Monetary Economists as Policymakers at the Federal Reserve

Several articles in recent years have claimed that more diversity in the sense of fewer economists on the Board of Governors and the Federal Open Market Committee (FOMC) would be a good thing (Fox “How Economics PhDs took over the federal reserve”; Zumbrum “Fed draws on academia, Goldman for recent appointees”; Calabria “Yes Fed has a diversity problem”; Ricketts “The Fed could use less book learning and more street smarts”). This is of some importance. There currently are three vacancies out of seven positions on the Board. One will be filled by the Vice Chairman for Bank Supervision. Several of the twelve bank presidents have turned over in the last few years and more may well turn over in the next few years.

This clamor seems to having an effect or at least reflects an opinion held by Reserve Banks’ boards of directors. The number of Ph.D. economists heading Federal Reserve Banks has fallen in recent years. Three presidents who were professional monetary economists and took strong stands have left, Naryana Kocherlakota, Charles Plosser and Jeffrey Lacker. The first two have been replaced by non-economists and the latter may well be also.

Positions at the Board are different than Reserve Bank presidents. Some positions at the Board are allocated to community bankers or bank supervision (Calabria 2016). The number of professional monetary economists who are community bankers is small and there is no reason to think that such a community banker would know more about monetary policy than other community bankers. The most important qualifications of the Vice Chairman for Bank Supervision concern knowledge about regulation (Davidson and Tracy 2017). There are qualifications for Board members based on geographic distribution that should be taken seriously (Calabria 2016).

These assorted criteria do not apply to Reserve Bank presidents. Furthermore, the operational work at Reserve Banks of clearing checks has disappeared and Reserve Bank’s most important roles concern monetary policy and supervision and regulation. Supervision and regulation at Reserve Banks is a Board function delegated by the Board to Reserve Banks. In the end, the Board is in charge of supervision and regulation.

If there is a reason to have Reserve Banks, monetary policy is it. Reserve Bank presidents have their own economics staff to brief them, a luxury that members of the Board of Governors do not have. Some of the Reserve Bank presidents who are economists have been quite effective at raising issues about monetary policy such as the desirability of the Federal Reserve’s holdings of mortage-backed securities.

Nonetheless, some think monetary policy would be better if fewer Presidents of Reserve Banks were economists. Would it?

There are two aspects of being a policymaker at the FOMC. Monetary economists have some expertise at one and substantial expertise concerning the other.

The FOMC sets the specific goals of monetary policy. The general goals are set by law but the specific goals in terms of inflation and real economic activity are determined by the FOMC. (I think it would be better if specific goals were set by Congress and the Administration but they are not.) Monetary economists have some expertise at determining the goals because they have thought about them more than most people, but staff assisting presidents provide this knowledge to some extent.

The FOMC’s other task is to use monetary policy tools to produce the goals. Whether or not members of the FOMC are economists, economists brief presidents of Federal Reserve Banks before FOMC meetings and monetary economists have particular expertise concerning these issues.

It takes serious economic analysis to understand how monetary policy worked even before the financial crisis. That is more true today.

There is not a consensus among monetary economists about how monetary policy works in the context of current policies such as interest on excess reserves and Quantitative Easing. (Or for that matter, even what the effects of Quantitative Easing are.) A Principles of Economics course is not sufficient to have the economics background to reach an informed judgement about how monetary policy works today and why alternatives are in error. An undergraduate economics degree twenty or thirty years ago is of no more use.

While it is possible for an economic advisor to teach a non-economist enough to understand the issues, it is difficult to imagine a policymaker ignoring the judgement of the economists who brief him or her. Some non-economists have been involved enough in monetary policy issues to have strong opinions before they are appointed. (Quarles is an example of someone who is being considered and has at least one strong opinion about monetary policy (Davidson and Tracy 2017).) Many if not almost all have not.

Economic advisors provide informed analyses and the FOMC meetings are informed discussion of the economy and monetary economics. Some policymakers are comfortable with briefings that reflect different opinions. Some are not. The judgements of the economists providing the briefing will play an important role in the choices made by a president, whether there is one point of view or more than one.

The economists briefing the President will play a far larger role if a President is not a monetary economist. The policymaker’s policy preferences might be different than the staff’s preferences on occasion but even these differences are unlikely to be important.

The argument is to appoint more presidents at Federal Reserve Banks who have no expertise in monetary economics and will be on the FOMC. Such appointments are unlikely to increase the level of discourse or the soundness of decisions at the FOMC. If such appointments have any effect, they most likely will enhance the importance of views held by the Reserve Banks’ economics staffs.

REFERENCES

Calabria, Mark. 2016. “Yes, the Fed Has a Diversity Problem.” Cato at Liberty. June 23, at https://www.cato.org/blog/yes-federal-reserve-has-diversity-problem.

Davidson, Kate, and Ryan Tracy. 2017. “Expected Fed Pick on Collision Course with Current Members on Rates.” Wall Street Journal, April 17, at https://www.wsj.com/articles/expected-fed-pick-on-collision-course-with-current-members-on-rates-1492469900.

Fox, Justin. 2014. “How Economics Ph.D.s Took Over the Federal Reserve.” Harvard Business Review, February 3, at https://hbr.org/2014/02/how-economics-phds-took-over-the-federal-reserve.

Ricketts, Joe. 2017. “The Fed Could Use Less Book Learning and More Street Smarts.” Wall Street Journal. April 10, at https://www.wsj.com/articles/the-fed-could-use-less-book-learning-and-more-street-smarts-1491864871.

Zumbrun, Josh. 2015. “Fed Draws on Academia, Goldman for Recent Appointees.” Wall Street Journal, November 10, at https://www.wsj.com/articles/fed-draws-on-academia-goldman-for-recent-appointees-1447177296.

Payday lending

An early payday lender.
Shylock
The Consumer Financial Protection Bureau (CFPB) has unveiled new rules for payday lenders. Payday lenders are the lenders that everyone loves to hate, modern Shylocks. It is doubtful that anyone grows up thinking “I want to grow up be a payday lender.”

Dave Ramsey, who provides generally excellent financial advice, has a page advising “Don’t do it.” While that is good advice, it is not an option for everyone all the time. His advice not to borrow on credit cards is good advice too.

Payday lenders make loans to people for small dollar amounts for short periods. Indeed, they get their name from a common practice of making a loan to people until their next payday.

Interest rates are quite high compared to say, a car loan. Interest rates on new car loans are in the neighborhood of 1.5 to 3.0 percent and payday lending rates range from 150 to over 500 percent per year. Payday loans are for small sums for short periods of time with a lump-sum payment in a couple of weeks.

If the loan is not rolled over, the annual interest rate is misleading. A two-percent interest rate for a week compounded for a year is 180 percent. If a $300 loan is taken out for a week at two percent, that is $6. That is hardly an appalling amount.

Studies have found that payday lending often is the cheapest source of short-term credit available to people in short-term financial difficulties. They are not stupid; they have an emergency or have fallen on hard times.

The reason for some people’s concern is the failure of some people to pay off the loan, instead borrowing the $306 for another week, and so on until, at the end of year, they owe $840 for the $300. Not a good outcome for sure.

Restricting the availability of these loans means that some people will no longer have this source of credit available. They are worse off as they see it. They have to rely on more expensive sources, miss payments on debts they owe or adjust some other way.

It is of course possible to think that the government and some of its experts know better than low-income people with bad credit. I think that is just arrogance speaking.

If restricting credit is a bad answer, what is a better way to help low-income people with bad credit and financial difficulties?

A better answer is to make more credit available to low-income people with bad credit. This will drive down the interest rates.

More personalized lending can get around some of the difficulties of loans reflected in payday loans. I don’t know how successful it has been, but the Church of England has the right idea. In 2014, they proposed making credit available through churches. (I learned about this in the excellent book For God and Profit: How Banking and Finance Can Serve the Common Good)
Credit unions in the United States used to make short-term loans to members in small-dollar amounts. I know; I got one while in my twenties after a car accident.

The more rules and restrictions are put in place, the more difficult it is for institutions to make loans such as payday loans. The simple economics indicate that increasing the supply of such loans is a solution, not restricting supply.

An economist’s encounter with contemporary theologians

I went to a Lumen Christi conference last week (may 19-20), a meeting mainly of economists and theologians. The general topic was Catholic social thought and the specific topic was the the environment. At breakfast, I was sitting at a table with three theologians. Somehow it went all wrong and I don’t understand it even after thinking it over.

I mentioned that I had been at the Federal Reserve Bank of Atlanta and had left partly because of dissatisfaction with the increases in regulation after the Financial Crisis of 2007-2008. It seemed that they immediately assumed that I thought there should be no regulation of banks or financial markets.

One of the theologians gave a talk later that day at which he said that people should live in smaller, more densely situated homes, ride bikes instead of drive cars, and in general have a standard of living similar to what they had in the 1950s. He mentioned in particular that he thinks it is a waste to have so many resources devoted to improving phones, for example from the iPhone 5 to iPhone 6. He thinks a house of 1500 square feet should be more than adequate for people and decried McMansions of 3000 square feet. (In Atlanta, it takes more like 5 or 6 thousand square feet to get that barb.)

Apparently he didn’t really mean it about the 1950s lifestyle.

At his session, I brought up the comment about a 1950s lifestyle. I used the enormous advances in medical care for heart disease and the general increase in life expectancy of older people as an example of dramatic improvement since the 1950s. I asked him who should decide whether such research is important. He merely replied that it is obvious that medical research is important while some other research (on phones I am sure) is unimportant.

He did not understand that I was asking how his preferences about research would be implemented. That problem is harder if, as I thought, some research would be fine and other research not.

To me as an economist, “who decides” means whose preferences get implemented and how. Some people might agree that some research is more important than other research in some sense. I was not merely asking if some people could agree.

He most likely does not know that those advances are related. Digital imaging is incredibly important in modern medicine including treatment of heart attacks and preventive medicine. My mother-in-law’s pacemaker has digital storage of its activity that is uploaded to the doctor once a month.

I found all of this unsettling in an odd way. One of the theologians commented later about me that “It takes all kinds.” The complete inability to find any way to discuss things despite, at least at the start, some good will is a shame.

Bitcoin and government regulation

Governments are starting to regulate Bitcoin and other cryptocurrencies. Is this good or bad? Why? Norbert Michel and I wrote a Heritage Backgrounder piece on Bitcoin and other cryptocurrencies, Bits and Pieces: The Digital World of Bitcoin Currency. We discuss the main aspects of Bitcoin without getting into technical details. We also discuss some of the possibilities for the future and indicate ways that the government can adapt to stay out of the way.
We don’t really take a stand on whether Bitcoin itself will succeed; time will tell that.
We do point out ways that the growth of Bitcoin and other cryptocurrencies could be throttled by government regulation and laws and suggest ways to avoid that outcome.

Immigration and refugees

In the United States, we tend to focus on immigration issues in this country. The system – if it can be called a “system” in any sense – is functioning in a way that almost no one would recognize as sensible.

Increased immigration is not unique to the United States. There are many more immigrants in European countries than just 15 years ago. It is fairly common to see people of Asian origin speaking Italian or Spanish on the subways in those countries.

Illegal immigration is not unique either. In fact, it is a massive problem in Europe right now similar in some ways to migration from Cuba to the United States. In the mid-1990s, as the Congressional Research Service summarizes, many Cubans died in small boats escaping to the United States and this was widely reported in the press. It is little reported, but about 25,000 Cubans travel in small boats to the United States each year even now. (I am not sure how many are returned to Cuba by the U.S. government due to an almost incredibly horrible policy.)

Europe has a similar problem today. Thousands of people are fleeing the violence in North Africa. The simplest way is to sail in a boat across the Mediterranean. European countries are confronted by some of the same problems as the United States was then.

The first point of entry for many of these refugees is Greece. Greece hardly is in a position to help the refugees much. Permanent employment for an immigrant is a fantasy in a country with an unemployment rate of about 25 percent for the last seven years. So they move on from Greece.

Because of the open borders in the European Union, people can travel from Greece to many more attractive countries. Many of these other countries are concerned about the implications of many refugees ill equipped to live outside their native lands.

An opinion piece in the Greek newspaper Kathimerini suggested “To solve, Europe’s migrant crisis, give them a place of their own.” This sounds interesting for an instant, but not longer than that. In fact, it is a ridiculous proposal. The proposal is

The United Nations should … identify large areas where migrants could both live and work while retaining their nationality. Granted an indefinite stay, these migrants would also have the possibility of attaining citizenship. These areas would, by definition, be empty and probably inhospitable; the UN’s aim would be to make them comfortably habitable.

A short version of this: Let them live in the Sahara desert. But wait, that’s in the neighborhood of where they’re leaving. In Europe, I know of no such even relatively “empty and … inhospitable” area. Moreover, it would have to be owned by a government I guess or the owners would have to be expropriated.

The U.S. version of this would be: Let them live in Death Valley. What would keep them there when the bright lights of Los Angeles and Phoenix are where they can find gainful employment? “Empty and inhospitable areas” are not a great place to try to make a go of it.

What is the solution, or even a good solution? I don’t know. Arguably, free migration with private charity and no guaranteed benefits from the government would work reasonably well in many ways. The current world is so far from this. There are big arguments about immigration, of course.

There are two arguments that appeal to me. One argument: with current welfare in place, free migration would be a massive drain on taxpayers in the United States. Another argument: two wrongs don’t make a right. The existence of welfare should not stop a commitment to free migration of people. I incline to the former argument: free migration of people from Mexico and Central America given current institutions in the United States is a recipe for a big new burden on taxpayers in the United States.

Actually, under current arrangements, sponsored migration of refugees arranged by private groups seems to work reasonably well when it is feasible. I don’t know of such efforts underway now, although it seems that would be the ideal resolution for these refugees in the United States. It might work reasonably well in Europe. It also would deal with a complaint in the United States right now, that the U.S. government is not doing nearly enough to help Christians being raped and killed by ISIS.

Greece: Taking Stock

The third bailout of Greece is in progress. What can be said?

First, beware those forecasting what politicians will do. The Greek Prime Minister, Alexis Tsipras, got a 61-39 vote against an austerity program offered by other eurozone countries. He then promptly agreed to a more demanding program just a week later.

There are a variety of ways to view Tsipras’s about face. I find it most plausible that the other eurozone countries held fast and he found himself staring into an abyss with serious hardships for Greek people. And he did not want to be responsible for that. Whatever the reason, the real lesson is that politicians’ actions are hard to predict.

What can be learned more broadly?

It is worth starting out with a basic observation: This is a road that should not have been travelled in the first place. As part of the bailout programs, Greece has defaulted on private creditors already. It would have been better for Greece if this had been done immediately without piling on yet more debt.

Being in a monetary union does not require that member states not default. U.S. states defaulted in the 1840s and the commonwealth of Puerto Rico is very likely to default in the near future. Cities in the United States have defaulted on their debts as well. A default by Puerto Rico will not provide any evidence about the willingness of the U.S. government to service its debt and will have at most a negligible effect on the U.S. dollar or its use anywhere in the world.

A beneficial result of an immediate default by Greece might have been a widespread recognition in Greece that things could not continue as they were.

That said, bygones are bygones. That is not the path the eurozone has been on for several years.

Still, Greece will not have growth leading to incomes similar to other European countries without major changes in the economy, whether Greece defaults explicitly or it defaults implicitly by a restructuring of the debt.

There has been a lot of ink spilt about pensions in Greece. Government pensions in Greece allow people to retire and receive checks when people are younger than in Germany or the United States. Pensions currently are equal to one-quarter of Greek GDP and are expected to grow faster than even relatively high long-term predictions of GDP growth. Tsipras made the point that change was inevitable as part of a speech in Parliament this week. To the best of my knowledge, politicians in Greece have avoided even suggesting changes were necessary until now. Previous governments have blamed changes on the insistence of eurozone governments lending funds to the Greek government.

Instead of necessary reforms, politicians in Greece have been good at raising taxes, maybe lowering spending some but have made too few reforms that can have long-lasting effects.

While not suggesting it’s the most serious problem, Greece’s railroads are a good example of problems that affect much of Greece’s economy. Greece’s railroads are government owned and have a substantial debt and deficit. The railroads have borrowed a lot in the past leading to a large debt and they add to it every day they operate. The railroad union has secured relatively high pay and pensions.

One part of the proposed reforms in Greece is privatization of the railroads. Short of changing union contracts, it is hard to see Greek railroads having a positive value in a sale. Changing union contracts would be likely to mean a costly strike, and the difficulties facing the owners would only be worse if the new owners of the railroad were foreigners.

It is hard to see privatization of the railroads being successful without widespread support by Greek citizens. As things stand, there is no evidence such support is there.

It is hard to see the current bailout being more successful than the earlier two agreements. The major issue for Greece’s long-run growth is not taxes and government spending, although government spending and taxes are quite high even by European standards.

The major issue in Greece is an economy with little scope for private enterprise, which is the driver of long-term growth.

A note: I have not posted in while but will be more systematic now.

Greece’s sovereign-debt crisis heats up, a lot

I have been following the financial crisis since its beginnings in 2007. While in the United States it seems that the crisis is all over and has been for a while, the private financial crisis blended into and partly became a sovereign-debt crisis in Europe.

Everything calmed down for a while but things have heated up recently.

To summarize developments a bit as I understand them. I do have to assume some familiarity with Greece’s problems.

Greece has an extremely serious problem with deficits and debts, very high government spending, and a tax system with high tax rates but ineffective tax collection.

A new Greek government has been voted in, at least partly based on resentment against the terms imposed by the Eurozone, the European Community and the IMF to provide assistance to Greece. Today a meeting to agree on any new terms for the Greek government fell apart. There are no plans for a further meeting. The current bailout program ends on February 28.

If the Greek government is to attain its objective of getting better terms, there must be more meetings in the near future. Otherwise the Greek government will run out of funds in the next month or so, unless it goes along with an extension of the current agreement. But the new Greek government ran on a promise not to extend the current agreement and has said that extending the agreement is unacceptable.

A related development at the same time suggests that there is another problem. Greek people are withdrawing euros from the banks and storing them against the possibility that Greece will go off the euro. The banks have about 14 weeks of collateral to get funds from the Central Bank of Greece at the current rate of withdrawal, according to one estimate. This drain of funds from the banks will only accelerate.

The Greek politicians think raising pensions, employing more government workers and raising the minimum wage will lead to growth. The Germans and most other European politicians don’t agree. Not many economists would agree either.

I think the Greek government will stick to demanding they be able to institute these three policies. They are ideologues, Marxists actually. I also think the drain of cash from the banks will accelerate. I am not sure when they’ll have to limit withdrawals. I think capital controls are quite possible.

Then it depends, but I think the other Eurozone governments have relatively little wiggle room. They have voters too.

Any forecast is a forecast of what the Greek and Eurozone countries and politicians will do. I doubt the Eurozone will go along with the three demands by the Greek government. Maybe Prime Minister Alexis Tsipras will rise to the occasion; maybe not.

It’s a forecast. This whole thing has dragged out a lot longer than I thought it would. The Greek people do not realize how serious the problem is. No politician is telling them. The problems are the evil “troika” and especially the Germans (who conquered Greece during World War II), and this has been the story all along.

To illustrate the level of discussion in Greece,

A Greek leftist newspaper close to the ruling party in Athens published a cartoon last week which showed [German Finance Minister] Schaeuble in a Nazi uniform. He is quoted saying “we insist on soap from your fat” and “we are discussing fertilizer from your ashes”, references to the fate of Jews in Nazi death camps.

Quantitative easing and inflation

The end of large-scale asset purchases by the Federal Reserve to implement quantitative easing was announced on October 29. While the Federal Reserve will not decrease its extraordinary holdings of securities, it will not increase them either. By coincidence, this came at about the same time I was giving a talk in Cork, Ireland about quantitative easing by the Fed and by the European Central Bank.

There is widespread misunderstanding of how the Fed implements quantitative easing and the implications for the economy. (One particularly careful but ultimately unsuccessful attempt is “Must `Quantitative Easing’ End in Inflation?”.)

Quantitative easing is a policy of large-scale purchases of assets by the Federal Reserve. The Fed has increased reserve balances from about $13 billion before the financial crisis to about $2.7 trillion at the end of October 2014. If that’s not a big increase, nothing is.

Many have been surprised by the fact that quantitative easing on this scale has not been accompanied by substantial inflation. As a general rule, increases in bank’s reserves are accompanied by increases in the quantity of money and followed by higher prices. This seems not to be the case for the United States. Why?

Nominal quantity of money in the United States from 2000 to 2014

Nominal quantity of money in the United States from 2000 to 2014

The nominal quantity of money has not increased at a particularly high rate, let alone an alarming rate. The nearby figure shows the growth of the nominal quantity of money in the United States. The measure used is a standard one, M2, which basically consists of U.S. currency and bank deposits in the United States. The line shows a fairly steady growth of the quantity of money in the United States. Not surprisingly, inflation has not taken off either.

There normally has been a fairly close relationship between purchases of assets by the Fed and M2. What changed?

First, the Federal Reserve now pays interest on reserves held by banks at the Federal Reserve. This need not explain the disconnect between the Fed’s purchases of assets by itself, but it does when combined with a second observation.

Interest rates on excess reserves, federal funds and Treasury bills

Interest rates on excess reserves, federal funds and Treasury bills

The interest rate paid by the Fed on reserves is higher than the interest rates on similar risk-free assets. The second figure shows interest rates paid by the Fed on reserves, on Treasury bills and on Federal funds. Treasury bills are short-term government securities with zero risk of not being repaid. The federal funds rate is the interest rate at which banks borrow and lend reserves at the Fed among themselves. The solid line shows the interest rate on reserves, which has been 25 basis points (1/4 percentage point) for some time. The rate paid by the Fed on reserves is greater than the rates on Treasury bills and federal funds.

There are many things that can said about this, but the fact that the Fed is paying more than the Treasury for short-term funds is sufficient to explain why M2 has not increased. Both interest from the Treasury and from the Fed are risk free; balances at the Fed are better since they pay a higher interest rate. Banks have every incentive to hold excess reserves rather than Treasury bills.

Why does anyone hold Treasury bills given these interest rates? Not everyone is able to earn interest on reserves at the Fed. Among other institutions, money market funds and the government-sponsored-enterprises Fannie Mae and Freddie Mac cannot earn interest on reserves.

Banks are able to borrow funds from those institutions at rates less than the interest on excess reserves and then deposit the funds at the Fed, at which point the banks earn the difference between the 25 basis points (1/4 of a percentage point) on excess reserves and the lower rate at which they borrowed. In effect, the interest on excess reserves and the lower rate on Treasury bills set up an arbitrage for banks in short-term borrowing and lending.

At least so soon after the financial crisis, banks are not likely to want to fund long-term loans by this very short-term funding. (Overnight funding of asset positions is exactly what got investment banks into difficulties in the Financial Crisis of 2008-2009.) The Fed ends up with higher reserves funding its asset purchases with no apparent effect on M2 as a result.

The failure to expand bank loans is even less surprising since about half of the increase in reserves is held by U.S. branches of foreign banks. Most of these banks are not in the business of making car loans or similar loans in the United States and are not likely to go into that business simply because they borrow and lend short-term funds as an arbitrage. Even if they were so inclined, they are not likely to be inclined to fund relatively long-term assets by borrowing very short term, any more than U.S. banks are.

Are Bitcoin Mining Pools a Natural Monopoly?

Bitcoin relies on competitive mining to add new blockchains, thereby finalizing transactions and creating new bitcoins.

If there is a monopoly in mining bitcoins, then Bitcoin fails to achieve a design goal of having an open process which does not rely on one trusted entity such as a private firm or a central bank. The monopolist must be trusted or else Bitcoin falls apart.

Miners solve a computational problem: finding a hash less than or equal to a target value. Miners are participating in a contest to be first and the winner takes all.

Miners face the risk every period that they will not win; if they lose, they receive zero. Miners reduce this risk by combining in pools of miners and sharing the payoff when a member of the pool finds a hash less than the target value.

By itself, if all miners are risk averse, the optimal strategy is to form a single mining pool. Furthermore, even if there is more than one pool, a risk averse miner is better off joining the biggest pool if all the pools are the same in all other respects. The bigger the pool, the less risk an individual miner faces.

distribution of mining

Distribution of mining for four prior days on July 4, 2014

There is a tendency toward a natural monopoly in mining due to this pooling of risk in mining pools. This does not imply that a monopoly is an inevitable result or even a particularly likely one. After all, there is more than one pool. The attached graph shows the distribution of payouts on July 4, 2014 for the prior four days. At times, Ghash.IO has included 40 to 50 percent of all mining activity.

Why is there more than one pool? One answer would be that mining is on its way to becoming one pool and it just has not gotten there yet. A different answer consistent with differences across pools is that pools have different payout schemes and other characteristics which appeal to different miners. If differences across pools are the explanation for there being more than one pool today, there is no necessary reason there ever will be just one pool. A third answer would be based on the behavior of pools that become more dominant. As a pool becomes more dominant in miners’ computations, its terms to miners become less attractive. Possibly this third answer is part of the explanation as well.

All of this is assertion with the underlying argument. The following discussion inevitably gets somewhat complicated to support the assertions. I have tried to make it as clear as I can and avoid technical details.

The Details

Mining is organized into pools of miners. For some time, a single miner with one computer has not been able to mine on his own without highly variable returns. While mining is organized as a contest to be first, finding a hash less than or equal to the target hash is a matter of computing hashes and searching over an extremely large space to find a hash less than or equal to the target. Directed search is useless because nearby hashes bear no relationship to each other. Skill in searching is non-existent; search might as well be random over the space.

The variance of returns from mining alone is substantial. Illustrative calculations show how high the variance is.

One bitcoin mining calculator shows that a mining rig with a hash rate of 1,650 Gigahashes per second would break even on its initial outlay of $1495 after 86 days if it receives the expected revenue each and every day. It also shows that the expected time for the miner to find a block on his own is 507 days. If this block pays off roughly $600 for each of the 25 bitcoins, this is a payoff of $15,000. The implied variability in the time to payoff is huge.

This can be seen in a way which illustrates the issue more directly. Suppose that the difficulty were constant at 16,818,461,371, the total number of mining Gigahashes per second (Ghash/s) were constant at 143,627,333 Ghash/s and the payoff of 25 bitcoins also were constant with a price of $600 per bitcoin. (Other than the prices, these are the parameters on July 4, 2104 and the price is roughly $600. Success in finding a winning hash would generate a payoff of $15,000. Nice. Suppose that a miner mines at the rate of 1,650 Ghash/s. This miner has a probability of 0.00115 percent of finding the winning hash value in any ten-minute period.

Mining alone is risky in the sense that one might do quite well, and one might do quite badly.

The probability of success in a ten-minute period is the same as the fraction of total Gigahashes performed by a miner. The probability that a miner with a hash rate of 1,650 Ghash/s would find a hash less than the target in any 10-minute period is 0.11488*10-2 percent at the current difficulty rate.

If this probability of success is constant, mining for a year has a probability of one or more successes of 45 percent. Mining for two years has a probability of one or more successes of 70 percent. Conversely, the probability of not having received a single bitcoin is 30 percent after mining for two years. Even after mining for four years, the probability of not having earned a single bitcoin would be 9 percent. This is a rather bad outcome given the outlay for the mining equipment and the electricity.

Mining in a pool reduces this variance. And the bigger the pool, the more the variance is reduced.

In the limit, if all miners belonged to one mining pool and it always took ten minutes to find a hash less than or equal to the target, every miner would receive a fraction of 25 bitcoins equal to their effort every period. There would be no variability in return. The miner above would receive 17.23 cents every ten minutes, or $24.81 a day. While not grand, after a year this is $9057.19, which is not trivial given the likely outlay. This overestimates the actual likely revenue because the difficulty increases over time and the payoff in terms of bitcoins decreases, but the numbers illustrate the point. If everyone is in one pool, the risk of losing the contest to produce a successful hash is zero.

In these simplified circumstances, pooling ones’ work with all other miners generates a 100 percent probability of earning $18,114.38 in two years. Mining alone has a probability of 30 percent of generating no return at all in two years.

Even if a pool does not include all miners, the variability of the return will be less the larger the pool.

In reality of course, belonging to a pool will not reduce the variance completely. I have abstracted from the possibility that a hash less than or equal to the target will be found in less than ten minutes or more than ten minutes. This is common risk and pooling risk across miners will not reduce it. It is just there in the environment. But pooling risk across miners can reduce the risk that an individual miner will face because they may not be first.

Mining is a contest to be first. Why is it different than other contests, such as athletic contests or contests to become CEO of a company? In those contests, there are skill differences across participants. The contest to be first reveals qualities that have value to viewers, stockholders and others.

The contest to find the winning hash is affected by the number of hashes that can be done on hardware run by individuals and will be affected by downtime which can be shortened by skill. Still, in the end, the search for a hash reveals nothing about miners themselves.

Finding a hash less than or equal to the target does serve useful functions in the bitcoin economy: 1. finalizing transactions; 2. distributing new bitcoins. Those are quite important.

It now would almost be traditional for me as an outsider to say that Bitcoin must change its operation to deal with this difficulty.

I’m not going to say that. Rather, as I indicated in the first part of the blog, I think that other factors will prevent mining from being monopolized. Indeed, for reasons I indicated in my previous blog, I think that it is important that most pools be identifiable and develop reputations. It’s the “unknown” mining pools that are more likely to cause problems than GHash.

Sorry for this being so long but I don’t see how to make it shorter.

 

Bitcoin mining and monopoly

Bitcoin mining has come under scrutiny recently because one mining pool, GHash, seemed to have more than half the mining resources used in mining Bitcoin. Bitcoin mining is important because the bitcoin protocol relies on competitive mining to authenticate transactions as well as to create and distribute new bitcoins.

The existing discussions of this issue are at best incomplete.

It has been claimed by Eyal and Sirer in their paper “Majority is not Enough: Bitcoin Mining is Vulnerable” that they “show that the Bitcoin protocol is not incentive-compatible.” As a result, they have argued for a “hard fork” because it is possible for a miner to gain more than a proportionate share of earnings – new bitcoins and transactions fees – once it has sufficient computing power under its control.

It is important to note what they actually show. They show that it is possible for a participant in mining with sufficient resources to gain more than a proportionate share of earnings by a strategy of mining privately and revealing its new blocks strategically. Revelation occurs when other miners – call them public miners – find a block. If private mining has not found a block, then the private miner moves to the new blockchain and continues. If the private block has one or more new blocks, then the private mining announces those blocks. The new private addition will contain at least one block and sometimes two or more blocks. The greater-than-proportionate earnings come from having more than one block sometimes. The more mining power, the higher is the probability of adding more than one block.

Currently, such a participant would be a mining pool. The practical example which has accumulated on the order of half of mining power is the mining pool GHash.

In “The Economics of Bitcoin Mining”, Kroll, Davey and Felten argue that Bitcoin is susceptible to attacks from determined adversaries who are willing to expend resources to disrupt Bitcoin. They argue, as a result, that Bitcoin inevitably will have a governance structure which is identifiable.

How would an economist, as compared to computer scientists, approach this issue?

First, mining bitcoins is a dynamic game. Equilibrium occurs for multiple periods. Second, miners are not anonymous in the sense that any miner, let alone a mining pool with a large fraction of total resources, is anonymous. To be clear, the identities of the people who are miners may well be anonymous but the miners, as miners, are not anonymous. It is not the case that all peers in the bitcoin universe are treated the same and are unknown. For example, the Bitcoin Wiki lists a number of fallback nodes considered reliable. It also compares the characteristics of mining pools.

In a reputational equilibrium, participants develop reputations and maintain them. The reputations are maintained because failure to do so results in outcomes that have lower value than maintaining the reputation. This is the situation which confronted GHash recently and the pool behaved as I would have expected, taking actions to continue creation of bitcoins.

Mining can be supported by a reputational equilibrium because the game is dynamic, there are a finite number of participants, and at least some participants are not anonymous,. The identities of the participants matter. Any strategy such as switching addresses to hide any particular strategy (such as superseding existing blocks as in Eyal and Shirer) will be evident quickly. For example, other participants would have an incentive to ignore blocks announced by that miner and move on.

This does not mean that the current protocol deals with known attacks, let alone all possible attacks. It does not. In fact, it is not possible to have a set of rules that provides pre-determined actions in all possible states of the world. There is not enough ink or hard-disk space in the world, and there probably still would be unknown attacks no matter how much effort were devoted to thinking of new ones.

A structure to determine the rules for Bitcoin in unforeseen eventualities is inevitable. And it does exist of course as the Bitcoin Foundation. In part, this echoes a point made by Kroll, Davey and Felten.

Bitcoin is not a completely anonymous implementation of a set of rules that can run forever with no human oversight. But then, this is true for open-source software, so it’s hard to see how it could be true for something as complicated as a digital currency.

I am not, of course, claiming that I have shown there is a reputational equilibrium for mining. I haven’t. I have outlined what it would have to look like. There would be a problem completing this analysis though.

The mining protocol creates the observed tendency toward monopoly in mining. In the next week, I will discuss why on this blog.