Bitcoin has been a hot topic in the news over the last few weeks.

The digital currency has its adherents. The Winklevoss twins, made famous by the movie Social Network after suing Mark Zuckerberg for allegedly stealing the concept of Facebook, now purportedly own millions of dollars worth of Bitcoins.

It also has its detractors. Paul Krugman has argued that the whole enterprise is misguided. Bitcoin aficionados are, he writes, “misled by the desire to divorce the value of money from the society it serves”.

Still others cannot seem to make up their mind. Digital advocacy group, Electronic Frontier Foundation (EFF) accepted Bitcoin donations for a time, but became uncomfortable with its ambiguous legal status and shady associations, such as with the online black market Silk Road, and decided to stop accepting Bitcoin in 2011. A couple of years on and the EFF’s activism director is speaking at a conference on Bitcoin 2013: The Future of Payments.

Recent media interest has been fuelled by the extraordinary roller-coaster ride that is the Bitcoin price. In early April, online trading saw Bitcoins changing hands for over US$200. At the time of writing, prices are back below US$100. As with many markets, it’s hard to say exactly what is driving the price. Speculators, like the Winklevoss twins, buying Bitcoins will have helped push up prices, while reports that Silk Road has suffered both a deflation-driven collapse in activity and hacking attacks may have contributed to the down-swings.

Although not obvious on the chart above, dramatic price movements are nothing new for Bitcoin. Switching to a logarithmic scale makes the picture clearer. After all, a $2 fall from a price of $10 is just as significant as a $40 fall from a price of $200. The 60% fall from $230 to $91 over April has certainly been dramatic. But back in June 2011, after reaching peak of almost $30, the price fell by 90% within a few months.

The volatility of Bitcoin prices is orders of magnitude higher than traditional currencies. Since the start of the year the price of gold has been tumbling, with a consequent spike in its price volatility. Even so, Bitcoin’s volatility is almost ten times higher. The chart below compares the volatilities of Bitcoin, gold and the Australian dollar (AUD).

A week or so ago, armed with this data, I was well advanced in my plans for a blog post taking Bitcoin as the basis for a reflection on the nature of money. I would start with some of the traditional, text-book characteristics of money. A medium of exchange? Bitcoin ticks this box, with a growing range of online businesses accepting payment in Bitcoin (including WordPress, so not just underground drug sites). A store of value? That’s more dubious, given the extremely high volatility. It may appeal to speculators, but with daily volatility of around 15%, it’s hard to argue that it is a low risk place to park your cash. A unit of account? Again, the volatility gets in the way.

That was the plan, until a conversation with a colleague propelled me in a different direction.

She asked me what this whole Bitcoin business was all about. Breezily, I claimed to know all about it, having first written about Bitcoin two years ago and then again a year later. I launched into a description of the cryptographic basis for the operation of Bitcoin and went on to talk about its extreme volatility.

I then remarked that when I first wrote about it, it was only worth about $1, but had since risen to over $200.

“So,” she asked, “did you buy any back then?”

That shut me up for a moment.

Of course I hadn’t bought any. What gave me pause was not that I had missed an investment opportunity that would have returned 20,000%, but that I was so caught up in the theory of Bitcoin that it had not occurred to me to see what transacting in Bitcoin was actually like in practice. So I resolved to buy some.

This turned out not to be so easy. While there are many Bitcoin exchanges, paying for Bitcoins means jumping through a few hoops. Perhaps because the whole philosophy of Bitcoin is to bypass the traditional banking system. Perhaps because banks don’t like the look of most of them and will not provide them with credit card services. Whatever the reason, your typical Bitcoin exchange will not accept credit card payments. Many insist on copies of a passport or driver’s licence before allowing wire transactions, neither of which I would be prepared to provide.

Eventually I found BitInnovate, which allows the purchase of Bitcoin through Australian bank branches. Even so, the process was an elaborate one. After placing an order on the site, payment must be made in person (no online transfers), in cash, at a branch within four hours of placing the order. If payment is not made, the order is cancelled. Elaborate, but manageable, and no identification is required.

But before I could proceed, I had to set myself up with a Bitcoin wallet. As a novice, I chose the standard Bitcoin-Qt application. I downloaded and installed the software, and then it began to “synchronise transactions”. This gets to the heart of how bitcoins work. As a purely digital currency, they are based on “public key cryptography”, which is also the basis for all electronic commerce across the internet. The way I make a Bitcoin payment to, say, Bob is to electronically sign it over to him using my secret “private key”. Anyone with access to my “public key” can then verify that the Bitcoin now belongs to Bob not me. Likewise, the way I get a Bitcoin in the first place is to have it signed over to me from someone else. In case you are wondering what one of these Bitcoin public keys looks like, mine is 1Q31t2vdeC8XFdbTc2J26EsrPrsL1DKfzr. Feel free to make Bitcoin donations to the Mule using that code!

In this way, rather than relying on a trusted third party (such as a bank), to keep track of transactions, the ownership of every one of the approximately 11 million Bitcoins is established by the historical trail of transactions going back to when each one was first “mined”. Actually, it’s worse than that, because Bitcoin transactions can involve fractions of a Bitcoin as well.

So, when my Bitcoin wallet told me it needed to “synchronise transactions”, what it meant was that it was about to download a history of every single Bitcoin transaction ever. No problem, I thought. Two days and 9 gigabytes (!) later, I was ready for action. Now I could have avoided this huge download by using an online Bitcoin wallet instead, but then I would have been back to trusting a third party, which rather defeats the purpose.

The cryptographic transaction trail may be the brilliant insight that makes Bitcoin work and I knew all about in it theory. But in practice, it may well also be Bitcoin’s fatal flaw. Today, a new wallet will download around 10 gigabytes of data to get started, and that figure will only grow over time. The more successful Bitcoin is, the higher the barrier to entry for new users will become. I suspect that means Bitcoin will either fail completely or simply remain a niche novelty.

Still, it is an interesting novelty, and despite the challenges, I decided to continue with my investigations and managed to buy a couple of Bitcoins. The seller’s commission was $20 and falling prices have since cost me another $20 or so. So, I am down on the deal, but, as I have been telling myself, I bought these Bitcoins on scientific rather than investment grounds.

Of course, if the price goes for another run, I reserve the right to change my explanation.

Regular guest writer, James Glover, returns to the Mule today to look at the figures behind the proposed NDIS.

The National Disability Insurance Scheme (NDIS) is in the news again. A welcome development for people with disability and their carers and families…and friends and pretty much anyone else who cares about their fellow humans. It is not a platitude to say that disability can strike anyone at any time in their life and the stories of these people are truly moving and shaming, especially as we live in one of the richest countries in the world. Adults who are only provided with two assisted showers a week and parents providing 24/7 care to profoundly disabled children but who cannot afford a new specialised wheelchair because there is limited funding for such things (wheelchairs cost from $500 for the basic models, of which I have two, and range up to $20,000 or more). In August 2011 The Productivity Commission reported on and recommended the NDIS and since then pretty much everyone agrees it is a good idea if we could only agree how to fund it.

So what does it replace? Currently most people with serious disabilities that prevent them from, inter alia, working, can receive the disability support pension (DSP). A small number will have insurance payouts if they were “lucky” enough to to have someone else to blame for their disability. In addition, anyone can receive a rebate on medications in excess of about $1,200 a year and, of course, access to (not quite free) public health care. On top of that, there are concession cards for public transport and a taxi card system which provides half-price taxi fares to partially make up for many disabled peoples inability to use public transport. The DSP does not depend on a specific disability and for a single adult over 21 with no children it is about $19,000 a year. For child under 18 who is living at home it is about $9,000 a year. While this would appear enough to live on (forgetting overseas holidays or a mortgage) most such people rely on additional support services for everything from basic medical equipment to respite for carers. There are currently 820,000 people, about 4% of the population, on the DSP. The Productivity Commission estimates 440,000 people on the NDIS so most of these will not be eligible for the NDIS but may still receive the DSP. People 65 and over of pensionable age are not eligible for the DSP and will not be eligible for the NDIS.

The purpose of the NDIS is to provide funding for care in line with the specific requirements of the recipients, and will mean additional support to the DSP for some. You can read more about it at ndis.gov.au. Unlike the DSP, it isn’t a fortnightly stipend or, like standard disability or employment insurance, a lump sum. The government is planning to roll out pilot programs in many regions in the next few years, aiming for a complete national program by 2018-19. I won’t go into the politics but it seems even politicians can feel shame and  bipartisan support for the NDIS is emerging with a good chance of a bill through this parliament in the next few weeks. The total cost of the NDIS is often quoted as $18bn a year. Some funding is proposed from an additional 0.5% to the Medicare levy. Other funding wil come jointly from the federal government and the states. The proposed levy will raise about $3.8bn a year, so nowhere near enough for the full cost. If you subsume the half the DSP cost of $11bn a year that (only) leaves an outstanding amount of $8-10bn a year to be funded even with the Medicare Levy. Hopefully with bipartisan support the full NDIS will be implemented sooner rather than later.

So that’s the background on the NDIS. The real purpose of this article though is to consider the question “How many disabled people are there in Australia anyway?”.

Well that’s easy, just read any article on disability–for instance this one by disability advocate and media personality Stella Young–and you’ll be told the answer: 20%. 20%. 20%! I am a huge admirer of Stella Young’s work, so don’t get me wrong if I choose to disagree with her on this. The 20% figure gets quoted so frequently it must be true. Well maybe. People questioning this figure are directed to the 2009 ABS Census report on disability where the self-reported disability figure is 18.1% (+/-1.3%). So a round 20% is not too bad, right? Well like all statistics, the details are important. Firstly this includes people of all ages and, not surprisingly, many more older people have disabilites. From 40% at 65-69 to 88% at 90+. For those under 65 the figure is 13.2%. It increases with age and, in the 45-54 age group, is about the average 18%. Anyway why does it matter if the true figure is overstated? Well one reason is that while there is widespread support for the NDIS, the one concern that keeps coming up is who is eligible.

According to the Productivity Commission report they estimate 440,000 people on the NDIS of whom 330,000 would be disabled, and the rest made up of carers and people on preventative programs.

This report has a deeper analysis, which takes the figures at face value. It also includes breakdowns by disabling condition. I have paraphrased these in the following table based on some of the major causes of disability. And look, there are those perennial favourites of those who think all disabled people are really bludgers: back problems,stress and depression, making up about 18% of the total. Not quite bankrupting the country then.

But what constitutes disability? It is basically a lack of normal activity rather than a set of diseases per se. The ABS report has 5 activity based categories, four of which are based on “restrictions on core activities: communication, mobility, self care”. There are “profound”, “severe”, “moderate” and “mild” levels of disability. A fifth category is  “schooling or employment restriction”, but overlaps with the first four. Here is a table with the breakdown by category and age group. Combining those with a core activity limitation with employment/school limitations the figure is 15.3%. The difference between this and the higher self-reported 18% figure I suspect comes from peope who feel a bit crap a lot of the time, but aren’t signficiantly prevented from their activities. So I would estimate the number of disabled people to be more like 15% than 20%. For those under 65 this is 11%. The NDIS has a similar definition but includes social activities as well, but don’t yet provide any breakdowns.

So much for the figures from the ABS, which I think we can all agree are definitive, right?  Looking at the ABS figures for this group (under 65) they total 345,000. But wait! The figure of 15.3% is based on a total number of respondents to the census of only 9.5 million people. If the reportage rate was the same as the general population of 22m then there would be about 700,000 severe or profoundly disabled people. But the Productivity Commission only estimates 330,000 or half this number on the NDIS! The alternative to the unlikely event that less than 50% of profoundly or severely disabled people will end up on the NDIS is that the reported ABS figure for people in this category is correct but the rate is wrong. While the overall reportage rate is about 50% it looks like the reportage rate for disabled people in the severe and profound category is closer to 100%. If this was also true for the other categories of disabled people then that suggests that the real rate of disability is less than 9% and maybe as low as 7%. Assuming the reportage rate is the same as the rest of the population, ie 50%, for the other categories then the disability rate might be as high as 13%. So lets split it and say 10%. In any event the widely reported figure of 20% is well above the highest estimates based on the ABS and Productivity Commission data. The real rate of disability is closer to 10% than 20%.

Does it matter? Maybe. If you claim that 20% of the population are disabled, people start quickly calculating that the cost is unsupportable if all of those people are on the NDIS! Which of course they won’t be. Fewer than half of disabled people are already on the DSP. Less than half of those will transfer to the NDIS. Overstating the percentage of disabled people isn’t necessarily a good argument for the NDIS if it reduces support from otherwise sympathetic people.

A final thought: in the large Australian organisation I work for, there are a fair few disabled people, some of whom I think would be categorised as severe. With proper support many disabled people can gain suitable education or training and hence employment and support themselves and contribute to the economic activity of the nation. The more people with disability who are employed the fewer on the DSP or NDIS, the more money for those who really have no choice. Supporting people with disability into employment is as important, in my opinion, as supporting them in living and care through the NDIS.

[This article was rewritten following some comments and some further research. In line with all my articles on Stubbornmule this article is about estimating rough numbers from scarce data "back of the beercoaster" style rather than disability politics, it just happens I have a personal interest in this subject]

I spend a lot of time trawling the internet for data, particularly economic and financial data. Yahoo Finance and Google Finance are handy for market data and “FRED”, the St. Louis Fed is an excellent, albeit US-centric, resource for a broad range of financial aggregates. While these sites make it very easy to automate data downloads, most sites (including, unfortunately, the Australian Bureau of Statistics) provide data in Excel format or other inconvenient forms. At times this has become sufficiently frustrating that I have periodically entertained vague plans to build my own time-series data web-site that would source data from across the world and the web, making it available in consistent, useful way.

Needless to say, I never got around to it, but it seems that someone else has. Today I stumbled across Quandl, which aggregates and re-publishes over 5 million time-series. The data can be presented as charts on their website, downloaded or accessed programmatically through their application programming interface (API). There is even an R package available to make it easy to load data directly into my favourite statistical package, R.

Here is an example of how it all works. Quandl has data on the Australian All Ordinaries index. To read this data into R, you will first need to register with Quandl and obtain an authentication key for the API. This key is a random string, which looks something like this jEGfHz9HF7C3zTus6ZuK (this one is not a real key!). Once you have your key, you can fire up R and install and load the R package by entering the following commands:

install.packages("Quandl")
library(Quandl)


Once this is done, you will need to find the Quandl code for the data you are interested in. Near the bottom of the Quandl page, there is a pane showing the data-set information, including the provenance of the data.

Armed with the text labelled “Quandl Code”, in this case “YAHOO/INDEX_AORD”, you now have everything you need. I will assume you already have the ggplot2 and scales packages installed. To plot the history of the All Ordinaries, simply enter the following code (replacing the string in the third line with your own authentication key).

library(ggplot2)
library(scales)
Quandl.auth("jEGfHz9HF7C3zTus6ZuK")
aord ggplot(aord, aes(x=Date, y=Close)) + geom_line() + labs(x="")

I can see I am going to have fun with Quandl. It even has Bitcoin price history. But that is a subject for another post.

Once again a misconception is gaining currency. There is increased talk of a build up of cash just waiting to be converted into equities or other assets. I wrote about this years ago in cash on the sidelines, but apparently the financial commentariat did not read the post, so it is time to revisit the subject.

I believe that the reason the misconception is so widespread is that the subject is not discussed in technical terms, but in metaphors. Some of you have heard the phrase “the great rotation”, which refers to the idea that investors will shift en masse from cash and bonds to shares. It’s a compelling phrase, but it leaves one question unanswered: who will sell the shares to these rotating investors and, given that these sellers will be paid for their shares, what happens to the money they receive? It’s still cash after all. Likewise, if these rotators are selling their bonds, someone has to buy them. Post-rotation, there is still just as much cash in the system and just as many bonds. Cash and bonds don’t just magically turn into shares. Reality is messy…why spoil a good metaphor?

A simpler, more dramatic and more vacuous metaphor that has also made a reappearance is the “wall of liquidity”.

No one using this compelling phrase would be so crass as to explain what it means. Such is its power, it is assumed that we all know what it means. So, let’s have a look at “wall of liquidity” out in the wild. In an article about rising bank share prices, Michael Bennet wrote in The Australian:

But pump-priming by global central banks has created a so-called wall of liquidity looking for income that is flowing out of cash and into high-dividend-paying stocks, with banks attractive due to their fully franked dividends.

Here it certainly sounds as though “wall of liquidity” is just “cash on the sidelines” in a fancy suit. But let’s zero in for a moment on the other metaphor in this sentence, “pump-priming”. Doubtless, the author has the US Federal Reserve (Fed) in mind. The standard line runs something like this: with low interest rates and purchases of securities through the “QE” (quantitative easing) programs, the Fed has flooded the banks with liquidity. More prosaically, reserve balances (i.e. the accounts banks have with the Fed) have grown. So far so good, as the chart below shows.

The next step in this line of thinking is that as this cash builds, it is a “wall of liquidity” desperate to find somewhere to go and, in the quest for investments, it will push up asset prices.

But before we can accept this reasoning, there is an important point to note. Reserves with the Fed are assets of banks only. Contrary to a common misconception, these reserves cannot be lent, they can only be shuffled around from bank to bank. Nevertheless, there is a theory that, because in the US and some other countries, a certain percentage of bank deposits must be backed by reserve balances, there is a “money multiplier” which determines a fixed relationship between reserve balances and bank deposits*. If this theory is correct, bank deposits should have grown as dramatically as reserve balances. They have not.

Taking the same chart and displaying it on a log scale shows that growth in deposit balances has been very steady over the last 20 years.

Whatever is going on in financial markets, it has nothing to do with a dramatic build up of cash which is poised to be converted into “risk assets”.

Yet another way to see this is to think about what is going on in Australian banks at the moment. Credit growth is slow in Australia. This is not because banks are reluctant to lend. Quite the contrary. Banks are looking at the slow credit growth and fretting about their ability to deliver the earnings growth that their shareholders have come to expect. The problem is that there is a lack of demand for credit as households and businesses continue to save and pay down debts. In response, banks have begun to compete aggressively on price and, in some cases, on terms to attempt to grow the size of their slice of a pie that is not growing. And yet these very same banks continue to compete for customer deposits. Australian banks are not sitting on vast cash reserves that are compelling them to lend. Rather it is simply renewed risk appetite that is driving banks to compete for lending.

The same is true around the world. Looking at cash balances as a sign that yields will fall and asset prices will rise is a pointless exercise. What is happening is much simpler. Animal spirits are emerging once more. Low interest rates (not cash balances) will help, but fundamentally it is risk appetite that drives markets.

The last time I heard people talking in terms of walls of liquidity was in 2005-2006 in the lead-up to the global financial crisis. These putative piles of cash were used to support a change of paradigm in which the returns for risk could stay low indefinitely. Of course this turned out to be dramatically wrong. The cash didn’t disappear, but risk appetite did. I am not predicting another crash yet, but I do foresee this nonsense being used to justify more risk-taking for lower returns. If that happens for long enough, then there will be another crash.

* As an aside, given that Australia has no minimum reserve requirements, if the money multiplier theory was valid, there should be an infinite amount of deposits in the Australian banking system. For the record, this is not the case.

Photo credit: AP

Here is a rant about events in Cyprus. Normal dispassionate service will resume here at the Mule in the next post.

Over the weekend, the European crisis took a sickening new twist in Cyprus. The government of Cyprus announced a “levy” on Cypriot depositors as part of a deal to secure a bailout of its ailing banks by international lenders. In doing so, it has dramatically demonstrated how completely Cyprus and other eurozone nations have surrendered their sovereignty to the technocrats of the European Commission, the European Central Bank (ECB) and the IMF.

The president of Cyprus Nicos Anastasiades has told his citizens, subject to getting the numbers in parliament, his government is about renege on past promises and appropriate the savings of pensioners to make good the failings of others. This is not the first time that the global financial crisis has claimed innocent victims, but it is perhaps the most striking example of this phenomenon.

Cyprus’s financial woes stem from the fact that their banks had significant investments in Greek government bonds. Back in March 2012, as part of the bailout of Greece, investors in these bonds suffered a “haircut” of 53.5%. Somewhat less euphemistically, holders of these bonds lost more than half of their investment. This left Cyprus’s banks in deep trouble and, while negotiations with Europe for a bailout continued, the ECB kept them afloat with emergency funding. The threat of suspending that ECB support was the gun to Anastasiades’s head that led him to agree to the disgraceful bailout scheme.

As the European crisis has rolled on, the European technocrats have become increasingly committed to “private sector involvement” (PSI). At face value, the principle is sound. The use of public money to rescue private sector banks leads to moral hazard. If lenders to banks expect to be bailed out, they may be tempted to allow banks to be ever more reckless in their risk-taking.

When a bank suffers losses, there is a hierarchy that determines who will suffer losses. The hierarchy typically works like this: investors in the bank’s shares are the first lose their investment; next to lose are investors in so-called “hybrid debt” (not quite lending, not quite equity, this includes things like preference shares); if the bank has issued “subordinated debt”, investors in these securities come next, followed by “senior debt” providers (typically in the form of bank-issued bonds). Depositors are the last to lose money and retail depositors with small balances typically have additional protection in the form of deposit protection provided by the government or a government agency*.

Depositor protection is extremely important. Despite being private companies, banks provide a critical role for the smooth running of an economy and so cannot be left at the mercy of the “creative destruction” of capitalism. In today’s society it is not really possible to opt out of the banking system and simply being paid a wage requires a bank account. It would be impractical, inefficient and unreasonable to expect every retail depositor to analyse the financial health of their bank before choosing where to deposit their money. When a bank collapses, shareholders should lose money. Wholesale investors should lose money. Retail depositors should be protected.

This reality is not lost on the lawmakers of Cyprus and for over 10 years, Cyprus depositors have supposedly been provided with deposit protection on balances under €100,000. The details of the levy have not yet been finalised, but the initial proposal involves a levy of 9.9% on all deposit balances over €100,000 and 6.5% on all deposits below €100,000. Anastasiades has effectively said, Oh, that deposit protection scheme? Well we had our fingers crossed when we made that promise. That explains the weasel word “levy” or “tax”. Of course your deposits are still protected against losses. You will not suffer a loss, it’s just that there’s a new tax we’re bringing in…

As if this dramatic breach of faith was not enough, there is no moral justice here either. Like Ireland before it (and indeed Australia), Cyprus did see rapid growth of private sector debt in the lead up to the crisis. So why not levy the tax on reckless borrowers not prudent savers?

Cyprus should rue the day that it surrendered its sovereignty by joining the euro zone in 2008. Cyprus would still be facing economic challenges today, but it would be free to determine its own fiscal policy, stimulate the economy (if it managed to keep politically-motivated deficit hawks at bay) and, of course, it would be able to honour its promise to protect retail depositors.

* Before the financial crisis, Australian depositors had no deposit protection. The assumption was that prudential oversight of banks provided sufficient protection for depositors. That changed after the crisis and now deposits below $250,000 are protected.

I have been digging through some family archives and came across an old bank passbook belonging to my great grandfather, William Booth. He lived in Perthville in the central west of NSW. His account was with the Bank of New South Wales, Bathurst branch.

Pasted inside the front cover is a statement of the account keeping fees. I was born after decimalisation, so 5/- was not immediately meaningful to me. It turns out that the semi-annual fee is five shillings. To complicate matters further, the first transaction in the passbook is dated 1903, so these are British shillings. Australia did not introduce its own currency until 1910.

Having worked out that much, I was interested to compare 1903 account keeping fees to account keeping fees today. So, the next step was to convert five 1903 British shillings into present day Australian dollars. The website Measuring Worth comes in handy for this purpose. The site’s banner features the following quote from Adam Smith’s The Wealth of Nations (1776).

The real price of every thing, what every thing really costs to the man who wants to acquire it, is the toil and trouble of acquiring it… But though labour be the real measure of the exchangeable value of all commodities, it is not that by which their value is commonly estimated… Every commodity, besides, is more frequently exchanged for, and thereby compared with, other commodities than with labour.

With that in mind, it provides a range of present day values for five 1903 shillings. Well, almost present day: their data series extend to 2011, so in 2011 terms five shillings is worth any one of the following

Back in the day of William Booth, account keeping involved someone manually reconciling three columns of pounds, shillings and pence. These days the process is computer-assisted, so a retail price adjustment may be more appropriate than average earnings or any of the other measures.With UK inflation running at 2.6% over 2012, I can tweak £22.00 to £22.57. Using the current exchange rate, that amounts to A$33.33. Strictly speaking, even though Australia used British pounds in 1903, I should use an Australian retail index, but as Measuring Worth only has US, UK, Japanese and Chinese conversions at the moment, I will stick with the British approach.

So, Mr Booth was paying just over $5 per month in service fees for his banking. The Bank of New South Wales has since become Westpac. According to the Westpac website, the monthly service fee for the “Westpac Choice” transaction account is $5. Fees at other banks would be very similar. So, perhaps surprisingly, account keeping fees seem to have changed very little over the last 110 years!

Given the level of automation in banking today, it would be reasonable to expect that fees would be lower than they are today. Certainly if the five shillings were adjusted based on average wages, the cost of Mr Booth’s account keeping would be more like $20 per month. Not only that, like every other bank, Westpac also offers a basic account option with zero account keeping fees. I am sure that would not have been an option in 1903.

A favourite podcast of mine is known in our household as “Danny’s podcast” in honour of the friend who first put me on to it. The podcast is better known as Radiolab and last week’s episode turned on the theme of Speed. After answering the question, what is the fastest sense, attention turned to high-frequency trading. As the Radiolab hosts are more comfortable with science than finance, they turned for assistance to David Kestenbaum from the Planet Money podcast.

In a past Mule post, I expressed reservations about the merits of high-frequency trading. Just last year, there was talk in the European parliament of enforcing a delay on electronic trading. Some critics argue that high-frequency trading creates instability in financial markets and may have been to blame for the “flash crash” of 2010.

One of the more intriguing aspects of high-frequency trading was brought out in the podcast during an interview with a technologist from the US trading firm Tradeworx. Bemoaning the cost of constantly competing to allow faster and faster trading (millions of dollars are being thrown at shaving milliseconds from the time to send trades to an exchange), he said that high-frequency traders were caught in a prisoner’s dilemma.

The prisoner’s dilemma is a staple of the study of the branch of mathematics known as “game theory“, which seeks to analyse strategic decision-making. Here is a quick overview for anyone unfamiliar with it.

Two criminals are arrested and taken to separate cells to ensure they cannot communicate with one another. The police have enough evidence to send each man to jail for one year. With a confession the police could get a conviction on a more serious charge. So, the police point out to each prisoner that cooperation will help reduce their sentence. If neither prisoner confesses, both will face one year in prison. If one testifies against his partner in crime, he will go free while the partner will get three years in prison on the main charge. But, if they both confess, that cooperation is not worth as much and both will be sentenced to two years in jail.

So, what should each prisoner do? No matter what the other prisoner does, confessing will improve their outcome, either from one year to none if the other does not confess, or from three years to two if the other does confess. So, the only rational thing to do is to confess. If both prisoners follow this logic, they will both get two years. And yet, if they had both kept quiet, it would have only been one year each, which would be better for both of them. The problem is that the “global optimum” is hard to obtain because there is too much of a risk for each prisoner that the other will defect.

The same is true for the high-frequency traders. While it might be cheaper for all of them to call a truce and freeze their technology at its current state, there would always be the risk that one firm breaks the truce and gains an edge. So, they all continue to compete in the speed race.

But the prisoner’s dilemma applies to more players than just the trading firms themselves.

If one of the major exchanges, such as the NASDAQ tried to stop the speed race, then it may well find itself losing business to any other exchange which continued to facilitate faster trading. An exchange without trading does not last long.

Governments too face the dilemma. There is already intense competition between exchanges operating in different countries and no government would want to lose the kudos and, more importantly, revenue that comes with playing host to a major financial centre. Would the UK government, for example, want to put London at a disadvantage to Europe or the US? Unlikely.

The German government is now delaying plans to curb high-frequency trading, in order to “clarify technical details”. I suspect that this will turn out to be a rather long delay.

It has been quite some time since I wrote about the mechanics of money, but today I am at it again. The catalyst is not, as some might expect, the recent discussions about the possibility of the US Treasury minting a trillion dollar coin, but rather a recent discussion I had with a banker about deposits on a small tropical island.

While deposit levels at banks in Australia are below upcoming regulatory minimums, leading to intense competition in the pricing of term deposits, the banker I spoke to was facing the opposite problem in the small nation of Paradise Island (not its real name).

As he told the story, despite offering rather unattractive interest rates on deposits, deposit balances had continued to grow. Worse, demand for loans was weak and so the bank was forced to keep growing balances on deposit with the island nation’s central bank. Since banks like to diversify their investments, this situation was not ideal. Ordinarily, he said, deposits would build up as exporters took in payments for their goods, but periodically these balances would be swept out again as they remitted their profits to offshore parent companies. This did not seem to be happening any more. Exactly why these deposits were growing was a mystery and, short of closing the doors of all their branches, he did not really know how to stop these balances from growing.

With years of reading Bill Mitchell under my belt, I knew that the way to think about this question was to take a macro perspective rather than thinking from the perspective of one bank.

The first thing I focused on was the balances with the central bank. A popular misconception is that banks can choose between holding deposits with the central bank or lending the money to their customers. In fact they cannot. The central bank itself only has two types of “customer”: banks and the government. You and I cannot walk into the central bank and open up an account. This means that the only thing that can happen with central bank balances is that they move around from one bank to another or to and fro between the government and banks.

Imagine for a moment that the bank arranges a $100,000 loan for me to buy a nice little shack on one of Paradise Island’s beaches. If the shack vendor banks with my bank, then our bank will see both its loans and its deposits increase by $100,000. On the other hand, if the  vendor banks elsewhere, my bank will have to transfer $100,000 to the vendor’s bank. This is done by moving money between the banks’ respective  accounts with the central bank. So, in this case, my bank has an increase in its loans of $100,000 and a decrease of $100,000 in its deposits with the central bank. But that central bank deposit has not left the system (and it has not gone to me). Rather, it has moved from one bank to another.

While there will be movements in central bank balances in this fashion from one bank to another in the normal course of business transactions, balances will tend to average out to reflect each bank’s market share. So, my banker friend is unlikely to be alone in seeing deposits with the central bank growing. Indeed, looking at the aggregate bank balances with the Paradise Island central bank, it becomes evident that there is a systematic trend.

Aggregate Balances with the Central Bank

So how does this happen? The most likely explanation is that the balances are coming from the government. As the government spends money, behind the scenes there will be money moving from the government’s account at the central bank to the accounts of commercial banks. This can happen if the government is running a deficit, spending more money than it is receiving. But that is not the case here. In fact, Paradise Island has been running a surplus of late.

A bit more digging through the national accounts reveals the answer. Paradise Island receives aid from larger developed nations and the  government has been spending most, but not all of this aid. The twist is that this aid has come in the form of foreign currency, which the government then deposits with the central bank in return for local currency balances which it is then able to spend. As a result, the central bank’s foreign asset balances have also been steadily growing. The similarity of these two charts is no coincidence: the two sides of a balance sheets must balance and the growth in the central bank’s assets directly mirrors the growth in their liabilities, in the form of commercial bank deposits. This is an example of what is known as “grossing up the balance sheet”.

 Foreign Assets of the Central Bank

So the growth in bank deposit balances with the central bank has nothing to do with Paradise Islanders hoarding money or choosing not to remit their profits offshore. Instead it is the direct result of the government spending its aid money. If the local banks want to have less of their money tied up in deposits with the central bank, rather than pointlessly trying to incentivise their customers to borrow or place their deposits elsewhere, they should consider encouraging the central bank to sell some of their foreign assets, reversing the grossing up of the balance sheet.

For me the most interesting aspect of this discussion is the fact that even if you can see exactly what is going on inside your own institution, it can be difficult to understand the workings of the system as a whole.

The Mule is travelling and, while he contemplates possible posts by the sea, regular guest contributor James Glover has stepped in with an analysis of applause.

It may seem indulgent (and possibly non productive) but Friday Afternoon Physics (FAP) like Friday Afternoon Maths is one of my favourite activities. It is also the holiday season and as the owner of this blog is busy counting echidnas down south I wanted to share what is so far my favourite FAP for 2013.

The question is: why isn’t it the case that the more people are clapping in an auditorium that the volume actually decreases?

Now this may seem like a dumb question. Surely the more people clapping = more noise = louder. Right? Well except that it isn’t true. Noise cancelling headphones work by detecting the incoming noise signal and producing a signal of exactly the opposite shape. Detected sound (by our auditory system – ears + brain) is a variation in the ambient pressure. So noise cancelling headphones actually produce, on average, a slightly higher pressure as they carry energy from both the original signal and the noise cancelling signal. Your ear drums don’t care what the overall pressure is though (up to a point) just the differences. An electrical device can’t easily produce an exactly cancelling sound but it can produce a sound with the opposite signal at the same average pressure. So if a lot of people are clapping randomly then while this increases the overall pressure the differential contributions tend, on average, to cancel each other out.

This just doesn’t just seem counterintuitive but experience suggests that the clapping in a room with more people is louder than a room with less people. But it would appear mathematically to be correct. Just as the average of a sequence of random variables has a smaller average amplitude from the mean (the standard deviation) so it must be the case that the more people in a room clapping will have a higher average pressure (not detectable by our auditory system) but also a lower variation (which is what we detect as volume).

Our solution: people nearby are less likely to average out than people far away. If we divided the room into people nearby (say under 25m) and those further out it would appear that the smaller contribution from those further out is not just because they are further way but because there contribution actually evens out. It raises the overall pressure but not so much the apparent volume. In fact in the simplest models it would actually decrease the more people there were present!

My insight is this: next time you are in a concert hall with say 1000 people compare the apparent volume with say a hall with 10,000 people. It would be deafening if it scaled up with distance alone. I am not sure about this but it appears to be true.

My final piece of evidence for this is the following: modern concert halls try to reduce unnecessary echoes, but total reduction of echo is bad. They used to do this by adding partial noise absorbing materials to the roof and walls. That is a disaster. A concert hall without echoes is a soulless place. Modern concert halls add random topographical features (usually in the ceiling at eg. random heights) that produce decoherence. Decoherence means the sound waves reflected back have different phases and hence quickly (but not too quickly) are undetectable as they tend to cancel each other out. The refurbishment of Hamer Hall in Melbourne did exactly this. So the solo horn in Brahms First Piano Concerto reflects but doesn’t reverb. Something similar happens with those noise “reduction” walls you see along freeways. They don’t absorb noise but all those cockatoos and gum leaves act to randomise the noise signal from the highway and even it out – the ear doesn’t notice the increase in average pressure but enjoys the decrease in variation.

Friday Afternoon Physics is good. It doesn’t lead to Nobel (or IgNobel) prizes but occasionally leads to Back of the Beer Coaster Calculations. Just prior to our discussion of this question we also worked out that 2-3 tankers a day could supply Melbourne with fresh water from Antarctica. But that’s another post.

Editors note: the echidna count so far has been zero.

Even if you haven’t heard of Jon Ronson, you have probably heard of one of his books. He wrote The Men Who Stare At Goats, which has been made into a film starring George Clooney. I have just finished reading a more recent, if lesser known book by Ronson: The Psychopath Test. It is an intriguing, anecdotal exploration of the nature of madness, with a particular focus on psychopathy.

The book is loosely centred on the psychopath test of the title, better known as the Hare Psychopath Checklist in honor of its creator, Canadian psychologist Robert Hare or, more simply, PCL-R (“Psychopath Checklist – Revised”). On his journey towards a better understanding of anti-social madness, Ronson attended a training course in the use of the PCL-R led by Hare himself. Armed with this qualification, Ronson found his new ability to expertly identify psychopaths out in the wild gave him an exciting sense of power. It is a sense of power that readers such as myself can readily share: it wasn’t long before I was attempting to spot corporate psychopaths in the upper echelons of my own place of work.

Here is how the test works: through a more rigorous interview process than I have had the opportunity to perform, your potential psychopath is scored on a scale of 0 to 2 on each of the categories below.

1. Glibness/superficial charm
2. Grandiose sense of self-worth
3. Pathological lying
4. Cunning/manipulative
5. Lack of remorse or guilt
6. Shallow affect
7. Callousness, lack of empathy
8. Failure to accept responsibility for own actions
9. Need for stimulation/proneness to boredom
10. Parasitic lifestyle
11. Poor behavioural control
12. Lack of realistic long-term goals
13. Impulsivity
14. Irresponsibility
15. Juvenile delinquency
16. Early behaviour problems
17. Revocation of conditional release
18. Promiscuous sexual behaviour
19. Many short-term (marital) relationships
20. Criminal versatility

Roughly speaking, a score of 30 or more suggests you have a psychopath on your hands. Reading Ronson’s book, I got the impression that there are currently few treatment options for a psychopath and those that veer towards criminality rather than high-flying success in the corporate world tend to be locked up for a very long time.

Over a sherry at a recently opened Spanish bar in Sydney, with the help of a colleague, I attempted an analysis of the executive at my firm I considered to be the best prospect for a high score on the PCL-R. Sadly, we only managed to chalk up 20 points. Apparently not a psychopath after all and, while that score is still reasonably high, I have to further concede that there may have been some overly-enthusiastic interpretations of the checklist involved in the assessment.

My own attempt at psychopath diagnosis brought me to sympathise further with Ronson, who found that the thrill of power was, after a while, replaced by doubt. Perhaps things are actually a bit more complicated after all. Even an interview with Al Dunlap, initially a slam-dunk candidate for the label of corporate psychopath, particularly given his extensive collection of statues of animals of prey (psychopaths apparently tend to see the world in terms of predators and prey), left Ronson uncertain of the appropriateness of the label of madness.

The lesson then is that I should use my new-found knowledge of PCL-R with care. As should you. Even so, I will not delete the list from this post as a precaution. After all, you could easily find it on Wikipedia; such is the power and the peril of the internet.