Saturday, May 17, 2008

Political bubbles

In response to this Wall Street Journal article, describing a number of scholars developing mathematical models of market bubbles, I posted the following comment at Marginal Revolution which is worth reposting here:
The scholars quoted in the original article sound like they are just engaging in a fancy form of technical analysis, which purports to capture in mathematics the psychology of the crowd, but in almost all cases turns out to be worthless numerology.

The fancy math doesn't explain bubbles any better than [Robert] Schiller's simple driving analogy: there is a big event at an obscure location (let's call it Burning Man, out in the middle of the desert somewhere). People driving to the event are very uncertain of the directions. At a certain intersection, on average 60% of them correctly believe they must turn right and 40% incorrectly believe they must turn left. But they can usually reduce their uncertainty by observing the behavior of others, who are somewhat more likely to be correct than wrong, and altering their [probability estimates] accordingly. Normally this works, but on rare occasions it goes wrong: for example, if the first three cars happen to turn left, the fourth, who had believed with 60% confidence that right was the proper direction, will rationally change his mind and go left. Thus a string of bad luck can make all the cars start going off in the wrong direction, except for those handful of drivers that are strongly confident in their knowledge that one should go right.

Where this analogy goes off the rails as public policy analysis is with the tacit hubris that certain academics from sufficiently elite schools are flying above the whole event in a helicopter and can direct traffic, if only their mathematical analysis is fancy enough. Rather academics and policy makers are in the traffic themselves, generally seeing information biased in ways similar to or even more extreme than the information investors see and act on. In many cases mispriced markets create arbitrage opportunities for truly knowledgeable investors, but analogs to such arbitrage opportunities, i.e. the ability to be rewarded for correcting actual misinformation, are much less prevalent in academic and political policy circles. We should thus expect political policy to be much more prone to biased political fads and herd-following than markets are. Both markets and governments may often take wrong directions, but for politics the inability to correct wrong directions may be endemic. Markets tend to correct themselves, usually in the short run and practically always in the long run, depending on the costs of arbitrage, but there is often no easy way to recognize or correct a political bubble.

Thus, applying the same rational uncertainty assumptions to politics as we do to markets, if we give political decisionmakers the power to "pop" bubbles they think they recognize, they will probably tend to make genuine market bubbles worse, will prevent markets from sending genuine supply and demand signals, and will introduce other extra transaction costs.

Tuesday, May 13, 2008

Ben Bernanke plays John Law

John Law and the Mississippi Bubble are fairly well-known to economic historians, but one wonders whether the supposed economic experts who run the U.S. Federal Reserve remember it.

To briefly summarize (and necessarily oversimply), Law was an economist and gambler put in charge of the French central bank in the early 18th century. The bank issued notes (i.e. paper money) backed primarily reserves of, not gold or silver, nor French sovereign debt, but of stock in the Mississippi Company, which owned huge tracks of recently acquired, but hardly settled, American frontier land. In other words, the currency was backed by speculative real estate ventures. After a few good years, the scheme quickly collapsed in hyperinflation and bankruptcy.

Fast forward to today. The Federal Reserve has traditionally used as reserves, on top of some gold, U.S. federal debt (Treasuries), considered a "risk free" investment (actually they are by market measures of risk generally the lowest risk, but not risk-free, as anyone holding Treasuries during periods of dollar inflation can attest to). Quite recently, however, this has changed:

What has replaced Treasuries in the Fed's hoard? Here's how Randy Waldman puts it:
The difference, about $475B, represents an investment by the central bank in risky assets of the US financial sector.
In other words, the Fed has been replacing the lowest-risk asset, U.S. Treasuries, with assets considered such high risks that trading has often practically halted on them, i.e. the securitized forms of U.S. real estate debt incurred by people who now, we are finding, often cannot or do not pay off their loans. The Federal Reserve is now backing the dollar with securities that have been found to be full of moral hazard.

The Fed does have a tool for eliminating most of this debt problem: inflation. If the Fed can flood the economy with enough dollars, presumably enough of these will reach debtors that they will be able to continue paying their mortgages. By investing in shaky debt, Fed has given itself a huge incentive to further inflate the dollar. It has given itself further incentive to fleece holders of dollar liabilities, including investors in dollar-denominated debt, in order to bail out the real estate market.

We have seen a massive runup in commodity prices during the the same period during which real estate debt has replaced Treasuries in the Fed's portfolio. The dollar has already fallen steeply, and people ranging from retirement funds to second- and third-tie consumers of commodities are hedging against a quite possible further collapse of the dollar. Commodity producers are betting against the dollar by keeping commodities in the ground instead of ramping up production, and food is being stockpiled in every poor country where the currency is linked to the dollar. As I recently wrote:
The dichotomy [most economic commentators have made] between a presumably inefficient "bubble" caused by "speculation" and fundamental (geological and technological) scarcity presents a false choice.

The more likely alternative is that the parallel price rises of practically all commodities (not just oil) are a rational and socially efficient response to the inflation (M3 etc.) of the dollar and to a lesser extent of the euro. The vast increase in "non-commercial" or "speculative" participation in commodity futures reflects a greatly increased use of commodities over the last 5 years for their monetary qualities, just as Carl Menger and others would predict. See Commodity Derivatives: the New Currencies and The "Hoarding" and "Speculation" in Commodities.

Sunday, May 11, 2008

Daydreams in passing

Recently I've been both daydreaming and pondering some of the problems that daydreaming can cause.

I've recently learned that not only do interstellar meteors rudely hit our lovely planet, but some of them may be quite valuable, e.g. black diamond, which leading researchers believe to be the products of supernovae. The Amsterdam diamond sold in 2001 for about $52,000 per gram. The fact that multiple black diamonds have been found on earth suggests that there may be many tonnes of such diamonds flying through the solar system at any given time. By naive extrapolation one tonne of black diamond should be worth $52 billion, but common sense suggests otherwise. If somebody launched a robot to grab a tonne of black diamond out of the darkness of deep space and fling it into the sea, then cut and polished it up for auction, the resulting gem(s) would almost surely fetch only a tiny fraction of that $52 billion. This presents the interesting puzzle: what happens when a collectible, the value of which depends on its stable scarcity, (and thus, its shape of its demand curve depends in part on the shape of its supply curve), suddenly is discovered to be common? Its price might fall far faster than would be expected for a normal commodity demanded solely for its consumption. This suggests, too, that the recent rise in the use of commodities for their monetary properties may in some cases be quite fragile. Where new cheap sources or substitutions are discovered for a commodity, the price of that commodity might fall much farther and faster than if consumption alone shaped the demand curve. This may be a good argument for the gold bugs, if such a breakthrough is less likely for precious metals like gold than for other commodities. I find it a good argument for diversification across a basket or index of commodities. Either of these strategies is still vulnerable to a a return to good fiat currency policy by the U.S. Federal Reserve or the European Central Bank.

Speaking of daydreaming about space, Mike Thomas well describes the utter waste NASA has made, and is still trying to make, out of our tax money and our daydreams. That NASA has talked many space fans into believing that government can successfuly plan for and design infrastructure for hypothetical future business exceeds in idiocy even the old state socialism, which showed time and again (with over a hundred million starved) that central agencies couldn't plan satisfactorily for even present industrial needs.

And now for a nice exercise in pure daydreaming: SETI, the Search for Extraterrestrial Intelligence. The Drake Equation makes it all sound very scientific, but plausible inputs into the Drake Equation can make its ouptut vary by nearly twenty orders of magnitude. At one extreme there may be no civilizations in the visible universe except us. At the other extreme many SETI people believe that each galaxy may be full of millions of rather compressed and cryptic civilizations. There are plenty of people who find one extreme quite plausible and the other quite implausible, for each extreme, and plenty of plausible arguments for each side, but in fact we just don't know. SETI is an obvious example of an error that is far too common, if less obviously so, in many other areas of science: too many people who style themselves as scientists present highly uncertain opinions, based on obscure or questionable assumptions, as if they were accurate facts or settled theories. The precision and confidence of their language often far exceeds their accuracy. Modern science is so specialized that even the vast majority of fellow scientists often don't have the time to dig in to unearth the hidden assumptions behind their fellows' claims. They like us come to accept opinions, possibly of a highly uncertain nature, as facts based on the authority of the scientists.

Mistaking precision for accuracy is also one of the big problems with with attempting to predict the future needs of commerce, as NASA has purported to do. As if exagerated claims to accuracy and the hiding of assumptions weren't bad enough, due to the dominance of one kind of funding, namely government funding, most of the scientists in some fields share common biases, especially political biases to justify expanded government budgets. Authority increasingly takes the form of political power, funding increasingly requires political power, and political power, rather than facts, has been increasingly the source of "scientific consensus." Here is more on the the trouble with modern science.

Saturday, May 03, 2008

Bank notes from the free banking era

I have a beautful private collection of bank notes from the Free Banking Era in the United States (1837-1863). During this era the U.S. had no central bank and paper money was issued by a variety of private banks. Some was even issued by manufacturing and retail companies. This money was backed by gold, silver, real estate, stocks, bonds, and a wide variety of other assets. You can no longer cash them in, but they are now worth often substantial sums as collectibles. As you can see below, the note designs were more varied and creative than modern money, and were remarkably free of politicians' faces.

I am selling some of my collection. Nobody is printing any more of this kind of money and it is a great hedge against inflation. If you want to shop around, feel free to Google for what other people are asking: search for the name of the bank and state, and look for vendors such as Denly's, Beast Coins, and Don C. Kelly. (Make sure you're looking at fresh prices though -- as you might imagine, along with commodities and many other collectibles their dollar prices have risen substantially over the past year). For most notes I'm offering a significant discount. All my notes were bought from reputable dealers.

Please send your order or query to me at nszabo AT law DOT gwu DOT edu. To compute the total charge add $10 for shipping and handling within the U.S., $20 for overseas.

n.b.: the pictures shown are for same design, year, bank, and denomination as my own, but are not pictures of my own notes. My own notes are well protected and in the same shape I bought them, generally good to extremely fine. All my notes are hand-signed by the issuers unless I indicate "not issued." You get your full money back (minus shipping) if you return them for any reason within 60 days.

Please send your order or query to me at nszabo AT law DOT gwu DOT edu. To compute the total charge add $10 for shipping and handling within the U.S., $20 for overseas.

Bank of De Soto, Nebraska, $1 (1863)

Boone County Bank, Indiania, $20 (1860)

Tecumseh Bank, Michigan, $1 (year unknown)
$60. Not issued.

Store at Alleghany Furnace, $5 (1858)
$100. Not issued. "Allegheny Furnace" is misspelled "Alleghany Furnace." I don't know if this is unique to this note, or otherwise whether this fact is good, bad, or indifferent to the value.

Great Western Railroad Co., Iowa, $2 (1858)
$110. Two holes have been punched and bit of one corner has been cut out of this one, probably indicating that it is a cancelled note. Very rare.

Bank of Manchester, Michigan, $2 (1837)

Hagerstown Bank, Maryland, $5 (probably 1857)
$95. Not issued.

Merchants and Mechanics Bank, Michigan, $5 (year unknown)
$145. Not issued.

Marine Fire Insurance Co., Wisconsin, $2 (1844)

I've also got a signed $1 Los Angeles Clearing House Certificate from the pre-Federal Reserve Days (1907), $15.

Please send your order or query to me at nszabo AT law DOT gwu DOT edu. To compute the total charge add $10 for shipping and handling within the U.S., $20 for overseas.

Tuesday, April 22, 2008

The "hoarding" and "speculation" in commodities

It is a gross violation of Occam's Razor to attribute the recent very broad-based run-up in dollar commodity prices primarily to the plethora of disparate causes to which they have been attributed: "peak oil", the war in Iraq, ethanol subsidies displacing food, and so on. Rises in industrial demand, increases in the costs of transporting commodities due to high oil prices, and so on explain only a small fraction of the rise in other commodity prices, and do not explain at all why precious metal prices have increased alongside those of other commodities. Occam's Razor points us, as it did to wise investors and economists in the 1970s, to the one kind of commodity all these other commodities have in common: the currencies they are priced in.

In the 1980s, there were just as many of these disparate bullish factors for commodities as in the 1970s and as today. In the 1980s there was increasing industrial demand in Asia and the developing world, and the Iran/Iraq war drove insurance rates for oil tankers in the Persian Gulf into the stratosphere, yet commodity prices in dollars and dollar-linked currencies broadly fell, due to the emphasis of the Federal Reserve on fighting inflation throughout the 1980s.

Commodity prices now reflect more the value of commodities as stores of value and hedges or media of exchange, i.e. their values as money substitutes or hedges, than they reflect demand for their industrial consumption. The trend lines for global industrial demand have not really changed that much -- the increases in Asia are largely offset by slower demand growth in Europe and the U.S., and at today's high prices we will see industrial demand slowly fall in the U.S. and Europe and level off in Asia.

But demand for the oft-dreaded but ill-understood "hoarding" and "speculation", that is storing extra commodities (often off-the-books, or at least not in the officially measured warehouses) and the purchase of extra commodity futures and other commodity derivatives to hedge transactions based on government currencies, will remain strong as long as the Federal Reserve continues to inflate the dollar supply, and as long as many developing countries continue to link their currencies to this dollar. Commodity prices in dollars will level off, and then move back down close to historical trends based largely on just industrial consumption, if or when the Fed stops increasing the supply of dollars faster than the demand for dollars. If the Fed continues trying to inflate its way out of the latest bubble-following slump, commodities will not be the next bubble: instead they will form the basis of the new de facto currencies of high finance. See

The monetary value of liquid commodities


Commodity derivatives: the new currencies

Obviously the euro also plays a big role, but it is important to observe that the euro too has inflated, just to a lesser degree than the dollar. The euro has not developed the track record that would make many international investors think euro-denominated debt does not need to be hedged with commodity derivatives. Some wise investors still remember the hyper-inflations and outright defaults of the late 1920s and early 1930s that made many government bonds almost worthless, the destruction in the value of the U.S. debt in the 1970s from inflation, and many similar episodes. In these circumstances commodities are usually safer than government debt denominated in the fiat currencies of the same governments that owe that debt.

That's why the current flight to safety involves commodities as much or more than it involves government debt, and indeed the debts of less robust governments (ranging from municipalities in developed countries to the national debts of less developed countries) are no longer considered safe. It is well known by now that U.S. Treasuries are "safe deposit boxes" that pay negative real rates of interest -- i.e. one must pay for the privilege of storing one's wealth in a form backed by the vast future revenues of the IRS. They are a way losing one's wealth with less rapidity and volatility than with many alternative investments, not a way of actually building wealth. Commodities also store rather than build wealth. By contrast to Treasuries, commodities are more volatile, but are not subject to unknown future amounts of fiat currency inflation. A mix of U.S. Treasuries, European debt, and commodity derivatives now forms the ideal safe "store the cash under your bed" portfolio. Government debt alone is far too risky during periods when central banks are not strongly committed to reigning in money supplies.

[The above is based on comments I made at the Marginal Revolution blog].

Tuesday, April 15, 2008

Gas stations grant real options

Imagine if the only place you could refill your gas tank was at home, so that you could never choose to drive farther than one tankful of gas would carry you. Furthermore, imagine that it usually required most of a tankful to get from one place you want to go to another -- or to get back home. So you usually could choose to go only one place per trip, and even when you could go more than one place, you had to plan the entire trip well ahead of time and could not deviate from it, no matter how much your needs changed while on the trip.

That is largely the situation with space operations today. You have to plan the entire mission ahead of time. If in mid-mission you discover that you want to change the plane of your orbit, or extend the life of your satellite, or make any other change that requires more propellant than you long ago planned for, you are out of luck. If you want to reserve a wide variety of such decisions instead of committing to the entire plan up-front, it won't happen unless you launch a great deal of extra propellant that you will probably never use.

Refueling capabilities and orbital propellant depots can change that. They provide choices -- what economists call real options.

Like financial options, in an uncertain world real options often have substantial value. The kinds of real options commonly encountered in the business world include input mix options (options to use different inputs to deliver the substantially same output), output mix options (to use the same inputs to deliver different outputs), termination options (to abandon early failing projects or projects that have become unimportant), intensity or scale options (options to increase or decrease output), options to stop and restart, and switching options (the option to abandon one mean or end and change to another). All of these options can have a substantial operational and financial value that is not captured by traditional analysis of fixed plans.

Propellant depots don't provide substantially cheaper propellant: it must all, for the near future, still be launched quite expensively from earth. And propellant depots don't provide an infinite variety of choices. They won't make it affordable for astronauts headed for Mars to return back home when they discover that they forgot to pack their toothbrushes. Orbital mechanics is relentless and an option to take on extra, but still expensive, propellant can only change things so much, and you especially won't be able to afford such an option if you're off the beaten path. But propellant depots and refuelable satellites will allow those operating satellites in common orbits, such as geosynchronous orbit and low polar earth orbit, to change plans during a satellite's lifetime by adding a wide variety of valuable real options, for example:

* Spy satellites have highly uncertain propellant usage, and often end their lifetimes mostly full of propellant or exhaust their propellant long before any other components have degraded. Propellant depots will give spy satellites real options to optimize time over certain targets, to avoid a variety of attacks by changing orbits, and add flexibility to respond to other unpredictable challenges.

* Commercial satellites: depots will extend the lifetimes of satellites that prove to be important, and allow satellites to be relocated over new locations as markets change. (With a few extra features on a depot tanker, propellant already on board a broken satellite, or a satellite that has proved to be unimportant, might be "siphoned" back into the tanker and used on a working and important spacecraft).

* Upper stages and satellites can be checked out to make sure they are in working order on orbit before being fueled. Immediate systems failure, which is a common failure mode, need no longer result in the waste of expensive propellant.

This short list is probably the tip of the iceberg. Real options are about the unpredictable, and it's hard to make a list of the unpredictable ahead of time. On-orbit refueling and orbital propellant depots are not just a technology, they are part of a new paradigm. They are part of thinking of space activities in terms of real options instead of fixed plans. This paradigm recognizes uncertainties in space missions and businesses that traditonal fixed space planning has neglected. Making good use of propellant depots requires not only technology, but the recognition of these uncertainties, and as a result a recognition of the options that businessmen, militaries, and scientists would like to retain. Those options can then be brought to reality with refuelable satellites and orbital depots, quite possibly in association with other technologies that enhance mission flexibility in other ways. It's not propellant depots and refueling capabilities by themselves that will be beneficial, it will be their use to enable a wide variety of new and valuable real options for spacecraft operators and users. It will be a crucial and lucrative entrepreneurial task to identify these real options and enable them with refuelable satellites, depots, and probably a wide variety of other techniques and services.

Going back to our humble earthbound example, real options explain why most commuters prefer cars (with gas stations available in a wide variety of locations) to mass transist. Mass transist resembles far more the fixed plan -- travel from home to work and back every day, and that's it. Under the fixed-plan assumption, mass transit is far less expensive and far more energy-efficient than automobiles. Cars, and the gas stations that refuel them, provide real options -- to pick up kids from baseball today, to go to a class after work tommorrow, to go shopping at one of a wide variety of stores, to visit your doctor or the emergency room when you get sick, to pick up your friend from the airport after work the next day, and so on. Mass transit and traditional space mission planning both represent the mentality of artificial certainty, the idea that we can simply plot out the future and it will come to fruition just so. At least space mission planners have the excuse of orbital mechanics, which is highly predictable. Human beings are not, nor are the vast variety of our needs and desires known to planners. Economic comparisons between mass transit and automobiles that don't account for the vast number and variety of options made real by the the latter will grossly underestimate the value of automobiles.


Real options analysis also allows planning for discontinous risk, rather than the artificial assumption that risk is a continuous function that can be modeled simply by adding a risk premium to a risk-free interest rate. More on that, and the implications for space mission evaluation, here.

Here is an introduction to mathematical analysis of real options, and here is a discussion of orbital depots for propellants that turn into vapors at normal temperatures, and are thus hard to store.

Wednesday, April 09, 2008

Bit gold markets

The basic idea of bit gold is for "bit gold miners" to set their computers to solving computationally intensive mathematical puzzles, then to publish the solutions to these puzzles in secure public registries, giving them unique title to these provably scarce and securely timestamped bits. These titles to timestamped bits will be more secure and provably scarce than precious metals, collectibles, and any other objects that have ever been used as money. In a description of bit gold, which was mostly an overview of the technology, I wrote about how, because the algorithms and architectures for solving computationally intensive mathematical puzzles to create bit gold will often be dramatically improved, the bits (the puzzle solutions) from one period (anywhere from seconds to weeks, let's say a week) to the next are not fungible. But fungible units can be created from non-fungible ones:
bit gold will not be fungible based on a simple function of, for example, the length of the string. Instead, to create fungible units dealers will have to combine different-valued pieces of bit gold into larger units of approximately equal value. This is analogous to what many commodity dealers do today [pooling commodities with a wide variety of qualities into a handful of standard grades] to make commodity markets possible.
Bit strings (puzzle problem/solution pairs) are securely timestamped by their time of publication. More recent solutions that have been produced in greater quantities will be discounted by markets. To create fungible units dealers will bundle strings of different value into pools of a standard value (i.e. collect strings into a pool so that the sum of the market values of the strings in the pool add up to the standard value).

It's a bit indirect, but computers can easily handle these logistics. Leaving aside the gold metaphor for a minute, one can think of these bit strings as digital rare postage stamps. Each stamp might trade for a different price, but one can sort stamps into pools so that the prices of stamps in each pool add up to the same total price. Then divide each pool into tranches to create your standard currency denominations.

The rare stamp metaphor is, however, in other ways very misleading. Unlike stamps, but like gold, there are no ongoing changes in subjective valuations between bit strings to worry about, but instead the demand for bit gold is purely for its monetary functions, and thus purely based on how scarce the supply of puzzles solved during a given time period was and is. As a result, pooling and tranching will work far better for bit gold than it does for actual rare postage stamps.

This deserves more elaboration. It seems to be a common objection to bit gold that the mere difference in the price of a bit from one time period to the next produced by technology improvements introduce intractible subjective valuations, making the matter of comparing one week to the next subject to too much uncertainty and transaction costs, as occurs with many collectibles. Just as pooling and tranching rare postage stamps would be a somewhat risky affair as subjective valuations of the underlying stamps change, so too this is supposed for bit gold.

The problem that would occur if we tried to turn most collectibles into a standard currency by pooling and tranching is that, besides a subjective aesthetic component in the demand curve that doesn't come into play with computer bits, their scarcity is uncertain. Art can turn out to be forged, rare stamps thought to be lost or to have never existed might be found, and so on. The supply curve, in other words, can be highly uncertain and in danger of elasticity. Since the supply and demand curves of different pools can change differently over time, the relative values of pools would diverge from their initial values, so that trying to use tranches as standard denominations of a currency would create arbitrage opportunities.

By sharp contrast bit gold will be entirely public: no one gains secure title to any puzzle solutions until they are published. Thus, the exact amount and kind of puzzle solutions during a given period are well known, and perfectly define the supply curve relative to future weeks for all time thereafter.

There will be, in other words, a perfectly objective, measurable, and inelastic supply curve, completely derivable from the relative scarcity of bits (puzzle solutions) on the week (or the day, or the hour, or the minute, if necessary) of their publication. Arbitrage to set the different prices of different weeks (or minutes) can be computerized on this basis. The demand curve, the demand for puzzle solutions for the monetary functions they can perform as a store of value and medium of exchange, will be based on recognition of the superiority of bit gold as a form of money that is more secure and has a far less elastic supply curve than traditional commodities such as precious metals. Since there are no aesthetic differences, the demand curve will be the same function of scarcity for all weeks (or minutes), so it won't affect the simple scheme of automated arbitrage between epochs with different supply curves. The supply and demand curves of different pools will change in the same way over time, and the relative values of pools will not diverge from their initial relative values. Using tranches as standard denominations for a currency does not create arbitrage opportunities.

For most of history collectibles were used for as stores of value and media of exchange; aesthetics played an important role. But before we can separate out the roles of scarcity and aesthetics, we must ask why humans evolved such aesthetic values. The aesthetic instincts, for example the instinct to collect shiny things, evolved just because in the evolutionary environment they approximated an instinct to collect scarce things, and to distinguish hard-to-find from easy-to-find things, i.e. an instinct to recognize and collect objects that can best perform monetary functions, as I describe here, in the "Evolution..." section early in the paper, and the "Attributes of Collectibles" section late in the paper.

As a proximate matter, the contribution to the demand curve from demand for monetary functions (store of value or medium of exchange or both) and the contribution from aesthetic considerations are completely separable. One can demand a commodity for its aesthetic value, or for its value as money, or for both, or for neither. Thus a check for a million dollars might have a design that is utterly philistine, yet the check is still worth a million dollars.

The value of gold today is almost entirely based on its monetary value rather than mere aesthetic value. There are plenty of metals that are as shiny and smooth as gold, but people don't demand them as a store of value or medium of exchange because they are common. There are plenty of rocks that look as good as diamonds, but "diamonds are a girl's best friend" because they are hard to obtain and thus hold their value. Value comes to attach to the unique aesthetic features of gold or diamonds because these features signal scarcity. The value of precious metals or gems as stores of value, media of exchange, or even as cultural icons does not come from these aesthetic features, it is only signalled by them. It is their secure scarcity, not their aesthetic features, that allows them to be more securely used as a store of value and thus gives them a monetary value, and often a corresponding emotional and cultural value, far above the often trivial value they would have if they had the same aesthetics but were common.

There will be a problem defining futures contracts for yet-to-be produced bit gold: how much it might cost to solve a given puzzle a year later, or even a month, will be a very uncertain matter. But the pools that define currencies will be based on spot prices for already produced bit gold, not on futures.

[These comments edit and add to comments of mine under previous blog post(s)]

Wednesday, April 02, 2008

Commodity derivatives: the new currencies

Unable to otherwise explain today's high commodity prices, Frank Veneroso and others fear we are in a commodity bubble. Exhibit A is the recent vast increase in the use of commodity derivatives[*]:

Here's how Veneroso observes the unprecedented state of our commodity markets:
Though the six-fold increase in such positions over a few brief years is dramatic , it is the magnitude of these positions that is most alarming...It is hard to know what to make of this data. But it is noteworthy that several years ago, at the then prevailing lower commodity prices, the entire above ground stock of all commodity inventories was only in the hundreds of billions of dollars. Even if only a fraction of the increase in global commodity derivative aggregates in recent years corresponds to a net long position of investors or speculators, implying speculative and investment positions of a “few trillions of dollars,” it would appear that this increased demand for commodity derivative positions has overwhelmed what have been relatively small markets...

No wonder, then, that this cycle’s bull market in commodity prices has gone higher in inflation-adjusted terms [i.e. in terms of the CPI and PPI -- a poor near-term measure of inflation, see below] and for longer than in all prior uninterrupted half-decade cycles in the past.
I agree with Veneroso that the recent commodities boom has a strong causal link to the recent rise in the amount and variety of commodity derivatives. But I couldn't disagree with him more about the role of inflation. Prices, and especially wages, react very slowly to changes in money supply, so that the CPI and PPI are trailing indicators. The leading indicators are increases in money supply in excess to increased demand for money and the associated (if disproportionate) increases in commodity prices.

M3, an estimate of the supply of dollars (including a reconstructed estimate for recent years). M3 is increasing at the highest rate since the 1970s, as are to a lesser extent the supplies of euros and other major currencies, resulting in a commodity boom not seen since the 1970s. Source:

The recent vast increase in commodity derivatives, and the resulting commodity boom, is a largely rational response to the vast increase in the supply, relative to demand, for the dollar and to a lesser extent the euro and most other major currencies during most of the last decade. This despite the fact that commodities prices have in the last year risen (at about 40%/year) much faster than the growth of money supply (about 15%/yr). To see why, observe that one of the most useful but least talked about uses of derivatives is their ability to simulate the economic behavior (primarily risk and return) of one kind of asset based on contracts for another kind of asset or performed in another legal environment. The classic example is Eurodollars. But let's take a general scenario:

Alice wants to promise Bob to transfer asset X. But the risks associated with Bob holding asset X on his balance sheet, or Alice holding liability X on her balance sheet, until actual transfer of the asset, are too high, or the transaction costs of actually transfering X from Alice to Bob are too high, or both.

(1) Solution for risks of holding asset X on books: derivatives. Alice has both assets and liabilities on her books. These have individual and net risks just like an investment portfolio. If Alice has the same amount of assets and liabilities all denominated in the same currency, her portfolio is balanced. But if, for example, she imports from Europe (thus creating liabilities in euros) and sells in the U.S. (creating assets in dollars), her portfolio becomes strongly subject to risk of dollar devaluation against the euro. If a new asset or liability creates such unbalanced risk, it can be hedged with derivatives.

(2) Solution for transaction cost of transferring asset X from Alice to Bob: use derivatives to create a synthetic asset. Construct from derivatives and asset Y a synthetic asset that economically behaves like asset X. These separate derivatives and asset Y that form the synthetic all can be transfered with low transaction costs, thus forming an asset economically equivalent to asset X but that, unlike X, can be transferred from Alice to Bob at low cost.

The reason these uses of derivatives are seldom talked about is that the main cause of problem (1) is the instability of government currencies that it is legally necessary (for a variety of reasons) for contracts to be denominated in. The cause of problem (2) is usually a legal barrier to a particular transaction -- a tax, exchange control, risk caused by regulation, or risk of confiscation in Bob's jurisdiction are four examples. People who route around the law tend to do so quietly, explaining their acts by euphemism, even if as here the new route is perfectly legal and is made necessary by deep flaws in the law or the way the law is executed.

There are often, in other words, huge discrepencies between the contract terms required or incentivized by law and the most economically efficient contract terms. Partly this is due to political stupidity, and partly to the inevitable profound imperfection of any body of rules.

(3) A third function of derivatives is simply as a store of value: a way to diversify or hedge inflation risk in an investment portfolio that otherwise contains either (a) debt denominated in a potentially inflating currency, (b) equity in companies with assets consisting mainly of debts denominated in a potentially inflating currency, or (c) both.

In performing functions (1) and (2), derivatives usually substitute for or augment currencies as a medium of exchange. For (3) they substitute for or augment the monetary function of a store of value. Most derivatives, in other words, perform largely monetary functions. They augment or substitute for a flawed method of payment or a flawed store of value.

Gold prices in dollars (and, not pictured here, the dollar prices of many other commonly traded commodities) roughly follow changes in the global monetary base of dollars. Source:

In a climate where one or more commonly used currencies are inflating (and by "inflation" I simply mean rise in money supply without concurrent rise in demand for that currency, not the CPI or any particular and usually trailing measure of inflation), derivatives, if they can be analyzed and traded at low cost, are very much in demand. Furthermore, if all of the currencies practically available for contractual payment terms are inflating, these derivatives will come to be increasingly based, not on currency-denominated debt, but on commodities, especially commodities for which supply and demand are relatively inelastic in the short and medium terms.

Why is it rational, rather than reflecting a bubble, for the recent rise in commodity prices to outpace the recent rise in money supply? The rise in commodity prices reflects the increase not just in supply of dollars per unit of commodity, but greatly increased demand for a commodity as money, i.e. for the monetary functions it serves either directly or indirectly via derivatives, on top of the relatively steady demand for consumption. As I have argued elsewhere, this increase is broad-based: all commodities that can be traded with low transaction costs on modern markets, and that exhibit short- and medium-term inelasticity of supply and consumption demand, are useful for and are being used as reserves for the new derivative currencies. Where computerized analysis lowers mental transaction costs, as with modern derivatives, it pays to diversify one's books, portfolios, and hedges among multiple currencies.

Of course, the traditional use of commodities futures and derivatives by commodity producers and consumers to hedge the assets and liabilities of the commodity sales and purchases inherent in their business continues. But these don't account for the vast majority of commodity derivatives use in recent years.

Before modern computers, networks, and software engineering, the cost of such derivatives was usually prohibitive. In the last period of monetary inflation and the resulting commodity boom, the 1970s, derivatives were available to few and only the very simplest hedges or synthetic assets could be understood, and even then very imperfectly. Today derivatives, and their use in very complex hedges and synthetic assets, are much better understood by most of their users, thanks to computerized game tree analysis, and are available to many. They can be designed, simulated, and traded electronically with very low transaction costs. Computerized derivatives are smart contracts that lower mental transaction costs. So much so, that they've created a vast new world of contractual relationships completely impossible with the brain alone.

Speaking perhaps a bit metaphorically, we are witnessing the rise of new and privately issued fractional reserve currencies. They need not and effectively cannot legally be called "money" by their "issuers", nor can they effectively be used directly in most contracts for payments. But they can be used indirectly to hedge payment terms or investments denominated in flawed, that is in inflating or otherwise unstable, government currencies in which normal contracts and instruments are generally denominated. The results are synthetic "currencies" that, in their economic behavior, may be almost indistinguishable from a tradtional commodity-backed and privately issued fractional reserve currency.

No wonder the Federal Reserve and other central banks are moving hard to usurp jurisdiction over derivatives (per, for example, the recently announced Paulsen plan here in the U.S. to consolidate a variety of financial regulation under the Federal Reserve). To effectively regulate derivatives, for better or worse, the Fed will have to understand them first. But they do not have this knowledge. Indeed no human brain holds this knowledge. The knowledge needed to understand the dizzying variety of derivatives exists mainly in the form of computer simulations.

Derivatives, the money of the digital era, perform monetary functions in competition with the Federal Reserve's dollars, an increasingly primitive holdover of the paper era. By regulating derivatives the Federal Reserve regulates its competition. This creates a profound conflict of interest. It's like putting Rust Belt executives in charge of Silicon Valley. Such regulation may cause, not the popping of a commodity bubble, but the destruction of a nascent economic order made necessary by the prediliction of the Federal Reserve and other central banks to inflate their fiat currencies. Whether ignorance or conflict of interest will play the greater role in the destruction of the new currencies, or whether one will cancel the other out leaving the derivatives markets in relative freedom, remains to be seen.

[Obligatory Wikipedia links: Eurodollars, elasticity]

[H/T: I learned of Venero's paper from Byrne Hobart]

[Here's a prior explanation of mine giving a broader overview of why commodity prices reflect demand for their monetary functions as well as for their consumption, but not explaining the role of derivatives].

[*] These numbers are a bit stale -- it would be great to see to what extent this growth has continued. If any reader has data on commodity derivative use through 2007, please let me know.

[UPDATE: here is more straightforward article that gets the basic facts right: production up, inventories up, consumption down, prices up -- inexplicable if consumption is the only major source of demand -- but gets the explanation wrong, replacing the rational and efficient use of commodity derivatives as money that I have described here with the typical speculations about "speculation" resulting in a "bubble"].

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Friday, March 28, 2008


Laches is the common-law name for the concept more commonly known as "the statute of limitations."[*] The idea is that, if a wrong has been done, or there is otherwise a dispute, we put a limit on the time within which the victim or the victim's estate can file charges or sue for damages. Laches or statutes of limitations apply to practically all kinds of wrongs of any nature. There are three strong reasons for setting time limits on redressing wrongs:

(1) Memories fade, witnesses die, and evidence is degraded or destroyed, rendering the rights and wrongs of the case increasingly uncertain and susceptible to biased propaganda.

(2) Security, confidence in, and stability of legal rights are crucial to a civilized legal system. But if we go back far enough, the "chain of title" for almost every legal right we have (including our political as well as economic rights) can be plausibly argued to be illegitimate due to some kind of unredressed wrong: some commission of force or fraud that was never remedied. Without a time limit, hardly any legal right of almost any kind could be held with legal security.

(3) Having the estate of one person be responsible to the estate of another person for a wrong committed by the ancestor of one to the ancestor of the other gets us too far away from the individual responsibility and the shaping of behavior through incentives that is at the core of law.

Laches should also be a core political principle. Allowing some classes of citizens to extract "reparations" from other classes of citizens for harms done by some or many of the ancestors of members of one class to some or many of the ancestors of another class, without setting any time limits, renders the legal rights of all persons insecure. Evaluations of ancient wrongs are susceptible to very distorted propaganda. Punishments of individuals who did not commit the wrongs do not deter the recurrence of such wrongs in the future, and indeed are themselves wrongs that foster further resentment and breed more future claims for redress. The moral imperative holding the members of one very imperfectly defined class, rather than persons who actually committed the wrongs, for the wrongs committed to some of the members or ancestors of another class, already doubtful, becomes increasingly doubtful as time goes by, as does the power of such laws or other political acts to shape behavior to desirable ends through incentives.

[*] Technically, the term "statute of limitations" applies where a statute expressly sets a time limit, and the doctrine of laches applies where no such statute exists.

Wednesday, March 26, 2008

How our frog was boiled

Libertarians have long observed with regret the radical expansion of the power of the United States federal government over its original scope under the Constitution of 1789. Lovers of freedom tend to blame two chief culprits for this expansion: President Abraham Lincoln, who instigated our Civil War, and President Franklin Delano Roosevelt with his New Deal. And indeed, these Presidents did instigate some noxious precedents: Abraham Lincoln the draft and income tax, FDR the advocacy of positive substantive rights and the birth of practically unlimited regulatory power of federal government. Some cite villains from the Progressive Era, such as Theodore Roosevelt and Woodrow Wilson.

However, these theories oversimplify U.S. history to the point where the real and fixable sources of our loss of freedom cannot be identified. They make it sound like if we could simply go back in history and remove a handful of powerful villains, or avoid a handful of crises, then we would be living in a much freer society today. That is very far from the reality.

The consequences of even Lincoln and FDR were not unmixed. Lincoln damaged some freedoms, but he also greatly increased freedom by ending slavery. The Civil War Amendments, especially the 14th Amendment, eventually led to a great increase in the enforcement of unenumerated rights (hence the name of this blog!) and the Bill of Rights against the states (and, for reasons I relate here, hence also against the federal government). Among the leading countries in the middle of the evil 20th century, the United States despite FDR was the most free. FDR destroyed the threat of fascism and appointed most of the Justices who ended forced and unequal segregation by race. One can easily argue, especially in the case of FDR, that the curses outweighed the blessings, but one cannot seriously portray even these powerful Presidents as unmixed enemies of freedom. It's great fun, and may be morally imperative, to blaspheme these great gods in the pantheon of government worship, but criticisms of these particular actors don't get us to the core of why, in the face of a Constitution that outline a strictly enumerated set of powers, the adherents of that religion were able burst far beyond those bounds and render them nugatory.

The expansion of power of the U.S. federal government was not primarily due to villians, crises, or revolutions, but far more resembled the proverbial boiling frog: it mostly happened by small and obscure steps that were not widely noted by lovers of freedom at the time, and have seldom been noted by us since. The slow rot of Constitutional protections against federal power stemmed from subtle but endemic flaws in the original frame of our federal government, the rise of an economy where large numbers of people earned income from auditable corporations (making the income tax, the most lucrative tax in history, practical), and the disappearance of frontiers of free land to which the overtaxed or overregulated could flee. This article focuses primarily on the first, the clearest and most fixable cause, the procedural flaws in our Constitution.

The U.S. Constitution lists a number of enumerated powers, beyond which Congress was granted no power to legislate. In other words, the U.S. Congress was supposed to have a small, close-ended list of powers, and this is still recognized by the Supreme Court as theoretically true today. If this had remained true in practice, as well as legal theory, the U.S. federal government would be a radically libertarian entity today. That it is no longer practically true, is, more than any other factor, due to the long series of usurpations of power by Congress under the Commerce Clause, which in its words gives the Congress the power to regulate “commerce among the States.” At the time, this power was thought to be limited to power to regulate the transport of goods and persons across State boundaries, and indeed in the first century of the Constitution it was largely in practical fact so limited. (There are a number of other causes, such as the 16th Amendment of 1913 legalizing the income tax, but the Commerce Clause is the way in which Congress has most expanded its power to regulated, and an extremely vast expansion it has been).

It’s fairly obvious why Congress, by itself, has not and would not seriously let any kind of Constitutional text limit its own power. Less obvious is why the Supreme Court, which has the final word on interpreting Congressional power to legislate under the Constitution, would allow Congress to so greatly expand its powers. But that is just what it did, by many slow and incremental steps.

Under Chief Justice Marshall, there were a number of cases restricting the power of States to regulate what Marshall argued was interstate commerce, and thus under federal jurisdiction. In immediate effect these were libertarian decisions, since they overturned often burdensome State laws. The Marshall Court, and the Story Court that followed it, refused to find, even once, any limits on the federal Commerce Clause power. Although it was generally agreed that “commerce among the States” was limited to the transport of goods and persons across state lines, Marshall refused to define it in this manner, or indeed define any clear outer limited to the Commerce power. Indeed, in dicta (sentences in a legal opinion that are not legally binding, because they are not logically necessary for reaching the verdict), Marshall suggested that any activity that “effects” such transport might be regulated. Although Marshall’s nationalist ideology set the tone, overturning state laws and ignoring federal laws, this pattern of limiting state usurpations but ignoring federal usurpations was largely continued by future courts, for reasons of bias or conflicts of interest caused by court selection and structure which I describe here.

Although there were a handful of cases limiting the Commerce Clause in very narrow and specific ways at the end of the 19th century, the Swift v. U.S. case in 1905 greatly expanded the Clause’s scope to cover manufacturing, not just the transport of goods or persons across State borders, on the theory that the manufactured goods would end up in interstate commerce. This was part of the so-called “Progressive” movement, the rise of the modern religion of "the government", an omnipotent deity called upon by the national press to solve any major problem deemed to be national in scope. This era saw the greatest expansions of federal power in U.S. history, including its basic tools of financial power, the Federal Reserve system and the 16th Amendment in 1913 legalizing the income tax. During this era, in which states also greatly expanded their powers, the Supreme Court was again far more active at limiting the states than limiting federal power. The “Progressive Era” was a very broad and general ideological movement, and most of it cannot be pinned on any particular politician. Drivers of the movement included the steam press and news wire agencies, which promulgated a national view (that vague godlike phrase, “the government”, came to refer to the federal rather than state government during this era). Under this new media system information transfer became dominated by the press releases of powerful governments and corporations. The spread of government-mandated education, again inculcating a very nationalist view, in the latter half of the 19th century also played a large role. The end of free arable land on the Western frontier and the rise of the auditable corporation also played crucial roles in facilitating much greater levels of taxation. During this era, except for a handful of minor victories, the federal courts did not prevent Congress and the President under the impetus of this movement from usurping vast powers not granted them under the original meaning of the Constitution.

After this, the New Deal simply delivered the coup de grace. In Wickard v. Fillburn, the Court proved it had no desire to limit the federal government in any serious way, using Marshall’s “effects” dicta to justify its holding that growing wheat on your own small farm for your own consumption is “commerce among the States." Quite recently, the Supreme Court reconfirmed this absurdity: growing marijuana in your house is also “commerce among the States.” And thus the frog has been boiled. To this day our amphibian does not realize that it has already been cooked. The idea that the U.S. Supreme Court, given this long history of precedents, and the same kinds of selectional and operational biases it has always operated under, will ever seriously limit federal power again, just because that is what the Constitution says it must do, is far-fetched. Our courts as currently structured will only protect certain narrow rights of persons under the Bill of Rights from otherwise omnipotent governments. The idea that “We the People” will somehow elect a Congress or President that will voluntarily waive their own powers is even more absurd. Libertarians are playing a game with a very stacked deck, and that deck is stacked by the Constitution itself, the very same Constitution that in its original meaning was, substantively, radically libertarian, but that included procedural incentives for Congress and the Courts to slowly aggrandize federal powers.

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