Monday, August 3, 2015

Freshwater macro, China's silver standard, and the yuan peg

1934 Chinese silver dollar with Sun Yat-sen on the obverse side. The ship may be in freshwater.

I have been hitting my head against the wall these last few weeks trying to understand Chinese monetary policy, a project that I've probably made harder than necessary by starting in the distant past, specifically with the nation's experience during the Great Depression. Taking a reading break, I was surprised to see that Paul Krugman's recent post on the topic of freshwater macro had surprising parallels to my own admittedly esoteric readings on Chinese monetary history.

Unlike most nations, China was on a silver standard during the Great Depression. The consensus view, at least up until it was challenged by the freshwater economists that people Krugman's post, had always been that the silver standard protected China from the first stage of the Great Depression, only to betray the nation by imposing on it a terrible internal devaluation as silver prices rose. This would eventually lead China to forsake the silver standard. This consensus view has been championed by the likes of Milton Friedman and Anna Schwartz in their monumental Monetary History of the United States.

This consensus view is a decidedly non-freshwater take on things as it it depends on features like sticky prices and money illusion to generate its conclusions. After all, given the huge rise in the value of silver, as long as Chinese prices and wages—the reciprocal of the silver price—could adjust smoothly downwards, then the internal devaluation forced on China would be relatively painless. If money is non-neutral, however, then that adjustment is impeded by price rigidities. With prices locked at artificially high levels, inventories go unsold, unemployment rises, and we get a recession.

Just to add some more colour, China's internal devaluation was imposed on it by American President Franklin D. Roosevelt in two fell swoops, first by de-linking the U.S. from gold in 1933 and then by buying up mass quantities of silver starting in 1934. The first step ignited an economic rebound in the U.S. and around the world that helped push up all prices including that of silver. As for the second, Roosevelt was fulfilling a campaign promise to those who supported him in the western states where a strong silver lobby resided thanks to the abundance of silver mines. The price of silver, which had fallen from 60 cents in 1928 to below 30 cents in 1932, quickly rose back above its 1928 levels, as illustrated in the chart below. According to one contemporary account, that of Arthur N. Young, an American financial adviser to the Nationalist government, "China passed from moderate prosperity to deep depression."

As I mentioned at the outset, this consensus view was challenged by the freshwater economists, no less than the freshest of them all, Thomas Sargent (who was once referred to as "distilled water"), in a 1988 paper coauthored with Loren Brandt (RePEc link). New data showed that Chinese GDP rose in 1933 and only declined modestly in 1934, this due to a harvest failure, not a monetary disturbance. So much for a brutal internal devaluation.

According to Sargent and Brandt, it appeared that "that there was little or no Phillips curve tradeoff between inflation and output growth in China." In non econo-speak, deflation.not.bad. They put forth several reasons for this, including a short duration of nominal contracts and village level mechanisms for "haggling and adjusting loan payments in the event of a crop failure." In essence, Chinese prices were very quick to adjust to silver's incredible rise.

Four years later, Friedman responded (without Schwartz) to what he referred to as the freshwater economists' "highly imaginative and theoretically attractive interpretation." (Here's the RePEc link). His point was that foreign trade data, which apparently has a firmer statistical basis than the output data on which Sargent and Brandt depended, revealed that imports had fallen on a real basis from 1931 to 1935, and particularly sharply from 1933 to 1935. So we are back to a story in which, it would seem, the rise in silver did place a significant drag on the Chinese economy, although Friedman grudgingly allowed for the fact that perhaps he may have "overestimated" the real effects of the silver deflation.

So this battle of economic titans leads to a watered-down story in which Roosevelt's silver purchases probably had *some* deleterious effects on China. China would go on to leave the silver standard, although what probably provided the final nudge was a bank run that kicked off in the financial centre of Shanghai in 1934. Depositors steadily withdrew the white metal from their accounts in anticipation of some combination of a devaluation of the currency, exchange controls, and an all-out exit from the silver standard, a process outlined in a 1988 paper by Kevin Chang (and referenced by Friedman). This self-fulfilling mechanism, very similar in nature to the recent run on Greece, may have encouraged the authorities to sever the currency's linkage to silver and put it on a managed fiat standard. The Chinese economy went on to perform very well in 1935 and 1936, although that all ended with the Japanese invasion in 1937.


As I mentioned at the outset, these events and the way they were perceived by freshwater and non-freshwater economists seem to me to have some relevance to modern Chinese monetary policy. As in 1934, China is to some extent importing made-in-US monetary policy. The yuan is effectively pegged to the U.S. dollar, so any change in the purchasing power of the dollar leads to a concurrent change in the purchasing power of the yuan.

There's an asterisk to this. In 1934, China was a relatively open economy whereas today China makes use of capital controls. By immobilizing wealth, these controls make cross-border arbitrage more difficult, thus providing Chinese monetary authorities with a certain degree of latitude in establishing a made-in-China monetary policy.  But capital controls have become increasingly porous over the years, especially as the effort to internationalize the yuan—which requires more open capital markets—gains momentum. By maintaining the peg and becoming more open, China's monetary policy is getting ever more like it was in 1934.

As best I can tell, the monetary policy that Fed Chair Janet Yellen is exporting to China is getting tighter. One measure of this, albeit an imperfect one, is the incredible rise of the U.S. dollar over the last year. Given its peg, the yuan has gone along for the ride. Another indication of tightness in the U.S. is Scott Sumner's nominal GDP betting market which shows nominal growth expectations for 2015 falling from around 5% to 3.2%. That's quite a decline. On a longer time scale, consider that the Fed has been consistently missing its core PCE price target of 2% since 2009, or that the employment cost index just printed its lowest monthly increase on record.

If Chinese prices are as flexible as Brandt and Sargent claimed they were in 1934, then the tightening of U.S. dollar, like the rise in silver, is no cause for concern for China. But if Chinese prices are to some extent rigid, then we've got a Friedman & Schwartz explanation whereby the importation of Yellen's tight monetary policy could have very real repercussions for the Chinese economy, and for the rest of the world given China's size.

Interestingly, since 2014 Chinese monetary authorities have been widening the band in which the yuan is allowed to trade against the U.S. dollar. And the peg, which authorities had been gently pushing higher since 2005, has been brought to a standstill. The last time the Chinese allowed the peg to stop crawling higher was in 2008 during the credit crisis, a halt that Scott Sumner once went so far as to say saved the world from a depression.

Chinese GDP [edit: GDP growth] continues to fall to multi-decade lows while the monetary authorities consistently undershoot their stated inflation objectives. In pausing the yuan's appreciation, the Chinese authorities could very well be executing something like a Friedman & Schwartz-style exit from the silver standard in order to save their economy from tight U.S. monetary policy. This time it isn't an insane silver buying program that is at fault, but the Fed's odd reticence to reduce rates to anything below 0.25%. Further tightening from Yellen may only provoke more offsetting from the Chinese... unless, of course, the sort of thinking underlying Wallace and Brandt takes hold and Chinese authorities decide to allow domestic prices to take the full brunt of adjustment.

Friday, July 24, 2015

Know thyself... or carry a wallet

Of all the axioms of utility theory, the completeness axiom is perhaps the most questionable.  
- Robert Aumann, Nobel Prize Winner

One of the reasons you keep a well-stocked wallet in your pocket is because you don't know very much about yourself. Know thyself, as the Greeks say, and you can skimp on the amount of media-of-exchange you keep on hand.

Greater self-awareness leads to a cleaner "mapping out" of an individual's tastes and the preferred timetable for the enjoyment of those tastes. For instance, a moment of self reflection might lead you to conclude that pistachio ice cream at 8:31 PM next Friday is the best possible state of the world. If a complete set of futures markets exists, you can purchase a futures contract that is time stamped to deliver pistachio ice cream at 8:31 PM Friday, guaranteeing ahead of time that your tastes will be satisfied.

The problem is that introspection is difficult. We simply don't have the time, knowledge, or energy to sketch out a full timetable of carefully-delineated tastes and preferences. Even if we are blessed with a full range of futures markets, missing preferences prevent us from making use of these contracts.

Instead of committing ahead of time to satisfying taste A rather than tastes B, C or D at 8:31 PM Friday, an individual may prefer to remain non-committal. They can act on this preference by buying a broad range of option contracts that allow them to satisfy tastes A through D over a fuzzier time period, say Friday evening-ish. At the last minute they'll exercise just one of these many options while allowing the others to expire worthless. This sort of last minute off-the-cuff gauging of preferences allows for direct appeal to the mind's current state. This is surely a far more accurate way to get what one wants than trying to imagine what tastes will be like a week from now and locking that decision in by buying the relevant futures contract.

The problem is that the real world is bedeviled by not only missing preferences but also missing markets. Options on future consumption don't exist. Try buying a range of options exercisable between 6 and 10 PM Friday on twenty different flavours of ice cream.

There's an alternative. People can mimic an option buying strategy by allocating a portion of their portfolio to 'monetary assets,' those assets which are more liquid, stable, and cheaper to store than regular assets. The ability of a monetary asset to act as a good store of value up until the final act of acquiring a consumption good means that its owner needn't worry about lacking sufficient purchasing power to satisfy any of tastes A to D. And the liquidity of these monetary assets means that they needn't worry about being unable to swap for whatever consumption good they feel will satisfy their needs. So by holding a monetary asset, an individual has effectively bought themselves an option to satisfy a whole range of tastes at any point on Friday night. This is hassle-free flexibility.

Options aren't free. In financial markets, for instance, traders must pay a premium to secure an option. Likewise for liquidity. By holding monetary assets, individuals gain more flexibility surrounding the satisfaction of their tastes but give up potential returns. After all, a chequing deposit is more liquid than a term deposit, but a term deposit—which serves no monetary purposes—offers a superior capital gain.

So on the margin, people always measure the cost of becoming a bit more self aware against the drawbacks of holding monetary assets. If there is some low-hanging introspective fruit to be harvested, it may be worthwhile to spend a few minutes in reflection if this allows for a subsequent shift in wealth from liquid low-return assets (like chequing deposits) into illiquid high-return assets (like term deposits). On the other hand, if it is desirable to remain fluid and non-committal about tastes and the timetable for achieving them, cash and liquid securities are a means to buy this flexibility.


Here's the punchline.

Economists often (though not always) specify that individuals have a complete set of preferences. This means that the cast of characters that populate economic models come outfitted with fully specified sets of tastes and timetables for their enjoyment. There is no room for self-doubt, waffling, or vacillation. Nor do the people in these models need to spend any time or energy on introspection. Self-knowledge is free.

This no doubt makes economic models mathematically tractable. In the world outside of these models, however, our desire to hold liquidity is motivated by the fact that we are not fully self aware. Our tastes and timetables for realizing them are frequently left empty, usually because introspection is costly, inaccurate, and slow. Liquid media of exchange are an ideal way to stay flexible and uninformed about future tastes. By choosing to assume perfect self-knowledge, economists rule out at the outset some very important reasons people have for holding liquid media of exchange. With the 2008 credit crisis having illustrated the importance of liquidity factors, this seems like an unfortunate assumption to make.

Friday, July 17, 2015


The whippersnappers who work in the cryptocurrency domain are moving incredibly fast.

As I've been saying for a while, assets like bitcoin (or stocks) are unlikely to become popular as exchange media; they're just too damn volatile relative to incumbent fiat currencies. There's a new game in town though: stablecoin. These tokens are similar to bitcoin, but instead of bobbing wildly they have a fixed exchange rate to some other asset, say the U.S. dollar or gold.

Now this is a promising idea. If a crypto-asset can perfectly mimic a U.S. dollar deposit's purchasing power and risk profile, and do so at less cost than a bank, then the monopoly that banks currently maintain in the realm of electronic payments is in trouble. Rather than owning a Bank of America deposit, consumers may prefer to hold an equivalent stablecoin that performs all the same functions while saving on storage and transaction fees. To compete, banks will either have to bribe customers with higher interest rates on deposits, thus putting a crimp in their earnings, or go extinct.

Let's look at these stablecoin options more closely.

Type A: One foot in the legacy banking sector, one foot out

The unifying principle behind each type of stablecoin is the presence of some sort of backing, or security. Bitcoin, by way of comparison, is not backed. Stablecoin backing is typically achieved in two ways. With type A stablecoin, an organization creates a distributed ledger of tokens while maintaining a 1:1 reserve of dollars at a traditional bank. Owners of the tokens can cash out whenever they want into bank dollars at the stipulated rate, thus ensuring that the peg to the dollar holds. Until then, the tokens can be used as a stable medium of exchange. Examples of this are Tether and Ripple U.S dollar IOUs.

Could stablecoin be a bank killer?

We can think of a bank as enjoying stock and flow benefits from its deposit base. The existence of a stock of deposits provides it with a cost of funding advantage while the flow of those deposits from person to person generates fees.

Type A stablecoin pose no threat to the stock benefits that banks enjoy. After all, each stablecoin is always backed by an equivalent bank deposit held in reserve. If people want more stablecoin, the deposit base will have to grow, and that makes traditional bankers happy.

The flow benefits, however, are where the fireworks start. At the outset, people who receive stablecoin--through lack of familiarity--will probably choose to quickly cash out into good old fashioned deposits. But if stablecoin provides an extra range of services relative to deposits, rather than "kicking" back into the bank deposit layer, more people may choose to keep their liquid capital in the overlying stablecoin layer. Merchants will have more incentives to accept stablecoin, only adding to the snowball effect. Once all transactions are routed through the stablecoin layer, underlying deposits will have become entirely inert. While banks will continue to harvest the same stock benefits that they did before, they'll have effectively yielded up all the flow benefits to the upstarts.

So while Type A stablecoin doesn't kill banks, it certainly knocks them down a few wrungs.

By constructing a new layer on top of the deposit layer, stablecoin pioneers would be cribbing off the same playbook that bankers have been using since the profession emerged. Centuries ago, the first bank deposit layer was built on top of an original base money layer. Base money consisted then of gold and silver coin, but in more recent times it morphed into central bank banknotes and deposits. Because bank deposits inherited the price stability of base money (thanks to the promise to redeem in base money), and were highly convenient, bankers succeeded in driving transactions out of the base coinage layer and into the deposit layer. That's why gold and silver rarely appeared in circulation in the 19th century, being confined mostly to vaults. Perhaps one day stablecoin innovators will succeed in confining bank deposits to the "vault" in favour of mass stablecoin circulation. If this sort of displacement hadn't already been done before, I'd be more skeptical.*

Type B: Both feet out of the banking sector

More ambitious are type B stablecoin, which try to liberate themselves entirely from the traditional banking layer. Rather than using old-fashioned bank deposits as backing, a pre-existing issue of distributed digital tokens is used to secure the stablecoin's value.

As an example, take bitShares, a brand of bitcoin-like unbacked tokens. These tokens are every bit as volatile as bitcoin, up 10% one day and down 10% the next. Here's a chart. So far nothing new here, there are literally hundreds of bitcoin look-alikes.

The unique idea is to turn volatile water into stable wine by requiring that a varying amount of bitShares be used to back a second type of token, bitUSD. A bitUSD is a digital token that promises to provide its owner with a U.S. dollar-equivalent return. As long as each bitUSD is secured by, say, $3 worth of bitShares, the owner of one bitUSD will be able to cash out (into one U.S. dollar worth of bitShares) whenever they want and the peg to the U.S. dollar will hold.**

My understanding is that bitUSD, which debuted last year, is coming close to consistently hitting its peg. If bitUSD were to catch on as an alternative transactions layers, banks would lose not only their flow benefits but also stock benefits. After all, a bitUSD-branded stablecoin is not linked to an underlying deposit. We're talking complete devastation of the banking industry.

The system has some warts, however. If the market price of bitShares starts to fall, the scheme requires that more collateral in the form of bitShares be stumped up by the issuer of a bitUSD. This makes sense, it protects the peg. But what if the value of bitShares falls so much that the total market capitalization of bitShares is insufficient to back the total issue of bitUSD? At that point, bitUSD "breaks the buck." A bitUSD will be only worth something like 60 cents, or 30 cents, or 0 cents. Breaking the buck is what a U.S. money market mutual fund is said to do when it can't guarantee its one-to-one peg with the U.S. dollar.   

I'm skeptical of type B stablecoin for this very reason. Cryptocoin like bitcoin and bitShares are plagued by the zero problem; a price of nothing is just as good as a price of $100. They thus make awful backing assets, and any stablecoin that uses them as security has effectively yoked itself to the mast of the Titanic. A breaking of the buck isn't just probable, it is inevitable. Stability is an illusion. Maybe I'd get a bit more bullish on type B stablecoin if there emerged a brand that used digital backing assets not subject to the zero problem.

Anyways, keep your eye on these developments. Like I say, the young whippersnappers who are working on these projects aren't slowing down.

*In principle, type A stablecoin ideas are very similar to m-Pesa and Paypal. Both of these services construct new banking layers, but keep one leg back in the the existing banking infrastructure by ensuring that each Paypal or m-Pesa deposit is fully backed by deposits held at an underlying brick & mortar bank. See Izabella Kaminska, for instance, on m-Pesa.
 ** For those who like central bank analogies, this is an example of indirect convertibility, whereby a central bank sets market price of its liabilities in terms of, say, a bundle of goods, but only offers redemption in varying amounts of gold. See Woolsey and Yeager.  
*** Another working examples of Type B stablecoin is NuBits. Conceptual versions include Robert Sam's Seignorage Shares, the eDollar, and Vitalik Buterin's Schellingcoin.

Friday, July 10, 2015

There won't be a drachma-induced recovery

I catch both Lars Christensen and Brad DeLong making the claim that an introduction of the drachma will work wonders for Greece. Lars, for instance, says that:
However, Grexit will also remove the monetary straitjacket, which has had caused an enormous amount of economic hardship in Greece since 2008. The removal of this straitjacket will cause a significant easing of Greek monetary conditions, which in my view very likely will cause a sharp rise in nominal GDP in Greece in the coming years.
I hate to rain on the party, but even if a drachma is introduced and it collapses in value there won't necessarily be a drachma-induced recovery. Greece is currently in a straitjacket because its monetary standard -- the system for measuring and conveying economic value -- is a euro standard. Think of the euro as being akin to the metric system, a standard for measuring weights and distances, or dots per inch, a standard for measuring print resolution. An introduction of drachmas banknotes into circulation is simply not a sufficient condition to create the sort of effects that Brad and Lars want. To get their recovery, Brad and Lars need an all out monetary standard switch. But as long a Greek prices continue to be expressed in euros, drachmas will simply swim within the existing euro standard fish bowl. All sorts of mountains must be crossed before the penultimate switch of standards. This isn't "snap of the fingers" territory.

Drachma as another bitcoin

To better understand the destiny of a new drachma, its nice to have an example. Lucky for us, we can find one in the recent emergence of one of the world's newest currencies, bitcoin. Now Lars assumes that a collapse in the drachma will have all sorts of beneficial effects on the Greek economy. But does the world economy roar when bitcoin plunges? No, and here's why.

While merchants accept bitcoin as payment, they haven't accepted it as a standard. Sticker prices continue to be set in units like dollars, yen, pounds, etc., Bitcoin swims within the existing fiat standard. To accommodate those who want to pay in bitcoin, merchants will typically use the last-second bitcoin-to-dollar exchange rate (taken from foreign exchange markets) as the basis for the bitcoin price of their goods. Which means that as bitcoin plunges in value, the amount of bitcoin that retailers ask for their stuff is immediately adjusted upwards by a concomitant amount.

This is important because implicit in Brad and Lars's drachma recovery story is a certain degree of price stickiness. As the fundamental value of the standard unit plunges, sticker prices are slow to adjust upwards. Knowing that sticker prices will at some point start to catch up, people spend their currency now before it loses value, thus stoking an economic boom as merchants' inventories are drawn down. This sticky price effect is entirely lacking in bitcoin. Given a sickening collapse in bitcoin, those who own the stuff have no reason to spend it on before it loses value. After all, the amount of bitcoin that retailers require is adjusted every second, so prices in terms of bitcoin don't stay sticky. A bitcoin collapse therefore has no real effects on the world economy.

Applying this lesson to Greece, there's no guarantee that a decline in the drachma will boost the Greek economy. The appearance in circulation of drachma banknotes needn't mean that sticker prices will be set in drachmas. To determine how many drachmas Greeks must pay for an item, retailers may simply refer to its euro sticker prices and convert that amount into drachma by glancing at the last-second drachma-to-euro exchange rate. If so, then just as bitcoin prices are not sticky, neither will drachma prices. Without the requisite stickiness, a collapse in drachmas will not have the real effects that Lars and Brad want. Only a collapse in the euro, the monetary standard, will harness the sticky price effect the two implicitly invoke. But that effectively means Greece remains in its monetary straitjacket, despite having debuted a drachma.

Hurdles to switching

I've talked about the network externalities involved in switching standards before. Take an incumbent standard and a new standard. Even if the quality gap between the novel standard and the inferior incumbent is quite high, the costs of coordinating everyone onto the new standard may be too onerous for adoption to occur. Hysteresis, or lock in, is the result.

Switching to a drachma standard requires that a strong third party step in to overcome these network externalities. They need to punish, or credibly threaten to punish, those who refuse to comply. The Greek government, which has already demonstrated an inability to execute on basic tasks like tax collection, could very well lack the resources that are necessary to adequately perform the tasks of a third party.

Further militating against a drachma standard is its massive quality gap. A monetary standard should be as nuisance-free as possible. Merchants do not want to be adjusting their prices every day, and customers want to know that the blender they saw on a store's shelves on Tuesday will be worth the same amount when they go back on Wednesday. If sticker prices must be adjusted hourly, or even by the minute, the amount of time and mental space that people must allocate to calculation and measurement will displace other more meaningful activities. Like bitcoin, the drachma would probably be a one of the world's most volatile currencies; the incumbent euro one of its steadiest. So rather than improving on the euro standard, a drachma standard would represent a regression in quality.

Given that a strong government must spend a significant amount of resources getting its population to adopt a better standard, it's hard to imagine that a weak government will ever be able to foist an inferior standard on its population without facing a backlash. So contrary to Lars and Brad, there is no guarantee that issuing drachmas offers an ultimate salvation. In the end, there's probably very little difference between a Greece that introduces a drachma or one that doesn't, since either way the incumbent euro standard will likely stick around.

Note: This is very similar to my previous post on the topic. I've introduced the bitcoin analogy, which I think helps drive home the point, and also brought the quality gap to the forefront. 

Nick Rowe comments here.

Tuesday, July 7, 2015

A Visa/MasterCard theory of recessions

Statistical agencies employ data collectors who walk up and down aisles with hand-held computers gathering sticker prices for things like frozen french fries and bicycles. The data they collect gets amalgamated into an index and passed on to central bankers who use it as the basis for rate change decisions. It seems simple enough, but what happens if the source material has been corrupted? Might central bankers be reacting to mere shadows on the wall?

Here's how prices might go bad. Start with the U.S. and Canadian payments systems. For each credit card payment, a North American merchant must pay 1-2% in fees to the card networks Visa and MasterCard. Retailers in both countries have very different strategies for coping with this burden. In the U.S., retailers are permitted to offload network fees onto customers by asking them to pay a surcharge on each credit card payment. Because Canadian retailers are prohibited from surcharging customers, they react by marking up every sticker price in their store by a percent or two, the extra margin they collect sufficient to cover the card network fees. (Canadian retailers almost never offer cash discounts.) For a more complete explanation, see here.

This arcane difference in payments habits has the potential to result in a divergent evolution of prices, vastly different monetary policies, and an uncoupling of North American economic growth.

Consider what happens when the Visa and MasterCard networks decide to offer North American customers a universal 5% cash back reward. The networks fund this bonus by requiring merchants to submit a 5% fee on each card transaction. U.S. retailers cope with this levy by boosting the surcharge they apply on each card transaction to 5% or so, forcing the card-paying customer to bear the cost. Those Americans who pay with cash i.e. banknotes continue to get the sticker price, which stays constant. Without the ability to surcharge, Canadian retailers cope by boosting sticker prices by 5%, thereby indirectly passing the costs of the cash-back bonus onto the customer.

Marching up and down the aisles, U.S price collectorsdon't notice a thing. As a result, the U.S. consumer price index stays the same and the Fed doesn't lift a thumb. Canadian price collectors, however, find that prices have risen. Upon reception of this data, the Bank of Canada anxiously raises rates. This is because Bank officials believe that the rapidly rising price level indicates that the economy-wide rate of return (the natural rate of interest) has risen above the Bank's market rate, breeding inflation. A rate hike is necessary to bring the two rates back in lane, thus choking off the incipient inflation that seems to be developing. The natural rate hasn't budged, of course. All that has changed is the card networks' fee policy. Instead of bringing the market rate of interest in line with the natural rate, the Bank of Canada has been fooled into moving the market rate of interest above the natural rate.

If the card networks again increase the cash back reward, say to 10%, Canadian prices will rise even more. U.S. prices stay flat. The Bank of Canada once again confuses the effects a new cash-back policy with a rise in the natural rate of interest, tightening while the Fed stays pat.

Assuming that prices react rapidly and fluidly to central bank policy, then the Bank of Canada's tightening will simply drive consumer prices back down and restore equality between the natural rate of interest and the market rate. But if changes in monetary policy have effects on the real economy, then we've got problems. It could be that certain prices are sticky downward so that markets can't clear, the result being inventories of goods going unsold. Or perhaps the fact that debts are nominally denominated creates a Fisherian debt deflation. If so, then the Bank of Canada could end up unnecessarily driving Canada into a recession. The Federal Reserve, reacting to the very same set of stimuli, does not.

Now of course I'm exaggerating things. In real life such large increases in cash-back policy are unlikely. Nevertheless, we have seen a progressive increase in network fees over the years, enough to have probably inspired Canadian retailers to ratchet up sticker prices. As a result, Canadian CPI may be slightly over-stating actual inflation. On the U.S. side, consider that American retailers only recently gained the power to surcharge credit cards. As U.S. retailers roll out surcharge policies and reduce sticker prices, CPI will be pressured down. This may fool Fed officials into believing that the economy is slowing and draw them into an unnecessary rate cut when in realtiy all that has changed is credit card pricing habits. One wonders if the monetary authorities take into account these arcane features of our payment system when they set their monetary policies.

This answers a question I asked more than a year ago.

Tuesday, June 30, 2015

Euros without the Eurozone

This 2 euro coin is issued by Monaco, which is not a member of the Eurozone

Grexit isn't what people take it to be. The standard narrative is that Greece is approaching a fork in the road. It must either stay in the euro or adopt a new currency. I don't think this is an entirely accurate description of the actual fork that Greeks face. Over the next few months, Greece will either:
  • A) stay a member in good-standing of the institution called the "Eurozone" and continue to legitimately use that institution's currency, the euro, or
  • B) leave the Eurozone while continuing to use the euro 'illegitimately.'*
This means either the status quo of de jure (official) euroization or de facto (unofficial) euroization. In both cases, the euro stays.

The probability of a new drachma emerging is awfully low. The widespread idea that a sick country can rapidly debut a new currency and, more importantly, have that currency be universally adopted as a unit of account is magical thinking. Greece has been using the euro as a universal "language of exchange" for fifteen years. Switching over to a new unit is about as unlikely as Greeks suddenly beginning to speak German, network effects and all. Consider too the fact that Greeks don't want the drachma—they have consistently voted for euros. Syriza has no mandate to bring a new unit into existence. ***

Option B isn't an odd one. All sorts of countries 'illegitimately' piggy-back off the currencies managed by others. Zimbabwe, Ecuador, and Panama use the U.S. dollar without being card carrying members of the Federal Reserve System while Andorra, Kosovo, Montenegro, Monaco, San Marino, Vatican City use euros without being part of the Eurozone. Nor can the Eurozone can do anything to prevent de facto adoption of the euro by Greece. It's a decision that Greeks get to make themselves.

If Greece leaves the Eurozone on a de jure basis while staying a euro user, what will it be giving up?

The Greeks would NOT be losing the price stability and commonality already provided by Eurozone membership. These are presumably the features that lead most Greeks to declare in polls that they want to stay in the euro.

However, Greece would no longer get access to Eurozone lender of last resort facilities. One could argue that the nation would be better off without these facilities, given the discipline that a true 'no bailout' policy would enforce on both the banks and the government. Greece also loses direct access to the monopoly supplier of euro banknotes. A Greek banker can currently ask to have their Eurozone account be debited and a batch of freshly printed paper euros trucked over to their vault. Gone is that functionality. Panama has survived, even prospered, for decades without access to the Fed's discount window or Fed cash facilities.***

Greece would also lose its seat on the ECB Governing Council and therefore any say in determining monetary policy. Greece's one seat probably never gave it much influence anyways, especially compared to Germany's dominant influence in ECB decision making. Nor would Greek data be considered as an input into Eurozone policy decision should Greece leave. However, as it clocks in at just 2% or so of the Eurozone's total size, Greece's data could never have had much influence on the aggregates that ECB policy makers watched to begin with. Official user of euros or unnoffical, Greece will always lack an independent monetary policy.

Another concern is that Greece might not be allowed to use the ECB's Target2 real time settlement mechanism anymore. However, Denmark, Bulgaria, Poland, and Romania all connect to Target2, despite not being Eurozone members. Surely Greece would qualify. If not, it wouldn't be too complicated for Greek banks to set up their own payments system.

Lastly, Greece would forfeit all seigniorage revenues. Eurozone members currently get a share of the profits that the ECB earns on its monetary monopoly. I don't see this loss as being a big deal. Seigniorage has long since been eclipsed by taxes as the key source of a modern government's revenue.

The upshot is that whether Greece remains a legitimate member of the Eurozone or an unofficial user of the Eurozone's chief monetary product, the implications are about the same. There is no fork in the road, at least not from a monetary policy perspective; just a continuation of the same euro path as before.

I've left two features out. If Greece leaves, the claims and liabilities it has on the Eurozone must be unravelled and settled. Having invested around 200 million euros in the ECB when it was formed, Greece would have to be bought out by remaining Eurozone members at a reasonable price. Counterbalancing this would be Greece's obligation to unwind the debt that it has amassed to the Eurozone in the interim. This debt, known as its Target2 deficit, currently clocks in at around 100 billion euros, far in excess of the capital it is owed. It would take an incredible outlay of resources to pay this amount off. The advantage to the Greek population of staying in the Eurozone is that their debt need never be settled. After all, Target2 debts are by nature perpetual. Only by leaving do they face a final day of reckoning.

However, if Greece puts little-to-no cost on squelching on its debts, it may as well just leave the Eurozone without paying back the 100 billion it owes. It gets to continue to ride piggy-back on top of the euro, enjoying (almost) all the same benefits of being a Eurozone member, without being on the hook for anything. Why not perpetually bum cigarettes rather than pay for them?

Which is why Greece has a certain degree of power over the remaining Eurozone members. Should it shrug and leave, the remaining members are on hook for its unpaid tab. And once Greece goes down the de facto euroization path, how long before the next largest debtor to the rest of the Eurozone decides to shrug and leave? As Nick Rowe says, the last one holding a common currency is the sucker since they'll be left with everyone's bad debts. To keep the system going, the Euro project's architects need to do their best to ensure that Greeks aren't incentivized to just shrug and bum a free ride on the euro. I don't envy them their task, it's a difficult one.

The other aspect I've left out is the Greek banking system, which is probably insolvent. Once cutoff from the central bank that prints the stuff, Greek banks simply wouldn't be able to meet the rush to convert deposits into euro banknotes. The only way to return the banking system to functionality would be to chop the quantity of Greek bank deposits down to size so that the banks' asset base would be sufficient to absorb the run into cash. We're talking a multi-billion euro "bail-in" of depositors. The prospect of such a hit certainly tilts the decision between A and B back towards A.**

* Having been cut off from additional ECB lending, one might argue that Greece has already gone halfway towards exiting the Eurozone.
**  Paragraph added July 2.
*** Added cash facilities on July 2.
**** Added last two sentence to this paragraph on July 3.
Note: apologies for the constant additions, but this subject is complex and the situation getting more complex by the day, so rather than writing two or three posts I'm adding bits to the original.

Thursday, June 25, 2015

How monetary systems cope with a multitude of dollars

Over the last few decades, dollars have become incredibly heterogeneous. People can pay for stuff with traditional paper bank notes, debit cards, or a plethora of different credit cards. Each of these dollar brands comes with its own set of services and related costs. On the no frills side is cash. Paying with paper still incurs the lowest transaction costs, although at the same time it offers its owner no associated perks. On the fancy side is an American Express card, which costs around 3.5% per transaction but is twinned with a raft of benefits including reward points, the right to dispute a transaction, and insurance coverage. Mastercard and Visa come somewhere between. As you can see, spending one sort of dollar is very different from spending another sort.

The free banking era and the "multitude of dollars" problem

There's a precedent for this sort of dollar heterogeneity. During the U.S.'s so-called "free banking era" that lasted from the 1830s until 1863, hundreds of different types of banknotes circulated, each issued by a unique bank. Notes were universally redeemable in a certain quantity of gold. Varying physical distances between a note's final resting point and its birth at an issuing bank (often in another state) led to widely disparate redemption costs across note brands. A merchant in Philadelphia who was paid in local bank notes need only take a short walk in order to redeem the note. If that same merchant was paid in a note issued by a bank in Chicago, however, redemption was much more onerous due to the time and distance required to travel from Philadelphia to Chicago.

So in the same way that an American Express dollar is the most costly of the modern day dollars, a distant bank's notes were the most costly of the free banking era's dollars.

Here are two interesting problems. How can a merchant establish a single set of sticker prices while still accommodating a wide range of disparate dollar payments media? Second, consider the fact that shoppers paying with a premium card like American Express (or distant bank notes) enjoy the widest range of benefits, but should also face the highest costs. How can the system ensure that the person who enjoys the marginal benefits associated with a given payments medium also bears its marginal cost? Put differently, how is quid pro quo ensured?

The solution: surcharging

In the free-banking era, the "multitude of dollars" problem was solved by a form of discriminatory surcharging. To begin with, merchants displayed their sticker prices in terms of a single unit; standard U.S. dollars (defined as 1.5 grams of gold). When the customer arrived at the till, the merchant determined what sort of surcharge to apply to each of the banknotes proffered according to its distance-to-redemption. With hundreds of note-issuing banks in existence, this was a cumbersome task. In order to speed up the process, the merchant would consult what was called a "bank note reporter." This handy publication, which was compiled by professional bank note analysts, provided merchants of a certain location, say Philadelphia, with the rates for all bank notes that circulated in Philadelphia adjusted for their shipping costs.

The image below is a section from Van Court's Bank Note Reporter and Counterfeit Detector, which I've snipped from Gary Gorton's introduction to the subject. It shows the the recommended price at which a merchant in Philadelphia should accept notes from Vermont, Maine, Pennsylvania, and elsewhere.

A page from  Van Court's Bank Note Reporter and Counterfeit Detector (1843), showing multiple prices for various dollars. Notation: do=ditto, same as above | par=no discount | 20 = 20% discount | 1 = 1% discount | no sale = 100% discount | fail'd=failed bank, 100% discount | clos'd=bank closed, 100% discount

After a merchant had consulted his bank note reporter and tacked on the appropriate surcharge, it was time to redeem the note. Merchants didn't actually ship the notes themselves but sold them to a local note broker at a discount to face value. In fact, the numbers that Van Court published would have been sourced from this broker market. The broker in turn shipped the note back to the issuer, getting full face value upon redemption. The gap between face value and the initial purchase price covered the broker's shipping costs.

Thus the "multitude of dollars" problem was solved. By surcharging relative to a benchmark dollar, merchants succeeded in setting a single array of prices while accommodating a much wider range of heterogeneous payments media. This also allowed them to efficiently pass the marginal cost of using distant notes onto those customers who chose to pay with them, while rewarding customers who used low-cost local notes by not applying such surcharges.

So why not implement this same technique of surcharging today?

Consider that in our modern era, credit card networks recoup much of the cost of the services they provide (which are many, but include perks like rewards and the right to dispute a transaction) by requiring that card accepting retailers collect a fee from customers on the network's behalf. This parallels the free banking era, in which banks required third-parties to bear the cost of transporting notes for redemption.

The best way for a modern retailer to establish prices in this heterogeneous dollar world would be to replicate the solution settled upon by their free banking ancestors: set sticker prices in terms of the most basic unit, paper dollars, and exact an appropriately-sized surcharge on each card transaction at the till.

Rather than an old-fashioned Van Court's Recorder, a merchant could go about this by installing card-reading software that would quickly determine both the card being used and the appropriate surcharge. Thus, consumers who paid with premium cards, those cards that offer the most bundled services per transaction (and therefore incur the highest costs), would have to bear the largest surcharge while those with bare bones cards would pay a minimal surcharge. Anyone paying in cash, much like those who payed with local banknotes during the free banking era, would not incur any surcharge whatsoever. This system would ensure that each customer bears the marginal cost of their chosen means of payment. The retailer, who routes all of the surcharges they collect back to the card network, doesn't eat any costs and therefore succeeds in preserving their margins.

If only things were that easy. Though surcharging would be a great way to deal with the "multitude of dollars" problem, card networks like Visa and Mastercard have typically "legislated" against surcharges.* The networks can successfully impose this no-surcharge obligation on retailers because as an oligopoly, Visa and Mastercard can banish offenders from the network, putting a huge dent in the offender's sales. Why prevent surcharges? One reason the card networks probably do this is because they don't want the card-paying public to feel that they are being penalized in any way. If the feel put off, consumers might choose alternatives like cash and debit that aren't subject to surcharge.

Another solution: discounting

The no surcharge rule puts retailers in a bind. They are obligated to collect fees on behalf of the card networks, but without the ability to surcharge they're left absorbing the costs imposed by the networks while the customer enjoys all the benefits.

There's a neat way that that retailers can get around this hurdle. All they need to do is to mark up all their sticker prices to the level of the highest cost credit card, and then offer discounts to everyone who uses lower cost credit cards, debit cards, or cash. Discounting allows the merchant to collect the appropriate fee from each customer, funneling these fees back to the networks. As before, a given set of prices can accommodate a wide range of dollar payments media. Each party who enjoys a given marginal benefit also bears its respective marginal cost.

So as not to leave our analogy hanging, if this solution had been chosen by free-banking era retailers (perhaps because the free banks insisted that merchants avoid bank note surcharges), then the price level in Philadelphia would have been marked up to the value of the most-distant bank notes in circulation, say those from Chicago. Those paying in less-distant bank notes, say New Jersey notes, would have received an appropriately-sized discount.

An anomaly: we don't see discounts

Having outlined how to solve the modern "multitude of dollars" problem without surcharging, what happens in the real world? An odd phenomena tends to play out. While retailers have certainly marked up prices to a premium card standard (or thereabouts) in order to cover their costs, for some reason they rarely offer their customers discounts on cheaper payment options. Try asking for a cash discount at Walmart the next time you visit. This means that anyone who purchases something with cash, debit, or a bare bones credit card is being forced to pay for a juicy set of benefits associated with usage of an American Express card, namely fancy rewards and dispute rights, without actually getting to enjoy those benefits. Put differently, the merchant is effectively overcharging their customers by collecting more network fees than the networks actually require, keeping this excess to pad their bottom line.

Why this predatory behavior? Briglevics and Shy note that merchants may be wary of discounting if it creates confusion and distrust among customers. Potential delays at checkout counters might impose an extra set of costs on all parties. They also point out that merchants may not find it profitable to offer a cash discount to consumers who would use low-cost payments anyway. Schuh, Shy, Stavins, and Triest report that merchants may lack complete information on the full and exact merchant discount fees for their customers’ credit cards, and therefore can't implement a policy of accurate discounting.

Could it be that the right set of tools to provide discounts hasn't yet been created? Perhaps we need a modern version of Van Court's Bank Note reporter. Such a technology would allow merchants to rapidly determine the proper discount to apply to each disparate dollar type and clearly inform customers about the saving they have enjoyed.

Lack of technology may explain why cheap credit cards don't receive discounts relative to expensive ones, but it doesn't explain why cash discounts has never been adopted by retailers. One theory is that even if certain retailers start to offer discounts, the public may be too overloaded with information to switch, thus allowing the practice of predatory pricing to remain the status quo. Supporting this view is the following observation: while discounting for cash and debit payments is rare in most sectors of the economy, it is quite common among gas stations, as the image below shows.

Why so? Gas stations sell one homogeneous, universally available, repetitively-purchased good. Gas consumers are by-and-large brand insensitive, gas from one station being just as good as gas from another. Repetitive trips to buy one simple commodity probably makes it easier for lethargic consumers to make dispassionate price comparisons across competing gas stations. From the gas station owner's viewpoint, the consumers' price sensitivity only increases the efficacy of a policy of price discounts on cash and debit. After all, a gas station that offers users of low-cost credit cards a 0.5% discount or a cash discount of 1% should be able to win business away from station across the street that doesn't offer any discount whatsoever.

Other retailers, say department stores, sell a wider variety of things than gas stations, many of these items only being purchased from time to time. This makes comparison shopping more costly. Brand loyalty only increases the hassles of switching. Department stores may find that a policy of cash discounts is simply not worth the effort as discounts get lost in the morass of data that a consumer is bombarded with on an hourly basis.

That being said, the online world's ability to provide faster cross-retailer comparisons than are possible in a bricks & mortar world could shake things up. Surely some smart fintech entrepreneur can create a way for online merchants to rapidly measure the appropriate discount (or surcharge in those jurisdictions that allow it) to apply to each card before consummation. This same tool would provide a user-friendly format for online shoppers to "see" competing card discounts across a number of merchants prior to hitting the buy now button. Just like they'll cross the street to hit the cheapest gas station, they may divert their purchase to the lowest cost website. If this sort of thing caught on, we'd see long forgotten free banking customs replicated in our modern era.

*This is currently the case in Canada. In Australia, merchants have been allowed to surcharge since the early 2000s. US merchants recently won the right to surcharge, although it is probably too early to know what effect these rule changes will have.

Tuesday, June 16, 2015

Imaginary worlds with volatile money

On Twitter, Noah Smith asks:
He answers his own question on his blog. I pretty much agree. It's interesting to imagine science fiction worlds where people do use volatile instruments like stock as their medium of exchange. Why would people in these worlds be willing to adopt volatile media while people in our world don't?

Liquidity, the world's best insurance policy against uncertainty

First, we need to understand why our world has a preference for stable media of exchange. As Noah points out, people don't know exactly when they are going to need to spend money, or how much. Any individual faces the dizzying fact that any of an infinite number of events could hit them at any point in time. People have many ways to cope with this chaos, one of which is to build up an inventory of assets that can be deployed to help deal with surprises as they occur. Liquid assets—those that can be sold quickly, at low cost, and spent along multiple pathways, will do a better job of this than illiquid assets—those that take time to sell, incur transaction fees, and lack multiple pathways.

A buffer stock of liquidity offers people the same set of services as actual insurance, say a policy issued by GEICO. A home insurance policy immunizes against a range of disasters that might befall someone's residence. So does liquidity, since it can rapidly purchase materials and labour. If home insurance is cheaper than holding an inventory of liquidity (the cost of which, as Noah says, is an inferior expected return), then people will skimp on liquidity. Unfortunately there are only a limited range of future disasters against which people can purchase insurance. Good luck getting GEICO to insure you against a zombie outbreak, for instance. If a zombie scenario is something that you put a non-zero probability on, then staying a little more liquid than you otherwise would may alleviate some of your concerns. Come outbreak, the ability to rapidly dispatch liquid assets in all directions will come in handy.

Back to the question of volatility. If people are trying to build a moat against uncertainty, what use would insurance be if it offered $20,000 in protection on Tuesday, $17,000 on Wednesday, and $23,000 on Thursday? For the same reason that people require a fixed amount of insurance rather than a floating amount when constructing their moats, they will want to invest in stable liquid assets rather than volatile liquid assets. You can't solve for uncertainty with more uncertainty.

Liquidity is a virtuous circle

Liquidity is a virtuous circle; as an asset gets more liquid it becomes more attractive as an insurance policy, which brings in more buyers, which makes it more liquid, which increases its value as insurance, and so on. Once everyone holds the most-liquid asset(s), they have joined what in essence is an economy-wide mutual insurance scheme. At this point it makes little sense for a merchant to accept less-widely held assets as payment. Not only will it be a nuisance to set up the infrastructure, but the merchant runs into the coincidence of wants problem. Because the merchant's employees are already paid in the most-liquid asset, should the merchant accept volatile assets as payment he/she will have to bear the cost of converting them back into the standard unit. To avoid these inconveniences, only widely-held assets will be accepted by the merchant. A payments standard has developed.

Merchants will also try to please customers by setting their sticker prices in terms of the liquid asset. This reduces the calculational burden imposed on customers. At this point the asset has become a unit-of-account, and a pricing standard has developed. Adoption as unit-of-account provides all sorts of extra benefits to owners of the standard unit. As a courtesy, grocers and other retailers will typically keep their prices fixed for a few days, or weeks, which means that anyone who owns the standard unit knows ahead of time approximately how much food they'll be able to purchase. The tendency for prices to be sticky in terms of the unit of account only increases the standard unit's usefulness as a universal insurance policy.

The fact that shares aren't the unit-of-account means that consumers who own them miss out on all the uncertainty-alleviating benefits of sticky retail prices. They have no clue what their purchasing power will be one minute hence, let alone the next day.

Worlds with volatile money

If we lived in a world where we didn't need liquidity to shelter us from uncertainty, then we might be more receptive to using volatile media of exchange.

For instance, I sometimes wonder if the demand for dollar-denominated liquidity is less in Canada than in the U.S. since we Canadians have universal health care. With the nagging concern of how to pay for potentially life saving medical services solved for, we can economize on inventories of stable liquidity and seek out higher returns. Americans, who don't have such a product, probably need to hold larger dollar-denominated hoards in order to alleviate their queasiness about how they'll have to deal with future bodily harm.

Taking this idea to its limits, if an insurer were to introduce an "everything" insurance product (yes, this is science fiction), and it was cheaper than holding the standard liquid unit, then people would no longer need to self-insure against uncertainty by depending on the standard unit, typically central bank money and its banking derivatives. Instead, everyone would migrate their savings over to more volatile instruments like stocks, ETFs, or bitcoin, enjoying what Noah refers to as higher drift, or long-term returns. As long as GEICO is providing a low-cost universal salve against uncertainty, than people will be willing to shoulder all the inconveniences of fluctuating purchasing power insofar as it offers them a bit more drift.

With ownership of low volatility units (dollars, yen, etc) far less ubiquitous than before, and volatile asset (stocks, ETFs, bonds, etc) ownership much more prevalent, it might now make sense for merchants to incur the set-up costs of receiving volatile assets in payment. Furthermore, the fact that their employees will accept these volatile assets as salary, thus solving the coincidence of wants problem, will only accelerate the willingness of merchants to install the requisite infrastructure. After all, merchants can now pay their employees with the same ETF units that they receive from their customer, thus saving both commission expenses and the cost of incurring the difference between the bid and ask price. [1]

Information as a moat against uncertainty

In addition to liquidity and insurance, people can build their moats by acquiring more information. This is something I learnt from David Laidler. (If you want to learn about money via a fascinating detour through the history of monetary thought, you can't go wrong with these three books.) Knowledge allows individuals to better anticipate the future and plan accordingly, thus reducing the need for either liquidity or insurance contracts as hedges. If some cheap technology were to emerge that offered an infinite amount of free information (i.e. the internet?), then maybe people would cease amassing stable liquidity altogether. In this world, people's preferred solution to uncertainty would be to costlessly inform themselves and hold high return/high drift assets like stocks rather than stay uninformed and hold inferior, low return liquid assets.

Of course, we could also argue the opposite; that the internet has solved for one set of risks only to bring in a new set (identity theft, viruses etc), thus perpetuating the necessity of owning both GEICO insurance and liquid assets.

In sum, because our world lacks both infinite information and universal "everything" insurance policies, stable liquidity remain one of the cheapest ways to inoculate against uncertainty. The widespread prevalence of this monetary insurance across all strata of society has encouraged the development of a payments and pricing standards based on these assets. These standards further militate against the emergence volatile assets like bitcoin and shares as widespread media of exchange.

[1] I added this paragraph on June 19.

Friday, June 12, 2015

The dollarization of bitcoin

Bitcoin was supposed to result in the bitcoinization of the world; instead, I'd argue that the world of bitcoin is being dollarized.

A successful medium of exchange will be used by four types of actors: retailers, consumers, financial intermediaries, and speculators. In bitcoin's case, the inherent volatility of the cryptocurrency militates against its adoption by anyone other than speculators, leaving dollars as the default option.

Let's start with the first bit of the equation; retailers, or merchants. Entrepreneurs who have been trying to bring bitcoin to the mainstream have discovered that while merchants like the idea of allowing consumers to pay with bitcoin, the merchants themselves refuse to deal in the stuff. Instead, upon receipt of bitcoin, a merchant's bitcoin payments processors—usually an intermediary like Bitpay or Coinbase—will instantly convert bitcoin into U.S. dollars on behalf of the merchant. Retailers choose to dollarize rather than bitcoinize because they are afraid of bitcoin's volatility, and justifiably so.

The next bit of the equation is the consumer. I argued in my previous post that it is dubious whether paying in bitcoin offers mainstream consumers any benefits relative to dollar payments. People who buy with bitcoin must incur added costs in the form of trading fees if they wish to move from dollars into bitcoin. They must also bear the burden of bitcoin's volatility until the moment of making a purchase.

To drive mainstream consumer adoption of bitcoin, those intermediaries who are servicing buyers will have to begin offering the same sort of volatility-shielding services that bitcoin payments providers currently offer to merchants. A permanently shielded wallet, for instance, would allow consumers who want to make a purchase the opportunity to store value in U.S. dollar terms until the very last moment, at which point the intermediary takes on the bitcoin risk and consummates the deal. Of course, this only pivots things further towards dollarization, not bitcoinization.

The inevitable product that emerges will be a just-in-time bitcoin solution. Buyers have the benefits of holding dollars up until the moment at which they press the Buy Now button, at which point the intermediary takes over and sells their dollars for bitcoin. The switching of the payment from the dollar rails onto the bitcoin rails is only momentary. Upon receipt of the bitcoin payment an instant later, the merchant's payments provider will immediately sell the bitcoin and deliver dollars to the merchant. With both buyer and seller choosing to dollarize, neither has to suffer from bitcoin's volatility. However, they still get to enjoy whatever cost savings are provided by rapid just-in-time usage of the bitcoin rails. Only speculators and intermediaries, who have now taken on the responsibility of dealing in bitcoin from consumer and retailers, have avoided dollarization.

But hold on. If all parties to the transaction only want dollars, why not just cut bitcoin entirely out of the equation? Instead of a just-in-time swap of bitcoin, the intermediaries involved—the buyers' bitcoin wallet provider and the merchant's bitcoin payments processor—can get together and agree to exchange a dollar IOU instead, saving them the hassle of dealing in bitcoin. Gone are the exchange fees, the obligation to pay bitcoin's bid-ask spread, and slippage that might occur if bitcoin's price weaves dramatically as the transaction is going through. To spare readers the gritty details, the footnote below describes how bitcoin intermediaries might fashion a U.S. dollar IOU trading network.

This puts these bitcoin intermediaries in the rather odd position of no longer being part of the bitcoin universe. Instead, intermediaries have become like interlinked Paypals, offering U.S. dollar accounts to consumers and U.S. payment solutions to merchants.

Thus, in an effort to promote mass adoption of bitcoin, we've somewhat perversely arrived at the opposite, an all-out dollarization of what was supposed to be a bitcoin retail payments network. Buyer and merchant hold only dollars, and so-called bitcoin intermediaries like wallets and payments processors no longer deal in the stuff. That leaves only speculators to hold the bitcoin bag. This system of individual PayPals will be built on top of the very infrastructure that bitcoin was designed to tear down, namely the existing dollar rails run by incumbent banks and underpinned by the Federal Reserve.

This isn't to say that bitcoin is a failure as a retail payments option. But I have troubles seeing it ever going mainstream.  Even if bitcoin continues to exist as an arcane niche payments system for a community of like minded consumers and retailers, that's still constitutes quite a success, albeit one that has not lived up to many people's dreams.

In writing this, I stumbled on an earlier post by Guan that already arrived at a similar conclusion. If you've already read his post, my apologies for wasting your time and making you read mine.

The gritty details: Rather than trading bitcoin to settle payments between consumers and retailers, intermediaries can simply trade dollar IOUs. Costs should be lower than settling in bitcoin. To begin with, bitcoin intermediaries will have to maintain U.S. dollar clearing accounts with all the other bitcoin intermediaries. Over the course of a trading period, dollar payments will flow into an out of these clearing accounts. At the end of the day, each intermediary's account will be netted and cleared against all other intermediaries' accounts. The result is that some intermediaries will be owed dollars, others will owe. These balances will all be settled that very evening on the books of an underlying commercial bank, say Citi, where all intermediaries also maintain accounts. Since accounts are settled on the books of Citi, intermediaries needn't incur expensive inter-bank wire transfer fees. Citi has, in effect, become the central bank for a bitcoin based payments system, sans the bitcoin.