Book of the Week: The End of Alchemy

06 Oct 2016

This week I read The End of Alchemy by Mervyn King, the former governor of the Bank of England, because he had a front row seat to the financial crisis. This is a very dense book, but it was worth taking my time going through the book to learn about money and banking. Money, paper money was created to be exchanged for gold. Banking transforms secure short-term deposits into long-term risky investments. That is a feat more impressive than changing lead into gold, the focus on traditional alchemy. This book talks about the end of alchemy, and the future of money and banking. There are four concepts that are central to the book.

• disequilibrium - This is when things are out of whack. Things should be stabilizing, but something is resisting the natural forces. Whatever that is happening is unsustainable.
• radical uncertainty - We have no freaking clue what will happen in the future. If could assign probabilities to everything that could happen, then I can accurately price things. There is risk and there is uncertainty. In risk, you can assign a probability to every event of a dice through. You have risk management departments, not uncertainty management.
• the prisoner’s dilemma - The classical game theory argument. If you both do something, then you will both benefit. If one person does it and the other one doesn’t, then one who doesn’t will benefit more greatly. Nobody wants to move first.
• trust - Confucius says, you need 3 things for government: weapons, food and trust. Trust is the grease that lets the economy move.

Recap of the Past The increased labor from developing countries (China) lead to more trade and a trade deficit. Since people were fearful of the future, there was a high savings rate in China, which lead to a decrease in long-term interest rates. People invested in lower and lower return investments as interest rates dropped. The U.S. and Europe cut interest rates to stimulate demand. Capital is normally exported to developing countries since those risker developments have higher returns, but what happened was that capital was exported to developed countries. This means that advanced countries borrowed money from the less developed world. Banks in advanced countries increased the size of their balance sheet. The low interest rate increases asset prices, because people are seeking places to place their money. Banks tart taking more risk because of low interest rates. A savings and banking glut made debt a higher proportion of GDP. Shit happens and you have a liquidity crisis. The problem is that low interest rates lead to bad investments. Low interest also rob demand from the future since it shifts future demand into the present. This makes it harder and harder to get grow economically, because you keep depleting demand further and further in the future. Money There are two criteria for something to be used as money.

1. Acceptability - it is accepted by anyone you wish to buy “stuff” from.
2. Stability - there is some predictability in its value in a future transaction.

Money started as physical things that were traded. The most first thing to be used as money is a physical commodity, like ramen in prison. If you ask a rancher how big his herd is, it is like asking their bank account amount. Then it became promissory notes that could be redeemed for a commodity, usually gold. Then it became physical things that were symbolic representations with no to little intrinsic value, fiat currency. Now it exists in digital forms like your bank account, electronic transfers, credit card, etc. Money became eventually a way to store value. Amount of money is US is roughly two-thirds of GDP. For there to be liquidity, the supply of money needs to be able to change. If everyone hoards cash, there is no liquidity. Without real goods backing the money, hyperinflation can occur. Money is vaporware. Tale of Two Dinars [youtube https://www.youtube.com/watch?v=lVehcuJXe6I&w;=560&h;=315] After the First Gulf War, Iraq was split into two by the no-fly zone. Saddam started printing his own money, “Saddam” dinars, since he could not import money from abroad. The Kurds to the north used the “Swiss” dinar, which was the original currency printed on Swiss plates. There was no government backing the “Swiss” dinar and the money supply was fixed, because no one was printing anymore currency. The price of the two currencies changed as expectations on the future of the Saddam regime. It is possible to have a currency without a government backing it, but its value is determined by expectations of the future. Gold [caption id=”attachment_6025” align=”aligncenter” width=”522”] Bank of England (lady) being violated by Prime Minister trying to get her gold. This cartoon protests the introduction of paper money.[/caption] Currency was historically tied to gold by each government at a fixed rate. Nixon broke the link between the dollar and gold to fight against inflation. The good side of gold is that it is accepted by most parties for exchange, because supply is fixed. The bad side of gold is that is is heavy and the supply of gold cannot change. Both a benefit and a drawback. Economic growth causes price of gold to increase in terms of goods and services. You can’t run an growing economy on a fixed supply gold. This is probably why, Milton Friedman suggested increasing the money supply each year. Bitcoin is more like digital gold for those who don’t trust the government rather than something to be used as money. Scam The book mentions and interesting scam that illustrates survivor bias. Send out mailers to about six thousand people saying that the market will go up this week to half of them and the market will go down to the other half. The next week, do the same thing, but only mail to the people who got the correct prediction. Do this for 5 weeks and you’ll get about two hundred people who believe that you correctly predicted the market for 5 weeks. Now ask them to invest in you. Banking Reform Central banks were originally shrouded in mystique and mystery, but over time, they had to become more transparent. Their main function is to determine the money supply in the good and bad times. Banks are need to provide capital for economic growth. Their assets are long-term and risky while their liabilities are short-term, liquid and perceived as safe. The problem is that their limited liability screws things up and causes them to take more risks. The central bank then becomes the lender of last resort (LOLR). But one needs to care and differentiate between liquidity and solvency problems. You can’t fix an underlying solvency problem by providing more liquidity. One suggestion is to transition from a lender of last resort into a pawn-broker for all seasons (PFAS) with more collateralized debt to limit exposure. There are a lot of other things in the book that you will have to read for yourself. This book is too damn dense.