Credit and Law Of Large Numbers

While avoiding the discussion on whether credit is actual legal tender of a country, I can safely say that credit is a form of future money manifested through any form of financial instrument that cannot be repaid immediately.

It is easy to understand how rapid credit (both retail and wholesale) growth facilitates economic growth. When credit is expanding, consumers can borrow and spend more and businesses can borrow and invest (in productive ventures) more. Increasing consumption and investment creates jobs and expands income and profits. Moreover, the expansion of credit tends to cause the price of assets such as stocks and property to increase, thereby boosting the net worth of the public. However this cycle to work successfully, it is imperative that every credit gets fulfilled by repayment allowing it to recirculate.

Credit in an economy needs to be managed and a balance needs to be achieved. Most recent example of global financial downturn is a great example: Rising asset prices give the owners of assets more wealth (i.e. collateral) against which they can borrow still more. This cycle of expanding credit leading to increased spending, investment, job creation and wealth, followed by still more borrowing produces a happy upward spiral of  prosperity (so long as it continues). Eventually, however, every credit-induced economic boom comes to an end when one or more important sector of the economy becomes incapable of repaying the interest on its debt.

There are other doomsday scenario with credit, which happens in many under developed countries. This happens when credit is extended to the producer of goods who in turn is not able to put into sufficiently productive use either due to lack of knowledge (like rural farmers) or through deliberate actions (many industrialists in India take loans from bank, do not repay and rather siphon away the money from India to foreign banks like Swiss bank). Again when credit repayment extends out over several years, there is a permanent loss of revenue to the economy for goods and services. In effect the spending gets compressed into a smaller window, that results in stagnation until equilibrium (there is a availability of funds) returns. In the same way, it doesn’t do a company any good to sell its products for six months and then have six months off, if that isn’t how their production schedule is setup. This will result in lay-offs and other effects which, once again, reduce the “demand” side of the equation.

In general credit needs to paid to be an effective weapon of economic activity. The greatest threat to a credit is ‘default’ or rather probability of default to the credit issuer. As it is a probability, the law of large numbers comes into picture in the sense that frequencies of events with the same likelihood of occurrence even out , given enough instances. In short if the credit issuer gives a sufficient number loan to similar type of people then LLN (Law of Large Numbers) guarantees stable long term results for the averages of some random events. Given this, there exists a profitability model (like that of actuarial probability used in the Insurance industry) based on the final expectation calculation (*) .  So looking at it linearly(ignoring all other influences) we can see that a credit issuer can, not only survive if some loans go bad in his/her portfolio but also rather enhance his profitability by driving towards issuing more and more similar loans . All he needs to do is control the number of defaults to a minimum to maximize profitability given a particular set of loans.

Credit was significant as a form of payment in colonial America. Credit was present in all forms of trade including international trade between England and her colonies. Even in ancient times the concept of credit existed and many Buddhist monasteries acted as counterparty, almost like a modern bank to various parties like local king or merchants. However not till modern times, there was this widespread use of credit given to the individual citizens of a country materialized. This I think is the understanding behind rise of every great economy of modern world and the fundamental difference between the developing and developed countries i.e. a great infrastructure for managing and harnessing the power of credit to unleash the ‘animal spirits’.

LLN and the subsequent weighted mean to compute the expectation is linear function and do not have feedback loop associated with it. So, as long as the profitability increase linearly and probabilities of defaults remain consistent with large number loans disbursed, the economy will not be threatened and the growth will continue. However in real life, greed infuses nonlinear feedback in terms of returns and destabilized probability of defaults, or even when probability of default is a sure event (say one), this projects into spiraling growth and finally collapse of the economy. LLN , expected weighted mean can also be the rational justification for the spread of microfinance with its greatest avatar of microcredit. One can and should build an infrastructure keeping in mind that credit growth rate should be in tandem with the development rate of production and services. Small farmers, landless laborers in developing countries do not own adequate land and other assets which can be used as collateral, and consequently face a situation of inadequate availability of credit. It is they who need help and given their large numbers, LLN can easily be used to build any kind of profitability model for application of any kind of credit based financial instruments. Also being a significant, probably the most important part of the society, their well-being will have a greatest impact on the economy uplifting the entire country altogether. Only thing to keep in mind is not to kill the hens that are laying the eggs i.e. a sustainable amount of profits should be reinvested in the communities to enhance their lifestyle and building hope amongst the people , which would also act as further motivating factor.

Taking a step backward, looking at the whole issue at global level, the same concepts apply, only in this case the numbers are huge. So in a single global portfolio, the diversity of  probability of default will increase , so will the return variations, nonetheless running against such large numbers the linearity of the profitability model will be much more stable. Nonlinear feedback and spiraling growth will need to be huge to destabilize. However, if it is not properly managed sustaining the producers (farmers, landless laborers, industrial workers people who are directly engaged in real economic productivity: real economy as opposed to financial economy), that is there is no reinvestment of the profits leading to huge differences in the gap between rich and poor, the world itself will collapse, changing the face of the earth as we know it.

I would say, let us the harness the power of LLN and credit facility to bring the world together, include the global poor into a sustainable economic cycle. Let us be rich together, clearing the channels for generation and redistribution of wealth in a balance like the chakra (the wheel of Dharma) .

* According to the formula: () where X can take return value x₁  with probability of defaults p₁, value return x₂ with probability p₂

HealthCare Exchanges: Insurance products and other similar products whose risks and profitability models are dependent on the number of consumers buying should not be fully privatized.

The idea of exchange as I see is a mechanism to let loose market forces under a controlled environment. Setup a framework by having a set of well-defined laws, clearly define, quantize and standardize the value of whatever to be exchanged and finally give access to whomsoever would like to participate in the exchange activity. Simple as that, as they say and moreover it is , faster and cheaper than the lawyer-intensive process of negotiating bilateral licenses for intellectual property, the high cost of which discriminates against small companies. Too add more adjectives; it is collaborative, transparent and meritocratic.

I would argue that it is not that simple, because we need a solid in depth understanding of the nature of the concept ‘value’ that is being exchanged at the exchanges. We need to understand how it varies individually and also in groups (when coalesced together with other ‘value’). Strictly speaking, the exchange ‘value’ of anything (let us say commodity) is not identical to its price, but represents rather what (quantity of) other commodities it will exchange for, if traded. If that is the case, then price is a metadata tag with which we give the commodity a meaning in the world of finance. If we call this a notional price then the real price at which the commodity might exchange may be different i.e. the market price.  So there is a distinction between value of a commodity (notional price) and a market price.  Identification of the notional price is very subjective; depend on the present owner of the commodity and his/her perception of what he owns. Typically it will be cost of production plus markup. Market price is dependent on the demand-supply and the ability of the market participants to pay or as modern finance will say, it is dependent on the concepts of arbitrage-free, risk neutral valuation.

Notional price is the ‘value of a commodity’ as determined by the owner after considering its unique characteristics, cost of production, and owner’s perception of market swings and so on. While for certain products (like say vegetables in the vegetable market), it is rather simplistic representing the average quantity of human labor which is necessary to produce them, for others like financial instruments it is little deeper. The nominal price should not only represent the labor (all the research and other works) needed to produce; it also has the additional task representing the risk of that which it represents. Sometimes the price of this risk is way more than the cost of production of a financial instrument itself.  Say a stock, which represent the risk of performance of the underlying company or a bond which represent the credit risk of the bond issuer.

For most of the cases, be it a commodity ( like wheat, apples, fish) or simple financial products ( like stock and bonds ) the magnitude of the value of this risk is primarily not dependent on buyers of this product. Yes we can argue all the sides like the perception risk (dependent on buyer) and so on but for all practical purpose it is not, at least not like the way insurance products are dependent on. This I think is fundamental problem to be addressed in a healthcare exchange phenomenon or as a matter of fact for any exchange of insurance products. Two fundamental concepts on which insurance products values are dependent on are

·         law of large numbers (LLN) : According to the law, the average of the results obtained from a large number of trials should be close to the expected value, and will tend to become closer as more trials are performed.

For example, if a fair coin (where heads and tails come up equally often) is tossed 1,000,000 times, about half of the tosses will come up heads, and half will come up tails. The heads-to-tails ratio will be extremely close to 1:1. However, if the same coin is tossed only 10 times, the ratio will likely not be 1:1, and in fact might come out far different, say 3:7 or even 0:10.

·         concept of a  ‘weighted probability.’: a technique to find the total expected value of multiple events.

So let’s play this game:

• We are a small insurance company that insures 1000 people.
• Let’s say that 1 house will get flooded per year.
• So the probability of a house getting flooded is (1/1000)
• Therefore the probability of a house not getting flooded is (9999/1000)
• If a house gets flooded, we will have to pay $500,000
• Every person pays you $50 a month, $600 per year

According to the formula: (E[X] = x₁p₁₊ x2 p2+....xkpk) where X can take value x₁ with probability p₁, value x₂with probability p_2.

-500,000*(1/1000) + 600*(999/1000) = -500 + 599.94 = 99.94

So we will make $99.94 on average per person insured. Therefore you’ll make 1000*(99.94) = $99940.

The LLN guarantees stable long-term results for the averages of some random events. For example, while a casino may lose money in a single spin of the roulette wheel, its earnings will tend towards a predictable percentage over a large number of spins. Any winning streak by a player will eventually be overcome by the parameters of the game. It is important to remember that the LLN only applies (as the name indicates) when a large number of observations are considered. There is no principle that a small number of observations will coincide with the expected value or that a streak of one value will immediately be "balanced" by the others (i.e. gambler’s fallacy).

The nominal price and thus the premium amount of an insurance product is dependent on the above two concepts which in turn is related on the number of consumers consuming the product. This relationship is direct and will determine the existence of the product. There is almost none or little influence of financial economics of no arbitrage, risk neutral pricing on the market price. Market price of an insurance product is determined by actuarial probability, then why do we need an exchange ( in the sense NYSE operates)  like market place to manage competition. We can have a market like the vegetable market, where there are buyers and sellers, usually buyers do not become a seller.  There exists a profitability model for insurance product and competition for that profit is in distribution i.e. how many consumers can you enroll.

Anything that has profitability model can be privatized or rather to privatize any service we need to find out a profitability model.  Most common thinking is that well defined profit motive makes an organization more efficient, reduces waste i.e. deliver more for less. On the whole this is good for a society. This is the thinking behind privatization of the health care industry.

I would argue this is not always true; profit motive can make an organization more efficient but not more effective. Services , not only health care, but those which affect a large number of people , should and will always have certain other well defined goals other than pure profit.  In that scenario, single minded focus on profit, or marketplace built to just enhance that will defeat the very purpose of the existence of the service.

There should be a balance, while controlling costs, organizations should try to meet all the goals to justify its existence. Not sacrifice everything to the altar of profit and costs.

It is for this reason I believe that healthcare insurance and many other similar services in involving a large number of people should be semi private. Slight privatization will bring in the cost efficiency while the part public will harness motivation of providing quality service with other more larger goals in mind.

Global Currency is inevitable, question is what’s next ?

With dollar as a reserve currency gives United States a de-facto dominant role in the global economy.  Why will other countries subject themselves to U.S. fiscal and monetary policies over which they have no control?
In post-world war eras where US have come out as a winner, this acceptance would have been there, but today, in 2016, the world has changed a lot.

What happens today is that a nation’s currency is serving the geo-politically motivated perception of a global proxy for depth, strength and productivity of its economy and the stability of its political system. In many cases, particularly developing countries are suffering because of this perception. A number of developed countries while having a stable political system are not as productive as compared to several developing countries.  Yet people residing in these countries are enjoying a higher wage rate and luxuries for certain labor which could be produced elsewhere at much reduced cost. While morally this is exploitation but in pure economics term, from a global perspective, this is wastage of precious resources. This benefit of ease in price comparison (fringe benefit will be reduced transaction cost) along with labor mobility that is possible in today’s world outweighs everything.

Imagine a scenario; Britain has a negative shock because of fall in the prices of its largest export. Wages in Britain must fall compared to wages elsewhere in the world. With a global currency in play this will happen with macroeconomic adjustment and wages will fall in real terms. Today this do not happen , the nominal wages remain almost same and because of  ’perceptive’ exchange rate mechanism  the slack is mostly cut with a slight fall in the real rates.

As we all know that theoretically currencies should be valued based on trade flows but in reality that is flouted from both sides. While China may have been keeping its currency exchange rate low to boost exports, on the flip side, the developed countries have been trying to maintain a high exchange rate to keep its transaction cost lower. Some economist will say a new form of exploitation tool is the currency exchange rate. 

There is benefit for everybody, the developed world will get a level playing field for its industries and the developing countries will have stable currency and free from the dependencies on foreign monetary policy. Hegemony of exchange rate exploitation will end allowing them to benefit from pure productivity and efficiency of their economic activity.  The world will align itself more towards the mission of Finance that is efficient allocation of resources, no matter where in the world.

Yes there are significant hurdles to achieve that end as monetary policy could not be enacted on a country by country basis. Any change in monetary policy would have to be made at the worldwide level. The supply and printing of a global currency has to be maintained by a central banking authority, sealed from all external political interests. Unless we have a single global government to maintain uniform fiscal and monetary policy, I think it is almost impossible to create such an independent body with sufficient powers to manage a world currency. As long as we have multiple countries, we will have a collection of local economies restricted by the political boundaries, a world currency will not help as even though the currency/finance might flow easily, real economy will not flow easily, example labor movement will be restricted. Politics is the horse and economy is the cart.

The dream remains; it is just a matter of human ingenuity to solve. To start with we are already expanding the basket of global reserve currencies, stepping away from the dependency with dollar.  Then there is a rise of new technology, bitcoin offering the possibility of a technology based system that works with little human intervention, this might eliminate the conflict of the global vested interests.

Lastly I would say that this debate is same as thinking when to go for centralization (in this global currency) vis-a vis decentralization (local currency as it exists today). Human civilization, as a whole  always had political structure which was an open decentralized system (each country have its own system),  is one in which the entry of peers is not regulated. Any peer can enter or leave the system at any time. The idea of money, as it was discovered while we evolved as a society was also implemented in similar manner. There is no single centralized authority (there are central banks for each country but not for the whole of civilization) that makes decisions on behalf of all the parties. Instead each party, also called a peer, makes local autonomous decisions towards its individual goals which may possibly conflict with those of other peers. Peers directly interact with each other and share information or provide service to other peers.

Standing today , in the 21^st century if we look at human history , from Mesopotomia-Mohenjadro to Ashoka-Alexander to Mao-Lenin-English colonialism to information technology driven society of today on thing is always common i.e. an effort to centralize and control political structure (whatever its form is ) and reap the subsequent economic  benefits of a larger financial entity. With that trend in mind , in a global context the introduction and operation of global currency (centralization of the currency,  maybe managed via a centralized global bank ) is inevitable. It is just a matter of time , human society is inevitably is moving towards it.

The questions is what’s next ? like any natural phenomena this push towards centralization will reach its peak ,politically with a global government and economically with a global currency and then ….like a cycle decentralization will start. With higher fragmentation and entropy, what will our society look like then ? I don’t know. Will we believe in universal human rights then? One thing for sure whatever be it , this cycle of centralization and decentralization will continue forever, that is the balance , the spinning Chakra.