Sunday, December 08, 2013

Bitcoins and alternate currencies : some speculation

Greenspan seems to say that bitcoins are a bubble. Insofar as he is referring to them being prone to Tulip-Mania like irrationally high price rise and subsequent price fall, he is probably right. However, in claiming that they have no ‘basis’ and are hence a bubble is conceptually incorrect. This is because implicit in such a claim is another – that the ‘real’ currencies are not like this and have a more solid ‘basis’. In fact, they don’t. All modern currencies are fiat currencies. They do in fact have a stronger basis in the central bank, banking system and the home economy. However, conceptually they are no different than a widely accepted form of payment.

That is not to say that bitcoins are on their way to become an alternate currency anytime soon. However, that does bring forth an important question. How does something become a currency? Or less ambitiously, how can something like bitcoins in the modern world become a currency? (The former is too general a question and is very hard to answer. The latter is easier due to the particularization afforded by placing it in the current context.)

It boils down to development of a critical mass of individuals and organizations accepting something as a means of payment. Why they would do so is of course the next question. That has varied answers. Broadly though, I can think of the following three.
1. The (perception of) failure of the currently accepted currencies in some way – massive inflation worries is one possibility, difficulty in online payments is probably another, perception of over-regulation, lack of faith in banking system which backs most of the currency besides the central bank.
2. The opportunity to carry out some project not feasible in the current context.
3. Speculation over the wider acceptance of the new currency
The first and second motives are based in themselves. The third is a transient motive. However, the interplay among these has implications for whether something becomes a bubble and bursts or gets accepted as a real currency.

The question of critical mass is crucial. Currencies have tremendous network effect. If more and more people start accepting a currency, that in itself becomes a strong reason for even more to accept. The reverse also holds. One place where this is being played out even now is the status of Dollar as the reserve currency and the currency of choice for international trade, especially in oil. Below the critical mass, the people trading into the currency for the third motive above will quickly abandon it. With values falling, those in first two motives will also be forced to stop dealing in it.

This is where the institutional framework backing a currency and the economic interests served by it become crucial. If the currency manages to do something very useful for a sufficiently large group of people and organizations, they would try to find a way to make it work. In parallel, if the institutional framework for a currency is well developed and has a sponsor in a suitably empowered entity, it can grow.

Probably the most important element of the institutional set up is that of seigniorage. This is the privilege that comes to the ‘issuer’ of a currency, if there is one. In the gold standard currencies, there is no ‘issuer’ since everything is backed by equal value of gold. In the fiat currencies’ case, the central banks and hence their respective governments are the issuers. (Tangent: Rothbard describes brilliantly the evolution of the federal reserve in the US and the interaction between governments and central banks and monetization deficit etc.)

If the issuers get greedy, inflation ensues and can quickly become hyperinflation (Germany, Poland, Zimbabwe). I don’t know what the issuing mechanism for bitcoins is. I am sure something this obvious has already been dealt with and seigniorage hopefully taken out or made transparent. However, if and when the stature and acceptance of the currency grows, these worries might start haunting the users. It is interesting to draw a parallel with the growth of modern currencies and their convertibility into gold. Till as late as second world war, there was a constant tension between users and issuers of the currencies – the users routinely converting their currency holdings into ‘species’ (a term used for gold and silver) and issuers suspending ‘specie payment’ every now and then. 

For bitcoins, Dollar is the ‘specie’. As the users of bitcoins try to conduct transactions outside the regular users of bitcoins, they will need payment in ‘specie’. This is a crucial juncture. If the non-users of bitcoins keep insisting on payment in ‘specie’, the critical mass of bitcoin users may not grow much – although the legitimacy afforded by the notional acceptance of the bitcoins in the outside world is quite comforting for the present users to stay put. On the other hand if the non-users start to keep the bitcoins and postpone conversion, that could really provide a strong boost to the growth of bitcoins. The non-users thus become users or at least part-time users (they don’t actively transact but store bitcoins for speculative reasons.)
The case of a car dealership accepting bitcoins for payment is thus interesting. Equally interesting is the ban imposed by China onpayments using bitcoins.

The growth of capitalism and government spending in 19th century and early 20th century created the basis for the central banking and modern banking system that we know today – along with the fiat currencies that they support. The growth of internet in 21st century might be able to support a new form of currency – which is as unlike the current currencies as these current currencies were to gold back then! 

Friday, October 11, 2013

Origin of Wealth - review of part I

The title of the book - Origin of Wealth - is misleading. And that is a good thing. The origin of wealth could easily have been a history of money and wealth (not different from say ‘Ascent of Money’ – a great book but more descriptive than imaginative.) Instead it is precisely what the subtitle says – Evolution, Complexity and the Radical Remaking of Economics.

The book’s introduction talks in great detail about the failure of traditional economics and the challenges that has posed. The first chapter covers general question of how is wealth created and quickly moves on to describe economy as a complex system. The second chapter dwells on the traditional economics and its emphasis on equilibrium systems. So far nothing revolutionary and new happens. The fun starts with the third chapter entitled A Critique – Chaos and Cuban Cars. The similie is quite accurate. The basis of traditional economics seems as outdated as the Cuban cars. The experience of the Santa Fe institute dialogue is also very enlightening. It describes how natural scientists were nearly aghast at the assumption-making and theorizing of economists. The chapter goes through several “laws” of economics and describes how they don’t quite hold. It also goes on to describe why economics might have taken the ‘century long wrong turn’ by tracing the origins of this ill-fitting approach to Walras’ emphasis on using equilibrium models from half-baked theories of then available physics. The chapter ends with the coverage of what the author calls ‘misclassification of the economy’. That is apt. The Walrasian classification of an economy as a stable and equilibrium system is a gross oversimplification and fundamentally incorrect. An economy is a dynamic and non-linear and thus complex. This sets the stage of next section.

Chapter 4 is highly fascinating. It starts to get into the real complexity modeling. Although it covers a relatively simple model, it is quite illuminating. The sugarscape described in the chapter is quite an eye-opener. It talks of how markets, inequality, banking and so on emerge as properties of the system when modeled like a agent-based-system without specifying any of these things. Some steps seem like flights of fancy. However, the general tone is quite serious, believable and most importantly reproducible to anyone who bothers enough to model the sugarscape. I of course feel special affinity towards this approach since it gels well with my thinking about using agent based models and simulations to observe emergent properties rather than abstract those from intuition and black-box-like observation of the system as a whole.

Chapter 5 gets more general and still stays quite interesting. It talks about dynamics. The primary coverage is of static systems vs nonlinear systems. More importantly the idea of oscillating equillibria is discussed. Subsequently the chapter goes into the discussion of using nonlinear systems to explain economic phenomena such as business cycles. He exemplifies with the widget production case – which is itself quite interesting and hits home with the very real scenarios. The chapter also describes John Sterman’s attempt at nonlinear modeling of business cycles across industries.

Chapter 6 focuses on agents. This chapter also describes deductive learnings vs inductive learning and classifies the computer’s methodology as deductive and human ones as inductive. That is an interesting though known distinction. It still is brought home beautifully when the author notes that while Deep Blue can play chess as well as Gary Kasparov, the latter can also tie his shoelaces unlike the former. There are some things or skills which are very easily accessible to inductive learning but are very difficult for deductive thinking. Pattern recognition is a prime example. Human beings can reasonably read decently written hand-writing without much error and difficulty. Computers find it extremely hard to do so and have to go through a laborious process to get there – and still with errors.

Traditional economics assumes that human beings possess infinite deductive capacity and do not need inductive learning since they are already perfect in their decision making. The author then proposes that complexity economics would take the reverse view and try to model individuals as agents with inductive machinery and limited deductive powers – but a decent learning program. The frog example is quite illustrative in this regard. Subsequently the chapter goes through a more detailed agent based modeling of stock markets and describes how the simulation at Santa Fe institute led to indicating a close to real life stock market with the attendant volatility, booms and busts and so on. It boils down not to random noise but competing beliefs in the actors’ minds – different hypotheses about what makes money. The economy by extension can also be modeled using boundedly rational agent with inductive skills and competing hypotheses about how to achieve their goals.

The subsequent chapters cover emergence and evolution and are equally fascinating. I will cover them in another blog. The second part on evolution of physical and social technologies starts to look lot less exhilirating conceptually - so i might cover it briefly later.

Saturday, May 11, 2013

Evolution of institutions in human society

Institutions in human society can evolve in two ways.
For one, transactions which start to repeat get recognized by the relevant actors as conventions. Over time these conventions may give rise to more rigid institutions. This is emergent variety of the evolution of institutions.
Secondly, someone with coercive power (generally a state but in a narrower settings can be corporate head office or military general) imposes set of rules. These rules are either accepted by the recipients or rejected. When accepted they become institutionalized. (Even when rejected there might be a counter-institution that may develop in some cases.) The question of whether these rules are imposed on account of soft paternalism or vested interests or general lunacy (or idiosyncrasy) is immaterial. The common thread is that they are imposed from outside. They may be ‘sold’ to the recipients by their proponents – and if they are, it may be with the true intent or with a façade or some combination. It is also possible that the proponents are not all on the same page regarding the intent and that fact itself drives how the rules are sold.

In either case, once an institution evolves into more rigid form, it starts to guide/restrict behavior (that is whole purpose of any institution.) Since it is the transactions arising out of the behavior that gives rise to institutions in the first place, the evolution of subsequent institutions is then affected by the combination of transactions and current institutions. This also includes the modifications in the institutions.
Thus we come to the reflexive relationship between transactions of actors and the institutions that evolve out of them and guide their subsequent evolution.

It can be likened to the interrelationship between water and the ground shaped by it. The water has some tendencies, which are inherent to it. The ground has some starting structure. The movement of water then alters the ground in some ways. The evolved structure of the ground itself starts to affect subsequent behavior of water (with the same tendencies). The structure of the ground at any given point of time is hence an outcome of a complex process of interaction between the ground and the water.

In general self-emergent institutions tend to be solving some felt need. The imposed institutions may not necessarily do so. The ideological variety on paper at least aspires to address some need. The vested interests driven one will typically find a façade of a need to address.

How real the need is and how long it lasts will have an important bearing on the success or failure of the institution. However, the strength of the sponsor of the institution also has an equally important bearing on the success. It is entirely possible that a very naturally emergent institution was so strongly opposed by a powerful opponent that it failed to evolve. Its time having gone and it being replaced by something else, it may never evolve again. (some standards in the internet space are an example). On the other hand, it is possible that some institution exists primarily because its sponsor was so powerful and purposeful. (the continued presence of autocratic governments in middle east are an example). Most of the cases will of course be of an intermediate variety. Here the success of an institution will be a combination of inherent coherence of the institution with its context, its appeal to the audience and the strength of its sponsor.

Path of evolution
The other noteworthy aspect of this phenomenon is that the path of evolution of the institutions is not unique. Since the stimuli from transactions are partially stable and partially random, it is hard to imagine that the institutional evolution is unique and will flow from the starting point of the society and the tendencies of people.

Who builds them then?
Also noteworthy is the inference that the institution building is open to vested interests, soft paternalists/ideologues and the society itself. At all times some combination of these are trying to build institutions to their ends. The vested interests have selfish ends, the ideologues/soft paternalists have ideological ends and the society itself has no stated and coordinated goals (its behavior as a collective is emergent).

Who succeeds at what times is not a foregone conclusion. In fact these forces may be allying with each other as also opposing each other from time to time.
E.g. the "Nudge" theorists are trying to work against the natural dispositions of people which are supposed to be in their bad interest. Sometimes vested interests may have a common agenda in exploiting these natural dispositions (case in point is fatty food). So we have the ideologues vs vested interests plus society. At other times, some other combination may be at loggerheads. Sometimes it might boil down to just two out of these three participants.

Sunday, May 05, 2013

The idea of emergent phenomena and downward causation

Recently I came across some things written on emergent phenomena. While I was searching for “emergence” as a theme and thus was not enlightened about emergence itself, I did come across something interesting in the same domain. This is called downward causation.

Downward causation is when the higher order phenomenon exerts influence on its constituents. This effect, if it can be inferred from the structure of the system is called weak downward causation and if not, strong downward causation. The weak downward causation is relatively simple idea – the parts make the whole and the whole in turn affects the parts; and that the effects of whole on parts are integral to the coming together of parts. The strong downward causation is a much more powerful idea – since in this case the parts do make the whole but it starts to influence parts in ways not foreseeable from the parts alone. A set of new phenomena hence emerges at the level of the whole.

Let us work with an example. If a lot of people walking on a rope bridge decide for some reason to move towards its one side, the rope bridge will tilt to that side and could potentially trip. The whole in this case is influenced by its parts and influences the parts in turn. The fact that the rope bridge turns over is neither unpredictable nor surprising. On the other hand, in equity markets, the stocks constituting an index start to move in a similar direction, they make the index move in that direction. Now some market participants start to get influenced by the overall movement of the index in one direction and that guides their actions regarding the constituents of the index. In this case, the parts move the whole, the whole starts to influence the parts in unpredictable ways.

Another example is the economy. Let us specifically refer to what is called the paradox of thrift. While individually saving is considered a virtue, if everyone starts to save more in an economy, the total and per capita income is bound to fall. In a mathematical identity sense, this is weak form of downward causation since the behavior of the system can be predicted from the parts and their interconnections. Where it may start to become strong form downward causation is if the very act of falling incomes prompts people to save even more thus creating a vicious circle of greater savings and lesser incomes.

The presence of downward causation raises a fundamental epistemological question as regard our methods of enquiry in sciences hard and soft. The reductionist and analytical approach is likely to hit its bounds when dealing with real life due to presence of emergence and downward causation. Stated simply, knowing how electrons and molecules behave will still not tell us how systems like whether evolve and knowing how individuals react to economic incentives will not tell us how the economy will evolve. Granted that the study of parts is a crucial first step in most enquiries. The almost exclusive focus on reductionist methods is quite a limiting feature of our knowledge building endeavour though. In general the reductionist conclusions are aggregated clumsily into larger wholes (as in economics) or left to statistical techniques (e.g. thermodynamics and gas theory) or simply left alone (particle physics vs real objects).

Fritjof Capra draws attention to this in his emphasis on synthetic thinking besides analytical thinking in the pursuit of knowledge. As we grapple with the complexities of real life and real system, and armed with the computational power unheard of just 20 years ago, I suppose we can start to build models of emergent phenomena and downward causation.

Sunday, March 03, 2013

Random symmetry breaking and its continuation through human beings

In the book The Theories of Everything, John D Barrow describes a profound concept. It is called random symmetry breaking. It is quite a mouthful. The essence is simple though.

We believe (for good reason and with sufficient empirical comfort) that there are laws of nature. However, these laws are more like constraints rather than specific directions regarding the evolution of the universe - on any scale. To take an example, when the glass bowl falls on the floor, it breaks and its pieces fly in all sorts of directions. The law of gravitation (actually the curved space-time geometry because of earth's mass, in an Einsteinian universe, but for the example, law of gravity will be fine) will dictate that the bowl when unsupported should fall to the ground. Some complex laws of material physics will govern how much of impact can the material (glass in this case) handle and what happens when the impact exceeds that limit. Hence with sufficient comfort we can be sure that the bowl will break. The laws of nature as we know them will tell us as much. They won't however tell us how many pieces the bowl will break into and where they would fly and land.

We are not sure but quite certain that the laws governing these are not only unknown to us, but they don't exist. Stated simply, how the bowl break and where the pieces fly to are not governed by laws. What is it governed by then. That is where random symmetry breaking comes into picture. It tells us that some phenomena are random - purely so. They are not governed by laws. Other examples include which way the additional grain on a pile of sand goes, where the ball in the roulette settles and so on.

If you pause for a while and take a look around, you will realize that when it comes to real life, more is explained by random symmetry breaking or plain random occurrences than by laws of nature. The randomness drives the path of evolution of the universe lot more than laws. The laws can be likened to the guardians (a la Jedi in star wars) who watch out for the general structure of the universe. The specifics are left to the population. Random events and causes are the population while laws are these guardians. The laws are all powerful, but they do not determine singlehandedly how the universe evolves.

Nowhere is the phenomenon of randomness as useful as it is in biological evolution. The very basis of evolution is random exchange of genes among the mating members of a species - thus creating a population with a wide variety of attributes. Some of these are useful for survival and those individuals live to see another day and procreate. Thus the useful attributes percolate down the generations and harmful ones get eliminated. There is no design. Simply a lot of randomness thrown at the big bad world which then reacts to the species and kills all but the best. Over a period of time, majority of the species is "best" - so much so that  some members of a relatively more evolved species (but with still a limited imagination) have to invent the concept of an omnipotent deity to deal with the elegance of the outcome!! (for those who did not get the sarcasm, i am referring to human beings, inventing god)

Outside evolution also, random symmetry breaking continues to shape the evolution of physical world. This post is about its effects in the mental world of humans and its evolution. I have come to believe that the way we form beliefs and ideas is quite prone to randomness. Very many different stimuli constantly vie with each other to grab our attention. We like some and dislike others. However, an even more important thing is that we are exposed to some and not others. Thus the subset we like is already a subset of what we are exposed to. While we may choose to like or dislike something, it is generally hard to control what we are exposed to and what we are not. (Trust me, it is hard... and nature be my witness, i have tried!). What we are then is a product of a fairly random factors affecting our mental make-up, attitudes and thoughts.

It goes further.

I was reading up on habit formation. The sense i got through the limited understanding i could build in a short time is that we are essentially dopamine addicts - not very different from lab rats. The way we form habits is quite similar to how rats do it. That is not so bad. Habit formation is about efficient use of mental resources to automate some activity. However, when i studied the neurology of habit formation, i came across the mechanisms of some neural pathways becoming more active through constantly higher potential than the rest - thus causing them to fire quickly and release the reward in the brain (i.e. dopamine). We are in a way slaves to our neural pathways. Maybe not quite slaves. We are probably more like subjects of a king namely the structure of our neurons. We can affect how that structure evolves but we cannot change it overnight. We  are governed by it whether we like it or not.

How do these pathways get formed? Some are through willful actions of the individuals. Many others are simply responses to stimuli - and we are thus back at random symmetry breaking. The random stimuli that we are routinely exposed to make us react. These reactions affect the neural structure without our active control - albeit to a small degree. But all these small effects add up and soon we are evolving in two parallel tracks - one through our willful actions and one through random stimuli.

It is not always for the worse though. Random stimuli and our evolution in reaction to them is often more useful than willful action. But that still leaves the discomfort as regards free will. We do not even evolve with our only free will. In fact, what we consider our free will is itself a combination of some 'genuine' free will and some imposition from the neural circuitry of our (specific and respective) brains.

To that extent, we are part of the vast continuation of random symmetry breaking that is going on in the universe. We interfere with it on and off but the general direction is still governed by the flow of RSB!

Saturday, January 19, 2013

The Redundancy of Issuance of Government Debt

Governments have been issuing debt since the 1693 issue of government bonds by Bank of England to fund England's war against the French. In the times when governments did not have seigniorage it made sense to borrow. After all the government was like any other entity such as firms or trusts. In the era of fiat money though, government debt issuance is redundant.
Here's why. The money that we take for granted in the day to day operations of the economy is not unicolored. There is so-called high powered money (HPM) and there is credit money. The most familiar form of HPM is cash (with Gandhiji on it!). However, there are other forms of HPM - probably more relevant in the modern economy. These are governments account balances with commercial banks and commercial banks' deposits with the central bank (RBI in case of India). Basically, all of government's transactions - capital or P&L - are settled in HPM of some form or other.
Credit money on the other hand is the money stock created by banks on the basis of their lending activities. Banks are constrained in their lending by the capital adequacy ratio. To the extent that they do lend though, they in effect create credit money. This money is used by all of us for transactions. Unless we cash out our deposits, most of our economic activities remain in the domain of credit money. Banks settle transactions amongst themselves using HPM and through the settlement mechanism offered by the central bank. However, insofar as the transactions are between two accounts of the same bank, there is no settlement and both account-holders are dealing in purely credit money of that bank.
When we pay taxes or buy government securities in the primary market or undertake any activity that requires us to pay some money to the government, the bank where we hold an account settles the transaction using HPM. In the mirror image, when the government pays for goods and services to private entities, the banks where the recipients hold accounts get HPM. In general the government receives as well as pays money around the year and the HPM balances with banks keep moving up and down within a band.
However, in most modern economies, banks are allowed to borrow HPM from the central bank - in India this is the repo mechanism. Banks borrow HPM by keeping government securities as a collateral. They are also allowed to keep money with central bank. In India this is called reverse repo when banks keep money with RBI. This is allowed to smoothen the HPM flows within the economy as government buys and taxes, borrows and repays and banks also settle accounts amongst themselves besides with government.

Now back to issuance of government debt. Think about what happens when government issues fresh debt. Let us assume for now that banks have no net borrowing from the central bank and all the HPM they have is already being used. With the issuance of debt monies have to be paid by private individuals buying the bonds to the government. They write cheques from their bank accounts. These banks as mentioned above have to settle this transaction with the government in HPM. In this case they have no spare HPM. Hence they will go and borrow it from the central bank at the repo rate. The central bank then credits the accounts of these banks with it with HPM. This HPM is then given to the government - through the government's account with the central bank. The government could have avoided the entire process and simply credited the accounts of individuals it wanted to pay (without "borrowing" elsewhere, thus creating new money). That amounts to "money-printing". This money is created out of thin air. However, one would notice that the HPM required to settle the government borrowing is also coming out of thin air - through banks borrowing afresh from central bank. M1 (same as HPM) has grown by the same amount in both cases. The issuance of debt has merely added additional tradable financial securities in the economy.

Since banks pay interest as per the repo rate to the central bank, the interest payment from government is mostly sent back to it through the interest payment on repo borrowing by banks. The process just ends up creating more transactions in a circle.

Would the permit to print money not let lose the scourge of hyperinflation? This is where the behavioral implications might seem to suggest some relevance for issuance of debt after all. When the government is printing money, it can start to abuse its powers (a la Second Wiemar republic). When the government is borrowing, the fact that this creates a longer lasting liability might deter it from doing so indefinitely. There could also be legislation about debt ceiling like one in US. The reality of course is that the liability created by the government is matched by the asset in the form of lending by central bank to commercial banks for HPM of the same amount - thus leading to no new net liability.

Money printing and debt issuance by government are effectively the same. There was a difference in the times of gold-backed currencies. HPM could not be borrowed indefinitely and the government's borrowing came out of a finite pot of savings stock limited ultimately by the amount of gold in the central bank lockers. In that context, money printing was anyway not on - beyond what was backed by real gold. In case of fiat currencies, government borrowing is same as printing money.

It would seem that the concepts of debt-issuance, money multiplier, money supply, crowding out are built on the foundation of a pre-1971 monetary system which no longer exists. The fiat money based monetary system of today's requires a completely new approach.