Saturday, December 27, 2008

Bit gold markets

The basic idea of bit gold is for "bit gold miners" to set their computers to solving computationally intensive mathematical puzzles, then to publish the solutions to these puzzles in secure public registries, giving them unique title to these provably scarce and securely timestamped bits. These titles to timestamped bits will be more secure and provably scarce than precious metals, collectibles, and any other objects that have ever been used as money. In a description of bit gold, which was mostly an overview of the technology, I wrote about how, because the algorithms and architectures for solving computationally intensive mathematical puzzles to create bit gold will often be dramatically improved, the bits (the puzzle solutions) from one period (anywhere from seconds to weeks, let's say a week) to the next are not fungible. But fungible units can be created from non-fungible ones:
bit gold will not be fungible based on a simple function of, for example, the length of the string. Instead, to create fungible units dealers will have to combine different-valued pieces of bit gold into larger units of approximately equal value. This is analogous to what many commodity dealers do today [pooling commodities with a wide variety of qualities into a handful of standard grades] to make commodity markets possible.
Bit strings (puzzle problem/solution pairs) are securely timestamped by their time of publication. More recent solutions that have been produced in greater quantities will be discounted by markets. To create fungible units dealers will bundle strings of different value into pools of a standard value (i.e. collect strings into a pool so that the sum of the market values of the strings in the pool add up to the standard value).

It's a bit indirect, but computers can easily handle these logistics. Leaving aside the gold metaphor for a minute, one can think of these bit strings as digital rare postage stamps. Each stamp might trade for a different price, but one can sort stamps into pools so that the prices of stamps in each pool add up to the same total price. Then divide each pool into tranches to create your standard currency denominations.

The rare stamp metaphor is, however, in other ways very misleading. Unlike stamps, but like gold, there are no ongoing changes in subjective valuations between bit strings to worry about, but instead the demand for bit gold is purely for its monetary functions, and thus purely based on how scarce the supply of puzzles solved during a given time period was and is. As a result, pooling and tranching will work far better for bit gold than it does for actual rare postage stamps.

This deserves more elaboration. It seems to be a common objection to bit gold that the mere difference in the price of a bit from one time period to the next produced by technology improvements introduce intractible subjective valuations, making the matter of comparing one week to the next subject to too much uncertainty and transaction costs, as occurs with many collectibles. Just as pooling and tranching rare postage stamps would be a somewhat risky affair as subjective valuations of the underlying stamps change, so too this is supposed for bit gold.

The problem that would occur if we tried to turn most collectibles into a standard currency by pooling and tranching is that, besides a subjective aesthetic component in the demand curve that doesn't come into play with computer bits, their scarcity is uncertain. Art can turn out to be forged, rare stamps thought to be lost or to have never existed might be found, and so on. The supply curve, in other words, can be highly uncertain and in danger of elasticity. Since the supply and demand curves of different pools can change differently over time, the relative values of pools would diverge from their initial values, so that trying to use tranches as standard denominations of a currency would create arbitrage opportunities.

By sharp contrast bit gold will be entirely public: no one gains secure title to any puzzle solutions until they are published. Thus, the exact amount and kind of puzzle solutions during a given period are well known, and perfectly define the supply curve relative to future weeks for all time thereafter.

There will be, in other words, a perfectly objective, measurable, and inelastic supply curve, completely derivable from the relative scarcity of bits (puzzle solutions) on the week (or the day, or the hour, or the minute, if necessary) of their publication. Arbitrage to set the different prices of different weeks (or minutes) can be computerized on this basis. The demand curve, the demand for puzzle solutions for the monetary functions they can perform as a store of value and medium of exchange, will be based on recognition of the superiority of bit gold as a form of money that is more secure and has a far less elastic supply curve than traditional commodities such as precious metals. Since there are no aesthetic differences, the demand curve will be the same function of scarcity for all weeks (or minutes), so it won't affect the simple scheme of automated arbitrage between epochs with different supply curves. The supply and demand curves of different pools will change in the same way over time, and the relative values of pools will not diverge from their initial relative values. Using tranches as standard denominations for a currency does not create arbitrage opportunities.

For most of history collectibles were used for as stores of value and media of exchange; aesthetics played an important role. But before we can separate out the roles of scarcity and aesthetics, we must ask why humans evolved such aesthetic values. The aesthetic instincts, for example the instinct to collect shiny things, evolved just because in the evolutionary environment they approximated an instinct to collect scarce things, and to distinguish hard-to-find from easy-to-find things, i.e. an instinct to recognize and collect objects that can best perform monetary functions, as I describe here, in the "Evolution..." section early in the paper, and the "Attributes of Collectibles" section late in the paper.

As a proximate matter, the contribution to the demand curve from demand for monetary functions (store of value or medium of exchange or both) and the contribution from aesthetic considerations are completely separable. One can demand a commodity for its aesthetic value, or for its value as money, or for both, or for neither. Thus a check for a million dollars might have a design that is utterly philistine, yet the check is still worth a million dollars.

The value of gold today is almost entirely based on its monetary value rather than mere aesthetic value. There are plenty of metals that are as shiny and smooth as gold, but people don't demand them as a store of value or medium of exchange because they are common. There are plenty of rocks that look as good as diamonds, but "diamonds are a girl's best friend" because they are hard to obtain and thus hold their value. Value comes to attach to the unique aesthetic features of gold or diamonds because these features signal scarcity. The value of precious metals or gems as stores of value, media of exchange, or even as cultural icons does not come from these aesthetic features, it is only signalled by them. It is their secure scarcity, not their aesthetic features, that allows them to be more securely used as a store of value and thus gives them a monetary value, and often a corresponding emotional and cultural value, far above the often trivial value they would have if they had the same aesthetics but were common.

There will be a problem defining futures contracts for yet-to-be produced bit gold: how much it might cost to solve a given puzzle a year later, or even a month, will be a very uncertain matter. But the pools that define currencies will be based on spot prices for already produced bit gold, not on futures.

[These comments edit and add to comments of mine under previous blog post(s)]

Bit gold

A long time ago I hit upon the idea of bit gold. The problem, in a nutshell, is that our money currently depends on trust in a third party for its value. As many inflationary and hyperinflationary episodes during the 20th century demonstrated, this is not an ideal state of affairs. Similarly, private bank note issue, while it had various advantages as well as disadvantages, similarly depended on a trusted third party.

Precious metals and collectibles have an unforgeable scarcity due to the costliness of their creation. This once provided money the value of which was largely independent of any trusted third party. Precious metals have problems, however. It's too costly to assay metals repeatedly for common transactions. Thus a trusted third party (usually associated with a tax collector who accepted the coins as payment) was invoked to stamp a standard amount of the metal into a coin. Transporting large values of metal can be a rather insecure affair, as the British found when transporting gold across a U-boat infested Atlantic to Canada during World War I to support their gold standard. What's worse, you can't pay online with metal.

Thus, it would be very nice if there were a protocol whereby unforgeably costly bits could be created online with minimal dependence on trusted third parties, and then securely stored, transferred, and assayed with similar minimal trust. Bit gold.

My proposal for bit gold is based on computing a string of bits from a string of challenge bits, using functions called variously "client puzzle function," "proof of work function," or "secure benchmark function.". The resulting string of bits is the proof of work. Where a one-way function is prohibitively difficult to compute backwards, a secure benchmark function ideally comes with a specific cost, measured in compute cycles, to compute backwards.

Here are the main steps of the bit gold system that I envision:

(1) A public string of bits, the "challenge string," is created (see step 5).

(2) Alice on her computer generates the proof of work string from the challenge bits using a benchmark function.

(3) The proof of work is securely timestamped. This should work in a distributed fashion, with several different timestamp services so that no particular timestamp service need be substantially relied on.

(4) Alice adds the challenge string and the timestamped proof of work string to a distributed property title registryfor bit gold. Here, too, no single server is substantially relied on to properly operate the registry.

(5) The last-created string of bit gold provides the challenge bits for the next-created string.

(6) To verify that Alice is the owner of a particular string of bit gold, Bob checks the unforgeable chain of title in the bit gold title registry.

(7) To assay the value of a string of bit gold, Bob checks and verifies the challenge bits, the proof of work string, and the timestamp.

Note that Alice's control over her bit gold does not depend on her sole possession of the bits, but rather on her lead position in the unforgeable chain of title (chain of digital signatures) in the title registry.

All of this can be automated by software. The main limits to the security of the scheme are how well trust can be distributed in steps (3) and (4), and the problem of machine architecture which will be discussed below.

Hal Finney has implemented a variant of bit gold called RPOW (Reusable Proofs of Work). This relies on publishing the computer code for the "mint," which runs on a remote tamper-evident computer. The purchaser of of bit gold can then use remote attestation, which Finney calls the transparent server technique, to verify that a particular number of cycles were actually performed.

The main problem with all these schemes is that proof of work schemes depend on computer architecture, not just an abstract mathematics based on an abstract "compute cycle." (I wrote about this obscurely several years ago.) Thus, it might be possible to be a very low cost producer (by several orders of magnitude) and swamp the market with bit gold. However, since bit gold is timestamped, the time created as well as the mathematical difficulty of the work can be automatically proven. From this, it can usually be inferred what the cost of producing during that time period was.

Unlike fungible atoms of gold, but as with collector's items, a large supply during a given time period will drive down the value of those particular items. In this respect "bit gold" acts more like collector's items than like gold. However, the match between this ex post market and the auction determining the initial value might create a very substantial profit for the "bit gold miner" who invents and deploys an optimized computer architecture.

Thus, bit gold will not be fungible based on a simple function of, for example, the length of the string. Instead, to create fungible units dealers will have to combine different-valued pieces of bit gold into larger units of approximately equal value. This is analogous to what many commodity dealers do today to make commodity markets possible. Trust is still distributed because the estimated values of such bundles can be independently verified by many other parties in a largely or entirely automated fashion.

In summary, all money mankind has ever used has been insecure in one way or another. This insecurity has been manifested in a wide variety of ways, from counterfeiting to theft, but the most pernicious of which has probably been inflation. Bit gold may provide us with a money of unprecedented security from these dangers. The potential for initially hidden supply gluts due to hidden innovations in machine architecture is a potential flaw in bit gold, or at least an imperfection which the initial auctions and ex post exchanges of bit gold will have to address.

Saturday, October 11, 2008

Origins of the joint-stock corporation

The modern joint-stock corporation has many sources in medieval Europe. First among these was corporate law itself. Although the era is commonly referred to as "feudalism," for the hierarchy of individually owned "fiefs" of land and control of serfs as fixtures of that land, large amounts of wealth in Europe were actually controlled by corporate entities. Chief among these were church lands, the corporate entities being dioceses, religious orders and the Roman Church itself. These entities controlled a substantial fraction of the land in Western Europe. Furthermore cities (with varying degrees of political independence), merchant guilds, craft guilds, and many charitable entities (such as hospitals) were legal "corporations," i.e. artificial and perpetual legal persons under law. Some basic issues in corporate law (for example, when are officers individually liable for acts of the corporation, and when the corporation is liable for acts of its agents) had already been solved in canon law and urban law long before the joint-stock corporation.

Another source of the joint-stock corporation was the tradition of dividing ownership over tangible things into "shares." For example, it was common in Italian maritime states fund the construction and operation of ships by dividing them into a certain number of shares (24 and 64 were common divisions). Share owners were responsible for funding voyages (not including cargo, which was typically paid for by trading partnerships called commenda) as well as the initial construction capital, and divided up the profits (fees paid by the merchants less costs). This tradition faded away in Venice when that republic's government took over ship ownership, but thrived across the Italian penninsula in Genoa. Ship shares became embedded into maritime law all over Europe and even survived the British Empire (today in Canada when you register a boat the government still registers 64 shares in it for its owner). The only organization controlled by the shareholders, however, was the captain and crew of the ship.

The medieval organizations that most resembled later joint-stock corporations were the Genovese maone. These bore some strong resemblances to the publicani tax farming corporations of the Roman Republican era, although it is not clear how they could have survived the intervening Late Empire and Dark Ages other than as very obscure (and perhaps now lost) written descriptions. In form and function maone also bore strong resemblances to some early joint-stock companies such as the Bank of Amsterdam, Bank of England, and the Dutch and English East India Companies.

The Italian cities often sold off their tax receivables to wealthy merchants at a discount as a way to borrow funds. (Discounting was one of the many ways late medieval financiers avoided the rather lax and narrow usury restrictions). The debts were divided into equal shares called loca or partes. Legally, these shares were personal property (chattels) and could be freely traded.

Technically, no organization was created when the city sold its tax receivables to merchants. However, to effectively collect the taxes, the holders of loca formed an organization called a maona or societas comperarum. This organization would then subcontract to tax farmers to collect the taxes. By the fourteenth century, Genovese maone also engaged in military conquest and colonization. These were, quite literally, corporate raiders.

Normally, maone were temporary, but some of them ended up lasting for a long time. In 1346 the Maona di Chio e di Focea (a company for managing the taxes of Chios and Focea) was formed. This organization's members obtained from Genoa the exclusive right to collect taxes from Chios (an Aegean island) and Phocaea (a port on the Anatolian coast). But first the company would have to conquer them! Although technically a temporary organization, it lasted until 1566.

Rather than going to buy receivables from Genoa, subscriptions to the di Chio e di Focea's loca shares (still legally debt, but to be paid out in dividends as taxes and trading revenues were collected) went to fund 29 galleys to conquer Chios and Phocaea. The Genovese Republic, for a fee, granted the organization exclusive rights to collect taxes from the conquered territories as well as special trading privileges. The conquests, taxes, and trading were at least partially successful, and by the 16th century more than 600 persons owned loca of the maona. This function and some of this structure would later be emulated by the Dutch and English India Companies, but with a basic legal difference -- "shares" in these later joint-stock companies would constitute ownership (like ship shares) not debt as with the maona.

The most famous Genovese maona was the Officium procuratorum San Giorgio, later the Banco di San Giorgio. Founded in 1407, this bank (and a later Genovese bank along the same lines, the Bank of Genoa) would be the inspiration for later central banks such as the Bank of Amsterdam and the Bank of England. Banco di San Giorgio came to administer most of the Genovese Republic's debts. Dividends were paid out of tax collections (less directly than with earlier maona, but still more directly than the later Bank of England). The maona business was becoming more monopolistic, as it had become in Venice and would become with later central banks.

At the same time, however, the ship share system spread to northern Europe and branched out beyond ships. In Italy and Germany by the 16th century a wide variety of mines were divied up into ownership shares. During the Reformation, a pious follower of Martin Luther gave him some kuxen, shares in a mine in Saxony. Luther complained that he did not know what to do with them. (Indeed, since as with ship shares the mine managers could call on investors to pay up more capital, ownership was not for the financially naive).

Martin Luther

Ship shares and mine shares like these were issued in small numbers (usually between 24 and 640) and thus were not typically traded on exchanges. The number of employees was also small, usually no more than a few dozen. Kuxen were reportedly sometimes traded at the Leipzig fairs. Indeed, illiquidity was the rule in the first century of English joint-stock companies. It was not until the Vereenigde Oostindische Compagnie (the Dutch East India Company, founded out of a merger of smaller colonial companies in 1602) that volume existed to trade company shares on exhanges (which up to that time traded state and municipal bonds and commodities).

Interestingly, the first joint-stock companies chartered by the English Crown (starting in 1553) were companies involved in trading (the Muscovy and Levant companies), mining (the Royal Mines and the Mineral and Battery), and trading combined with conquest (the India Companies, the Virginia and Plymouth companies, etc.) The two mining companies borrowed not only shares but managers and engineers (presumably along with their techniques) from Germany. The Genovese for their part would have felt at home with the trading and conquest companies.

References include:

Harold Berman, Law and Revolution.

Guido Ferrarini, "Origins of Limited Liability Companies and Company Law Modernisation in Italy: A Historical Outline", Centro di Diritto e Finanza WP 5-2002.

Meir Kohn, "The Capital Market Before 1600", working paper 99-06, February 1999.

Emergency economics

For those of you who didn't catch me on econ-law a few months ago [2005] during the hurricanes, here is an expanded version of what I posted there:

Here are some alternative ways of rationing in an emergency. At least some of these have been written about by Yoram Barzel. We have witnessed all of them during hurricane Katrina [and also this summer (2008) during Ivan]:

(1) market prices ("price gouging")
(2) waiting in line
(3) centrally planned rationing
(4) don't ration: just let the resource run out
It's not clear that, even with perfect knowledge, with or without an emrgency, centrally planned rationing could operate without using one of the other methods of rationing. In any case, our very poor knowledge about each others' needs is sufficient to ensure that, short of a perfect price system, we can't get what we want without waiting in line, and sometimes we just can't get what we want (or even, the Rolling Stones notwithstanding, what we need). The worse the price system -- in other words, the higher the transaction costs -- the more we wait in line or do without, as East Germany once demonstrated (cf. West Germany) and as North Korea continues to demonstrate. Luckily for those of us in largely market price based economies, we need only wait in line when trying to do business with the government, call a toll-free service line, go to a hot movie on opening night, or during an emergency -- i.e. in the remaining situations where prices don't operate very well or at all, due to transaction costs imposed by law or otherwise.

Mises and Hayek long ago demonstrated the weakness of centrally planned economies such as the old Soviet Union (or today's North Korea) -- the lack of knowledge the government has about peoples' needs and desires. Similarly, lack of the requisite detailed rknowledge of the needs of others, especially at specific times of crisis when they need our help most, is a huge problem even if we were perfectly charitable. Not even the local governments exhibited much knowledge of the needs of their neighbors, especially in New Orleans. Much less did the state or Feds (FEMA being only the most glaring example) exhibit even a tiny fraction of the knowledge that would be required for an optimal outcome. This is not the fault of the people in the government agencies to not act as knowlegeably as they are capable of acting, but rather the fault is in their implied promises and our expectations. For example, TV commentators, watching pictures of some Coast Guard helicopters, seem to have come to expect that government agencies will swoop down from the sky and rescue everybody and take on other attributes of God. Such as, for example, being able to knowledgeably evacuate people and distribute other scarce goods and services in a disaster.

Per Mises and Hayek, even if the Soviet Union had been run by an perfectly beneficient dictator, people would have, short of a matching omniscience of said dictator (and of enough of his underlings to receive and act on the knowledge) still have waited in bread lines. When price controls hit gasoline in the United States in the 1970s, people similarly waited in gas lines.

In emergencies rationing becomes extreme: people wait in long lines, pay "extortionate" prices, or, even worse, do without. We are thrown into economically unfamiliar territory and transaction costs balloon. Goods will always be rationed in one or more of the above four ways, and in an emergency the rationing can be quite severe. Our charitable spirit can temporarily overcome self-interest, but it can't overcome the knowledge problem or the scarcity of goods.

Given that waiting in line, or doing without, are very painful (even sometimes deadly) alternatives, and that allowing the charge of very high prices can largely prevent use of these extreme and wasteful forms of rationing, why do we have price gouging laws?

Can price gouging laws be explained as follows? In a zero transaction cost world, consumers would successfully negotiate with retailers for an insurance policy that caps prices in case of emergency. This may be, for example, because retailers are better able to bear the risk of emergency supply shortages than consumers are, or because consumers don't want to bear the risk of having to have an unusually large amount of money at hand during an emergency. (Katrina may be a good example of this -- it reportedly struck just before many paychecks were due, leaving many people who live from paycheck to paycheck without funds). However, the transaction costs for negotiating with consumers for such contracts are too high. Therefore, the default retail sales contract should include such insurance. Price gouging laws are a convenient way to do this. More generally, if it weren't such a bother almost all of us would like to purchase insurance against volatile prices in order to make our budgets more predictable.

Whether and when wholesale contracts include such price caps provisions would provide interesting evidence in favor of or against this hypothesis, and under what conditions it would have been rational to for consumers and retailers to have made such a contract.

As we have seen, there is a strong economic argument against price gouging laws. Consistent application of market pricing during an emergency would minimize the other inefficient, and occasionally deadly, rationing methods above, especially (4)actually running out of emergency supplies. Consumers could be confident that supplies will not run out, so stocking up on excess supplies based on fear of imminently running out of the supply (such as we've seen consumers do in some areas recently with gasoline) would be minimized. Given modern technology, perhaps we should work on improving the availability of credit and liquidity in emergencies via always-up wireless devices and immediately payable liquidity insurance policies instead of price gouging laws.

Furthermore, the promise of very high prices might motivate retailers to fly in special deliveries of emergency supplies at otherwise prohibitive transportation rates. On can even imagine for-profit organizations doing many of the tasks that the National Guard, Red Cross, and similar organizations are doing now. Of course, the moral indignation would be enormous. People, at least in political discussion, tend to be extremely averse to "windfall profits" and seem to have a strong psychological preference for an implicit insurance policy that puts a price cap during emergencies on retail contracts.

Monday, September 22, 2008

Patent goo: self-replicating Paxil

In his novel Cat’s Cradle, science fiction writer Kurt Vonnegut postulated “Ice-9.” Ice-9 was a form of water that was frozen at room temperature and catalyzed any normal water it came in contact with into more crystals of Ice-9. Once released into the environment, it froze all water, including us. Eric Drexler in the 1980s raised the specter of nano-robots that made copies of themselves and ate everything in their path: "gray goo." A wide variety of similar hypothetical disasters have since been given referred to as some sort of "goo."

Self-replicating chemicals are not merely hypothetical: since Cat's Cradle, scientists have discovered some real-world example of crystals that seed the environment, converting other forms (polymorphs) of the crystal into their own. The population of the original polymorph diminishes as it is converted into the new form: it is a “disappearing polymorph.” In 1996 Abbott Labs began manufacturing the new anti-AIDS drug ritonavir. In 1998 a more stable polymorph appeared in the American manufacturing plant. It converted the old form of the drug into a new polymorph, Form 2, that did not fight AIDS nearly as well. Abbott’s plant was contaminated, and it could no longer manufacture effective rintonavir. Abbott continued to successfully manufacture the drug in its Italian plant. Then American scientists visited, and that plant too was contaminated was contaminated and could henceforth only produce the ineffective Form 2. Apparently the scientists had carried some Form 2 crystals into the plant on their clothing.

Another instance of the “disappearing polymorph” may be the anti-depressant, Paxil (U.S. brand name for the chemical paroxetine hydrochloride). No, self-replicating Paxil doesn’t naturally spread into our brains and make people happy for free. It's not "happy goo." On the contrary, self-replicating Paxil converted, according to one of the parties in the ensuing lawsuit, an old, and now off-patent, form of Paxil into a new, patented form of Paxil. Once the new form, the hemihydrate form of Paxil, was created, its crystals started floating about, converting small fractions of the old form, anhydrous Paxil, into hemihydrate. Both forms of the drug work equally well as an anti-depressant, but it became impossible to manufacture the off-patent anhydrate without some of it being converted into the patented form. Call it "patent goo."

Apotex, a generic drug manufacturer, was all set up to manufacture the off-patent anhydrous generic Paxil when it discovered small fractions of it were being converted into the hemihydrate. They couldn’t remove the contamination. Smithkline, owner of the patent on the hemihydrate, sued them for patent infringement. Apotex argued that the hemihydrate form occurred naturally, so that Smithkline’s patent was invalid. Smithkline argued that it was a disappearing polymorph, that the hemihydrate form had not existed before they had created it in their labs, and that it was up to Apotex to remove the hemihydrate from its product or pay it a royalty. Apotex was unable to remove the hemihydrate and unwilling to pay a royalty.

Judge Richard Posner heard this case in the trial court and wrote an opinion that contains a good explanation of the self-replicating Paxil controversy. The Federal Circuit heard the appeal and decided that Smithkline’s patent on the hemihydrate was invalid as “inherently anticipated” because anhydrate naturally converts into hemihydrate. Normally, anticipation would require an actual reference describing the claimed chemical structure (in patent lingo that the hemihydrate was "taught in the prior art"). But Judge Rader held that inherent anticipation occurs when, more likely than not, an operation that is taught in the prior art would result in the claimed chemical. The anhydrate which was taught in the prior art would more than likely result in natural creation of some hemihydrate. Judge Gajarsa in concurrence argued that the drug was discovered not invented, making it unpatentable subject matter. Gajarsa’s opinion may have inspired the United States Supreme Court to raise the subject matter issue on its own (i.e., it had not been argued by the parties to the case) in Metabolite. The Supreme Court is considering whether to take the appeal on the self-replicating Paxil case as well.

The kula ring

Just off the cost of New Guinea, Melanesians evolved (over thousands, and perhaps even tens of thousands, of years) a unique commercial institution known as the "kula ring" for the collectibles that circulated within it.

The unforgeably scarce kula collectibles doubled as "high power" money and mnemonic for stories and gossip. Many of the goods traded, mostly agricultural products, were available in different seasons, and so could not be traded in kind. Kula collectibles solved this double-coincidence problem as an unforgeabaly costly, wearable (for security), and circulated (literally!) money. Necklaces circulated clockwise, and armshells counter-clockwise, in a very regular pattern. By solving the double-coincidence problem an armshell or necklace would prove more valuable than its cost after only a few trades, but could circulate for decades. Gossip and stories that about prior owners of the collectibles further provided information about upstream credit and liquidity. In other Neolithic cultures collectibles, usually shells, circulated in a less regular pattern but had similar purposes and attributes.

Sunday, September 07, 2008

A letter from the industrial revolution

Images: Copper halfpenny minted by the Darbies' Coalbrookdale Company and celebrating the Iron Bridge.

Here's an interesting letter from the dawn of the industrial revolution. It was written in 1775 by Abiah Darby, mother of Abraham Darby (III) and wife of Abraham Darby (II), the son of Abraham Darby (I), who invented the process of smelting iron with coke made from coal. The Darby family were Quakers and produced several early industrialists and engineers. This small letter makes or implies several points that may have been crucial to the growth of industry that makes modern wealth possible:

* The importance of property rights and market prices in maintaining a sustainable balance between the supply and demand of wood. ("woods for charcoal became very Scarce and landed Gentlemen rose the prices of cord wood exceeding high"). Although wood became expensive, there remained a sufficient supply of wood for the buildings, mine works, wagons, rails, etc.

* The ability of people living with sufficient technology and secure property rights to bypass and surpass ecological limitations (in this case substituting coal for wood, and later due to this cheap iron-making process, iron and steel for wood).

* Decentralized money issue. Abiah points out that the remote area of Coalbrookdale, where coal and iron were available, still often operated as a barter economy. Thus apparently Abraham had to either coin tokens or open a bank to issue notes (common during this era) so that the Darbies could pay their workers.

* Darby II's invention of the iron-tracked railroad (improving the productivity of the horses by over six times and precursor to the later steam-powered railroad).

* The ability to securely establish large machine works and lay 20 miles of track out in the boondocks and not have them be torn up by trespassers and used for other purposes or confiscated or taxed into oblivion by local lords. In most of the rest of the world that could not be taken for granted.

* The use of atmospheric pressure (Papin/Savery/Newcomen) steam engines to drain the mines and supply water to the waterwheel pond. (The atmospheric engine apparently wasn't up to the job of directly powering the bellows for the blast furnaces; that came later with the Watt steam pressure engine). Steam engines allowed water to be pumped out of mines at a far greater rate, and thus allowed coal and iron mines to be dug far deeper, creating a large and inexpensive new supply of coal and iron.

The link is a Word document, which I don't recommend opening for security reasons, but I've copied the contents below:

Mrs. Abiah Darby on developments in the Darby ironworks at Coalbrookdale, 1708-1763

Esteemed Friend,

Thy very acceptable favour of the 9th ulto. claim'd my earliest acknowledgments, which I should immediately have made, had not thy kind condescension in taking notice of my late honour'd Husband, and requesting to be inform'd of any circumstance which may be interesting relating him, caused my delay-to recollect what might occur concerning his transactions or improvements in the Manufactory of Iron, so beneficial to this nation. But before I proceed further, I cannot help lamenting with thee in thy just observation, " that it has been universally observed, that the Destroyers of mankind are recorded and remembered, while the Benefactors are unnoticed and forgotten". This seems owing to the depravity of the mind, which centres in reaping the present advantages, and suffering obscurity to vail the original causes of such benefits; and even the very names of those to whom we are indebted for the important discoveries, to sink into oblivion. Whereas if they were handed down to posterity, gratitude would naturally arise in the commemoration of their ingenuity, and the great advantages injoyed from their indefatigable labours-I now make free to communicate what I have heard my Husband say, and what arises from my own knowledge; also what I am inform'd from a person now living, whose father came here as a workman at the first beginning of these Pit Coal Works.

Then to begin at the original. It was my Husband's Father, whose name he bore (Abraham Darby and who was the first that set on foot the Brass Works at or near Bristol) that attempted to mould and cast Iron pots, &c., in sand instead of Loam (as they were wont to do, which made it a tedious and more expensive process) in which he succeeded. This first attempt was tryed at an Air Furnace in Bristol. About the year 1709 he came into Shropshire to Coalbrookdale, and with other partners took a lease of the works, which only consisted of an old Blast Furnace and some Forges. He here cast Iron Goods in sand out of the Blast Furnace that blow'd with wood charcoal; for it was not yet thought of to blow with Pit Coal. Sometime after he suggested the thought, that it might be practable to smelt the Iron from the ore in the blast Furnace with Pit Coal: Upon this he first try'd with raw coal as it came out of the Mines, but it did not answer. He not discouraged, had the coal coak'd into Cynder, as is done for drying Malt, and it then succeeded to his satisfaction. But he found that only one sort of pit Coal would suit best for the purpose of making good Iron. -These were beneficial discoveries, for the moulding and casting in sand instead of Loam was of great service, both in respect to expence and expedition. And if we may compare little things with great-as the invention of printing was to writing, so was the moulding and casting in Sand to that of Loam. He then erected another Blast Furnace, and enlarged the Works. This discovery soon got abroad and became of great utility.

This Place and its environs was very barren, little money stiring amongst the Inhabitants. So that I have heard they were Obliged to exchange their small produce one to another instead of money, until he came and got the Works to bear, and made Money Circulate amongst the different parties who were employed by him. Yet notwithstanding the Service he was of to the Country, he had opposers and ill-wishers, and a remarkable circumstance of awful Memory occurs; of a person who endeavour'd to hinder the horses which carried the Iron Stone and Coal to the Furnaces, from coming through a road that he pretended had a right to Oppose: and one time when he saw the horses going alone, he in his Passion, wished he might Never Speak More if they should Ever come that way again. And instantly his Speech was stopped, and altho' he lived Several years after yet he Never Spoke More!

My Husband's Father died early in life; a religious good man, and an Eminent Minister amongst the people call'd Quakers.

My Husband Abraham Darby was but Six years old when his Father died-but he inherited his genius-enlarg'd upon his plan, and made many improvements. One of Consequence to the prosperity of these Works was as they [were] very short of water that in the Summer or dry Seasons they were obliged to blow very slow, and generally blow out the furnaces once a year, which was attended with great loss. But my Husband proposed the Erecting a Fire Engine to draw up the Water from the lower Works and convey it back into the upper po6ls, that by continual rotation of the Water the furnaces might be plentifully supplied; which answered Exceeding Well to these Works, and others have followed the Example.

But all this time the making of Barr Iron at Forges from Pit Coal pigs was not thought of. About 26 years ago my Husband conceived this happy thought-tbat it might be possible to make bar from pit coal pigs. Upon this he Sent some of our pigs to be tryed at the Forges, and that no prejudice might arise against them he did not discover from whence they came, or of what quality they were. And a good account being given of their working, he errected Blast Furnaces for Pig Iron for Forges. Edward Knight Esqr a capitol Iron Master urged my Husband to get a patent, that he might reap the benefit for years of this happy discovery: but he said he would not deprive the public of Such an Acquisition which he was Satisfyed it would be; and so it has proved, for it soon spread, and Many Furnaces both in this Neighbourhood and Several other places have been errected for this purpose.

Had not these discoveries been made the Iron trade of our own produce would have dwindled away, for woods for charcoal became very Scarce and landed Gentlemen rose the prices of cord wood exceeding high-indeed it would not have been to be got. But from pit coal being introduced in its stead the demand for wood charcoal is much lessen'd, and in a few years I apprehend will set the use of that article aside.

Many other improvements he was the author of. One of Service to these Works here they used to carry all their mine and coal upon horses' backs but he got roads made and laid with Sleepers and rails as they have them in the North of England for carring them to the Rivers, and brings them to the Furnaces in Waggons. And one waggon with three horses will bring as much as twenty horses used to bring on horses' backs. But this laying the roads with wood begot a Scarcity and rose the price of it. So that of late years the laying of the rails of cast Iron was substituted; which altho' expensive, answers well for Ware and Duration. We have in the different Works near twenty miles of this road which cost upwards of Eight hundred pounds a mile. That of Iron Wheels and axletrees for these waggons was I believe my Husband's Invention.

He kept himself confined to the Iron Trade and the Necessary Appendages annex'd thereto. He was just in Ms dealings-of universal benevolence and charity, living Strictly to the Rectitude of the Divine and Moral Law, held forth by his great Lord and Saviour, had an extraordinary command over his own spirit, which thro' the Assistance of Divine Grace enabled to bear up with fortitude above all opposition: for it may seem very strange, so valuable a man should have Antagonists, yet he had. Those called Gentlemen with an Envious Spirit could not bear to see him prosper; and others covetious; strove to make every advantage by raising their Rents of their collieries and lands in which he wanted to make roads; and endeavour'd to stop the works. But he surmounted all: and died in Peace beloved and Lamented by many.

The principle of least authority

I've written an article on my application of the principle of least authority to the interpretation of legal language. I argue that the United States Constitution, according to its original meaning, instructs judges to construe federal statutes, regulations, executive orders, and other official acts, as well as the Constitution itself, to confer the least authority consistent with their language.

This article is based on a longer paper on the origins of the non-delegation doctrine I wrote for law school. That paper highlights a little-known debate on the non-delegation doctrine applied to the question of whether Congress could delegate the power to define postal roads. James Madison, among others, argued that this was an unconstitutional delegation of legislative power to the executive.

Thursday, August 28, 2008

Antiques, time, gold, and bit gold

What do antiques, time, and gold have in common? They are costly, due either to their original cost or the improbability of their history, and it is difficult to spoof this costliness. For example, it is usually difficult to spend an extra hour at the office without sacrificing about an hour of your personal life.

Unforgeable costliness is a pattern that recurs in many human institutions and is fundamental to civilization. Modern employment is based on the time-rate wage. Our monetary system is based on money being made unforgeably costly either through collectibles, commodity standards, or (in modern fiat currencies) accounting.

The unforgeable costliness pattern includes the following basic steps:

(1) find or create a class of objects that is highly improbable, takes much effort to make, or both, and such that the measure of their costliness can be verified by other parties.

(2) use the objects to enable a protocol or institution to cross trust boundaries

There are some problems involved with implementing unforgeable costliness on a computer. If such problems can be overcome, we can achieve bit gold. This would be the first online currency based on highly distributed trust and unforgeable costliness rather than trust in a single entity and traditional accounting controls. Hal Finney has implemented a variant of bit gold based on a tamper-evident computer plug-in card, for which remote users can verify what code is running on the card.

Wednesday, August 27, 2008

Flying money: a brief overview

Abstract money today primarily involves accounts and other computerized bits, but traditionally came in the form of paper. The Chinese, who invented paper money called it "flying money." Abstract money is worthwhile because the dominant kind of money over human evolution, unforgeably costly commodities, can be quite costly to store and transport compared to abstract documents. For money the biggest costs of storage and transportation are typically not mundane real estate or carriage costs, but active security threats such as robbery and embezzlement.

Abstract documents, unlike unforgeably costly commodities, require trust in a human institution to enforce the abstract claims of value made in the document. This enforcement, if effective, lets the recipient of the document be confident that it can be converted into something of value, traditionally an unforgeably costly commodity that backs the document. If the recipient of the document wants to trade the document to third parties -- negotiate it -- this enforcement may also provide confidence to these third parties that they too can receive something of value in exchange for relinquishing the abstract claim.
alternative text
Enforcement typically came in the form of legal and reputation systems. For example, the Medieval European law merchant enforced contracts and monetary promises in the merchants' own courts, with remedies such as bankruptcy and expulsion from merchant guilds. Bosses (principals) enforced orders against their employees (agents), and there were also often family relationships within firms that increased trust within the firm.

In most modern legal systems, and in many traditional legal and merchant reputation systems, credit money has come in two basic forms -- drafts, or orders from a boss to his employee (in legal jargon, from a principal to his agent) to transfer goods to a certain person, and notes, or promises to transfer goods to a certain person. A draft was enforced privately, by the ways bosses normally discipline employees; a promise to pay was enforced by an enforcement agency, often a government, by reputation among merchants, or both. Often the document reifying money that we will examine took on both of these roles.

The draft, in particular the warehouse receipt, is probably oldest form of credit document. Warehouse receipts are issued to document the storage of personal property in a warehouse. Typically, a warehouse receipt is an acknowledgement that the warehouseman is holding the owner's goods. The receipt acts as a title to the goods; transferring the receipt is as good as transferring the goods. The receipt acts as an instruction to the warehouseman's agent to release the goods to whoever presents the receipt. Thus, it is more properly categorized as a draft (an order to an agent) than a note (a promise to pay), although in some ways and in some legal systems it has been treated as both.

Another kind of draft is a bill of lading. This is a receipt for transported goods, and an order for the transport agent at the other end to release the goods to a person authorized by the shipper to receive them.

Description of illustrations(in order): Sumerican clay envelope c. 3,500 B.C., probably a warehouse receipt or a billing of lading; plate for Chinese paper money, c. 1279 A.D., with recent print from that plate; private bank note of the Bank of Scotland, 1716; Early Mormon private bank (Kirkland Safety Society, Ohio, U.S.A.) note signed by Joseph Smith, 1837; private bank note from a private road and bridge operating company (Delaware Bridge Company, New Jersey, U.S.A.) 1838; warehouse receipt for silver with micro-barcodes 2002.

Sunday, August 24, 2008

Smart contracts expand credit opportunities

Way back in 1994 I wrote the following (the "keys" here were envisioned as digital codes acting as car keys):

If a loan was taken out to buy that car, and the owner failed to make payments, the smart contract could automatically invoke a lien, which returns control of the car keys to the bank. This smart lien might be much cheaper and more effective than a repo man.

I've since used this as one of the key examples of smart contracts, in particular smart contracts that help enforce security interests (collateral). Other kinds of smart contracts include digital rights management (for copyright licenses), financial cryptography (for payment systems and other kinds of financial contracts), price-sensitive controllers, and a wide variety of other possibilities. More recently, some real-world examples of the "auto-repo-auto" have appeared, and it is now becoming more common. Deborah Yao describes some more of these:

Starter-interrupt devices are becoming a popular way for lenders to ensure they get paid, and consumers seem willing to accept them to get into nicer cars, use a smaller down payment and qualify for a lower interest rate, according to device manufacturers.

...The companies make a variation of the same device: The units are connected to the starter and emit a brief series of sounds or flashes of light, days before the payment deadline. If the customer then makes a timely payment, he or she can contact the dealer for a new code that will allow them to operate the vehicle. Some devices are remotely controlled by dealers.

Note that the process is far more manual and that there is much more attention to the user interface than I was thinking about in 1994. It's becoming increasingly apparent that a good user interface is often key to good security (phishing is another big example of this). Contracts are ultimately relationships between people, so a smart contract protocol needs to go all the way from end to end -- from person to person. Furthermore, as long as the parties have access to a good legal system, making certain important steps manual is a good idea if it increases flexibility and safety without too substantially decreasing security or user friendliness.

My thanks to Ian Grigg for pointing me to Yao's article.

Wet code and dry

There's a strong distinction to be made between "wet code," interpreted by the brain, and "dry code," interpreted by computers. Human-read media is wet code whereas computer code and computer-readable files (to the extent a computer deals meaningfully with them) are "dry code." Law is wet code, interpreted by those on whom the law is imposed, and interpreted (often somewhat differently) by law enforcers, but most authoritatively (and even more differently) interpreted by judges. Human language is mostly wet code but to the extent computer programs crudely translate from one language to another, keyword-ad programs parse text to made an educated guess as to what ads a user will most likely click, and so on, human language text can also be dry code. Traditional contracts are wet code whereas smart contracts are mostly dry code. Secure property titles and the domain name system are mostly dry code.

Even "mostly dry code" often has surprisingly soggy portions. Smart contracts, for example, can use dialogs to communicate their nature to the user and to allow the user to at least input some parameters, make menu choices, and the like. These are cognitive channels that translate between wet code and dry code. Similarly, the human-readable name in the domain name system is wet code and trademark law is wet code that applies to domain names. Phishing is an attack against cognitive channels using ambiguous wet code, which is probably why dry code programmers have a hard time coming to grips with it.

The syntactic properties of wet and dry code are often very similar -- for example, both human and computer language can usually be parsed by pushdown automata into context-free grammars. But their semantic content is often radically different, and the semantic content of wet code is often simply unintelligible to a computer, for a variety of often mysterious reasons. If we had good enough theories of human semantics we could program such theories into the computer and the computer would then understand like a brain after all. But we don't, in most areas, so we mostly can't program computers to emulate humans. I believe these mysteries are primarily due to the highly evolved nature of the brain contrasted to the recent and thus naive designs of computers, especially with respect to computers' typical lack of good sensors (they're mostly still far more sensory-deprived than Helen Keller, who had a very informative sense of touch) and relative inability to learn from natural and social environments. Their ability to aggregate disparate kinds of information, for example through conceptual metaphor, is also relatively undeveloped.

As computers become "smarter" dry code is (very slowly) coming to do more that was formerly only done by wet code. Once it successfully emulates wet code it soon surpasses it in many respects; for example by now dry code can do simple arithmetic billions of times faster than the typical human. As the idea of smart contracts suggests, there are many fruitful analogies to be made from wet code to dry code, but we must keep in mind the radically different semantics, the strengths and weakness of each, and the need for each to interact with the other to solve real problems.

I don't think there is a "magic bullet" theory of artificial intelligence that will uncover the semantic mysteries and give computers intelligence in one fell swoop. I don't think that computers will mysteriously "wake up" one day in some magic transition from zombie to qualia. (I basically agree with Daniel Dennett in this respect). Instead, we will continue to chip away at formalizing human intelligence, a few "bits" at a time, and will never reach a "singularity" where all of a sudden we one day way wake up and realize computers have surpassed us. Instead, there will be numerous "micro-runaways" for particular narrow abilities that we learn how to teach computers to do, such as the runaway over the last century or so in the superiority of computers over humans in basic arithmetic. Computers and humans will continue to co-evolve with computers making the faster progress but falling far short of apocalyptic predictions of "Singularity," except to the extent that much of civilization is already a rolling singularity. For example people can't generally predict what's going to happen next in markets or which new startups will succeed in the long run.

Wednesday, August 20, 2008


Genovese coat of arms with gryphons and cross of St. George.

Genoa was the most commercially innovative city of premodern times. Insurance, the joint-stock corporation, close cooperation between navy and merchant marine, international trade and exploration, and banking all made substantial progress in Genoa. The basic drivers of these innovations were Genoa's merchant culture and its unprecedented commitment to freedom of contract.

La Lanterna, the harbor lighthouse. 40 meters of rock and 77 meters of tower put the lantern 117 meters above sea level at the harbor mouth. The current version dates from the 16th century, but a lighthouse tower has been at the location from at least the 12th century.

Genoa was probably a significant port under the Greeks, Etruscans, and then the Romans, but is not recorded as playing a major role in history during those periods. It declined in the Dark Ages but revived by the 11th century and was one of the first Italian towns to assert its independence. It played an important role in transporting and protecting crusader fleets and those of the merchants and colonists who followed. During the Crusades it gained footholds on the strategic bottlenecks of the Dardanelles and of the Bosporus across from Constantinople, giving it access to the Black Sea and the Silk Road to China.

The Genovese were the chief commercial innovators of the later Middle Ages, and if anything was key to their innovations it was their advanced contract law and their commitment to freedom of contract. Nothing showed this commitment more than its long struggle against Church doctrine banning usury, which at the time meant any charging of interest. Genovese contracts "hid" interest charges as profits (which were acceptable) or in exchange rates.

The Galata Tower, built by the Genovese on the Bosporus across from Constantinople during the crusades. Their shared control over the Bosporus opened up the lucrative Oriental trade and allowed them to plant colonies along the Black Sea.

An example of the use of exchange rates to incorporate interest was the "dry loan" which structured interest as a transport charge commonly used in a "wet loan" which were normally paid off in a distant city as a way of transmitting money. Church leaders recognized many of these ruses and complained, but since Genovese municipal judges were, like the rest of the Genovese community, staunch advocates of freedom of contract, and since the Church was dependent on Genovese power (for example to transport and protect crusaders and pilgrims on the seas), the judges winked at these ruses and the Church mostly did not crack down on the practice. In the process of developing these ruses the Genovese became creative drafters of commercial contracts and learned to distinguish elements such as risk, loan, and investment that had been bundled together and treated as inseparable in previous eras.

Perhaps the chief Genovese innovation was modern insurance unbundled from credit or investment:

In short succession Genoa developed insurance, insurance pools secured by landed estates, and reinsurance. Exchanges sprang up for trading public debt, commodity futures, and other commercial paper. Bankruptcy law and the settlement of international trade disputes reached new levels of sophistication. Accounting became widespread and double-entry bookkeeping was born. As a result of their cumulative breakthroughs in institutions and technology, Europeans became the first merchants to travel and trade around the entire globe.
Medieval Genovese merchants, like their Venetian rivals, traveled from Iceland to China. Later Genovese such as Christopher Columbus would lead exploration of the New World.

Insurance developed out of an ancient form of marine finance, a loan that only had to be paid back if the ship returned safely:

The earliest risk-pooling insurance contracts were structured similarly to, and enforced under the same legal principals as, loans. Indeed they bundled a loan from the combined investor/insurer with an insurance clause -- in the event that the ship was wrecked, the loan need not be paid back. In 14th century Genoa, we see the separation of the investor from the insurer, via a contract with its conditional clause but requiring no initial loan. Investment contracts became separate entities and could be contracted with different parties, greatly improving the spreading of risk for these ventures. Such improved risk management was crucial for the explosion of overseas trade that Europe initiated over the succeeding centuries.
One of the most innovative families were the Vivaldis. Frederico Vivaldi was the one of the first merchants to be insured in the new way, and we still have some of his insurance contracts. His ancestors Vandino and Ugolino Vivaldi were famous merchants and explorers of the west coast of Africa, pioneering new discoveries and a lucrative trade that would be exploited much more by the Portuguese starting in the 15th century, taking advantage of its naval control over the Straights of Gibraltar (which Genoa never clearly gained, since before the Portuguese conquest of Ceuta Muslims controlled both shores). Today the University of Genoa sits on the Via Vivaldi, named after this most adventurous of families.

The Genoan topography helped it protect warehouses full of goods, Genoa's main source of wealth, as well as its populace.

Another famous Genovese family was the D'orias. Tedesio D'Oria funded the Vivaldi brothers in their last voyage, an ill-fated attempt at the end of the 13th century to pioneer a route to India -- a feat not accomplished until about two hundred years later by the Portuguese. In the attempt they may have (re)discovered the Canary Islands, which in any case the Genovese would colonize by the middle of the 14th century. Andrea Doria was the most famous Genovese admiral, responsible for defeating the Turks in the naval battle of Lepanto, among other feats.

Genoa was also the birthplace of corporations traded by shares, the prototype for the later English joint-stock corporation. Like many of the early English joint-stock companies, most of the Genovese companies were colonial companies that derived their revenue from tribute, tax, and trade from the many colonies they established:

The medieval organizations that most resembled later joint-stock corporations were the Genovese maone. These bore some strong resemblances to the publicani tax farming corporations of the Roman Republican era, although it is not clear how they could have survived the intervening Late Empire and Dark Ages other than as very obscure (and perhaps now lost) written descriptions. In form and function maone also bore strong resemblances to some early joint-stock companies such as the Bank of Amsterdam, Bank of England, and the Dutch and English East India Companies.

Palazzo San Giorgio (St. George). The Bank of San Giorgio (est. 1407) came to handle most of the municipal debt, providing a prototype for later central banks such as the Bank of Amsterdam and the Bank of England.

The Italian cities often sold off their tax receivables to wealthy merchants at a discount as a way to borrow funds. (Discounting was one of the many ways late medieval financiers avoided the rather lax and formalistic usury restrictions that remained in Genoa). The debts were divided into equal shares called loca or partes. Legally, these debt shares were personal property (chattels) and could be freely traded.

Technically, no organization was created when the city sold its tax receivables to merchants. However, to effectively collect the taxes, the holders of loca formed an organization called a maona or societas comperarum. This organization would then subcontract to tax farmers to collect the taxes. By the fourteenth century, Genovese maone also engaged in military conquest and colonization. These were, quite literally, corporate raiders.

Il borsa (the Exchange). Genoa pioneered in issuing and trading shares of ships and of municipal and corporate debt.

Normally, maone were temporary, but some of them ended up lasting for a long time. In 1346 the Maona di Chio e di Focea (a company for managing the taxes of Chios and Focea) was formed. This organization's members obtained from Genoa the exclusive right to collect taxes from Chios (an Aegean island) and Phocaea (a port on the Anatolian coast). But first the company would have to conquer them! Although technically a temporary organization, it lasted until 1566.

Rather than going to buy receivables from Genoa, subscriptions to the di Chio e di Focea's loca shares (still legally debt, but to be paid out in dividends as taxes and trading revenues were collected) went to fund 29 galleys to conquer Chios and Phocaea. The Genovese Republic, for a fee, granted the organization exclusive rights to collect taxes from the conquered territories as well as special trading privileges. The conquests, taxes, and trading were at least partially successful, and by the 16th century more than 600 persons owned loca of this maona. This function and some of this structure would later be emulated by the Dutch and English India Companies, but with a basic legal difference -- "shares" in these later joint-stock companies would constitute ownership (like ship shares) not debt as with the maona.
Genoa was limited in its naval endeavors because Muslims, and then by the end of the 15th century the Portuguese and Spanish, controlled the Straights of Gibraltar. The Genovese nevertheless supplied several leading navigators of the great Age of Exploration, including Nicoloso da Recco, Lanzarotto Malecello, Antoniotto Uso di Mare, Christopher Colombus and probably the Cabots. Its merchants also played a leading role in investing in Spanish and later English endeavors. But with the Reformation the center of commercial innovation would move from Italy to the Netherlands and England. Those innovators stood on the shoulders of giants, and the biggest such giant had been Genoa.

Flag with traditional English symbols: gryphons and cross of St. George. More importantly, England borrowed and improved upon many Genovese commercial innovations, ushering in the modern era of global trade and the industrial revolution.

England was strongly allied with Genoa throughout much of the Middle Ages. It is thought by some that English symbols such as the Cross of St. George and the gryphon derive from this alliance. English ships flying the Cross of St. George in the Mediterranean were protected by Genovese fleets. More importantly, England derived many of the institutions most critical to the development of overseas trade and colonies and domestic industry from Genoa. England, like the Genovese and Portugal (and unlike many other powers of the time such as China) put their navy primarily on the task of protecting its merchant marine. Its joint stock corporations, many of them colonial, derived from the Genovese colonial companies with their interests divided into shares. Lloyd's of London, with "Names" putting up their estates as collateral for reinsurance, still has the same basic structure as the marine insurance pools pioneered in the 14th century by the Genovese.

Patterns of integrity

One of my main interests is the history of institutions, and in particular the patterns that recur in successful institutions. These organizational structures and security mechanisms allow naturally suspicious strangers to interact with integrity.

These patterns include tamper evidence, shared time, unforgeable costliness, separation of duties, the principle of least authority, risk sharing, and learning from our ancestors, among many others. These patterns have been useful for centuries, and (I can report after having spent many years working in the computer network security field) continue to be useful in the Internet era.


Unenumerated is going into reruns season. For the next few weeks I will be reposting the best articles from this blog. These will mostly be posts from previous years, so unless you have been a reader since the beginning or have read most of the archives many of these will be new to you.

Most blogs discuss the news or similar ephemera and for them reruns would be silly, but this blog mostly discusses issues of historical or otherwise long-term importance, and I will only be rerunning those kinds of articles. If you haven't read a particular old article from Unenumerated yet it will be as informative and entertaining today as when it was first posted.

I will probably have "theme weeks" where this blog will run several classic articles on a particular theme (jurisdiction, legal/political procedure, property, contracts, money, traditional security, online security protocols, media, etc.).

Monday, August 11, 2008

Inflation expectations, gold, and oil

James Hamilton (link below) commits an egregious, but all too common, error:
Yet another example, and the one people often think of first, would be if there is a higher inflation rate in the U.S. than Europe. In that case we might expect to see an increase in the price of oil that exactly equals (in percentage terms) the decrease in the value of the dollar...The graph below plots the cumulative logarithmic change since 1999 in the dollar price of one euro along with the dollar price of one barrel of oil...
Hamilton then computes correlation coefficients between dollar oil prices and the euro/dollar exchange rate, finds a number of periods in which they are not closely correlated, and concludes that the dollar does not explain most of the dramatic rise in oil prices. Why do we keep seeing this kind of reasoning from supposed authorities like Mr. Hamilton? The flaw should be quite obvious, but since I've seen it mindlessly and repeatedly perpetrated by a number of professors of economics over the last few months, allow me to tediously correct it: if greater inflation is expected in both the euro and the dollar, the price of oil will increase in both euros and dollars. The euro/dollar exchange rate reflects relative monetary changes between the dollar and the euro, and the monetary component of the dollar oil price reflects absolute monetary changes in the dollar. It is absurdly illogical to expect the relative and the absolute to be strongly correlated. If the monetary changes in the euro and the dollar are of similar magnitude and direction, oil and gold prices will go up or down for these monetary reasons while the exchange rate changes little for these reasons. If European and U.S. monetary authorities are reacting in similar ways to, for example, similar credit crunches, there is no reason to expect a substantial correlation between euro/dollar exchange rates and oil prices. We will see such correlation for monetary reasons only when they are reacting with substantially different magnitudes or in different directions.

In expectation terms, the euro/dollar exchange rate reflects relative inflation expectations and surprise relative inflation between the dollar and the euro, whereas the monetary component of the dollar oil price reflects absolute inflation expectations and surprise absolute inflation for the dollar.

Analyzing the weekly price quotes since 2000, I get a correlation coefficient of 0.93 between the dollar price of gold and the dollar price of oil -- both absolute measures of dollar inflation expectations and surprise dollar inflation. The alternative hypotheses, changes in expectations and surprises in technological/geological supply or industrial demand, have very different effects on gold and oil that should lead to low correlations between their prices. The high correlation between gold and oil implies that oil as well as gold price changes are dominated by monetary factors. Many professional economists seem to be in denial about these basics of life under fiat currencies, perhaps since this ruins using the highly visible gas prices for simple chapter 1 lessons about how the fundamentals of consumption demand and supply by themselves are supposed to fully determine prices. These chapter 1 exercises, besides neglecting expectations, assume fixed-value currencies, and spectacularly fail for mineral commodities in our world of fiat currencies. In that world there is a monetary component to mineral commodity prices exponential in size to the expected inflation rate. This monetary component always dominates the gold price and at more than minimal levels of expected inflation (i.e. > ~2%/year) it also dominates oil prices, as demonstrated by the high correlation between gold and oil prices since 2000.

[UPDATE: another thing that puzzles many economists is why oil consumption has not dramatically slackened, and indeed in some areas has still risen, in response to climbing oil prices. This demand puzzle is a problem for any theory, whether monetary or fundamental. The answer involves demand fundamentals, but does not involve fundamentals that have changed substantially in the last decade: demand forms a fairly constant backdrop for the monetarily-driven dramatic rise in oil prices; it does not itself explain the rise. The answer to the demand puzzle is that despite all the recent political sci-fi rhetoric to the contrary, oil is a superior form of energy, often with no economical ready substitutes, as well as a great chemical feedstock. Automobiles in particular give us quite valuable real options that the vast majority of us actively seek and are extremely reluctant to give up. When gas prices go up we cut back on luxuries and many other kinds of necessities to make room for greater gas expenditures. Alternatives are typically costly status items, like hybrids, that are not practical substitutes for most people. As a result the demand for oil is far less elastic than for most commodities. Furthermore, because the dramatic oil price rise of the last decade is largely a monetary not a fundamental effect, the costs of alternative energies and conservation are also inflating -- they are simply much stickier than oil prices and will thus lag but eventually catch up to them. Investments in them will turn out far worse than a mere fundamental analysis would indicate, and enough people remember the 1970s, and how tacky and dangerous the small cars everybody bought in the late 1970s and early 1980s seemed by the late 1980s, that this has made people more reluctant to buy small or alternative in the current runup. Adding to oil's inelasticity are the many countries that subsidize fuel consumption.

Observe that this inelasticity and these subsidies, while important for explaining the demand puzzle, have not changed substantially as dollar oil prices have climbed by more than a factor of 10 since 1998. The component of the demand curve reflecting fundamentals has gradually risen, but it has also risen by a similar proportion in many prior decades and can't explain any dramatic increase in oil prices. What has changed are inflation expectations, driven by increasing government deficits and expected central bank behavior in response to the credit crunch, among other monetary factors. Our higher oil and gold prices reflect, exponentially, the increase in these expectations.]

(Here's the link to Hamilton's erroneous analysis, H/T Marginal Revolution, and my comments above were originally made at that blog, and appear here slightly edited).

Here are two graphs I've recently made based on my historical studies of the relationships between inflation, long-term inflation expectations, gold, and oil (click to enlarge):

The first graph shows implied expected inflation based on historical weekly gold and oil prices, 2000-2008. The oil and gold prices are adjusted for an estimate of historical inflation (specifically inflation as measured by CPU-I up to the date of the price, as opposed to inflation expected after the date of the price, which these adjusted prices imply) and for a small fundamental long-term trend (see below). The absolute expected inflation is based on certain baseline assumptions, whereas the relative changes in inflation expectations are not based on these parameters but simply on the theory that the oil and gold prices reflect the net present value of expected inflation, which is an exponential function. There is a close correlation, specifically 0.93, between the weekly movements of gold and oil prices in this period. The expectations implied by oil include both monetary component reflected by this correlation as well as a much smaller component primarily reflecting differing expectations and surprises between gold and oil in industrial demand and technologicaly/geological supply.

The separate oil (in gold prices) expectation graph reflects this difference. My attribution of all the differences between gold and oil to these fundamentals assumes that there has been insignificant change in the relative demand for gold and oil as money, which may be dubious assumption give the great recent rise in the use of oil and other commodity derivatives to hedge inflation in investment portfolios, and also the possibility that the security of economic property rights (i.e. effective long-term control by the same entity) in oil has increased recently faster than that of gold. But the fundamental contribution to the price of oil in terms of gold must be substantial since the graph of the difference in price expectations between the two reflects major events impacting oil demand such as 9/11(which along with the recession from the dot-com crash greatly impacted world and especially U.S. travel, reducing oil demand).

A few potentially important monetary events, such as the appointment of Ben Bernanke to replace Alan Greenspan as Fed chairman, are also labeled. There is a significant increase in the both the level and volatility of inflation expectations around and after this appointment as the market tried to predict how inflationary Fed policy under Bernanke might become, and generally indicated that higher inflation could be expected from Bernanke than Greenspan. Even before Bernanke was chosen, the ballooning federal deficits after 9/11 caused a gradual but substantial increase in inflation expectations from then until the end of Greenspan's term. Over his entire leadership from 1987 to 2006, Greenspan lowered inflation expectations from about 4% to below 2%, and they then rose to about 2 1/2% by the end of Greenspan's term, and are back above 4% today. (Greenspan in his own book, The Age of Turbulence, published in 2007, says that with fiat currencies we can expect inflation of about 4.5% from here on out, a more pessimistic estimate than that probably implied by gold prices in 2007, but perhaps a bit more prescient than the market given that inflation expectations have increased to above 4% in 2008. Of course, remember that my model reflects changes in inflation expectations much better than absolute inflation expectations, so these absolute numbers are very approximate).

Not shown on these graphs is a very interesting possible difference of nearly 1% between inflation expectations implied by gold, recently a bit over 4%, and expectations implied by TIPS (U.S. Treasury bonds with returns adjusted by the U.S. CPU-I inflation index), recently 3.3% The difference may largely reflect the errors I have suggested might exist in my absolute (but not relative) numbers due to my choices of parameters, but they might also reflect one or more of the following:

(1) The difference between the consumption basket of the U.S. urban consumer (as reflected in the CPU-I) and a global consumption basket;

(2) Understatement of actual subjectively experienced inflation by the CPU-I formual based on errors in its formula, perhaps including the "hedonic" and other adjustments made to it in recent years (we don't have TIPS prices to measure differences in gold- and TIPS-implied inflation prior to 2005);

(3) subtleties involving discount rate and utility curve differences between the U.S. urban consumer and some global average; and/or

(4) Prices on the 10-year TIPS reflect inflation expectations only over the next 10 years, whereas gold reflects inflation expectations over an indefinetely long period. If some event (e.g. the baby boomers reaching years of requiring peak medical attention, causing U.S. government deficits to skyrocket) posing great inflation risks is expected to occur within a foreseeable period of time but not within the next 10 years, this could be reflected in a spread between the two implied expectations.

There is also a small component of long-term relative oil/gold fundamentals in my analysis. Since the 1950s, oil prices have increased on average 0.9%/year faster than gold, which I have attributed to a fundamental difference between the two: a greater proportion of oil is actually consumed every year than gold, and so oil is gradually (i.e. at 0.9%/year) becoming scarcer relative to demand than gold. The graphs and implied inflations are adjusted for this effect. This is as close the numbers attribute any reality to "peak oil" theories: they show that we do not face an imminent demise of the oil economy, only a very long and very gradual increase in the technological/geological scarcity relative to consumption demand for oil. Extrapolating the same rate as the last 50 years, the price of oil in terms of gold will take 80 years to double. Taking out monetary factors and this gradual effect, we have had in the recent years (indeed since 1999, although until about 2003 this was masked by low inflation expectations) a small acute crisis in the fundamentals of oil, rising a bit above the 0.9%/year trend as it did in the 1970s, but this burp not substantially greater than in many former years such as in the 1970s, and I expect it, as occured in the 1980s, to reverse from technological substitutes for and conservation of oil which we are currently (as in the late 1970s and early 1980s) overinvesting in, due to monetary effects on oil prices being mistaken for fundamental ones. This mistake will reify as alternative energies and conservation techniques (barring unexpected technological breakthroughs), with stickier prices lagging those of oil in reflecting inflation expectations, increase in price faster than oil in the next decade (assuming no further monetary problems that further increase inflation expectations and thus oil prices). Prices besides oil, gold, and to a lesser extend other mineral commodities are far stickier than those mineral prices. Once inflation expectations increase, it takes many years for other prices (and especially the stickiest prices of all, wages) to catch up to oil and gold: these other prices greatly lag both increases and decreases in oil and gold prices, and indeed may never catch up at all if the expectations turn out to be wrong (as they indeed often are, given how little information the market actually has on future U.S. government and Fed behavior!)

The second graph shows this expected versus the actual (or at least CPI-U) dollar inflation from 1968 to today. Again from the difference between oil and gold we can see some oil fundamentals such as the impact of the Asian/Russian crisis on lowering oil prices (in terms of gold as well as, in this case, dollars, as inflation expectations were also at their lowest) in 1998 and of the Iran/Iraq war which depressed oil prices in terms of gold in the 1980s (probably due to decreased security of long-term economic property rights in their oil and the need by these oil states to fund their war with limited ability to borrow).

Since I generated these graphs three weeks ago, there has been a substantial and as usual correlated drop in both dollar gold and oil prices, probably reflecting an easing of the credit crunch in the U.S. and more confidence that the Fed, seeing its inflationary behavior lead to immediate and politically consequential pain at the gas pump, is less likely to use high inflation to default on current U.S. debts than was thought in previous weeks. At the same time the overt default risk for Treasuries has nearly tripled, also reflecting some new political limits on inflationary default. By the way, in the most recent week the dollar also strengthened against the euro by a similar amount, so that the explanation for last week, but not most of the previous ones, involves a monetary improvement unique to the dollar rather than shared by the Fed and the ECB.

[UPDATE: here's a third graph showing implied inflation expectations derived from monthly quotes of gold and oil in dollars going back to 1974, using some different parameters than were used for the second graph econd graph. The two expectations have a correlation coefficient of 0.76. (I forgot to run the correlation with the parameters that generated the second graph, so I wanted to show the graph corresponding to the 0.76). This is still a strong correlation consistent with the long-term trends in oil and gold prices each reflecting a common estimate of future inflation -- gold and oil fundamentals are very different and so cannot lead to such strong correlation. This compared to two random walks with no long-term tendency to rise, which on average have no correlation.

Per the comments below, the 0.93 coefficient cited above might for statistical reasons suggest much more correlation than actually there due to the rising nature of both making the differences from the mean calculated in the coefficient consistently large and thus reducing the proportional difference in movements: a random walk that tends to rise can also have correlation coefficients in the .60's to .90's. Indeed taking correlations of differences we get only .25, on the high end of weak positive correlations, for one-week deltas, but this rises with the weeks of difference: I've calculated up to 40 week deltas which give 0.64, a strong correlation. This suggests that weekly fluctuations are dominated more by non-monetary factors and the monetary factors don't start to dominate until the price movements are over about 6 months: fundamental fluctuations tend to be shorter term and tend (except for the 0.9% secular trend for which I've adjusted the data) cancel each other out. There are also as I undestand it, and I am admittedly no statistical expert, statistical reasons to expect that the 0.25 is too low in that such differencing can exagerate noise. For the two implied inflation expectations in the third graph, which have a 0.76 correlation coefficient, the exageratedly small differences in proportion due to large distances from the mean should be greatly reduced since the series is largely flat, finishing pretty much where it started. But all this must be subject to review by people far more knowledge in statistics than I. :-) ]