The problem of peer-to-peer financial system

There are many peer-to-peer financial platforms currently. However, there are many problems existing in the system. It has very high transaction costs and adverse selection problems. The amount asked by one borrower does not always exactly matches one existing potential lender, which means a lender may split his/her available funds or a borrower may need to ask for loans from several different lenders. This increases the transaction costs. Moreover, traditional banks have experts to analyze their borrowers' credibilities, but individuals may spend huge amount of time and resources on researching one lender. Some individuals may not be willing to spend too many resources on doing research, and borrowers tend to hide information from their potential lenders, then the problem of adverse selection appears. People believe that borrowers who borrow from the peer-to-peer platforms are highly risky, as they are not qualified to borrow from traditional banks. Therefore, I think the peer-to-peer platforms are platforms that offer individuals to buy smaller amount high yield bonds, there is no any magic in it.

People are becoming more diversified

People will become more and more diversified in terms of all aspects. In modern days, we have so many choices that we are easier to find something which is closest to our preference. Moreover, firms like non-price competitions rather than price competitions in order to have relatively higher revenues, especially they like differentiating their products from their competitors'. Such competitive strategy does not just give consumers more choices, but also make consumers self-correct their preferences and make consumers' preferences more complicated and diversified. Therefore, people's preferences are becoming more and more diversified. Moreover, people's skills, knowledge and information will be more and more diversified. We know that we cannot know all skills, knowledge and information, then we will make our own choices to learn some of the skills, knowledge and information. This will make people's knowledge, skills and information more and more diversified when there is an increase in skills, knowledge and information, which has been happening. In general, we can find people's preferences and capabilities becoming more diversified, which can cause people may become self-centred as they find fewer and fewer similarities with other people.

Where are we heading?

The Industrial Revolution centuries ago has made huge changes on our civilization in terms of the class structures, employment, the whole production process.  The importance of labour force has been diminishing over time since then. Currently we agree that manual labour is disappearing in our economy. People who have skills that machines do not have will be more employable. However, currently people are keen making machines smarter which makes the entire population less employable; therefore, people need to be educated longer in order to stay competitive. I think that the length of people being education will become longer and longer in order to set into the increasingly competitive labour market.

The end of OPEC

I read an article called "The Death of Opec", by Ed Crooks. He points out that there are many signs showing that the cartel is failing to unite together and form some sort of production freezing agreement. As I argue in one of my previous articles that once one member of a cartel cheats on other members, the cartel is about to collapse, the action taken by Saudi Arabia of increasing its supply contributes to the collapse of the OPEC. However, we will not see a big dramatic fall in the oil price, as although the cartel may collapse (the member countries cannot unite together and play a monopoly strategy), the oil market is still an oligopolistic market that the oil price will still be higher than a perfectly competitive market. Therefore, I think that the oil price will stay relatively stable unless there is some major innovation in the energy field.

Taxes and saving habit

Mr Abe's comment in meeting with other G7 leaders shows that he is likely to delay the previous planned increase in consumption tax. An increase in the tax can cause a decrease in consumption as it makes goods and services more expensive. However, as we know that the Japanese government has put much effort to increase the domestic inflation, the increase in tax may help to achieve this, if there is a social habit of saving. When the tax increases and people have sufficient income and savings, people need to reduce their savings to spend on consumption in order to maintain their original standards of livings. Japan is a country that has a social saving habit; therefore, I think that if the Japanese government can choose to increase taxes on consuming specific goods and services, it can help to reduce the people's savings, improve the government budget without reducing much consumption in the economy. The increase of government incomes from taxes can help to increase the investment level in the economy, which is another encouraging reason to increase taxes.

The fall in the US productivity should not be a surprise

Productivity is generally expressed as ratio of outputs to inputs in the production process. Productivity in the US is reported to fall for the first time in more than three decades. The productivity is measured in GDP per hour, which is actually the labour productivity. A fall in the productivity may not be caused by a lack of investment in innovation, as what Bart van Ark, the Conference Board's chief economist stated; it could be caused by firms' optimism about the future economic performance. In recent years, the US has very strong employment growth while the GDP growth rate is disappointing compared with the employment rate. This shows the output (GDP) grows much slowly than the input (employment) grows. Therefore, people should not be surprised about the fall in productivity. The reason for the firms to employ more people, despite their outputs grow narrowly, is largely because they believe the economy will lift up and the increase in their labour force can help them to take advantage in this coming economic boom. 

The tax avoidance crackdown could lead to a fall in the markets

Without cooperation across nations, multinational companies could avoid tax payment in high tax rate countries by transferring profits within the companies. However, currently nations work together to crack down the tax avoidance system. The companies will have to pay higher taxes in the future. This definitely will affect the companies' earnings; moreover, it could also affect the financial markets, especially the equity market. Additionally, their abilities to pay back loans may be affected by the reduction in their earnings after tax. Therefore, the governments could reduce their budget deficits, but if the pension funds are affected by the fall in the financial markets due to the reduction in companies' earnings after tax, the governments may have to increase their deficits to help the pension funds.

Deflation may lead to a permanent increase in the unemployment rate given certain causes of the deflation

Deflation by definition is a decrease in the general price level, which may be caused by a cut in the money supply, a decrease in costs of production and many other reasons. Deflation is a bad sign of the economic performance. When there is a deflation, there will be a decrease in the number of financial activities as well as consumption. However, such phenomenon can lead to an increase in the unemployment rates. When the deflation is caused by factors such as a decrease in costs of production, firms will cut their labour force and maintain or even reduce their previous production levels. Then the deflation problem can be solved as there is no excess supply in the market. The inflation level will be amended to the normal level; however, the unemployment rate increases permanently. Therefore, we may see increases in both the unemployment rate and the inflation rate, which violates the Phillips curve.

National boundaries affect the efficiency of resource allocation

In many developed countries, there is a deflationary pressure, which prevents the central banks from raising their base rates. However, in some developing countries, there is a huge inflationary pressure. The deflationary pressure could be seen as there is an excess of supply in the market; similarly, the inflationary pressure could be seen as there is an excess of demand. This creates an inefficient resource allocation that there are too many goods and services allocated in the developed economies. National boundaries limit the transporting of work forces, raw materials, goods and services across the boundaries. Therefore, I think that national boundaries prevent an improvement in our economies. However, I think that the real solution to solve the problem of deflation is to produce new types of goods and services that most people are willing to have by taking advantage of the technological innovations.

Being a pessimist or an optimist

We are loss aversive that we weight losses greater than gains. However, we are not pessimist in the market. Everyone knows there will be a recession ahead, it is just the nature. Being a pessimist means people in the market will have no incentives to make any move in the market. As we can see this is definitely not true. My opinion is that people are pessimist for immediate changes and optimists for the long term. Negative information may cause panic in the short term, but in the long term, people’s behaviour will not be affected.

What could happen if the Fed increases the rates

As I discussed yesterday that the market could overreact to the Fed's decision, then the market will fall. This could lead to an increase in the cost of financing, as when prices are falling, it is more expensive for firms to raise funds from equities, meanwhile the increase in the interests also increases the cost of raising liquidity from borrowing. Therefore, if this comes true, then the US economy is very likely to fall into a recession.

The Game between the Fed and the market

When the Fed announces a rise in the interest rates, the market generally responds negatively. The decision of increasing the interest rate made by the Fed aims to cool down the overheating market; however, the Fed does not want the market to overreact to its decision. However, the market may have incentives to overreact the Fed's decision, as the rise in the interest rate is unwelcome and overreaction may force the Fed to reconsider its decision. Therefore, the Fed may leave some room for the market to overreact when sending its message. However, this could affect the Fed's credibility. To gain a full credibility, the Fed has to send its accurate message and refuse to reconsider its choice when the market is overreacting. This generates another problem that the overreaction of the market should be overheated with exogenous information, leading to an actual collapse in the market. Therefore, I think the contractionary policies of any central bank are highly risky, especially when the market is less risk averse (the safe net built by the governments could affect the financial institutions' risk behaviour), as they are very likely to have the following two results: the market overreaction overheated by exogenous factors leads to an actual collapse of the market as well as the economy, or the Fed reconsiders its decision and the market is happy until the bubble eventually bursts inevitably.

The most rational outcome of the oil market should be a stable and relatively high price

Currently, some analysts suggest that there is a shortage of oil supply in the market. The oil price has reached the peak in 2016. The OPEC countries have started to control their supply in order to push up the oil. This action works. Previously, some OPEC countries tried to increase their supply in order to increase their market shares by beating their competitors with higher production costs. However, it ended with a low oil price and all oil exporters suffered from it. The oil market is oligopolistic and the oil exporters are playing repeated games in the market. It is important for these countries to find an equilibrium strategy and play it forever. Therefore, the most rational behaviour in the oil market should bring out a stable and relatively high oil price, as the suppliers have more market power than the demanders.

Repeated games may violate the expected utility theorem

In a game, we are not always able to get any pure strategy equilibrium, and instead often we get a mixed strategy equilibrium. Rock-paper-scissors is a classic game with a mixed strategy equilibrium. However, when we are actually playing the game, we sometimes do not randomly play our strategy as what the mixed strategy equilibrium says, we often try to work out the other player's next strategy based on his previous play and play our counter strategy. It is a mixed strategy equilibrium, as the other player will do exactly the same. However, we could imagine that the probabilities of the three strategies are no longer the same. Moreover, the game repeats over and over again, the probability of each strategy will vary from round to round. Such action violates the expected utility theorem, as the utility of each strategy should be the same based on the expected utility theorem, but sometimes, we do find that some strategy dominates another strategy when we actually make our decision. Therefore, in real life, especially when we are playing a repeated zero sum game, backward induction is not effective to help us to find the best strategy and the equilibrium, as people are taking action based on historical records. In order to find the best strategy or the equilibrium, we have to notice that players do not make decisions independently to maximize the so-called expected utility, they are more likely to take actions based on their opponents' historical strategies.

Violating the Expected Utility Theorem

There are three main critiques against the expected utility theorem: the Allais paradox, the Robin's Calibration Theorem and the Ellsburg paradox. These critics argue that the differences in the size of the stakes, the probabilities and the willingness to seek certainty change our expectations. However, there are plenty more factors that could cause a violation against the EUT. However, the EUT has been useful to simplify problems. Therefore, when we can set up a strict control group and a treatment group, the EUT is still suitable. However, when doing a social survey, modelling should be more precise and we should create a model beyond the EUT.

Risk and uncertainty

According to Knight 1921, risk and uncertainty are different: when we know something's probability objectively, then it is a risk, oppositely it is uncertainty. By this definition, when we go into a casino, we face risks instead of uncertainties, because the probability of winning objectively exists. However, actually almost all what we see in our financial system in our opinions are uncertainty as people cannot observe the probabilities accurately due to the complexity of the system. The probability of a crisis could objectively exist but we do not have the ability know the probability as the system is always changing and the probability is also changing. Moreover, the risks taken by all people directly and indirectly influence each other. When the amount of risks is too large and the activity of taking risks takes place too frequently, then we lose ability to calculate the probability of the risks we are taking, then they turn to be uncertainties. My opinion is uncertainty is a risk that we do not understand.

Simple system may be hard to be cheated with

Tax is something necessary but unwelcome, especially to the wealthiest class. Tax is a tool to narrow the wealth class and fund the government budget. However, due to the systemic differentiation and complexity, tax becomes relatively more difficult to collect. The financial system is very complex and the multinational institutions use their tax strategies to minimize their tax paying. Moreover, different countries have different tax levels that why people have offshore accounts to avoid accounts. Therefore, in order to increase the tax incomes, it is extremely difficult to simplify the financial system, but it may be a good idea for governments to simplify their tax systems, as making tax policies more straight forward can make firms and individuals unable to take advantages of the complex tax systems.

Germany is benefiting from the rescue scheme?

People criticize that Germany is benefiting from the rescue scheme and it could hurt the Eurozone economy as a whole. Firstly, we need to know how Germany is benefiting from the rescue scheme. As a creditor, Germany has a dominant position in discussing the economic affairs. During the negotiations, the interests of Germany could be ensured; however the interests of the debtors could be ignored. Such phenomenon has its advantage and disadvantage. The advantage is to give  creditors more incentives to lend their money and this can boost the supply of finance for the economic rescue scheme. With more fundings, the scheme could be effective. However, the disadvantage is that sometimes the interests of creditors and the interests of debtors conflict, when this happens, the scheme could be ineffective and even go badly. In conclusion, the creditors naturally gain some power in such negotiations; however, the debtors need some freedom to use the money as long as the money is used reasonably and effectively.

Could any other economy copy the Chinese miracle?

North Korea recently held a party congress. People had previously expected North Korea to announce opening its economy during the congress, the result disappointed many people. However, if North Korea decided to open its economy, would it be able to copy the Chinese miracle? My answer is no. I believe that the Chinese miracle is very unique that it could only happen in China. The factors that cause the big leap of the Chinese economic growth are unique. Firstly, the Chinese population is big enough to provide cheap labor force. Secondly, the Chinese has many ports to transport goods around the world. Thirdly, China had a very good relationship with Japan and was able to borrow from the Japanese banks and received orders from the Japanese companies. Moreover, the Japanese companies had helped to establish many manufactories in China as well. Fourthly, China has a stable and secured political environment. In addition, the single-party politics in China ensures that any policy established by the central government will not be easily replaced or abolished. These political factors reduce the political uncertainties for the foreign and domestic investors. In conclusion, I think the Chinese success is unique and could not be copied by other economies.

Modelling a market with differentiated products

In microeconomics, the simplest and most basic model is the supply-demand model with price and quantity of the two axes. In this modern time, what determines the sales of goods and services is far more than the price itself, especially when people are getting wealthier and most of these goods and services are getting more affordable. Moreover, firms are more willing to use non-price competition strategies, especially product differentiation. When products are differentiated, we choose products based on our own preferences besides their prices. Therefore, the supply-demand model can be less effective. If we only model one differentiated product, and exclude all other similar products, then we model a monopoly market. However, it is not a monopoly market indeed. However, if we apply a game theory, and firms are the players in the game, there is a general preference function of the market that represent different market shares when the products different prices and different functions, then firms will choose the market shares by choosing the price targets and the qualities of their productions according to their different costs of production.

A relative utility function

A utility function, especially when applying the function to a game theory model, should be in a relative term. When we believe people surrounding us have much better happier than us, by ignoring their own preference functions and applying their holdings to our own preference function, our happiness will be lower even if the absolute term is be not very bad. Therefore, in the game theory, sometimes we may accept a lower return as long as we can make ourselves better than other players. Such phenomenon may not always happen; however, it does sometimes exist.

Is Bitcoin real money?

Bitcoin has to have several characteristics to be used as a means of exchange. Firstly, it has to be accepted by all parties. Currently, Bitcoin is not accepted by all parties. Secondly, it can be divided to represent different values. Bitcoin has these characteristics. Thirdly, Bitcoin has to be able to be stored for a certain value. However, currently the price of Bitcoin fluctuates violently, and the value of Bitcoin is usually considered as its exchange rate to USD. Therefore, the value cannot maintain. In conclusion, as Bitcoin violates two of the three characteristics, we currently cannot say Bitcoin has become a new money, despite it can be true in the future.

Asymmetry of information and our economy

Without asymmetry of information, then there is no profitable business. With asymmetry of information, technological innovation could become profitable. Moreover, when the buyers know the cost of the sellers, then the maximum of the price the buyers are willing to pay is equal to the cost. Then there is no profit made for the sellers. Because no business could make profits, people have no incentive to start up their own business. If there is symmetry of information, the market solution becomes very inactive. Under such circumstance, social planning could achieve the allocation of resources, but the incentive for innovation, which I believe is the most valuable factor in advancing our economy, is still missing. Therefore, asymmetry of information always exists and is necessary for our economic growth.

Why is there a business cycle?

We often talk about the business cycle, as we believe that our economy is expanding in an upward trend but has upturn and downturn. The cycle of the upturn and downturn is called the business cycle. However, as we know that each cycle is different from the other, as the factors of the economy are always changing. I think that this is because we always try to manipulate our economy. We are not perfect that we cannot fully understand all effects of the policies and regulations designed by ourselves. The policies we design usually have immediate positive effects that can restore the market confidence and push up our economic growth. However, the negative effects will appear later after some time and cause the economic downturn. Once we realize the weakness in our economy, we start to add more regulations and policies which are also not perfect. Therefore, the business cycle is a man-made phenomenon rather than a natural phenomenon.

Once we receive false data

Sometimes when doing some research, we receive some unreliable data as the data providers may have some personal interests to deviate data from true values. However, if we understand the providers' utility function, it is possible to mitigate the bias of the data that we receive. The data provider wants to maximise the utility gained from deviating the data from true values, however the marginal utility is diminishing. Moreover, the provider wants to minimise the damage caused by deviating the data, and the marginal loss of deviating data is strictly increasing. Therefore, if we are able to model the gain and loss of the data provider from deviating the data from true values, it is possible to correct the data to true values.

The two views of bankrun

There are two views of bankrun. One view is bankrun is sunspot that it happens completely exogenous of the performance of  the economy and happens to be a coordination game where players choose to cooperate on the inefficient equilibrium. On the other hand, there is the business cycle view that bankrun is associated with economic condition, especially in a downturn, a bankrun is more likely to happen. There is a probability of the incentive compatibility constraint violated when people happen to be more likely to be early consumers. Then banks may not have sufficient liquidity to demand the excess demand in the market. Banks know this probability; however, they may accept such a probability due to their maximizing expected utility method. Therefore bankrun may happen. Both views suggest that bank run can be an equilibrium phenomenon. I personally more agree with the business cycle view.

Summary notes on paper on the relationship between the financial system and economic growth

I personally agree with Hassan, Sanchez and Yu (2011) that the financial system is necessary but not sufficient to guarantee a fast economic growth. As we can see from the past, before the 2007-08 financial crisis, the economists generally agreed that a larger financial system could generate higher economic growth, according to Schumpeter (1911) and King and Levine (1993). However, since the financial crisis, the economists' opinions have divided. Reinhert and Rogoff (2009) suggests that larger financial system could have a mixed outcome. Aghion (2010) thinks a larger system can alleviate liquidity constraints facilitating long-term investment and reduce the volatility. On the other hand, Cechetti and Kharroubi (2012) suggests a bigger system is bard for aggregate real growth and Blanchard and Labonne (2011) suggests that there is no clear relationship between the financial system and economic growth.