Friday 1 August 2014

A thanks to Linstock!

Hey Guys,
I just wanted to quickly thank Madeline Crowther from Linstock Communications who mentioned one of my recent essays in a blog post about the virtual economies of the world: Gaming the System. Give it a read, it's a short and interesting look at the politics and comms that are related to the virtual world of trade.
I shall be adding a short piece that I wrote in response to this later, so keep an eye out!

Enjoy,
K

Thursday 31 July 2014

Chaos in Basel: European Monetary Policy (Full Essay)

Chaos in Basel: European Monetary Policy (Pt. II)



In a recent report, the BIS have claimed that the recovery that is being made by the European economy needs to be dampened so as not to re-enter a grossly over-inflationary period of growth. A journalist for The Economist magazine going by ‘R.A.’ reported: ‘Though the BIS's diagnoses of the global economy's ills have evolved over time its policy recommendations have not. In its latest annual report, it argues that what the world needs now is higher interest rates.’[i] The BIS has fears that although the economies of the Europe have and will benefit from lower bank rates as it allows them greater domestic potential for consumption and investment, it is important to not just keep inflation low, now, but to keep it manageable in the future. R.A. did not take kindly to this and deftly countered by first picking some misconceptions that may have arisen from the reports, and then - seemingly unknowingly- discussing some of The International Monetary Fund’s (IMF’s) Managing Director Christine Lagarde’s fears from January this year. Firstly R.A. set about drawing a clear distinction between ‘loose’ and ‘tight’ monetary policy. Loose refers to when central banks expand the money supply and increase the flow of money in the economy through increasing demand- this can be either ‘aggressive’ or ‘passive’. From this, R.A. concludes that European Monetary policy is as yet to be classed as truly loose as there has been no QE/OMO thus far; ‘It's not the loosest possible policy if there are plenty more arrows in the quiver.’1 He asserts that before the policy for Europe tightens it must be loosened to allow for restructuring. Despite seemingly being opposed to the BIS and their suggestions, the two perspectives seem to have found a point of synthesis- the financial sector and economy alike needs restructuring. The difference lies in how they both suggest this should occur: where the BIS suggests that a contraction would force firms to adapt to the additional pressures of higher interest, making them more prudent. On the other hand, R.A. argues that ‘intense private-sector competition… and more inflation’ is still needed to avoid a return to abnormal economic conditions. Both of these suggestions seem plausible, with the European Central Bank (ECB) suggesting stress-tests[ii] for large commercial banks, but also encouraging loose monetary policy.
In another article, in The Financial Times, Chris Giles[iii] wrote of the OECD and their bid to get the European Central Bank (ECB) to slash base rates, and also broaden trade to allow for greater structural reforms ‘to boost productivity and create jobs through… domestic and international competition in both advanced and emerging economies.’ This position strongly supports that of R.A. from the abovementioned piece. Giles’ brings a more quantitative perspective to this issue, quoting the OECD’s findings on how the real GDP growth of the Eurozone is improving, but not completely out of the reach of negative figures (see Fig. 1). In addition to validating the stipulation made by R.A. Giles is able to expand the on argument by referring to the possible loss of economic capacity in the medium-to-long-term. There are a number of possible causes for this: long-term unemployment and a widespread loss of transferrable skills; falls in foreign and domestic investment due to a loss of confidence; and even an increase in inefficiency in investment due to a lack of use of the mechanisms and infrastructure for such an extended period.
All of the above analysis from this range of sources and from the macro-economic theory discussed points towards a middle path between the two solutions suggested that errs slightly on the side of loose monetary policy decisions. Had either perspective showed a greater depth of analysis of the other, they would have been much stronger, providing a deeper discussion. In spite of this, the strength of the arguments put forward by R.A. and Giles are far more convincing those of the BIS especially considering even some of the strongest recoveries that have been seen in developed western countries still are somewhat fragile.
Kavi Chauhan-08/07/2014


[i] R.A. (2014), Dead economies blow no bubbles. The Economist, London.
[ii] B. Moshinsky, J.Black, A. Speciale (2014), ECB Haggles on Pain to Inflict in Bank Health Check, Bloomberg News, Brussels and Frankfurt.
[iii] C. Giles, (2014), OECD urges European Central Banks to loosen monetary policy. The Financial Times, London.

Chaos in Basel: European Monetary Policy (Pt. I)



Over the past months, Europe has faced a number of broad ranging problems from fighting the pull of the ‘ogre’[i] that is deflation, to the juggling act between the needs of the driving economies, and the less developed ones, which has become more pertinent than ever before in this delicate recovery period. There are a number of differing views on how to solve the problems faced by central banks around Europe, and there are disputes about this at all levels of society from individuals to huge institutions such as the Bank of International Settlements (BIS) and the Organisation for Economic Co-operation and Development (OECD).
There are, in this debate two main schools of thought: expansionary and contractionary. Expansionary monetary policy aims to increase Aggregate Demand (AD) and induce demand-pull inflation. These changes are affected through a number of processes, the first of which is the most commonly discussed- base rates. If base rates are reduced, the amount that households have to pay on variable-rate mortgages and other simple necessities falls, raising Real Disposable Incomes (RDIs), and thus consumption (C). The base rate reduction would be able to increase levels of investment (I) as firms can borrow more cheaply and also use their increased levels of retained profits that would be gained from reduced amortization rates. To supplement this increase in the velocity of money in the economy, further expansionary policies would include Quantitative Easing (QE) (or Open Market Operations (OMO) as it is referred to in the Americas). QE is a method by which the Central Bank can expand the Money Supply (MS) for their currency through asset purchases (i.e. bonds) which injects money into commercial lenders providing more liquidity and thus reducing lending costs, encouraging growth. This could even develop into operations akin to the ‘Helicopter Drop’ wherein the ‘middle-men’ (high street banks) are completely avoided and the population are simply given money to spend, inducing further demand-pull inflation. In the long-run, there are other, additional effects of cheaper borrowing and increased liquidity in the market- the most prominent of which is the expansion of the potential output of the economy (i.e. Aggregate Supply (AS)). The expansion in AS could be caused by the falling price of investment as a result of the aforementioned processes, which translates as a reduction in the cost of factors of production.
There are also numerous effects on exchange rates and net-exports that can be traced back to changes in monetary policy; an expansion in the money supply will increase the value of the Euro (EUR) in its bilateral exchanges with major financial partners due to the high relative inflation. In ‘normal’ cases, where the Marshall-Lerner condition applies, this could lead to a deterioration of the current account and thus causing ‘demand-pull disinflation’, counterbalancing the effects of the initial inflation. In other cases, however, the Marshall-Lerner condition does not apply as in the UK where over 40% of food is imported, and the financial services and chemical products exported are of such high quality and so ingrained in foreign production processes that both exports and imports have very inelastic Price Elasticity’s of Demand (PEDs). Here, what is essentially a price increase for imports, and a reduction for exports, will lead to the current account position improving quite considerably, leading to an expansion of AD and demand-pull inflation. For the EU, fortunately, the net-exports are not as large a part of the economy as they are for the UK meaning that the inflation rate will be somewhat rebalanced, without large negative implications for the employment and national income (Y) when expansionary monetary policy is introduced.


Europe:
[i] C. Lagarde (2014), The Global Economy, National Press Club, Washington.

What does the rise of the Bitcoin imply for the future of Central Banking? (Full Essay)

What does the rise of the Bitcoin imply for the future of Central Banking? (Pt. V)



The next step that investment bank would have to take to legitimize Bitcoin would be to regulate the securities valued and derived from Bitcoin- without this, specific, structure of conduct, the market for Bitcoin-based derivatives would spiral into the same destructive chaos that consumed both the derivatives market in its infancy, and subprime-mortgage market in its adolescent years. If Bitcoin securities are not managed or overseen by an authoritative body- not necessarily the SEC- their volatility will lead to eventual collapse, in the same vain as the dystopian, lawless market, the above paragraph aims to avoid. An extension of this regulation could be to introduce Reserve Requirement Ratios (RRRs) and discount or base rates for Bitcoin lenders, to allow for greater control over this currency.
The penultimate method by which the likes of Mr. Carney and the Mrs. Yellen would need to adapt to the rise of the Bitcoin would be to accrue liquid reserves of the Bitcoin so that they would be able to respond with shocks to the ‘foreign’ bilateral exchange rates between their own currency and Bitcoin. In the same way that the huge reserves of USDs in China, to support its pegged exchange rate, it may be necessary for the Federal Reserve (Fed) and the BoE to attain Bitcoin reserves to guarantee a reasonable amount of stability. Without this further amalgamation of Bitcoin with Central Banks’ domestic currencies, Bitcoin will become disenfranchised, and excluded from global markets, and may be abandoned entirely. The accumulation of Central Reserves will also help to restrain the almost inevitable process of deflation that will occur in the Bitcoin system.
The above step leads, logically –as was hinted at in the closing sentences- to the final step that Central Banks would have to take to acclimatize to Bitcoin. Managing monetary stimulus through the procedures, such as Open Market Operations, in Bitcoin, would be the final step that Central Banks would need to take to be able to meet their goals, outlined in the opening paragraph. The Central Banks would have to manage deflation possibly through the use of ‘Bitcoin bonds’ which it could trade with commercial lenders to increase liquidity, when necessary.
The above mentioned alterations to the relationship between Bitcoins and Central Banks would lead to a very unfortunate problem for Bitcoin followers, and acolytes of ‘Satoshi Nakamoto’. The Bitcoin, through these changes would essentially become the USD, or the GBP, or the Euro, or the Hong Kong Dollar, or any other internationally traded currency- the only difference being that it has no domicile. Another unfortunate truth that supporters simply must come to terms with is that the Bitcoin is a currency that is almost destined to fail, as it relies so heavily on its rapid uptake and use that long-term, serious investments will plainly not be made. This view was supported by another case involving Mt. Gox wherein the price of Bitcoin fell by over 800USD within the space of a month (see Fig. 3). Despite this problem supposedly being with Mt. Gox, previously the world leading Bitcoin exchange, alone, many other Bitcoin exchanges have faced drops by as much as 200USD.
The only real thing that Central Banks of the world need to do to contain Bitcoin is wait. In a recent Financial Times analysis column[i], Mark Williams (former Federal Reserve risk examiner and a finance lecturer at Boston University’s School of Management) highlighted that: Bitcoin is unregulated, and is decentralized, and thus cannot properly develop without the fundamental structure of it being changed. The article reads that even the most established currencies require an entire team of highly skilled individuals to be managed, and that no algorithm that contemporary computers can run will be able to replace this. Even if the problem of the cap of the number of Bitcoins was solved; there would still be countless other struggles that would arise, due to the irrationality that is a fundamental part of human nature.
Kavi Chauhan- 05/02/2014


[i] M. Williams (2014), A dangerous mistake lies at Bitcoin’s intellectual core. The Financial Times.

What does the rise of the Bitcoin imply for the future of Central Banking? (Pt. IV)



In rebuttal to this, there is the perspective that the almost inherent volatility of this currency will ward of any and all serious investors, as well as the public- Fig. 3 shows how quickly an ‘investment’ in Bitcoin can turn sour (in almost half a month, Bitcoins value fell by over 50%). Many commentators have reiterated this point- encapsulated when, in an interview with The Financial Times, Barry Silbert (founder of the Bitcoin Investment Trust) said:
‘For Bitcoin to move to the mainstream there has to be a high level of trust [and] a higher level of consumer-investor protection’[i]
To compound this, there is a huge flaw associated with the storage of Bitcoins that simply ignores the idea of human error- if a Bitcoin holder forgets their password to their Bitcoin ‘wallet’ they will have literally no other means of accessing them. Now, it can be said that the same applies for the storage of cash- it is much more difficult to lose $7.5million in notes and coins than it is in Bitcoins, as Mr. James Howells proved late last year in his desperate attempt to find a hard-drive upon which he had the details of 7,500 Bitcoins, worth approximately $7.5m at the time of reporting[ii] This then implies that any of the above evaluation of how badly Bitcoins could damage Central Banking is almost null and void. Although the aforementioned parties may be involved with Bitcoin to a lesser extent, there will still be collateral damage from the Bitcoins wider uptake, if Bitcoin is taken up as some suggest it will be.
Despite this, some still believe that the Bitcoin will stabilise- if one entertains this notion, it is possible to have a much broader and more colourful discussion in much greater depth. If the Bitcoin were to stabilise and act as a fully-fledged currency, in its own right, there would be a significant threat to the Central Banks of the world. The proliferation of the idea of a fully decentralised currency would mean that monetary policy, one of the main anti-inflationary tools available to Governments, would no longer be accessible. This would almost comprehensively block Central Banks from performing any and all of their abovementioned primary functions, provided their power remain unchanged in spite of industrial changes. Due to the organic evolution of regulation, and finance as an entity, this is very unlikely to happen- to answer the above question in short, the Bitcoin, in the long-run, may indeed change our systems, but the negative effect on Central Banking will be negligible. Governor Carney has shown this, perfectly, when he adjusted the Bank’s stance on Forward Guidance. Before entering the monetary structure the UK knows today, it has worked using the European-exchange Rate Mechanism (ERM), the Gold Standard, and varying other degrees of Bank of England (BoE) independence.
For the Central Banks of the world to adapt, however, there are four key steps that must be taken so ensure their survival, they will have to: begin regulation and monitor transactions that take place under Bitcoin; manage Bitcoin loans and securities (as perhaps an extension of the Securities Exchange Commission); begin accruing liquid Bitcoin reserves; and finally control monetary injection and stimulus to avoid deflationary spirals. Once these have been discussed, an unfortunate truth will no doubt yield its ugly head.
The first of these four steps may prove to be difficult as many see the main attraction of Bitcoin to be its anonymity and confidentiality, as has been shown with the recent ‘Silk Road’ trial:
‘Silk Road... a “sprawling black-market bazaar” used by drug dealers ... to distribute hundreds of kilograms of illegal drugs and launder hundreds of millions of dollars’[iii]
Ross William Ulbricht ran this multimillion dollar enterprise and allowing drug dealers all over America and the world to exchange products, using Bitcoins and the alias ‘Dread Pirate Roberts’. He has recently been charged on four counts: operating a narcotics-trafficking scheme; money laundering conspiracy; computer hacking; and operating a continuing criminal enterprise. This could culminate in a final sentence of a minimum of 30 years. This, however, is just one case out possibly hundreds or thousands that have simply not been uncovered, yet. To stop the proliferation of these types of enterprise, it is necessary to begin integrating regulation slowly to this market- if we suddenly impose huge regulations, consumers may simply stop using Bitcoins, even if they are not partaking in the more sinister side of the currency. By tackling the problem of Tor –a global network of volunteer relays making it almost impossible to trace someone’s whereabouts or online activity- Central Banks will be able to make major headway on breaking down the ‘Dark Web’. This sudden abandonment of a currency, almost fully ingrained in our society -as is the case with this model- would lead to a widespread collapse of businesses that rely upon it, not too dissimilar to the collapse of the Gold Standard.

 
Fig. 3

[i] S. Foley (2014), Bitcoin enters a new phase. The Financial Times- FT World.
[ii] Unknown (2013), James Howells searches for hard drive worth £4-worth of Bitcoins stored. BBC News- South East Wales.
[iii] P. Hurtado (2014), Silk Road’s Ulbricht Gets Trial Date in Online Drug Case. Bloomberg Technology.