My views on Bitcoins

Bitcoins have become a hotspot for some investors and tech companies that the price for Bitcoins shots high and a Bitcoin relevant company, Blockchain (provides digital currency wallet services), has received $40m in venture capital funding. I think that the major reasons for the growing popularity in Bitcoins are the increasing trading between individuals (including individual groups, parties) across countries, exchange rate risk, and increasing number of online business activities. Moreover, when the price increases and Bitcoins become more popular, more investment and attention are drawn into this sector and this further increases the price and the popularity of Bitcoins. Of course, there are some people disliking Bitcoins that Mark Cuban calls Bitcoins a bubble and plans to invest in another digital coin; the idea of digital coins is very popular at the moment.

I think that the most important characteristics are its decentralisation, artificial scarcity, design for ownership. Before discussing these characteristics more specifically, we have to assume that Bitcoins are a commonly accepted currency; this is important because without this assumption, there is no point for us to discuss the use of Bitcoins in our life. Firstly, its decentralisation means that no government or organisation has control of it, so the Bitcoin monetary system is relatively fixed and this reduces the uncertainties in the future. Secondly, the monetary system is designed based on artificial scarcity that there would only ever be 21 million Bitcoins in total. This means that Bitcoins theoretically should always appreciate against currencies backed by governments. This is because the supply of Bitcoins is in decline over time and meanwhile the supply of other currencies is relatively stable or increasing over time. Moreover, if we believe the world economy is always on an increasing trend, the Bitcoin system will always be in a deflation as the total amount of Bitcoins is fixed but the available products that can be consumed increase; moreover, most economies have inflation over time, this implies their currencies are devaluing. Therefore, the price of Bitcoins should always increase. Thirdly, its design for ownership is very special, each individual has a unique private signature. I question the privacy of using Bitcoins. Of course, such private signature does not require a government ID; however, when people use Bitcoins more commonly and frequently, each individual is more likely to have one specific address rather than multiple addresses for convenience. Although the owners are not explicitly identified, their Bitcoins addresses become their new IDs. In addition, it is possible for individuals to conduct many strategies to increase privacy, but in order to be more convenience, there will always be a sacrifice of privacy.

In my opinion, Bitcoins have several challenges. Firstly, the advantage of low or no transaction costs can be vanishing when Bitcoins are used more and more often. It does not have transaction costs because the transaction does not have an intermediary. However, when Bitcoins are used more often, a financial market will definitely occur in the Bitcoin world that people have the need for saving and borrowing. When people open their Bitcoin bank accounts for saving and borrowing, the intermediary will appear and the transaction costs will be not different from the costs in other monetary systems. Secondly, it is possible for everyone to invent a new digital currency as long as the new system has all necessary characteristics for being a currency. Mark Cuban plans to invest in another digital currency and some other investors may do the same; therefore, it is important for Bitcoins to expand its influence ahead of any other digital currency to win the majority of the digital currency market. Thirdly, Bitcoins’ another major challenge is from governments’ regulations. Governments are more likely to oppose the idea of Bitcoins, as when Bitcoins become influential enough, governments will lose control of monetary policies. In addition, governments and other regulators are highly likely to impose regulations to break the privacy of Bitcoins in order to fight against crimes like money laundry. 

Overall, I think that Bitcoins have a bright future, but its time has not come yet.

When is being short-sighted better than being “long-sighted”?

Yesterday I suggested that being “long-sighted” is better at using resources than being short-sighted; however, sometimes it is perfectly rational for individuals to make decisions that seem short-sighted.

One classical example is that in some countries, due to their political system designs, their politicians are more likely to make decisions that seem short-sighted. When making policy decisions, these politicians tend to choose policies which can have short-term effects rather than those whose effects have longer time lags. This is because politicians’ individual interests do not perfectly match the social general interests. Although politicians’ individual interests are to win their elections and to win elections often requires making policy decisions that can benefit the society, there is no obvious paradox between the two interests, the frequency of elections and the frequency of social benefits are different. The frequency of election is usually once every four to five years; on the other hand, social benefits are continuous effects, because of this, there is no clear cutting point on the time line to check the accurate effects of all types of policies. Therefore, to win public support, politicians are more interested in choosing the policies that can deliver results before the next election, and these policies often target short-term problems and benefits.

From the politician example, we can see that sometimes choosing between different options is based on individual interests, when an individual has a more urgent short-term goal, he/she is more likely to choose the short-sighted target. When individuals have similar targets but different constraints (politicians and voters have more limited time constraints than the entire society or our civilisation), more restricted time constraints is a reason for choosing short-sighted options.

Why many people are short-sighted

We like to criticize some people are short-sighted and ignore long-term benefits when making their decisions; however, being short-sighted could be a way to avoid risk. Short term gains in many cases are more likely to be certain than long-term benefits; therefore, when making decisions, long-term benefits should definitely be higher than short-term benefits to compensate its higher risk.

Long-term benefits in many cases are significantly greater than short-term benefits; however, long-term benefits are estimated benefits and expected benefits, people can have different expectations and calculation methods, because of the long time gap, such differences are wider than the differences between people's short-term expected benefits. Therefore, when people are making short-term decisions, they are more likely to make similar decisions when people are making long-term decisions. In addition, a long-term strategy involves more opportunity costs, as when the time period is longer, there are more alternative options available. As people expect there would be a lot more options and better opportunities appearing in the future, people become more likely to choose strategies to gain short-term benefits.

However, why is being short-sighted criticised, especially given long-term strategies have so much risk. This is because having a long-term strategy or goal is an effective and efficient way to use personal resources. As having a long-term strategy aims to use all available personal resources to achieve a long-term goal, the amount of resources to use is greater than the amount of resources to achieve a short-term goal. When more resources are used, due to economies of scale, the average profits are greater than when seeking short-term benefits.

A government's major risk

Governments are also possible to fail to pay back their loans due to their lacks of financing ability. However, a government is likely to face incredible risk when it does not have an independent monetary system. The most classic example is the Eurozone economy. In the Eurozone, countries do not have their independent central banks, they have one united central bank. When they do not have their own independent central banks, they cannot lower the real value of their loans as they do not have influence over the inflation rate via their monetary policies so they cannot use monetary policies to lower their costs of borrowing. Such governemnts' default risk is very likely to be higher than those with independent central banks.

However, exogenous factors are very important sources of risk. Governments have limited control over these exogenous factors unless they have significant global influence. For example, the US is the largest economy and has very influential power over the global economy, when it experiences an economic crisis, other economies are very likely to be dragged into the crisis as well. However, many countries do not have such influence, their currencies are not the mainstream currencies used in global trading; therefore, their exports and imports largely depend on other economies' performance and the values of their currencies are also likely to be dependent of other large economies' currencies. When there is a strong correlation but weak influence, their economies become very fragile towards exogenous risks. In addition, the risk of black swan events can be exogenous and endogenous.

Overall, the government's major default risk comes from ineffective tools to generate economic growth when necessary and uncontrollable and unobserved events which damage the economy.

Negative effects of borrowing

Today I want to talk about the negative effects of borrowing. Yesterday I described how a government could use bonds to continuously generate economic stimulus; however, borrowing bonds could also cause negative effects.

The positive effects of borrowing bonds have one basic fundament that the government has to be able to effectively generate stable economic growth. However, when an economy cannot generate stable economic growth effectively, borrowing bonds may not help to stimulate the economy. In addition, such government usually has to bear high yields (high costs of borrowing), so the government not only is unable to generate effective economic growth, but also is very likely to accumulate very high loans to pay back. Under such circumstance, a government's credit rating is very likely to be lowered and this will further increase the costs of borrowing; the loan burden will accumulate and slow down the economic growth.

Moreover, even some governments with good and healthy economies are not necessarily possible to continue endless bond borrowing process. Because larger amounts of loans usually mean higher level of risks, when a government continues to borrow loans endless, its risk increases significantly; although if the economy does not seem to have any problem, the yield will not increase and the government is able to borrow as many loans as previously, when there is a black swan event or an exogenous risk, the yield will shoot skyhigh and the government may not be able to pay back its loans by its in-declined economy.

Overall, borrowing as much as possible seems desirable in the short term, but significantly increases the risk.

The optimal side of borrowing more

Borrowing in some particular countries used to be seen as the worst self-financing way, as at the time, people were more used to generating more wealth based on pre-owned wealth, risks at the time were greater and the tools of avoiding risk were very limited. However, nowadays, all countries have issued national bonds to fund their governments. Such financing method could have its positive effects (of course, it could have negative effects as well, which I will discuss tomorrow).

Once a government is able to borrow more to fund itself, its budget constraint will be shifted outwards, so fiscal policies could receive more financial support in order to be more effective. When fiscal policies become more effective, the economic growth rates could increase, it can lead to an increase in the tax incomes. It gives the government to pay back its loans and borrow more loans in the future. Moreover, such improvement in the economy could lead to an improvement in its government's credibility.

A government's credibility determines its currency value and its bond yield. When a government has a very good credit rating, its currency value could increase and its bond yield could be lower. Under such circumstance, the exports could become less competitive as the currency appreciation lowers their price competitiveness; however, the decrease in bond yields lowers the costs of borrowing more bonds, and especially if the exports are not very dependent on their price competitive, the economy could enjoy further stimulus from borrowing cheaper loans.

When in most governments, economic growth rate and tax income increase are seen as two important measurements of a government achievement; therefore, borrowing will only become larger over time.

Interest rate and default risk

When a company and a government has very high default risk, the bonds issued by such company or government have to have high yields to attract investors, institutions and other governments to buy their bonds. However, a government with a weak financing ability is likely to fall into a debt trap.

When the yield increases, it means the amount of the government has to pay also increases, it adds more burden on the government. Usually the change in the bond market is an act in the financial market and caused by short-term effects; however, when a government is facing a serious financial difficulty, the situation of high yields is very likely to be a long-term issue. When the yield is high, the risk of default is also high. Because when a government has a financial difficulty, it usually implies the government does not have the support from its domestic economy and the investment and consumption does not efficiently generate enough incomes and taxes, the way for a government to pay back more bonds is austerity. However, austerity has been proved to be ineffective to encourage economic growth and tax growth many times during our history. Therefore, an increase in the bond yield will add more burden on the government and reduce its ability to generate more growth and tax incomes, and this will lead to a further increase in the bond yield.

Therefore, I think when a bond yield is higher than another bond yield, its time to maturity should also be longer, especially towards a government. This is because I believe, unlike companies which could bankrupt very suddenly, governments could face some financial difficulties, but because of foreign aids and trading, a government which does not have any wars (including civil wars) is more secure in the long term, as for a government, sometimes its limitation is time, and giving it more time could help the government to make more policies to encourage economic growth and wait for the boom period of the economic cycle.

No investigation, no risk?

When a government announces it will start a probe to investigate some certain sectors, the market usually will immediately lower its expectations in these about-to-investigated sectors. Such sudden shifts in market expectations are understandable and reasonable to many of us; however, when such shift is too large, I think that it is a mistake made by the market.

When a government decides to step into a sector to conduct an investigation, as long as the government has access to more information than the market does, then a decrease in the market expectation is reasonable as the market believes that the information which is known to the government but unknown to the market shows that the probability of wrongdoing in the sector is greater than the market expectation and is significant enough for the government to take actions. Under such circumstance, the market could lower its expectation as it is reasonable to believe the risk is greater than the market expectation, but before the result is announced, the market cannot be certain about how great the risk can be; therefore, a decrease in the market expectation is reasonable, but a sharp decrease does not accurately represent the government expectation. Although it is impossible for the market to change its expectation perfectly to the government expectation, as some information is still unknown to the market, the market can see the signal sent by the government to estimate the government expectations.

On the other hand, a sharp change in the market expectation shows that the market does not fully take the possibility of a government investigation into account. Each market has its unique characteristics and level of regulation and risk to the entire economy, based on these factors, the market could know the risk of wrongdoing in the market and how much the government attention on the sector is, thus they could estimate the possibility of a government conducting an investigation in the sector.

The development of social welfare and benefits

Since early last century, many countries have been developing their social welfare systems that people with disadvantageous backgrounds in many countries, especially in those developed European countries, have been given social benefits to support their livings.

During our history, the first turning point of significant increases in ordinary labour wages was that the US car company, Ford, increased its employees' wages and its employees could be possible to afford a Model T car, which was a cheap type of car produced by Ford. Before Model T, cars had been seen as luxury goods; in addition, the majority of labour forces at the time around the world received very limited incomes. The increase in average labour incomes could increase the revenues of many companies because of the increase in the number of their potential consumers.

Nowadays, when many companies see opportunities of lowering their costs of production, they could start to replace some of their employees with computers and other machinery. However, such transformation could increase the unemployment rate in the society. When more people become unemployed, their consumption will significantly reduce so the consumption will reduce and the revenues for the companies will decrease. Without any intervention, the companies have to balance the reduction in the revenues and the reduction in the costs of production via replacing labours with machinery.

However, if the government is able to provide more social benefits for the unemployed population than previously, the incomes of those whose jobs are replaced by machinery do not change significantly. Under such circumstance, the companies are able to replace their labour forces with machinery without any limitation and the governments provide the population with higher and higher benefits to prevent the consumption from dropping, this could lead to many people losing incentives to develop their skills and seeking new jobs. Therefore, in the future, it is likely for the social class boundaries to be more solid.

Scale or margin

Revenue is the product of quantity and price and profit is equal to revenue minus cost. For a company to increase its profit, there are two ways to increase the revenue or reduce the cost. However, there could be a correlation between revenue and cost.

As there are two determinants for revenue, the price could have a negative correlation with the quantity. If a company is large enough, the quantity reflects the market supply, when the quantity increases, it implies an increase in the market supply, and an increase in the market supply usually leads to a decrease in the market price. However, an increase in the quantity usually can lead to a decrease in the average cost of production, due to the economies of scale, as the quantity increases, the marginal cost is declining and the average cost also decreases. Therefore, when a company decides to lift the quantity of production, the cost could decrease but the price could also decrease. Similarly, when a company has the market power and decides to lift the price for its products, the quantity is very likely to decrease and the average cost is likely to increase. 

A company can choose to increase the scale or increase the margin to boost its revenues. Increasing the scale is the same as increasing the quantity and increasing the margin is the same as increasing the price. When choosing between the two methods, the company has to consider the market elasticity of demand. As when the elasticity of demand shows consumers are inelastic, an increase in the price could lead to a small decrease in the quantity; therefore, it may be better to increase the price, especially when the average cost of production does not increase significantly. On the other hand, when the market demand is elastic, it is definitely better for the company to increase the quantity rather than the price. 

Risk, expectation and market active level

Individuals have different expectations because of the existence of known and unknown risks, as there are different expectations, individuals make different consumption and investment decisions. In one economy, individuals in the economy will form an overall expectation, which could be from individual expectations. When the overall expectations are different, the market active levels in the economies with different overall expectations are different.

However, individual expectations and the overall expectation can interact with each other. The majority of the population is very likely to amend their individual expectations according to the overall expectations reported by some official authorities; meanwhile, the overall expectations could be influenced by some individual expectations, such as some large financial institutions' expectations. Such interaction could make the overall expectation and individual expectations be moving towards each other, and in the economy, when all individuals' expectations about economies are similar, the majority of the population has similar expectations about different economies around the world.

However, individuals still have some disagreement about others' expectations. This is because individuals work in different sectors and live in different environments, they have access to different information. Sometimes they could be right and sometimes they could wrong. Usually, they are more likely to be wrong when their expectations are significantly different from the mainstream overall expectation because they do not have full access to the information. However, when they try to make expectations or estimations about an economy they are unfamiliar with, they are more likely to follow the mainstream expectations.

factors wich determine market active level

The market active level is to what extent people including domestic citizens and foreigners are willing to invest and consume in the market. People's willingness to invest and consume is determined by people's utility demand and financial demand. Utility demand is how useful a product or a service is once it has been purchased; financial demand is how much money could be gained by selling an owned product or service.

When individuals are making their consumption or investment decisions, they compare the utility demand and the financial demand and plan their individual portfolios to maximise the overall returns of their utility and financial demands. Utilities are usually pre-determined and in all markets, utilities offered by the same products and services are usually similar in all markets (sometimes they can be different due to different cultural or geographical factors). Therefore, the utility cannot determine the different market active levels between different markets. Financial demand is the most important factor that determines the differences in market active levels.

Financial demand is not fixed, it varies over time. It is also determined by individual expectations. Such expectations may not be accurate or true, but they can still determine the financial market situation at the moment. Without expectation, financial demand would be fixed and there would be no difference between markets because if there was no expectation, it would imply there would be no risk and such market would be different from normal good or service market and the returns from the financial market are the compensation for bearing the risk.

Therefore, the factor that make the market active levels in different markets is individuals' expectations about the markets.

Factors determining market size

The market size that an economy can have access to is very important in terms of determining the GDP size and its potential growth. There are several factors that could determine the market size that an economy can access to.

Firstly, the market size is partially contributed by historical heritage. When a country has a large land and a large population, such country definitely has an economy that has the access to a large market. As the population and the land pre-determine the size of the domestic market. In the past, some countries used to use wars as their tools to expand their domestic markets, including expanding their colonies; however, in modern eras, wars are forbidden and unpopular. starting wars usually make a country face sanctions from the world community, so the size of the domestic market is pre-determined by historical factors.

Secondly, the market size is partially determined by a country's diplomacy. If a country can have a clear and effective diplomatic strategy, it can allow the country to negotiate with other countries to seek for advantageous trade deals. When more advantageous trade deals are made, the country does not only have access to more foreign markets but also has lower costs to have access to overseas markets.

Thirdly, the market size is also determined by the size of the own domestic market. When a country has a very large domestic market, other economies are also willing to have access to this market. Trading is not a one-side activity when one side starts to trade with the other side, both sides will eventually trade with each other, as during trading they are more likely to find mutual interests.

Two main factors determine the growth

Swiss Central Bank blames its strong currency for weak economic growth. I think that there are two main factors determining an economy's growth other than its currency value: one is market size, the other is market active level.

When an economy has a very active market and has the access to a large market around the world, the economy can experience higher economic growth compared with other economies with similar GDP size. This is why China's gross GDP could catch up with and take over the Japanese, as maybe Japanese had a similar GDP amount and had the same access to the world market, maybe Japanese had some advantages of accessing to the world market, but the low inflation rate and its strong currency limited the Japanese economic active level, so it gave China some market active level advantages to generate faster GDP growth rates.

The GDP is the sum of government spending, consumption, investment and current account. These factors are all determined by the market size and market active level. In addition, monetary policy and fiscal policy can both try to improve the market active level by encouraging more economic activities by lowering the costs of borrowing and actively increase the number of economic activities. Additionally, many countries are seeking for trade deals with other countries, such strategy aims to enlarge their economies' market sizes.

Possible structural changes led by widening wealth gap

Yesterday I talked that if the wealth gap around the world keeps widening, a structural change could happen in the banking sector that more resources would be redistributed from commercial banking to private banking, as when the wealth gap becomes wider, the private banking sector becomes more profitable than the commercial banking sector. Today I want to talk about other structural changes could be led by widening wealth gap.

Firstly, when the wealth gap is widening, investment markets could become more isolated from the general public. This is because when the wealth gap is widening, more people do not have the abilities to access to the financial markets. When the number of potential investors becomes smaller, the need for an open financial market becomes much less necessary. In addition, having more individuals have the access to financial markets could be a good thing and a bad thing, because it could create a great opportunity for some individual to earn more incomes from financial markets but it could also make some individuals lose more of their incomes and poorer individuals are more likely to lose wealth in financial markets than wealthier individuals.

Secondly, when the wealth gap is widening, providing welfare could become a kind of business. In Germany, some firms and organisations have been doing businesses in the social welfare sector. Providing more social welfare could make disadvantageous people fall into a welfare gap. When people could live in relatively comfortable lives by being provided with social welfare without working, they will lose their incentives to work hard to earn more incomes. In addition, they could also lose incentives to give their children education and make their future generations not have any abilities to work or earn more incomes.

Individuals' capability of borrowing and lending

Individuals use the financial market to borrow and lend in order to expand their current budgets or their budgets in the future. The interest rates are not added to counter the potential risk, also to compensate the loss of the potential gains from the budget lend out. Therefore, the interest rate is the sum of risk premium, inflation and risk-free rates.

Inflation and risk-free rate are two factors that are determined by the outside world instead of individuals; meanwhile, the risk premium is partially determined by individuals, including employment status and income and other factors.

I always estimate that in the future, the wealth gap existing in our society will become wider; if such estimation is true, I can also expect the differences between individuals' capabilities of borrowing and lending will become larger as well. People who are more capable of lending money to others are also more capable of borrowing more money than the others. When the wealth gap becomes larger, the gap between the most capable people (who can borrow and lend more easily) and the least capable people (who are hardly able to borrow or lend from banks) becomes large. When more people are pushed towards the least capable end, then many banks may stop their commercial banking services as the majority of the population cannot sufficiently provide banks with sufficient assets to support their lending businesses and meanwhile, they do not have the ability to borrow enough to make banks profitable. Under such circumstance, borrowing and lending business for individuals becomes less profitable, as the amount of borrowing and saving is large but the overall volume is insufficient. Under such circumstance, banks will shrink their commercial banking business and use more resources in private banking business which is more profitable.

Overall, the redistribution of wealth is very necessary for our society as if we allow the wealth gap becomes wider and wider, more and more opportunities will be closed for the disadvantageous population and there could be a structural change to make the disadvantageous population more disadvantageous.

Why private companies may become more popular than public companies in the future?

My prediction is that in the future, private companies will become more and more popular than public companies because of several reasons. Firstly, I always expect the wealth gap among the world population will become wider and wider because technology is able to take over more and more basic jobs from our human beings and capitalists are more capable of accumulating their wealth. When the global wealth becomes more concentrated in a small group of people, the targets for companies to seek investment become narrower. Seeking investment in the public financial market becomes less attractive, as having access to a big market does not necessarily increase their chances of being invested due to the limited number of potential investors. Under such circumstance, one major advantage of becoming a public company is not so significant anymore. Secondly, private companies have many advantages in terms of management. Entrepreneurs would like to have as much control over their companies as possible; therefore, when there is no difference between staying in private and going public in terms of financing, they are highly likely to make their companies stay in private. Thirdly, in the future, not only wealth gap can make small investor start to disappear, the technology and the gravity of large capital will also push small investors out of the market. When there are only large investors existing in the market, these large investors could be very willing to shut down the public market, as the existence of some small investors could increase their costs of buying and selling, when shutting down the public market, they have the resources to set up direct connection between the sell side and the buy side. When they are making large-scale deals, the costs of setting up such connections are relatively small.

Spot black swan events in reality

Yesterday I talked about how we could use AI to spot relationships between different factors and limit the problem of omitting important factors and I also discussed how people's risk preferences influence the overall expected outcomes in the economy.

Combining these two points, I think we can use AI to discover some black swan events and even make their probabilities computable. One of many reasons of why black swan events exist is because they could be ignored by our human beings. When we are using AI to search for all relevant factors, it is impossible to say that there will be no likelihood of omitted variables, but the number of omitted factors is very likely to decrease. Therefore, I think using AI to spot black swan events is one effective way.

In addition, there are other ways to spot black swan events. Some black swan events are not entirely ignored by the whole population, they are observed by a minority of the population. This is partial because of the specialisation within our economy and society. When labours enter their industries for too many years, their skills, information and knowledge become isolated from the outside world. Therefore, cooperation across sectors is necessary, so labours within one particular industry can have access to information from other sectors. In the future, labours with knowledge of multiple fields are more suitable for the economy and the society.

Is it possible for anything to statistically analysed?

Today I want to discuss the possibility of statistically analysing every issue in the real world. Firstly, it is possible to analyse every issue in the real world; however, the real problem is how accurate and useful the results will be. I also believe in the future, when more information is available, technology is developing, it will be more accurate to conduct statistical data analysis.

I do have a rough method for computers to conduct data analysis for interested matters without too much manual interaction; however, I am not a computer programmer, so I do not have the professional skills or knowledge to discuss very specific problems in my method. I do believe in the future, more information will become available on the Internet and if computers are fast enough at the time, they will be able to collect all the information from the Internet. Computers need to find out the correlations between different factors, as well as the significances of the correlations. Because there are countless factors, it is impossible for computers to find all relavent variables according to the input interested variables and a continuous practice and a storage of correlations between variables are required. Computers should be like AlphoGo to practice a lot and improve its own abilities to find out the most accurate correlations between variables. Once an interested variable is inputted, the computer can use its storage to find out relevant variables and use the relevant variables to form an equation to provide a statistical description of the interested variable.

Such process has several advantages. Computers can form more complicated transformation to fit the reality better than we manually fit the models. In addition, once computers spot relevant variables and store the information and will never omit these variables; however, when we manually design models, it is very possible for us to omit some important variables. More importantly, AlphaGo has shown to us that AI can improve itself, so I believe it is possible for computers to develop better-fitted regression models without our intervention.

States with high probabilities and medium returns in the population

Yesterday I suggested that when there is a state with a very tiny probability occurs, many people are betting against the existence of the state; therefore, when the state becomes the reality, it causes greater impacts than the difference of the expected outcome and the state outcome. Today I want to further discuss this topic.

The expected outcome is the accumulation of the products of each state's probability and its outcome. However, when it comes to individual decisions, in some cases, individuals have to make their choices between several states and the expected outcomes are not guaranteed. Each individual has his/her personal risk preference and based on their risk preferences, they choose their preferred states. It is commonly believed that the majority of the population has risk averse risk preferences. If I assume that all individuals in the population have risk averse risk preferences, when a state has a higher probability, the number of people choosing this state becomes larger. When more people choose one particular state, the price for this state rises as the demand increases, so the return for the state decreases. Vice verse, the returns for states with lower probabilities become larger.

In addition, if assuming it is a zero-sum game, the overall outcome does not change, so the average return does not change and is meaningless. The median outcome or return in the population changes when we assume risk averse risk preferences or risk neutral risk preference, as the number of people choosing states with high probabilities under the risk averse risk preference assumption is greater than the number under the risk neutral risk preference assumption, the returns for states with high probabilities under the risk averse risk preference assumption are lower than the returns for the same states under the risk neutral risk preference assumption. Therefore, the median return of individuals when the general risk preference of the population is risk averse is lower than the median return and the expected return of individuals when the general risk preference of the population is risk neutral.

Election, politics and economics

Nowadays, I start to think the most significant, influential political events are black swan events. The majority of the political events including elections, referendums is not black swan events and has clear probabilities and has limited influence on the markets as well as the economies. Usually, when the unlikely states of such events take place, they may cause immediate shocks in the markets and the economies in the short term; however, in a relatively long term, such impacts are relatively less significant. This is because of several reasons. Firstly, when there are several parties in politics, the best strategy for any of them to win the political power is to target the middle voters, this will make their political actions more and more similar and the expected policy changes due to politics become less significant. Secondly, politics has been partially serving the economics. Many governments have found that to gain political power and influence and provide political stability, they have to build strong economies to make their people become wealthier. When they design political decisions based on economic factors, the people in the markets and the economies are gaining more information and even directing the political actions, so they have the better estimation of future political changes and their impacts on the markets and the economies. Thirdly, globalisation and other communications and cooperation across sectors have made one individual change be much more difficult to cause significant impacts on the whole.

However, there are some rare events which seem impossible taking place. These events are out of control and hard to be predicted; moreover, the majority of the population ignores their existences before they take place or believe they will never occur. Under such circumstance, these events occur and cause significant impacts on our economies and markets.These events do have the same characteristics that black swan events have, as the majority of the population ignore their existence and are betting against them. The reason that makes them have such characteristics is not about their causes or probabilities, it is because their probabilities are too small and the majority of the population choose to bet against their existence and such irrationality is the black swan factor in these cases.

Black swan and its computability

One of three important characteristics of black swan events is its non-computability and one of the most important factors that cause the economic crises is these black swan events. As I mentioned yesterday, the most common way to deal with black swan events is to ignore these black swan events, because usually, these events are unknown. If we do not know the existence of these black swan events or their causes, we do not have any effective way to estimate their likelihood and their expected costs. Yesterday I said that terrorist attacks could be seen as black swan events; however, the governments cannot treat terrorist attacks as black swan events and they use all available resources to find information about the possibilities of terrorist attacks and estimate the possibilities. The actions taken by the governments make terrorist attacks no longer black swan events, as when the more information is held, the easier it becomes to estimate the possibility.

It is the same for other known black swan events; of course, we still do not have any method to deal with unknown black swan events. For known black swan events, the main reason for the existence of known black swan events is their causes are complicated or unknown. When having more information, it helps to understand some of their causes and improve the accuracy of estimating the possibilities. However, collecting information has costs, especially when collecting difficult and complicated information. In addition, the costs also increase when using the collected information to conduct complicated models to estimate the possibilities. It is impossible to estimate the possibilities perfectly. When dealing more complicated factors, the costs increase significantly, as they have to recruit experts and buy high-speed computers to design and conduct complicated models. When the costs of collecting information and estimation are too high, some events automatically become black swan events.

Terrorist attack's economic costs

Terrorist attacks are horrifying and kill so many innocent lives; however, the costs of terrorist attacks are far more than killing and hurting innocent people. They have significantly high social costs including economic costs.

Firstly, the existence of terrorist attacks makes all the governments under terrorist threats have to have spent significant government funding to fight against terrorist attacks. Such use of resources is definitely going to occupy the uses of resources in other sectors: people are recruited from other sectors, including data analysis, money and equipment are taken from other fields as well. The returns of such use of resources mainly focus on the anti-terrorist field and such use of public resources has relatively limited multiple effects than government investment in other fields does. Secondly, terrorist attacks are almost black swan events that are non-computable (and other characteristics that black swan events have) and add more uncertainties to our individual lives and activities as well as business operations and other economic activities. Although when dealing with black swan events, we usually choose to ignore the effects of black swan events, once a terrorist attack occurs, it will cause an immediate damage to our society and terrorist attacks in the short term no longer are black swan events and based on the information released from intelligent agencies and other government parts, people are able to compute the risks of terrorist attacks and this immediately increases the short-term costs, as the possibility of terrorist attacks lowers the expected returns. Thirdly, terrorist attacks could increase the possibilities of social unrest and discrimination, the recent example is the US president's proposed migration ban. This also increases of our social costs.

Overall, the damage of terrorist attacks increases the costs of providing security and raises the social uncertainties.

How much can the financial market prices influence the inflation rate?

Yesterday I talked about the price changes in financial markets and ordinary markets follow some different rules, today I want to discuss the interaction between the prices in financial markets and the prices in ordinary markets.

My understanding is that the prices in financial markets represent the demand for the supply side. When investors believe there is more production in the future, the prices in financial markets are likely to increase. Such increase in the demand for more investment on the supply side could be caused by several reasons. Firstly, it could be caused by an increase in the demand side, as when more demand appears in the market, the market price increases and it can attract more investment in the field. Secondly, it could be caused by an increase in the expected returns in the future. If it is caused by the first reason, the prices in financial markets and ordinary markets move in the same direction with similar degrees. Under such circumstance, we can say that the price changes in ordinary markets lead to price changes in financial markets, as the increase in demand in ordinary markets is the cause. If it is caused by the second reason, the prices may move in the same direction; however, the prices in financial markets are likely to increase with greater degrees than the prices in ordinary markets. Under this situation, usually, price changes in financial markets do not affect the prices in ordinary markets, as the prices in financial markets are influenced by the expected returns in the future but the expected returns in the future do not affect the utilities gained from consumption in ordinary markets so have no influence on prices in ordinary markets.

Overall, the ordinary market price changes could have impacts on the financial market prices but the price changes in financial markets have limited influence on the ordinary market price level.

The pricing setting differences in the ordinary market and the financial market

Prices are set in the financial market and the ordinary market based on some similar concepts and some different concepts. Let's discuss the similar concepts first. Prices are set in the both markets based on the relationship of demand and supply. It is almost the Golden rule that when the supply increases, the price will decrease and when the demand increases, the price will increase. Both markets follow this rule without a doubt. Secondly, in both markets, the concepts of substitutes and compliance goods remain and prices change accordingly. Thirdly, in reality, both markets are not perfectly competitive and there is no perfect information in either market. Of course, the two markets have many different characteristics.

Firstly, the prices of goods in ordinary markets are believed to be diminishing over time; however, many assets in the financial markets usually have increasing prices, especially when they are believed to good assets. This is because the utility of an ordinary good is fully consumed once the good is assumed, and the value of the good is diminishing over time. In addition, in a perfectly competitive, prices should be equal to the costs of production which are certain. However, a financial asset is different. The utility and benefit of a financial asset are not fully consumed when they are consumed. Moreover, the price is set based on people's expected returns and expected costs. When the time is processing, some uncertainties become certain, so the expectations are changing over time, thus prices are more likely to increase over time when some risk disappear over time. Moreover, financial assets can produce returns over time and ordinary goods cannot produce any further values. Secondly, in ordinary markets, the supply side is usually the side with more market power; in financial markets, the demand side usually can have more power than the supply side. Of course in both markets, there are some exceptions. This is because, in financial markets, the demand side has the rare resources, cash, that all the supply parties are bargaining for; in other words, the demand side controls the rarity in the market. Thirdly, when goods are traded freely without limitation, in ordinary markets, large demanders can have price advantages; while in financial markets, smaller demanded can have more price advantages. This is because when bargaining for the same financial asset, the supply is usually constrained, and prices are set at different prices, small consumers can consume at the market price but large demanders demand more than the market can supply at the current level, so when they want to consume the full amount, they have to lift the market price and lose price advantages.

The oil price and the economic growth

Yesterday I pointed out during an economic boom the oil price would be highly likely to be relatively higher than when it is an ordinary time period. However, how much can we use the oil price as an indicator of the outputs of our economy?

It is reasonable because crude oil is many products' important raw materials and fuel most motor engines, crude oil could partially represent the general production of the world economy, when the amount of the global outputs is large, the demand for crude oil is definitely high, and vice versa. From this side, the increase in the world demand will lead to an increase in the demand for crude oil, thus increasing the oil price. However, oppositely the supply side of crude oil could also impact on the oil price.

As the market for crude oil is an oligopoly market, the OPEC has significant power to impact the oil price; therefore, the oil price is partially controlled by the supply side. When the supply side has some control over the market oil, the oil price does not fully reflect the actual changes of market supply and demand. Therefore, when the OPEC does not have any actions in the oil market, the oil price could reflect the market demand for crude oil, and the global outputs.

However, sometimes the OPEC's action is not obvious and is hard to be seen. When this is the case, we can use the economic growth in these OPEC countries, when there is a significant change in the economic growth rates in these countries comparing with the global economic growth rate, we could say that the possibilitiy of taking actions in the oil market to impact the price change is high, so the credibility of using the oil price to reflect the world economic growth.