economics | Guillaume's blog

Ignorance is bliss

Yesterday I read through a fascinating paper called Opacity and the Optimality of Debt for Liquidity Provision. The main point is that welfare of participants is maximized when using debt instruments to trade, rather than, say equity or real assets. The reason is that participants will be less worried about a debt than by a piece of equity, so they will seek less information, which in turn will maximize the issuance of debt, and maximize welfare.

Of course, while all of this is fine, a serious financial crisis can happen when everyone starts doubting at once about the debt that no-one seemed to question at all.

What’s fascinating is that according to the authors: welfare is maximized when participants are equally ignorant of the actual quality of the debt and trade simply according to its face value:

In this economy government policies that increase transparency would reduce welfare. This would seem to be counter to the intuition built from the idea of efficient markets.

They do not stop there. They actually claim that the complexity of securitization, CDOs, etc. is good because it increases costs about figuring out the exact value, which in turns maximizes welfare because it facilitates trade as long as everyone is equally unwilling to do any homework (if I understand correctly):

Clearly, if complexity raises the cost of producing information, raises ?, this can be welfare improving. Suppose that agent A could choose a level of complexity for the security designed at t=1. This corresponds to choosing some ? less than a given maximum. For large w, agent A would always choose to issue the most complex security, the one with the maximum ? because this maximizes the amount of debt that will be accepted by agent B without triggering information production.

More, they even justify one of the roles of the central bank as maintaining the opacity and secrecy.

The lender-of-last- resort’s role is to exchange information-insensitive debt for information-sensitive debt, possibly at a subsidized price to prevent information production, or, to make the private debt, which has become information-sensitive, information-insensitive. This prevents the crisis from being worse…

Wealth vs. money and other selected F. Soddy quotes

I just finished reading Wealth, Virtual Wealth and Debt (1926) by Nobel prize-winning chemist Frederick Soddy. I really enjoy reading these old books… On one hand it is depressing to see the high hopes that existed in the 1920s after what was known until 1939 as the Great War. Thinkers like Soddy seemed very optimistic that the same revolution that had happened in science was about to impact the world of economics, and with it monetary policy and positively impact the world’s poverty. As we all know, history took a very different path then.

On the other hand, reading this book fills you with optimism since one may argue that the context was not ripe for change back then. It may be now. The big contextual change since the 30s is that there is a larger awareness worldwide on the fact that earth will run out of the life-friendly deposits and environment it has offered gratis so far. We may not have reached the tipping point yet. A couple more major crisis, food and/or environmentally related, may be needed for that unfortunately. Crisis is ??????, “decisive moment”.

If I had to summarize the book in a few bullet points:

wealth is not the same as money. Wealth is what enables and sustains life, it is the product of available energy. Whereas money only values what is scarce. Air, water, land is wealth, but economists won’t measure it until it becomes rare enough that it will have a price.
wealth is limited by fundamental laws of physics. As long as we are bound to the earth, no wealth generating process is free of any waste. There is always waste, heat, loss (including for building solar panels).
money is wealth that does not exist, it is merely information, something that represents the wealth we gave out, without anything in return. The quantity of wealth that community participants are willing to give away against acknowledgement of community debt is the community’s wealth, since it allows the community to cooperate. The unit we use to measure this “virtual wealth” is money and obviously it’s not because the quantity of money increase, that the virtual wealth does too.
As far as solutions are concerned, Soddy essentially recommends issuance of money to be done at zero cost to the community, i.e. by the government, not by banks, and regulated via taxes according to a price index. He recommends that deposits at banks be fully backed with customers paying for account maintenance. He believes that it is possible to convert from a system where money is created by bank and government accumulate debts to a system where government have no debt, issue the money and banks only lend the money that their customers are asking them to lend.

And now a few quotes:

Originally wealth meant wealth – the state of well being, just as health means the state of being hale.

The century that has come and gone has seen a steady alteration in the significance of the word wealth from its original meaning, wealth, as the requisites that enable and empower life, to debt, the right of the creditor to demand wealth and the duty of the debtor to supply it. (p97)

Credit means surely that the creditor gives up to the borrower the use of the property lent. It is true that in granting bank credit the bank gives up nothing whatever, but the community does, and the borrower receives it.

Wealth has proved a quantity to difficult and too involved for analysis by the modern economist. The earlier economists did, according to their lights, attempt to deal with it; but the modern school have more and more taken it and its origin for granted and confined themselves to the study of debt, or, as we shall see, with chrematistics rather than economics. Debts are subject to the laws of mathematics rather than physics. Unlike wealth, which is the subject to the laws of thermodynamics, debts do not rot with old age and are not consumed in the process of living.

Power over men is the essence of debt. Power over Nature is the essence of wealth. The not owing and not possessing wealth owed to one individual by another or by the community gives that individual power over the other or the community until the debt is paid. When paid, the not-owner becomes owner. The wealth he now possesses, but the power over men he loses.

Wealth is the product of useful or available energy. Economics deal not with, but entirely with the flow of useful and available energy and its transformations into useless forms, and physical wealth as a product of the control and direction of this flow.

Money is not wealth even to the individual, but the evidence that the owner of the money has not received the wealth to which he is entitled, and that he can demand it at his own convenience. So that in a community, of necessity, the aggregate money, irrespective of its amount, represents the aggregate value of the wealth which the community prefers to be owed on these terms rather than to own. This negative quantity of wealth I term the Virtual Wealth of the community because the community is obliged, by its monetary system and the necessity of having one, to act as through it possessed this much more wealth than it actually does possess.

This Virtual Wealth is thus a peculiar part of national credit, and is sharply to be distinguished from the rest, which, indeed is the only part of the national credit usually recognized, and which is in no way different from that of an individual. […] The National Debt must continue to be paid for until it is repaid. Whereas the Virtual Wealth of the community, although it is National Debt in one sense, is permanent, necessary, beneficial, normally non-repayable and non-interest-bearing debt.

The nation must act, and continue indefinitely to act, as if it possessed more wealth than it does possess, by the aggregate purchasing power of its money, but the important thing is that this Virtual Wealth does not exist. It is an imaginary negative quantity – a deficit or debt of wealth, subject neither to the laws of conservation nor thermodynamics.

It is not the amount of money people have that is of any real importance, but the amount of wealth they are in a position to obtain any time in the future on demand, and therefore go without in the present, that is of importance.

It is the virtual wealth which measures the value or purchasing power of money, and not money which measures the value of wealth.

The virtual wealth has little to do with the quantity of money. The habits of a community are essentially conservative, so that it can only change within comparatively small limits. Whereas the quantity of money, on the other hand, is absolutely and entirely arbitrary and can be theoretically be made as small as or as great as the nation pleases without any limit whatsoever.

Money is debt that need not be repaid at all, and indeed can only be repaid by the community itself obtaining possession of the money and destroying it. These are the only kind of debt that are wholly beneficial to the community. They need not bear any interest whatever.

Money = authorized token of the indebtedness of the whole community to the individual possessing the token.

Money is a debt repayable in wealth. Whereas most debts are repayable in money.

Reputation badges as a driver for benevolent behavior

I’ve had a couple travel hours today to continue my reading of Richard Alexander’s The Biology of Moral Systems. The essential thesis of the book is that our moral, benevolent behaviors are motivated by our desire to receive indirectly reciprocal benevolent behaviors from others in a way that maximize the reproduction of our genetic capital. “Indirect” means that we may not get the reciprocal behavior from the same individual as the one we originally were benevolent to. There is another indirection since we may not even ourselves get the reciprocal behavior, but it might be given to our descendants or relatives. As Jean told me a few months ago, we might want to call this “slow reciprocity”.

In other words, we are acting morally and being benevolent to others, sometimes making this moral behaviors into law because it will serve the reproduction of our genes. For instance, monogamy rule limits competition between males, which maximizes every male’s chance to reproduce.

Another example are empirical evidences that social recognition of donations is an important incentive in pro-social activities, as if we cared about talking about our donations/moral behaviors in return for reputability and ultimately obtain an indirect return even if it won’t be ourselves but our children or great grand children who will enjoy it.

For instance, this paper documents an experiment that shows that when people know that their donations are being watched, they tend to donate more.

Another example is a study on blood donors in Italy that has shown that “that donors significantly increase the frequency of their donations immediately before reaching the thresholds for which the rewards are given, but only if the prizes are publicly announced in the local newspaper and awarded in a public ceremony”.

In a Web 2.0 world, this public announcement would translate to the blood bank issuing a virtual badge certificate, that the donor would be able to shout out to their friends on Facebook or publish on their Web sites.

There are many blood donors Facebook groups, but I don’t believe anyone requires a certified blood donation to become a member. The closest think to a blood donor reputation badge is the I give blood application, allows your blood center to automagically upload your donation and cholesterol history and your blood type to your profile page.

Badges are also used in the Foursquare social game application, but are less serious. “They are little rewards you earn for doing interesting things – e.g. staying out late on a school night or visiting places far outside your neighborhood”.

Despite the positive potential that these reputation badges could unleash, I am not aware of any standard mechanism in social networks that support this. You can advertise a donation you’re making via TipJoy, but you can’t get a certified donor/benefactor/donator for all the good things you’ve done.

As Jody Reale mentioned this morning: “Why nothing positive is ever recorded in one’s “permanent record.”

One simple way to achieve this would be for non-profits receiving donations to publish on their Web site the name of the donors. This is something Wikipedia does. It wouldn’t take much for donation receivers to microformat these pages with hReview (the URI pointing to the Web identity of the donor), in a way that it can be easily extracted, aggregated and re-published on social networks.