank hawks can’t have it both ways. Either the Euro is a single currency, which means a Euro in a bank in Cyprus is a Euro in a bank in Italy is a Euro in a bank in Germany so you can use it for payments, or it isn’t. That absolutely means that whetever happens to one Eurozone commercial bank in terms of crisis response has to be collectivized across the zone. Otherwise we don’t have the benefts of a single currency. We just have the penalties and there is no reason that electorates should accept such a flawed construction.

The free trade externality

Neoclassical economists will tell you that, invariably, free trade is a good thing. If there’s a barrier to trade between any two parties anywhere in the world, everyone would be better off with its removal. That’s not necessarily so. Often it is, but I present here a case for where and when protection is necessary for trade to lead to a universally good outcome.

Following a somewhat paradoxical Enlightenment result known as comparative advantage economists will point out that even if one party is better at everything than another, so long as they have different natural efficiencies they benefit from specializing. For example if Italy can produce both wheat and wine better than England, but Italy is better at wine than wheat and England the opposite, it will be to their mutual benefit if they specialize so Italy produces only wine, England only wheat, and they trade. At a basic level, the model holds.

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The morality of money

Recently, philosopher Michael Sandel headed this debate (essays, public lecture) on the moral dynamics that result when money is introduced to activities that are normally motivated by other means: duty, friendship, etc. Sandel makes an argument of two pillars: One, money may somehow corrupt the transaction it is involved with; two, given existing inequality, making everything a product can yield very negative distributional outcomes.

To be honest, I think he uses too many words. Let me try to do better:

1. Subjective transactions

Sometimes, we care not just about the objective goods or services that are produced and exchanged, but also for the subjective experience of the participants in the transaction. We care that a gift is an expression of love and not a forced or calculated gesture. We care that expert or legal judgements are free of personal interest, and that honour is given according to merit rather than in exchange for favours. Men care that women are at least happy with sex, unless they’re sadists and want the opposite. Most of us are alarmed when others make transactions that are too invasive or too damaging to the self, such as selling organs, being a soldier or a prostitute, or working under hazardous or unhealthy conditions, because we suspect these people are facing terrible choices that we would like to not have to face. When people volunteer to do something worthy or refrain from something selfish out of a sense of community, duty, or justice, we care not just that they do the right thing but also that they maintain and nourish these valuable feelings.

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On Debt

In the aftermath of the financial crisis, and with a raging sovereign debt crisis in Europe, notably Greece, it’s worth stopping to consider what debt is. Even as so much is written on the subject, when I read journalistic or even some economists’ accounts of the debt crisis I’m left feeling that they don’t understand what debt is, or rather that they bring a moral frame to the concept that is unhelpful and out of touch with reality.

There are only three formulations of debt, as an economic transaction between strangers, that are moral and advisable:

  • An investment future: If you have a pile of cash, the net present value of keeping it as cash for a year is a few percent below face value, because of inflation and the risk it might be stolen or destroyed. You can give it to someone who can realize a better NPV and share some of that with you, so you both win. You could give it to Facebook in exchange of stock, or to a bank that invests in sub-prime mortgages. You could give it to the government of Germany, or of Greece. These differ in risk and return, and the market does a rough job of pricing them, but it’s always your investment decision. You can ask politically for an investment to be insured, or bailed out, and that simply means socializing losses by inflation or other means. Often, this is the right thing to do.
  • An option to sell: A secured debt, such as a mortgage, is really an option to sell the collateral to the bank at some future date, for some variable amount that’s equal to your then outstanding obligation. Again, it’s a business decision. The lenders should plan according to the possibility that they may get the full payment schedule or the collateral, presumably whatever is worth less in the ensuing economic conditions. If they forecast that poorly, well, too bad. There’s nothing moral or otherwise beholding of the borrower in a secured debt arrangement.
  • Due payment: Invoices for goods or services are a short term loan from the supplier to the client, granted as part of the cost of doing business. This debt does carry moral weight because it affects the cash flow of both parties a great deal and because only the value of the relationship, and a firm’s reputation, really compel a firm to pay it.

These are acceptable, modern forms of debt. Notice that, apart from the case of honorable business debt, there’s no moral angle to it. If you have surplus you give it to someone in the hope of achieving a better NPV, and maybe you get that or you don’t. There are no reckless borrowers or predatory lenders, and debt is not some kind of crushing moral obligation in this world. Continue reading

The three faces of capitalism

There are three activities that a capitalist firm does. Every firm engages in all three at different times, but the balance and the timing bring about radically different outcomes: Financially, in immediate human welfare, for development, and morally. I therefore call these the three faces of capitalism.

  • Capital formation:In capital formation the firm consumes financial assets (usually cash) and builds real assets that it will later use for production or extraction. Capital formation thus takes two forms:
    • Productive capital formation, such as technical innovation, the building of customer relationships and goodwill, channels to market, facilities or machinery, organizational and human capital.
    • Extractive capital formation, such as the acquisition of monopoly licenses or exclusivities, financial muscle, commodity stocks, control over suppliers or distributors, land, and all IP assets.
  • Production: Production is what an industrial, agricultural, or service firm does. Resources come in, labor and and devices are applied, and goods or services come out. The goal of production is to sell the goods or services at a profit, while minimising the share paid to suppliers and labor, and the running cost of devices.
  • Extraction: Extraction is what a landlord, bank, media company, utility, mining company, or retailer does. These firms have a productive function, but their dominant mode of business is to extract rents from assets that they own, while rationing those assets so as to command the maximum price.

The companies that people admire, Google, Apple, the great electrical and electronic firms, the venerable auto and aviation firms, the computer companies, the large and small software houses, big infrastructure, big science, universities, and medicine are all admired because of their productive capital formation: R&D, innovation, bright ideas, making what previously didn’t exist or wasn’t possible. Productive capital is seen as a beacon of hope and progress for humanity, and great store is set by it wittingly or unwittingly.

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On Feminism

The purpose of feminism is not to treat men and women the same. The core problem of feminism is to redress the natural imbalance of reproductive costs and decisions, which biologically fall almost entirely on women. As such, feminism has to be an “affirmative action”, not an “equal opportunity” movement.

For a woman, a chance at reproduction is as good as assured. For practical purposes, she can make her offspring herself. However, on her own she would face the entire cost of bearing and raising young, which is enormous. A man’s reproduction is not assured. He has to find or make a woman willing to have his young. Beyond that, only social and emotional factors motivate the man to share into the costs of raising the offspring, and the man needs high confidence of fatherhood before competing on their behalf for resources and power in the world. This is the natural situation, devoid of any value judgments. Nature lumps all the costs, but also the decisions, on women. Feminism is the attempt, throughout history, to balance the costs with men.

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