tag:blogger.com,1999:blog-15371928105368542612024-03-05T13:13:22.585-05:00Dean's doughHalf-baked thoughts on money, finance, and economics.dWjhttp://www.blogger.com/profile/12072494989829344049noreply@blogger.comBlogger175125tag:blogger.com,1999:blog-1537192810536854261.post-62643268828106797052023-03-25T19:16:00.003-04:002023-03-25T19:16:56.246-04:00Swiss coco<p>
Financial and economic wealth are largely a function of expectations. A factory is valuable because I expect that it will help produce something that people want; a house is valuable because I expect that it will be a place people want to live. If people suddenly stop wanting to buy what the factory produces — or if they stop wanting to live in that house — then the factory or house loses its value, even if it is physically unchanged.
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The size of a bank's liabilities to depositors is pretty clear in dollar terms, at least in principle; the bank owes a precise amount of dollars to depositors, and it owes it to them now.
In a practical sense the liability is somewhat lower; the depositors won't all ask for their money right away, even if the bank charges fees. If the bank pays a low enough interest rate and charges fees, then, even with the costs of maintaining the bank accounts, the deposits provide the bank with a cheap source of funding that, in a true economic sense, reduces the size of the liability.
Even in that sense, though, the true economic size of the deposits owed to customers is probably not a lot lower than the nominal size.
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The asset side of the bank is murkier. If the bank has made a ten-year loan, the value of being entitled to that money depends on how things go over the next ten years; it depends on the ability of the bank to fund itself more cheaply than the interest rate on the loan,<a href="#230325-1" name="r230325-1">[1]</a> and it depends on the ability (and sometimes willingness) of the borrower to actually pay it. The bank may even have investments in companies or real estate, and their value depends on the ability of those assets to provide things people want in the future. There are accounting rules about how we're supposed to guess at the value of these things, but these are merely conventional guesses.
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These accounting guesses have some real force insofar as banking regulators impose solvency requirements on banks; the regulators want the bank's assets to be worth more than the liabilities, and use accounting guesses for at least some of those requirements.<a href="#230325-2" name="r230325-2">[2]</a> The regulator's primary purpose is to protect the payment system, and particularly to protect the depositors' ability to get and use their deposits. The solvency requirements serve this in two ways: in the short run, if a bank is low on actual cash but has a lot of assets, it can sell assets or put assets up as collateral to borrow money to give to depositors. To the extent that this is our primary concern, the value of the assets should be reckoned based on the amount of money that could be acquired somewhat quickly by selling or borrowing against them. The primary purpose of the solvency requirement, however, is long-run: if the cash flows from the assets are anticipated to be reliably lower than the cash flows being paid on the liabilities, then eventually the bank will run out of cash, even if the depositors don't do anything weird. A regulation that is only worried about this concern is only worried about cash flows, not how much the asset could be sold for today.
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There is an important sense in which, if the market value of your assets is lower than your liabilities, the market is saying that its best guess is that your cash flows in will not ultimately keep up with your cash flows out, but there is a fair amount of wiggle-room here. Market prices of assets bounce around a bit, and if the assets of a bank have gone down in the past three months, the bankers could well say, well, perhaps they will go back up in the next three months. Within certain constraints, the ability of the bank to hold onto cheap deposits does become important; even if the markets imply that funding costs over the life of the asset will eat up cash flows, if the bank can effectively borrow from depositors more cheaply, it may be able to survive. There are accounting rules that codify in certain ways how banks can get away with this; in particular, they can declare that they don't intend to sell certain assets, and if the market price changes they can ignore that change.<a href="#230325-3" name="r230325-3">[3]</a> To some degree this feels like wishful thinking to me, but there's an element of wishful thinking in a well-capitalized bank as well; in one case you're hoping that the market is right, and that the cash flows in will be larger than the cash flows out, while in the other case you're hoping that the market is wrong. Even if we made banks use the market value for all of their assets,<a href="#230325-4" name="r230325-4">[4]</a> the difference between a bank that is solvent and one that is insolvent is not a crisp one; there is a continuum, which is just one reason that the requirement is not just that assets exceed liabilities, but that they do so by some margin.
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One new way to evade insolvency was introduced after the 2007–2009 financial crisis: the contingent convertible bond. "Bond" here is something of a misnomer, but they look like bonds in that they typically pay out a fixed interest rate and can be called in after a period of time, much like paying off a bond. Their key feature, though, is that they don't pay out if the bank's assets don't exceed the bank's liabilities by more than a certain specified margin. These "cocos" are designed to be liabilities as long as the bank can afford them, but to go away if liabilities are too large as a fraction of assets; if assets lose value, the cocos take the hit, and the depositors and other claimants on the bank are protected.
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Different cocos work in different ways, perhaps in part with different purposes in mind. Most notably, some of them convert into stock or something similar when the asset-to-liability ratio gets too low. (These are the ones that are best called "contingent convertible bonds", though the term "coco" includes other securities that work rather differently.) Some of them convert into ... nothing. They go away. In each of these cases, though, they cease being liabilities, and thereby help restore the asset-to-liability ratio. If their purpose is to deal with <em>long</em>-term sustainability, rather than <em>short</em>-term sustainability (which is the purpose of <em>liquidity</em> regulations rather than <em>capital</em> regulations), then what matters about these things is their cash flow. A lot of them <em>don't</em> convert; they stop paying interest while the bank is in violation of its asset-to-liability requirements, but continue to sit around waiting to pay out again if the bank's situation improves. If the problem is a temporary market dip, or the bank has enough going-concern value that it can ultimately make it, these bonds don't get wiped out; they will lose some value when things look dicey, but it does relatively little harm to let them sit there dormant if the bank gets into trouble, only coming back if the bank's problems turn out to be temporary. It makes a lot of sense to me that they would largely work this way. Even from a short-term standpoint, a bond that works this way is a relatively small encumberance to selling or borrowing against assets, as the liability in practice remains small as long as there's much question of the bank's being able to repay secured loans.
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The big exception, though — the point at which it seems like you have to make the coco's impairment final — is when the bank is being sold, especially if it's being sold as a matter of distress. In theory it might make a kind of sense to have the cocos paid off based on a sort of option value, but I can see why, as a practical matter, you might prefer that they be redeemed at par or zero. There's no longer an actual bank here (whose assets and liabilities could be assessed), so the best you could imagine is that it somehow continues to hedge the value of the assets the bank had when it was sold. Prospective buyers may well be averse to carrying around this strange option, and if the assets of the old bank are being folded into those of the purchasing bank, determining whether they recovered or not becomes onerous. Situations like this are usually messy and difficult as things are, and the value of being able to write this liability to zero in these situations seems compelling.
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A week ago, the largest bank in Switzerland (UBS) acquired the second-largest bank in Switzerland (Credit Suisse). Both banks did the deal under duress from their primary regulator; Credit Suisse was on the brink of failure, but wanted to keep trying to recover, while UBS saw the balance sheet of Credit Suisse as unsafe at any price. Credit Suisse had some cocos that explicitly provided that they could be converted into nothing in a situation like this, and a lot of the holders of the cocos were disappointed to learn this. Cocos issued by banks in the European Union tend not to have such a provision. The Swiss cocos, indeed, had the provision that they would convert into nothing if the asset-to-liability ratio, as determined by accountants, were breached, even if the bank continued as a going concern. In actual fact, it is clear that UBS (and other potential suitors) thought that Credit Suisse's assets were worth a lot less than their accounting value; perhaps they should have been written down shortly before the takeover, anyway. After the fact, the fact that it was in the provisions of the bond (and was well within the spirit of how the bonds were intended to behave) means, of course, that they could do this; my assertion in this post is that such bonds <em>should</em> be written to be zero-able in this sort of situation, but that, outside of such forced-sale situations, the way the rest of Europe does things — with payments suspended, but the bond still sitting there, dormant, to potentially claim upside surprises if the bank recovers — makes more sense to me.
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<a name="230325-1" href="#r230325-1">[1]</a> This is especially important if the loan is a fixed-rate loan, i.e. the amount of dollars that are to be paid along the way is set when the loan is made. A lot of business loans have interest rates that adjust with time, which reduces this problem.<br/>
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<a name="230325-2" href="#r230325-2">[2]</a> There are in fact a number of requirements, and especially large banks these days are in trouble with the regulator if traditional accounting measures of assets aren't enough above liabilities, but also if <em>other</em> measures of assets aren't enough above other measures of liabilities.<br/>
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<a name="230325-3" href="#r230325-3">[3]</a> Again, this doesn't apply to all of the requirements that the largest banks face.<br/>
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<a name="230325-4" href="#r230325-4">[4]</a> And, to be clear, banks often have some assets that don't really have clear market values; if nothing else, traditional banks have office furniture, and any guess as to how much it could be sold or pawned for in an emergency is going to be pretty imprecise.
dWjhttp://www.blogger.com/profile/12072494989829344049noreply@blogger.com0tag:blogger.com,1999:blog-1537192810536854261.post-10829451458342243852022-08-26T11:10:00.001-04:002022-08-26T11:10:08.386-04:00Tiebout sorting and local governance<p>I'm a fan of Tiebout sorting and institutional diversity in general; I would like for people moving to an area to have a practical choice of what kind of town and neighborhood they live in, and (for example) for people who want high taxes and high services to be able to live in a town that provides that while people who want low taxes and fewer municipal services to be able to choose that, instead of having towns in an area that have more between-town homogeneity and contentious fights in each town, with few people getting what they actually want. Furthermore, citizens who want to pay high taxes to invest in long-run improvements (better roads, better schools, etc.) should be able to secure those investments from people who might move in and vote for lower taxes, milking the assets (in which the previous residents invested) as they depreciate. To the extent that it's practical, people should get the local governance they want by choosing the town, rather than by changing it. </p><p>There are extents, of course, to which it's not practical, or otherwise not desirable. You don't want towns generally to feel they don't have to serve anyone who finds it comparatively easy to move, and a town that is poorly run needs to be ultimately accountable to voters. If the preferences of citizens of a metropolitan area shift, even if you want to continue to have a variety of options, the mix of options will need to change. While it may make sense for the people with less of a practical exit option to carry more weight in shaping how the town changes, you don't want institutional arrangements that lead to no towns in an area serving a large group of people in that area just because those people can move. While I raise this as a warning against too little direct and immediate democratic accountability, it's also a danger of too much direct and immediate democratic accountability; <a href="https://www.nber.org/papers/w8942">Mayor Curley of Boston seems to have intentionally driven voters who didn't vote for him</a> out of the city and into the suburbs to cement his hold on power. The institutional arrangement should ensure that citizens who are willing and able to move between towns are well-served, while also making it hard enough for them to change the towns that they give serious consideration to voting with their feet and don't remove options for everyone.<br /></p><p>In light of these considerations, I'm envisioning a conglomerate metropolitan area, perhaps like London, which has 32 "boroughs" with some variety of institutional arrangements and a fair amount of devolved power, but some centralized power as well. One thought that I have is that the boroughs would have councils with some seats elected by the locals with the least practical exit options (however determined) but additional seats appointed by the central body, which would be elected by voters without regard to exit options. If the population of a borough drops, perhaps the make-up of the local council would be less locally determined; perhaps there would also be some funding tied to population. The hope is that the boroughs would be fairly distinct from each other, and people moving to the area for the first time or relatively able to move from one borough to another would have a variety of attractive options, while making it difficult for them to choose a different borough and try to make it more like those that already exist.</p>dWjhttp://www.blogger.com/profile/12072494989829344049noreply@blogger.com0tag:blogger.com,1999:blog-1537192810536854261.post-70921420575698030542022-04-03T20:14:00.000-04:002022-04-03T20:14:02.372-04:00price controls and rationing<p> There's been inflation, and there have been calls for price controls, and so I've been reading a bit about price controls in history. Pretty much every time price controls with substantial bite<a href="#220403-1" name="r220403-1">[1]</a> are implemented, you get shortages and black markets; additionally, I had failed to consider how expensive enforcement costs frequently are. Usually the government gives up on price controls fairly quickly as it becomes clear that the problems created are worse than any mitigation; exceptions seem to be in cases where there is some other form of rationing taking place, typically in war time.</p><p>There may be a semantic argument whether rationing avoids shortages or repackages them, and they certainly don't avoid the black markets or enforcement costs, but they do create a little bit more reliability; sometimes consumers are unable to buy as much as the rationing system entitles them to, but it will be less common that they will be unable to buy anything than it will if there is not rationing and similar price controls are enforced. This made me wonder whether, if price controls did gain political popularity now, we could mitigate some of their effects by implementing a rationing program as well. After a bit more thought, though, it occured to me that this is a bit redundant; if you impose and enforce a rationing program, that should bring down market demand and reduce prices. If the rationing is tight enough to bring prices to where you would "control" them, the control becomes superfluous; if it is not, then it isn't enough to restore the sort of reliability being sought with the controls in place, either.</p><p>As a political matter, perhaps the price controls would not be superfluous; the price controls may be the popular part, at least to the extent that people don't realize that it will amount to stochastic rationing. The implementation cost, even if greater than many people appreciate, may also be less than that of a rationing system, and it would certainly tend not to fall directly on individual consumers to the same degree; carrying around ration coupons would be less convenient than heading to the store and seeing what they have in stock. It would, however, keep prices "controlled" while substantially mitigating the biggest problem simple dictated price controls present — and you wouldn't even need the price controls themselves to do it.</p>
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<a name="220403-1" href="#r220403-1">[1]</a> If the price is set at $5, and the market price would be $5.10, effects will naturally be minimal; if the price is set at $5 and the market price would be $20, but only for a couple of weeks, some of the effects won't have time to develop. I'm mostly considering settings where the price is kept well away from the free price for a substantial period of time.
dWjhttp://www.blogger.com/profile/12072494989829344049noreply@blogger.com0tag:blogger.com,1999:blog-1537192810536854261.post-67056315698345535412021-08-31T15:14:00.001-04:002021-08-31T15:14:31.868-04:00Reg NMS<p>There is renewed discussion of the possibility of banning payment for order flow in the United States, and the proposed ban appears to be addressing some issues in the wrong way. Those issues are oddities of "Reg NMS" --- that's "National Market System" --- that convert a dozen or so stock exchanges into a single, abstract "stock market". And my proposal, ultimately, is that we ban exchanges from charging commissions to liquidity takers.</p><p>I want to note that this is ultimately an accounting requirement --- and Reg NMS is why it matters. If I place an order to an exchange to buy a stock for $64.03, and the lowest price at which anyone is willing to sell is $64.05, the order sits there until someone comes along to sell at $64.03. If and when they do, the exchange typically charges each of us a commission; I'm really paying $64.031, and they're clearing $64.028. If the seller were not allowed to pay a commission, you could report the price as $64.031 instead, and charge me a .3 cent commission instead of .2 cents; the same cash changes hands in the same ways, we're just reporting the trade differently.</p><p>The problem is that, for many orders subject to certain concessions to the laws of physics (namely the speed at which information can be transmitted), an order to trade "at market" has to go to the exchange with the "best" price. Because of this, some exchanges actually have a <i>negative</i> commission for liquidity providers --- they might charge me $64.029, and only pay the seller $64.026. By telling a seller (or, more to the point, the seller's broker) who will only clear $64.026 by selling on my exchange that they can sell there for "$64.03", they can attract a sell order that could perhaps have cleared more (net of commissions) somewhere else. By requiring that the commission be paid by the trader whose order is resting on the book, you're simply aligning the reported bids and asks with the prices that would actually be obtained by a trader hitting them.</p><p>Most of "payment for order flow" similarly constitutes a sleight-of-hand involving careful but economically meaningless distinctions between "prices" and "commissions".</p>dWjhttp://www.blogger.com/profile/12072494989829344049noreply@blogger.com0tag:blogger.com,1999:blog-1537192810536854261.post-36405725407239221462021-08-18T18:10:00.002-04:002021-08-18T18:10:35.138-04:00bounded cognition in evolutionary game theorySuppose you have a set of agents that, for behavioral and strategic reasons, all "cooperate" with each other, but would recognize if one of the other agents started to "defect"; cooperating would be an evolutionarily stable strategy in this context. If the society gets larger you might expect there to be a point (Dunbar's number, for example) where the agents can't keep track of all of the other agents anymore; suppose, in fact, that we have 1400 agents, each of which is designed to keep track of 140 agents. As long as all but a couple of agents continue to "cooperate", you're still fine; if the number creeps above 20 or so, then the information required to keep track of who has been cooperating and who has been defecting gets to 140 bits, and so one might suppose that would overwhelm the agents, and there would be a tipping point around there where cooperation would break down.dWjhttp://www.blogger.com/profile/12072494989829344049noreply@blogger.com0tag:blogger.com,1999:blog-1537192810536854261.post-4161771437827521192021-06-14T17:43:00.004-04:002021-06-14T17:43:51.363-04:00free will<p> At some point I intend to read some philosophical works on free will and determinism, but I want to record a thought I have that may be unoriginal, refuted, or both.</p><p>"Free will", as I think about it, I believe entails the ability to take an action that was not predetermined. ("Causality" on some level requires free will, because I have to have a sensible way of thinking that Y did happen when X did happen but wouldn't have happened if X hadn't happened; I need for the very notion of a counterfactual to make sense. Part of the reason I'm interested in free will is that I'm interested in causality.) Perhaps, however, if I live in a world that is ultimately deterministic but in which I in some practical sense can't predict whether X will happen, but can predict that Y will happen if X does, perhaps that gives rise to the perception of "free will" that I require. If minds of the a similar order of complexity to my own are unable to predict whether I will do X or not, perhaps that amounts to "freedom".<br /><br />This perhaps fits into the notion of "compatibilism" -- again, I haven't read as much as I eventually should.<br /></p>dWjhttp://www.blogger.com/profile/12072494989829344049noreply@blogger.com0tag:blogger.com,1999:blog-1537192810536854261.post-18392206533332226332021-03-07T19:23:00.002-05:002021-03-07T19:23:26.615-05:00rationing<p>My previous post mentioned power shortages in Texas; to some extent generally, but especially when there are power shortages, retail allocation of electricity in the United States is mostly not done by a market mechanism. Similarly, the covid vaccine is not being allocated by market mechanisms. In both cases, more centralized government or quasi-government organizations are making decisions about priorities.</p><p>In all cases, it seems that an important consideration for the prioritization schemes should be pump-priming; you have this resource that is bitingly scarce, with a high marginal benefit, and so first and foremost you would prefer not to have to make choices, that is to have as much production as possible. In both cases we seem to have had failures of this sort; some of the shortage of gas to gas-powered electricity generators appears to have been due to power cuts to gas infrastructure, and while health care workers were given high priority for vaccines, apparently the vaccine makers themselves were not, and have suffered some slowdown because of employees out during the third wave.</p><p>In an idealized market, the gas systems would have outbid other buyers for power, and vaccine producers, being paid marginal benefit for additional vaccine production, would outbid most buyers to allocate those vaccines to their own employees. In a (politically and otherwise) realistic market, I don't know whether that would have worked out. In any case, it seems like a useful point for future designers of rationing schemes to keep in mind; if a scarce good is extremely valuable, then using some of it to produce more of it is probably a good idea.</p>dWjhttp://www.blogger.com/profile/12072494989829344049noreply@blogger.com0tag:blogger.com,1999:blog-1537192810536854261.post-28936660380680740202021-02-26T13:23:00.002-05:002021-02-26T13:23:28.351-05:00energy prices<p> A week or two ago, Texas experienced some unusual weather which, by means of a couple different mechanisms, reduced the supply of electricity while increasing its demand. The wholesale price of electricity shot up to $9 per kWh, where it is capped, and many people had their power shut off altogether as they were sacrificed to preserve electricity for priority customers (e.g. hospitals). Other people kept receiving power; some of them have retail providers who pass along the wholesale price of the power, and many of them are now seeing very large power bills, some over $10,000.</p><p>There are a few things that I've been thinking about related to this.</p><ul><li>If you were to draw an actual "marginal benefit" curve, based on some plausible measure of customers' own valuation of marginal units of power, it doesn't seem to me like it would be as inelastic as these price dynamics imply. My impression is that a lot of the people who were shut off would have been unwilling to pay $10,000 to instead have power through the week, and especially that, given the choice between paying $10,000 to use that much power or $5,000 to have half as much, they would have opted for the latter. Perhaps I'm simply wrong here; suppose I'm not.<ul><li>How well were the customers paying variable rates able to track and control their use of electricity? Presumably they have some kind of smart meter that at least knows when they used power; are their meters able to communicate the price in real time, maybe shut off appliances or change thermostats? (Did these people take steps to lower thermostats themselves?)</li><li>What is it about the way the market is structured that caused the price to get well ahead of marginal benefit (assuming, again, that that's what happened)? Perhaps if <em>more</em> consumers had been on variable-rate plans the system would have been more robust. Any power that was used that was not worth the price to the customers was presumably used either in ignorance of the price or under an arrangement in which the person deciding to use the power was insulated from the cost.</li></ul></li><li>The <em>supply</em> side, on the other hand, does seem really to have been quite inelastic; the marginal cost, I'm guessing, was well under $1 per kWh up to a very high percentage of the amount actually being supplied, with a sharp upturn at that point. Classical Marshallian welfare analysis suggests that, in such a context, "producer" surplus will be very high. In a rational expectations model with free entry, sellers would expect these kinds of episodes and the surplus would be used to cover fixed costs and/or induce entry. In the real world, it does look like a nice reward for the producers that were able to keep producing power, perhaps because they had prepared better for a situation like this, or perhaps because they were lucky. (Usually there's some of each.) I don't know whether it's likely to induce local improvements to robustness or not.</li><li>Some of the drop in supply seems to have been that gas-fired plants weren't able to get natural gas. Few if any retail gas customers seem to have lost gas, however; it was apparently prioritized first to households, with power plants lower in priority. I have heard the word "obviously" attached to this decision, perhaps because cutting off gas to households that use gas during a cold snap would mean those houses would lose heat, yet what did happen is that many houses that use <em>electricity</em> for heat had <em>their</em> heat cut off during a cold snap. I don't know that the physics of the gas pipes would allow households to have some throttled quantity of gas, but it seems likely that some alternation — rolling gas-outs designed to provide gas to households when it's likely they're dropping below some temperature like 45 or 55 degrees, but provide some gas to the plants producing the power to heat other houses — would have been better on the whole.</li></ul>dWjhttp://www.blogger.com/profile/12072494989829344049noreply@blogger.com0tag:blogger.com,1999:blog-1537192810536854261.post-37222312549606613202021-02-09T13:43:00.001-05:002021-02-09T13:43:27.704-05:00Runoff voting with runoff<p>Voting for a single winner between two candidates is straightforward; if the candidates and voters are all to be symmetric, then asking each voter which candidate to prefer and electing the candidate with more votes is relatively<a href="#210209-1" name="r210209-1">[1]</a> problem-free and is the obvious way to determine a winner. With multiple candidates things get tricky; in particular, our usual plurality system results in "vote splitting", where the result depends as much on which candidates decide to run as it does on who the voters prefer; for example, perhaps Alice gets 40% of the vote, Bob gets 39%, and Carol gets 21%, and it may be the case that more voters preferred Bob to Alice, but some of them voted for Carol instead. <br /><br />One increasingly popular way of addressing this is with instant runoff voting; voters in Maine (and, going forward, Alaska) rank their options, indicating that one candidate is the voter's first choice, another the second choice, and so on. When the votes are tallied, each vote is counted for the candidate ranked first, but if no candidate gets a majority, the candidate with the fewest votes is eliminated, and ballots are recounted, being credited to the highest ranked remaining candidate. Older runoff systems in the United States ask voters to come back to vote in subsequent rounds with fewer candidates, but the instant runoff with ranked ballots can do this automatically without calling the voters back to the polls because the voters have implicitly left instructions on how they wish to vote in the runoff.</p><p>One problem with this procedure is that it can frequently eliminate popular second choices. For example, it may be that the 40% who voted for Alice prefer Carol to Bob, and the 39% who voted for Bob prefer Carol to Alice; Carol is the top choice of fewer voters than the others, but is nobody's least favorite candidate, and in particular she would win the election if either of the other candidates dropped out. A majority of the voters prefer Carol to Alice, and a majority prefer Carol to Bob, but Carol is dropped from the runoff, and one of candidates who she would have beat will win instead.</p><p>This is not too hard to fix with a relatively small change to the procedure: when deciding which candidate to eliminate, we look at both of the two candidates with the fewest votes, and eliminate whichever is ranked lower on more ballots. In this case, we see that Bob and Carol have the fewest first-place votes, so one of them will be eliminated; because 61% of voters prefer Carol to Bob, we eliminate Bob. Alice and Carol are in the runoff, where Carol wins.</p><p>Maine has published the ballots from the House of Representatives election for 2018 in its second district, and, while I have trouble figuring out exactly how the state interpreted some of the ballots, I can use them for an example. By my count, Poliquin was the top choice of 134,358 voters, Golden of 132,145, Bond of 16,650, and Hoar of 6,996. In Maine, this was enough to eliminate Hoar; in my system, we first compare him to Bond. Of the ballots expressing a preference between them, there were 43,131 more ballots that had Bond ranked above Hoar than vice versa; it is only after we observe this that we eliminate Hoar. This leaves three candidates, and we redistribute the 6,996 votes for Hoar; Poliquin now has 135,275 votes, Golden has 133,381, and Bond has 19,313. Because Golden beats Bond by 96,458 votes when only those two candidates are considered, we eliminate Bond. Less than 4,000 of her votes transfer to Poliquin, though; in the final round, he has 139,238 votes, while Golden has 142,664. Golden is therefore elected.</p><p></p><table><tbody><tr><td>Golden</td><td>132,145</td><td bgcolor="pink">133,381</td><td>142,664</td></tr><tr><td>Poliquin</td><td>134,358</td><td>135,275</td><td>139,238</td></tr><tr><td>Bond</td><td bgcolor="pink">16,650</td><td bgcolor="red">19,313</td></tr><tr><td>Hoar</td><td bgcolor="red">6,996</td></tr></tbody></table><p><br /></p>
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<a name="210209-1" href="#r210209-1">[1]</a> I'm going to assume away exact ties, as I so often do.
dWjhttp://www.blogger.com/profile/12072494989829344049noreply@blogger.com0tag:blogger.com,1999:blog-1537192810536854261.post-31095038544711910882021-01-20T14:09:00.001-05:002021-01-20T14:09:07.849-05:00selling volatility<p>It occasionally happens that, for some exogenous reason, some market participant or group of participants sells a lot of options on a stock, and it is then noted that this means the sell-side of Wall Street is often involuntarily buying them, which typically means that those sell-side shops will go out and delta-hedge; since these move one-for-one with the stock when the stock price is high, and don't move when the stock price is low, that entails buying the stock as it rises (nearish the strike price), and selling as it falls, thereby stabilizing the price. </p><p>All of this is well and good, but I'm inclined to skip some steps; the buy-side agents are selling volatility, and that should generally push down the price of volatility. In most markets, selling a thing pushes down the price, and when ordinary supply and demand work reasonably well, reequilibration at the lower price will entail moving to a situation in which the marginal cost of the thing is lower than it was at the beginning, and the detailed mechanics don't really matter that much. "Volatility" may seem abstract, but it works the same way.</p><p>An important special case here is the mortgage bond market; homeowners there have (and to some extent use) an option on interest rates, and when those become more likely to be exercised, that tends to destabilize long-term interest rates. Again, you can walk through a discussion of interest-rate investors trying to match shrinking durations, and eventually you find dropping interest rates being pushed lower and rising ones pushed higher, but if you're just interested in the dynamics of interest rates themselves, you can skip all these steps; a bunch of people who have no idea what duration, convexity, or volatility mean are unwittingly long volatility, and that pushes up prices.</p><p>I'm posting this at the moment because Matt Levine is writing about greenshoes, which are options granted to underwriters of IPOs, for the purpose of enabling the underwriter to stabilize the price of the IPO. The details of the mechanics are a bit different from what you might think based solely on that sentence, but, as I keep saying, it's not that sensitive to mechanics; if the company thrusts options into the financial system, that has the effect of pushing down volatility. Some people don't like greenshoes, and a problem with them that Levine argues is probably hypothetical is noted in his newsletter. It has made sense to me for a long time to let locked-up shareholders sell at some minimum price before the lockup period ends, e.g. you IPO at $40 and tell certain classes of shareholders that they can't sell below $60 in the first six months, rather than tell them they can't sell at all.<a href="#210120-1" name="r210120-1">[1]</a> I wonder now whether it makes sense to distribute warrants with the initial share allocation.<a href="#210120-2" name="r210120-2">[2]</a> <a href="#210120-3" name="r210120-3">[3]</a></p><p>It's hard to remember one's previous state of ignorance, especially when it's been so long, but I believe that 20 or 25 years ago I assumed an IPO worked more or less like a direct listing with a capital raise; until much more recently I didn't realize that those weren't even allowed. (I became aware of that when discussion of changing that heated up, and it looks like in 2021 it will finally be permitted to do what I assumed in the 1990s was the way a company went public.) I mention this in substantial part by way of warning that the hard parts of finance are legal and customary, where, as is true of most people, by "hard parts" I mean "the parts I don't know and/or understand so well."</p><p><br /></p>
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<a name="210120-1" href="#r210120-1">[1]</a> In a certain kind of theory, this should make no difference; forward-looking investors on the day of the IPO know these shares will be available to the supply side of the market in six months, and should price that in. A lot of my practical concerns with ideas I'm putting forward in this post are related to the extent to which this fails in practice, and the related fact that the amount of genuine "float" in the early days of a new issue is quite small.<br/>
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<a name="210120-2" href="#r210120-2">[2]</a> In this case the size of the early float of shares endorses my proposal, insofar as the reasons the float is so small are likely not to apply to these warrants.<br/>
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<a name="210120-3" href="#r210120-3">[3]</a> One of the complaints about the greenshoe is that companies don't like not knowing how many shares they're selling; as I've argued in some previous posts, a lot of companies should be offering more of a bona fide, upward-sloping supply curve anyway. If the warrants execute, it's likely the investors think the company can make good use of their additional dollars, while if they don't, they don't, and the company should have some idea what it would best do with the additional investment should it be forthcoming. It is perhaps worth noting here that if demand is volatile, an elastic supply curve is a way of absorbing some of that volatility into quantity rather than price; if you don't like talk of "selling volatility", perhaps the fact that a warrant exercise increases the quantity supplied is more intuitive.
dWjhttp://www.blogger.com/profile/12072494989829344049noreply@blogger.com0tag:blogger.com,1999:blog-1537192810536854261.post-70267805725792582702021-01-19T13:16:00.002-05:002021-01-19T13:16:22.420-05:00index minus<p>In a certain kind of ideal market, securities lending fees should be zero; at any positive price, there would be effectively infinite supply. In actual practice, a lot of shareholders, for institutional or other reasons, don't lend out their shares. Those that do lend out shares tend to be price-inelastic, at least above some de minimus price; they'll lend out all of the shares they have available. Retail borrowers typically don't directly pay a lending fee; they pay it indirectly in various ways, and those ways tend not to respond to the level of the actual fee; if the actual fee is higher than what the broker is getting from the customer, they are simply unable to borrow. Retail demand, thus, is also very inelastic for most possible prices, but with a dramatic elastic region around a particular price that depends on things like nominal interest rates.</p><p>Index investing has grown a lot in the last generation (after growing a lot in the generation before that); a lot of people simply own the S&P 500 in some literal or practical sense. The saver owns the same fraction of every company in the index. Some retail investors have, for a while, adopted an "index plus" strategy of putting most of their money in a passive index fund but putting a little bit in stocks that they select. Increasingly, people are interested in something like an "index minus" strategy; they are largely agnostic about most stocks, except that they think they should own "stocks", but there are a few stocks that they think are overpriced, or think are bad for ESG-related reasons. My impression is that, at least at the retail level, they mostly end up just buying an ESG fund, or buying an S&P fund and perhaps selling a couple of stocks short, and that that's about the best they can do.</p><p>I'm trying to work out in my head whether there's a sensible market for an index minus brokerage-type account; the broker here would guarantee that a customer could in some sense "sell short", but only in the amount that that customer owned the stock. To the extent that different customers "short" different stocks, part of the custodial assets of the company could be in a Vanguard S&P fund or do something with futures. To the extent they don't, the company might have to do some of the work of a fund itself, perhaps including some securities lending, and would have some of the same economies of scale that most mutual funds do. I think this ends up looking a bit like a subsidy to customers selling hard-to-borrow securities, but the limit on the size of the sale keeps that manageable, and it may be an attractive enough idea to enough people looking to put their money in stocks, many of whom would only sell cheap-to-borrow stocks anyway, that there's a business opportunity to be had here anyway.</p>dWjhttp://www.blogger.com/profile/12072494989829344049noreply@blogger.com0tag:blogger.com,1999:blog-1537192810536854261.post-905214806108431072020-10-24T12:59:00.006-04:002020-10-24T12:59:57.913-04:00sales tax as monetary policy<p> This falls well in the half-baked (or less) wheelhouse of this blog: to help assist monetary policy, we should have a national sales tax that follows the short-term interest rate. If short-term rates are 0, the sales tax goes away; if they're around a 5% annual rate, we have a tax of 2.5%, if it's an 8% annual rate the tax is 4%, etc.</p><p>I came to this idea, such as it is, from thinking about "Modern Monetary Theory", the advocates of which want to use fiscal policy to control inflation to a much greater extent than we do now; in particular, if inflation got too high, we would raise taxes to take money out of circulation to cool it down. What I haven't heard noted in my consumption of their material is that what you would need to tax would be consumption, not income. In particular, if you had a class of subsistence-plus farmers who had income but never spent it, taxing them would do no good whatsoever for reining in inflation; the money they're sitting on is economically inert. If demand for the quantity of goods and services being produced is high enough to push up prices, the only way to prevent that is to somehow effectively reduce that demand, and the way you would do that in anything like this framework would be a combination of reducing the ability of people who want to spend money to do so and of encouraging those people to delay their spending. To the extent that you get people to save their money, that addresses the problem.</p><p>An important thing to note about encouraging people to save money rather than spend is that it depends on real interest rates, not nominal ones; "real" in this context means "inflation-adjusted", except that what actually matters is not realized inflation, but expected inflation. For a given interest rate, people will generally be more willing to save if they think inflation will be low (so they can buy more stuff in the future if the save now) than if they think inflation will be high; by the time we know what actual inflation is over a time period, it's well after the decision was made. Another important thing to note is that, if the sales tax is changing with time, your actual purchasing power at a given time depends on after-tax prices. In the short-run, a tax response to inflation means that you're responding to an erosion in purchasing power by further eroding people's purchasing power. If you link it to interest rates (or something else in the economy that's likely to be low in recessions and high in inflationary expansions), though, that higher tax is at least expected to be temporary — the expected after-tax inflation rate is lower than the expected before-tax inflation rate. (Or, if you prefer, there's a tax incentive for deferring spending to a time when the tax has come down.)</p><p>I find this easier to discuss in terms of periods of high inflation, but it should work the other way, too; if people think a sales tax is going to kick in in two years, spending more now becomes comparatively more attractive, and the after-tax real interest rate is lower even before taking account of the result that we're hoping this has on inflation. If you can make this credible — if you can make people really believe that there will be a sales tax in two years — then this should enhance the ability of low nominal interest rates to get people spending money now, while avoiding some of the mechanical and psychological difficulties associated with negative nominal interest rates.</p><p>If we could ignore mechanical difficulties, of course, negative interest rates would be more attractive, but so would a negative sales tax; note that what's important for the substitution effect is not the level of the tax, but its expected change, and to the extent that we're trying to affect the amount of money in the system and expect that to do some work for us, a tax that's actually negative when we're trying to stimulate spending is in fact what we'd want. (While the primary logic of mailing out checks this past spring was straightforward relief rather than stimulus, it provided some nominal stimulus by enabling spending.) To some extent you could get the money-balance effect by lowering other taxes instead — even with this sales-tax scheme, funding the government probably requires positive income tax rates, but they could be lower if some of the revenue comes from the sales tax instead — but maybe a negative sales tax would be easier than some other negative taxes. The idea of a negative income tax has gotten more attention, and to some extent, with the EITC, we have that. It may also be, though, that "the sales tax" would be better implemented through the income tax, where it might look more like a savings incentive — instead of a 5% sales tax, you would increase income tax rates 5 percentage points above their baseline level, but with a 5% credit for new savings, making clear that part of the point is encouraging people to save the money to spend later instead of now, and instead of a -5% sales tax you could have temporarily lower income tax rates, but with a similarly temporary savings tax to encourage spending now. One problem with doing it this way is also a problem with using a value-added tax, which is sometimes said to be equivalent to a consumption tax; that problem is one of timing. I envision the tax changing in the middle of a year, rather than having a constant value for each tax year; maybe that's unnecessary. A value-added tax takes time to bubble its way up through the supply chain. In either case, though, a delay in implementation causes the tax to trip over its own feet a bit; remember that a significant part of the effect is to come from the expected mean-reversion, that is that raising the tax should lead to the expectation that it will be lower in the future than it is now, and saying "we're going to raise, you'll feel the rise in six months" encourages exactly the opposite of what we want in the near-term.</p>dWjhttp://www.blogger.com/profile/12072494989829344049noreply@blogger.com0tag:blogger.com,1999:blog-1537192810536854261.post-53292146557767587332020-06-28T15:38:00.003-04:002020-06-28T15:38:43.363-04:00errata and addendaI have a couple of what should be edits to previous posts, but I've had issues with blogspot editing in the past, so I'm going to record them here and hope that's adequate.<br />
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About 7 weeks ago <a href="https://deansdough.blogspot.com/2020/05/batch-auctions-for-foreign-exchange.html">I wrote about the foreign exchange market</a>; apparently the market has become less decentralized than I had realized. The CME group ("Chicago Mercantile Exchange") owns a platform called EBS, and Refinitiv has a platform called Matching; these account for something like 30% of foreign exchange trading. There are other smaller exchanges, and Cboe Global Markets ("Chicago Board Options Exchange") is launching a new market called Cboe FX Central.<br />
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About 3.5 weeks ago <a href="https://deansdough.blogspot.com/2020/06/a-simplistic-guide-to-fair-value-for.html">I wrote a post with the term "Fair Value" in the title</a>. I sort of regret calling it that, because it's not the "Fair Value" that Warren Buffett and Benjamin Graham are talking about, even if that's what I meant to invoke. The measure I described will have a bit of a "Fair Value" feel to a CFO, in that it calculates a value for the company independent of any price data from securities markets, and recommends that the company buy its stock if it's cheaper than that and sell if it's more expensive. If companies reported such a thing, they really shouldn't call it "fair value", and if I'm going to allude to the term, I should give more emphasis than I did to the last two sentences of that post, which basically describe how it differs from the investor's notion of "fair value". It's a summary statistic about internal investment opportunities that leaves to the shareholders the decision as to whether (or how much) internal investment is actually attractive; whether the stock is actually worth that amount is up to the shareholders to decide.</li></ul>dWjhttp://www.blogger.com/profile/12072494989829344049noreply@blogger.com0tag:blogger.com,1999:blog-1537192810536854261.post-13701198548145624072020-06-15T16:18:00.001-04:002020-06-15T16:18:46.396-04:00stock-market wealth<div>
A lot of the people in Jane Austen novels seem to "have" an income. I don't quite understand this; they don't seem to have jobs, exactly, and my least bad guess is that they own estates that have much more regular cash flows than I would expect manorial estates to have. Let's suppose, though, that one "has" an income of $1 million per year, coming from such an estate. What is the "wealth" value<a href="#200615-1" name="r200615-1">[1]</a> of the estate? Well, if comparably safe investments generally pay a 5% interest rate, a prospective buyer would be indifferent between paying $20 million for the estate versus investing that elsewhere, so the estate is worth $20 million. If interest rates were instead 4%, the estate would be worth $25 million.</div>
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One of the things I've been hearing lately is that many billionaires have "made" billions of more dollars since March 23, or (less incorrectly) that their wealth has gone up billions of more dollars since then. In a few cases, company profits (or prospect of future corporate profits) have gone up, but mostly they have not; since Feb 23, in fact, most company's prospects, especially in the near term, have gone down considerably. Interest rates, however, have also gone down. Mr. Darcy's income has gone down, but so has the income associated with any means of saving for the future, and indeed the latter has dropped sufficiently that, if Darcy were willing and able to sell his estate to someone else, he could get a higher price for it than before.</div>
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Does this mean he's richer than before? To reiterate, other forms of saving have gone down, too; he can't take the money and put it somewhere where it will allow him to spend more on an ongoing basis. If he has always wanted to blow all of his prospects on a bacchanal, followed by a life of penury after that, then his wealth has gone up, but if he was uninterested in selling before and is uninterested in selling now, as seems quite likely, his best allocation of his wealth over time results in a lower consumption path, not a higher one — it follows the income, not the capitalized wealth.</div>
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In what senses can we say that he is richer, or even more daringly turn the change in the capitalized value of his wealth into something like an income? Especially for this latter step, it seems most reasonable if Darcy has been, is now, and expects to continue to be a trader, timing the market, buying low and selling high. If he had a cash endowment at the beginning of the year, he would be better off having bought the estate in March than he would be buying it now. If the continued value of his trading prowess is unaffected by the drop in interest rates, his ability to consume may be higher than it was before. Conversely, it seems most obviously the case that his wealth has gone, not up, if his asset is entirely illiquid, he has no way of knowing what its capitalized value is, and he has simply been informed by his foreman that the income will be lower for the foreseeable future.</div>
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A lot of this is entailed<a href="#200615-2" name="r200615-2">[2]</a> in the standard economic principle that the best measure of a person's wealth, in the long-run, is likely to be his or her level of consumption, or in any case that that's a better measure than that person's income or the total value we can assign to those of the person's tangible assets to which we can assign value. If the stream of value that you had expected to consume is no longer one you can afford, you have gotten poorer, not richer, regardless of how that's measured in today's dollars.</div>
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<a name="200615-1" href="#r200615-1">[1]</a> We would often call this a "capitalized" value.<br/>
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<a name="200615-2" href="#r200615-2">[2]</a> Not in the real-estate sense of Jane Austen's world.
dWjhttp://www.blogger.com/profile/12072494989829344049noreply@blogger.com0tag:blogger.com,1999:blog-1537192810536854261.post-13024020878894524742020-06-04T14:50:00.000-04:002020-06-04T14:50:19.134-04:00A simplistic guide to Fair Value for CFOsSuppose a company can reasonably determine that if it made $300 million in new investment, its earnings (perhaps before interest and taxes) would be about 5% higher, in the long-run, than if it didn't.<a href="#200604-1" name="r200604-1">[1]</a> That basically means that the company's market cap (perhaps enterprise value) should be $6 billion<a href="#200604-2" name="r200604-2">[2]</a> — independent of your cost of capital. If you're trading at $3 billion, that means your cost of capital is high, and in fact is higher than your marginal internal rate of return; if you have cash that you're looking to deploy, you should return it to shareholders, perhaps by buying back stock.<a href="#200604-3" name="r200604-3">[3]</a> If you're trading at $10 billion, your cost of capital is lower than your marginal internal rate of return, and you should invest that $300 million internally, issuing new stock if necessary (and possible) to do so.<br />
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I've never been a CFO, and may be all wrong here, but the way schools present corporate finance the process is often sketched out as, well, you figure out your weighted average cost of capital, and your internal rate of return, and there are strategies for trying to do these things, but cost of equity in particular is pretty slippery. And it seems to me that it frequently doesn't matter; there's a simpler approach that avoids the questions that are hard, the answers to which largely cancel out by the time you get to the part that's actionable. So it seems to me that a lot of companies should often issue, somewhere in their quarterly or annual reports, ranges of what they think their "fair value" is, with the understanding that they're likely to buy below that range and sell above it. If they did, I'm sure some people would misunderstand and complain, not least because so many people seem to make those two things their primary hobbies; that his has, as a side-effect, some tendency to stabilize the stock price and to make money trading the company's own stock (if you hit both ends of the range in the same period) will probably be called "manipulation" or, I don't know, "profiteering" or something — the people I have in mind aren't careful about language. Some people might also imagine that the company is trying to tell stock traders that its price should stay in that range, which is not at all the point; certainly the company's buying and selling would not, in the face of big macroeconomic news, be expected to create hard price barriers. The range is an indication of internal rates of return of new investment, but in a non-traditional language; if shareholders decide the demand a higher rate of return than they'd been expecting, the price of the stock can go down and the company accepts that verdict.
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<a name="200604-1" href="#r200604-1">[1]</a> This is intended to be "in expectation", using a risk-neutral measure, but is still subject to supposing, for example, that you can reasonably estimate an expected glide-path that follows the otherwise expected glide-path, just some multiple higher. I mean, you don't need the glide-paths, which is part of the point of the post; you only need the multiple. And so I think that it's likely that there are a lot of environments in which a CFO could reasonably say that it's between 4% and 6%, in some reasonable expected sense, meaning, again, that it could end up outside that range, but that you can justify that reasonably well in the light of what should be reasonably known now.<br/>
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<a name="200604-2" href="#r200604-2">[2]</a> Or, continuing the previous footnote, maybe $5 billion or $7.5 billion.<br/>
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<a name="200604-3" href="#r200604-3">[3]</a> Ignoring other capital structure issues, which I think should be largely independent of this.
dWjhttp://www.blogger.com/profile/12072494989829344049noreply@blogger.com0tag:blogger.com,1999:blog-1537192810536854261.post-2778865922135994172020-05-11T18:02:00.000-04:002020-05-11T18:02:00.367-04:00Reopening the economy; cost benefit analysis<a href="https://jensfi.blogspot.com/2020/04/reopening-economy.html">Elsewhere I provide a back-of-the-envelope cost-benefit statistic to guide reopening the economy from the covid shutdowns;</a> here I want to extend the model a bit. In that post I work in terms of the sort of model in which we use a reproduction number — in particular, a fairly homogeneous model. There I look at assessing the cost of creating opportunities for the disease to spread, and here I want to allow at least some variation in that.<br />
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For at least the past month I have been largely thinking about the epidemiology of the disease in terms of multiple populations; these could be counties or states, and it was county and state data that moved me toward this framework, but I've occasionally thought in terms of multiple populations in the same area, one of which engages in much more "social distancing" than the other. I think the following crude model will be sufficient for my purposes: suppose time is discrete, and consider a vector v at each time, with each component indicating infectious cases in a particular area, and v<sub>t+1</sub>=Rv<sub>t</sub>, where the reproduction number R is now a matrix instead of a number. I don't suppose that it's constant with time, but I am going to consider changing one element R<sub>ij</sub> at a single moment in time with R unchanged at all other times; to be clear, it may be changing over time, but the counterfactual follows the same path as the baseline scenario except for a single element of the matrix at a single time.<br />
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For T>t+1 let M<sub>T</sub> be the product of the transition matrices from time t+1 to time T-1, such that v<sub>T</sub>=M<sub>T</sub>Rv<sub>t</sub>. The change in v<sub>T,l</sub> due to a change in R<sub>ij</sub>
is the amount of that change times M<sub>T,li</sub> v<sub>t,j</sub>. If you can place a cost on each exposure — a cost that may be different at different times and different for different populations — and multiply each row of each M<sub>T</sub> by the relevant cost and then add up the M, you get a matrix C; the associated marginal cost of an increase in R<sub>ij</sub> is C<sub>li</sub>v<sub>t,j</sub>, i.e. the relevant cost from the C matrix times the current prevalence in the population from which we're increasing the spread.<a href="#200511-1" name="r200511-1">[1]</a> The real question, now, is how to get any kind of bead on C. In parallel with the earlier post, I'll note that the sum over rows of CRv is the total cost of all future infections; this will allow us to make contact with other attempts to do a cost benefit analysis on the entire crisis.<br />
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I'm not sure there's benefit in producing more formulas by imposing more structure on C; I could note that, if R were constant (and all of its eigenvalues below 1) and the costs were constant or exponentially declining, then we would basically have C=(1-R)<sup>-1</sup>, and even with varying R we can maybe read something off of that. It's worse to transmit infections to places that tend to transmit more infections; it's worse to transmit infections to places that do so, and so on.
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<a name="200511-1" href="#r200511-1">[1]</a> This may seem on some level obvious; I would kind of hope it does. Note an implication, though: there is substantial benefit in cutting transmission from a hotspot, and that benefit is largely independent of whether it's to a hotspot or seeding a new location. In conversation I sometimes get the impression that people think that, well, if we're trading people between hotspots, that doesn't matter, but if each infected person in each place transmits the disease, on average, to 0.8 people in their hotspot and 0.4 in the other, you will get exponential growth that could be eliminated by stopping the interchange.
dWjhttp://www.blogger.com/profile/12072494989829344049noreply@blogger.com0tag:blogger.com,1999:blog-1537192810536854261.post-80348856400837144212020-05-09T14:24:00.000-04:002020-05-09T14:24:28.318-04:00batch auctions for foreign exchangeThe foreign exchange market is quite decentralized, and I've been thinking recently that it might be convenient for some players in the market for there to be a daily batch auction, perhaps early in the morning in NYC, late morning in London, and evening in Tokyo. Academics often seem to like batch auctions for the thickness (liquidity) they offer, but one of my motivations was the existence of currency derivatives and indexes; there are traders who may be trying to hedge in the spot market against an "end-of-day" risk, and I thought having a batch auction that provided fixes for derivatives would make it easier to avoid some basis risk.<br />
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Foreign exchange markets can feel a bit like barter in some ways; if I'm buying pounds from a trader in London, we'll both think of ourselves as the buyer, and if someone in Europe wants to trade dollars for yen, it's not clear whether that's a purchase or a sale.<a href="#200509-1" name="r200509-1">[1]</a> In some ways, a centralized auction alleviates the double-coincidence-of-wants problem and makes barter feasible and even makes money (or, in this case, a vehicle currency) redundant, but there is a complication: consider a trader who enters, into the auction, an order expressing a desire to exchange 10 euros for 900 yen, and suppose the auction determines that the clearing price is 100 yen per euro. A European entering an order to buy 900 yen expects to end up exchanging 9 euros for 900 yen, while a Japanese person entering an order to sell 10 euros expects to exchange 10 euros for 1000 yen. An American may wish to hand over 10 euros and receive 900 yen and to receive the gains from trade in US dollars. An order now should specify the currency of the order, which may be the currency the trader wants to buy, or sell, or something else. In more generality, the trader may express three baskets of currencies, expecting that, if the trade is executed, the trader will give up basket A and receive basket B and some multiple of basket C such that the currency received and the currency provided have the same value at the clearing prices.<br />
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Actually determining how to clear the markets turns out to be equivalent to solving a convex optimization problem, at least if currencies are arbitrarily divisible and orders can be partially executed, at least provided that, for each order that executes, the currency associated with that order is provided by some combination of other orders that execute. The solution technique is likely to involve iteratively finding the excess demand for different currencies given different price vectors, and it seems likely that in a practical distributed setting you would want to group orders by currency, where you would first figure out, given the proposed price, which orders execute, the total gains from trade those orders, and how much currency that adds to the demand vector. One potential complication here is created by orders that clear exactly, with no gains from trade, which may end up partially executing; when excess demand of different groups of orders is being aggregated it may be necessary, especially late in the process of finding the execution price, to retain a lot of possible excess demand vectors to aggregate the partial calculations.
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<a name="200509-1" href="#r200509-1">[1]</a> This is the source of some confusion regarding options at times; the terms "put" and "call" are similarly poorly defined. In some ways, though, this is clarifying, though I think I should let go of this particular tangent at this point.
dWjhttp://www.blogger.com/profile/12072494989829344049noreply@blogger.com0tag:blogger.com,1999:blog-1537192810536854261.post-35188185950545140262020-03-30T14:59:00.001-04:002020-03-30T14:59:25.111-04:00A quick thought on the size of the firmIn times of war, pandemic, or other emergency, particularly when there are quick shifts in the environment, it seems that the sorts of coordination that are amenable to top-down approaches on a large scale become more significant, while the sorts of coordination that they're bad at, or that lower-level coordination is good at, don't change. In Coase's framework, this suggests that the optimal firm size has suddenly gotten larger. (It obviously has other, more political/legal implications as well.)dWjhttp://www.blogger.com/profile/12072494989829344049noreply@blogger.com0tag:blogger.com,1999:blog-1537192810536854261.post-69678964087749125222020-02-25T13:16:00.000-05:002020-02-25T13:16:16.017-05:00how fed policy worksThis post is perhaps on the wrong blog; there's little if anything in this post that I intend to be speculative or even novel. I've been hearing some talk from laymen about fed policy that makes me think that they are thinking about some things very differently from how I, and I think most economists, do, and I'm writing this post as a guide to a framework that's more in the realm of mainstream economics.<br />
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Suppose you're in a car on a stunt track, and you're supposed to go up a ramp and jump over a ravine; you need to be going at least some minimum speed when you get to the top of the ramp or you won't make it across. One thing you would want to do, if you're well below that speed, is to start accelerating well before you get to the ramp. If you put the pedal to the metal hundreds of yards out, and someone criticized this decision on the grounds that if you push the gas pedal as hard as you can now, you won't be able to push it any harder when you close within a hundred yards of the ramp, you would think that criticism was nuts.<a href="#200225-1" name="r200225-1">[1]</a> It would sound exactly as nuts as the complaint that cutting the federal reserve policy interest rate in response to a small slowdown in the economy "uses up ammunition", and that the fed should instead "save up ammunition" for if there's a full-blown recession.<br />
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Certainly in every economics model I've seen — and (not quite the same thing), I'm pretty sure that almost<a href="#200225-2" name="r200225-2">[2]</a> every economist is quite confident that this is true — it is not the rate <em>cut</em> that is stimulative; it is the <em>low rate</em> that is stimulative. "Low" will depend on context — indeed, a low rate is typically a sign that policy hasn't been stimulative recently — but from a given starting point, lowering the rate sooner will allow stimulation to accumulate longer; trying to postpone the cut will increase the need for stimulus in the future.<br />
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The simplest model, then, with the fewest possible explicit moving parts, is that there is some "neutral interest rate", not known with full precision and subject to influence from noisy external factors, and that policy is contractionary if the policy rate is higher than it and stimulative if the policy rate is lower than it.<a href="#200225-3" name="r200225-3">[3]</a> If policy is stimulative, that will tend to raise the future neutral interest rate, and if it's contractionary it will tend to lower it. Note that the system — at least parameterized this way — is unstable; if you keep the policy rate fixed forever, the natural rate will either find itself above the policy rate, and will then be pushed higher (by inflationary expectations as aggregate demand picks up), making the policy rate even more stimulative, making it move higher even faster, or the natural rate will find itself below the policy rate, and will similarly move ever lower as a deflationary spiral takes hold. If you're making monetary policy by controlling an interest rate, then, you need to move it in response to noise, pushing it above the natural rate when the natural rate gets high and below it when the natural rate gets low.<br />
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And this, then, gets me closer to another comment I hear, which is that long-term interest rates are driven entirely by expectations for future short-term rates, which may in some sense be true, and that therefore the fed has complete control of long-term rates, which is in important ways false, at least where we're talking about <em>real</em> interest rates.<a href="#200225-4" name="r200225-4">[4]</a> I recently mentioned to my class that if you want to know how many jobs there will be in the economy next year, ask an economist, but if you want to know how many jobs there will be in thirty years, you should ask a demographer; similarly, in the short run the fed may have a fair amount of latitude, but if it's avoiding both hyperinflation and depression, an interest rate that's too high now implies a lower range of reasonable policy rate options in the future. Expectations about long-term average future real rates should be formulated (almost) entirely on the basis of economic phenomena, and not on some institutional analysis of the fed or psychological analysis of its governors.
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<a name="200225-1" href="#r200225-1">[1]</a> You'd be right.<br/>
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<a name="200225-2" href="#r200225-2">[2]</a> This is the "Dean almost", wherein I have an excessive aversion to making categorical statements about large groups of people; you can probably drop the "almost".<br/>
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<a name="200225-3" href="#r200225-3">[3]</a> To be clear, all the standard models could be reduced to this sort of model; they would differ in how (much) outside factors affect the neutral rate, and how stimulative or contractionary deviation from that rate is.<br/>
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<a name="200225-4" href="#r200225-4">[4]</a> If the fed has a credible inflation target, then control of long-term real rates and control of long-term nominal rates are basically the same.
dWjhttp://www.blogger.com/profile/12072494989829344049noreply@blogger.com0tag:blogger.com,1999:blog-1537192810536854261.post-61129983327087516022019-12-30T12:30:00.001-05:002019-12-30T12:30:11.745-05:00counterfactuals, probability, and logicThere's a natural connection between set theory and logic that can be more or less drawn by considering the set of possible universes, and making a correspondence between a binary statement ("watermelon is a fruit") and the set of universes in which it's true. The statement "A and B" is true in exactly those universes in the intersection of the two sets; logical "and" is equivalent to set intersection. "or" is the union. "not" is the complement relative to the set of possible universes. "A implies B" means "either A is false or B is true".<a href="#191230-1" name="r191230-1">[1]</a><br />
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We can extend this common notion of logic and sets by introducing probability theory. For any probability distribution on the set of universes, there's a probability that A is true, and a probability that B is true. If we know (for all elements of the set) that A implies B, then we know that for any probability distribution, the probability that A is true is less than or equal to the probability that B is true; perhaps less obviously, the converse is also true, at least for finite sets of universes: if it is the case that the probability that A is true is less than or equal to the probability that B is true no matter what valid probability distribution is used, then A implies B. If we restrict to one probability distribution, or a proper subset of all possible probability distributions, then there might be more to say; in particular, with one distribution, we can do Bayesian inference, and since P(A|A)=1, we have that if A implies B, P(B|A)=1.<br />
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Suppose we ask, "what would have happened if the Axis had won World War II?" To some extent the answer necessarily depends on how we fill out the counterfactual. In settings where we feel as though we have a reasonable answer to a counterfactual question like this, I think it's because we think there is some distribution (or distributions) of universes that is somehow "reasonable", and that, conditional on the information provided in the counterfactual, that answer is more likely than its complement. For questions that are particularly ill-formed<a href="#191230-2" name="r191230-2">[2]</a> may suffer from being conditional on far-fetched possibilities, but also may suffer from conditioning on information that is relatively independent of other interesting information; A is interesting about B if P(B|A) is close to 0 or 1 and substantially different from P(B).
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<a name="191230-1" href="#r191230-1">[1]</a> You might ultimately know which universe you're in, or that you're in one of a restricted set of universes, but that's separate from the concerns of formal logic.<br/>
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<a name="191230-2" href="#r191230-2">[2]</a> I have in mind, in particular, the sort of question my son asks, e.g. "What if a baby beat a grandmaster in chess?", which tend to have the additional flaw that it's not clear what about the proposed reality is being asked.
dWjhttp://www.blogger.com/profile/12072494989829344049noreply@blogger.com0tag:blogger.com,1999:blog-1537192810536854261.post-22485454066652061372019-11-27T13:54:00.001-05:002019-11-27T13:54:54.176-05:00trading on the blockchainBitcoin is regarded as a digital currency, to some extent, but I often find it useful to think of blockchain as a system for indelibly publishing messages. In the case of bitcoin, these messages are largely of the form "I am taking the bitcoin I got from [provenance] and giving X of it to [bitcoin address] and Y of it to [other bitcoin address]", and as part of the system of maintaining the blockchain it is verified that the sender has bitcoin from that provenance in a quantity that is no less than X+Y.<br />
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Actually buying bitcoin involves, as do all transactions, two legs: you give someone dollars or euros or pizza, and they publish a message on the blockchain publicly relinquishing some bitcoin to you. There are exchanges that get together people who want to trade dollars for bitcoin and people who want to trade bitcoin for dollars. When a match is found, the dollars are conveyed in some usual dollar-conveyance manner, and a bitcoin conveyance is published on bitcoin's blockchain. I'm starting, though, to sort of envision a system in which the blockchain itself serves as the exchange.<br />
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Consider a blockchain on which the messages took the form of "I trade W units of asset A and X units of asset B, from [provenances], for Y units of asset C and Z units of asset D." The process of incorporating a new block of such messages into the blockchain would require verifying that the person submitting the message has at least W units of A and X of B from the stated provenances, and also verifying that <em>the entire block</em> gives up at least as much of every asset as it conveys. If there is a very small set of prices that clear the market, then calculating how to put such trades together into a valid block gets computationally hard if a lot of these bids are very close to worth zero, but if there aren't too many assets, and there are a fair number of orders that give up a nonnegligible amount of value for some set of market prices, it becomes practically tractable, and certainly sufficiently tractable to reasonably incorporate into the "proof of work" that is part of bitcoin mining.<br />
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There are two big technological barriers that occur to me: the simpler one is that there has to be a way to cancel an order that doesn't get executed. It seems to me that bitcoin must have a way to deal with this — that, if I publish "I give Sam 2 bitcoins" and it doesn't go through within a reasonable amount of time that there must be a way to withdraw it or for it to expire — but I don't know what it is. Probably the message should include some sort of timestamp and/or expiration time, along with a hash of the message that includes the expiration. An actual cancel may be impossible.<br />
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The other, perhaps bigger, issue, is how the assets get on the relevant blockchain in the first place. If the only messages convey bitcoin, and all bitcoin originate at some level of indirection from bitcoin mining, then you have a fully closed system, and it's all fine. I can really only trade things that are on the blockchain, and for this to be useful they have to be able to somehow get there.<br />
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One possibility goes back to an older idea I had, and one that I later came to be was largely Ripple's initial idea, which is <a href="http://deansdough.blogspot.com/2019/07/free-banking.html">essentially to let each person have an asset that they can create out of thin air,</a> simply by being them. I can trade "Dean's dollars" in any quantity for anything I can persuade other people to sell me; <a href="http://deansdough.blogspot.com/2019/07/free-banking.html#190714-1">the problem is just in getting them accepted.</a>. The provenance is just me. Other people can then trade them as they will, once I have put them out there. Maybe some of my friends would be willing to accept a certain amount of Dean's dollars among themselves; widespread acceptance would probably only come to a few currencies issued by a few people who are in some sense trusted (perhaps trusted to back their currency at some ratio with some basket of off-blockchain asset). You could imagine State Street publishing a list of blockchain addresses it maintains in which it promises to keep the "currency" of each address linked to a corresponding ETF.dWjhttp://www.blogger.com/profile/12072494989829344049noreply@blogger.com0tag:blogger.com,1999:blog-1537192810536854261.post-45500758911877707022019-08-08T16:00:00.003-04:002019-08-08T16:00:51.383-04:00bond ratingsMatt Levine mentions a <a data-auth="NotApplicable" href="https://link.mail.bloombergbusiness.com/click/17721463.16444/aHR0cHM6Ly93d3cud3NqLmNvbS9hcnRpY2xlcy9pbmZsYXRlZC1ib25kLXJhdGluZ3MtaGVscGVkLXNwdXItdGhlLWZpbmFuY2lhbC1jcmlzaXMtdGhleXJlLWJhY2stMTE1NjUxOTQ5NTE/57d817393f92a424d68dafccCae1b369a">front-page Wall Street Journal article</a> in today's newsletter, and notes, interestingly, <br />
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Moody’s Corp., for instance, gave lower grades to some tranches of commercial mortgage-backed securities than its competitors did, with the result that “by 2015, issuers ‘essentially stopped soliciting our ratings’ on those slices.” And investors priced those tranches accordingly:<br />
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Investors demanded higher yields on triple-B portions of deals without Moody’s ratings than on triple-B slices that included Moody’s during 2011 to 2014, according to a Journal analysis of Commercial Mortgage Alert data. The difference was about three-tenths of a percentage point more, on average, than benchmark triple-B rated CMBS—which means it was costlier to borrow than comparably rated debt.</blockquote>
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So this looks like one more level of rationality than in what I perceive to be the conventional wisdom: in particular, the issuers do have an incentive to solicit more credible, less lenient ratings, but they don't realize (or act on) them.<a href="#190808-1" name="r190808-1">[1]</a><br />
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The rational equilibrium story you'd like to tell, provided you have a degree from the University of Chicago, is that an issuer would pay for a credible bond rating because bond buyers are risk-averse and will, on average, underpay for a bond that would be rated (say) BBB+ if it is instead unrated because they don't know that it should be rated BBB+. Because I'm in recent possession of an "ambiguity" hammer, I see an "ambiguity" nail here; "BBB+" is itself essentially a probability of default, and while <a href="https://en.wikipedia.org/wiki/Linkage_principle">one can construct purely Bayesian models with risk-averse agents in which credibly revealing additional information is of positive value to sellers</a>, I look at this and wonder whether ambiguity aversion, in which buyers don't know the right probability and are more willing to take on quantified than unquantified risks, can play an additional role.
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<a name="190808-1" href="#r190808-1">[1]</a> There's some level on which "one more level of rationality than the conventional wisdom" makes a lot of sense; this suggests as a rule of thumb that you should try to be two levels more rational than the conventional wisdom, provided you have a good idea what that is.
dWjhttp://www.blogger.com/profile/12072494989829344049noreply@blogger.com0tag:blogger.com,1999:blog-1537192810536854261.post-9119173521958770152019-08-05T20:43:00.002-04:002019-08-05T20:43:59.300-04:00money supply and the business cycleI ended my previous post with the suggestion that <a href="https://deansdough.blogspot.com/2019/07/free-banking.html">the ability to borrow be viewed as part of the money supply</a>; it's worth noting that this is even more pro-cyclical<a href="#190805-1" name="r190805-1">[1]</a> than usual measures of the money supply.
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<a name="190805-1" href="#r190805-1">[1]</a> As far as I know. Fact-checking isn't strictly opposed to the spirit of this blog, but while this is an assertion I'm making based on intuition that is less informed than most of the assertions I make here, I don't feel like trying to figure out whether it's true.
dWjhttp://www.blogger.com/profile/12072494989829344049noreply@blogger.com0tag:blogger.com,1999:blog-1537192810536854261.post-25079872689989839882019-07-14T18:34:00.001-04:002019-07-14T20:50:34.069-04:00free bankingBitcoin and, to a lesser extent, Ethereum are pretty well-known cryptocurrencies at this point; only slightly behind them in scale is something called Ripple. My understanding, though, is that Ripple started as something else, though not a <em>lot</em> different. A cryptocurrency system is essentially a system for indelibly publishing statements of the form "I Alice have 42.3 units of currency from Source X of which I hereby give 24.9 units to Bob and retain 17.3 units for myself," and I won't here go into why the numbers don't quite add up. My understanding is that Ripple collected statements of the form "I Alice owe Bob 24.9 units of currency," with some capacity for detecting cycles, so that if Bob owed Carol 24.9 or more units and Carol owed Alice 24.9 or more units those might be cancelled against each other, and if Bob wanted to transfer the debt that Alice owed him to Carol (so that now she owes Carol the money instead of owing it to Bob), there might have been a capacity for that, too.<br />
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If I'm wrong about Ripple's historical origins, I don't really care. Let's discuss such a system anyway.<br />
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The bitcoin blockchain has a mechanism by which a positive number of bitcoins actually exist — in fact, it's an important part of the way the blockchain works — but we don't really need that to be the case. As long as there are a lot of people who are each willing to lend some amount of money to each of several other people, you can run the system entirely on credit, where the total amount of currency in circulation is zero. If I'm willing to lend Bob up to 25 units, I can "sell" him a good for up to that amount of money, with his payment going into the system; I've sold it for the IOU. If Carol is willing to lend Bob up to 15 units, and has an item I wish to buy (and she wishes to sell) in exchange for 15 units worth of debt from Bob, we can use Bob's debt to mediate our exchange.<br />
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Of course, if Bob and Carol and I don't really know each other, there's an issue. If there's someone we all trust for some reason — let's call him Uncle Sam — and I (by some means or another) am owed money by <em>him</em>, then we're in a fine (and very familiar) place; I can buy things from Bob and Carol by novating to them the debt from Sam.<a href="#190714-1" name="r190714-1">[1]</a> <br />
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At this point, I've perhaps worked backward a bit; my point is that the supply of money doesn't depend on any monetary base, and certainly not any commodity (or other) backing. "Medium of exchange" is essentially created wherever credit is extended.<a href="#190714-2" name="r190714-2">[2]</a> We can, in principal, have "net cash" of zero in an economy, with every unit of currency representing the entirely unsecured liability of a private individual.<br />
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In closing, I'll note that there are many measures of "money supply", the broadest of which include commercial paper; I think it probable that there are purposes for which lines of credit, credit card credit limits, and pledgeable assets should be counted as contributing to the supply of money.
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<a name="190714-1" href="#r190714-1">[1]</a> Hyman Minsky is reported to have observed, "Anyone can create money; the problem lies in getting it accepted."<br/>
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<a name="190714-2" href="#r190714-2">[2]</a> This is more or less one of the best points that the adherents of "Modern Monetary Theory" have made.
dWjhttp://www.blogger.com/profile/12072494989829344049noreply@blogger.com0tag:blogger.com,1999:blog-1537192810536854261.post-41620289275240061992019-06-18T13:13:00.000-04:002019-06-18T13:13:30.777-04:00Facebook's stablecoin and interestPer Matt Levine, <a href="https://libra.org/en-US/about-currency-reserve/#the_reserve">Facebook is setting up a cryptocurrency backed by a variety of low-risk assets,</a> but they're not stabilizing it the way I would.<br />
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Users of Libra do not receive a return from the reserve. The reserve will be invested in low-risk assets that will yield interest over time. The revenue from this interest will first go to support the operating expenses of the association — to fund investments in the growth and development of the ecosystem, grants to nonprofit and multilateral organizations, engineering research, etc. Once that is covered, part of the remaining returns will go to pay dividends to early investors in the Libra Investment Token for their initial contributions.</blockquote>
If one were to use Libra as a unit of account, and ask what the "risk-free" interest rate in Libra would be, the answer should be more or less equal to the average return on the assets being used to back it. I would propose that instead they retain all returns in the reserve, take out a fixed fee (say 2% per year) to manage the ecosystem and pay out returns to investors, and allow the value of the coin to follow the pro-rata share of the reserve. This fixes the "risk-free" interest rate for Libra at 2% — if it takes off and becomes a significant unit of account for long-term transactions, this will increase its suitability for that purpose by eliminating interest rate risk. In particular, even if some of the currencies in the basket start to hyperinflate badly, and their interest rates go way up, the coin remains stable in a more absolute sense, and the rate at which it depreciates compared to risk-free investments is relatively unaffected.<br /><br /><b>Note 1</b>: I would like to see a fixed interest rate; I use 2% in the example, but another number might be better. It should be high enough that the costs are covered, which might be a tricky number to come up with if those costs don't scale linearly with the size of the pool; probably you should pick a conservative size and expect that the early backers may have to subsidize it while it's small. Conditional on its being "large enough", though, I'd rather it be as small as possible, though of course my money's not on the line here.<br />
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<b>Note 2</b>: If the interest rate is close to 0, and you're in a society in which "interest" is repugnant, then denominating transactions in this currency allows you to avoid the problems this creates for positive interest currencies. This note highlights that "interest" isn't some absolute economic phenomenon; it's a property of the unit of account, and in particular of its failure over time to capture the true market rate at which value at different points of time are being traded.<br />
<br />dWjhttp://www.blogger.com/profile/12072494989829344049noreply@blogger.com0