Believe those who are seeking the truth. Doubt those who find it. Andre Gide

Thursday, February 22, 2018

The recession of 2012-13 and the taper tantrum

I admit this is a rather strange title for a post, but bear with me. Every once in a while I reflect back on the so-called "taper tantrum" event in the summer of 2013 when Fed Chair Ben Bernanke made an off-the-cuff remark that the FOMC was thinking of maybe slowing down the pace QE3 asset purchases (see here). The stock market had a temporary sell-off, which turned out to be no big deal. What I find more interesting is how long bond yields rose sharply and persistently. Even more interesting, real bond yields behaved in this manner--see the figure below.

OK, so maybe the initial sell-off of bonds could be interpreted as the market being surprised that QE3 (an open-ended program) might terminate earlier than expected. But I just can't believe that QE programs can have such persistent effects on real interest rates. If that's the case, then what explains the broad pattern on display above, including the decline in real yields over 2011-2013?

I attribute it largely to the recession of 2012-2013. Wait, what recession, you say? Well, let's take a look. Contrary to standard practice, I'm going to look at per capita consumption (of nondurables and services). Here is what the data looks like. 
Consumption growth per capita was negative from 2012.1-2013.3. The taper tantrum occurred in 2013.3.  As you can see by this measure, the economy weakened considerably over the period 2011-2013. Over the same time, real bond yields declined. This is most easily explained as the consequence of an increasingly bearish outlook manifesting itself as an increase in the demand for safety (bonds).

Consumption growth turned positive in 2013.4, and continued to climb well into 2015. So while the tantrum may have contributed to the spike up in yields, the reason they stayed higher is because of an increasingly bullish outlook for the economy.

Does this interpretation make sense? What events were leading to the bearish outlook beginning in 2011. Certainly the events in Europe had something to do with it. I also think that domestic factors had a role to play, in particular, fiscal policy. Consider the following diagram.

What would the consumption and GDP dynamic have looked like if government purchases (per capita) had instead remain constant?

Monday, February 19, 2018

U.S. GDP Expenditure Components

One way to decompose the GDP is in terms of its expenditure components, Y ≡ C + I + G + NX. I like to write "≡" instead of "=" to remind myself that this decomposition is measurement, not theory.
In what follows, consumption is measured in terms of nondurables and services only--I add consumer durables with private investment. The data is inflation-adjusted, quarterly, and I report year-over-year percent changes. I'll start with recent history (since 2010) and then later look at a longer sample (beginning in 1960).
Let me begin with GDP and consumption. I like to study consumption dynamics because I have some notion of Milton Friedman's "permanent income hypothesis" in the back of my mind. The idea is that individuals base their expenditures on nondurable goods and services more on their wealth (a stock) rather on income (a flow)--at least, to the extent they can draw on savings and/or access credit markets. To a first approximation then, one could interpret consumption as the trend for GDP. According to the theory, consumption should respond less strongly to perceived transitory changes in income (GDP) and more strongly to perceive permanent changes in income (GDP). In any case, here's what the data looks like for the U.S. since 2010. 
GDP growth since the end of the Great Recession has averaged about 2%, consumption growth somewhat less. Two things stand out for me. The first is the anemic consumption growth from 2011-early 2014 and in particular 2012-2013. Why were American households so bearish? (Note that the unemployment rate is declining throughout this sample period.) Things seemed to turn around in 2014, but then tailed off somewhat in 2015. Coincidentally (or not), that was the year in which the Fed talked out loud about "lift off" -- raising its policy rate for the first time from 25bp where it had remained since 2009. The second is where we're at now. Yes, GDP growth has rebounded somewhat since early 2016, but we're still well within the bounds of recent history (so, no sign of some impending boom). The tale is told by consumption growth, which has remained steady at about 2%. 
The following diagram plots private investment spending, decomposed into residential, non-residential, and consumer durables spending (note that the scales vary across figures).  
The growth rate in consumer durables spending is relatively stable in this sample period, averaging between 5-10%. Residential investment, which collapsed during the Great Recession, did not turn around until late 2011. It has grown as rapidly as 15% in 2012-2013 (the years of anemic consumption growth cited above), but has slowed down markedly since 2016. In terms of non-residential investment, it was surprising (to me) the weakness it displayed, especially in 2016 (this may have been due, at least in part, to the collapse in oil prices, which held back investment in the energy sector.)
Well, here's a picture for you. Government purchases of goods and services actually declined for most of this sample period. (Government investment consists mainly of structures and computer hardware/software (see here) and accounts for about 20% of government purchases.) I've been reflecting a lot on this picture lately because it looks different from what many may think, and also, it looks different from historical behavior (as we'll see below).  
For completeness, I include export and import growth. Nothing too interesting here. 
What does this same data look like from a longer time perspective? I reproduce the four figures above starting in 1960. 
This is really a striking figure, in my view. There are so many things that catch my eye. The first and most obvious is the decline in volatility beginning around 1985 (this is the so-called Great Moderation). Less obvious, but something worth noting is an apparent growing asymmetry associated with the Great Moderation. In particular, growth recessions seem roughly as severe as they've always been. What's missing are the sharp growth booms. Third, it seems to me that consumption growth was much less volatile than GDP growth prior to 1985. Andrew Spewak and I discuss this here. One possible explanation is that business cycle downturns are generally expected to be much more persistent than in the past (why this might be so would be an interesting question to investigate). Finally, and perhaps most important, economic growth since 2000 has slowed down significantly. St. Louis Fed President Jim Bullard argues we are in a low-growth regime (see here). Is this a recurring phenomenon, as suggested by Schumpeter (see here)? How much of the slowdown is explained by a post WW2 transition dynamic? 
Here is private investment spending across categories, 
Again, the Great Moderation is evident, apart from the monumental collapse of residential investment spending in the Great Recession. 
Like private investment, government investment is relatively volatile (though one wonders why this should be the case for government). The most striking aspect of this diagram is the collapse government spending in the immediate aftermath of the Great Recession. One can't help but wonder about the wisdom of such policy during such a period of economic weakness. For those in favor of reducing (G/Y), a more gradual policy would almost surely have been better (e.g., by letting Y grow into G, not by cutting G). 
Finally, for completeness, here is export and import growth. 
It's interesting that the Great Moderation shows up along this dimension as well.
If you have an economic theory that explains all these patterns, I'd be very interested to hear about it below.  

Thursday, February 8, 2018

Fiscal theories of the price-level

This post is me thinking out loud about how fiscal considerations may influence the price-level.  The question of what determines the price-level is an old one. It's a question that economists struggle with to this day.

To begin, what do we mean by the price-level? Loosely, the price-level refers to the "cost-of-living," where cost is measured in units of money. Living refers to the flow of services consumed (destroyed) for the purpose of survival/enjoyment. (Note that the cost-of-living might alternatively be measured as the amount of labor one must expend per unit of consumption, but this would require a separate discussion.)

Measuring aggregate material living standards is challenging for two reasons. First, people consume a variety of goods and services. Suppose that the price of food goes up and the price of shelter goes down. Does the cost-of-living go up or down? Second, different people have different material needs/wants (and individual wants and needs change over time too). Statisticians do the best they can to address these complications by constructing "average consumption bundles" as done in the calculation of the Consumer Price Index (CPI). The following diagram plots the change in the price-level (the inflation rate) for several categories of goods and services:

In what follows, I'm going to abstract from inflation and focus only on the theory of the price-level (inflation is the rate of change in the price-level over an extended period of time). To this end, think of a very simple world where the real GDP (y) is fixed and determined exogenously (independent of monetary policy). Assume that the expected rate of inflation is zero. Then, by the Fisher equation, the nominal interest rate corresponds to the real interest rate. I want to think of this interest rate as being potentially influenced by monetary policy (I like to think of r as representing the real yield on treasury debt, where treasury debt possesses a liquidity premium.)

Perhaps the oldest theory of the price-level is the so-called Quantity Theory of Money (QTM). It seems clear enough that people and agencies are willing to accept and hold money because money facilitates transactions--it provides liquidity services. In the simplest version of the QTM, the demand for real money balances takes the form L(y), where L is increasing in y. The idea here is that the demand for liquidity is increasing in the level of aggregate economic activity (as indexed by y).

Next, the QTM assumes that the supply of money (M) is determined by the central bank. Let P denote the price-level. Then (M/P) denotes the supply of real money balances. The QTM asserts that the price-level is determined by an equilibrium condition which equates the supply of real money balances with the demand for real money balances. Mathematically,

[1] M/P = L(y)

Condition [1] can be explained as the consequence of the "hot potato" effect. The idea is that someone must be willing to hold the extant money supply. If M/P > L, then the money supply exceeds money demand. In this case, people will presumably try to dispose of their money holdings (by spending them on goods and services). People accepting money for payment will be thinking the same thing--they are willing to accept the money, but only selling their goods at a higher price. The "hot potato" effect ceases only when condition [1] holds. The same logic applies in reverse when M/P < L (with everyone wanting to get their hands on the potato).

Now, suppose that y varies over time. Then the QTM suggests that a central bank can keep the price-level stable at P0 by letting the money supply move in proportion to money demand; i.e., M = L(y)*P0. This is what is meant by "furbishing an elastic currency." This reminds us as well that interpreting money-price correlations in the data are tricky if money demand is "unstable."

O.K., so now let's see where fiscal policy fits in here. Let D denote the outstanding stock of government debt. If a central bank is restricted to create money only out of government debt, then we can write M = θD, where 0 < θ < 1 is the fraction of the debt monetized by the central bank. If the central bank wants to increase the money supply, it would conduct an "open market operation" in which it buys bonds for newly-issued money, resulting in an increase in θ. Note that the money supply may increase through changes in D for a constant θ.

Let B denote the bonds held by the private sector (i.e., not including the bonds held by the central bank). That is, B = (1 - θ)D. The interest expense of the public debt is given by rB. Note, while the treasury actually pays an interest expense rD, the interest payments to the central bank rM are remitted to the treasury, leaving a net cost equal to rB = r(D-M). Thus, the central bank is in a position to lower the interest expense of the public debt by monetizing a larger fraction of it (I discuss this in more detail here and here.) To the extent that the central bank influences r, it is also in a position to lower the interest expense by lowering r.

Now let's write down the government "budget constraint." Let T denote tax revenue (net of transfers) and let G denote government purchases (of goods and services). Then, assuming that default is not an option, the government budget constraint is given by,

[2] = G + rB

The difference T - G is called the primary budget surplus (deficit, if negative). So another way to read [2] is that the interest expense of the government debt must be financed with a primary surplus. Note that if r < 0, then the government is in a position to run a perpetual primary deficit. (The more general condition is r < g, where g is the growth rate of the economy, which I've normalized here to be zero.)
In most monetary models, the fiscal policy plays no role in determining the price-level. The reason for this lies in the implicit assumption that taxes are non-distortionary (e.g., lump-sum) and that the fiscal authority passively adjusts T to ensure that condition [2] holds.  This latter assumption is sometimes labeled a Ricardian fiscal regime. In a Ricardian regime, fiscal policy does not matter for the price-level. To see this, suppose that the central bank increases r. Then the fiscal authority increases T (or decreases G) with no change in the money supply or price-level. Or, imagine that the fiscal authority increases D. In this case, the central bank can keep the money supply constant by lowering θ, the fraction of debt it chooses to monetize. If so, then B will increase. In a Ricardian regime, the fiscal authority will again either increase T (or decrease G), leaving the price-level unchanged. 

But suppose fiscal policy does not behave in the Ricardian manner described above. To take an example, suppose that the fiscal authority instead targets T, or T-G, or (T-G)/P, etc. For concreteness, suppose it targets the real primary surplus τ = (T-G)/P.  In this case, condition [2] can be written as, 

[3] τ = r(B/P)

Condition [3] forms the basis of what is known as the fiscal theory of the price-level (FTPL); see Cochrane (1998). The idea is as follows. Imagine a world where there is no need for money (a cashless economy), so that condition [1] is irrelevant. Imagine too that the real rate of interest is determined by market-forces, so that r > 0 represents the "natural" rate of interest. Finally, imagine that the outstanding stock of debt D = B is nominal. Then the price-level is determined by condition [3] which, while resembling a government budget constraint, is in fact a standard stock-valuation equation. To see this, rewrite [3] as follows,

[4] (B/P) = τ/r

The right-hand-side of [4] represents the present value of a perpetual flow of primary government budget surpluses τ. The left-hand-side of [4] measures the real value of the government's debt. The equation [4] asserts that the real value of government debt is equal to the present value of the stream of primary surpluses. This is analogous to the way one might value the equity of a company that generates a stream of profits τ. 

Note that condition [4] looks a lot like condition [1]. We can use the same "hot potato" analogy to describe the determination of the price-level in this case. For example, suppose that (B/P) > τ/r. Then people and agencies will presumably want to sell the over-valued government debt (for goods and services). People are willing to accept these nominal claims, but only if they are sold more cheaply--that is, if the goods sold to acquire the bonds can be sold at a higher price. As before, this hot potato effect ceases only when condition [4] holds. 

I'm still not sure what to think about the FTPL. While I lean more toward the QTM view, I do believe that fiscal considerations can have an important influence on the price-level. The way I'm inclined to think about this, however, is as follows. 

Since nominal government debt represent claims against government money, it's not surprising that such debt inherits a degree of "moneyness." To the extent this is true, the measure of money M used in equation [1] should be expanded to include the liquid component of government debt. Let X < B denote the liquid component of government debt. There are a few ways to think about this. One obvious way is to imagine that the banking sector creates deposit liabilities out of X. Or we could imagine that X is accepted directly as payment for goods and services, at least, for a subset of agencies (China, for example, effectively exports goods and services for X). In any case, the appropriate measure of money is given by M + X. In the limiting case where X = B, the relevant money supply becomes the entire government debt D = M + B, so that condition [1] becomes, 

[5] D/P = L(y)

In a world where government debt becomes increasingly more relevant as an exchange medium than central bank money, control over the money supply is effectively transferred to the fiscal authority.  This is another sense, distinct from the FTPL, in which fiscal policy might influence the price-level. The difference boils down to the source of money demand -- is it primarily liquidity-preference, or is it because money/debt instruments are viewed as tax-backed liabilities?

There is, of course, much that I've left out here.  While the assumed invariance of real economic activity to monetary and fiscal policy is not a bad place to start for the question at hand, it is clearly not a good place to end. As well, the model should be extended to permit sustained inflation. All of this can be easily done and I'll try to come back to it later. 

Something I do not think is critical for the issue at hand is modeling private money creation (beyond the monetization of government debt modeled above). To the extent that banks monetize positive NPV projects, the money they create out of private assets (in the act of lending) creates value that is commensurate with additional liabilities created. In short, accretive share issuances (good bank loans) are not likely to  be dilutive (inflationary). Of course, the same is true of newly-issued government money if the new money is used to finance positive NPV projects (including the employment of labor in cases of severe underemployment). 

Sunday, January 21, 2018

Blockchain: what it is, what it does, and why you probably don't need one

Dilbert - by Scott Adams
Interest in blockchain is at a fever pitch lately. This is in large part due to the eye-popping price dynamics of Bitcoin--the original bad-boy cryptocurrency--which everyone knows is powered by blockchain...whatever that is. But no matter. Given that even big players like Goldman Sachs are getting into the act (check out their super slick presentation here: Blockchain--The New Technology of Trust) maybe it's time to figure out what all the fuss is about. What follows is based on my slide deck which I recently presented at the Olin School of Business at a Blockchain Panel (I will link up to video as soon as it becomes available) 

Things are a little confusing out there I think in part because not enough care is taken in defining terms before assessing pros and cons. And when terms are defined, they sometimes include desired outcomes as a part of their definition. For example, blockchain is often described as consisting of (among other things) an immutable ledger. This is like defining a titanic to be an unsinkable ship. 

So what do people mean when they bandy about the term blockchain? I recently had a chance to learn about the project from a corporate perspective as represented by Ed Corno of IBM (see IBM Blockchain), the other member of the panel I mentioned above. From Ed's slide deck we have the following definition:
Blockchain: a shared, replicated, permissioned ledger with consensus, provenance, immutability and finality. 
Well, if this is what blockchain is, then maybe I want one too! The issue I have with this definition (apart from the fact that it confounds descriptive elements with desired outcomes) is that it glosses over what I consider to be an important defining characteristic of blockchain: the consensus mechanism. Loosely speaking, there are two ways to achieve consensus. One is reputation-based (trust) and the other is game-based (trustless). 

I'm not 100% sure, but I believe the corporate versions of blockchain are likely to stick to the standard model of reputation-based accounting. In this case, the efficiency gains of "blockchain" boil down to the gains associated with making databases more synchronized across trading partners, more cryptographically secure, more visible,  more complete, etc. In short, there is nothing revolutionary or radical going on here -- it's just the usual advancement of the technology and methods associated with the on-going problem of database management. Labeling the endeavor blockchain is alright, I guess. It certainly makes for good marketing!

On the other hand, game-based blockchains--like the one that power Bitcoin--are, in my view, potentially more revolutionary. But before I explain why I think this, I want to step back a bit and describe my bird's eye view of what's happening in this space. 
A Database of Individual Action Histories

The type of information that concerns us here is not what one might label "knowledge," say, as in the recipe for a nuclear bomb. The information in question relates more to a set of events that have happened in the past, in particular, events relating to individual actions. Consider, for example, "David washed your car two days ago." This type of information is intrinsically useless in the sense that it is not usable in any productive manner. In addition to work histories like this, the same is true of customer service histories, delivery/receipt histories, credit histories, or any performance-related history. And yet, people value such information. It forms the bedrock of reputation and perhaps even of identity. As such, it is frequently used as a form of currency. 

Why is intrinsically useless history of this form valued? A monetary theorist may tell you it's because of a lack of commitment or a lack of trust (see Evil is the Root of All Money). If people could be relied upon to make good on their promises a priori, their track records would largely be irrelevant from an economic perspective. A good reputation is a form of capital. It is valued because it persuades creditors (believers) that more reputable agencies are more likely to make good on their promises. We keep our money in a bank not because we think bankers are angels, but because we believe the long-term franchise value of banking exceeds the short-run benefit a bank would derive from appropriating our funds. (Well, that's the theory, at least. Admittedly, it doesn't work perfectly.) 

Note something important here. Because histories are just information, they can be created "out of thin air." And, indeed, this is the fundamental source of the problem: people have an incentive to fabricate or counterfeit individual histories (their own and perhaps those of others) for a personal gain that comes at the expense of the community. No society can thrive, let alone survive, if its members have to worry excessively about others taking credit for their own personal contributions to the broader community. I'm writing this blog post in part (well, perhaps mainly) because I'm hoping to get credit for it. 

Since humans (like bankers) are not angels, what is wanted is an honest and immutable database of histories (defined over a set of actions that are relevant for the community in question). Its purpose is to eliminate false claims of sociable behavior (acts which are tantamount to counterfeiting currency). Imagine too eliminating the frustration of discordant records. How much time is wasted in trying to settle "he said/she said" claims inside and outside of law courts? The ultimate goal, of course, is to promote fair and efficient outcomes. We may not want something like this creepy Santa Claus technology, but something similar defined over a restricted domain for a given application would be nice. 

Organizing History

Let e(t) denote a set of events, or actions (relevant to the community in question), performed by an individual at date t = 1,2,3,... An individual history at date t is denoted 

h(t-1) = { e(t-1), e(t-2), ..., e(0) }, t = 1,2,3,... 

Aggregating over individual events, we can let E(t) denote the set of individual actions at date t, and let H(t-1) denote the communal history, that is, the set of individual histories of people belonging to the community in question:

H(t-1) = { E(t-1), E(t-2), ... , E(0) }, t = 1,2,3,...

Observe that E(t) can be thought of as a "block" of information (relating to a set of actions taken by members of the community at date t). If this is so, then H(t-1) consists of time-stamped blocks of information connected in sequence to form a chain of blocks. In this sense, any database consisting of a complete history of (community-relevant) events can be thought of as a "blockchain." 

Note that there are other ways of organizing history. For example, consider a cash-based economy where people are anonymous and let e(t) denote acquisitions of cash (if positive) or expenditures of cash (if negative). Then an individual's cash balances at the beginning of date t is given by h(t-1) = e(t-1) + e(t-2) + ... + e(0). This is the sense in which "money is memory." Measuring a person's worth by how much money they have serves as a crude summary statistic of the net contributions they've made to society in the past (assuming they did not steal or counterfeit the money, of course). Another way to organize history is to specify h(t-1) = { e(t-1) }. This is the "what have you done for me lately?" model of remembering favors. The possibilities are endless. But an essential component of blockchain is that it contains a complete history of all community-relevant events. (We could perhaps generalize to truncated histories if data storage is a problem.)

Database Management Systems (DBMS) and the Read/Write Privilege

Alright then, suppose that a given community (consisting of people, different divisions within a firm, different firms in a supply chain, etc.) wants to manage a chained-block of histories H(t-1) over time. How is this to be done? 

Along with a specification of what is to constitute the relevant information to be contained in the database, any DBMS will have to specify parameters restricting:

  1. The Read Privilege (who, what, and how);
  2. The Write Privilege (who, what, and how). 

That is, who gets to gets to read and write history? Is the database to be completely open, like a public library? Or will some information be held in locked vaults, accessible only with permission? And if by permission, how is this to be granted? By a trusted person, by algorithm, or some other manner? Even more important is the question of who gets to write history. As I explained earlier, the possibility for manipulation along this dimension is immense. How to guard against to attempts to fabricate history?

Historically, in "small" communities (think traditional hunter-gatherer societies) this was accomplished more or less automatically. There are no strangers in a small, isolated village and communal monitoring is relatively easy. Brave deeds and foul acts alike, unobserved by some or even most, rapidly become common knowledge. This is true even of the small communities we belong to today (at work, in clubs, families, friends, etc.). Kocherlakota (1996) labels H(t-1) in this scenario "societal memory." I like to think of it as a virtual database of individual histories living in a distributed ledger of brains talking to each other in a P2P fashion, with additions to, and maintenance of, the shared history determined through a consensus mechanism. In this primitive DBMS, read and write privileges are largely open, the latter being subject to consensus. It all sounds so...blockchainy. 

While the primitive "blockchain" described above works well enough for small societies, it doesn't scale very well. Today, the traditional local networks of human brains have been augmented (and to some extent replaced) by a local and global networks of computers capable of communicating over the Internet. Achieving rapid consensus in a large heterogeneous community characterized by a vast flows of information is a rather daunting task. 

The "solution" to this problem has largely taken the form of proprietary databases with highly restricted read privileges managed by trusted entities who are delegated the write privilege. The double-spend problem for digital money, for example, is solved by delegating the record-keeping task to a bank, located within a banking system, performing debit/credit operations on a set of proprietary ledgers connected to a central hub (a clearing agency) typically managed by a central bank.

The Problem and the Blockchain Solution

Depending on your perspective, the system that has evolved to date is either (if you are born before 1980) a great improvement over how things operated when we were young, or (if you are born post 1980) a hopelessly tangled hodgepodge of networks that have trouble communicating with each other and are intolerably vulnerable to data breaches (see figure below, courtesy Ed Corno of IBM). 

The solution to this present state of affairs is presented as blockchain (defined earlier) which Ed depicts in the following way,
Well sure, this looks like a more organized way to keep the books and clear up communication channels, though the details concerning how consensus is achieved in this system remain a little hazy to me. As I mentioned earlier, I'm guessing that it'll be based on some reputation-based mechanism. But if this is the case, then why can't we depict the solution in the following way? 

That is, gather all the agents and agencies interacting with each other, forming them into a more organized community, but keep it based on the traditional client-server (or hub-and-spoke) model. In the center, we have the set of trusted "historians" (bankers, accountants, auditors, database managers, etc.) who are granted the write-privilege. Communications between members may be intermediated either by historians or take place in a P2P manner with the historians listening in. The database can consist of the chain-blocked sets of information (blockchain) H(t-1) described above. The parameters governing the read-privilege can be determined beforehand by the needs of the community. The database could be made completely open--which is equivalent to rendering it shared. And, of course, multiple copies of the database can be made as often as is deemed necessary. 

The point I'm making is, if we're ultimately going to depend on reputation-based consensus mechanisms, then we need no new innovation (like blockchain) to organize a database. While I'm no expert in the field of database management, it seems to me that standard protocols, for example, in the form of SQL Server 2017, can accommodate what is needed technologically and operationally (if anyone disagrees with me on this matter, please comment below).

Extending the Write Privilege: Game-Based Consensus

As explained above, extending the read-privilege is not a problem technologically. We are all free to publish our diaries online, creating a shared-distributed ledger of our innermost thoughts. Extending the write-privilege to unknown or untrusted parties, however, is an entirely different matter. Of course, this depends in part on the nature of the information to be stored. Wikipedia seems to work tolerably well. But its hard to use Wikipedia as currency. This is not the case with personal action histories. You don't want other people writing your diary! 

Well, fine, so you don't trust "the Man." What then? One alternative is to game the write privilege. The idea is to replace the trusted historian with a set of delegates drawn from the community (a set potentially consisting of the entire community). Next, have these delegates play a validation/consensus game designed in such a way that the equilibrium (say, Nash or some other solution concept) strategy profile chosen by each delegate at every date t = 1,2,3,... entails: (1) No tampering with recorded history H(t-1); and (2) Only true blocks E(t) are validated and appended to the ledger H(t-1).

What we have done here is replace one type of faith for another. Instead of having faith in mechanisms that rely on personal reputations, we must now trust that the mechanism governing non-cooperative play in the validation/consensus game will deliver a unique equilibrium outcome with the desired properties. I think this is in part what people mean when I hear them say "trust the math." 

Well, trusting the math is one thing. Trusting in the outcome of a non-cooperative game is quite another matter. The relevant field in economics is called mechanism design. I'm not going to get into details here, but suffice it to say, it's not so straightforward designing mechanisms with sure-fire good properties. Ironically, mechanisms like Bitcoin will have to build up trust the old-fashioned way--through positive user experience (much the same way most of us trust our vehicles to function, even if we have little idea how an internal combustion engine works). 

Of course, the same holds true for games based on reputational mechanisms. The difference is, I think, that non-cooperative consensus games are intrinsically more costly to operate than their reputational counterparts. The proof-of-work game played by Bitcoin miners, for example, is made intentionally costly (to prevent DDoS attacks) even though validating the relevant transaction information is virtually costless if left in the hands of a trusted validator. And if a lack of transparency is the problem for trusted systems, this conceptually separate issue can be dealt with by extending the read-privilege communally.  

Having said this, I think that depending on the circumstances and the application, the cost associated with a game-based consensus mechanism may be worth incurring. I think we have to remain agnostic on this matter for now and see how future developments unfold. 

Blockchain: Powering DAOs
If Blockchain (with non-cooperative consensus) has a comparative advantage, where might it be? To me, the clear application is in supporting Decentralized Autonomous Organizations (DAOs).  A DAO is basically a set of rules written as a computer program. Because it possesses no central authority or node, it can offer tailor-made "legal" systems unencumbered by prevailing laws and regulations, at least, insofar as transactions are limited to virtual fulfillments (e.g., debit/credit operations on a ledger). 

Bitcoin is an example of a DAO, though the intermediaries that are associated with Bitcoin obviously are not. Ethereum is a platform that permits the construction of more sophisticated DAOs via the use of smart contracts. The comparative advantages of DAOs are that they permit: (1) a higher degree of anonymity;  (2) permissionless access and use; and (3) commitment to contractual terms (smart contracts). 

It's not immediately clear to me what value these comparative advantages have for registered businesses. There may be a role for legally compliant smart contracts (a tricky business for international transactions). But perhaps the potential is much more than I can presently imagine. Time will tell.

Link to my past posts on the subject of Bitcoin and Blockchain.

Wednesday, January 10, 2018

Lowflation: Then and Now

The term "lowflation" was initially coined by economists at the IMF in 2014 (see here). It refers to an inflation rate that is persistently low (relative to some target) and positive (so, not deflation). Here is what lowflation looks like in the United States:

How should we think about lowflation? I've written a bit on the subject here and here. Is the phenomenon unusual? Is it something we should worry about?

As it turns out, the phenomenon is not unusual even in recent U.S. monetary history. The following diagram plots the PCE core inflation rate for the United States since 1960. The shaded areas represent "lowflation" episodes--periods in which PCE core inflation is below 2%.

The early 1960s was also an era of lowflation. So was the more recent period 1996-2003. The period 2004-2008 of (slightly above 2%) inflation seems more like a recent aberration.

Is lowflation a problem? Perhaps. But if it is, it certainly doesn't seem to show up in the economy's RGDP growth performance. The following figure plots the growth rate of RGDP and RGDP per capita for each of the high and low inflation episodes identified in the early figure.

In this sample period, economic growth in lowflation episodes averages about the same as growth in non-lowflation episodes. What is one to make of this?

Wednesday, December 27, 2017

Fedcoin and blockchain

I see Campbell Harvey promoting the idea of Fedcoin here: "Bitcoin is Big. But Fedcoin is Bigger." I'm not sure I agree with his pitch for the idea.

Let's start with Harvey's claim that
"Bitcoin and other cryptocurrencies are based on a complicated technology known as blockchain, which acts like a digital ledger of all transactions completed with the currency."
Complicated? Well, yes and no. As I explain here "Why the blockchain should be familiar to you," there's a sense in which blockchain technology--a growing record of communal history existing on a distributed virtual ledger updated via a communal consensus algorithm--is an ancient innovation. Indeed, I claim that most of our small-group social interactions today still make extensive use of blockchain technology. Of course, the underlying mechanics of how Bitcoin works seems complicated to most people. But the same could be said of how electronic payments are executed today.

A digital ledger of all transactions completed with the currency? Well, not exactly. Remember, there are always two sides to any transaction, with money flowing in one direction and something else flowing in the other. Bitcoin does not record what moves in the other direction. All that is recorded is the movement of bitcoin from wallet to wallet. The identity of who owns each particular wallet need not be visible. This is quite unlike the way digital money works in the banking system, where the identities of transacting parties are visible on proprietary ledgers.

He goes on to suggest that 
"It [blockchain] is somewhat similar to the serial number that you find on every dollar bill, but it actually means something because it makes bitcoin nearly impossible to counterfeit."
The notion that a monetary unit in the blockchain can be thought of as a unique non-counterfeitable serial number is not a bad analogy. The analogy recognizes that the object of concern relates to the money itself (as is the case for physical cash) and not on the identity of who owns the money (as is the case for present-day bank-sector digital money). And so, when one speaks of central banks making use of "blockchain" technology, I presume that one means the issuance of digital bearer instruments and not just plain old digital money accounts (like what we already have today at 

Unfortunately, Harvey never really defines what he means by Fedcoin. At times, I think he is talking about digital cash (digital bearer instruments secured on a blockchain). At other times, I think he's just talking about plain old central bank digital money being made available to the broader public. 

Harvey identifies the following benefits associated with Fedcoin: 1) Unlike physical cash, transactions would be visible; 2) it would permit a central bank to implement negative interest rate policies; 3) it would permit the implementation of helicopter cash. 

I'm not exactly sure what he imagines would be visible in a Fedcoin transaction. A lot depends on how the system is set up and whether the money exists as a digital bearer instrument or as plain digital money in an identifiable account. As for negative interest rate policy, yes it would be possible, though this would hardly serve as a panacea as far as monetary policy is concerned. Finally, helicopter cash is possible even today. The barrier here is not technological, it is political. 

On top of this, Harvey also suggests efficiency gains in payments are possible:
"Fedcoin, by contrast, would be decentralized to various Federal Reserve banks. There would be central control over the money supply, just as we have today, but meanwhile, the technology would offer vast improvements in transaction efficiency. Digital transactions are quick, cheap and potentially a lot more secure than the system we have today."
The technology (blockchain, I presume) would offer vast improvements in transaction efficiency? I confess that I simply cannot see what people are talking about when they say things like this. In my mind, there is nothing that can beat a centrally managed ledger (with backups) in terms of cost efficiency. Consensus record-keeping methods are inherently slower and more costly. There may be applications where these costs are worth bearing. But managing a central bank digital currency is not one of these applications. 


My writings on the subject of Bitcoin can be found here: Collected Works.

Thursday, December 21, 2017

My perspective on the Bitcoin Project (collected works)

It's true, I really did say that.
It's Christmas time and I'm in a giving mood. So I thought I'd collect all my writings and talks related to Bitcoin and blockchain in one easy-to-access spot.

Like many people, I first took notice of Bitcoin in 2013, after its price soared to over $1000, before plummeting significantly. Thank goodness I didn't buy any back then (D'oh!). Many economists dismissed the phenomenon as just another bubble/scam. This was my initial instinct as well, but after checking under the hood, I discovered something intriguing and worth learning more about.

Bitcoin/blockchain is generally much better understood today than it was back then, although an air of mystery persists. But the concept is not very complicated at all, even if the underlying mechanics are. I liken this situation to how we understand machines. For example, most of us roughly understand how an internal combustion engine works, even if we don't know enough to build or repair one ourselves. Hopefully, you'll find some similar level intuition in my writings on the subject below.  You may also find my posts and presentations of interest because I approach the subject from the perspective of an academic / central banker.

I list my blog posts and talks on the subject below in chronological order (to monitor how my thinking evolves on the subject).

[1] Why Gold and Bitcoin Make Lousy Money. April 23, 2013. Link to blog post.
[2] Bitcoin and Beyond: The Possibilities and Pitfalls of Virtual Currencies. Dialogue with the Fed (a public lecture hosted by the Federal Reserve Bank of St. Louis), March 31, 2014. Slide deck. Link to presentation.

[3] The Virtual Currency Revolution. Opening address at the DATA annual meeting, April 10, 2014. Link to presentation.

[4] Cryptocurrencies: Bitcoin and Beyond. SFU Vancouver Speakers Series, July 7, 2014. Link to presentation.

[5] Bitcoin and Beyond: The Possibilities and Pitfalls of Virtual Currency. Federal Reserve Bank of Atlanta, Jacksonville Branch, November 16, 2014. Updated slide deck.

[6] Bitcoiners: Surely We Can Do Buiter Than This? November 27, 2014. Link to blog post.
[7] Money and Payments, or How We Move Marbles. February 1, 2015. Link to blog post.

[8] Fedcoin: On the Desirability of a Government Cryptocurrency. International Workshop on P2P Financial Systems, Frankfurt, February, 2015. Link to presentation. Link to related blog post.

[9] Bitcoin: A Decentralized Public-Legder Digital-Asset-Transfer Mechanism. Bendheim Lecture, Princeton University, May 1, 2015. Link to presentation.

[10] Fedcoin and the Implications of Cryptocurrencies Issued by Central Banks. June 15, 2015. Link to podcast.
[11] Bitcoin and Central Banking. November 12, 2015. Link to blog post.
[12] Is Bitcoin a Safe Asset? March 27, 2016. Link to blog post.
[13] Monetary Policy Implications of Blockchain Technology. May 1, 2016. Link to blog post.
[14] Why the Blockchain Should Be Familiar to You, May 5, 2016. Link to blog post.
[15] Can the Blockchain Kill Fake News? December 30, 2016. Link to blog post.

[16] Tyler Cowen on Central Bank Cryptocurrencies. November 27, 2017. Link to blog post

There's still much more I'd like to write about. I find what's happening with BTC fees rather interesting. Somewhere in one of my talks above I speculated that in the long-run, the fees miners charge were likely to rise to Visa and Mastercard rates. It looks like we're well beyond that now, but is this temporary or likely to persist?

The price dynamics right now are astounding, of course. But remember that the success or failure of the Bitcoin Project does not depend on the market price of BTC (as long as it stays above zero). The potential revolution here is in record-keeping. Who knew that accounting might offer so much fun and excitement?

[17] Fedcoin and Blockchain. December 27, 2017. Link to blog post
[18] Blockchain: What it is, what it does, and why you probably don't need one. January 21, 2018. Link to blog post