This is scary as hell...

On the 2010 food crisis. It seems that all the economists that I have any respect for are universally predicting Armageddon of some sort coming soon. The imbalances in the world economy are currently so huge and are absolutely not being corrected. Something is almost certain to go kaboom (a Minsky moment?) in the not too distant future but its rather tricky to figure out exactly what will be the trigger. An upcoming food crisis could just do the trick.

Nauseating video...

In the light of my recent posts about why the banking sector is far too big, I suggest this man should be be fired (perhaps out of a cannon).

"The banking sector employs 1.3 million people"... What a waste of manpower!

Great explanation of how deregulation and fraud contributed to the crisis.

Pensions madness

Just saw this article on the BBC news website - business section. It stated that 39% of UK household wealth was in "pensions assets". This is crazy. The entire concept of "pensions assets" is absurd and unnecessary, read all the way to the end of this article if you need convincing of that.

Of course the banks are making a massive sums from "managing" this 39% of our wealth.

Steve Keen being interviewed on the Keiser Report.

If only all economics programs were this intelligent...

The interview starts about twelve and a half minutes in to the film.

Deflation and inflation at the same time.

It seems that some of my ideas are coming together...

Following on from my last post about how the banking sector make most of their money from pseudo-investments. It fits in rather neatly with my earlier post about how you could have inflation and deflation at the same time. I suspect that the total money supply is decreasing because of the reduction in price of pseudo investments. Governments (encouraged by the banks) are attempting to expand the money supply enough to prop up the pseudo-investment market, but because people are newly reluctant to get involved in the pseudo-investments, the effect of this new money is simply to cause inflation in goods which are part of "real" trade.

Why are bankers so rich?

"Why are bankers so rich?" was actually just about the first question I wanted to answer when I started studying economics. During my studies I got an inkling of an idea here and an inkling there, but I was never 100% convinced that I'd really cracked the question. That is until about an hour ago, when it came to me in a flash. I am now completely convinced I have the right answer. If you are a banker, you might like to look away now, you're not going to come out of this well.

My answer builds upon key concepts, many of which I have discussed in earlier blog entries. In particular:

"Money" does not mirror barter very well.
Most "savings" are just agreements between people.
There is a pretense at the heart of our pensions system.
Rational exuberance combined with Austrian School Business Cycle Theory.

When you put all these concepts together you should realise that a far far too large a fraction of money today circulates for the purposes of "investment". Way larger than could possibly be accounted for by the true needs of investment. Think about this for a second...

What is investment really?

I'd suggest that investment is things like

• Borrowing money to build new factories.
• Borrowing money to build new machines that make stuff.
• Borrowing money to pay employees in the early stages of a new company before it starts to make a profit.
• Borrowing money to research new manufacturing processes.

Now we do need plenty of that kind of thing going on, but how much is plenty? What fraction of mankind's manpower should go into that? 10%? 20%? even maybe 30%... but obviously there comes a point where it becomes too much. After all, at some point someone has to go and manufacture all the lovely stuff that can come about after the "investment". If 95% of mankind's efforts were all "investment", then almost nothing would ever get made! Personally I think that something like 10-15% is in the right ballpark. Now if 10-15% of mankind's work was involved in investment, and if we had barter system in place, then you would expect about 15% of bartering transactions to be concerned with this investing. However "money" does not reflect barter very well. Strange things can happen with "money" see here for example.

Now lets have a think about things which are non-investments or pseudo-investments (none of these activities significantly enhance mankind's ability to make stuff):

• Borrowing money to speculate in the price of companies*.
• Borrowing money to speculate on the price of housing.
• Borrowing money to speculate on the price of commodities.
• Lending money to someone who wants to have a new car/kitchen/holiday without having saved up to buy it.

* Now you may say that when an investor buys shares in a company he is putting real money into the company, the company gets the money and will often spend it on new machinery etc. But note that it is only the first purchase of shares that has this effect. All further exchanges of shares give nothing whatsoever to the original company and most (99%?) share transactions that go on in a stock exchange are secondary transactions.

Now lets think about what happens in our financial system.

Step 1. Politicians worldwide continuously pronounce "We must have more investment in our economy - lets keep interest rates low".
Step 2. We have a charade of a pensions system (read my blog entry) in which great chunks of society's money circulates for the purposes of "saving for our retirements".
Step 3. Our fractional reserve banking system allows money to be created to follow and exacerbate any speculative bubbles.
Step 4. People wanting "real" investments (potential factory owners and the like) have to compete with unproductive bubble investments for money. If the unproductive bubble investments are rising in value fast then it actually becomes hard to get real investments happening.... the politicians will then suggest lowering interest rates... which of course just feeds the bubble and does not solve the lack of "real" investments problem.

The upshot of these steps is that the vast majority of money transactions in our society take place for the purposes of "investing" in non-investments! Any amount at all would be a bad thing, but to have the majority of our money doing this is nothing short of a disaster. Now consider who is actually doing these transactions, and the answer is the banks. And of course they have to take their fees for their expertise managing these pseudo-investments!

That's why the banking sector is so bloated.

We do need a banking sector for organizing "real" investments. But their work in organizing pseudo-investments is a sham. People think that because the bankers are so rich, that they must be doing something really valuable. But for their pseudo-investment work this is not the case. The bankers are getting rich in just the same way as the mafia get rich. They are contributing nothing whilst taking our money.

The solution is to take action to reduce/eliminate pseudo investment. It should be illegal to borrow to speculate. The pensions system should be redesigned as described here.

The diagram below illustrates the situation. The paired arrows in each box represent money flowing back an forth in relation to that sector. The arrows underneath the boxes show the sums going to the banking sector. Notice that exchanges of money in ordinary trade results in very little going to the banks. Indeed if exchanges are carried out in cash, then the banks get zero, and even when debit cards are used the banks take only pennies for each transaction. In the case of "Real investments" though, the banks take a much bigger cut of the money flows, after all they have lent the people this money and they want their interest and fees for their expertise in arranging these loans (I have no objection to the banking sector collecting this particular flow of money). In a healthy economy there should be no other boxes in the diagram, unfortunately there is a huge third box called pseudo-investments, and again the banks charge interest and fees on these flows. The whole third box is a colossal waste of effort which achieves nothing other than providing a massive flow of money to bankers. And what's worse, a notion wastes the potentially useful manpower of the bankers, who would be better employed actually making stuff!

To what degree to the banks inflate the monetary base?

Click on the image for a full size version.

Here is something I have been pondering... is the money supply in a semi-continuous state of being at the maximum allowed by fractional reserve banking? Perhaps only becoming reduced during the hangover of an asset bubble bursting? I am still researching this question, but in the mean time here is a graph I made showing M3/M0 and M3/M1 for the US dollar from 1959. Irritatingly the US have chosen to keep M3 under wraps in recent years, I wonder why?

It looks to me that the more significant figure is the M3/M1 ratio, that would appear to correlate better with the degree of monetary madness there is in the world. The M3/currency (M0) ratio appears to not to have any remarkable value, whereas M3/M1 is clearly headed towards uncharted territory.

The graph was created using the data at the bottom of this wikipedia page.

Derivatives...

I am trying to get my head around the hundreds of trillions in derivatives that are still out there and came across the following, remarkably clear, YouTube video. I have no idea why its only had 4000 hits.



I have just discovered that this vid was in fact edited down from a 40 minute version here.

How does the US make this transition?

I'm repeating myself from my last post but, you hear people talking about "export based" economies as if it were a permanent condition. Presumably people who talk about export based economies assume that countries that appear to be "export based" will remain "export based" forever. Strangely you don't often hear about "import based" economies! Its obviously nonsensical! No country could be an "import based" economy forever! I will suggest a translation of these terms.

• Export based economy = Country temporarily giving goods to other countries in return for IOU's.
• Import based economy = Country temporarily receiving goods from other countries that they will have to fully pay back (in goods) in the long term.

So in the long term the US will have to pay China back in goods. The question is how can this happen? How can the US economy make a transition to a state where its populous are busy making stuff to give to China? Presumably the goods will gave to be better value than the ones the Chinese make for themselves otherwise why would the Chinese buy them? Presumably this can not happen until the wages paid for a certain level of production in the US is lower than the wages paid for that same level of production in China. How's that going to happen?

I see a lot of pain ahead. This crisis sure as hell isn't over.

China doing the right thing

I've always thought it was strange when you see people say that this or that country's economy is "based on exports", as if that was just "the kind of thing they're in to", something fundamental, to do with their character. I think to myself... "hang on a second, that means that they make a load of stuff and give it to other people!". To me its just a temporary thing that a country can do for a while, building up I.O.U's from other countries to use on a rainy day. There is no way any country would or should do this indefinitely. In this crisis some people are looking at china saying "how sad, their 'export based' economy is going to be devastated because the West is not buying any more". I would say well that's rubbish. Its no problem at all. They just have to stop making stuff to give to foreigners and consume it themselves instead. Now one problem with this scenario is that if the Chinese are worried about the future they will been keen to save and reluctant to spend. But there is a cure - you see up until now China has not had much of a system of social security so the Chinese were very keen to save for their old age or if they lost their jobs. But now China is starting to build a "social safety net". This will have an enormous effect of the savings rates. After all why save so much for the future if the government will look after you if things go wrong. This is exactly the right thing to do. I can see China's economy marching ahead in the next decade or so even if America goes down the plug hole (which it might!).

Here's a nice video on the subject

:

Bailing out the Titanic with a thimble..

I have recently been hatching a new theory...

Steve keen has likened the process of attempting to keep up the money supply to bailing out the titanic with a thimble. This is part of his argument for massive deflation.

Well I'm not so sure about it being the titanic that needs to be bailed out. And I'll illustrate it with a thought experiment. Imagine a simple primitive society with no banking, only gold coins used for exchange. People in this society spend their money on one of two things 1. Food. 2. Diamonds. The food they eat and the diamonds they like to wear as jewellery. They can make all the food they need with relative ease and so on average, on any given day, 90% of the coins in existence change hands diamond trading and only 10% change hands trading food. Now one day, God is looking down on this land and decides to do a monetary experiment on the people. He suddenly makes all the diamonds disappear, and at the same time makes 90% of the coins disappear (he does this evenly over the entire population in proportion to how many coins each person had in the first place). God then wonders, what will happen to the price of food? I suggest that the answer just may be "noting at all". The money supply might have shrunk by a factor of ten, but then the stuff they spend their money on has correspondingly shrunk at the same time.

Now I know that this fairy tale may have all sorts of problems with it in the details, but I just wonder if this type of phenomena might be going on to some degree in the real world right now. Maybe the diamonds could correspond to some types of (that mountain of) derivatives that have gone out of fashion. If this is the case then the reduction in some countries money supply may just be "diamonds and coins" disappearing at the same time, leaving the money available for the "food" (or should I say "everything else which are not derivatives") relatively unaltered. Well at least not nearly as altered as the reduction in overall money supply would suggest.

If I'm right then you may see the price of goods in the shops rise while the money supply shrinks... Come to think of it I don't know whether that scenario would be called inflation or deflation.... maybe there's no term for it. Perhaps it just needs to be called prices-rising-while-money-supply-shrinks.

The value of money - someone else pondering the same question.

Following on from my earlier posts about the value (purchasing power) of money here and here. I have discovered that Ludvig von Mises, one of the founders of the "Austrian" school of economics had pondered the same question. i.e. what determines the purchases power of a purely fiat (not backed by gold or any other asset) currency. To answer this question Mises proposed his "regression theory". This theory relies upon the assumption that all currencies, even fiat ones, were at some earlier time, non fiat, i.e. they were backed by some commodity. Mises suggested (a rather clumsy theory in my opinion) that you can trace the value of a fiat currency through time back to the point where it was not fiat and therefore derive the purchasing power of a fiat currency in modern times. Mises also thought that if a new pure fiat currency as suddenly hoist upon a society then its value could not be determined for the following reason: Imagine day one of the new fiat currency - you are a shop keeper selling some product, say a television set - what on earth do you charge?... Lets say that in the days of the old currency a television set usually sold for about ten times the cost of a kettle. You could see what kettles were selling for and then charge ten times as much as that, but because its day one of the new currency the people selling the kettles also have no idea what to charge. This is an apparent impasse and Mises assumed the situation was insoluble.

This situation is rather like saying if X depends on Y and Y depends on X then you can never find out what X and Y are. For example if we say:

X = 2 times Y
and
Y = X / 2

Then this arrangement does not find a specific X and Y. There are infinitely many X's and Y's that fit. I guess this is why Mises thought that the problem was insoluble. But this is where he missed an opportunity to make a less clumsy version of his theory because the X and Y problem is not always insoluble. Consider the statements

X = sqrt(Y)
and
Y = sqrt(X)

I wrote a little computer program to demonstrate what happens when you start off with some arbitrarily chosen values for X and Y.

XY_demonstration()
{
  a = 12;
  b = 7;

  for (i = 1;i < 10;i++)
  {
    a = sqrt(b);
    b = sqrt(a);
    print ("a = %f b = %f\n",a,b);
  }
} 

The output when you run the program is as follows:

a = 2.6458 b = 1.6266
a = 1.2754 b = 1.1293
a = 1.0627 b = 1.0309
a = 1.0153 b = 1.0076
a = 1.0038 b = 1.0019
a = 1.0010 b = 1.0005
a = 1.0002 b = 1.0001
a = 1.0001 b = 1.0000
a = 1.0000 b = 1.0000

Now x=1 and Y = 1 is the correct (and only) solution!

What this demonstrates is that even if you start out with the wrong values, the correct values can quickly emerge all by themselves. So in the case of the TV seller and the Kettle seller, as long as someone can be persuaded to have a stab at an initial selling price and as long as the selling price is viewable to all around, then this can give other people a benchmark and people can make more informed guesses as to their prices.

I need to add a bit of detail here. When the TV seller sets his price to say 1000 units of the new currency the Kettle seller can not immediately conclude that he should be selling his kettles for exactly 100 units. It may be that the TV's price is too cheap, or perhaps too expensive. What the Kettle seller should do is wait a while and see what happens. If a big crowd of people instantly form outside the TV shop scrambling to buy every TV in sight then the kettle seller can deduce that perhaps the price was too low and he may try selling his kettles for 200 units. However if the TV's went unsold for months then the kettle seller can deduce that the price was too high and he may try selling his kettles for 50 units. Obviously everyone will be carefully watching everyone else. The key thing they are trying to arrange is for their typical time-to-sale to be about right. Too short and that may indicate that your price is too low, too long (incurring storage costs) and that tells you your prices are too high.

Deriving the purchasing power of a new fiat currency is thus not impossible.

Great news about the US coming out of recession...?

I've watched pretty much every single Peter Schiff video on you tube. They're all good, but I thought that yesterdays offering was so important that I would post it here.

The value of money. A computer simulation.

Back in March I wrote a blog entry on the value of money in which I suggested a mechanism whereby it may be possible to write a computer simulation of an economy in which the value of money could be discovered. Well I finally have some results...

But first of all I should be clear about exactly what problem I am trying to solve, so I shall present the following conundrum. Imagine a very simple society in which there is only one commodity: sandwiches. Everyone in the land grows the ingredients for their sandwiches in their gardens. Often they will exchange sandwiches with their neighbors just for variety. There is no money in this society only barter. But then one day the king of the land says "I've just invented something I'm going to call money. It consists of metal coins called shekels. I will give everyone in the land 1000 shekels and from now on bartering is banned. All exchanges must be via the medium of exchanging shekels. What's more, nobody is allowed to eat their own sandwiches." The question now is: how many shekels will a sandwich cost? It may well be that on day one, people will not have a clue and all sorts of silly prices may get paid... but presumably over time the price will gravitate towards a certain value. What will that value be? I suspect that no economist (to date) has ever answered this question.

I actually thought of this problem around ten years ago but only recently did I work out that it was soluble via a computer simulation and now I've finally written it and tweaked the many parameters such that I get a stable price.

What I'd like to do now is publish this work, but I am not in a position to do this on my own. My academic credentials (in the field of economics) are simply not good enough, and I am not currently working in an academic institution. So I am seeking a partner.

I shall publish more information about my simulations at a later date. I may even make the source code public domain. By the way, there is no reason the simulation could not be expanded to incorporate multiple commodities, lending, banking and many other features to make it more accurately reflect the real world.

Would you buy US government bonds?

This chart, the "dollar index", shows the value of the dollar verses a basket of other currencies. Presumably at some point people/institutions/foreign governments are going to refuse to buy US government bonds unless the interest offered on them is high enough to compensate for the depreciating dollar. And when that happens, the US is in one hell of a lot of trouble.

Dow hits 10,000 - is that good?

The recent rise is the Dow may look to some like signs that this crisis is coming to an end and that "green shoots" are growing everywhere. But first of all it should be pointed out that the rise in the Dow over the past year has been matched by an almost equal drop in the value of the dollar (as measured against a basket of other currencies - the "dollar index").

Dow 1 year ago: 8852
Dow today: 9995
Change: 12.9% (lets open the champagne!)

Dollar index 1 year ago: 82.4
Dollar index today: 75.5
Change: -8.4% (oops!)

Dow as priced in foreign currencies 1 year ago: 729,400
Dow as priced in foreign currencies today: 754,600
Change: 3.4% (better put that champagne away...)

Personally I suspect that even this modest 3.4% real rise in the Dow, owes more to irrational/rational exuberance than anything else.

Money as Debt II

The following movie fixes some important errors in the original.

          Money as Debt II.

We won't see major fast deflation in the UK or US

The inflation deflation issue is really starting to drive me crazy. My favorite economic commentators seem divided on the issue. Steve Keen, Karl Denninger, Michael Shedlock and Max Keiser are all saying that there will be deflation while Peter Schiff and Mark Faber are still insisting on hyperinflation. Ultimately it will be down to politics because the politicians are in charge of the printing presses and there is no limit to how much can be printed. Certainly of the government did nothing then there would be massive sharp deflation. So one could argue that on the spectrum from massive deflation to massive inflation, almost anything is possible. But I'm going to stick my neck out here and rule out a section of the spectrum: Substantial fast deflation is very unlikely. The reason I have come to this conclusion is twofold: Firstly if significant deflation were to be allowed then too many people would be unable to make their mortgage repayments. This would lead to an outcry so large that politicians would immediately be forced to create more money. Secondly, the government's debt repayments would effectively be giving too much away. The numerical ammount that must be paid to existing holders of government bonds is fixed, this means that if we had deflation then each dollar that the US government paid out would become dramatically more valuable in terms of US goods and services.

Please note that at the moment I am not ruling out any other part of the spectrum, there could indeed be deflation, but if that happened then it would be a very long slow drawn out process like in Japan.

Free trade and Austrian economics

I have a lot of time for Austrian School economics (AE). Peter Schiff (an Austrian) is one of my all time favorite economists. Austrians believe that the free market sorts out a great many economic problems all by itself, both to the benefit of workers and bosses. From what I have read so far I have realized that there are a surprising number of areas where this appears true. Many more areas than I had assumed before analyzing in detail.

Unfortunately it appears that because this principle is true very often, many Austrians have taken the intellectual leap to assuming that it is absolutely 100% always true. Even to the extent that their answer to all economic problems is "The government should do nothing at all". I firmly disagree with this position and developed the following thought experiment to argue that an AE based economy should not "do noting at all" when faced with a question of whether to control free trade with other countries:

I get the impression that a large part of AE is based on the premise that if A sells B product X then that proves that both sides are happy with the deal. But that's only true at the precise moment of exchange. It may be that B finds out that the product X, wrapped in the shiny paper, breaks after a few days and he wishes he had never purchased it in the first place. Now Austrians then say that if B was disappointed with X then A gets a bad reputation and so the system gradually "fixes" itself. But that's only true if there is a reasonable number of trials of purchasing X from A. But with a big trade imbalance it seems that the side that builds up the pile of IOU's does not really get to have many "trials" to see what they're worth...

Imagine there are just two countries in the world. One base on AE the other is rather like America. In the AE country, people like to save for the future. Oil may be running out, global warming may be coming, people are aging... etc etc, they better save for the future. One way to save for the future is to consume less than you make, sell the excess to the other country in return for IOU's and store your IOU's for the future. After all, when the hard times come they can always cash in their IOU's. Meanwhile the other country (USA) is rather short sighted - their government are interfering with the market, the national philosophy is spend spend spend. They see that this neighboring AE country is willing to swap their real produce for IOU's and they take full advantage. Both economies will gradually become skewed towards this arrangement. The USA will become full of shopping malls and have few factories. This may go on for a few decades. Both countries appear to be doing fine, the people in both countries seem fully employed (the Americans in shops, the AE country in factories). Now fast forward a few decades and some hard times hit the AE country. Oil shortages hamper production. The people are getting poorer... but never mind, they have the big pile of American IOU's. They can make up for their shortfall of produce by buying some from the Americans. But as soon as they start spending their IOU's on American goods the (now very few) American factories quickly reach full capacity and their prices will shoot up. This effectively slashes the value of the IOU's.... Product X, wrapped in the shiny paper, has broken..... Maybe the leaders in the AE country should have seen this coming and taken some kind of evasive action rather than doing "nothing at all".

Bank of england answers questions on Q.E.

The deputy governor of the Bank of England answers questions submitted by the public about quantitative easing here.

Social security - a disagreement with Peter Schiff

I just saw this YouTube video in which Peter Schiff, Max Kaiser, Ron Paul all criticized the US social security system as a Ponzi scheme. Now I agree that it is a Ponzi scheme - but that's not necessarily bad! And here's why...

First of all I will describe a bad Ponzi scheme and then explain how a slight tweak can make it good.

Imagine I set up a financial institution or "retirement club" for people on average earnings. My advertising states - "save 20% of your income with us for 40 years, then on retirement we'll pay out a 'pension' which will have grown in line with national average earnings". Say I limit the club to exactly 1000 members. During the initial 40 years I need not invest a single cent of the money that was coming in - I could even spend it all on a luxury lifestyle. But when people started retiring I would, at that point, have to stop my extravagant spending and simply start paying the retired people the money that was coming in from the working savers. This "Ponzi scheme" is now no longer working to my benefit. I'll get nothing from now on. Over the years the amount of money paid out would automatically adjust in line with wages because the money coming in is always a fixed fraction of the (working) club members earnings. Now, ignoring the problem of what I live on, this is now a stable state and could continue indefinitely so long as I could always keep the membership fully subscribed. This is a bad, dangerous scheme for my members however because if at some point I failed to find new members then the retirees would lose everything - a disaster.

Now for the tweak. Imagine that this exact same scheme is run by the government. Imagine that instead of a 1000 member club, it is now a membership of "the entire nation". Now it is guaranteed that there will always be new members. Now the one flaw in the "Ponzi" scheme has disappeared. It is no longer a bad scheme! It works! It can go on forever! No problem!

I wrote a related article about pensions a few months ago here.

Inflation vs Hyperinflation vs Deflation (again).

This issue is so critical and yest so hard to decide that I think it is worth looking at from every possible point of view. I'm going to make two lists, one for things that increase the money supply and one of things that decrease it:

("customers" = individuals, businesses, foreign governments etc. MS = money supply. MB = monetary base)
Don't forget that MB is much smaller than MS.

Factors that can lead to increases:

• Customers taking out new loans from banks. (Directly increases MS)
  
• Governments printing money to buy their own bonds to "pay" for their debt. (Directly increases MB)
  
• Governments printing money expressly for the purposes of avoiding deflation. (Directly increases MB)
• Lowering reserve requirements (gives permission to increase MS via extra allowed loans, but that's if the banks can find suitable borrowers)
• Lowering capital requirements (gives permission to increase MS via extra allowed loans, but that's if the banks can find suitable borrowers)
  

Factors that can lead to decreases:

• Customers paying back loans to banks (Directly decreases MS)
• Customers defaulting on bank loans (Directly decreases MS)
• Raising reserve requirements (leads to decreased MS)
  
• Raising capital requirements (leads to decreased MS)
  

I know this does not answer the question of whether we are going to have inflation or deflation in the next few years, but I hope that it at least breaks down the problem in to more manageable chunks. I'd love to hear you comments on A) have I got the right things in the lists and B) what are the prospects for the future developments of size of each of the items in the lists.

Laissez-faire economics is sub-optimal - a proof.

There are many people that seem to believe that the solution to every problem in economics can be solved by removing regulation and "letting the markets decide". Other people disagree and will produce all sorts of "hand waving" arguments to explain why that's sub-optimal. I recently realized that a certain, reasonably well studied, statistical conundrum has a striking parallel to a problem in economics and its study could remove the need for some of these "hand waving" arguments and replace them with mathematical proof. The conundrum is known as "the multi-armed bandit problem" - but before I explain what it is, or its solution, I'd better explain the problem in economics that I believe it so neatly parallels.

The problem in economics is this: who should make new product X. Communists might say "lets have an expert government committee choose a single company Y and only allow them to make it" whereas the free marketeers would say "let multiple companies A, B, C, D and E make it and the market will decide which is the best and let the others go bust - and for gods sake don't let the government interfere with this process!".

Now I will introduce the statistical conundrum. Its called the multi-armed bandit problem:
Imagine you have a collection of one armed bandits in a casino. Each one has a certain "payout rate" which corresponds to the percentage of the money paid in to it, that it will pay out (in the long run). In real casinos this is often set at something like 80-90 percent, but imagine that this particular model of one armed bandit can be set to a any predefined payout rate (0% to 100%) using a dial inside the machine that the casino owner can set with a screwdriver. Now let’s say that one night the casino owner comes in and sets each bandit to a different payout rate, no two are the same. Now you arrive the following morning with a great big bag of coins. You are determined to spend the whole day playing on these bandits and you have complete freedom to choose which ones you play on... you are allowed to switch from one to another at will. Now the question is, what is your strategy for selecting bandits such that you come home with the greatest winnings?

I'll give you one possible solution: put 50 coins in each of the bandits in order to make an estimate of the payout rates. Then stick to the one that appeared to have the highest rate for the rest of the day. This solution is certainly better that simply selecting the bandits at random, but can be mathematically proven to be sub-optimal, i.e. there are known strategies that will lead to greater winnings. One problem with this strategy is that if two bandits paid out rather good, but very similar, amounts than it may not be very clear which is better. It may be more profitable to continue playing these two for a greater number of trials to gain more confidence in your determination of which is the best one. The problem illustrates what is known as an "exploitation-exploration dilemma". The "exploration" referring to the effort exploring which bandit may be the best (e.g. the 50 coin trial at the start) and the "exploitation" refers to simply repeatedly playing the bandit which you estimate is the best.

I believe this conundrum is analogous to the process of choosing companies to make products in a free market. The bandits are like the companies, the payouts are like the goods and the gambler is like the public, choosing the “company” that produces the best “goods”. At the start of the process the gambler/public does not know for sure who can make the best version of product X so he must try each one. Then, if it becomes obvious that some companies are better than others, the known bad companies will cease to be tried (= “go bust”) while the still-possibly-best will get tried some more.

Now there is one more complication that needs to be added to the standard multi-armed bandit problem to make it even more analogous to real life business. There is a variation called the “restless bandit problem” where the payout rates are not fixed but rather, evolve over time. This is more like a real company where the management and employees will change over time. Their manufacturing equipment may wear our, break or become redundant and a host of other things may happen that will change the ability of the company to produce good products. Now in the restless bandit problem it is essential to do more “exploration” than in the case of the standard multi-armed bandit problem. You would never want to entirely give up trying a previously poorly performing bandit because it may have now evolved into a better performing bandit.

It can be mathematically proven that for the restless bandit problem, a strategy of “playing all for a short while and then exclusively playing on the one that appeared best forever more” is a sub-optimal strategy. There is too little “exploration”. It is sub optimal for at least two reasons.

1. You may be mistaken in your estimate of which one is the best (how could this be?**)
2. The true best bandit may change over time.

This result has important implications for free marketeers. I believe it proves that the free market is sub optimal. This is because a free market acts like the “too little exploration” strategy. The thing is that in a free market, companies that fall short of producing the best goods tend to go bust even if they only fall short by a small margin. Obviously when a company goes bust, it can never be “tried” again, it doesn’t get a second chance. The succeeding company (or very small number of companies) tends to grow and dominate the market. Once a company dominates a market then it can start to raise its prices and employ a plethora of strategies to suppress rivals, that have nothing to do with producing the best goods for the consumer. For example:

• Tying up exclusive distribution channels
• Using your size to get raw materials for less than any new rivals can
• Using your size to negotiate higher prices from retailers than any new rivals could.

These factors make the “too little exploration” strategy even more sub-optimal in the restless bandit domain because it’s as if, as soon as we make up our minds and settle on the bandit that we think is best, it almost certainly reduces its payout rate.

Now in the exploration-exploitation dilemma, it is perfectly possible to do too much exploration. In the extreme that would be like playing all of the bandits equally often. And this can easily be proven to be sub optimal. So there is a balance to be struck.

In the real world there are many things that could be done to make sure that there is enough “exploration” in an economy, many of which are already in place to a greater or lesser extent in many countries around the world. Any laws that aim to prevent monopolies or encourages overly large companies to split in to smaller parts are a good start. So, one might say that effectively the world is already aware of the problem. But I hope that this article A) gives some mathematical support for these kind of policies and B) proves that free market fundamentalism is a sub-optimal strategy.
---

** Say you have 2 bandits A and B. A has a payout rate of 60% (in the long run), B has a payout rate of 70% (in the long run). If the sample you have measured so far is small (e.g. 10 coins or so) then it is very easy for A to have paid out more than B just by fluke. The same kind of "mistake" can happen in the economic world with two companies. Say you have two companies A and B. Say that company A is currently fundamentally better than company B, it's management are smarter, it's workers are more hard working etc and in the long run, given a choice of 10 yet-to-be-invented products to make, it would make 9 of them better than B would. Unfortunately the first of these products to be invented was the one product it makes worse than B so the consumer would incorrectly guess that B was the better company.

Properties of monetary systems

The following article is thinking out loud...

How can it possibly be that some leading economists think we need to worry about deflation, while at the same time other leading economists think we need to worry about hyperinflation? The answer I believe is our damned fractional reserve banking system. The way it behaves is just so hard to understand. I believe this is fundamentally because it so poorly reflects the true nature of trade. Let me explain with a little thought experiment and some mathematics:

Imagine a "barter" system which had developed in the modern world. Imagine that all sorts of sophisticated transactions were arranged with the help of some I.T. and a good legal system such that you could have phenomena like lending and investment and all the "financial" interactions you'd expect in a capitalist system. You could envisage the flow of goods and services between people as a flow or vector field. This field would have both "sources" and "sinks". With the sources corresponding to the addition of value (e.g. assembling raw materials in to goods) and sinks corresponding to the loss of value (wearing out of goods).

The I.T. and the legal contracts would have to be very complex indeed to make this work and so people may want to introduce a system of "money" to simplify things. Now it seems obvious to me that the money system should as accurately as possible mirror the transactions that are going on in this barter system and an easy way to imagine this, is to consider that we have cash that simply flows in the opposite direction to the goods. You would have two equal and opposite vector fields. Unfortunately money can not do this precisely because it can not have sources and sinks in the same way as goods, but it would be a close approximation and money can always adjust its own value to make up for the minor discrepancies.

So why then have we ended up with this crazy fractional reserve banking system in which the total amount of money in the system can grow and shrink by a factor of ten!! In what way does that mirror the flow of trade?

I believe that the immense difficulties of understanding the world economy are largely due to this non-correspondence.

My experience with Wikipedia

I recently had a go at making a couple of edits of some disingenuous statements in the "Fractional Reserve Banking" section in Wikipedia. Now maybe I need to R.T.F.M., but the F.M. of Wikipedia seems just endless... It seems that after you make an edit you are supposed to explain your changes in a single line of text... which I duly did. But in no time at all someone undid my changes giving no explanation whatsoever. Then I tried to contact him through Wikipedia so that we could perhaps resolve the disagreement between us, but I found that I was barred from doing so because I wasn't a sufficiently established user. I was stumped. So now I have just tried making one of my edits again, stating that I'd like some explanation if anyone wanted to undo it. I wanted to add as part of my explanation that anyone about to undo my change should contact me but it seemed that the space Wikipedia allowed me was not big enough for such a sentence! I'm sure I have something wrong here - if anyone would like to explain to me the error of my ways please do.

One of many flaws in fractional reserve banking

With our current fractional reserve banking system system, if the government want to create P new dollars in order to fund an emergency project, it is inevitable in the long run, whether they like it or not, that the money supply will grow by 10 times P, or should I say M times P, where M is the money multiplier (currently rumored to be around 10 ish). Is this really desirable?

While I'm on the subject, can anyone point me in the direction of a really good argument in support of fractional reserve banking (as opposed to 100% reserve banking)? I've seen all sorts of articles saying "it ain't as bad as people think" in response to criticisms, but I'm struggling to find an article which positively says "its really good and here's why".

Did the Fed double the money supply?

I just watched this YouTube video in which Ron Paul said the the Fed had just doubled the money supply. But (thinking out loud here), I suspect that what the fed have just done is doubled the monetary base, which is not the same thing at all. The money supply can only expand up to is maximum (as allowed by fractional reserve limits) if the banks can find enough people who are both willing to borrow and a good enough bet that they can pay back. Now it strikes me that if there is a sustained period in which people are reluctant to borrow, then we may not get hyperinflation after all. We may instead end up in a situation like Japan with a combination of near zero interest rates combined with close to zero inflation.

The banks would of course hate this scenario with a passion because with no borrowing their profits will dissapear. So they will try every trick in the book to get people to borrow more.

World's biggest financial news story

It seems that this story is being kept quiet. I wonder why?

Stop press: I've just heard an exceptionally good analysis of this story by Max Keiser in this broadcast - its all to do with "Peek-a-boo accounting". Youtube vid here.

UPDATE 21st June: here.

How to improve the study of economics - two ideas.

There is a very marked difference between the progress of most sciences and the progress of economics. In most sciences people come up with assorted theories, they design experiments and then theories either flourish or they get shot down, never to be seen again. The bulk of the ideas in physics for example, are uncontroversial, there are very few "alternative" theories which hang around for long. In economics however things are very different. It is almost impossible to do any meaningful experiments. For this reason bad theories can hang around for ages, perhaps forever.

I'd like to present two ideas for making improved progress in economics:

1. Build computer simulations.

In recent years computers have become comfortably fast enough so that they could run simulations of entire populations. Simulating economies could revolutionize the subject in several ways.

• The process of trying to get a simulation to show all the same patterns as a real economy would, in itself, be an enlightening experience.
  
• Once a working simulation has been built, new theories could be tested within it.
  
• The accuracy of peoples simulations would give bragging rights to the best economists rather than the economists with the most popular ideas.

2. Change the nature of research papers...

I recently saw a short bio-pic about the economist Murry Rothbard in which it was stated that he was a prolific author, apparently he wrote 20 books - I immediately thought to myself - that guarantees that his work will never be properly digested. If I want to learn about his best ideas, which of his 20 books do I read? Do I have to read all of them? How about having the default format for a "paper" being an html document with hyperlinks. Encourage multiple iterations where readers give feedback about sections they found hard to understand or disagreed with. Allow the author to re-write sections, correct errors and add additional documents linked from the original to expand on points that some readers thought needed further detail or thought contentious.

I my time in academia I noticed that scientists were encouraged to write as many papers as possible. This led to a situation where if you had two closely related ideas in a field you would be encouraged to write them up in two separate papers. It also led to a situation where scientists were discouraged from making things too clear in their papers because that meant that others could too easily use your ideas to generate their own papers which may then diminish your opportunities for publishing in that field in the future. This system is a minor handicap in a field with good opportunities for experimentation where bad theories will get thrown out - but in economics its a disaster - a recipe for a never ending stream of repeated errors.

If instead, economists were rewarded for the quality of their work rather than the quantity, then perhaps the field could take a few steps forward.

Pensions casino - supporting articles on the BBC

Back in March I wrote a blog entry The pensions casino - an alternative. Then just today I came across this article and this article both on the BBC news website and which both support my prognosis... they could have just subscribed to my blog instead.

Fractional reserve banking - at last some support!

CORRECTION: THIS ARTICLE IS WRONG - THE COMMENT EXPLAINS WHY. I AM LEAVING THIS BLOG ENTRY HERE FOR REFERENCE.

On the 28th of March 2009 I wrote a blog entry called The most important thing to understand about banks. It was the result of my research in to fractional reserve banking. The key thing that I had worked out was that it was just too easy for bankers to earn money. Or more specifically, if the "money multiplier" was M and the banks could lend money to borrowers with the borrowers paying interest at rate I, then the amount of interest that banks could earn on their starting reserves was effectively (M x I). At the time I felt like I was the only person on the planet to have worked this out because I had never seen anyone else say it. I thought that perhaps I had made some mistake. But then I came across the following, rather long (3.5 hours!), but very good, documentary called The Money Masters - How International Bankers Gained Control of America, and at 19 mins 25 seconds in to the movie they say

"every bank in the U.S. is allowed to loan out at least ten times more money than they actually have, thats why they get rich on charging lets say 8% interest -its not really 8% per year which is their income, its 80%, thats why bank buildings are always the largest in town".

I was right!

So while I am happy to find some support for my conclusions, I am not at all happy with the way the banks are screwing the rest of the economy.

Politicians know nothing about banking

I came across a link to the House of Commons Treasury Committee report on the banking crisis in the UK, entitled "Banking Crisis: dealing with the failure of the UK banks" here. I thought this would be a good time to check out just how well understood the problems of fractional reserve banking and fiat money are amongst politicians. To test this I did a little search to find out how many occurrences of certain key phrases there were in the 129 page document. And here are the results:

• "Fractional reserve" - NIL
• "Money multiplier" - NIL
• "money supply" - NIL
• "M3" - NIL
• "Reserve requirements" - NIL
• "Fiat currency" - NIL
• "Gold standard" - NIL
• "High powered money" - NIL
• "Monetary base" - NIL
  

No wonder the banks have been able to pull the wool over the eyes of politicians for so long.

Capital gains tax - part legitimate - part theft

I'm in the middle of reading George Cooper's "The Origin of Financial Crises". After looking at the section called "A brief aside - on the topic of inflation and taxation" I realized something that had never occurred to me before, about capital gains tax. I already knew that when the government print (or otherwise allow the creation of) new money, then this is a kind of tax. If the total money supply went up 10% then in the long term the spending power of our savings would diminish by 10% and the government would have an extra load of money in its coffers. But I had also assumed that if, instead of having our savings in cash we had it held in some asset like gold for example then our "savings" would be protected from the government... but I was wrong! And here's why:

Imagine a world in which, for decades, most countries had a near zero inflation rate (hard to imagine I know!). Now lets say you'd been tipped off that your government was about to double its money supply overnight. In preparation for this you use all your savings to buy gold. The government then create the new money and as expected the value of your national currency halves relative to other currencies of the world. The value of your gold, as measured in any foreign currency, remains unchanged - but measured in your own currency appears to have doubled. Now here comes the nasty surprise - when you then try to sell your gold back in to your own currency, your government step in and say "please pay us capital gains tax!". That's not fair. Your capital has not gained any value at all! Its the same stuff! Its value, as measured in any other currency, has not changed! Why should you have to pay a "gains" tax when there has been no gain!

Now you may be wondering why I've given this entry the title of "part legitimate - part theft" and that's because I can see a legitimate reason for capital gains tax. If, during a low inflationary period, a rich person invests in some stock that genuinely rises in value (as measured in any currency) then I think it is reasonable to tax the gain. After all, why should we allow rich people to gain extra money simply by virtue of being rich. So in conclusion I'd say that taxing any genuine component of a gain is legitimate, but taxing "imaginary" gains, caused by the government printing money, is simply theft.

I wonder if this observation could be grounds for withholding part of your capital gains tax?

• Perhaps you could legitimately only report your estimated "true" capital gains after having allowed for any government-induced inflation?
• If a tax is called a "gains" tax, are the inland revenue allowed to tax you when there are no gains? If a tax was called a "bicycle trading profits tax" and you made some money by trading cheese, would the inland revenue be allowed to use the bicycle tax to take money from your cheese trading profits? Would any lawyers out there care to comment?

P.S. I was just explaining the contents of this blog entry to someone else who didn't quite get it and I had to try explaining the story from another angle. So here it is. Imagine you've saved £10,000 which will buy you a new car, call it the Toyota ZPF-X, when your current old banger finally conks out. Of course you've already paid income tax on this money. Now you stored this money in some kind of stock/bond/gold/whatever. Now fast forward a few years and your old banger finally dies. The government have been printing loads of money and so now inflation has caused the same Toyota ZPF-X to cost £15,000. Your investment has protected you against your currencies inflation, and it is now worth £15,000. Your savings have stood still - you started with enough money to buy the car and you've ended up with enough money to buy that same car... you've already paid the income tax on that money. But now the government want to tax you for a second time on your "gain".

Rational Exuberance

Professor Robert Shiller subscribes to a theory about the psychology of asset bubbles called "irrational exuberance". The theory makes three basic claims about asset bubbles.

1. They get triggered by something external.
2. The prices rise because of a contagious fever of excitement about getting rich based on stories they hear from their friends and in the media.
3. The bubble bursts at some point because it can not rise forever, but we have little clue of the timing.

After thinking about the psychology of bubbles from an AI standpoint, I have come to the conclusion that he may be wrong on all three counts.

I'd like to propose my theory of asset bubbles which I will call "rational exuberance". Now the first step in describing my theory is to consider our thought processes in determining what we are willing to pay for an asset. I suggest that it is made up from two components that are considered separately and then combined in to a final conclusion. The components are:

A) The estimated reasonable price of the asset excluding any thoughts about how the assets price may change in the future. This is a kind of true price which reflects how much we desire the asset for its own sake, rather than as a speculative investment.

B) Our estimate of what we expect the price to be at the time when we expect to sell the asset.

Now in a stable, zero inflation, environment, estimates A and B would be one and the same value. However we would generally expect B to be different to A because of a combination of factors including general inflation, immigration rates, the birth rate, unemployment rates, social trends, the rate of housebuilding and all sorts of complicated things that people find hard to predict. I would suggest that people generally feel unable to estimate the sum total of these effects and so instead will use what I will call the "insect tracking" method:

Imagine someone observing a small spider that has just been placed on a stick. They have no idea about its motivations or what its going to do, but then they see it start to crawl in a particular direction along the stick, at first they are not sure whether its going to keep going in the same direction or perhaps it will suddenly stop or maybe head in the opposite direction.... but then imagine that it appeared to move fairly constantly in a particular direction (lets say from left to right) for several seconds. The longer it kept going, the more confident the observer would become that in the next instant it would be further right than it is now. This kind of prediction based on previous events without the slightest understanding of the underlying driving forces is both completely natural and makes good logical sense. It is certainly true that with almost any system you care to observe in life, its future behavior tends to be the same as its past behavior at least in the short term. In the longer terms things can change. Let us say that our spider suddenly (and of course unexpectedly) stopped. What will happen next? Well the fact that its behavior suddenly changed (from moving to stationary) makes us suddenly less confident about where it will be in the next instant. I could go in to a lot of detail about the relationship between its behavior up to a particular point in time and our prediction of what will happen in the next instant afterwards, but for now I will summarize it with the statement "The longer a system is observed displaying behavior X, the more confident we become in the assumption that in the next instant it will continue to display behavior X". Now I am going to add an additional complication to the insect watching analogy. Let us say that we have arranged to have a heat source placed at the right hand end of the stick. The temperature at the end of the stick is known to be uncomfortably hot for the spider. Now lets run the experiment again: the spider, as before, heads off from left to right - and again the longer it continues to travel in this direction the more confident we become that it will continue to do so, but this time we need to add a proviso - we know that the spider will not carry on walking right up the the heat source - we know that's too hot. We know it will have to stop at some point. So now our spider watching prediction could be summarized as follows. "The longer a system is observed displaying behavior X, the more confident we become in the assumption that in the next instant it will continue to display behavior X, but if we know that behavior X becomes increasingly improbable over time, then our confidence in the predictive powers of past behavior will progressively diminish".

Now lets apply the insect watching ideas to the housing market. Shiller states that something external is needed to start a housing bubble - well, I'd re-phrase that as something external can start a housing bubble, but it can also start all by itself just by random fluctuations. Consider a small town in which every year a certain number of people move out and a certain number of people move in. Let us imagine that on average these numbers are approximately equal, but simply according to the law of random numbers, in one particular year the numbers may be quite different. Imagine that as a one-in-100-year event, there was a significant predominance of new people moving in, and not only that they were on average wealthier than the average of the people living there already. This entirely random event would cause house prices to rise significantly in this town over the year.... now the spider has started to move from left to right... the people watching house prices in the town have no idea that this was a special one off rare event that will not be repeated. Instead they start to predict that house prices in the area will continue to move upwards. Estate agents will start writing in their brochures that this is an up and coming town and purchases here would be a great investment. These "truthful" statements will make the purchase of properties in this town more attractive... the ball has started rolling and you can imagine what happens next. The spider is making a steady march from left to right. The higher prices in the town will cause the prices in the suburbs rise, then neighboring towns and so on and so on.

I'd like to nit pick with Shiller again at this point. Shiller states that the "hype" and "newspaper" stories are what is driving the rise. Where as I would state that its to a large degree, the rise that is driving the rise! The newspapers are just helping the process along. Like a second spider observer telling you "Hey, did you see that! The spider is going from left to right!". You could see that already yourself - but of course the confirmation from the second observer will support or intensify your belief (that you would of had anyway) that the spider will continue in that direction.

Now lets consider the bubble bursting. Shiller appears to think the turning point is beyond analysis. I however, feel it is an entirely logical process. Remember my earlier statement: "...but if we know that behavior X becomes increasingly improbable over time, then our confidence in the predictive powers of past behavior will progressively diminish". This could be re-phrased for the housing market as "In a rising market, the more improbably stupid house prices become, the less likely we are to believe that the current rising pattern will continue." The bubble will burst when the price rise non-believers start to outweigh the believers. I don't know if surveys have been done but I would hazard a guess that in any asset price bubbles one could a detect an increase in the proportion of "non believers" before the bursting point.

It should be noted that the point at which non-believers start to outnumber the believers may be helped along by some external event. Something which makes rising prices less probable. And the further the price rises had drifted in to the realms of the improbable, the smaller the external event that would be required to trigger the reversal in the direction of prices. Now there will always be people around who will point to this trigger and claim that this was the true reason prices reversed - but it is very likely that this was simply the straw that broke the camels back and if that event hadn't happened then something else, or even nothing at all other then the inevitable rise in the fraction of non-believers, would have shortly afterwards.

P.S. In response to a comment about this blog entry, I will add a little extra detail:

When I mention looking at the proportion of "non-believers", I don't mean the proportion of politicians/journalists/economists who say "This bubble has got to burst sometime". And I don't mean that we should listen to how vociferously they are proclaiming this. We all know people who were saying "this can't go on forever" (some were saying it many years in advance). Instead I mean simply monitor the fraction of ordinary potential house buyers who say "I'm NOT going to buy a house right now because I think that its value will not rise or may even fall by the time I want to sell it". They are the people who will stop the bubble. And the greater the preponderance of them, the sooner the bubble will burst.

My first ever investment

After years of not having invested in anything, I finally have decided that it is probably less risky to make an investment than not! As detailed in several posts I believe that there is a risk of the pound going through a period of very high inflation and so taking a serious nosedive on international markets.

So here's my investment of choice: ETFS All Commodities, as I understand it (and please tell me if you think I've got it wrong!) this is an investment which tracks the price of a basket of commodities like gold,copper,oil,assorted agricultural produce etc. Now its important to note that its tracking the price of the stuff itself, not the success of companies that make it.

There are many reasons I've chosen this:

1. Its diverse.
2. Commodities can never go out of fashion, nobody is ever going to say "Oh that copper junk, who needs that!" and this will be true for decades to come.
3. Unlike companies, commodities can never "go bust".
4. Many commodities, like oil, are running out and/or getting more expensive to extract (see this if you need persuading).
5. The worlds population is expanding, creating ever more demand.
6. It seems to me that the cost of commodities, in the very long term, should increase at least in line with world average (erm, maybe total) earnings.
7. After a big crash (like now) is probably a reasonable time to buy in.
8. I wouldn't matter if the UK (where I'm from) had some economic catastrophe as long as most of the rest of the world was doing ok and could hold up commodities prices.
   
9. Relatively cheap to invest - through Interactive Investor its £10 to buy in and £10 to sell regardless of the quantity. Then 0.49% P.A. management. No "stamp duty".
10. Buy or sell at any instant.

The only thing that worries me about this investment is that I haven't fully understood the mechanics of exactly how it is arranged "under the hood" and I don't fully understand the insurance that backs it up.

I would very much like your opinions on my investment.

Money disappearing in to thin air

Last month I wrote an article about how money disappears in to thin air when there is a preponderance of people paying back loans. In it I expressed surprise at how it seemed that almost nobody was discussing this effect, I felt like I was the only person to have noticed it! Now at last I have found some support from a section of the book "The Origin of Financial Crises" by George Cooper. Please read the following section:

I suspect that anyone who is not fully aware of this phenomenon can not conceivably understand what is going on in this financial crisis... at that includes almost everyone!

Banking is not like other industries

Consider this...

Imagine that someone was walking through a national park and accidentally stepped in a puddle of oil oozing out of the ground. After some further investigation it was realized that this was a, previously undiscovered, massive reserve of easily extractable oil... billions of barrels of the stuff equivalent to 10% of the nations GDP. Now lets say that the government gets to hear of this. What should it do? Lets consider a couple of options.

A) Let any old "group of guys with a big pump" extract it out of the ground and keep 100% of all the proceeds (Obviously this group will shortly become the richest guys in the country and consume 10% of the nations GDP between them).

B) Consider the oil to be a national asset. Design some special mechanism for remunerating the guys with the pump but make sure that the government (or the people) get the bulk of the profit. This could be done an myriad ways, but two simple options may be either tax them at a rate much higher than other industries or simply nationalize the pumping business.

Obviously any sane government would select some version of option B.

Now here is the problem. I would contend that the privilege of being a bank within our current fractional reserve/central banking system is rather analogous to being the "guys with the pump". Its just too easy to make money from banking with very little effort. The banking industry is absolutely not like any other (see here). The idea of just letting them get on with whatever they want to do and allowing them to pay normal taxes is a disaster for any nation.

My solution - option B.

So when exactly will the dollar collapse?

It seems that many economists are predicting the collapse of the US dollar. The argument goes something like this: The U.S. government is in huge debt. It maintains its borrowings by selling bonds. These bonds have to compete on the open market with other types of investments, so they have to offer a competitive balance of interest rate, security (against default) and protection against inflation. At the moment, the US is clinging on to the edge of the cliff for some rather temporary reasons...

1. People are still holding on to the (perhaps irrational) belief that the U.S. government could never conceivably default on its bonds and so the "risk premium" the US needs to offer on the bonds is negligible.
2. The rest of the world is in such a dire state that they don't know where else to put their money.
3. There is not much (obvious) inflation in the US.

Now many of the people who believe in the Armageddon scenario are being ridiculed by others who point to the relative strength of the dollar compared to so many other countries. But these three conditions can not remain favorable forever. I have been thinking about when exactly the dollar bubble will burst and it just occurred to me that there will be an upper limit - and that is when the first few countries start to pull out of this recession. As soon as that happens then there will be a new place for investors to put their money. The result of this is that US bonds will now have a serious competitor and the only way that the US can compete would be to raise the interest on their bonds... now this would quickly become very painful for the US and all their options would be horrid... they would fall off the cliff.

This is of course just an upper limit... the dollar collapse could be triggered before then at almost any time... including tomorrow.

The Pensions Casino - an alternative.

Until recently, I had very little idea of how pensions worked, but when I looked into it carefully, I realized it was enforced gambling! And the more I thought about it the more I realized how incredibly unfair and stupid the entire pensions system was. The reason it is so bad is that there are so many ways your pension could be dramatically bigger or dramatically smaller than you planned for, in ways that you can not reasonably control. To illustrate this consider two people born 5 years apart. Lets call them Mr Lucky (the older man) and Mr Unlucky. Let us imagine that they are both equally conscientious, equally hard working, equally intelligent (averagely intelligent), equally everything.

Now Mr Lucky starts his working life and starts saving towards his pension. Just by chance, this is at a time which is the end of a recession when stock prices are low. He's already off to a good start because his early pensions investments are likely to rise nicely.

5 years later Mr Unlucky starts his working life. He does a similar job, and saves the same fraction of his income toward his pension. Unfortunately now is the beginning of a stock bubble. His early pensions investments will turn out to be a disaster.

For several decades to come both men have investments in the stock market at the same time. Unfortunately Mr Unlucky's fund manager was not as financially savvy as Mr Lucky's. This was not really his fault - neither men are financial experts. How can anyone possibly expect your average man in the street to determine the different skill levels of two different fund managers? They can't. Mr Unlucky's fund gradually drifts even further behind Mr Lucky's... but it doesn't stop there...

The fund managers make their choices based on their knowledge of the markets and the fundamentals. However, a sizable component of the variability of stock prices are things that no fund manager could be expected to prepare for. Things like earthquakes, floods, political assassinations, industrial accidents etc... and you've guessed it - the floods and earthquakes just happened to be to the benefit of Mr Lucky's stocks and Mr Unlucky's fund manager's stock selections get badly hit, so his pension fund falls even further behind... and it doesn't stop there...

Now we come to retirement time... and would you believe it, Mr Lucky retires at the peak of another bubble... and oh dear, Mr Unlucky retires at the depths of a recession.

So there you have it - two similar guys doing similar jobs, saving similar fractions of their wages towards their retirements and yet their retirement incomes could be hugely different, based entirely on luck... is that fair? Is that how we want the system to work? Personally I find it extremely stressful worrying about my pension - am I going to be lucky or unlucky? What should I do? Should I just save way more than I really need just in case I'm unlucky? Or should I scrimp on my pension hoping I get lucky, then simply carry on working longer if I get unlucky?

Note that there two types of random variability between pensioners. One type is between pensioners of the same age. Lets call this stock selection variability. Another type is concerned with the start and end times of pensioners saving period. Call this bubble timing variability. Now bubble timing variability will affect entire age groups of pensioners, some of them having miserable retirements others having good ones.

Now of course the people who really pay (or rather, "pay back") for old people in their retirement are working people. These wild fluctuations in pensions are inefficient for us workers. We feel sorry for Mr Unlucky when we see him on the TV in some documentary about old people not being able to afford their heating bills. While at the same time cursing that we have to work so hard to support Mr Lucky who seems to have superfluous wealth. Just imagine if you applied the same pensions system in your own home... imagine you have your old grandma and grandpa living with you. They've both worked hard all their lives... now at dinner time you serve grandma a feast of the finest foods and champagne, while you give your grandpa a slice of bread and a glass of water. They say "what did we do to deserve this?" and you have to remind them that grandma thought Ebay was a great idea and grandpa liked Betamax. Now you may say that this is simply how life is - if you get lucky then you do better in life if you're unlucky then you do worse. But that's not true in all aspects of life, and people can usually select the degree of risk they want to take. If you want to be a professional stock broker then you may get rich or you may go bust -it goes with the territory. People choose to be stockbrokers. Nobody who loses on the stock market ever says "gee, nobody told me there was any risk involved". But we can choose to take a less risky career. Say you become employed as a plumber. there's not much risk in that. If business gets bed then, you can always retrain as something else. There's no chance of ever suddenly being wiped out as a plumber. So you see there are some choices in our working lives which are inherently risky and some inherently safe. Now when it come to designing a pensions system, is it so obvious that we should select a mechanism so full of risk? I think not. I think its possible to design an inherently safe mechanism.

Now the first characteristic I wanted for my system is that people who save more in their working lives should get more - and roughly speaking if you save twice as much as the average guy in your working life then you should get twice as much in your retirement.

The second characteristic of the system is that people must be forced to save for at least a minimum standard of living in retirement. Now some people may say "how dare you take away our freedom! Its up to us to individually decide what we save for retirement". To which I would say, "but not saving throughout your life puts a blatantly unfair burden on the rest of society when you retire. We can't just stand by and watch you become homeless and starve. We'll be forced to give you a certain minimum standard of living for free". I would also add that the amount we are forced to save for retirement will be very small. Just enough so that you could have a bare minimum quality of life.

My system to achieve all these things is the following:

The government invent a new type of tax (but of course we don't want to call it a tax!), call this compulsory elderly-support. Say its X%. This is the minimum. People can optionally also put whatever extra they want in to the elderly-support system. The continuous flow of elderly-support money that comes in from workers is used to pay money to the retired. Note that this is all happening at one instant - there is no pretense that some investment is being put in storage for future use. Its plain and simply workers-now-support-retired-people-now. So the next question is how to apportion the money - this is where we need to do a little mathematical jiggery pokery. The money is not distributed evenly amongst retired people, instead it is (roughly speaking) distributed in proportion to the amount of money those retired people fed in to the elderly-support system during their working lives. The maths required to achieve this is not trivial, but it is certainly doable.

So what are the advantages of this system?

• Nobody is being forced to predict the stock market. People who save similar amounts will be similarly comfortable in their retirements.
• If a country develops well and has a boom, then the retired population will automatically benefit from the boom.
• If the country has a recession then retired people will take their share of the burden, rather than requiring an unbearably large fraction of the now-poorer nations GDP.
• The whole system will be far more predictable for pensioners, workers and government.

My predictions...

OK, just for fun I am going to make a set of predictions so that in a few years time you can all look back and laugh at how wrong I was.

I predict the the price of Gold, as measured in Chinese Yuan, will rise dramatically then fall again over the next few years and end up lower than it is now. I say measured in Chinese Yuan because I think that will be the worlds most stable currency over the coming years.

I predict that the dollar will lose at least 30% of its value against the Chinese Yuan over the next few years, but the change in rates will be very uneven, there will be a sudden drop over a very short period.

I predict that the average U.S. and Chinese hourly incomes will move dramatically closer together. I think the gap will halve.

I think that the GDP of China will overtake that of the US within 5 years.

I think the tax rates in both the US and UK for the better off will be forced to rise significantly.

I think that the interest rates offered by the US for their government bonds will, at some point, at least double from where they are today.

I predict that the average PE ratio of the companies in the Dow Jones index will fall to about 7ish.

I predict the price of oil will be three times as high in five years time as it is now even when adjusted for inflation.

I predict unemployment in the US and UK will rise to 15%.

I Predict that the contribution to the GDP of the UK of the banking sector will be reduced to less than 20% - even after the recession.

Ditch the dollar.

The pressure is building. I think the dollar bubble is going to burst. The U.N. Commission of Experts on International Financial Reform are about to recommend that governments worldwide ditch the dollar as their reserve currency.

P.S. The original title of this blog entry was "Ditch the dollar?"... but on reflection I think the question mark is inappropriate!

Global Warming - a recent development.

Global warming, and the degree to which it is man-made will have and is already having a huge impact on the course of the world economy....

First off, I should say that for most of the past 20 years I have been a firm believer in man made global warming. Not because I was any great authority on the science of it, but more because, as a scientist myself, I am included to go along with the consensus opinion of scientists unless there is very good evidence presented to the contrary. All the arguments about the financial motivations of the scientists (for or against man-made global warming) did not influence me. Also the opinions of non-scientists, journalists and politicians held no sway whatsoever. Then when I saw the "great global warming swindle" my beliefs were shaken. I was no instant convert to the other side, but it alerted me that perhaps I should look in to this.... which I duly did. After some research I gradually realized that most of what the "swindle" program was saying was either misleading or downright wrong. My faith in the mainstream view was restored... but then, when I was looking in to the subject in even more detail I came across this lecture (on video: part1, part2) by Dr Roy Spencer given in March 2008. This lecture blew me away. It seems that the climate modelers have entirely omitted a very important phenomena which I don't think they have corrected to this day. Dr Spencer believes that if these factors are added to the climate models then the effects of our added carbon dioxide are dramatically reduced. By the way Dr Spencer does not believe that global warming is not happening, he simply believes that the man-made component of it is much smaller than previously thought. Two extra aspects of this have made me more inclined to believe his views. 1. His work is relatively recent. If it was much older then I would be inclined to dismiss it because the IPCC et al would have already considered it in detail and if it was found to be correct then they would already have changed their opinions. and 2. I can not find anything anywhere giving reasons his data or his arguments are wrong. When I saw his lecture, the very first thing I did was to do a Google search on him, confidently expecting to see him described as some kind of nutcase and to find articles describing the flaws in his logic - but was amazed to find no such thing. What I find equally amazing is how few people have watched the video - only 2400 at the time of writing.

So in summary, global warming is happening and will cause mankind huge problems... but we may not have to feel so guilty about it!

Wen Jiabao, "a little bit worried" about U.S. defaulting.

China's Premier Wen Jiabao has just been speaking at a news conference. I wrote down some of his words...

"Of course we are concerned about the safety of our assets. To be honest I'm a little bit worried, and I would like to, through you, call on the United states to honor its word and stay a credible nation and ensure the safety of Chinese assets".

Obviously the Premier was nervous because he had read my earlier blog entry.

Now the reason I think it is so significant the Wen Jiabao has publicly stated that he is worried about ability of the U.S. to pay its debts is because of something called the "risk premium". Everyone knows that when banks lend to high risk (usually poor) people that stand a higher than normal risk of not paying back then what they do is to charge a higher rate of interest. The "extra" part of the interest being to cover the risk of not getting the money back. Now currently the U.S. borrows money (to finance its great debts) from abroad, by issuing bonds. The bonds are really a statement saying "Give me your $X now, and I'll pay you back $X+bonus% later". Now the bonus% has to be high enough to A) be competitive with interest available elsewhere through other investments AND B) has to be high enough to compensate potential customers for their perceived risk of not getting their money back. So of course the higher the perceived risk the higher the effective interest rate the U.S. has to pay on its borrowings.

Now look again at the table at the bottom of my earlier blog entry... Scared? You should be!