Category Archives: Banking

… Artificial Intelligence

Over the last year artificial intelligence (AI) has become nearly ubiquitous in the news. Just recently, Elon Musk called it a threat to human civilization. His warnings have been the direst, but many other people think that AI has the potential to replace billions of human jobs, and we need to adapt now to prevent mass-unemployment.

This represents a naïve view of capitalism, but one that is increasingly popular with politicians, pundits, and people who listen to them. Jobs may certainly be cut, but it is more likely that new jobs, in the traditional sense, simply will not be created. Companies will reduce labor costs across the board, leaving more profits for business owners and their remaining knowledge workers. Prices for goods and services that involve automated labor will also come down, relative to all other prices. The result will be more discretionary income, and where we choose to spend it will determine in what sectors new jobs will be created. Certainly, there will be people left behind, at least temporarily. Society may need to step in and assist those people. However, in the long-term, so long as workers have the necessary knowledge skills to manage AI, automation, and other technologies, the economy will benefit, and not be harmed, by the AI-age.

As more and more work becomes automated, there will certainly be less work to be done, in the aggregate, by humans. There is always the opportunity for new work to emerge – work that does not exist today and work that we have not conceived of yet as being possible, necessary, or important. However, this work may also be able to be automated. Some may say that there will always be work for humans to manage the automation – repairs on robots and writing code for the automation software, to begin with. I see no reason to think that this cannot be automated either.

As a result of this ubiquitous automation, there may be no jobs left for humans at all, sometime in the future. People fear that we would be left with artificial/robotic economic overlords. I also think that this is a naïve understanding of the economy. In fact, I think that the AI-age could also be a post-capitalism age. People would work less and the work left to us would be judgement based. How do we apportion the food that the robots are cultivating? Who should have the rights to exploit minerals that we can mine from the Earth (and asteroids!), since nearly everyone would have limitless abilities to produce with those metals and minerals? I doubt that we would want to automate the answers to these types of important questions. Even if we did want to, it would not be wise, because the ability to think critically would then be diminished worldwide and not be passed down to future generations. In some respects, everyone in the post-capitalism age would be one of Plato’s philosopher kings. We could also dedicate more work-time to art and creation, as well as its consumption.

AI isn’t just ubiquitous in the news anymore. It is become increasingly common in our homes and in our pockets. Chat bots and digital personal assistants and home devices like Amazon Echo’s Alexa, Siri, and Google Now are all examples of artificial intelligence. My phone is always trying to guess where I am and when I should leave for events. That’s AI in my pocket (I’ve actually been meaning to turn that off, since I don’t have a car).

As AI proliferates, so too does how we are talking about it. Along with AI, people mention machine learning, deep learning, and cognitive computing. In general, it seems to me that AI is an umbrella term that encompasses all of these techniques. In popular terms, AI refers to consumer applications where a computer is emulating activities that we would typically conduct with another person. Think of talking with Alexa as a prime example. Getting down-to-the-minute weather predictions from an app, rather than a meteorologist, is another good example. In more technical terms, AI refers to all applications in which a computer is doing what used to be restricted to the domain of a biological brain: sensing and cataloguing information, processing and analyzing it, and using that synthesized information to recognize patterns, to make predictions, and to take decisions.

Ex Machina

Machine Learning

Consider a smart watch or wrist band that records the time its user wakes up every morning for an entire month. After collecting that data for a month, it calculates an average weekday wake up time and sets an alarm automatically. For three out of five proceeding weekday mornings the user snoozed the alarm ten minutes, and on two of the mornings the user got up as soon as the alarm went off. Using this new information, the wearable revises the wakeup time to be slightly later, and thereafter continues to monitor and revise the wakeup time according to the user’s actual behavior.

This is an example of machine learning. Without any user input the machine makes inferences, assesses their veracity, and iterates accordingly. However, it’s quite rudimentary. The techniques used are fairly basic, and the result was not something that the human mind could not have arrived to on its own.

A more complex application would involve inferring where the user works based on normal daily travel patterns (unless you have turned it off, your smartphone is probably already transmitting this information), and then analyzing traffic on the roadways and the activities of other users to automatically set the user’s alarm so that they arrive at work (or school, or the gym, etc.) at their preferred time. By relying on more information for decision making the analysis techniques become more complex and begin to resemble artificial intelligence.

More important to understand than the capabilities of machine learning, is that its approach to information analysis vastly different from traditional analytical decision making. For instance, a financial institution can feed a computer vast quantities of information on borrowers and their loan performance history. A machine learning program could then process all of this information and determine what variables are best correlated with loan performance. Traditionally, a bank would apply financial and economic theory to create credit models and then test the model, altering it to find the best fit. The machine learning approach relies on a completely different paradigm. Rather than approaching the problem with a basis of assumptions, using machine learning implies ignorance, or at the very least an openness to unanticipated patterns and relationships. Machine learning tests all possible relationships and patterns and makes the best predictions, even if they go against our intuitions. Industries and practitioners that are not accustomed to this approach or unwilling to appreciate its merits may soon find themselves outpaced and outperformed by more machine-savvy competitors.

Deep Learning

Deep learning is an even more sophisticated form of machine learning. Deep learning employs a non-parametric data analysis technique called neural networks (or neural nets) to identify relationships between data. The technique is referred to as a neural net because it resembles the structure of neurons in the brain.

Here is a YouTube video that does a fairly good job of explaining the technique in a short amount of time:

https://www.youtube.com/watch?v=i6ECFrV_BVA

Simple!

Deep learning is powerful enough to accomplish advanced pattern recognition – pattern recognition which can be deployed in situations as diverse as understanding what is happening on city streets and high-speed highways (self-driving vehicles) to learning what different types of animals look like and then making drawings of them. I can imagine a deep learning application that is fed many thousands of oncological images and trains itself to identify cancer. As doctors confirm or reject the conclusion of the program it would store this information and refine its own predictions. Eventually, the program would become more accurate than doctors and radiologists.

This extreme accuracy is what has people such as Elon Musk concerned about artificial intelligence. Will we need doctors if algorithms are better at their work than the doctors themselves?

Cognitive Computing

Cognitive computing is a term I have been hearing less and less. Artificial intelligence seems to have become the preferred buzzword. However, I think that cognitive computing retains a unique definition and is useful to understand many technologies. Generally, cognitive computing are computing processes that are designed to emulate how humans process information and think. Watson is the most famous cognitive computer, and its name and its promoted abilities all seem to allude to a human mind.

One of Watson’s abilities is natural language processing. Rather than having to be fed data in a neat spreadsheet or form, Watson can consume unstructured data, make heads or tails with them, and then process the data. In business school a common assignment is creating a pro forma financial statement from a professor’s explanation of the financial conditions of a company. It’s fairly rote and mechanical. Students have to translate the explanation of the finances into a familiar form which then does the mathematical processing. Cognitive computing skips that translation step. It can understand the natural language explanation of the company’s finances and directly make the necessary computations for the pro forma.

In fact, it seems that Goldman Sachs and other investment banks are doing just that. They’ve been announcing more and more investments in AI along with reductions in the sizes of their M&A teams over the last few years. Goldman Sachs may have gone the furthest. Their CEO has declared that Goldman is really just a “tech” company, and the former Chief Information Officer is now the CFO of the company.

Machine-powered gaming is also a direct application of cognitive computing, because it pits computer cognition directly against human cognition. AI watchers were stunned early this year when a Google designed machine was able to defeat a Go master. Go is an ancient Chinese game that is strategically very complex. For those of us of the Indo-European persuasion, Go is more difficult and complex than chess.

Quantum Computing

One of the challenges with artificial intelligence is that conventional super-computers do not possess enough processing power to crunch through all the nodes in deep neural networks fast enough. Physicists and computer engineers are working on a solution known as quantum computing. Traditional computers store information in bits, which can either represent a 1 or a 0. However, using the quantum physics concept of superposition, a quantum bit, or qubit, can exist in both states at once. If engineers can create stable computers that harness qubits, computing power will exponentially increase.

Here is a good explanation of the concept and recent developments in the field.

Quantum computing would rapidly improve our abilities to create deep neural networks and accelerate the development of artificial intelligence. However, quantum computers will be so powerful, they may be able to easily crack the codes of even the most powerful computer encryption and security systems. Parallel to the development of quantum computing, society needs to invest in new cyber-security techniques that are complementary to quantum computing, not made obsolete by it.

 

I encourage everyone, no matter what job they have, what they enjoy doing, or how they interact with other people in the world, to consider, ‘how can some of the tasks that I do be automated?’ Try to imagine what it would take to automate the task and what the analytical system would be structured like. Then think about what value you can add as an individual, so that you remain necessary, despite the elimination of a human performing the task. Also consider how society needs to prepare and train its members so that the most people benefit from the advantages of AI, and the fewest people are left behind. That is likely the true message the Elon Musk is urging our policy makers to hear, and I hope that they hear it.

… the Tea Party

Jeb HensarlingHow is it that I often hold the same opinions on legislation as Jeb Hensarling?

Jeb Hensarling is not a person I am particularly fond of. He consistently votes against hate crime legislation, LGBTQ rights, pro-choice and women’s rights, and other morally correct things to do. He is socially conservative, and promulgates all of the negative social rhetoric that characterizes social conservativism. The world would be a better place if he were not a Member of Congress. Nevertheless, I actually agree with many of his positions on economics. How could I be so diametrically opposed to conservatism and yet agree with some of his policy?

I think the answer to this question lies in the distinction between social and economic policy, or more so, social conservatism and economic conservativism. I would characterize my political position as economically conservative, and much farther to the left socially. As a society we have coopted all of conservatism into Republicanism, and all of liberalism into being a Democratic, but truly that is not the case. The political spectrum is at least two-dimensional, and I certainly do not identity myself on the one-dimensional left-right spectrum.

Jeb Hensarling is the Chairman of the House Financial Services, which makes his opinions on financial matters of outsized importance. And recently, he has come out against a number of policies that I too do not hold favorably:

  • Export-Import Bank
  • Flood Insurance
  • Terrorism Insurance

Before diving into the policies and the foundations for our opposition, it is helpful to expound a bit on my personal economic philosophy. Market intervention is warranted by the government when there is the presence of a market failure. Furthermore, regulation is justified when government policy creates perverse incentives that ought to be contained. For instance, heavy industry generates pollution, which is a cost that people who do not necessarily consume the products of industry have to incur. This is known as a negative externality and is an example of a market failure. Therefore I believe that the government has a role in helping to resolve this failure.

Similarly, many countries in the world have deposit insurance for banks. Because of this assurance banks may take more risky gambles. This is known as moral hazard. Therefore I believe that the government is justified in regulating banking, insofar as the regulations are crafted to control the moral hazard that its policies create. However, beyond these types of corrective interventions in the market, I believe that the government should not intervene and let market forces prevail, which is to the benefit of all actors in the economy. I believe that those statements express a philosophy of economic conservativism. And certainly, in terms of economics, I may not be as far right as certain conservative politicians – the Rands come to mind – but I am certainly to the right of most self-identified liberals.

Export-Import Bank

Recently, since this section of the article was drafted, Congress outgunned our man Jeb and pushed the reauthorization of the bank through

The Ex-Im Bank is a government sponsored enterprise, first established during the FDR Administration. It borrows money at the government borrowing rate (Treasury rate), and then uses that money to support American industrial exports abroad. It has four main financial programs:

  • Direct loans to foreign purchasers
  • Guaranteeing loans made by banks to foreign purchasers
  • Insuring loans made by US exporters and banks to foreign purchasers
  • Loan guarantees for working capital lines of credit made by banks to American industrial firms

The purpose of these financial activities is to promote exports; in particular, to finance exports that the private sector deems too risky. Loan guarantees make up the bulk of Ex-Im financing. Direct loans are second up. Smaller firms typically take advantage of the working capital guarantees, particularly since their banks get nervous when receivables are in a foreign currency.

Due to the Ex-Im Bank’s ability to borrow at the Treasury rate it is a very profitably institution. So profitable in fact, it kicks money back to the Treasury – about $1 billion a year. The bank is not appropriated any budget funds, and has a very low default rate. However, the mission of the bank is not to generate income for the federal government. The purpose is to promote exports, support the American industrial and manufacturing economic base, and create jobs. Jobs jobs jobs!

airplaneHensarling & Co. dislike the Ex-Im Bank because they consider it “corporate welfare,” a clever piece of rhetoric meant to mean, ‘giving money to rich companies that don’t need taxpayer help making any more of it.’ They claim that for all the money it dishes out it is fundamentally excluding other businesses. Other worthy businesses. And this is not right, so they oppose the bank, which primarily support America’s largest companies, such as Boeing, GE, and Caterpillar.

This simply is not the case. To construct the Ex-Im Bank as a deliberate attempt by the US government to support fat cats at the expense of other businesses is a distortion of reality. The government does not spend any money on the bank. Given the government’s ability to borrow at low rates, the government could set up any number of financial institutions with a similar financing model and support any industry it sees fit. It just happens to be that for 80 years the government has chosen to specifically support industrial exports (and many other industries, which the Tea Party is choosing not to mention). The opponents of Ex-Im are simply using the bank for political theatre. Like most of their arguments, their rhetoric is misleading.

Why don’t I particularly care for the Ex-Im Bank? It is because there is no evidence to point to a market failure in the export financing sector. Furthermore, the bank creates export subsidies, which distort international markets away from their natural equilibrium. It’s the same reason that I am in favor of free trade agreements. However, over 60 countries have export credit agencies like the Ex-Im Bank, so there is more or less an even playing field. But there would be just as much of an even playing field if every country scrapped their subsidies and let the market take care of international trade on its own.

Furthermore, the Ex-Im Bank is a government sponsored enterprise (GSE). It borrows at government rates and uses that money to guarantee loans aligned with the government’s long-term goals. This is exactly like Fannie Mae and Freddie Mac, the two most notorious GSE’s (which, not to my surprise, Hensarling also opposes and has sought to wind down). Now I am not saying that the Ex-Im Bank is headed towards a default a-bomb (nor am I saying that it is not), but in general, I am opposed to GSE’s. When the government supports a particular market and not others it picks winners and losers. Not particular companies as winners and losers (like Hen-chmen claims), but particular industries, as the recipients of capital or not. People see winners and shift their capital to those fields. Capital pools in one industry, whereas a more even distribution among industries may be more optimal. In addition, it actually creates moral hazard, wherein financers take on more risk than they normally would have because of the government guarantee.

With Fannie Mae and Freddie Mac, this all contributed to a huge housing bubble. The country did not need so many new single family homes. We needed affordable housing, infrastructure, investments in education, and a host of other capital intensive construction, but because of the government supporting home ownership, everyone went full speed ahead into housing until it was too late.

I don’t believe that we are in a manufacturing and industrial export bubble; however, the market may be distorted by the cheap capital flowing to the sector from the government. The market may naturally be demanding renewable energy, infrastructure, affordable housing, technology, and software, but instead a disproportionate flow of capital is going to heavy industry. In my opinion, it would just be better to not directly financially support particular industries with capital, and instead just create policies that allow industries to flourish naturally (tax policy, employment policy, intellectual capital and patents, etc.).

During an industry’s infancy direct capital support may even be the correct policy, but as an industry matures, which heavy industry in the United States certainly has, so too does the policy need to, and the capital support needs to taper and eventually disappear. This has not happened, and we continue to see massive American firms such as GE, Boeing, and Caterpillar, getting the largest sums of our export credit support.

Flood Insurance

I nearly wrote an article about government flood insurance a few years ago after Hurricane Sandy, but everything that needed to be said at the time was published by other people, so I abstained from writing my own opinion. But I think that now is an appropriate time to return to the topic.

hurricane-sandy-nyc

Private homeowner’s insurance does not cover flooding. It used to, until the 1950’s and 60’s, when losses were mounting to insurance companies, premiums were rising, poorer people in flood zones were left – ahem­ – without a paddle, and insurance companies began dropping flood coverage altogether. Federal flood insurance covers this gap. Homeowners pay premiums and the government covers losses. Originally, the program was implemented to reduce the government’s exposure to flood losses. FEMA was paying out large sums after natural disasters to uninsured homeowners, so the insurance program was extended to communities in flood zones that were willing to adopt flood mitigation and management plans. In addition, the federal government hoped that by pooling funds into a national program, localized events could be covered and absorbed by premiums paid into the system nationwide.

However, in practice, the supposedly self-sustaining program has become costly and far from self-sustaining. Rates remain below market levels and risk has been poorly quantified and distributed. The system (which is administered by FEMA – they’re doin’ a heckofa job!) has borrowed from Treasury on multiple occasions, and is currently $24 billion – ahem – underwater.

One of the problems is the flood maps. Anyone living in a flood zone as indicated on these maps is legally required to have flood insurance. But the maps are outdated and not accurate. They underestimate the risk of floods. As a result, people who are in fact in flood zones, even though they do not have insurance because the maps do not require them to, are getting flooded out and requesting emergency relief funds. Plus, people who do have coverage are under-insured because the maps are not adequately estimating the risk that they are under.

The problem with risk identification does not point to a philosophical objection to the policy, but instead a problem with how it is carried out. These problems could be resolved by simply updating the flood maps and having premiums reflect actual risk. However, I have a more fundamental objection to the national flood insurance program: people who do not live in flood zones are subsidizing people who do live in flood zones.

I am from the Hudson Valley, which is historically a relatively safe place to live and not flood-prone. It is one of the reasons why I love my home region. And as a taxpayer, I do not want my tax money to be subsidizing people who have multiple homes or choose to live in riskier areas, such as beachside. Government policy should be incentivizing development in less-risk regions, and people who elect to live in riskier zones should foot the entire bill themselves (in this case through a private flood insurance market).

Of course, there are always questions of poverty and mobility. There are many impoverished communities around the United States in flood prone areas. I am amenable to a program that assists these communities, but this would be a vastly scaled down national flood insurance program, not the $24 billion indebted behemoth that we see today. Over time the country would be better off if flood-prone regions became less populated. Scaling back flood insurance would achieve that. Some of the saved money could even be used for relocation assistance, or any number of other assistance programs.

Terrorism Insurance

The Terrorism Risk Insurance Act (TRIA) was enacted after September 11, 2001 so that large development projects could continue as insurance companies, banks, and developers, readjusted their models for terrorism risk. It has been continually renewed since them. It is supported by Congresspersons and Senators from major metropolitan areas, developers, and of course insurance companies who can transfer their risk to the federal government. Organizations such as the NFL and NASCAR also support TRIA, since it helps to insure large events such as the Super Bowl.

Treading into appropriate risk and terrorism is an ideological minefield. Dare I ‘let the terrorists win’? Pushing aside those considerations (which, yes, I believe are asinine), if there is risk in development, then I believe that the federal government and by extension, the taxpaying public, should not have to bear the risk. This is a running theme in this article and a general belief of mine. Investors should bear risk, not anyone else. If large-scale development is too risky because of the potential for terrorist attacks, then do not engage in large-scale development, or at least modify plans to disperse risk and make them less desirable or less likely targets.

A market failure common in insurance is adverse selection. Adverse selection is when the people most likely to have to make a claim buy the most insurance. This overwhelms the mutual risk sharing pool of premiums (since not many people who are not making claims are paying in) and the insurance scheme fails. It is very common in health insurance. Sicker people bought more insurance, and as a result policies were always going up and up and up, forcing out healthier people (and putting them at risk for sudden and expensive health emergencies). The individual mandate in the affordable Care Act was meant to address this very issue of adverse selection. But I do not see any adverse selection taking place in the terrorism insurance market. The case can certainly be made that New York and a handful of other states bear more risk, but insurance is administered at the state level anyway, so this risk concentration is not contributing to any adverse selection at a national level.

Another theme in this article is that I do not categorically oppose all of these programs and want their subsidies rescinded, immediately. However, moderation and more specific selection of beneficiaries are imperative. With the example of terrorism insurance, perhaps developers in Washington DC do bear outsized risk due to the presence of the federal government. The government could then rightfully offer terrorism insurance for developments in the District of Columbia. And as I mentioned in the case of the Export-Import Bank, direct government support of infant industries may be warranted and appropriate. However, I do not agree with these largescale subsidy programs.

TRIA is likely a program that had its merits in 2001 and 2002 when America was one big patriotic brothel and everyone wanted to do anything that they could to fight the terrorists and help the country get out of a recession quickly. However, since then, there have not been any terrorist attacks and there has never been a terrorist insurance claim filed (the Secretary of the Treasury has to declare an act of terrorism for the government to backstop the insurers, and he declined to do so after the Boston Marathon Bombing). Since 2001 terrorism insurance has just become a profit getting boondoggle for the insurance companies. New developments are required to have terrorism protection by the banks, so the insurance companies are guaranteed revenue, while the federal government backstops the majority of the risk. The risk is also extremely difficult to quantify and model, because terrorism attacks have been extremely rare, are subjectively defined, and the loss distribution of the attacks has been extremely wide. This directly calls into question the insurance industry’s pleas for government support.

Twin Towers

Luckily, there have not been any terrorist attacks in the United States since September 11. As a result, terrorism insurance has only cost tax payers $1 million a year in administrative fees. However, were there to be an attack, in addition to the loss of life, injuries, and property damage, a huge hole may get blown in the national budget. Taxpayers, whether or not they are shareholders of development companies, would have to fill this hole.

Essential Air Services

I am not aware of Representative Hensarling’s position on Essential Air Services (EAS), but it is a government program in the vein of the others that I have discussed here in this article. I am not a fan of the program.

Prior to 1978 the government heavily regulated air travel. Fares and routes were mandated by the government. This system provided flights to smaller and more remote cities around the country. After deregulation, communities feared that airlines would eliminate flights to smaller cities, since these flights are less profitable. In response, the government enacted EAS, subsidizing flights to 160 rural communities around the country (43 of these communities are in Alaska). Excluding Alaska, which has separate operating parameters, the program cost $241 million in 2014. Apply the Eric Test: Is there evidence of a market failure in the rural aviation industry? I don’t believe so.

Small Airport

By subsidizing flights to smaller rural cities the government is making the cities marginally more attractive places to live. However, the economy works most efficiently when labor moves to where it is in demand. During the early and mid-20th century smaller rural cities were certainly labor centers. Agriculture was more labor intensive and employed more Americans, mining was more prominent, and industry and manufacturing was more dispersed. However, in the current economy demand is concentrated in larger cities that have hi-tech firms, universities, established industries, cargo infrastructure, and large health care systems. Smaller rural cities ought to shrink in size until they reach equilibrium – residents who desire to remain in the city and receive satisfaction from doing so can live there, and they can pay workers in the service industry sufficient wages so that everyone in the city can maintain happy and healthy lifestyles. EAS disturbs this equilibrium, and we are all paying for it! I don’t like it.

I do not propose that these communities be immediately cut off. People and communities need time to adjust. However, over time, service needs to be transferred away from these communities, and I suspect that population will decrease as well. Many of these communities were once thriving, due to the presence of industry, such as mining, which is no longer present. These people would now be better off, and so would the rest of the country, if they moved to other population centers where their labor is in demand and they have easier access to public and private services, such as quality health care, education, shopping, entertainment, banking, government services, and social networks. Kill EAS, Jeb!

Government subsidies and related economic support programs are often pet projects of politicians from around the country. That is why so often politicians from across the aisle get in bed together on these issues. If the policy benefits their district or state they will support it, political and economic philosophies aside. To see through this political theatre and their rhetoric apply the Eric Test: Is there evidence to indicate the presence of a market failure? If not, oppose the policy or regulation.

https://www.washingtonpost.com/opinions/robert-samuelson-the-misleading-debate-on-the-export-import-bank/2014/07/01/91bb7208-0138-11e4-8572-4b1b969b6322_story.html

http://www.nytimes.com/2015/06/26/business/jeb-hensarlings-fight-against-ex-im-bank-succeeds-for-the-moment.html?_r=0

http://www.insurancejournal.com/news/national/2014/05/22/329812.htm

http://www.politico.com/story/2014/03/jeb-hensarling-financial-services-compromise-104502

https://www.transportation.gov/sites/dot.gov/files/docs/Subsidized%20EAS%20report%20for%20non-Alaska%20communities-Jun%202014.pdf

http://www.theguardian.com/business/2014/jun/19/congress-renews-tria-terrorism-insurance-bill

… Bitcoin Mining

This is part three of a four-part series of posts on the Economics of Oil. Previous posts:

Oil PumpThe Economics of Gas Prices

The Economics of International Oil Price Conspiracies

The Economics of Airfare

 

BitcoinFirst off, at this point you are probably wondering what similarities Bitcoins have to oil. I suppose that the main hypothesis of this post is that Bitcoins are nothing more than a plain old commodity, just like oil, and they are subject to the same market forces. In fact, at this moment “Bitcoin miners” are struggling with the same issues that shale oil producers in North Dakota and oil sands extractors in Alberta, Canada are struggling with.

Bitcoins are a digital currency. They do not exist in any physical form, and there is no central monetary authority, like the United States Federal Reserve or the European Central Bank, that can issue new Bitcoins. The currency was established in 2009 on a system of computers. The computers maintain a running log of every Bitcoin transaction (basically a big long list of debits and credits) known as the “Blockchain.” The computers interact with each other to clear transactions and verify that their registries on the Blockchain are legitimate. Every time a user successfully verifies a block of transactions (which is a complicated computing algorithm that needs to be “solved”) the transactions are processed and that user receives a pre-determined number of newly minted Bitcoins for her efforts.

The designers of Bitcoin programmed the software so that the algorithms that need to be solved to verify the Blockchain and win yourself new Bitcoins get solved about every ten minutes. As more computers are added to the system, the algorithms are programmed to get more difficult. And with more and more user-systems vying for the new Bitcoins, more and more powerful computer systems are needed to be the first system to successfully verify the Blockchain and win the digi-cash. Basically, mining Bitcoins is deliberately designed to get progressively more difficult over time. Cloud computing companies are literally selling use of their systems to Bitcoin miners. Massive amounts of capital are being put into configuring powerful computer systems. And this comes with its own costs and externalities. A lot of electricity is needed to cool super-computing systems, and if the electricity is generated through non-renewable means then there is the additional cost of the pollution that is generated.

A Bitcoin mining operation

A Bitcoin mining operation

The similarity between Bitcoins and oil, I contend, is not because Bitcoins are “mined” in this digital sense. Rather, it is because we allocate capital to Bitcoin mining in much the same way we allocate capital to oil extraction. Bitcoins have absolutely no intrinsic value. They only have value as expressed in terms of other currencies (such as US Dollars or Euros). So, ostensibly, Bitcoins have exchange rates and have an ever changing value to them. Yes, certain companies do accept Bitcoins in lieu of traditions currencies, but prices are still expressed in the traditional currency and then converted into Bitcoins based on the prevailing exchange rate. This is what drives Bitcoin miners to devote their computing power to Bitcoin mining. They can then sell their Bitcoins for other currencies and use that money in the traditional sense.

Bitcoin Price Chart

The value of a Bitcoin, expressed in US Dollars

 

So when the exchange rate, or rather the value of Bitcoins goes down, there is less incentive for Bitcoin miners to devote their computing power to Bitcoin mining because they could be using their super computers for more lucrative endeavors. And mining Bitcoins is an expense endeavor. It requires ever more sophisticated computer equipment as well as vast amounts of electricity to cool the computers. And this is just like oil. It costs money to get oil out of the ground and into barrels, just like it costs money to mine Bitcoins. And if the price of oil falls below what it costs a company to extract oil, that company will shutter rigs until the price of oil climbs back up. All the same, if the value of Bitcoins drops below what it costs to mine them, the digital mining company will flip the switch to ‘off.’

Another interesting attribute about Bitcoins is that every four years, since the currency’s establishment in 2009, the number of Bitcoins that can be mined by a new block verification halves. So from 2009 through the end of 2012 the number was 50, now it is 25, and in 2017 it will be 12.5. By 2030 the number of Bitcoins will be limited to around 21 million. To me, this raises an interesting question. If Bitcoin only works because the people mining the coins for a profit are also verifying the Blockchain, once there are no more Bitcoin to mine, won’t everyone spending massive amounts of money on super-computing capabilities just stop bothering, making it impossible to verify transactions and trade Bitcoins, essentially destroying the currency? There needs to be an expectation that the value of a Bitcoin will be perpetually increasing, otherwise the entire system will cease to function.

And that is precisely what is happening right now in the United States oil extraction business (well, not a total destruction of value, but the drop in the price of oil is certainly concussing the current system). The number of oil rigs in the United States, as reported by Baker Hughes, peaked in October at 1,609 rigs. It has since fallen to 1,421 rigs. This basically indicates that exploration for new oil, which accounts for an enormous initial investment, is dropping off; however, United States domestic production is still surging. US crude production added 60,000 barrels a day last week, according to the Energy Information Administration (EIA). That puts the United States at 9.19 million barrels a day. However, as the price continues to fall and companies alter their exploration and investment plans, we very well may see domestic production peak.

An abundance of oil was discovered in North Dakota that was relatively cheap to extract, given the price of oil. So producers flocked to western North Dakota (a place where even geese wouldn’t flock to) and started to drill baby, drill. Over the same time period, emerging economies, such as China, and developed economies, such as those of Europe and Japan, slowed down. The demand for oil decreased, but the supply was steadily increasing. This has precipitated a large drop in the price of oil. Normally, we would expect Saudi Arabia to cuts its own production of the black gold to stabilize the price, but as I previous wrote, I believe they are not doing that this time around for political reasons. But it doesn’t hurt that this “price war” could help drive the Bakken Shalers out of business. Whereas Saudi Arabia only spends between $5 and $6 to get a barrel out of the ground, in North Dakota it costs maybe $42 on average to extract it out of the ground and get a 10% return on capital. The lower oil goes, the more it hurts American and Canadian producers, whereas Saudi Arabia has $900 billion of cash reserves on hand to ride out any prolonged dip in the price of oil.

Crude Prices

As a result of the flooded market and Saudi Arabia’s decision, the price of oil has dropped below the point at which it is profitable to continue to pump it out of the ground in the Bakken Shale fields of North Dakota. North Dakota, which has undoubtedly had the best performing economy in the country, even throughout the Recession (home prices in North Dakota actually went up through the Recession, whereas in most of the rest of the country they were plummeting), may finally see its wings melt. Texas, Oklahoma, Colorado, Louisiana, Alaska, and parts of Canada, may also see employment losses. The Federal Reserve Bank of Texas has estimated that there may be 140,000 job losses in Texas alone in 2015 as a result of the drop in the price of oil. Policy makers and regulators are also bracing for some troubles ahead for certain banks, housing markets, and even state budgets that rely on oil revenues.

Fill Up at the PumpHowever, over all, the drop in the price of oil will be good for the American economy. By saving at the pump Americans will be able to pad their savings accounts as well as go out and buy other things that will spur the economy. The Keystone Pipeline, which has been in the headlines for years now, might wind up being a moot point after all. The Pipeline was intended to bring crude oil from the oil sands of northern Alberta, Canada, to the US Gulf Coast. But oil sands extraction is costly and may drop in the future now that the price of oil is so much lower. If the pipeline ever gets built nothing may ever run through it.

As for Bitcoins, the only possible positive outcome of the boom (or is it a bubble?) that I see is that computing power might become exchange traded. First, companies became exchange traded on stock markets. And since then commodities and even more obscure assets like shipping contracts (Baltic Dry index) have become traded on exchanges. I don’t see any reason why computing power couldn’t become exchange traded in the future. Cloud computing companies are already offering their services over the internet to global markets; if there is enough volume in the market all that is needed is for the contracts to be standardized so that they could be traded freely between suppliers, consumers, and even speculators.

In the case of Bitcoin, I fear that by creating this digital currency and beginning to accept payments denominated by it, we are simply letting people with immense computing power at their disposal generate wealth for themselves. In addition, they are diverting their computing power from other uses that might be better for society, such as genomic coding, and in the process driving up the price for computer processing for the rest of us.

Sources:

http://www.economist.com/blogs/babbage/2011/06/virtual-currency

http://www.economist.com/blogs/economist-explains/2013/04/economist-explains-how-does-bitcoin-work

http://www.bloomberg.com/news/2015-01-14/gravy-train-derails-for-oil-patch-workers-laid-off-in-downturn.html

http://www.bloomberg.com/news/2015-01-15/oil-advances-as-opec-forecasts-slower-growth-in-u-s-supply.html

http://www.marketwatch.com/story/bitcoin-price-plunges-prompting-concerns-about-mining-activity-2015-01-14-121034915

http://www.economist.com/blogs/economist-explains/2014/12/economist-explains-4

http://www.marketwatch.com/story/opec-is-wrong-to-think-it-can-outlast-us-on-oil-prices-2014-12-02

… Oil

Having now written four articles on oil, its price, and the consequences that has for everyday uses of oil, such as gasoline and airfare, I have decided to turn these into a series of posts I am calling the Economics of Oil.

Fill Up at the PumpPart 1:

The Economics of Gas Prices

 

 

Oil PumpPart 2:

The Economics of International Oil Price Conspiracies

 

 

airplanePart 3:

The Economics of Airfare

 

 

Bitcoin MiningPart 4: 

The Economics of Bitcoing Mining*

 

 

As always, comments are welcome and encouraged, even if you disagree with me on any point.

*And yes, you will see just how much similarity Bitcoin mining has to oil

… the Inter-Oceanic Canal

Ometepe Island, in Lake Nicaragua

Ometepe Island, in Lake Nicaragua

Today marks the day that Nicaragua and her Chinese backers are breaking ground on the grand inter-oceanic canal that in five years will bisect the Central American isthmus and allow super-tankers too large for the Panama Canal to make the Pacific-Atlantic journey with ease.

Except it is never going to happen.

The history of Nicaragua is basically the history of failed canal attempts, and the foreign manipulation and betrayal, as well as the domestic anguish and languish that this brings. This is no less than the 72nd official proposal for a Nicaraguan canal. This won’t even be the first time that construction has begun. The first plans for a canal across Nicaragua were hatched by the conquistadors way back in the 1500’s, and Cornelius Vanderbilt nearly secured the financing he needed to construct the canal before the Civil War scuttled his attempts. But he did manage to incite a war and build a railroad through Nicaragua in the meantime.

Anyone who looks at a map of Central America may be puzzled by the proposal for a canal through Nicaragua. Costa Rica and Panama are far less wide. Nicaragua is the largest country, by area, in Central America. However, Nicaragua also has the largest lake in the region, Lake Nicaragua. At its closest, it is only 17 km from the Pacific Ocean. And Lake Nicaragua drains all the way to to the Caribbean Sea by way of the Rio San Juan (San Juan, or Saint John River). The vast majority of Nicaragua is an Atlantic, not a Pacific watershed. The Rio San Juan is rocky, shallow, and fraught with rapids at spots, but that has not stopped pirates from sneaking all the way up the river, as well as steam ships from being towed up the river. It is the most logical path for a successful canal through Central America.

As treacherous as the terrain of the river, the geopolitics of the river are far more rocky. The Rio San Juan is the border between Nicaragua and Costa Rica. However, it is the only riparian border in the world that is wholly owned by one country – in this case Nicaragua. And that has created endless problems and disputes with Costa Rica. So many, in fact, that the proposed route of the canal is completely bypassing the river and being cut straight through the interior of Nicaragua (and even so Costa Rica still has watershed issues that they claim Nicaragua is not responding to, in regards to the canal).

I don’t see why this time around should be any different from the 71 other attempts.

The main, insurmountable obstacle this time is the estimated price of the canal. Panama started with a good ‘ole American-made canal. Let’s say a Ford. And they have made a series of upgrades through the years. Let’s say right now they have a nice BMW model. To compete with Panama, Nicaragua is trying to acquire a Buggati. A $50 billion Bugatti, super-wide, super-deep, complete with access roads and highways, two deep-water ports, an airport, electric generation, pipelines, free-trade zones, a railroad, and a number of other necessary supply and infrastructure projects! They estimate it will take 50,000 workers and only take five years to complete.

So how is Nicaragua going to secure investors willing to provide nearly 4.5x its annual GDP ($11.26 billion, 2013 estimate, according to the World Bank)? I’ve put together a small list of possible backers and will go through my thoughts on each:

  • China
  • Nordic Sovereign Wealth Funds
  • Middle Eastern Sovereign Wealth Funds
  • Malaysian Sovereign Wealth Fund
  • Big Banks, the Backers of the Many Engineering Marvels of the Past
  • Venezuela and ALBA

China

If you ask a Nicaraguan where the money is going to come from they always say “China.” I don’t think so. Sure, the main investor at this point is a Chinese telecom mogul. And he is a multi-billionaire. But no one in the world has $50 billion to throw around, and our man in China is quick to point out that he has absolutely no backing from the Chinese government with regards to the canal. No one believes him, but it makes it very unlikely that he can muster $50 billion from his own domestic sources. Besides, between 2010 and 2012 China invested $101 billion, in total, in the entire continent of Africa (source: Business Insider). To think that they would even put half of that into one small country is irrational.

Nordic Sovereign Wealth Funds

I’ll make this one easy. Nordic countries, primarily Norway, have a lot of oil money that they are saving. But they are not going to invest it in Nicaragua. These countries have already pulled back on diplomatic channels and foreign aid to Nicaragua because of transparency concerns. They’re not going to pull a 180 and start pumping billions into a project fraught with questions and uncertainty.

Malaysian Sovereign Wealth Fund

Same story as Norway. They’re saving their oil money, and they’re not going to give it to Nicaragua. Unfortunately, this year, Malaysian Airlines, owned partially by the fund, had a rough one, losing two 777’s in their tragic entirety. The fund had to bail out the airline.  The price of oil is tumbling, which is probably helping to prop up Malaysian Airlines, on the one hand, but it is stunting the funds cash flow, on the other hand. I doubt they will be announcing a non-stop to Managua from KL anytime soon.

Middle East Sovereign Wealth Funds

And that leaves the Arabs. This is where I see the miracle coming from, if it comes from anywhere. Everyone knows that the Arabs have lots of oil wealth. And they’re known for the audacious. For one, Dubai. For seconds, it was the Arabs who bailed out some of the banks and hedge funds in the early days of the Sub-Prime Mortgage Crisis, long before Lehman Brothers became all too well known. So maybe, just maybe, a jet-setting Chinese man and Ortega’s outdated mustache can convince the right mix of petrocrats to throw in a good chunk of the $50 billion and really get the show on the road.

The Big Banks

No way Josue. Big banks in America, Europe, and elsewhere, are under immense pressure to demonstrate the viability of their investments. American regulators would pounce on any bankers working on this less-than transparent project, and European banks are already very bearish on shipping, since Northern European banks with shipping exposure were under extra scrutiny during the recently completed European banking stress tests, since global shipping has been very weak since the global recession.

Venezuela and ALBA

For years Hugo Chávez’s Venezuela was the standard-bearer for Latin-American Leftist opposition to America. When Chavez died last year his followers all started pounding their chest to become his heir. This included Correa in Ecuador, Ortega here in Nicaragua, Evo Morales in Bolivia, and of course Maduro in Venezuela. For years Venezuela, and its leftist sphere of influence, the Bolivarian Alliance of the Americas (ALBA in Spanish), have been financing cheap oil for member states as well as other social development projects. However, this all comes from Venezuelan stability and a steady stream of oil dollars into her state coffers. But with oil prices tumbling and Venezuela simmering in social unrest, it’s another no way Josue.

It is serenely ironic that the same trends, the rise of US oil and gas production, are giving rise to the need for an American super-canal, while at the same time driving the nail into the coffin of possible financing options, by driving down the price of oil.

The Sovereign Wealth Fund Institute has a nice map showing the size of sovereign wealth funds around the world. Click on the map for the link:

Red circles represent oil wealth, and blue circles represent other wealth (often mineral)

Red circles represent oil wealth, and blue circles represent other wealth (often mineral)

So it is never going to happen. But that does not mean I do not want it to happen. No one doubts that Nicaragua is starved for development. It is tied for being the second-poorest country in the Americas. Haiti takes the unfortunate crown, with Bolivia tied for second with Nicaragua.

The largest concern, after the obvious financing issues, is environmental. First and foremost, there is a 20-foot tide differential between the east and west coasts. And plans for the canal have not addressed this engineering obstacle yet. But furthermore, the canal will drive through protected wetlands, productive agricultural communities, and protected indigenous communities on the Caribbean coast. This is all not to mention that the route will go straight through and require the dredging of Lake Nicaragua, which is the largest source of freshwater in Central America. It is already an extremely fragile freshwater ecosystem due to agricultural and other pollutants streaming into the lake. Everyone from locals to parties interested in the fledgling tourism industry are in extreme opposition to the canal.

But lastly, I doubt that Nicaraguans will reap the benefits of the canal, which is how Ortega is selling the whole scheme to his people. The Chinese development corporation has a 50-year concession on profits, with another 50-year option to extend. Ortega is promising 250,000 jobs that will be born as a result of the canal, plus the need for 50,000 laborers on the construction. But of course I have my doubts. The canal will drive through some of the most sparsely populated and least developed departments of the country. Hundreds of thousands of people will have to relocate in order to realize those 250,000 jobs, which will lead to a lot of social strains on the country. Plus, given the under-education of the Nicaraguan people, the best-paying of the 50,000 construction jobs will mostly go to foreigners, not Nicaraguans. And I think it also bears mentioning that the highest HIV rates in Nicaragua are often in mobile populations, much like the worker camps will be. Has anyone put any thought into the epidemiological and public health effects of this project?

Nicaragua and the Chinese development company hired McKinsey to conduct a feasibility study. Officials refuse to release the results, but they are quick to point out the stellar economic projections. In 2013 GDP growth paced along at 4.6%. Official projections for the canal show that in the first year of construction GDP growth will skyrocket to above 14% and stay there for the foreseeable future. I just finished reading Confessions of an Economic Hitman. I hated the book. It was poorly written and not believable. But I can’t fail to mention that the author emphasized that the main tool of an economic hitman is inflated growth projections. It is guaranteed that the construction of a canal would attract a ton of foreign direct investment in Nicaragua, but sustained rates above 10% are preposterous and only part of the Chinese boondoggle to attract investment in the first place.

If the project ever truly gets off the drawing board (the groundbreaking today is ceremonial, nothing more) I will be in opposition. I fear that Nicaragua will bear many negative externalities while reaping few benefits.

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