CFA Society Chicago Book Club:

The Accidental Superpower: The Next Generation of American Preeminence and the Coming Global Disorder by Peter Zeihan

superpowerGeography is destiny.  Demography is second.  Everything else is a distant third.  That’s the takeaway from Peter Zeihan’s The Accidental Superpower: The Next Generation of American Preeminence and the Coming Global Disorder, which was the book of the month for the CFA Society Chicago’s Book Club in January 2017.  From settling the Nile Valley to deep water navigation and the shale oil revolution, Mr. Zeihan explains how geography influences almost every aspect of civilization from formation to eventual demise.  Landlocked countries tend not to have navies of any consequence.  Countries with neighboring threats tend not to have excess resources to project military power beyond their borders.  Countries lacking internal resources are more likely to engage in trade.  The fact that the US is facing two oceans and has no neighboring threats coupled with its need to secure energy and goods explains how she can—and has—projected her power abroad for decades in part to secure global trade.  The shale revolution and ample food supplies coupled with the rising costs of extra-continental labor and domestic supply chain alternatives such as 3D printing explain why she might no longer need or care to.  The conclusion is that a newly self-sufficient and relatively young US will withdraw from participating in global trade and security while the rest of the world collapses under the weight of its aging populations and competition for scarce food and energy.  How’d we get here?

To answer that question, rewind to the beginning of the book, which starts at the end of World War II, the most destructive war in human history, and the agreement that helped in part to ensure that it never happened again, the Bretton Woods Agreement, signed by 44 countries at the Mount Washington Hotel in Bretton Woods, New Hampshire.  In addition to the consequences of that momentous agreement, we learn that its namesake town and the Hotel at which it was signed were so overwhelmed the 730 delegates that descended upon it that the Hotel’s manager locked himself in his office with a case of whiskey at one point during the gathering and refused to come out.  Those anecdotes along with Mr. Zeihan’s wry sense of humor alone made the book well worth reading.  The Agreement’s consequences were threefold: (1) all the signatories’ currencies were to be freely convertible into US dollars at a fixed rate, and the US dollar was likewise to be exchangeable for gold at a fixed rate, (2) the US would protect maritime shipping, and (3) the signatories would be part of a “strategic umbrella” of protection against the common Soviet threat.

Just as geography had ordained that the WWII belligerents compete militarily to secure markets, resources, and shipping, the Bretton Woods Agreement with the stroke of a pen ensured that they would no longer need to.  Being freshly ravaged by war and facing a common Soviet threat further ensured their assentation to the agreement.  In addition to Bretton Woods, there was one more ingredient in the elixir that spawned the post-war boom: demography.  The signatories boasted youthful populations.  Few variables in economics are known with near certainty for any extended period of time.  Demographic variables are an exception.  At any given time in any given country, one can tell with reasonable certainty how many skilled young workers will be entering the workforce.  Skilled workers don’t magically fall from the sky ready to leave home and acquire gainful employment, as much as their parents may wish it. There is a pipeline from birth to school to adulthood.  Once in the workforce, laborers again follow a predictable life cycle. As they begin working, they begin paying taxes and saving.  As their savings grow, they deploy their savings into capital markets until they finally retire, spend down their savings, and increasingly rely on the next generation of tax payers for their welfare.  Here again the US, while still aging, is relatively young and demographically well positioned relative to the rest of the World, Mr. Zeihan argues.

The book club members welcomed Mr. Zeihan’s geographic and demographic analysis as a compliment to traditional economic and financial modes of analysis. The members did, however, cast doubt on some of his conclusions and predictions.  The first was the premise and title of the book, Accidental Superpower.  One member noted that the Founders were quite deliberate in their desires to build the US into a military and economic superpower, the subject of a recent popular musical.  No one gave serious credence to Mr. Zeihan’s prediction that Alberta, Canada, might become the 51st state.  If Mr. Zeihan had cast a critical eye towards the US and applied some of the same analysis that he applied to the rest of the world, he might have found similar fissures.  Many Western and Southern US States are net beneficiaries of federal aid and lament the federal government’s intrusions in their lives.  If armed standoffs like 2014 one with Amon Bundy in Nevada become more commonplace, it’s at least as plausible as some of Mr. Zeihan’s other claims that net-contributor states might leave those states to fend for themselves.  More importantly, Mr. Zeihan’s arguments about geography and physical capital didn’t seem as relevant to the Members as the author claimed them to be in the internet age, and one certainly doesn’t have to be a naval power to wreak havoc in the cyberwar era, as the US again learned in the 2016 election of Mr. Trump as President.

Alberta, Canada, might indeed become the 51st and prove the Club Members wrong, and even with its other potential omissions and shortcomings, Accidental Superpower was an eminently enjoyable and worthwhile read.

CFA Society Chicago Book Club:

The Only Game in Town by Mohamed El-Erian

the-only-game-in-townExtraordinary central bank interventions during economic crises aren’t new.  In his Pulitzer Prize-winning Lords of Finance, Liaquat Ahamed mentions Emperor Tiberius injecting one million gold pieces into the Roman economy to keep it from collapsing in 33 AD.  Extraordinary central bank policy coordination similarly isn’t new, as Mr. Ahamed notes with the frequent meetings between the heads of British, French, US, and German Central Banks and the resulting coordinated policy actions during the First World War and the Great Depression.  What is new is the extent and duration of those interventions and the absence of any corresponding fiscal or structural reforms. After Tiberius’s intervention, Rome soon returned its focus to commerce, conquest, and imperial assassination.  Roman merchants and farmers didn’t sit idly waiting for the next round of monetary stimulus and then dispose of their wares and crops in panicked fire sales when cheap money didn’t materialize.  Contrast that with our times.  Six years into an economic expansion, interest rates remain at historic lows—even negative in several major economies—with little hope of fiscal or structural reform.  A small uptick in volatility can elicit calls for further quantitative easing (college campuses apparently aren’t the only places where people are clamoring for safe spaces).  Central banks have become The Only Game in Town, the title of Dr. El-Erian’s book and the subject of the CFA Society Chicago’s July 19, 2016, Book Club meeting.

Dr. El-Erian brings uniquely diverse cultural, educational, and professional perspectives to the financial crisis and the ensuing central bank interventions.  His mother is French and his Father is Egyptian, and he spent time growing up in Egypt, in France, where his father was the Egyptian Ambassador to that country, and in New York City, where his father worked at the United Nations.  His enrichment continued in the United Kingdom where he attended boarding school, Cambridge, and finally Oxford, where he earned a doctorate in economics.  His professional resume is equally diverse and impressive.  It includes the International Monetary Fund (IMF), Harvard University’s endowment, and PIMCO, one of the world’s largest bond investors with approximately $2 trillion under management.  It’s there where Dr. El-Erian served as co-CIO along with PIMCO-founder Bill Gross.  That’s in addition to his numerous publications, boards and committees, and his previous book, When Markets Collide, which won the Financial Times and Goldman Sachs Business Book of the Year Award as well as The Economist’s Book of the Year Award in 2008.

In addition to his qualifications to write on the subject, Mr. El-Erian served as CFA Society Chicago’s keynote speaker at its 2015 Annual Dinner, which further piqued Book Club members’ interest.  In his exposition of the issues facing global markets and central banks’ responses to them, Dr El-Erian didn’t disappoint the assembled Book Club Members.  In the plain-spoken fashion that made When Markets Collide a classic, he explained complex, interdisciplinary phenomenon in simple terms with the assistance of helpful metaphors.

For example, he explained the collapse in confidence and liquidity during the crisis in terms of a drive through: Customers pay at the first window and receive their food at the second.  When customers aren’t confident that they’ll receive their food at the second window, they’ll demand it at the first window.  When restaurants don’t relent, both parties that otherwise wish to transact will walk away – market failure.  As another example, he explained that trying to push certain products and activities out of the banking system was like pushing on a waterbed.  Rather than remove the activity, pushing simply displaces the activity to elsewhere in the bank and non-bank financial sectors.

Dr. El-Erian also noted the increase in the size and power of the end-users of capital, the buy-side, relative to financial intermediaries, the sell-side.  The phenomenon has been noted, among others, by John Rogers, the former CEO and President of the CFA Institute, in A New Era of Fiduciary Capitalism? Let’s Hope So, which appeared in the May/June 2014 edition of the Financial Analysts Journal.  Dr. El-Erian explained the consequence of that transformation, namely that the growing end-users are trying to force more transactions through the shrinking pipes of the financial intermediaries.  The result in the financial world is as calamitous as the result in the plumbing world.

In all, Dr. El-Erian noted nine challenging trends in global economies related to extraordinary extended central bank interventions, the subject of Part Three of his book: inadequate growth models, high unemployment, increased inequality, decreased institutional credibility, political gridlock, increased trade imbalances and tensions between the core and the periphery of the global economy, the rise of shadow banking, decreased liquidity (the pipes mentioned above), and finally the increased complacency among market participants due to a perceived central bank put.  In that exposition Dr. El-Erian touched on several insightful points.  For example, he noted the Bank of International Settlements (BIS) meetings allowing for back-channel discussions and problem solving between the monetary authorities of different economies.  A similar mechanism for averting armed conflicts through international organizations such as the United Nations has been noted in Bruce Russett and John O’Neal’s Triangulating Peace.  Perhaps a longer book would have allowed those points to be developed further.  The Only Game in Town is only 296 pages, including appendix.

That largely concluded the exposition of the problem, where Book Club Members gave Dr. El-Erian high marks.  The remainder of the book was a meandering attempt to solve the problems noted in the first part of the book, which left members disappointed.  The desultory journey covered bi-modal distributions, behavioral finance, several other topics, and even a section on diversity in the workplace.  One member quipped that the last chapter of the book was probably a last-gasp effort to fulfill a contractual minimum page requirement with the publisher.  Dr. El-Erian had a similar chapter on organizational leadership at the end of When Markets Collide.  In that book he also noted the failure of macro-prudential regulators such as the IMF, his former employer, to balance their academic training with technical knowledge gleaned from actual market participants.  Perhaps better institutional leadership and reforms, including more diversity, could foster economic stability and growth, but Dr. El-Erian failed to argue the point persuasively, at least in the judgement of the participating Book Club members.

The Only Game in Town is a worthwhile addition to the discussion about the continued role of central banks in the current economy and the potential pitfalls of continuing down the current path.  Even though Dr. El-Erian ultimately failed to solve the problems he elucidated, he’s hardly alone in that regard.

CFA Society Chicago Book Club:

Age of Ambition: Chasing Fortune, Truth, and Faith in the New China by Evan Osnos

age of ambitionMost of us have a well-formed macro perspective on China. It’s the world’s second largest economy and a key U.S. trading partner with growing influence in Asia and globally. In Age of Ambition Evan Osnos takes us beyond the statistics, building a complex portrait of China through its people. The author introduces us to citizens from all walks of life with widely different views on politics, the economy, social issues and the Country’s future. He reveals the monumental changes, challenges and contradictions China faces by telling their stories, tracing their lives over the years and exploring their goals, aspirations and attitudes. It’s an up close and personal look that’s highly engaging.

We follow several progressive reformers like Ai Weiwei, a famous artist who publicly mocks inequities; Han Han, a snarky and wildly popular blogger who takes aim at rampant hypocrisy; Liu Xiaobo, a leading voice for human rights who won a Nobel Peace Prize while imprisoned for advocating political reforms; and Chen Guangcheng, the “blind peasant lawyer” who helps his poor rural neighbors fight injustice by local officials.

We also meet conservative nationalists like Lin Yifu who defected from Taiwan to China in 1979 with the dream of helping China reclaim its greatness. He became a chief economist at World Bank and evangelized China’s central planning methods. Tang Jie is a graduate student whose viral patriotic video inspired Chinese people to stand against protests of China’s repression in Tibet. He and other nationalists view foreign criticism as part of an ongoing plot to encircle and weaken China. Interviews with these and other personalities span years and it’s fascinating to observe how their views develop as the country rapidly evolves.

The author takes us beyond the headlines of scandals and disasters like China’s real estate boom, organized crime and explosive growth in Macau, riots in the Uighur region, earthquake in Sichuan, conflict with Japan over the Diaoyu Islands and the “Harmony Express” bullet train crash. State controlled media tries to shape these stories but is often undermined when details emerge. The collapse of schools in the Sichuan earthquake and the “Harmony Express” crash were eventually linked to corruption that allowed shoddy building practices. Fraud was so widespread in the railroad ministry that its chief Liu Zhijun was convicted of taking kickbacks and bribery to win a Party Central Committee post. However, the truth-seeking public also can pay a price. After the Sichuan earthquake, parents who demanded information about missing children were detained.

Several book club attendees thought the author could have quantified the material better. And we also noted he doesn’t take a position or recommend action to resolve the country’s challenges. It’s true, Age of Ambition isn’t China-by-the-numbers, but it does offer rich insight into the Chinese worldview and their perspective on the country’s challenges. Our discussion was made especially interesting having Yunjin Wang and Yang Xu, CFA, add clarity and context about their home country. Both felt the book was accurate, but also noted significant changes have occurred in the short time since it was published in 2014, including the crack down on fraud and tightening of the “Great Firewall” by incoming President Xi Jinping, as well as the profound effects of ongoing economic shifts.

Key takeaways from Age of Ambition were the existential threats facing the Communist Party and their hold on power:

EXTREME WEALTH INEQUALITY

Market-based policies have created dramatic growth, but the benefits have gone mostly to politically connected businessmen and officials. China’s true Gini coefficient of wealth distribution is estimated at 0.61, among the world’s worst. This inequality stands in stark contrast to the Party’s ideal of a classless society. There’s growing frustration with the lack of social mobility. Wages for college grads have been flat since 2003 and there are six million new college grads per year. Meanwhile economic growth is slowing. “Parental connections” were found to be the most decisive factor in a child’s earning potential instead of “parental education,” the typical factor in other countries.

THE INTERNET

The Party is wary of fast-moving ideas, even those that support the government. Control of information is absolutely crucial to them and the book gives a fascinating look at their methods: the “Great Firewall,” text message monitoring, “Fifty Centers” paid to disrupt sensitive online conversations, orders issued to news outlets and publishers on forbidden words and topics, etc. But despite this censorship we see how artists, bloggers and activists use the internet to expose corruption and express their views, often with tragic consequences. Internet and mobile phone penetration are growing fast, so this challenge will continue.

INNOVATION

To transition its economy toward domestic consumption and grow its service industries, China needs to foster innovation, but official propaganda aiming to have citizens “sing as one voice” and a deeply-rooted requirement for conformity work directly against building a culture of creativity and innovation.

INDIVIDUALITY

The Party controls the legal system, education, industry, media, communications and faith groups, but as Chinese people become educated, urbanized and wealthier they’re craving more autonomy in their work, family and spiritual lives. This works against Party efforts to “harmonize” society.

Overall, Age of Ambition is a well-written and highly insightful book that’s sure to enrich your understanding of China’s people, challenges and future.

CFA Society Chicago Book Club:

The Green and the Black: The Complete Story of the Shale Revolution, the Fight Over Fracking, and the Future of Energy by Gary Senovitz

GreenBlackOne of the benefits of being a part of the book club is learning about industries, markets, or products that are outside one’s normal course of life.  I know little of the oil and gas industry, having spent most of my life researching and working in the financial service industry.  I would encourage everyone to keep an eye on the Book Club upcoming lists, and choose one or two that would increase your breadth of knowledge and join us for the discussion.

What happens when a self-described New York liberal (the Green) meets an oilman (the Black)?  Or in an interesting twist of fate they are the same person?  Senovitz is a Managing Director of a Private Equity firm (Lime Rock) in New York that specializes in the oil and gas industry, and is also a devout liberal worried about environmental issues and the future effects of climate change.   The end result is a very entertaining and even handed account of hydraulic fracking and a great story of its history and development.

The book begins with the history of hydraulic fracking and with riveting accounts of its biggest pioneers such as Audrey McClendon of Chesapeake Energy, George Mitchell of Mitchell Energy, Mark Papa of EOG Resources  and Harold Hamm of Continental Resources.  The four are described as the Mount Rushmore of the Shale Revolution.  Their stories are a big part of the boom that led to the success of fracking: risk takers always seemingly on the edge of bankruptcy.  They persevered by staying true to their beliefs and their refusal to give up while others scoffed and laughed at them.  Many accomplished their success, simply because they did not know what else to do but continue to try.

The narrative continues to wind through many of the issues surrounding fracking.  The author breaks down the Documentary Gasland as more staged propaganda than facts and leading to an unneeded public hysteria, but also highlights real concerns such as surface contamination and noise which are very damaging and must be properly managed.  Senovitz remains tortured that fracking will lead to more carbon use, but he runs through large amount of statistics to make his case that it is really a natural gas boom that has led to the United States greatly reducing its dependence on coal and lowering its carbon emissions.  Other benefits include creating jobs, reducing American dependency on foreign energy and improving lives globally by spreading cheaper energy worldwide.

The author also describes the ongoing battle between the Yes in My Backyard (YIMBY) vs. the Not in My Backyard (NIMBY) factions.  States like New York and California (NIMBYs) have no problem utilizing massive amounts of the energy from states like North Dakota and Pennsylvania (YIMBYs), but refuse to let fracking on their home turf.  This visible hypocrisy is well discussed, and the author leaves no doubt that the NIMBY’s arguments are more political than sensible economic or scientific positions.

We found the book to be quick paced, and enjoyable.  The narrative provides a wealth of information that is important for all to consider on this controversial activity.  The Green and the Black is one of those special books which keep many of us returning to the book club.  Please join us in the future; we believe you will not regret the time.

CFA Society Chicago Book Club:

While America Aged: How Pension Debts Ruined General Motors, Stopped the NYC Subways, Bankrupted San Diego, and Looms as the Next Financial Crisis by Roger Lowenstein

While America AgedThe specter of unfunded pension liabilities haunts many of our major cities and a large number of public companies. This is especially true in the city of Chicago as public unions continue to threaten to strike over benefits and unfunded pension liabilities. We discussed Roger Lowenstein’s book about this topic at a well-attended CFA Society Chicago Book Club meeting held in April. The book attempts to answer why the private pension system as conceived in the United States has failed.

Mr. Lowenstein divides his book into three parts. Each part addresses the pension crisis from the perspective of; a public company (General Motors), public service workers in New York, and the public service worker pension plan for the city of San Diego.

Part One: Who Owns General Motors?

The question asks whether it is the shareholders or workers who own a publicly traded company.  GM was one of the most successful companies in the world, however due to labor union gains at the bargaining table, its future cash flow would not accrue to its shareholders, but rather to its pension obligations.

This part of the book revolves around Walter Reuther and the UAW. Mr. Reuther became the visionary leader of the UAW in the 1930’s. In 1950 Mr. Reuther crafted what Fortune Magazine dubbed the “Treaty of Detroit”. It was a 5-year agreement which committed GM to guarantee a pension, wage increases with a cost of living formula and hospital and medical insurance at half cost. It was the inability to fund these ever-growing commitments which eventually led to the downfall of GM.

Part Two: The Public Freight

Pension plans for city workers help to guarantee a stable work force; a highly desirable trait for teachers, firemen and transportation workers. Reliable bus and train service is critical for the economy of a city. The second part of the book examines the history of wages and pensions for the public workers of New York City.

The most effective union leader was Michael Quill, an Irish immigrant who was a member of the IRA and fought in the rebellion against the British. In the 1930’s, the Transit Workers Union (“TWU”) was led by a coalition of Communists and former IRA activists. In 1937, Mr. Quill became President of the TWU. A 13-day strike in 1965 permanently changed the dynamic between the unions and the city. New Yorkers endured the worst traffic-jams in its history during this strike. The state government reacted by passing stricter laws prohibiting strikes by public workers. These laws were ignored as union leaders happily went to jail. The citizens of any municipality are captive customers and are unable to shop elsewhere for subway service or police protection.

Part Three: Debacle in San Diego

The risk that the government will put the expense of a pension plan onto future generations is illustrated by the city of San Diego. By the summer of 2005, the municipal pension fund in San Diego, the San Diego City Employees Retirement System (“SDCERS”) was underfunded by $1.7 billion. How it got that way is addressed in the third part of this book.

In 2005 the national press referred to San Diego as “Enron-by-the-Sea”. The cause of the underfunding was the extreme reluctance of local politicians to raise money by increasing taxes. The political climate in the city was very conservative with a mistrust of any tax. The city covered its cash shortfalls by continuing to avoid making the required pension contributions.

Labor unions in the city began to contribute heavily to political campaigns; this was more effective in San Diego which had a weak form of city government where a relatively small amount of votes could sway elections. In the end, public employee unions had political clout on par with business interests. City managers became more adept at structuring solutions which circumvented state laws regarding the required funding of SDCERS.

Conclusion: The Way Out?

The author has a few suggestions as to how to mitigate some of the risks endemic to these pension and health care schemes. However, most participants at the Book Club thought they were rather weak. The author is of the opinion that the 401K is not an adequate substitution for a pension and advocates a “national” 401K offering matching credits to lower wage earners. He also suggests that 401K providers be required to offer an annuity as a default option. The author ends the book with a plea to strengthen social security by raising taxes, an unpopular but perhaps necessary measure.

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CFA Society Chicago Book Club:

My Side of the Street: Why Wolves, Flash Boys, Quants, and Masters of the Universe Don’t Represent the Real Wall Street by Jason DeSena Trennert

my sideIf you have a history in this business or seeking to pursue it, have read any of the popular finance books, or simply sat back and enjoyed some of the classic Wall Street movies, you will certainly appreciate this well-crafted and first hand perspective of the finance industry.  The title was quite interesting because if you are a voracious reader of investment literature, you will reflect back on the excesses in the Wolf of Wall Street, the questionable high frequency trading dark pools in Flash Boys, or the so called “Master of the Universe” in Bonfire of the Vanities.  The author paints a much different picture for people who have formed their views on Wall Street based on the financial crisis, outsized bonuses, insider trading scandals, options back-dating, and movies like Boiler Room.  He describes the hundreds of thousands of finance professionals that work hard every day to support their families, pay their mortgage, and act with ethics in their business practices.

You can learn a significant amount from someone as successful as Mr. Jason Trennert.  The opportunity to learn his side of the street can be very valuable to our own careers.  Mr. Trennert, also known as “Jase” by those close to him, takes us through his experiences starting off as a cold caller, moving on to institutional sales with extensive travel and client facing interaction, business school at Wharton, and eventually starting his own firm.  Ultimately, it seems that his love for macro, entrepreneurial spirit, and past experiences set him on the path to start Strategas.  You can learn from Mr. Trennert’s experiences on how to break into Wall Street, build connections, go from back to front office, the value of reading both investment literature and non-fiction, the importance of curbing the late night entertaining, when to say no to opportunities, and perhaps when to know it’s time to become the captain of your own ship.  At the end of the book, Mr. Trennert offers some wise career tips such as assuming no one will help you until you’ve accomplished something, focus on achievement rather than status, live CAPM, play your strengths, Wall Street is both large and small, and finally….Read!

 

Upcoming Schedule:

April 19, 2016: While America Aged: How Pension Debts Ruined General Motors, Stopped the NYC Subways, Bankrupted San Diego, and Loom as the Next Financial Crisis by Roger Lowenstein

May 17, 2016: The Green and the Black: The Complete Story of the Shale Revolution, the Fight over Fracking, and the Future of Energy by Gary Sernovitz

June 21, 2016: Age of Ambition: Chasing Fortune, Truth, and Faith in the New China by Evan Osnos

 

To sign up for a future book club event, please click here:

http://www.cfachicago.org/apps/eve_events.asp

CFA Society Chicago Book Club: “The Age of CryptoCurrency: How Bitcoin and Digital Money are Challenging the Global Economic Order” by Paul Vigna and Michael J. Casey

Bitcoin with its underlying blockchain technology is by far the most controversial and least understood of the fintech innovations revolutionizing financial services. Since it was conceived in 2008 it has generally been viewed with suspicion, even outright derision. But both the currency and the technology are gaining legitimacy and there’s growing interest in its potential, as shown by these informal indicators:

  • Strong growth in startup funding by top VCs and investors: bitbetween 2013 and 2015 venture investments grew from $95M to $622M per this recap http://www.coindesk.com/bitcoin-venture-capital/
  • Improvement in price volatility (but still far from stable): high/low in 2013 was $1,147/$13, and in 2015 was $456/$214
  • Robust discussions at the 2016 World Economic Forum, European Parliament, IMF, CFTC and other venues to consider the value, drawbacks and risks of bitcoin and blockchain
  • Continuing evolution of regulations: New York’s BitLicense requirements, IRS and CFTC rulings, general openness in the UK, Hong Kong, Switzerland, Bulgaria, Romania and elsewhere

At the February CFA Chicago Book Club meeting we discussed Paul Vigna’s and Michael J. Casey’s excellent book on all things bitcoin and blockchain. The two Wall Street Journal reporters thoroughly explored the origins, mechanics, personalities, motivations, recent developments and future of this fascinating technology.

There’s a shroud of ambiguity around bitcoin. It can be characterized as a currency, commodity, payment protocol or an expansive platform for trading anything of value, and the authors clearly explain each of these perspectives. They also describe the underlying technology and its two key breakthroughs: a universal ledger that captures every transaction and is continuously verified, and an incentive system for “nodes” to maintain the ledger. Bitcoin exists as a chain of digital signatures. Owners privately transfer coins by digitally signing a hash of the previous transaction and the public key of the next owner, adding their signatures to the end of the coin. Note, a “hash” is just a long string of characters and hashing is a common technique used in encryption and data-storage. The open source blockchain code tells computer nodes how to collaborate in maintaining the integrity of the universal bitcoin ledger via a process called mining.

Everyone’s heard about bitcoin “miners” who dig up newly minted electronic currency, but mining is really a misnomer. Networked computer nodes do the work of confirming that transactions are valid, verifying the ledger is correct, getting all other nodes to agree, closing the previous block of transactions and opening a new one. While doing so they can earn new bitcoin as a reward. There’s more to it, but essentially this is mining. The sequential blocks of transactions form the chronological blockchain ledger. One block, or group of transactions, is closed and a new one is opened every 10 minutes or so. Anyone with a computer and internet access can establish a node and mine, but to increase the likelihood of earning bitcoin miners employ massive computer power. There are dedicated server farms in the U.S. and abroad using computers designed just for this purpose. China is especially active in bitcoin mining.

The origins of bitcoin have contributed to its mystique and notoriety. A person or group named Satoshi Nakamoto conceived the open-source computer code on October 31st, 2008, by posting on a message board for cryptographers. It caught the attention of Hal Finney who dabbled in encryption technology in his off hours. He and Sathoshi worked to get the open-source protocol running in 2009, and slowly others began to adopt and use bitcoin. The cryptocurrency also appealed to “Cypherpunks”, an anarchic, libertarian group concerned with privacy protection and subverting the power of banks and governments to create economic crises and serve corporate interests at the expense of citizens. Satoshi’s true identity and motivation for introducing bitcoin aren’t known. He or she essentially disappeared in 2011 and past communications were encrypted, sparingly worded and didn’t elaborate on philosophy.

The current system for handling credit card transactions illustrates the problem bitcoin intends to solve. The authors walk through an everyday coffee purchase: seven entities are involved, including the merchant, front-end processors, payment processors, banks, credit card associations, clearing houses, etc. These entities share our banking and personal information, and of course earn fees which are paid by the merchant and ultimately you and I. Fees can total 3%, and much more when traveling abroad. This same transaction using bitcoin is strictly between the merchant and purchaser. The universal ledger confirms funds are available and validates the transaction. No personal information is shared because bitcoin is encrypted. No third party intermediaries are needed and no transaction fees are charged. In this scenario there’s no need for banks, credit cards, payment processors, dollars, euro or yen. Bitcoin proponents envision huge economic benefits from eliminating transaction fees.

A growing list of merchants accept bitcoin as payment for some or all of their products, including Dell, DISH Network, Microsoft, Expedia, Overstock, Newegg and many others. However, there are good reasons to be skeptical. Public perception suffered after several hacking incidents. For example, Mt. Gox, an early bitcoin exchange lost 650,000 of its client’s bitcoins and finally collapsed, impacting 127,000 users. Silk Road was another high-profile debacle. It was an Ebay-like site for trading in illegal drugs and assassinations that used encryption to hide web traffic and the anonymity of bitcoin to keep transactions private. Its operator, Ross Ulbricht was sentenced to life in prison for money laundering and trafficking narcotics. There’s also conflict within the bitcoin community itself, most recently related to a proposal to expand bitcoin transaction volume capacity, which is a small fraction of established payment systems. The argument exploded very publicly into death threats, virus attacks and censoring bitcoin discussion boards. Breakdowns like these, coupled with extreme price volatility in past years and other concerns damage public trust in bitcoin as a reliable currency.

Trust is a recurring theme in the book. In our current system banks and other central institutions maintain the central ledger that establishes the essential trust in who owes what to whom. Various parties in this system dedicate enormous resources to verify their records match and confirm trust. But with bitcoin, trust is automated. To be effective as currency bitcoin must be widely held and widely accepted. It’s the classic “chicken or egg” dilemma. Money must be a unit of account, a store of value and a medium of exchange, three conditions banks are currently tasked with safeguarding. But there’s an enormous cost for this in money, privacy, and economic damage banks are perceived to cause in crises. The authors deftly explore multiple perspectives on trust and the central role of banks:

  • In developing countries millions of people lack access to banks. Bitcoin may be an ideal solution for countries with limited banking infrastructure, weak legal systems, 10%-20% fees on transfers from citizens working abroad and a high degree of self-employment.
  • Russia’s and China’s national security depends on controlling their national currencies, so unregulated and encrypted bitcoin may be a threat to government’s hold on power.
  • Developed countries incur hundreds of billions in transaction fees that could be used productively. But unlike bitcoin, the incumbent system allows for Keynesian intervention during crises to offset currency hoarding.

To the extent bitcoin has obstacles; the underlying blockchain technology has opportunities. Financial institutions are using it to create more efficient financial payment, trading and settlement systems. Major firms actively exploring blockchain solutions include Bank of America, Banco Santander, IBM, ING, Mizuho, NASDAQ, PwC, UBS and many others. Meanwhile, startups like Next, Ripple, Mastercoin, Ethereum, BitShares, Counterparty, Stellar and others are developing digital asset exchanges for peer-to-peer trading. The authors explore a variety of blockchain applications that extend beyond digital currency. Decentralized autonomous corporations (DACs) are similar to crowd-funding but DAC shareholders participate in ownership and any increase or decrease in value. Reputation markets for restaurateurs, contractors, freelancers, etc. use blockchain to hold their record of customer reviews, which can then be securitized to monetize goodwill. Voting can use an encrypted private key to send a tiny amount of bitcoin to a polling wallet. Votes are time-stamped and permanent in the blockchain to prevent fraud. Smart contracts, where bitcoin payments are made to a neutral wallet and disbursements are triggered automatically. Examples include homeowner’s escrow for insurance and tax payments, and credit default swaps where a credit event automatically triggers payment to the CDS owner. Smart property, where digital ownership tokens are assigned as property deeds, titles and certifications of ownership, makes them easily tradable with other digital asset claims. There are endless applications using the blockchain platform, and it’s seen by some as the internet all over again.

Blockchain clearly has a very bright future. As for bitcoin as digital currency, the authors present several future scenarios and discuss potential government reactions and the impact on various stakeholders:

  • Bitcoin is adopted worldwide: The UK, Canada, Switzerland and Singapore are poised to lead due to their innovation-friendly regulations. The U.S. would take a back seat given the restrictions here. Banks and governments would have greatly diminished power. Millions of unbanked people in developing countries would gain access to an efficient financial system.
  • Bitcoin is not adopted: The obstacles to realizing the grand vision are never overcome and a ‘just good enough’ option with lower fees and greater efficiency takes hold within the existing system.
  • Hybrid system: Bitcoin grows alongside the existing system and national fiat currencies continue to be used. Exchanges are needed to convert to and from digital currency. Blockchain technology is used by institutions to improve transaction confirmations, payment systems, etc. Credit card companies, payment processors and currency traders could disappear. Or bitcoin could be adopted principally for online and certain other types of commerce.
  • Multi-coin world: Currency itself becomes less important. The principle means of exchange could be smart property trading on blockchain-based exchanges where property items are divided to level needed. Commerce becomes a form of barter without the limitations of trading physical property. The authors posited selling half a horse for a flight to LA!
  • National cryptocurrency: Countries launch their own digital currency using blockchain technology. People trade currency peer to peer without intermediaries, but control is still centralized leaving the state as the ultimate counterparty. Governments retain the ability to use policy measures to stimulate the economy. Cross-border transfers of digital currencies are difficult to restrict which undermines capital controls. The U.S. digital dollar has an enhanced role as a reserve currency, but the Fed is more accountable to the global marketplace. For example, if the U.S. digital dollar were mismanaged other currencies would become favored.

Regardless which of these scenarios is realized, bitcoin and blockchain have staggering potential to reshape financial services and other areas of the economy. They can no longer be dismissed as a fringe, radical movement. It will be fascinating to observe this space in the coming months and years.

 

Upcoming Schedule:

March 15, 2016: My Side of the Street: Why Wolves, Flash Boys, Quants, and Masters of the Universe Don’t Represent the Real Wall Street by Jason DeSena Trennert

April 19, 2016: While America Aged: How Pension Debts Ruined General Motors, Stopped the NYC Subways, Bankrupted San Diego, and Loom as the Next Financial Crisis by Roger Lowenstein

May 17, 2016: TBD

To sign up for a future book club event, please click here:

http://www.cfachicago.org/apps/eve_events.asp

CFA Society Chicago Book Club:

The Entrepreneurial State: Debunking Public Vs. Private Sector Myths by Mariana Mazzucato

The Entrepreneurial StateAround the time we read this book, a major global growth scare was negatively impacting the financial markets.  Examples were the China slowdown which weakened emerging market exports, Japan’s ability to stimulate demand after two lost decades, and the low inflation and growth coming out of Europe.  Growth is known to be export or investment led, but a traditional catalyst has historically been technological led innovation.  Looking at Europe over the past decade, there has been a lingering question as to why Europe has not been a major innovator.  Why has the US been a major leader in technological innovation producing companies like Google or Apple?  Where are the Silicon Valley’s of Europe?  Is it possible that government led European austerity could be a major contributor to stagnant growth?  The author thinks yes.

Austerity programs in Europe have led to reduced government spending and an expectation that the private sector is going to lead the way in innovation.  Looking at the US, and despite popular opinion, the high risk and innovative catalysts for growth have not come from venture capitalists or the private sector.  It has been the State.  Against popular myth, the State doesn’t just invest in infrastructure, correct market failures, take part in countercyclical Keynesian fiscal policies, or create the right economic conditions for the private sector.  The State has actually been extremely entrepreneurial and has led the way in nanotechnology, the internet, GPS, touch screen display, SIRI, green technologies, and biotech among other things.  The State is not at the back end of innovation but at the forefront.  The issue with the private sector is that they are quite focused on short-term profits and an eventual exit strategy which has put downward pressure on the time horizon resulting in shorter term 3-5yr projects rather than the high risk and highly uncertain 15 year projects which have produced the major growth catalysts such as the internet.  While 9 out of 10 high risk investments will fail, it takes just the 1 to more than offset the other 9 failures.  While that 1 positive outlier has handsomely rewarded and offset the unprofitable investments for venture capitalists, the reward to the State has come in the form of indirect taxation revenue which has been only a fraction of the total high risk investment return and has certainly not compensated for the high risk of these uncertain long term investments.  For more State run innovation led growth to continue, we need to find a way for the high risks to be rewarded without only the fractional indirect return of taxation.

The bottom line is that high levels of government austerity can significantly curb long term innovation and growth.  Especially considering that economies can’t rely on the private sector to invest in the high risk and uncertain areas that can be the major turning points or catalysts for growth.  If the State could have a much greater combined direct and indirect return on their investments, then perhaps the State would have a much greater pool of assets to invest towards high risk investments which could accelerate long term growth.

 

Upcoming Schedule:

February 16, 2016: The Age of Cryptocurrency: How Bitcoin and Digital Money are Challenging the Global Economic Order by Paul Vigna and Michael J. Casey

March 15, 2016: My Side of the Street: Why Wolves, Flash Boys, Quants, and Masters of the Universe Don’t Represent the Real Wall Street by Jason DeSena Trennert

April 19, 2016: While America Aged: How Pension Debts Ruined General Motors, Stopped the NYC Subways, Bankrupted San Diego, and Loom as the Next Financial Crisis by Roger Lowenstein

To sign up for a future book club event, please click here:

http://www.cfachicago.org/apps/eve_events.asp

CFA Society Chicago Book Club:

Rise of the Robots: Technology and the Threat of a Jobless Future by Martin Ford

Martin Ford, a software engineer by trade, projects a veryrise-of-the-robots-side bleak future for the working prospects of humanity.  In a world that sees its share of apocalypse futures through Hollywood movies and TV shows, one can easily dismiss the premise of his book as another alarmist tale.  However, as the reader pushes through the seemingly endless examples of worker displacement in global commerce, it starts to sink in that maybe we are in for a rough time.  With the arrival of self-driving cars, automated tellers, digitalized customer service machines, 3-D printers, computer written news articles, drone delivery systems, and robotic assembly lines one starts to wonder if there is anything that cannot be automated.  Even in our own industry robo-advisors and computer trading systems are burgeoning industries.

The cause of all this technological advancement, in Mr. Ford’s view, has been the shortsightedness of capitalists driven by extending their bottom line by cutting expenses, increasing productivity and demanding less expensive labor.  After all, in a demand driven economy what happens if there is no demand as individuals find themselves short on the resources needed to buy the goods produced?  This new economy is driving inequality and it will only continue to get worse.  Education has been no panacea as graduates find themselves prepared for a world in which their skills are no longer required.  The top will continue to grow and the masses will be left to fend for themselves.

The reality is that policy makers and regulators are woefully behind the curve, and given today’s dysfunctional governments, why would anything change.  His solution is for an immediate $10,000 minimum guaranteed income for all.  How that is the magic number is lacking in derivation, but he defends the concept in order to keep the demand engine going in a jobless future.  He highlights a large array of taxes to pay for this transfer of wealth (carbon tax, VAT, wealth tax, technology tax, etc.), and defends the transfer to face the oncoming scenario where a majority of the population is not working.    Although the large majority of the change is out in the future, say 2050, we need to start now to ease the transition, and give the policy makers time to adjust the income guarantee and tax structure in the future.

At the club’s meeting we shared our ideas of this potential new world.   We felt that the book was a bit short on detailed specifics, as Charterholders who crave detailed data generally are when faced with a conceptual thesis.   But overall we felt the time spent was very enlightening.

First we talked about the time frame, mostly agreeing that it usually takes much longer than experts, like Mr. Ford, initially foresee.   However, we had difficulty denying that in the far future his reality of limited workers (those to keep the technology running) would not come to fruition.   We discussed changes in our industry that were examples of technological change.  The group contemplated and had big discussions on how does society, and namely democracy, work when the vast majority of voters are not productive.   In a short term practical discussion, we talked on how to position investments to take advantage of the changing world.

This was the second book we embarked upon looking at the future of technology this year (the other being Second Machine Age: Work, Progress, and Prosperity in a Time of Brilliant Technologies written by Erik Brynjolfsson and Andrew McAfee – see previous blog), and each highlighted that the world was changing very fast and society needs to start addressing the changes.  We all agreed these are very important challenges and would recommend everyone to read one or the other to get a sense of the dynamics that are changing our world.

Upcoming Schedule:

January 19, 2016: The Entrepreneurial State: Debunking Public Vs. Private Sector Myths by Mariana Mazzucato

February 16, 2016: The Age of Cryptocurrency: How Bitcoin and Digital Money are Challenging the Global Economic Order by Paul Vigna and Michael J. Casey

March 15, 2016: Pension Finance: Putting the Risks and Costs of Defined Benefit Plans Back Under Your Control by Barton Waring

To sign up for a future book club event, please click here:

http://www.cfachicago.org/apps/eve_events.asp

CFA Society Chicago Book Club:

No Ordinary Disruption: The Four Global Forces Breaking All the Trends by Richard Dobbs, James Manyika, Jonathan Woetzel

No ordinary disruptionEverything can be measured, and what gets measured gets managed.” So reads the motto of one of the world’s most pre-eminent consultancies, McKinsey & Co. This month’s CFA Society Chicago Book Club Selection, No Ordinary Disruption: The Four Global Forces Breaking All of the Trends, is written by three men from McKinsey and they truly take this tagline to heart. The “four global forces” in the title include: urbanization, the challenges of changing demography, technological advance and acceleration, and growing interconnectedness of the global economy. Major news outlets have focused on these forces in some form or another for many years (or perhaps decades), but the main value that this book brings is its focus on anecdotes and “measurements.”

The first half of the book focuses on the forces themselves and where we find evidence of their existence. The center of global economic growth has been moving east for some time and many Chinese and Indians (among others) find themselves commanding a larger standard of living. Meanwhile, “The West” has been fraught with stagnation and labor’s replacement with capital in many industries due to technological advances. Furthermore, the demography of many developed nations has produced more retirees per working person. Each of these facets is well laid out with stories of real life examples in the development of smarter and less expensive robots, the crises affecting aging developed economies, and the rise of emerging markets.

The second half of the book begins to falter a bit with the prescription on what to do about the changes coming. Almost every single course of action recommended would be common in MBA programs or even undergraduate studies of business. Employers and companies are encouraged to adapt to this new environment we find ourselves on the brink of.  Which skills will be necessary aren’t named specifically, but the emphasis is really on the ability to change. This reflects the true challenge going forward in managing that which is measured.

Overall, the book provided for a great discussion on what the future will look like and how it affects the investment profession. Even though its prescriptions weren’t always insightful or groundbreaking, the idea of a different economy and investment environment can be both frightening and exciting. We will continue to watch these factors to see where they take us going forward.

 

Upcoming Schedule:

January 19, 2016: The Entrepreneurial State: Debunking Public Vs. Private Sector Myths by Mariana Mazzucato

February 16, 2016: TBD

March 15, 2016: Pension Finance: Putting the Risks and Costs of Defined Benefit Plans Back Under Your Control by Barton Waring

To sign up for a future book club event, please click here:

http://www.cfachicago.org/apps/eve_events.asp