Bits and coins

Bitcoins – a new way to get rich! They are going up! up! up! Excitement is spreading. Tiny island of Alderney wants to become the first jurisdiction to mint Bitcoins in partnership with UK’s Royal Mint (FT article¹). It seems Bitcoins are going mainstream now.  Is it all for real?

I am not so sure. I think it is a bubbling bubble. As Greenspan remarked (Sydney Morning Herald article²), there is no intrinsic value to the currency or credit of the issuing entity backing it. Then holding a Bitcoin does not give a right of being paid any money by anyone.  In a recent report³ Citibank raises the issue of competition from other virtual currencies also.

However, the brand seems to have a deeper appeal to the faithful. Its anti-establishment nature is one. Ability to go around government restrictions is another. A South China Morning Post story⁴ talks of Bitcoin popularity in China, partly for its ability to avoid capital controls. It also makes transactions more convenient and cheaper in the new e-conomy. A story in The Hindu⁵ talks about small tea gardens in India exploring Bitcoins usage to lower transaction fees.

So what do regulators think? Governments don’t like things they can’t control. They have some genuine concerns too. Ease of money laundering and illicit fund flow is one. Regulators might also worry about virtual currencies creating an alternate financial system in extreme scenario, thereby increasing financial volatility. On Friday, People’s bank of China (PBoC) banned financial institutions from dealing in Bitcoins (Bloomberg⁶). Thailand has already declared Bitcoins illegal. However, most regulators are as yet undecided.

A likely future scenario is of regulations gradually increasing around Bitcoin usage. However, virtual currencies won’t go away until & unless alternative arrangements evolve to fill the voids that they fill today.

References:

1. ‘Alderney looks to cash in on virtual Bitcoins with Royal Mint reality’ – Financial Times
2. ‘Bitcoin a bubble, not a currency says former Fed chief Alan Greenspan’- The Sydney Morning Herald
3. ‘More on Bitcoin as a currency’ – Citi research
4. ‘Chinese Yuan dominates global Bitcoin trade’- South China Morning Post
5. ‘Tea growers explore Bitcoin option to expand global biz’ – The Hindu
6. ‘China bans financial companies from Bitcoin transactions’- Bloomberg

Popular discontent in Brazil

A recent article about middle class protests in Brazil had some interesting explanations for the events, which I’d like to share. The analysis cited three main reasons for the protests.

First, infrastructure improvement didn’t keep pace with improvement in people’s homes & offices i.e. growth rate of people’s income exceeded growth rate of economy. This caused discontentment in middle class.

A high growth rate of purchasing power implies fast income growth and/or higher credit availability. Then there are two ways discontent can grow. One, when economic conditions stop improving. This can be via stagnation in wages, or reduction in credit availability. Discontent can also brew if rate of improvement of economic conditions is not sufficient i.e. growth rate of economic conditions could be positive, but slower than negative forces, so that overall situation deteriorates. E.g. wage growth rate could be positive but still lower than consumer or asset price inflation. So the situation is effectively contraction in income. A salient feature of US style capitalism is an increase in inequality. A few people benefit from asset price inflation, while majority pays the price. This produces a sense of injustice, thereby exacerbating discontent.

Second, income of boom years was consumed and not invested. So a lot of improvement in people’s condition was short term and didn’t carry through in lean period. People also borrow more to keep the party going as long as possible, which means that when the party ends, not only do wages get pressured, debt burden hurts too.

Third, related to previous two, is consumerism, wanting to consume more and more. People got everything they want easily (via credit) and not being able to do that any longer made them angry.

It is interesting to note significant role of credit in this story. Looked one way, credit provides an ability to consume more than one can afford. Governments of major countries are promoting the same with easy money. However, we already know how this movie ends. If we compare the response of governments with what an individual would do, most countries do not fare very well:

		US	EU	JP	CN
1	Increase income (Create production capacity)	X	X		√
2	Control costs	X	√	X	X
3	Save money	X	X	X	X
4	Reduce debt	X	√	X	X
	Else
5	Get more debt	√	√	√

Wage Story

Last Monday morning I was sitting at airport, seeing off my better half, when I chanced upon a small advertisement for a shoe shine service. Like everything else at airports this also seemed a bit overpriced. My thoughts moved to broader topic of high minimum wages in certain countries. Are they beneficial for economies or harmful? Do high wages impede economic growth?

 

One can argue from both sides. Disadvantages of high wages include reduced efficiency in the system, higher manpower cost for companies and higher hurdle rate for starting new companies. Thus higher wages can impede job growth. However, on the positive side, higher wages promote more equitable distribution of wealth. By putting more money in pocket of poor they help increase domestic consumption (since poor spend a greater proportion of their income than the rich).

 

Okay, so what are the conditions where higher wage system is more appropriate? If a country has higher wages, then companies will need to charge more to offset manpower costs. So prices will be higher (Price levels only. Inflation may or may not be high). A rich society will be able to afford these elevated prices, poorer society will find cheaper alternatives (informal economy). Additionally, in most cases the society with high price levels would need to have relatively low population growth rates. This is because high wages would lead to relatively slower rate of job creation. (This assumes that the economy is not dominated by fast growing high value add industries). Then, one can conclude that high minimum wages are more appropriate for developed economies (high GDP per capita, high PPP, slow population growth), while low wage system is more appropriate for developing economies (low GDP per capita, faster population growth, need for more job creation).

 

A high wage system, however, is more difficult to maintain in recessions and slow growth periods. High price levels imply more difficulty for poor to survive. Thus a need for government support programs like social security, unemployment benefits etc. However, if this support is removed or reduced then it’ll have direct implications for society in magnitude (roughly) proportional to number of unemployed. Variants of results are visible in developed economies all over – political tilt towards socialism (US), increase in support for extremist parties (Netherlands, France), breakdown in social order (Greece), and governments avoiding reforms (taking short term measures to solve long term problems) to appease masses (France).

 

Efforts to counter this via money printing can have only limited success. In fact, certain amount of deflation would help, by bringing prices down to affordable levels. Of course, economic activity would still need to accelerate to avoid a downward spiral.

Mexican Puzzle

Prostitution doesn't pay in Mexico

Mexico's prostitutes must be very poor. Dear reader, if you were to have some spare time and decided to leisurely skim through Mexico's national accounts tables, you will also come across a table 'Household consumption and private non-profit, total spending on the domestic market', classified by purpose showing household spending categories. In this table, within the section 'Total miscellaneous goods and services', is a sub-heading - 'Prostitution'. Obviously it must be a fairly important industry in there. However, the recorded expenditure in this category for last few years has consistently been zero. Does that mean that Mexico's prostitutes are the most underpaid in work and they do their job just for the love of God? The reality is probably that prostitution is big business but mostly in informal sector. Thus a big expenditure category with zero official expenditure.

Japan: back to past

Japan finally decided to raise sales tax from 5% to 8%, effective Apr2014, with some offsetting stimulus measures, mainly in form of corporate tax reduction. With this, the government has taken firm steps towards the familiar low growth levels. 

Japanese consumers are already suffering from supply side inflation. Closure of nuclear power plants and fall in yen are leading to higher import price inflation, and thus higher domestic inflation. Higher sales tax on top of that will hurt domestic consumption strongly. 

The government hopes to increase Japanese household income to counter this problem. So they are asking the industry whether they can do something about it. The government also has a goodie bag of its own which includes tax exemptions for new house purchases and for equity investments. The problem is that these measures are not sustainable. In a land of shrinking population housing demand can be stimulated only so far. When that population is ageing, it saves a lot and that also in safe options like bank deposits and government bonds. Hoping to move them to equity markets is rather ambitious. 

What Japan really needs is structural reforms. That is a very difficult and potentially unpopular task, especially in a traditional society. That is also the topic of Mr. Abe’s third arrow which seems to have gone missing.

Demographic Effects

Last week financial press had two interesting articles about economic effects of declining populations. FT mentioned a paper by Masaaki Shirakawa, former governor of BoJ, where he claims that decline in a country’s working age population leads to deflation. Older people spend less than the young, and take less debt. As a result, domestic demand falls and deflationary pressures build. This is where the second article picks up. A research paper quoted in Reuters claimed that monetary policy becomes less effective as societies age. Older people save more, borrow less and therefore are less sensitive to interest rate changes than the young. Therefore, as societies age, central banks have to pull harder to achieve the same end results.

Central banks in ageing western (and some Asian) countries are already doing that. Policy rates are at historic low and for historic long. QE, a different version of the same concept of cheaper debt, also has no end in sight. The effect is higher investment flows leading to asset price inflation, and potentially a bubble somewhere. That somewhere may well be developing markets. Huge amount of hot money inflow is having destabilizing effect in these countries. Asset price inflation with possible asset bubble is one such effect. Higher interest rate volatility and market uncertainty are others.

The second observation of fall in domestic demand in ageing countries also suggests that these economies may need to be rebalanced away from credit fueled domestic consumption. Then, fiscal policies become more important for economic growth. Also, deflation may only be a mechanism to shrink industry down to demand level. Then, central banks might want to rethink their stance of fighting deflation by all means. Net conclusion – rethink current monetary policies.