Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

In the sister blog and on Twitter during September-December 2016

The following posts appeared on the sister blog (on Computing) during September-December 2016.

Tweets during September-December 2016 (other than blog post tweets):

Financial crises prior to the typewriter

The Bank of England’s Bank Underground blog has a “Christmas Special” on financial crises in the UK in 1847, 1857 and 1866. The first commercially successful typewriter was invented only in 1868 and so all the letters from the Chancellor to the Governor of the Bank of England were handwritten. I was familiar with these letters from reading Andreades’ excellent History of the Bank of England, and several other sources, but unlike the Bank Underground blog posts, none of these sources contain any facsimile of the actual letters. What struck me was that these letters were written in rather poor handwriting. The blog posts take the pain of transcribing these letters, and without this, I would not have been able to decipher some of these words. This is all the more surprising since Andreades does state (at least in once case, page 336) that the official letter was sent two days after the Bank of England was unofficially informed about the decision.

Bank Underground also links to a newspaper article written by Karl Marx about the 1857 suspension of the Bank Act. I find it hard to disagree with the following observation of Marx about the report of the Select Committee of Parliament on the operation of the Bank Act:

The Committee, it would appear, had to decide on a very simple alternative. Either the periodical violation of the law by the Government was right, and then the law must be wrong, or the law was right, and then the Government ought to be interdicted from arbitrarily tampering with it. But will it be believed that the Committee has contrived to simultaneously vindicate the perpetuity of the law and the periodical recurrence of its infraction? Laws have usually been designed to circumscribe the discretionary power of Government. Here, on the contrary, the law seems only continued in order to continue to the Executive the discretionary power of overruling it.

More than a century and a half later, nowhere in the world have we been able to solve this dilemma of the excessive discretionary power of the government in times of crisis.

Euro Introduction as Demonetization

Peter Guy at Regulation Asia has an interesting piece describing the introduction of the euro as a process of demonetization:

Europeans practiced excessive cash-based tax avoidance for decades before the euro arrived. When forced to exchange their paper currencies, lira, francs, and pesetas, bundles of cash emerged in suitcases to buy other cash-generating assets like real estate.

The irony of it all is that today the €500 note is the currency note of choice for money launderers because of its large denomination (the 1000 Swiss franc note is more valuable but it is nowhere near as ubiquitous as the euro note). As Guy points out:

The euro was easier to launder with banks around the world than the individual currencies it replaced.

Guy also refers to the dangers of a cashless society, but that argument has been made far more eloquently and persuasively by Scott Garrett. The more I think about these issues, the more I think that cryptocurrencies must be a critical element of a modern monetary system in a democratic society.

A digital device for every Indian

It is my view that if India wants to replace cash with digital payments, it must be prepared to issue a digital device to every Indian and simply absorb the fiscal cost of doing so. The alternative is a tiered payment system with high quality payments for those with smartphones, a second tier solution for those with feature phones and a broken model for those with neither. Such a tiered payment system that makes some Indians second class citizens in their own country is fundamentally irreconcilable with our democratic values and with the constitutional guarantee of legal treatment.

Cash gives the poorest of the poor access to a retail payment system that meets the gold standard for payment systems: real time gross settlement in central bank money. It is unacceptable to give them anything less than this in a digital solution. Settlement in commercial bank money or other inferior forms of money can be a choice, it can never be a compulsion. I might voluntarily choose to adopt a paytm wallet or a bank wallet and take the credit risk that the wallet provider might fail; but I should not be forced to do so as the price for participating in digital payments. This means two things:

  1. The Reserve Bank of India should introduce electronic money on its own in the form of an official e-wallet because only an e-wallet filled with central bank money can replace cash. This would also solve the problem of interoperability between different wallets. A core function of the central bank is to be the “tender of the tender” – the issuer and maintainer of legal tender of the country. A central bank that abdicates this responsibility forfeits its raison d’être.

  2. Every Indian must be issued a digital device that allows first class access to the digital payment system. There is room for bringing the cost of this device down by careful design that pares it down to just its core functionality. I would think that a starting point for this might be something like the Raspberry Pi which is enough of a general purpose computer to run at least a bitcoin SPV client. The Raspberry Pi costs about $35, but a suitably pruned down device manufactured in truly large scale might cost only $20. Giving one such device to every Aadhar holder might cost about 1.5 trillion rupees.

In my view, this cost is affordable for a country at our stage of economic size and development, and is also quite reasonable in comparison to other big ticket fiscal expenditure (for example, large defence contracts, infrastructure projects or subsidy schemes). It is perfectly fine for you to take the opposite view that this cost is unacceptable. What you cannot do is to use that view as the justification for building a great payment system for the elite at the cost of taking away from the poor what they have today – a payment system (cash) that allows them to settle in real time in central bank money.

More on cash alternatives

In two recent blog posts, I argued that the post-demonetisation problems in India are not due so much to an absence of cash, but an environment that is implicitly or explicitly discouraging the emergence of cash alternatives. Free markets can solve these problems if we let them do so.

Here are three examples of cash alternatives from three continents that I came across post demonetisation:

  1. Tokens in Telengana in India (h/t Mostly Economics and Sonali Jain’s comments on my blog post)

  2. Bond notes in Zimbabwe: Though these notes are issued by a government, these count as cash substitutes because these bonds/notes are not issued by the government that issues the underlying currency.

  3. Bitcoin in Venezuela (h/t FT Alphaville): Only a year ago, I was thinking that Bitcoin had failed as a currency while succeeding enormously as a technology (the blockchain), but state failures around the world have been so great that now I think we can no longer rule out Bitcoin emerging as a major global currency.

Cash and credit redux

I have received a lot of push back against my blog post about cash being less important than credit. I would also freely admit that the evidence on the ground during this week does not suggest a smoothly functioning credit economy. But the reason for this unfortunate situation is not that cash is essential for a functioning economy. The true reason for the difficulties that we are seeing now is something more alarming – a partial disruption of credit expansion.

Cash substitutes are not emerging because there is a legitimate fear that the creation of such substitutes could be misconstrued as facilitating money laundering. For example, based on local and global historical experience, I am quite confident that if my Institute were to issue 500 rupee tokens or IOUs, it would circulate freely as money not only among the couple of thousand people on campus but also outside the campus (within a radius of a kilometre or so). A decade or two ago, during a period of shortage of small coins, many shops and institutions did issue coupons to substitute for the coins and these circulated quite freely. Today, however, probably no institution would want to tread that path for lack of clarity on how the government would react to such a move. Employers who have not been able to pay salaries in cash are not issuing IOUs which could ameliorate the cash shortage.

I firmly believe that the government should immediately step in with a public announcement that it would not frown upon the creation of temporary cash substitutes. In times like this, cash substitutes are essential because shortages lead to hoarding and much of the cash being paid out from the banks is not entering circulation, but is being locked away for future contingencies (cash could be even scarcer tomorrow than it is today). Almost everybody that I have talked to is today targeting a cash balance that is at least twice what they were holding two weeks ago. This has been the case historically as well as described very well in, for example, Andrew, A. Piatt. “Hoarding in the Panic of 1907.” The Quarterly Journal of Economics (1908): 290-299 (sorry that is behind a paywall).

As regards the feasibility of cash substitutes, I would once again link to the Irish experience that I linked to in my previous blog post. I would in addition describe the US experience of 1907. My source for this is unfortunately behind a paywall and I can only quote some material from there. The paper that I am referring to was published in the Quarterly Journal of Economics in 1908 shortly after the crisis of 1907 (Andrew, A. Piatt. “Substitutes for Cash in the Panic of 1907.” The Quarterly Journal of Economics 22.4 (1908): 497-516) and was based on extensive primary and secondary data collection. The author states that he wrote letters “addressed to banks in all cities of 25,000 or more inhabitants” and reports having got responses from 145 out of 147 such cities (response rates to mail surveys were much higher in those days than they are now!).

… we may safely place an estimate of the total issue of substitutes for cash above 500 millions. For two months or more these devices furnished the principal means of payment for the greater part of the country, passing almost as freely as greenbacks or bank-notes from hand to hand and from one locality to another. The San Francisco certificates, for instance, circulated, not only in California, but in Nevada and in south-eastern Oregon, some reaching as far east as Philadelphia, some as far west as the Hawaiian Islands. The banks of Pittsburg, on the other hand, reported remittances of certificates and checks, in denominations ranging from $1 up, from as scattered localities as Cleveland, Cincinnati, St. Louis, Chicago, Milwaukee, Duluth, Philadelphia, Danville, Va., and Spokane.

To put that $500 million number in perspective, the total coin and paper currency in circulation in the US was only about $2,800 million and the total gold coins was only $560 million (this data is from the Federal Reserve of St. Louis). In other words, cash substitutes were almost equal to the total gold coins in circulation and almost 20% of the entire gold and paper currency.

Andrew describes many different cash substitutes, but I would quote only one: bearer cheques “payable only through the clearing house,” (this clause meant they could not be redeemed for cash but could only be converted into other cash substitutes).

Last of all among the emergency devices were the pay checks payable to bearer drawn by bank customers upon their banks in currency denominations and used in all parts of the country in payment of wages and in settlement of other commercial obligations. These checks were generally “payable only through the clearing house,” … they were not a liability of the clearing- house association or of the bank on which they were drawn, but of the firm or corporation for whose benefit they were issued.

The pay-check system reached its largest development in Pittsburg, where during the panic some $47,000,000 were issued, much of which was in denominations of $1 and $2.

Pay checks were also issued by railroads, mining companies, manufacturers, and store-keepers in a large number of other cities. Shops and stores and places of amusement in the neighborhood of their issue generally accepted them, and it is, indeed, surprising, considering their variety, their liability to counterfeit, and their general lack of security, how little real difficulty was experienced in getting them to circulate in lieu of cash

The last paragraph in the paper about cash substitutes in general is worth quoting in full:

Most of this currency was illegal, but no one thought of prosecuting or interfering with its issuers. Much of it was subject to a 10 per cent. tax, but no one thought of collecting the tax. As practically all of it bore the words “payable only through the clearing house,” its holders could not demand payment for it in cash. In plain language it was an inconvertible paper money issued without the sanction of law, an anachronism in our time, yet necessitated by conditions for which our banking laws did not provide. During the period of apprehension, when banks were being run upon and legal money had disappeared in hoards, in default of any legal means of relief, it worked effectively and doubtless prevented multitudes of bankruptcies which otherwise would have occurred.

Markets will find solutions to most problems if the government steps out of the way. In 1907, governments in the US were willing to do precisely that. Andrew quotes several official announcements during the panic of 1907 that allowed the creation of cash substitutes. For example, the following was a letter from the Government of Indiana of October 28, 1907:

To THE INDIANA BANKS AND TRUST COMPANIES:

Gentlemen,-Your bank being solvent, should it adopt the same rule that has been adopted by the banks of Indianapolis and refuse to pay to any depositor or holder of a check only a limited amount of money in cash and settle the balance due by issuing certified checks, or drafts on correspondents, such act, in this emergency, will not be considered an act of insolvency by this department.

The same rule will apply to trust companies.

P.S.-The question of your solvency is to be determined by yourselves upon an examination of your present condition.

The question today is whether the Indian government is willing to be bold and imaginative, and allow the market to find solutions to the current problems that are beyond the power of governments to solve.

Why not a helicopter drop of new rupee notes?

A helicopter drop of new currency notes might be the perfect solution to the logistic problems arising out of last week’s demonetization of most of the Indian currency. The pressing logistical problems are about getting the new notes to the remote and under banked rural areas of the country. There is also a concern about solving the problems of the poor who were more reliant on currency than the rich, and have less access to credit which can substitute for cash. The simplest solution is to simply drop currency notes from the sky across the length and breadth of the country so that every Indian receives some money to carry on their daily activities without worry.

There is a strong fiscal justification for this free gift of money to every Indian. The whole purpose of the demonetization exercise is to destroy the stock of unaccounted holdings of currency in India. If we assume that 40% of the 14 trillion rupees of the old notes represent untaxed income and will not therefore be exchanged for new notes, there is a gain of over 5 trillion rupees which amounts to about 4,000 rupees for every man, woman and child in India. A helicopter drop of this magnitude would simply be a way distributing this windfall gain equally to the people of India in a kind of negative poll tax. The alternative to this equal distribution would be a reduction in the income tax rate or the GST rate which would distribute the benefits more to the rich than to the poor. In fact, the costs of demonetization are falling equally on the rich and the poor. The poor man stands in the queue for the same few hours to get his 1,000 rupees as the rich man does to get his 24,000. There is therefore every reason to spread the benefits also equally among all.

In addition, there are huge logistic benefits from a helicopter drop. It gets money directly in the hands of those who need it most without wasting their time. Farmers can spend their time harvesting the crop instead of standing in queues in a far away branch. Urban poor do not have to forsake their daily wages to go to the bank. This also ensures minimal disruption to economic activities. In fact, demonetization could become so popular among the common people that we would be able to demonetize our currency every 5-10 years instead of doing it only once in 30-40 years.

Helicopter drops of money are a well established tool in economic theory. The Nobel laureate, Milton Friedman was perhaps the first person to discuss the idea his 1969 paper on The Optimal Quantity of Money. The greatest living exponent of helicopter drops is former Fed Chairman, Ben Bernanke who endorsed the idea in his 2002 speech on deflation and has apparently been advising Japanese Prime Minister Shinzo Abe to try it. It is quite likely that apart from solving the logistics problems of demonetization, the helicopter money drop would also stimulate the economy at a time when it is facing several headwinds. It would certainly do more to increase rural spending than rate cuts by the central bank which seem to get lost in monetary transmission.

Economists are more willing to contemplate bold ideas, while politicians and bureaucrats tend to be cowardly in their approach. In India, today, we have the perfect constellation of factors that make a helicopter drop economically sensible and politically feasible. If a bill were to be moved in parliament to provide statutory basis for a helicopter drop, I am confident that almost all MPs who want to be reelected in 2019 will support the bill and it would be passed by an overwhelming majority.

In my dreams, the Indian government invites Ben Bernanke to advise it on the helicopter drop and also lets him ride the chopper on its first flight and drop the first wad of new notes with his own hands. It also invites Japanese prime minister Shinzo Abe to witness the inauguration of this programme. Today, Japanese tourists come to India to visit the holy sites of Buddhism. Perhaps, future generations of Japanese will come to India to visit the parliament which pioneered the first helicopter drop that was emulated in Japan and eventually lifted that country out of deflation. It is all a dream, but it could well become reality if the Indian government is willing to be bold and imaginative.

It is not money but credit that makes the world go round

After the Indian government withdrew most of the Indian currency notes from circulation last night, there has been a fear that this would be so disruptive that the economy would just go off the cliff. I think this fear is totally misplaced. Contrary to what some economists might tell us, money does not make the world go round. We finance people know that the world actually runs on credit. Economists tend to think that credit is what you use when you run out of money. Nothing could be further from the truth. In reality, money is what you use when your credit has run out. I work for my employer on credit, my newspaper vendor sells me newspaper on credit, companies buy raw material on credit and sell their products on credit. If you find somebody having difficulty doing any of these transactions on credit, you can be sure that that somebody is a whisker away from bankruptcy.

Yes, today you will not be able to go to your neighbourhood grocery store and buy anything with the 500 rupee note in your wallet. But if you cannot buy whatever you like on credit from the same neighbourhood grocery store, then you have a very serious problem on your hand; a problem that will not go away when the banks reopen tomorrow. If you really find yourself in that position, you should be very worried and you should drop everything that you are doing, and work slowly and painstakingly on rebuilding your credit. For in a capitalist society, if you have lost your credit, you have lost everything.

So, yes, the Indian economy will be fine even though it is denuded of most of its currency for the next few days. Apart from the few people who are travelling (other than your credit card, you have no credit amidst strangers), it will not even be too inconvenient for the vast majority of people. I have no first hand knowledge of the black economy and would be reluctant to comment on that, but I suspect that this too runs more on credit than on cash. It might be premature to conclude that the economy would suffer from a fall in demand due to disruption of the black economy.

If you want historical evidence on how the world copes with disruptions to money supply, I would recommend an excellent article early this year by the Bank of England on how Ireland coped with a six month long bank strike in the 1970s. Or you could look at the experience from 19th century US in the wake of frequent bank failures and how cities and towns rebuilt their economy on alternative credit networks. Or you could read Niklas Blanchard on complementary currencies.

How to make the banks paranoid about security?

All online businesses are highly vulnerable to hacking, but the business response to this threat ranges from paranoia to complacency. Banks are among those that are most complacent, and there is a lot that regulators can and should do to change that.

Let me start with an example of a paranoid online business – online pornography. A few days ago a distributed denial of service attack on a large DNS server took down several major websites including Twitter, Spotify, Reddit, Etsy, Wired, and PayPal. While these giants tottered, adult entertainment sites like pornhub.com withstood the attack. The secret was DNS redundancy; to bring pornhub.com down, you would have to take down several DNS servers, not just one. Or consider another example: Wikileaks whose total security budget might be a rounding error for many large banks. Wikileaks has angered some of the most powerful nation states in the world, but the only disruption that Wikileaks has suffered is Ecuador cutting off the internet lines to its founder Julian Assange who is holed up in the Ecuadorian embassy for several years now. Wikileaks claims to have activated contingency plans and its twitter feed has continued to be very active.

Compared to these organizations that run their websites as a serious activity, banks come across as utterly complacent and casual about computer security. Let me give a few examples:

  1. My internet banking passwords are among my weaker passwords not because I am careless, but because most banks do not allow me to use high quality passwords. To combat Moore’s law, I have been increasing my default password length every year or so, and now this default length exceeds the maximum allowed by most banking sites in India. Most banks also disallow various special characters that my random password generator produces by default.

  2. A few days ago it was reported that over three million Indian debit cards had been compromised but the breach was not detected for several weeks. Many banks have tried to turn this into a business opportunity by discouraging their customers from using ATMs of other banks. If some banks are running vulnerable ATMs, they must be publicly identified and their ATMs must be shut down promptly and ruthlessly. A general discouragement of other bank ATMs only helps each bank to save on interconnect charges.

  3. Anecdotal evidence suggests that banks are extremely reluctant to disclose or correct vulnerabilities detected by their own security audits due to fear that it might hurt their business. They find it cheaper to compensate the few customers who do complain loudly enough. Most customers are neither knowledgeable enough to complain, or vociferous enough to succeed.

In banking regulation, there has been a progressive shift towards considering systemic (also called macro-prudential) risks rather than the idiosyncratic risk of failure of a single bank. This lesson has to be applied to cyber risks as well. A breach in any bank opens up a threat surface for the entire interconnected financial system. The regulatory response to the breach must not be based on the loss to the bank in question; it must consider the risks posed to the entire system.

This means that failure to disclose breaches must be punished a lot more severely than the actual breach itself. Undisclosed breaches pose huge systemic risks because of the difficulty of defending against the unknown enemy. For India, I would think that an appropriate calibration of the penalty would require that the fine for unreasonable delay in disclosing a breach affecting a million customers should amount to approximately one year’s cyclically adjusted profits of the entire banking system.

A couple of such large fines would shake the banks out of their complacency and induce a healthy dose of paranoia in the banks. It would also shift the cost benefit analysis towards investing more in security. Perhaps they will hire some personnel from organizations like pornhub.com who are demonstrably better at running an online business. As Andy Gove wrote in Only the Paranoid Survive:

You need to plan the way a fire department plans: It cannot anticipate where the next fire will be, so it has to shape an energetic and efficient team that is capable of responding to the unanticipated as well as to any ordinary event.

Could China fork Bitcoin?

Ever since Ethereum forked into two competing cryptocurrencies , I have been thinking about China orchestrating a fork of the leading cryptocurrency Bitcoin. Izabella’s post at FT Alphaville on Bitcoin as a Chinese capital outflow proxy has finally pushed me to write up my wild speculation on this possibility. I do not have as much practice as Lewis Carroll’s Red Queen who claimed to have “believed as many as six impossible things before breakfast.”, but I am willing to indulge myself with some wild speculation once a quarter. (And, it is more than three months since I posted my wild speculation on the 1000 Swiss franc note.)

The starting point of all my speculation is that China is experiencing significant capital flight and Bitcoin is a sufficiently important medium of this flight for the Bitcoin price to serve as a proxy for this capital flight as explained in Izabella’s post. The Chinese financial system is also experiencing severe stress and if this stress goes beyond the tipping point towards a rapid erosion of confidence in the renminbi, it is not inconceivable that Bitcoin becomes a significant parallel currency in China. Instead of getting dollarized, China could get Bitcoinized.

In such a scenario, the Chinese government would of course want to gain control over Bitcoin. There are three factors that make it possible for the Chinese government to succeed:

  1. Chinese miners control a large part of the hashing power of the Bitcoin network. A Chinese fork of Bitcoin will have no shortage of mining capacity.

  2. The Great Firewall of China would allow China to isolate Chinese Bitcoin from Classic Bitcoin, making it impossible for Chinese nodes to connect to any nodes outside China.

  3. The government could prod the Chinese internet trinity (Alibaba, Baidu and Tencent) to accept Chinese Bitcoin, thereby making it the de facto currency of China.

The translucence of the Bitcoin blockchain would allow the Chinese government to monitor Bitcoin transactions to a far greater extent than it can monitor cash transactions. It could thus become another instrumentality of government control. A process that starts out as a form of rebellion against the government could thus end up strengthening its grip on the society.

What would this do to Bitcoin itself? Chinese Bitcoin could probably reach a market capitalization of several hundred billion dollars (may be even a trillion dollars) very quickly. Through a rub on effect, Classic Bitcoin itself could reach a hundred billion dollars of valuation compared to its current value of ten billion dollars. But that would also provide the motive for powerful nation states to attack Bitcoin. The US would be tempted to use its entire cyber war capabilities to disrupt Chinese Bitcoin, and China would probably throw everything it has to try and destroy Classic Bitcoin. Given Bitcoin’s vulnerability to the 51% attack, it is quite likely that neither of the two Bitcoins would survive such a concerted attack. But if one or both do survive, cryptocurrencies would probably go mainstream very quickly.