Category Archives: economics

Ring-fencing rogue traders

Kweku Adoboli managed to cost UBS over $2 billion with his rogue trading, and has now cost chief executive Oswald Grübel his job. While this time the buck stopped at the top, it is more than can be said for many previous rogue trading cases. Grübel was called out of retirement to take the helm of UBS as it faced the global financial crisis, so perhaps a return to retirement was an easier choice than it would have been for the chief executives of Société Générale, NAB*, Allied Irish and other past victims of rogue traders.

But what has surprised me about this latest rogue trading incident is reactions like this one from the Economist:

For UBS and its shareholders, the immediate questions should be why it was still vulnerable to this sort of alleged manipulation more than three years after Mr Kerviel’s [the Société Générale rogue trader] loss.

Of course banks are aware of the risk of rogue trading, but it does not mean that protecting themselves against this risk is a simple matter. Trading businesses are complex, with many interconnected computer systems, some old, some new, most dealing with transactions in real time. It is a case of asymmetric warfare: the bank has to defend itself against every possible attack, but the rogue trader only has to find a single point of weakness. The UBS loss may be another reminder for banks of just how much an insider can cost them, but I am confident that there will be another spectacular rogue trading case within the next five years.

Little wonder then that Sir John Vickers, in his report on UK banking, has recommended that banks should “ring-fence” their investment banking operations (including financial markets trading businesses) from their retail and commercial banking arms. The idea is that, while governments will always want to protect the financial system that is so central to their economy, tax-payers should not end up on the hook for losses arising from risky investment banking activity.

Banking regulators around the world have been intently pursuing ideas like this over the last couple of years and the Adoboli case will only add to their determination to impose some form of “recovery and resolution” framework on banks. Before this work is complete, I would not be too surprised if UBS have spun off their investment banking arm. It is becoming all a bit much for Swiss shareholders to cope with.

* UPDATE: My memory served me poorly: the CEO of NAB, Frank Cicutto, did in fact resign after their FX trading fraud.

Dissonance and Debt

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Ever since Standard & Poor’s downgraded the US government from AAA to AA+ I have been drawn into debates about the risks posed by growing US government debt. Ever since reading the book Mistakes Were Made by Carol Tavris and Elliot Aronson I have been fascinated by cognitive dissonance and as my debt debates kept following the same pattern I became convinced the explanation for this pattern lay in cognitive dissonance. Coincidentally, I then read a post by Bill Mitchell discussing a paper by Adam Kessler analysing the views of mainstream economists in terms of cognitive dissonance.

For those as yet unfamiliar with the concept of cognitive dissonance, it refers to the discomfort people feel when faced with conflicting information. The brain tends to react to cognitive dissonance by quickly eliminating the conflict and restoring consonance.

One of many examples of cognitive dissonance in Mistakes Were Made arises when people with prejudices are presented with evidence that contradicts their prejudices. Tavris and Aronson quote Gordon Allport, who wrote The Nature of Prejudice over fifty years ago. Allport illustrated a typical pattern of dissonance-blocking in the following dialogue:

Mr. X: The trouble with Jews is that they only take care of their own group.

Mr. Y: But the record of the Community Chest campaign shows that they give more generously, in proportion to their numbers, to the general charities of the community, than do non-Jews.

Mr X: That shows that they are always trying to buy favor and intrude into Christian affairs. They think of nothing but money; that is why there are so many Jewish bankers.

Mr Y: But a recent study shows that the percentage of Jews in the banking business is negligible, far smaller than the percentage of non-Jews.

Mr X: That’s just it: they don’t go in for respectable businesses; they are only in the movie business or run night clubs.

Time and time again Mr X. shakes off contradictions to his prejudice with a non-sequitur, responding with a completely unrelated argument in support of his prejudices. My conversations about US debt have been eerily similar:

Me: This Standard & Poor’s downgrade is a bit silly. The US has got past the farce of the debt-ceiling and, unless they choose to default next time they run up against that ceiling, their debt is much safer than euro sovereign debt from the likes of Greece and Ireland.

Mr. Z: But they’ve just kicked the can down the road. Unless they do something about their deficits and cut all their entitlement spending, they are basically bankrupt.

Me: But the US government is effectively the monopoly issuer of US dollars and all their debt is denominated in US dollars: they cannot run out. So, they never have to default, unless their crazy politicians choose to.

Mr Z: Oh, sure, they can fire up the printing presses and simply print money, but that will always be inflationary.

Me: What about Japan? They ran deficits and their government debt has been growing for years and that hasn’t led to inflation. In fact, they could do with a bit of inflation, but have been unable to generate it. Government deficits will only be inflationary if the government is spending at the same time as the private sector and is overheating aggregate demand.

Mr Z: But Japan has been a basket-case for years, no-one would want the US to end up like Japan!

See the similarity? Almost every time I try to make the point that countries which control their own fiat free-floating currencies and only borrow in that currency (such as the US, UK, Australia, Canada and Japan) can never be forced to default on their debt, the conversation quickly veers away to inflation, Japan and anything but the central point. That’s cognitive dissonance for you.

Train in vain

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James Glover is a regular contributor to the Stubborn Mule who tries, whenever possible, to incorporate back of the beer coaster calculations in his posts. Here his beer coaster helps him skewer the prospects of high speed rail in Australia.

Don’t get me wrong–I love trains. I have caught trains around Europe and even the train from Sydney to Melbourne just for the pleasure of it. My favourite train journey, from London to Edinburgh up the east coast, was made particularly memorable one trip because I was (a) sitting in First Class (as usual), and (b) sharing a booth with two particularly rotund members of the House of Lords including Lord Lawrence “Mad-Eye” Mooney. So, whatever you do please don’t accuse me of trainist tendencies.

With that in mind, you would think I’d be excited by the release of a government report into building a high-speed train line from Melbourne to Sydney and from Sydney to Brisbane, via Newcastle and the Gold Coast. Sadly however the report recommending construction of this train line contains figures which crush any chance of this actually happening. The estimated cost of the build is $100 billion and there would be an estimated 54 million passengers per year. So how does that work out on a beer coaster? To convert $100 billion to an equivalent annual funding cost we just work out how much the government would pay, perpetually, to borrow this amount. At current government long-term yields of 6.00% this represents an annual interest cost of $6 billion. If the government wanted to pay back the capital in 25 years, a typical benchmark for infrastructure projects, the annual payments would increase to about $8 billion. So, calling it 50 million passengers a year, represents a cost per passenger of $160 per trip. That doesn’t seem so bad given that the cost of a one-way plane ticket between Sydney and Melbourne is about $200-400.

Is this just a coincidence? Sadly, no. It appears the planners have flipped the beer coaster over to its dark rum-soaked side to work out how many passengers they would require to make the project commercially feasible and competitive against air travel. It’s a time honoured trick but one that doesn’t stand up to closer scrutiny. In the interest of beercoasternomics and because a Google search failed to find the answer, I estimate the daily number of air passengers between Sydney and Melbourne. Turning to webjet.com, I counted 75 flights from Melbourne to Sydney on a Wednesday. From memory a typical plane on that route has about 40 rows and 6 passengers per row or about 250 passengers. That represents a total of fewer than 20,000 passengers per day. Double that for the return journey and add 25% for the numbers travelling to and from Brisbane. Let’s call it 50,000 passengers per day. Over a whole year our generous estimate of airline passenger numbers Sydney-Melbourne-Brisbane is 20 million. I’m guessing it is really no more than 5 million a year but lets call it 20 million anyway. Even at that figure it falls far short of the 50 million required to make the high-speed rail line economically viable. So why have the planners been so brazen in their estimate? That becomes clear if we used a still optimistic but realistic figure, in my opinion, of say 2 million potential rail passengers a year (which is still over 5000 per day), then the average cost of each passenger, one-way, would be $4,000! I rarely approve the use of ~~“dead dog’s dicks”~~ exclamation marks [strikethrough courtesy of a prudish editor], but really!!! Should this line ever get built I will be a frequent and enthusiastic user of it. $150 for $4,000 value is the sort of bargain that would make a late-night shopping channel host blush.

I suspect by including a few commuter stops at the beginning and end of their trips such as Brisbane to Gold Coast and Sydney to Newcastle and maybe even a new commuter line or two, e.g. Sydney to Epping, they have boosted the overall passenger numbers. But then those people are hardly going to pay over $150 for a short trip. The majority of the cost will still be borne by the (maximum) 2 million intercity travellers. Though even including short trip passengers 50 million seems excessively high until you realise it is really just the figure they need to make the numbers work.

So, sadly, the numbers don’t add up. I won’t comment on the politics except to say the feasibility study is one of promises the Labor Party made to get Greens’ support to form a government. Nor will I comment on the claims that there are hidden environmental and economic benefits. High speed rail in Australia is the classic white elephant which, according to Wikipedia, was a gift made by Thai Kings to obnoxious courtiers to bankrupt them due to the high cost of maintenance of these sacred pachyderms. Some will bring up the precedents of Europe or Asia, but there you have either cheap labour and government requisitioned land or a high density of large cities. Australia has none of these.

As The Clash so prophetically sang: it’s a train in vain.

Currencies punching above their weight

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I recently enjoyed lunch with a group of former colleagues. At one point, the conversation turned to the Australian dollar, a natural enough topic for a bunch of finance types. Someone observed that the Aussie is the 5th most actively traded currency in the world, which is impressive since Australia is certainly not the 5th largest economy in the world (that honour currently goes to France).

Thinking about Australian dollar punching above its weight led me to wonder which country had the most actively traded currency relative to the size of its economy. A quick vote around the lunch table came up with four candidates: the Australian dollar, the New Zealand dollar (which is much beloved by hedge funds), the Swiss franc and the Norwegian krone. The most popular choice among these was the Australian dollar. I was wavering between the New Zealand dollar and the Norwegian krone, but none of us knew the answer. That meant only one thing: a Stubborn Mule post would ensue to settle the bet.

Starting with turnover in the chart below, it is no surprise that the US dollar is by far the most actively traded currency. Not only is the United States the largest economy in the world, but an enormous amount of international trade is conducted in US dollars, and sellers and buyers have to transact in the currency markets to convert US dollars to and from their local currency.

Top 10 Currencies by Turnover (2010)

There are a number of reasons the Australian dollar is traded as much as it is. Our higher interest rates attract many into the carry trade (borrowing in low interest rate currencies, investing in higher interest rate currencies and hoping that the currency you are buying does not collapse). As a very commodity-driven country, many international investors see investing in Australia as a proxy for investing in commodities and, more particularly, jumping onto the China growth band-wagon. For many investors, simply buying the Australian dollar is cheaper and easier than investing in our stock-market.

But back to our bet. Only one of the assembled diners picked the Swiss franc, but it turns out to be at the top of the league table. With a GDP in 2010 of US$500 billion, there was average of $253 billion traded in Swiss francs every day in April 2010!

I have never made a close study of the Swiss franc, so I would be very interested in hearing any theories people may have as to why it is so heavily traded.

Next in the list is New Zealand, so my instincts were right there (let’s not mention the fact that I also tipped the Norwegian krone which came in a disappointing 11th place). Interestingly, third and fourth place, the Hong Kong and Singapore dollar respectively, did not even make it into our short list. And it turns out that the Australian dollar ranks 5th not only in terms of outright turnover, but also in turnover relative to economy size.

Top 10 Currencies by Daily Turnover relative to Annual GDP (2010)

If you are interested in exploring the league table further, the table below has all of the data.

Currency	Daily Turnover (US$)	Annual GDP (US$)	Turnover/GDP (%)
Swiss franc	253	500.3	50.6
New Zealand dollar	63	128.4	49.1
Hong Kong dollar	94	215.4	43.6
Singapore dollar	56	181.9	30.8
Australian dollar	302	1013	29.8
US dollar	3378	14440	23.4
Pound sterling	513	2680	19.1
Swedish krona	87	479	18.2
Japanese yen	755	4911	15.4
Canadian dollar	210	1500	14
Norwegian krone	53	451.8	11.7
Hungarian forint	17	155.9	10.9
South African rand	29	276.8	10.5
Euro	1555	18140	8.6
Danish krone	23	340	6.8
Korean won	60	929.1	6.5
Polish zloty	32	527.9	6.1
Malaysian ringgit	11	221.6	5
New Taiwan dollar	19	391.4	4.9
Mexican peso	50	1088	4.6
Philipine peso	7	166.9	4.2
Turkish new lira	29	730	4
Chilean peso	7	169.5	4.1
Czech koruna	8	216.4	3.7
Indian rupee	38	1207	3.1
Israeli new shekel	6	202.1	3
Thai baht	8	273.3	2.9
Russian Rouble	36	1677	2.1
Brazilian real	27	1573	1.7
Colombian peso	4	240.8	1.7
Indonesian rupiah	6	511.8	1.2
Chinese renminbi	34	4327	0.8
Saudi Riyal	2	469.4	0.4
Other currencies	190	NA	NA

Data sources
Currency turnover: Bank for International Settlements (BIS)
GDP: CIA World Fact Book (official exchange rates)

Looking beyond the financial crisis

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The IMF has been busy of late, what with their attempts to stave off European sovereign defaults and shenanigans of its erstwhile managing director, Dominic Strauss-Kahn. I have been busy too (for rather different reasons I hasten to add) and so it has taken me a while to get to looking at the IMF’s most recent World Economic Outlook (WEO) report, which was released back in April.

The WEO is prepared twice a year and, whatever one’s views of the merits of the economic ideas of the IMF and their role on the world stage, the report provides a rich source of data and includes both historical data and five-year forecasts.

I was interested to compare the effect of the global financial crisis on the most challenged euro nations, the so-called “PIIGS”, Portugal, Ireland, Italy, Greece and Spain, to a few other countries. To account for differences in population and currencies, I chose Gross Domestic Product per capita expressed in US dollars as the measure for this comparison*. Even so, care needs to be taken in interpreting the results. Exchange rates do introduce a fair degree of volatility as is evident in the chart below: the trajectory of US GDP per capita is quite steady, although the downward dip over recent years is clearly evident, while the paths for every other country wiggle up and down with the vagaries of currency markets. Nevertheless, it is striking to see the IMF projecting that Australia will dramatically outpace the other countries in this group, thanks to the combination of a resources boom and escaping relatively unscathed from the financial crisis of the last few years. I should point out that, while taking the gold medal in this group, Australia is not the overall winner in the IMF 2016 forecast stakes. That honor goes to the small nation of Luxembourg, and Qatar is not far behind.

History and IMF forecasts of GDP per capita (in US$)

An alternative approach that seeks to eliminate exchange rate effects is to work in local currencies and make these comparable by scaling to a common base at some point in the past. Somewhat arbitrarily, I have chosen to base this comparison on 1996, which gives a 20 year span including the forecasts out to 2016. This time I have used inflation adjusted figures**. Interestingly, this approach sees Ireland coming out on top, which reflects the strength of their economic boom over the period immediately up to the start of the crisis.

History and IMF forecasts of GDP per capita (local currency index)

This chart shows even more clearly how unaffected Australia was by the financial crisis compared to other countries. Once again, these results should be treated with caution. Any comparison like this will be very dependent on the year chosen to base the indices. If only I had chosen the year 2000, Australia would be in the lead again!

* This is the IMF series NGDPDPC.
** This is the IMF series NGDPRPC, rebased to 100 in 1996.

Return of the Drachma?

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It has been reported that Greece is considering leaving the euro and re-establishing its own currency*.

More than a year ago, I argued that being part of the euro seriously exacerbated Greece’s economic woes, and for the reasons given there, I do think that re-establishing sovereignty over its currency is in Greece’s interests in the long run. Nevertheless, it would be a painful process exiting the monetary union.

To begin with, there are all sorts of practical complexities. The switch to the euro was an enormous project, years in the planning and to switch back would require major logistical and systems changes for banks and businesses across the country. Mind you, the work involved may act as a stimulus to employment! The other challenge, is that Greece still has significant quantities of public and private debt denominated in euro. Inevitably, there would be defaults and restructuring of this debt. That, combined with the fact that the new currency would be launched by a country known around the world to be in dire economic straits, would result in ongoing weakness of the new currency. While a weak currency would have some advantages, making Greece’s exports far more competitive than they have any hope of being while the country retains the euro, imports would become very expensive and there would be significant inflationary pressure. The problems Iceland has faced since its default provide a useful comparison, although Greece does have the advantage of a broader domestic production base.

So, while an exit from the euro would be an unpleasant experience, it is probably just the medicine that patient requires.

* Thanks to @magpie for drawing this article to my attention.

S&P being silly again

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The debt rating agency Standard and Poor’s (S&P) has placed their rating of the US on negative outlook. What this means is that they are giving advance warning that they may downgrade their rating of the US from its current AAA level (the highest possible rating). Their actions were motivated by concern about “very large budget deficits and rising government indebtedness”.

To me this shows that S&P do not have a good enough understanding of macroeconomics to be in the business of providing sovereign ratings. How can I doubt such an experienced and reputable organisation as S&P? Well, keep in mind that this is the same agency which maintained investment grade ratings for the likes of Bear Stearns, Lehman Brothers and AIG right up to the point where these firms were on the brink of collapse (while it was only Lehman that actually failed, that was only because the other two were bailed out). Likewise, it is the same agency which assigned investment grade ratings to sub-prime CDOs and other structured securities many of which only ended up returning cents in the dollar to investors during the global financial crisis.

Of course many commentators are very nervous about the growth in US government debt (notably, the bond market seems far more sanguine) and typically assert, with little justification, that growing government debt will lead inevitably to one or more of:

a failure of the government to be able to meet its debt obligations,
rising inflation as the government seeks to deflate away its debt (and interest rates will rise in anticipation of this future inflation), and
a collapse of the currency as the government seeks to devalue its way out of the problem.

Before considering how likely these consequences really are, it is important to emphasise that while there is a widespread tendency to label all of these as a form of “default” by the government it is only the first of the three, a failure of the government to make its payment obligations, that the S&P rating reflects.

In fact, I do not consider any of the three consequences above to be inevitable. The quick and easy counter is to point to Japan. As its government debt swelled to 100% of gross domestic product (GDP) and beyond, it never missed a payment, would have loved to generate a bit of inflation but consistently failed year after year and, while its currency has its ups and downs, the Yen remains one of the world’s solid currencies. While I certainly do not think that the US should aspire to repeat Japan’s experience over the last couple of decades (I would hope for a better recovery for them), this point should at least dent the simplistic assumption that default, inflation or currency collapse follow rising government debt as night follows day.

Since it is only a true default that is relevant for the S&P rating, it is worth considering more specifically how likely it is that the US government will be unable to honour its debt obligations. Regular readers of the blog will know that I regularly make the point at the heart of the “modern monetary theory” school of macroeconomics, namely that in a country where the government is the monopoly issuer of a free-floating currency, the government cannot run out of money. If your reaction to that is “of course they can print money, but that would be inflationary!”, ask yourself why that did not happen in Japan and then remind yourself that even if it did happen, it is not relevant to the S&P rating.

There is one important caveat to this monopoly issuer of the currency argument. While it certainly establishes that the US government will never be forced to default on its debt, it is still possible that it could choose to default. This choice could come about in a dysfunctional kind of way since the US imposes various constraints on itself, in particularly a congress legislated ceiling on the level of debt the government may issue. So it is possible that a failure of congress to agree to loosen these self-imposed constraints could end up engineering a default. Now that is a more subtle scenario than the one that S&P is worried about, but since it is possible, it is worth considering how serious debt-servicing is becoming for the US government. To make a comparison over time meaningful, I will take the usual approach of looking at the numbers as a proportion of GDP. Taking the lead from a recent Business Insider piece*, the chart below shows US government interest payments as a share of GDP rather than the outright size of the debt. This has the advantage of taking interest rates into account as well: even if your debt is large, it is easier to meet your payment obligations if interest rates are low than if they are high.

US federal government interest payments as a share of GDP

So the interest servicing position of the US government has actually improved of late and is certainly much better than it was in the 1980s and 1990s. So why is S&P reacting now? I would say it is because timing is not their strong suit (and they do not really understand what they are doing). Ahh, you say, but what happens when interest rates start going up? Since the US Federal Reserve controls short-term interest rates and of late, through its Quantitative Easing programs, has been playing around with longer-term interest rates as well, the US government is in a somewhat better position than a typical home-borrower, and interest rates will only start to rise once economic activity picks up again. Then the magic of automatic stabilisers come into play: tax receipts will rise as companies make more profit and more people are back at work, and unemployment benefits and other government expenditure will drop and the growth of government debt will slow or reverse.

So, there is no need for panic. Once again, the rating agencies are showing that we should not be paying too much attention to them. After all, as they all repeatedly said in hearings in the wake of the financial crisis, their ratings are just “opinions” and not always very useful ones at that.

Data Source: Federal Reserve of St Louis (“FRED” database).

* As Bill Mitchell, @ramanan and others have noted the Business Insider chart, while looking much the same as my chart, has the scale of the vertical axis out by a factor 10.

Carbon tax

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Our regular guest writer James Glover (@zebra) returns to the Stubborn Mule today to look at the real cost of carbon tax…and who pays the cost.

It is no surprise that the latest Newspoll shows the Labor Government sinking under a concerted attack by the Opposition, and its supporters in the media, over the Carbon Tax. The incessant cry of “a great big new tax” was bound to have an effect on the marginal voters who derive their political views in atavistic ways. In fact most of the political arguments lately recently seem to revolve around the distinction between levies and taxes. The trick seems to be if your opponents propose it then it is a tax and if you propose it is a levy—the latter being used by both sides to describe variously the flood levy (Labor) and the parental leave levy (Coalition). Taxes, as opposed to levies, apparently lead to profligate spending and are downright un-Australian. It makes you wonder what they use to fund hospitals, schools and roads.

So how does the Carbon Tax work? And what does it mean to say it is “revenue neutral”? Is it really a tax or “not really a tax” as the Treasurer, Wayne Swan, claims? Suppose the government wants to set up a Carbon Tax for the purposes of reducing carbon emmissions. It does this by imposing a tax (or levy or fee) on the price of goods and services that are deemed to ultimately cause high but avoidable (hence no agriculture) emissions of carbon. This of course raises the price of these goods e.g. electricity. If we impose a Carbon Tax on coal-generated electricity (the sine qua non of carbon emitters) then expect the power companies to pass on all or most of the increase to consumers. Now here’s the thing, the money the tax raises will have gone to subsidise the increased power bills of these very same power consumers. By exactly the same amount as the price should rise. So in effect nothing happens. In other words, at a base level the Carbon Tax does nothing. It has no benefits and no costs. Isn’t it really “a great big snooze tax” and not “a great big new tax”?

The Carbon Tax has one (fully intended) important consequence. If power emitters want to increase their profits they can do so by switching to lower carbon emitting alternatives. These might already be available or they can pay to research and develop them. And because of the tax what was previously uneconomic will now be made viable. Since these alternatives are really more expensive than coal-based power, without the tax, you might ask what is really happening at the cost end. It seems like a tax which costs nobody nothing, magically makes alternatives to carbon emitting industries economic. Voila!

Well that’s what the government would have you believe. On closer examination though it is precisely when the Carbon Tax has its intended effect that the cost gets passed onto consumers. But not when the Carbon tax is first introduced. To see why let’s have a look at an example.

Suppose the cost per unit of producing electricity from coal is $100. The power company charges $110 to consumers and so makes a $10 profit. The Govt introduces a 20% Carbon Tax on the cost of producing electricity using coal. This raises the price to $130 in order for the company to maintain its $10 profit margin. That’s $100 for the coal, $20 for the tax and a profit of $10. The extra $20 gets passed onto the consumer whose bill is now $130 per unit. However after the $20 subsidy (paid for by the $20 proceeds of the tax) they still only pay $110.

In other words: the producers, the consumers, and the government are no better or worse off immediately after a Carbon Tax is introduced. But what happens if the Carbon Tax is successful in reducing emissions? That is when consumers end up paying more. The cost to the company, including the tax, of producing one unit of electricity is $120. Suppose an alternative non carbon-emitting energy source is found which costs $115 per unit. This is more than the coal-based cost before the tax, but less than the cost with the Carbon Tax as this carbon-free energy source, let’s call it “sunshine”, attracts no Carbon Tax. So the company, in order to maintain their profit of $10, charges $125 per unit, less than coal based power with a Carbon Tax. But now the consumer receives no subsidy either so even though their total bill has dropped from $130 (with carbon tax and a subsidy) to $125 without a subsidy. It now actually costs them $125, an increase of $15 over the cost before the carbon tax was introduced and even immediately afterwards. This of course is the extra $15 per unit that it costs to produced electricity from sunshine rather than coal.

That is how the Carbon Tax really works and ends up costing the consumer. You start out with a Carbon Tax which costs nobody anything and end up without a Carbon Tax that everybody ends up paying more for. When it has its intended effect, and there is no coal based power, but also no more money for subsidies. And, in principle, no more carbon pollution.That of course though is really the point. There is a (currently) hidden cost of producing carbon as carbon dioxide and methane in global warming and that is, if the system works, the $15 extra you pay to solve the problem by removing carbon from the economy.

Virtual currency

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Thanks to my new job, the rate of Stubborn Mule posts has declined somewhat over the last few weeks (to say nothing of Mule Bites podcasts!). Still, my commute has allowed me to catch up on my podcast listening and a particularly interesting one was the recent Security Now episode about the “virtual currency” Bitcoin. Here is how Bitcoin is described on their website:

Bitcoin is a peer-to-peer digital currency. Peer-to-peer (P2P) means that there is no central authority to issue new money or keep track of transactions. Instead, these tasks are managed collectively by the nodes of the network.

Given that e-commerce is already widespread on the internet, what exactly is new about this idea of a virtual currency? The key to this question is understanding the difference between money in the form of “currency” (notes and coins) and money in the form of balances in your bank account. Currency is essentially anonymous. If I hand you a $10 note, we don’t need anyone to facilitate the transaction and you can take that $10 and spend it with no further reference to me or anyone other else. To move $10 from my bank account to yours is quite different. Before we could even start, we both had to provide extensive identification to our respective banks to open bank accounts. Then, you would have to provide me with enough account information for me to instruct my bank to transfer money from my account to yours. Both banks would retain records of the transfer for a long period of time and, if the transaction was rather bigger than $10, the chances are that there may even be requirements for our banks to notify a government agency in case we were engaged in money laundering. Even if I paid you using a credit card, the information exchange would be much the same.

The Bitcoin virtual currency aims to mimic some of the essential characteristics of currency while allowing transactions to be conducted online. To do so, it makes very creative use of a powerful encryption technology known as “public key cryptography”.

Public key encryption involves encrypting data in a rather unusual way: one key is used to encode the data and a different key is used to decode the data. This is in contrast to “symmetric key encryption” in which the same key is used for both encoding and decoding data. To appreciate the difference, consider a less electronic scenario. I want to exchange messages with you using a locked box and ensure no-one else can open it. If we already have identical keys to the one padlock there is no problem. I simply pop my message in the box, pop on the padlock and post it to you. When you receive the box, you can use your key to open the box, read the message, reply and pop the same padlock on the box before sending it back. But what do we do if we don’t both have keys to the one padlock? There is a tricky solution. I put the message in the box, secure it with my padlock and send it to you. Once you get it, although you cannot open my lock, you add your own padlock to the box and return it to me. Once I get it back, I unlock my own lock and send the box back. You can then open your lock and read my message. While in transit, no-one can open the box. It’s certainly an elaborate protocol and, of course, I’m ignoring crowbars and the like, but it gives a rough analogy* for how public key encryption works.

When it comes to data encryption, both users will create a “key pair”. One key they keep to themselves (this is known as the “private key”) and one key they can share with the world (the “public key”). I can then let you (and indeed the whole world) know what my public key is. When I want to send you a message, I encrypt it using your public key and send it to you. The only way to decode it is using your private key, which only you have. Even though everyone can find out what your public key is, only you can decode the message. When you want to send a message back to me, you encode it using my public key. So, anyone who knows my public key can send me a message for my eyes only. As a side benefit, public key encryption can also provide authentication. If you send me a message encrypted using my public key, I would ideally like to confirm that it really came from you not someone else (after all, everyone knows my public key). To deal with this, you can also send a copy of the same message encoded using your private key. Once I have decoded your message with my private key, I can also decode the second message using your public key. If the two messages are the same, I know that whoever sent me the encoded message also had access to your private key, so I can be reasonably sure it was you. In practice, authentication works a little bit differently to this, using a “hash” of the original message (otherwise anyone could decode the secret message using your public key). This authentication process is known as “digital signing”.

All of that may seem like a bit of a diversion, but public key cryptography is at the heart of the Bitcoin idea. Essentially, a Bitcoin is a blob of data and if I want to give you one of my Bitcoins, I add your public key to the blob and then sign it using my private key. This means that anyone who has access to my public key (i.e. the whole world) can confirm that I intended to pass the coin onto you. As a result, Bitcoins have their entire transaction history embedded in them! To decide who “owns” a Bitcoin, we just need to look at the last public key in the transaction chain. Whoever owns that key, owns the Bitcoin.

“How is that anonymous?” I hear you ask. Since “keys” are just strings of data themselves, there is no reason you have to advertise the fact that, say “6ab54765f65” is your public key. While the whole world can see that the owner of “6ab54765f65” owns a number of Bitcoins, that does not mean that anyone has to know your secret identity.

The other important feature of Bitcoins is that there is no centralised coordinator of the Bitcoin records. There is no bank keeping the records. The Bitcoin algorithm is public and information about Bitcoin transaction histories is shared across a peer-to-peer network which allows anyone to independently verify Bitcoin transactions.

It’s a fascinating idea and I don’t know if it will take off. It is only in beta, but there are a number of websites that have begun accepting Bitcoins for payment, as well as sites which will trade Bitcoins for “real” money. I will be watching with interest.

* It really is quite rough, only showing that a secure exchange without key exchanges is possible. Other features, such as authentication and the key asymmetry (either key can lock and then the other key unlocks) are not captured.

Where does the money go?

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A regular Mule reader drew my attention to an article in the Sydney Morning Herald (also published in The Age) which attempts to defend Australian banks from some of the criticisms levelled at them in recent months. It is something of a laundry list of points, some accurate, some dubious and has little in the way of hard data behind it.

What my correspondent was more interested in, however, was that one powerful argument was missing. If banks had not bolstered their margins by raising mortgage rates by more than the Reserve Bank cash rate rises, the Reserve Bank would in all likelihood have increased the cash rate by even more. This contention is supported by the Reserve Bank’s own board meeting minutes from the 2 November meeting. Discussing the considerations which led to the November rate hike, the following observations appear:

Members noted that lending rates might increase by more than the cash rate, but this tendency would not be lessened by delaying a change in the cash rate. Lending rates had been rising relative to the cash rate since the global financial crisis, and the Board had taken this into account in setting the cash rate. It would continue to take account of any changes in margins in its decisions in the period ahead.

From this it seems clear that if the banks had kept to moving their mortgage rates in line with the cash rate, the cash rate would now be higher and the end results for borrowers would be much the same.

Of course, if this had happened, bank margins would have been squeezed, which leads to this question from my correspondent:

Where banks don’t increase margins but RBA increases base rate more so overall level the same, where does the “banks’ profit” go? RBA [Reserve Bank of Australia]?

This question gets to the heart of how banks work.

While we tend to think of banks as lenders, it can be more useful to think of them as intermediaries between borrowers and lenders. The real lenders are the banks’ depositors and bondholders. Banks pay interest on deposits and bonds and charge a somewhat higher rate interest on their loans. The difference between the interest they pay and the interest they receive is their net interest margin which, along with fees and charges, is their source of profit. In the wake of the financial crisis, the market for deposits has become very competitive and bond investors now demand higher returns on bank debt compared to lower risk alternatives (such as government bonds…at least if the government in question is not European!). Both of these effects have resulted in the interest banks pay increasing by more than the amount the Reserve Bank’s cash rate has increased. Banks have attempted to recoup the resulting increases in the interest they pay by passing through bigger increases to their borrowers (you can read more of the details in an earlier post on bank funding costs).

So, if banks had kept their mortgage rates strictly in line with the Reserve Bank’s cash rate, their margins would certainly have been smaller than they are today. If that had happened, where would the money have done? It does not go to the Reserve Bank: while they set the target rate, the Reserve Bank itself does very little lending at that rate. Rather they ensure that any lending overnight from one bank to another is done at or very close to the target rate by promising to lend or borrow large amounts at rates only slightly above or below the target respectively. No, the real beneficiaries of the higher rates are the ultimate lenders: depositors and bondholders.

Anyone with a balance in a superannuation fund is likely to have a certain amount invested in bond funds which would invest in, among other things, bonds issued by banks. Self-funded retirees and others seeking to keep their investment risk to a minimum may have money in bank term deposits rather than shares or property. All of these people lend money to banks and benefit through higher earnings when interest rates go up*. The banks do get some of the benefit themselves. Some deposit balances are paid little or no interest and so when the cash rate rises, these deposits represent an increasingly cheap source of funds for banks, although these low interest balances represent a much smaller proportion of banks’ funding than they used to.

The effect of changing interest rates is thus an exercise in wealth redistribution between the ultimate borrowers (including those borrowing to buy a home), the ultimate lenders (depositors and investors) and the banks themselves. What we have seen over recent months can be seen as a bit of a tussle between banks on the one hand and depositors and investors on the other as to who should get how much of the higher rates borrowers are paying.

* There is a timing issue for bond investors: fixed rate bonds actually fall in value when interest rates go up, but from that point onwards the ongoing earnings of the investment are higher.