Into the Woods

The global capital market 40 years ago was a very different place. Even though in 1971 Nixon had just suspended the dollar's convertibility into gold, substantial measure of direct control over private capital movements, considered “a permanent feature of the post-war system” by John Maynard Keynes, remained in place. Since the time of Bretton Woods, when capital sums did flow across national borders, they would go from government to government, like the payments under foreign aid such as the Marshall Plan. Even tourists could be prevented from going abroad with more than a pocketful of currency if governments felt unable to make their currencies convertible.

The trend after Bretton Woods was for free trade to be revived in the post-war years but for capital controls to be tightened rather than loosened over time. For example, the Interest Equalization Act enacted by the U.S. in 1963 was designed to discourage Americans from investing in foreign securities by adding a tax that can be up to 15% of their purchase price. Unanchoring of dollar from gold in 1971 paved the way for other important changes to come. Following the Arab oil embargo of 1973, U.S. abandoned its capital controls in 1974. This was followed by UK in 1979. Within a short time, most other major economies lifted their capital controls as well. Governments around the world came to the realization that: if capital were to flow freely across borders, countries must choose between fixing their currencies and controlling their domestic monetary conditions; they cannot have both. Since the dollar was no longer tied to gold, the choice then became obvious: currencies were allowed to float relative to the dollar for the first time, driven by market forces rather than pegged to the dollar that was no longer anchored in gold.

Evolution of International Monetary Systems: (1) Gold Standard, (2) Bretton Woods, (3) Post Bretton Woods.

"Trilemma": A tough juggling act for central bankers on a tight rope.

According to what the economists describe as the trilemma, countries cannot have fixed exchange rates, free capital movements and independent monetary policy all at the same time. Under the gold standard, exchange rates were fixed and capital could move around but central banks were forced to adjust interest rates to ensure they did not run out of reserves. This could lead to deflationary pressure on the real economy, and cycles of booms and busts. Under the Bretton Woods system, fixed exchange rates with occasional adjustments were allowed; monetary policies can be independent of liquidity needs as capital mobility was highly restricted. When that system broke down in the 1970’s, the world moved to largely floating exchange rates. Capital flowed freely around the world but the result has been fairly regular financial crises.

In fact, the last financial crisis has been so huge that one is tempted to reconsider the bargain. Moreover, no one seems to be particularly happy with today's international monetary system — the set of rules, norms and institutions that govern the world's currencies and the flow of capital across borders. According to The Economist, there are three broad complaints: (1) dominance of the dollar as a reserve currency and exposure to U.S. domestic monetary policy; (2) accumulation of vast foreign exchange reserves weighing down long-term interest rates; and last but not least (3) scale and volatility of capital flows, especially the "hot money" variety, and their destabilizing effects on national economies.

This brings us to the present day global currency regime, dubbed Bretton Woods II in 2003 by a trio of economists, Dooley, Folkerts-Landau and Garber (all now at Duetsche Bank). They realized that the dynamics of today’s international monetary system is best understood as comprising a core with the U.S. as its center and a managed exchange rate periphery in Asia. Their influential 2003 paper argued that the normal evolution of the international monetary system involves the emergence of a periphery for which the development strategy is export-led growth supported by undervalued exchange rates, capital controls and official capital outflows in the form of accumulation of reserve asset claims on the center country. The success of this strategy in fostering economic growth allows the periphery to graduate to the center. Financial liberalization and open capital markets, in turn, require floating exchange rates among the center countries.

Structure of a revived Bretton Woods system comprising a US-Europe-Japan core and an emerging markets periphery.

In the 1950’s, under the Bretton Woods system, the U.S. was the center region, while Europe and Japan, whose capital had been destroyed by the war, constituted the emerging periphery. Once their capital stock rebuilt and institutions restored, the periphery graduated to the center in the 1970’s as they shifted towards free markets, floated their currencies, and lifted capital controls. With the discrediting of the socialist model in the 1980’s among the developing countries, and then the collapse of communism around 1989-1991, a new periphery began to form around the US-Europe-Japan center. These periphery countries, e.g., BRICs and other emerging markets in Asia, discovered that their cumulated capital stock was inefficient as they opened their economies to trade, and were willing to accommodate foreign capital as they pursued an export-led development strategy. Accordingly, the economic success of this group of countries in the last decade brought the structure of the international monetary system full circle to its essential Bretton Woods era form. It seems that the system has not fundamentally changed, according to Dooley, Folkerts-Landau and Garber, “it just occasionally reloads a periphery.”

The Bretton Woods system had served its purpose well while it lasted. But we're not out of the woods, yet. So it is perhaps time again to seriously think about a new architectural vision for our international monetary system; this time with a new understanding of the effects of the periphery on the center. A good starting point may be to ask fundamental questions that probe the trilemma of today’s international economics revolving around: (1) monetary policies, (2) capital mobility, and (3) exchange rates. For instance: Are symbiotic imbalances between the core and the periphery a necessary feature of global economic growth? How might one facilitate the reallocation of capital among nation states? Is there a better way to organize the world’s currencies? Most importantly, we like to understand the pivotal role of a financial intermediary that a center country such as the U.S. can play in the system. What do you think?

References:

1. Rueff, Jacques and Hirsch, Fred (1965, June). The Role and Rule of Gold: An Argument. Princeton Essays in International Finance, no. 47, Princeton University International Finance Section.
2. Dooley, Michael and Folkerts-Landau, David and Garber, Peter (2003, September). An Essay on the Revived Bretton Woods System. NBER Working Paper 9971. Retrieved from: http://www.nber.org/papers/w9971.pdf
3. Eichengreen, Barry (2004, May). Global Imbalances and the Lessons of Bretton Woods. NBER Working Paper 10497. Retrieved from: http://www.nber.org/papers/w10497.pdf
4. Dooley, Michael and Folkerts-Landau, David and Garber, Peter (2008, March 12). Asia, Interest Rates, and the Dollar (2nd Edition). Deustsche Bank Research. Retrieved from: http://people.ucsc.edu/~mpd/Asia_Interest_rates_and_the_dollar.pdf
5. Dooley, Michael and Folkerts-Landau, David and Garber, Peter (2014, August 29). The Revived Bretton Woods System’s First Decade. Deustsche Bank Special Report. Retrieved from: http://www.fullertreacymoney.com/system/data/files/PDFs/2014/August/27th/DB_SpecialReport_2014-08-26_0900b8c088aa314a.pdf
6. Geruguson, Niall (2008). The Ascent of Money: A Financial History of the World. The Penguin Press.

Stone Money

“Economists like to argue that money belongs in the same class as the wheel and the inclined plane among ancient inventions of great social utility. Price stability allows the invention to work with minimal friction.”

— Ben Bernanke (February 24, 2006)

We have already seen how Bitcoin can work quite well as a medium of exchange or as a store of value without being itself a unit of account; such function is fulfilled quite nicely by stable fiat money. In an insightful 1996 article titled: “Money is Memory” by Narayana Kocherlakota (who is now the current president of Federal Reserve Bank of Minneapolis), money is viewed as playing the role of memory in keeping track of past exchanges in human society. In fact, the argument presented in the paper foreshadows the arrival of block-chained public ledger based digital currencies such as Bitcoin in 2009. But the story of money as community memory had begun much earlier.

Stone Money on the South Pacific Island of Yap.

Moving the Giant Penny: It seemed a good idea at the time... (Source: DC Comics).

The story took us to a tiny island in the South Pacific Ocean known as the Island of Yap. There is no gold or silver on Yap. But hundreds of years ago, explorers from Yap found limestone quarries in surrounding islands hundreds of miles away. They carved out enormous donut-shaped stone discs up to twelve feet in diameter, and with great effort sailed these stone discs back across the sea in canoes and on rafts.

Nobody knows if these stone discs started out as money. But at some point the Yap islanders realized what most societies realize: they need something valuable that everyone on the island agrees can be used to pay for stuff. And the Yap islanders decided that these beautiful and precious stone discs, mined and carved with great care and transported hundreds of miles across the sea with great effort, would be money.

A piece of stone money was highly valuable, and really heavy. One wouldn’t use it for everyday transactions. Stone money was for something significant – a daughter’s dowry or livestock, for example. Stone money is a good store of value and could be traded in a jiffy to tide a family over hard times. When the time came for a significant trade, the stone disc changed hands according to island protocol. How it worked was that the two parties in the transaction loudly and publicly declared that this particular stone disc here was now property of so-and-so, and then left the stone disc right where it was. The stone disc remained unmoved, but everyone on the island knew the stone disc now has a new owner. In other words, a transaction history of the stone disc was kept alive in the collective memory of the Yap islanders.

What’s most interesting is the fact that a stone disc does not even need to be on the island to count as money. Many generations ago, according to the island’s oral tradition, the ancestor of a wealthy family on the island was bringing back an enormous stone disc on a raft to be towed homeward when a storm hit. The expedition party, to save their lives, was obliged to cut the raft adrift, and the stone sank out of sight. When they returned back home, the crew members all testified that the stone disc was of magnificent proportions and extraordinary quality, and that it was lost to the sea through no fault of the owner. Thereupon it was universally agreed that the mere accident of its sinking to the bottom of the ocean ought not to affect the stone's marketable value, since it was all chipped out in proper form. The stone’s purchasing power remains unquestioned for generations, even though no one on the island has seen it for over a hundred years, as valid as if it were leaning visibly against the side of the owner’s family hut.

The story of stone money attests to the power of simple trust, enduring faith, and community memory. After all, money is just paper and metal, or even stone – what is truly interesting is why and how people choose to earn it, save it, give it away, or exchange it for other things, the retelling of which recalls a trail of memory in the all-too-human network of gifts and exchanges, accompanied by a quiet whisper that says: “I was here.”

“... any technological advantages offered by money are also offered by an alternative technology: memory. Moreover, in at least some environments, memory may technologically dominate money. Money may only be an imperfect substitute for high quality information storage and access. … the government’s monopoly on seignorage might be in some jeopardy as information access and storage costs decline.”

— Narayana Kocherlakota ("Money is Memory", 1996)

References:

1. Friedman, Milton (1991, February). The Island of Stone Money. The Hoover Institution, Working Papers in Economics E-91-3. Retrieved from: http://hoohila.stanford.edu/workingpapers/getWorkingPaper.php?filename=E-91-3.pdf
2. Irwin, Neil (2013, April 12). Bitcoin is ludicrous, but it tells us something important about the nature of money. Wonkblog, The Washington Post. Retrieved from: http://www.washingtonpost.com/blogs/wonkblog/wp/2013/04/12/bitcoin-is-ludicrous-but-it-tells-us-something-important-about-the-nature-of-money/
3. Krugman, Paul (2013, April 12). Adam Smith Hates Bitcoin. The Opinion Pages, New York Times. Retrieved from: http://krugman.blogs.nytimes.com/2013/04/12/adam-smith-hates-bitcoin/
4. Kocherlakota, Narayana (1996, October). Money is Memory. Federal Reserve Bank of Minneapolis, Research Department Staff Report 218. Retrieved from: https://www.minneapolisfed.org/research/sr/sr218.pdf

5. Nakamoto, Satoshi (2009). Bitcoin: A Peer-to-Peer Electronic Cash System. Retrieved from: https://bitcoin.org/bitcoin.pdf

Planet Bitcoin

“The root problem with conventional currency is all the trust that’s required to make it work. The central bank must be trusted not to debase the currency, but the history of fiat currencies is full of breaches of that trust. Banks must be trusted to hold our money and transfer it electronically, but they lend it out in waves of credit bubbles with hardly a fraction in reserve.”

— Satoshi Nakamoto (2009)

What does the macroeconomics of Bitcoins look like? This is a question worth pondering over as it highlights some of the salient features of money, currencies, and their valuations but in a much simpler environment, i.e., without the distortions wrought by the world’s central banks through their currency interventions. So let’s imagine taking a trip to an alternate planet in the financial universe where all goods and services are denominated in fiat currencies, i.e., currencies endorsed by the governments on the planet, but which can be also be easily bought and sold in Bitcoins as an alternative. For ease of exposition, we shall refer to this make-believe world as simply “Planet Bitcoin.”

On Planet Bitcoin, we can identify four representative classes of inhabitants: (i) The Users, who choose to use Bitcoins as a medium of exchange whenever and wherever they could even though the unit of accounts for all goods and services are in fiat currencies; (ii) The Dealers, who trade in Bitcoins so as to facilitate currency exchanges between Bitcoins and fiat currencies; (iii) The Miners, who create Bitcoins and put them into circulation; and (iv) The Hoarders, who hold onto Bitcoins as an investment and view Bitcoins as a good store of value.

Meet the Representative Inhabitants of Planet Bitcoin: User, Dealer, Miner, and Hoarder.

Let’s posit that the law of supply and demand works just as well on Planet Bitcoin as on planet Earth, and that the supply and demand of Bitcoins itself is no exception. The key is in finding the right metrics. We know that Bitcoins, by definition, has a maximum money supply that is capped at 21 million Bitcoins. As of today, over 14 million Bitcoins have been issued and are in circulation, constituting a Bitcoin market capitalization of over 3 billion USD at current exchange rate of approximately 225 USD per Bitcoin. In recent months, the Bitcoin economy as measured by its estimated daily transaction volume has been fluctuating around 150,000 Bitcoins, representing about 40 million USD worth of goods and services in 100,000 transactions daily. In addition, the daily exchange trade volume of Bitcoins fluctuates around 5,000 to 8,000 Bitcoins representing about 2 million USD of daily exchange trading volume.

We hope to understand the macroeconomics of Bitcoins using the following metrics as proxies for aggregate supply and demand of Bitcoins: (1) Transaction Volume, (2) Trade Volume, (3) Transaction Number, and (4) Effective Money Supply. In particular, how would interactions among the Users, Dealers, Miners and Hoarders on Planet Bitcoin affect these metrics? More importantly, what is their net effect on the valuation of Bitcoin?

To provide a starting point for discussion, we shall presently invoke the following equation of exchange as applied to Bitcoin as a basic framework for our analysis:

    M V = P Q

where, for a given period on Planet Bitcoin,

• M is the effective amount of Bitcoins in circulation (i.e., effective money supply).
• V is the velocity of money, or how often a Bitcoin is transacted (i.e., per Bitcoin transaction number).
• P is the price level as measured in Bitcoins (i.e., inverse of Bitcoin valuation).
• Q is the fiat money sum of all goods and services transacted with Bitcoins (i.e., transaction volume).

We can consider the price level as the inverse of Bitcoin valuation, i.e., with respect to some fiat currency. After all, higher Bitcoin valuation means lower prices and vice versa. Rearranging the equation of exchange slightly, we arrive at the following expression for valuation of Bitcoin (BTC):

    BTC = 1/P = Q/(M V)

Notice that fiat money is now considered real and Bitcoins nominal in the equation of exchange. It is now easier to see how the different activities of Users, Miners, and Hoarders interact together on Planet Bitcoin as described by this Bitcoin valuation formula as experienced by the Dealers:

Causal links showing how activities by User, Miner, and Hoarder affect key metrics in the valuation formula positively or negatively as seen by Dealer, whose trading activities have no net effect on Bitcoin valuation.

It becomes clear that increased demand for Bitcoins by Hoarders and Users raises Bitcoin valuation by reducing its effective money supply in two ways: (1) hoarding a Bitcoin over a longer term effectively takes it out of circulation for an extended period of time; and (2) transacting with a Bitcoin increases utilization of the money supply by making that Bitcoin temporarily unavailable for use by others for a brief period surrounding the transaction. The trading activities of Dealers facilitate the exchange of Bitcoins with fiat currencies by taking the opposite side of the trade but otherwise do not have any noticeable long-term impact on the supply or demand of Bitcoins. On the supply side, Miners can still work to gradually expand the total number of Bitcoins, reducing its valuation in the process at least until the maximum cap of 21 million Bitcoins is reached.

It would be interesting to actually substitute Bitcoin statistics into the formula and to conduct an empirical study of Bitcoin valuation based on the metrics suggested in the above. The caveat here is to not let the denominator term MV easily collapse into just the estimated Bitcoins transaction volume, as it would then make the equation of exchange trivially true almost by definition (since the numerator Q is just fiat money transaction volume!). The real challenge is in finding separate measurements (or proxies) for M and V that is useful from a Bitcoin valuation perspective. If anyone is interested in conducting such an empirical study we would love to hear about it.

Transported back to our real world on planet Earth, we can now more clearly see that our foreign exchange market is similarly comprised of market participants with identifiable roles: (i) commercial companies, especially multi-national companies, which have natural interests in foreign exchange through their payments for cross-border flow of goods and services, as well as foreign direct investments, and are thus the primary Users of foreign exchange; (ii) banks, financial firms, traders and other speculators playing the role of Dealers in foreign exchange; and (iii) money-printing central banks who are both the Miners and the Hoarders of significant foreign exchange reserves. These participants interact through a number of interconnected marketplaces in New York, London, Tokyo, Hong Kong, and Singapore that together form the backbone of our modern decentralized foreign exchange market.

“You never change things by fighting the existing reality. To change something, build a new model that makes the existing model obsolete.”

— R. Buckminster Fuller (1895-1983)

References:

1. Pacia, Chris (2014, February 8). Bitcoin Explained Like You’re Five: Part 5 – Macroeconomics. Retrieved from: https://chrispacia.wordpress.com/2014/02/08/bitcoin-explained-like-youre-five-part-5-macroeconomics/
2. Wang, Joseph Chen-Yu (2014, February 11). A Simple Macroeconomic Model of Bitcoin. Retrieved from: http://ssrn.com/abstract=2394024 or http://dx.doi.org/10.2139/ssrn.2394024
3. Ciaian, Pavel and Rajcaniova, Miroslava and Kancs, d’Artis (2014). The Economics of BitCoin Price Formation. Arxiv. Retrieved from: http://arxiv.org/ftp/arxiv/papers/1405/1405.4498.pdf

Quantamental Universe

“In the work of the scientist, formulating the problem may be the better part of the discovery, the solution often needs less insight and originality than the formulation.”

— George Polya (1887-1985)

Quantitative and fundamental analyses were thought to be mutually exclusive. However, since 2012 there is a new breed of models and strategies emerging that goes by the name “Quantamental.” When an investment manager has fundamental conviction on a security and quantitative models agree, the subsequent performance is superior to either discipline alone. The reason why combining these two approaches increases overall risk-adjusted return is that there is generally low correlation of returns between fundamental strategies and quantitative strategies.

Originally used for stock valuation, both quantitative and fundamental analysts basically share the same underlying factors such as company financials, price/earnings ratios, credit ratings, and measures of market sentiments. That is the reason why these two distinct analytical styles can be combined together. But what does the world of capital flow, interest rates, and exchange rates look like from the vantage point of a 'quantitative + fundamental' currency trader or a central banker?

How does one map the "Quantamental World" of capital flow, interest and exchange rates?

Modern macroeconomic models are designed to be mathematical formalization of the entire economy. This ambitious approach could be frustrating for many outside the field of econometrics. Many economists prefer verbal intuitions as a way to convey understanding. Verbal intuition can be helpful in understanding bits and pieces of macro models. However, it is almost always misleading about how they fit together. It is exactly the imprecision and incompleteness of verbal intuition that forces macroeconomists to include the entire economy in their models.

We anticipate a trend toward quantamental trading among institutional currency traders. Quantitative macroeconomic models driven by real-world databases shall have an important role to play in every quantamental trader's toolkit. After all, there is a strong need to understand the greater macroeconomic context of exchange rate movements, given the unusual exchange rates volatility of recent months. If anyone has one to recommend, we certainly would love to hear about it!

“An economist is a man who, when he finds something works in practice, wonders if it works in theory.”

— John Williams (2014)

References:

1. Galı´, Jordi and Gertler, Mark (2007). Macroeconomic Modeling for Monetary Policy Evaluation. Journal of Economic Perspectives, Vol. 21, No. 4, pp. 25-45. Retrieved from: http://www.econ.nyu.edu/user/gertlerm/jep.21.4.pdf
2. Smets, Frank and Wouters, Rafael (2007, February). Shocks and Frictions in US Business Cycles: A Bayesian DSGE Approach. European Central Bank, Working Paper Series, No. 722. Retrieved from: https://www.ecb.europa.eu/pub/pdf/scpwps/ecbwp722.pdf
3. Hara, Maoko and Ichiue, Hibiki and Nakamura, Koji and Shirota, Toyoichiro (2009). Practical Use of Macroeconomic Models at Central Banks. Bank of Japan Review, 2009-E-1. Retrieved from: https://www.boj.or.jp/en/research/wps_rev/rev_2009/data/rev09e01.pdf
4. Kocherlakota, Narayana (2010, May). Modern Macroeconomic Models as Tools for Economic Policy. Federal Reserve Bank of Minneapolis, 2009 Annual Report Essay. Retrieved from: https://www.minneapolisfed.org/publications/the-region/modern-macroeconomic-models-as-tools-for-economic-policy
5. Amisano, Gianni and Geweke, John (2013, April). Prediction Using Several Macroeconomic Models. European Central Bank, Working Paper Series, No. 1537. Retrieved from: https://www.ecb.europa.eu/pub/pdf/scpwps/ecbwp1537.pdf
6. Wieland, Volker,  and Cwik, Tobias and Müller, Gernot J. and Schmidt, Sebastian and Wolters, Mark (2012). A New Comparative Approach to Macroeconomic Modeling and Policy Analysis. Journal of Economic Behavior and Organization, August 2012, Vol. 83, 523-541. Retrieved from: http://www.macromodelbase.com/system/files/upload/Wielandetal_120123_0.pdf
7. Whitehouse, Mark (2010, November 30). Economists’ Grail: A Post-Crash Model. Wall Street Journal. Retrieved from: http://www.wsj.com/articles/SB10001424052702303891804575576523458637864
8. Eggertsson, Gauti and Mehrotra, Neil (2014, October). A Model of Secular Stagnation. NBER Working Paper 20574. Retrieved from: http://www.nber.org/papers/w20574.pdf
9. Williams, John C. (2014, January 16). Monetary Policy at the Zero Lower Bound: Putting Theory into Practice. Brookings Institution. Retrieved from: http://www.brookings.edu/~/media/research/files/papers/2014/01/16-monetary-policy-zero-lower-bound/16-monetary-policy-zero-lower-bound-williams.pdf