# Money’s use: the unit of exchange

Picking up from my previous post on the value of money which talked about its use as the unit of account we continue here with the next benefit, unit of exchange.

So every good has two values, the first is its retail value, X. This is what people would pay for it because they want it (or need it). The second is its exchange value, Y; this is what people who don’t want it would pay for it and they would do this because they can exchange it later on. So by definition X should be higher than Y otherwise people would not buy it to sell it on since they would make a loss.

So, let’s take a situation. Let’s say person A wants to buy a cell phone, but the only thing he has in excess is a microwave.  So A goes to meet another person, person B (who has an extra cell phone) so he can exchange his microwave for the cell phone. It could be that B wants or needs the microwave, and if that’s the case, that’s what economists call a “double coincidence of wants”. In this case he will get fairly close to the X value of the microwave since person B wants it.

If however person B does not want the microwave then he will not want to exchange it. That is unless he is making a profit from this transaction, and the only way he can do that is by thinking he can exchange it for a higher value than he will get it for. So person A will get a value close to Y in this case.

This difference between X and Y is the cost that person A will suffer in the second but not the first scenario. It is the second transaction cost that takes place without money.

As I mentioned before, money is essential to the division of labor of society.As a last demonstration of division of labour’s important to the exchange value, let’s imagine that a bakers TV broke down. Without the presence of money, he will have to spend hours and hours on end trying to learn how this works, and then fix the TV. These hours are of considerable value to people, but with money, the baker can essentially fix the TV by baking cookies. He has the ability to liquefy his effort and make it take any form he wishes it to without suffering much of a transaction cost at all. I find this amazing, how you manage to achieve everything people can do with equal efficiency by doing just one thing what you can do most efficiently. That is unless labour prices are distorted.

Now so far we have assumed that both parties know the true value of what is being offered. If however B does not know what A’s product is worth the transaction is crippled since B would need to be educated. This education process is costly and if he is exchanging it for the purpose of reselling it, then he might also expect that who he sells it to will also need to bear an education cost. So the price person B will pay will be Y minus the cost of acquiring this information, which means A got even less value out of his product.

So in our economy with millions of products, we can introduce money and what this does is make X=Y.

Money isn’t some artificial thing that was dreamt up, it was a spontaneous process, one where people saw immediate benefit from its use. There was no real need for government to issue currency as medium of exchange; historically gold and silver fulfill an equally good role. The criteria for a good medium of exchange are durability, portability, recognisability, divisibility, homogeneity and scarcity (this one is tricky with elastic money). As a side effect, when something becomes the medium of exchange, its value is no longer determined by its intrinsic value but by its value for trading.

As a final note, it should be obvious that money is only worth something in the context of the economy’s output. If you have 10% of all money in the economy, you essentially own 10% of value of the economy. So printing money doesn’t really create value, it merely increases the medium with which to exchange things, the amount of things to exchange has not changed.

# Do we need patents/intellectual property?

It’s easy to think that industries can’t work without patents, and this is very true to some extent. Many biotech firms make a loss year in and year out, hoping to survive until that patent gets accepted. But this is a static view of the world; let’s take a moment to consider how the world would look without these patents. To be sure demand for medicine and this kind of research would still remain and as long as demand remains, then there will be solutions. Maybe the political process will create funding for such projects, though that would probably not be very efficient. So how can the private sector profit without patents?  How do other industries which don’t have the luxury of patents/IP(intellectual property) property do this? Let’s start with the latter question.

# The theory

If a fashion designer comes up with a great new style of dressing, but can’t patent it and the next day all others do something similar what has he gained? Well reputation of course. Monetizing reputation is then easy; this fashion designer will be the first to be called by people who want something designed. Or if he has a certain brand or logo associated with him, it will signal competency to the consumer boosting his sales. This same process is also present in finance, most notably, investment banking, one bank invents(or finds) a market, then, the other’s join in, nobody can claim that investment banks don’t have the incentive to innovate, in fact most of the media coverage suggests they innovate in excess. Part of what allows them to thrive is this lack of patents, which allows instant liquidity through the duplication of products. Reputation actually works surprisingly like patents; they give you a great name (which you can use to profit) but fade with time. I’m sure it’s no surprise to anybody that having a good reputation allows a company to charge a premium for its products and if no premium is charged then they have an advantage over equally priced competitors.

# Music

Music is to me is the industry which is most undeserving of IP. US copyright protection is active until 70 years after the author’s death! Not only does protecting music not produce better music(no surprise since it’s an art and not a science) but the structure of IP law doesn’t even take into account how the market works. Most of the profits of music are usually made within 10 years of release so protecting it for another century seems kind of insane. Especially if you wish to use an extract from one of these artists after he dies, you have to be chasing down his heirs (who could be anywhere) to ask for permissions.

The theory described above is probably the easiest to prove in the music industry. Artists can improve their reputation by releasing popular music (which can be done with almost no cost, thanks to peer to peer sharing) and can then monetize it by using their reputation, perhaps to advertise or in concerts. The greater their reputation the higher they can charge for their concerts, and the more money they can get from advertising. Businesses (like movie studios) may also wish to contract them to create music for them. It’s hard to make a statement that is “ceteris paribus”(all things being equal) consistent, but since illegal pirating has commenced, I would say music has grown much more popular, there are more artists today than there have ever been. This is in fact partly helped by youtube (an example of how artists can make money without IP) but this was the case before youtube ever started. There is no doubt in my mind that more pirating of a given artists music, boosts his concert sales. Perhaps the most frustrating thing the about the music industry is that they are crippling peer to peer networking technologies which have very high potential welfare benefits for the everyday consumer.

# Pharmaceuticals

So now to the real challenge, how would pharmaceuticals get developed? Well in a very similar way really, though the industry would probably own a lot more hospitals. So a pharmaceutical firm develops something spectacular, let’s say they cure aids. Then their brand value will rise and their hospitals will be more popular because their doctors there will be perceived to be the best in class. Even without hospitals, their medicines would become more popular due to the prestige associated with their brand. There is still an incentive to create these products, in fact the incentive to innovate is strengthened like never before, since there is no chance to sit back and relax through rent seeking (royalties), you must now always be one step ahead of your competitors, you are forced to keep innovating, cure cancer, Alzheimer’s, death, etc.

You’ve got to remember that IP at the end of the day makes things much more expensive, and could bring things out of reach of certain people in the world. Although it might not be a big loss for people on the music end, it holds back the private sector from being able to distribute innovative medicinal practices to people all over the world. If a firm develops a technology, it is under no real pressure to start distributing it, since it can just sit back and claim royalties from others who wish to do the dirty work. However those others will have to overcharge for the product and will probably not have much incentive to do this. Whilst in a world with no patents, the incentive is for these pharmaceutical companies to get this product to all markets they can identify before anyone else. What’s their incentive to do this fast if they have 20 years until the patent expires and can claim royalties without effort or investment? Let’s not restrict competition, whoever can save the most people first, wins.

# Software

So now with the big boy of patents tackled, let’s go down to some chumps. Whilst the pharmaceutical industry is extreme in that the ratio of cost to create to the cost of copying is very high there are other industries which file thousands of patents without this ratio. One most extreme example is the software industry, most software innovation is incremental, created by teams of software engineers at very modest costs, worse yet most of these technologies quickly become obsolete. Each device (laptop, phone, etc) could potentially have hundreds of thousands of patents. We saw this summer how apple won a case over having rounded edges on smartphones. This creates endless opportunity to hamstring competitors.

# The costs

In practice of course all these processes are very costly to our economy; we produce lots and lots of lawyers to protect these patents. Patents increase the prices of goods, they allocate resources to patent races(which is not a good competitive trait to base competition on, see my other post), there is a cost of having to look through the Patent and Trademark office every time you do something, there is of course a lot of  filing of defensive patents, which are patents which won’t necessarily yield royalties but they are there because you are scared someone else will file it, and of course patents give birth to patent rent seekers who buy large number of patents and only make money through fees and if necessary by suing . It seems obvious to me that if we had less lawyers taking care of this stuff, the innovation process would be much quicker, not to mention that the lawyers might maybe join a profession that actually directly helps competitiveness(and not by cutting off opponents feet). Let’s also not forget that we as tax payers generally have to pay to keep these(e.g patent office) public institutions running.

# Fair use

In law “fair use” is a defense allowing for copying of short excerpts from a copyrighted work without a license. The rationale for this is that the transaction cost of negotiating a license for these is likely to exceed the value of the license. Yet even this law that has potential for being economically rational is so ill defined that the copyright owners can bring down this “short” phrasing to its bare minimum, for instance film studios insist that even a minute of their film is too much. Innovation comes in many forms, yet the most common is not the popularized “radical” but the “incremental” one. The lack of fair use objectivity in law is very damaging to the latter.

# Global patents

One of the most vital advantages of the Chinese economy is in fact this lack of respect for patents, it allows their firms to have much lower costs of production, and this cannot be duplicated in the west because we fear the courts reining in on us. In fact in developing countries there is a reluctance to file patents, since it is in essence just telling your competitors your recipe. Another well documented global phenomenon is that patents cause inequality in society, a fact shown by various studies that should not really surprise anyone.

Some inventions are not patentable and could be just as valuable to society but having patent systems is funneling innovation to only occur in areas which are patented. For instance, the theory of relativity could not be patented, same for the theory of evolution, and our understanding of DNA and more recently the Higgs Boson breakthrough. Patenting directs our scientists to projects that can be patented rather than on pure scientific research(which might have much more productive output in the long run).

A video game called lord of the rings online, was initially a product you paid for, and once sales started dropping the owners made it free to play (making money through in game purchasing), and the game saw its profitability rise higher than ever before not to mention a much bigger player base (which will likely be beneficial on the next release of this company).  This is an example how the private sector can build models based around other ways of making profit. If every purchase gets duplicated by the net, then in the future we might see consumers cooperate to see products see the light of day, this is perhaps what kickstarter is accomplishing, if you expect that after the release the whole world will be playing your game and you’re not too sure about making an in-game profit system then you can just put your projects on kickstarter and wait for consumers to cooperate and give you funding for it.

We need to call out things by their real names, so what is a patent? It’s very simple, it’s a monopoly. In short I would not call for elimination for the whole patent system; I am not that extreme (though I obviously understand where that argument would come from). I would however wish for patents to end for all products except drugs and maybe some other expensive but easy to copy technology (emphasis on the maybe), this moderate stance is only because I’m afraid to meddle with a chicken that lays golden eggs (medicine).

Open source movements have definitely shown me that people will create not only for money but because they love creating, it’s self-fulfilling (an opinion shared by Akira Kurosawa in Ikiru). The private enterprise is resilient enough to find ways to satisfy demand without such artificial methods. Government intervention should be done when systemic and chronic market failures exist, these conditions are not met in our world as far as patents and IP are concerned.

Articles:

When do economists agree?(fun)

Exponential Economist meets finite physicist(fun)

Bernake and student conversation(fun..ish)

What came first, the chicken or the egg? Empirical Evidence!(fun…ish)

What are the key functions of Asset management?

What is the price of going short volatility?

Bestiary of Economists!(fun)

The economics of video games(fun..ish)

Gravity and international finance

Foreign banks and financial development

Corporate governance in financial institutions

Too crooked to fail? (fun…ish)

With Mitt Romney having released his effective tax rate and it being below 15% there has been a debate about optimal capital taxation. Here’s a good academic paper on it, and a slightly more comprehensible article on it, there is also an unsmoothed graph presented after that article.

Videos:

Want to be a crony?

Should we end the Fed?

Do Indie Video games have a competitive advantage?

Random economics knowledge bites:

Lecture on macro0-economics(includes stuff on optimal currency area)

Marginal Revolution Site for economics

Fed lectures series

# Money’s use: the unit of account

As expected, during times of crisis people start critiquing the system.  Most notably I hear a lot about the evil of money. To really understand money we must first understand division of labour, people specialize in different fields, the often cited classic examples of division of labour are professions such as a farmer, butcher or carpenter. This division has allowed humanity to achieve enormous productivity gains(obviously this is a shameful summary). However when these professionals wish to exchange their product or service with another being, they are prone to suffering a transaction or accounting cost. This is because they do not know the value of their good in context to the rest of the world.

This is where the first of three functions of money comes in, in this first post of three I will talk about the first function, the Unit of account:

If the economy has n amount of goods or services, in an economy without a unit of account, the number of prices is denoted by:

Whilst in an economy with a unit of account, the number of prices around is merely:

So if the economy has seven goods, Beef, Carrots, Chairs, Pants, Chimay(Belgian beer), Water and Ipads. There are possible 21 possible combinations. These are:

The reason its n-1 and not n is because you assume they will use any one of these goods as a unit of exchange. For instance you could make chairs the unit of account, and everyone would agree to price their goods in chairs, so if the brewer wanted to buy an ipad, he would bring like 50 chairs to Steve Jobs(may he rest in peace) and exchange it for an Ipad. So now you only need to know six prices these are:

chairs to beef, chairs to Chimay, chairs to carrots, chairs to pants, chairs to water, and chairs to ipads.

It’s very troublesome to carry around all those chairs, what about something valuable but small then? Well maybe microprocessors? Well then how would you buy water? You might be forced to buy it by the tonne. If you try to add another object for less valuable transactions then the number of prices you need to know doubles(+ the exchange with the first unit of account).

So a convenient way to do this is to just have contracts entitling you to a certain value. In fact that’s what money IS, in the olden days bank notes were something you could literally go to the bank and redeem for gold, but even then nobody did because you could conduct all this business without ever having to lay a hand on the gold.

Anyways even though you’ve simplified the process of knowing a little, it’s not sufficient because in an economy with so many products as our own it’s still very troublesome to know all the prices.

# How to protect depositors without bailing out the bankers!

The above is Laiki’s(Cypriot bank to be bailed out) balance sheet, which I pulled off their latest annual statement. I highlighted the assets which are safe in yellow, the assets which are risky in green and the “other” in blue.

I then highlighted the liabilities which we are trying to protect, the deposits, in yellow, and the liabilities which we don’t in want to safeguard in green. I then added those up in 3 categories of assets and 2 categories of liabilities the result is the column on the left in the picture below.

I then give all the safe/liquid assets to the good bank along with an optimistic portion of long-term which will be paid back. It is likely the majority of these are loans to Greeks which are unsafe and will probably not be paid back in full, so I assumed an 80% repayment rate, which might be optimistic, but the approach also works with less optimistic repayment rates, the difference being the good bank’s capital ratio, the capital ratio and the repayment rate are positively correlated.

Assets

Essentially all of the liquid assets are given to the good bank and all the illiquid ones to the bad bank (in practice this would include some headquarters to continue with their remaining operations). The biggest asset for Laiki is the “advances to customers” this will have to undergo special evaluation for the split between liquid and illiquid to occur. The most important aspect here is that the bad bank holds the equity of the good bank, note that this means that the capital ratio for the bad bank remains fixed no matter how many assets are given to the good bank, nevertheless the good bank should have a maximum amount of liquid assets to ensure safety.

Liabilities

The only liability the good bank needs to take on is the customer deposits since it is what we are trying to protect and it is what prevents us from allowing them to declare bankruptcy. Once the deposits have been secured, capitalism can work again.

Equity

Both the old Laiki equity and the good bank Laiki equity are given to the bad bank.

What this achieves:

1)      The Deposits are safe and danger of a bank run is eliminated

2)      Remaining debt that was never promised a government guarantee goes to the bad bank.

3)      The old Laiki (bad bank) is still relatively better capitalized but still responsible for the decisions they made. If they do become insolvent they can declare bankruptcy without interfering with customers deposits, this means they can now be treated as a normal company.

4)      It’s important to highlight that this approach is not complementary(though it can be) to a bailout but a substitute, which does guarantee that bankers will not be over or under punished but will bear the fruits of their actions.

In practice

The good bank will continue to work under the Laiki brand and continue its operations just like normal whilst the bad bank will be running in the background trying to properly manage its existing assets. It will still benefit from profitable activity from the good bank but will be treated like a normal company. No public money (excluding any administrative costs to make this plan work) has been used and stability has been restored. Over time the good bank can also engage in secondary market trading and that can still follow the shareholder’s wishes and should the good bank face a similar crisis that Laiki is facing then the process can be renewed with a new good bank and the old good bank transformed into a new bad bank.

A pre-requisite for this approach to work is that there are sufficient safe assets, and a minor risk this mechanism faces is that banks will no longer favour liquid assets as to not allow this mechanism to work and force a bailout. This is however an extreme scenario that would not occur with properly executed regulation.

This innovative approach has been very well received academically but has not been applied anywhere yet.

# Price System: some assumptions

This randomly came up today and I got to thinking about when the price system is the best way to distribute things, I should mention that this is off the top of my head so it might not be a textbook complete answer. This is related to my other post about price gouging.

So the assumptions i’m going to talk about are going to be in order of ascending rarity: unequal utility; limited resources; limited wealth inequality; and rational people.

Unequal utility, this assumption is the easiest to meet, its hard to even think of a situation where utility is the same. This is because not everybody values things in the same way, even if its their life you are talking about, some people may be suicidal, whilst others might be willing to kill a hundred babies to live. The trick here is an element of perception of utility, one might perceive a higher or lower utility than the actual one he will get and that might distort things, but this is probably more relevant in the rational people section.

Limited resources, this is also fairly easy to assume, there’s never an infinite amount of resources. If you have an infinite amount of television sets available to people then they will maybe use the first 3 to watch 3 channels at once, maybe more if they handle more than that, then, the next couple will be for backup, then maybe you would like to use the next couple as chairs around the house, then the couple maybe for releasing stress by dropping them off the 7th floor. The point is that there is diminishing marginal utility from these televisions but since they are free you have no reason to stop getting them. Of course what matters is not whether or not the resource is infinite, but whether your access to it is infinite.

Limited wealth inequality is touched on in my last post but its also an important assumption. Relatively more money allows for relatively more leisure, if there is a heart for sale and someone only has 10 dollars and is willing to use it all to purchase this heard because his is about to expire. But someone else who is in fine shape whose heart is only 0.1% likely to fail him in the next decade but who has a trillion dollars, would maybe be willing to pay 1000 dollars to buy the heart and freeze it somewhere as insurance. Here excessive inequality has led to the item in question not being used to its highest utility.

I should mention that the wealth doesn’t have to be a liquid asset, even a house or future promises to achieve something, maybe even offering yourself up to be a sex slave, in this case even gender creates inequality, since if the vendor is a straight man, then females will have an extra option to exchange for the heart.

Rational people is in my mind the most far reaching assumption. This is because you might have people who use morals, religion, or have some other irrational mechanism with which they make decisions. There are many cases of people not adapting to their environment to offer up the service or product required to achieve their end means because of morals. You might be desperate for food and find someone selling a loaf of bread for 1000 dollars and think that he is ripping you off and so you decide to wait for someone cheaper to come along, without knowing if this cheaper vendor even exists.

Worse yet, even if there is perfect equality, and a given person x has a higher utility than everyone else and there is only a single unit of the product that will save him, and he knows that there is only one unit and only one chance to buy it(heck it could even be free), he might still decide to forego it due to religious reasons.

We must also assume rationality from the vendor’s side, although its perfectly rational to accept only cash if you don’t trust the people around you. If he does trust everyone to a good degree then he should be able to accept illiquid forms of cash as long as the time value of money is taken into account in the form of interest. It is also true that for the vendor to perfectly utilize the price system he must be able to analyze and calculate the perfect price for his product at any given time in order to make sure that he sells it at the highest price where it is going to be sold out. Even if you sell a bottle of water for 100 dollars, you would have been better off selling two for anything over 50, so its important to be able to price things as optimally as possible.

# Should feminists be suffering from existentialism?

Usually I don’t like him because he takes every chance he gets to jump on the “hate government bandwagon” but lets start with Thomas Sowell’s recent column anyway. He tell us what Ceteris Parabis is:

“The old — and repeatedly discredited — game of citing women’s incomes as some percentage of men’s incomes is being played once again, as part of the “war on women” theme.

Since women average fewer hours of work per year, and fewer years of consecutive full-time employment than men, among other differences, comparisons of male and female annual earnings are comparisons of apples and oranges, as various female economists have pointed out.

When you compare women and men in the same occupations with the same skills, education, hours of work, and many other factors that go into determining pay, the differences in incomes shrink to the vanishing point — and, in some cases, the women earn more than comparable men.”

Then lets move to this first paper here:

In 2003, a new law required that 40% of Norwegian firms’ directors be women—at the time only 9% of directors were women. We use the prequota cross-sectional variation in female board representation to instrument for exogenous changes to corporate boards following the quota. We find that the constraint imposed by the quota caused a significant drop in the stock price at the announcement of the law and a large decline in Tobin’s Q over the following years, consistent with the idea that firms choose boards to maximize value. The quota led to younger and less experienced boards, increases in leverage and acquisitions, and deterioration in operating performance.

Now on the the Bureau of labor statistics. On average women work less hours than men, men work 40 and women work 35 hours per week. So that’s another explanation of the mythical “gender wage gap”, you could try to argue that the dependent variable in the model should just be the earnings per hour, but it would not work because its natural that people who work more hours get the promotion. This study here also supports the BLS:

In our data, the median male physician with 10 years of experience works 11 hours per week more than the median female physician in our sample with 10 years of experience. Simply put, the majority of women physicians do not appear to work enough hours earning the physician-wage premium to amortize that profession’s higher upfront investments.

This is also backed by this study:

This paper documents and studies the gender gap in performance among associate lawyers in the United States. Unlike most high-skilled professions, the legal profession has widely-used objective methods to measure and reward lawyers’ productivity: the number of hours billed to clients and the amount of new-client revenue generated. We find clear evidence of a gender gap in annual performance with respect to both measures. Male lawyers bill ten-percent more hours and bring in more than double the new-client revenue. We show that the differential impact across genders in the presence of young children and the differences in aspirations to become a law-firm partner account for a large part of the difference in performance. These performance gaps have important consequences for gender gaps in earnings. While individual and firm characteristics explain up to 50 percent of earnings gap, the inclusion of performance measures explains most of the remainder.

Even though the equal pay act has existed since 1963, pressure from feminist groups continue to attempt to destroy equality. It was normal that women take a few decades to get close to men’s wages since even when you first passed the bill that didn’t suddenly bring women’s skills up to men’s standards, it had to take awhile. Yet this movement persists, earlier this year they tried to pass the “Paycheck fairness act” but thankfully the senate didn’t go for it.

If after all this time feminists have been masquerading equal pay under the veil of equal opportunity then I have a better approach for equal wages. Mandate women’s work hours to mirror mens hours! We also could try force the other sex to change, force men to work less hours!

Moving further up on the ridiculous scale: Women take some days off after giving birth, and even if parental leave is also a thing, the reality is women take more leave than men. So we could fix the wage gap by mandating all women to have abortions every time! Or biologically change men so that they can also have babies!

So there is no problem, meritocracy is at work, is it really a problem that women don’t prioritize wealth as much as men do?  I don’t think so. The market isn’t perfect but I have not seen conclusive aggregate evidence of market failure in this domain.

edit: here’s an interesting speech by Larry Summers on the topic http://www.harvard.edu/president/speeches/summers_2005/nber.php

# Shut up Romney, here’s why trickle down doesn’t work!

So you often hear right wingers advocate for cutting tax rates on the rich. Bush did this and so were born the “Bush Era” tax cuts. And now you have Romney advocating for the same thing if he is to be elected.

The logic they apply is probably not bad at all at face value. If you cut taxes on the rich then they will spend that money to create jobs by investing in society.

What it does miss however is one of the first things you read in an economics text books: a company will hire an employee if it can extract more value out of them than it has to pay them. So this means that the only thing that matters is how productive the employee is. The minimum wage creates a minimum level of productivity required so after a certain level of productivity is reached, then a company would hire. All of this is of course under the conditions that the markets the company is operating in are expanding or that it thinks it can steal market share with these new employees.

But maybe an employee isn’t productive the moment you hire them, but they have to take training and will learn on the job, so the company has to take a loss, and maybe the company can’t afford the loss(even though companies are sitting on record levels of cash in their bank accounts). And in some countries/states interning for free is illegal, so they can’t get rid of that loss or reduce their risk by evaluating candidates with on the job testing.

However companies can also borrow money, either from banks or by giving out bonds or whatever. And these days the cost of borrowing money is ridiculously low, a company should easily be able to find a 1% interest rate. But Romney is right, he will create jobs, it will just be the jobs that previously could not work because the company was not able to extract more than 1% value out of that employee. An example is someone who’s going rate at the job market was 70k but with the current interest rate they would only have been able to pay them 69.3k… a very rare occasion indeed, somehow the company could not afford to pay 700 dollars/pounds/whatever more, which would be much less with average incomes. So the jobs will ONLY be generated for cases where they can spare 69.3k but can not 70k, and these tax cuts are only for the richest, who are likely to have millions… so whats the probability that people with over 100k(in all likelihood, people who are millionaires) income, can’t afford to spare 700 dollars? not very high…

# Does Basel III make sense?

In the past couple of decades the sung mantra for deregulation has been overwhelmingly dominant yet today light touch regulation is shown to increase volatility in growth. With a new era of regulation taking place, perhaps the single most globally important measure is BASEL.  Although BASEL II was never fully fulfilled in the US, BASEL III is now in line to be implemented it’s important to understand the risk management mechanics of this series of regulatory implementations. BASEL aims to recommend to banks how to be solvent by creating a system that evaluates risk based on leverage and the rating of assets. The innovations of  BASEL III is that it introduces a buffer conservation which restricts shareholder compensation if the equity level is too low and a counter cyclical buffer which is an attempt at creating a more dynamic capital requirement which increases if the credit to GDP ratio rises. This is a great step in making BASEL more dynamic but as long as arbitrary static figures exist within it it’s likely to not be efficient.

It’s a romanticised notion that this is actually a policy which would reduce risk by limiting the amount of exposure allowed. However this can also be seen as a transfer of liquidity risk. From a retail banks point of view, the liquidity risk is passed to the citizen as he can now borrow less. The static figures of capital requirements also assume an excessive amount of knowledge as to how many good investments are really available, relying excessively on a top down approach measuring style of how much banks should lend. Additionally limiting leverage based on risk weight actually reduces diversification because it encourages investment in low risk assets as the number of low risk assets has not increased, this reduction in diversification could increase risk in the long run. This system also allows for an excessive amount of leverage if too many low risk assets are used. In the worst case scenario fruitful investment will not be undertaken and in the best case scenario predatory lending will decrease, having imperfect knowledge means at least one of these will occur.

However having risk weights also encourages banks to want to pass on the risks to other bearers who might not be optimal holders. For example holding mortgage-backed securities today on a balance sheet is a very expensive endeavour which encourages the passing of this risk. BASEL could have been the culprit behind the reckless behavior that caused the financial crisis since it indirectly encouraged securitization because of its ability to skip over capital requirements. This goes contrary to an optimal framework because to reduce risk on securitized assets the optimal practice is to keep them with bearers who have the most information about them, and the longer the chain of risk selling, the more fragmented and scarce on information on the product becomes. A more thought out policy would take measures to ensure that the holders of the risk were not too far from the entity whose risk they are holding. A more bottom up approach such as giving regulators guidelines on systemic risk is a much more potent way of controlling it. To boost regulatory performance, there should be incentives such as bonuses based on low systemic risk measurements to ensure there are parties actively pursuing the interest of taxpayers.

# Does the Volcker Rule fix finance?

One of the main governmental responses to the 2008 crisis was the Dodd-Frank Wall Street Reform and Consumer protection act. This act includes changes such say “say on pay” which requires shareholder approval on executive compensation and empowering the SEC by allowing it to exercise judgment on proxy voting and protecting the customer by capping interchange fees in banks with over 10 billion in assets. However the most important part of this reform is likely to be the Volcker Rule.

Named after Paul Volcker, the Volcker Rule is essentially a reincarnation of the Glass Steagall act. This rule prohibits deposit taking institutions from directly engaging in proprietary trading or speculation, this is also done by the prohibition of over 3% ownership in any given hedge fund or private equity fund. One point of view is that this reduces the market risk of retail institutions and shifts it to the investment banks, the theoretical subsequent result being that there is less market-making and a less efficient system that disrupts allocation of capital throughout the economy. Before the rule, banks held securitized assets on their balance sheets for weeks which would put them at risk of swings in the products value. In practice however investment banks will now take a much more cautious approach as they would now be using borrowed money from the retail banks.

An example of what we should expect to see if more risk reduction is taking place is a more cautionary approach by investment banks. At the next booming period we will be able to juxtapose investment banks before and after the Volcker Rule. The norm so far has been to create securitized mortgages and hold in the bank’s balance sheets typically for a couple of weeks until they could be sold, this was the “warehouse” function of banks in the securitization process. If a more cautionary approach is taken, a reduction in the “warehouse” aspect of securitization will take place and there will be a greater incentive to directly link buyers and sellers beforehand. This could be an indication that the previous system was run on moral hazard of investment banks not bearing their own risks.

Although there are claimants that this rule will greatly cripple markets, by crippling access to liquid, if the investment opportunities are truly there, then other industries will be able to pick up the slack without putting as much risk on the consumer(lets not forget how much money companies are sitting on today). Without citizens bearing the risk it’s probable that risk-taking will be reduced and the dropping of standards would not occur without sufficient reason. This bearing of risk will likely result in a demand for greater transparency, the benefit will be a decline in cloudy activities, such as shadow banking.