Author Archives: Jonathan Parker

Is Bitcoin a viable currency?

The media and blogosphere have been full of Bitcoin discussions recently and almost everyone has an opinion, but most of these opinions are tied to the technology of Bitcoin, that is, whether this new currency represents a major technological revolution in money.  So, most commentary has focused on questions about Bitcoin’s technological advantages: Is it really secure?  Is it truly anonymous?  Can it be counterfeited?  Are transaction costs actually lower?   Here, here and here are a few of examples and they contain comments like “Bitcoin is the first practical solution to a longstanding problem in computer science called the Byzantine Generals Problem.”  That is, they focus on the technology of Bitcoin.

But what of the finance and economics of Bitcoin?  Does it have the economic properties to be a viable currency?  I don’t think so.

Good money had three economic properties and uses.  It is a unit of account, used to measure and write contracts for things like income, wealth, and prices of goods.  It is a means of payment, used to avoid barter.  And it is a store of value, held to be able to make transactions in the future.  Of these three properties the third is the most important.  Unless money has a stable value, it does not serve the purposes that it should.  People will be wary of accepting something that might lose lots of value, and something with a volatile price makes a bad unit of account.

And my argument is not just that Bitcoin has had wild fluctuations in value that undermine its role as a viable currency, but deeper, that Bitcoin is destined to have wild fluctuations – it is poorly designed and conceived and so is likely to fail as a currency.  Why?

First, and primarily, Bitcoin lacks a mechanism for setting the supply of Bitcoin equal to the demand for Bitcoin to maintain its value.  History is replete with examples of governments that tied their hands in the supply of their currencies, much like Bitcoin has done.  What happens?  The value of the currency fluctuates.  Often a lot.  Before the founding of the Fed in the US, the dollar was backed by gold, and gold discoveries lead to inflations, and collapses in the price of gold to recessions and even financial crises.  Since the end of the Great Depression in the US, the Fed has actively managed the money supply to achieve price stability (at some times better than others).

Consider the example of the Y2K scare.  Before January 1, 2000, people were concerned that the change from the year 1999 to the year 2000 could lead to serious errors in computer systems, and in particular that it might become hard to use credit cards or get money out of a bank (or worse, bank deposits might even get lost).  As a result, people withdrew cash before New Year’s, lots of it. (These types of cautionary actions were widespread: governments grounded all airline flights overnight.).  These withdrawals were increased demand for cash that might have driven up the price of dollars – ie. led to deflation and changed interest rates.  But the large increase in the demand for cash did not cause any such real economic effects.  Why?  Because when demand increased the Fed simply expanded the amount of currency in circulation.  When New Year’s came and went without serious incident, people re-deposited their cash and the Fed reduced the money supply. The US price level remained stable.

Similar examples abound.  Prior to the founding of the Fed, the seasonal agricultural cycle lead to big seasonal swings in the demand for credit and currency which lead to seasonal swings in nominal interest rates (that is, the usual interest rate we think of which is the real interest rates plus changes in the value of money, that is, plus inflation).  If Bitcoin gains traction, will it have a seasonal fluctuations in its value that track the seasonal spending patterns of the world.  Will Bitcoins be more valuable in early December and comparably cheap in January?

Every day, central banks supply their currencies in proportion to the needs of the users of their currencies, so as to maintain a stable value for their currencies.  Bitcoin does not have a central bank.  It has a relatively inflexible supply mechanism (known as Bitcoin mining).  As a result, Bitcoin is destined not to have a stable value.  And a volatile price is bad for Bitcoin’s usefulness as a currency.  Central banks are an enormous competitive advantage for traditional currencies that the Bitcoin supply process completely lacks.

A second problem with maintaining a stable value is that digital currency is not really in limited supply. Its proponents will argue that it is.  The Bitcoin technology is carefully, maybe even brilliantly, designed to ensure that the supply grows slowly and it ultimately limited. But what happens when Bitcoin 2.0 comes out?  What if it has slightly better properties than the old technology?  Do people stop using Bitcoin 1.0 entirely leading it to become worthless?  Probably.  Is such a scenario likely?  Well,  think about the potential profits that one could make introducing Bitcoin 2.0, just by keeping a share of the initial number of coins.  These potential profits provide an incentive for the hi-tech business that comes up with a better Bitcoin to take over the digital currency market through advertising, lobbying, payments to businesses and so forth.  Or consider this alternative scenario.  Global banks start to provide currency transfers within their institutions but across borders that are as safe rapid, and low cost as Bitcoin payments.  There is no technological advantage to Bitcoin relative to a global bank with branches in many countries.  The point: while Bitcoin is in limited supply, digital currencies are not and neither are inexpensive ways to transfer money and make payments.

There are several other important cards stacked against Bitcoin.  But I will conclude with only one more., The “money supply” in the every country in the world is actually hard currency times the money multiplier – the ramping up of the hard currency into deposits in banks and lines of credit and gift cards and so forth.  In the US, the money supply – counting all of these money-like assets – is about twenty times the supply of hard currency.  And Bitcoin banking is developing and could go one of two ways.  First, it could be significantly private and unregulated.  The history of unregulated banking is that it is a disaster full of bank runs, volatile price levels currency collapses and so on.  The banking sector’s volatility becomes the volatility of the supply of Bitcoins which becomes price volatility.  Look just recently how the collapse of a single Bitcoin exchange affected the price of Bitcoins.  The second way Bitcoin banking could go would be as a regulated banking sector, becoming part of the tradition banking sector.  But then several claimed benefits of Bitcoin go out the window.  The true, large supply of Bitcoin is governed by banking regulation (but in every country in the world – what a mess!).  And while a Bitcoin is anonymous, a Bitcoin deposit is not anonymous. Once a bank gives you a credit for a Bitcoin and knows who you are, can it see in the Bitcoin chain how it was spent?  Not sure, but I would worry about it.

In sum, I am not worried about the technology – I have complete confidence that people at the other end of the MIT campus can solve almost all of the technological problems.  But the finance is suspect.  I am guessing that Bitcoin either remains small and volatile, with only transactions of suspect legality willing to accept the volatility as the price of true anonymity, or that Bitcoin goes down in history as a bubble, ultimately as worthless as the sequence of zeroes and ones that make up each coin.

Stress test scenarios miss the boat

Professor Jonathan Parker

The Dodd-Frank act requires that large financial institutions be more closely monitored for exposure to systematic risks.  A key part of this monitoring is stress testing.  Regulators announce a set of adverse scenarios, and financial institutions calculate and report their losses in each scenario.  Regulators get to see how exposed the institutions are.

The OCC has now released the scenarios for 2014.  You can easily download and look at them here.  The scenarios detail lots of economic outcomes: each scenario has 28 variables that mostly turn bad.  But I am really disappointed – this regulatory approach is not addressing the financial-crisis type exposures at all.

There are only three scenarios, one of which is the baseline scenario. The other two are really two typical recessions – one bad, one worse.  What use is this?  Where are those once a century scenarios, like a house price collapse?  Where are the unlikely but possible bad scenarios like a run on the US dollar or US debt?  How about a large fiscal inflation?  In none of the adverse scenarios do long interest rates.  My suggestion: reverse the detail – more scenarios, each with fewer variables.  There are many factors in asset pricing for a reason – there are many sources of risk.  Regulators seem to think there is only one.  Be more creative. Think about unlikely bad outcomes  That’s the entire benefit of the exercise.  Make banks think about these scenarios; make regulators aware of how bad (or not) the unlikely scenarios would be.

Large financial institutions do not have to evaluate their losses in the scenarios that keep me up at night.  I hope the regulators also do not sleep so well.

Jonathan A. Parker is the International Programs Professor in Management and a Professor of Finance at the MIT Sloan School of Management.

Optimal Contracting and the Securitization of Human Capital

Professor Jonathan Parker

An interesting new company, Fantex, is securitizing human capital.  They are offering assets whose payouts are determined by a given athlete’s future earnings, in this case both Arian Foster and Vernon Davis, players in the National Football League.  Here is a New York Times article from today, and here is a more complete description from former Goldman Sachs employee and current Grantland writer Katie Baker.  (Before heading out to buy, note that the convertible bonds that the story describes are pretty complex and not just a bond backed by a share-of income.)

This financial innovation could be bad thing, and I expect that sports leagues make this illegal, or at least a violation of the terms of contracts.

Why?  Because private contracts like NFL contracts are typically carefully structured by employers and employees to balance risk-sharing and incentives (and to be consistent with salary cap rules).  On the one hand, employees do not want lots of income volatility.  For a given expected income, people prefer to be paid a certain amount, rather than having to bear uncertainty due to variations in future performance, particularly due to factors that are beyond their control.  On the other hand, employees that get paid more if they do better have an incentive to do better, to train harder, eat right, etc.  Would someone work as hard if they were only getting fifty percent of the money they earned?   In general, economists think not.   This dis-incentive is the source of the economic cost of taxes, why higher taxes mean lower output.  So contracts provide insurance and a safe payment where the effects of monetary incentives are weak or the effects of forces beyond the employee control are large (such as for injuries).  Similarly, contracts provide incentives and a variable payment where the effects of incentives are large and mostly controlled by the employee (such as attendance at practice or weight gain).

The central lesson of this theory is that incentives are costly.  Because employees dislike risk, a contract involving more incentives has to pay more on average to the employee to compensate for bearing the additional risks.

Now suppose that an optimal contract is agreed to by both parties.  But now a new securitization market opens, and the employee takes the incentives part of the contract, for which they are on average being paid more, and securitizes it so as to insure the risk away (at least partly).  The employee has just re-written the contract in a way that is disadvantageous to the employer who now no longer has an employee with (as strong) incentives to perform well.  Anticipating this possibility undermines the writing of the original contract.

An analogy might help.  Imagine a CEO who was highly incentivized by company stock and as a result highly paid securitizing his human capital.  Securitization the CEO’s human capital would look like the CEO shorting the company stock – turning the expected high income into a sure thing, unaffected by company performance.  Thus CEO contracts and US regulations prohibit this.  And this is socially optimal (at least the bit about prohibiting shorting own-company stock).

So, while, the general idea of securitizing human capital seems great, it can undermine incentives.  For contractual relationships (rather than spot labor markets), it opens the possibility for employees to change incentives after contracts have been written.  In the case of Arian Foster, we are only talking about 5 percent of earnings.   But if I were the NFL, I would be quite concerned about my employees using financial instruments to weaken the strength of incentives.

Jonathan A. Parker is the International Programs Professor in Management and a Professor of Finance at the MIT Sloan School of Management.