1. An Economy with Personal Currency: Theory and Evidence Martin Angerer, Jürgen Huber, Martin Shubik and Shyam Sunder Yale School of Management Faculty Workshop, October 1, 2008

2. Background of Theory

3. BEYOND GENERAL EQUILIBRIUM Work brings together two strands: Strategic Market Games (M.S.) and Minimal Intelligence Agents (S.S.) General Equilibrium is the right abstraction to study efficient prices. But it is inadequate for dynamics. Strategic Market games offer a fully defined process model of trade.

4. Arrow’s Concern Arrow worried (1972) that process models would proliferate too many special cases. They do, but there is a solution: Minimal Institutions and bounding behavior. 3 trading mechanisms—natural lower bounds. 2 types of agents—von Neumann players and minimal intelligence players (upper and lower bounds).

5. 6/22/2015An Economy with Personal Money5 An Overview Background paper briefly: Three Minimal Market Institutions Is personal currency/credit issued by individuals sufficient to operate an economy efficiently with no outside or government money? Sahi-Yao (1991) and Sorin (1995)’s construction of a strategic market game proves that it is possible We report on a laboratory experiment in which each agent issues IOUs, and a costless efficient clearinghouse adjusts the exchange rates so markets always clear Result: when information system and clearinghouse preclude moral hazard, information asymmetry or need for trust, such economy operates efficiently without government money Result: When agents have opportunity to default on their delivery promises, a high enough penalty is needed for efficiency It may be better to look for explanations for the prevalence of government money either in the abovementioned frictions, or in our unwillingness to experiment with innovation

6. Three Minimal Market Institutions: Theory and Experimental Evidence Jürgen Huber, Martin Shubik, and Shyam Sunder

7. 6/22/2015An Economy with Personal Money7 Outline Three minimal market designs Experimental implementation Results compared to three benchmarks: –General equilibrium –Non-cooperative equilibrium with 10 traders –Minimally-intelligent traders (simulation) Concluding remarks

8. 6/22/2015An Economy with Personal Money8 Market setup (in all three settings) Two goods (A and B) traded for money Each trader endowed with either good A or B, and money Multiplicative earnings function: Earnings = √(A. B) + net money Money carried over from period to period (except in double auction)

9. 6/22/2015An Economy with Personal Money9 Three Minimal Market Institutions 1.The sell-all model (strategy set dimension 1: all commodity endowment sold; each trader bids an amount of money to buy each commodity) 2.The buy-sell model (strategy set dimension 2: each trader offers the quantity of the endowed good and bids money for the other good) 3.The simultaneous double auction model (strategy set dimension 4: each trader offers to sell each good and bids to buy each good)

10. 6/22/2015An Economy with Personal Money10 Sell All Market

11. 6/22/2015An Economy with Personal Money11

12. 6/22/2015An Economy with Personal Money12 Buy-Sell Market

13. 6/22/2015An Economy with Personal Money13

14. 6/22/2015An Economy with Personal Money14 Double Auction

15. 6/22/2015An Economy with Personal Money15 Endowments (Good A, Good B, Money) (200, 0, 6000) or (0, 200, 6000) in sell-all (200, 0, 4000) or (0, 200, 4000) in buy-sell 20, 0 4000) or (0, 20, 4000) in double- auction 10 traders in each market (5+5) One buy-sell market with 20 traders (10+10)

16. 6/22/2015An Economy with Personal Money16 Initial Endowment CGE Quantity/ Price NCE (5+5) Quantity/ Price ABABAB Sell All2000100/20 110/20.190/ 20.1 Buy Sell2000100/20 122/2078/ 20 Double Auction20010/ 100 11/ 1009 100 General and Non-Cooperative Equilibria

17. 6/22/2015An Economy with Personal Money17 Comparison of markets I

18. 6/22/2015An Economy with Personal Money18 Comparison of markets II

19. 6/22/2015An Economy with Personal Money19 Symmetry Buy-sell Sell-all Double auction

20. 6/22/2015An Economy with Personal Money20 Comparison of markets III

21. 6/22/2015An Economy with Personal Money21 Avg. Prices Buy-sell Sell-all Double auction

22. 6/22/2015An Economy with Personal Money22 Trading vol. Buy-sell Sell-all Double auction

23. 6/22/2015An Economy with Personal Money23 Conclusions from the Background Paper The non-cooperative and general competitive equilibrium models provide a reasonable anchor to locate the observed outcomes of the three market mechanisms Unlike well known results from many partial equilibrium double auctions, prices and allocations in our double auctions reveal significant and persistent deviations from CGE predictions The market form has a significant influence on allocative efficiency and the return distribution: the outcome paths from the three market mechanisms exhibit significant differences among them.

24. A Practical Example A few days ago the New York Stock Exchange provided a good example of a primarily credit-driven market with exogenous uncertainty

25. 6/22/2015An Economy with Personal Money25 The Current Paper: Need for Government Money? Is outside or government money necessary to operate an economy efficiently? Proponents of alternatives to government money suggest that if all individuals and institutions could issue debt as means of payment, market will sort out the risk and reputations of accepting such paper; For example, Black (1970); rates of interest in the City of London for “prime” and “lesser” names, discounting of bills issued by hundreds of banks in the free banking era of the U.S.

26. 6/22/2015An Economy with Personal Money26 Summary Results Outside or government money is not needed if there is perfect clearing and no default Result is valid under conditions which are clearly counterfactual (like M&M on neutrality of cost of capital with respect to leverage) Logical possibility of such an economy does not mean that an economy will actually function smoothly with private money under exogenous uncertainty, and dispersed and imperfect information Process dynamics, trust and evaluation are core issues in functioning of a financial system and are absent in Black or M&M equilibrium models Presence of moral hazard requires sufficiently high penalties on defaults for efficient functioning

27. 6/22/2015An Economy with Personal Money27 Equilibrium Sorin establishes the existence of an active non-cooperative equilibrium set of prices and exchange rates which converges to a competitive equilibrium as the number of traders increases The clearinghouse calculates prices and exchange rates by balancing the expenditures and revenues for all

28. 6/22/2015An Economy with Personal Money28 Sorin (1995) Model Consider a set A of n agents and set I of m goods. There are m posts, one for each good where each agent α bids quantity of money bi α for good i and offers a quantity of goods qi α of good i for sale. t(α) is the exchange rate for currency of agent α.The equations defining prices in terms of the unit of account t(1) are: And the budget balance gives

29. 6/22/2015An Economy with Personal Money29 Acceptability of Government Money No bank (much less individual) can match visibility of government Government’s reputation is known to all Government is better able to enforce the rules of the game Government money expedites and simplifies taxation as an unintended consequence Hands additional policy options to government (e.g., financing of wars and control of economy) Acceptability of IOUs requires trust; trust in government may be higher in most instances than in even big banks (individuals have little chance) Everyone-a-banker game could be seen as a simplified version of governments issuing their own money in international exchanges to settle their payments Treatment 1: No frictional and informational issues: is the logical possibility of private money economy also a behavioral possibility Treatment 2: Introduce moral hazard of default, and vary penalties

30. 6/22/2015An Economy with Personal Money30 Laboratory Model Computer implements the sell-all model Uses the quantities endowed and money bid for each good to calculate a market clearing price for each good and exchange rates for each trader’s money Computer acts as a clearing house as well as a perfect reputation enforcement mechanism (no reneging, no bankruptcy in Treatment 1) Examines every-one-a-banker model in absence of uncertainty- related explanations for government money Yields high efficiencies Key theoretical claim that government money is not needed for efficiency exchanges is supported experimentally under these circumstances –Ideal contract enforcement, credit evaluation, and clearing arrangements

31. 6/22/2015An Economy with Personal Money31 Experiment Two goods Two types of traders with endowment (200,0) and (0, 200) Upper limit on IOUs issued: 6,000 Each agent submits bids for each good each period subject to the sum of the two bids < 6,000 Computer calculates the prices of two goods in each personal currency and allocates goods Points earned = √(C A * C B ) CE: 2000 IOUs issued to get 100 units of each good NCE: with 5+5 agents, bid 2214+1811 for the two goods

32. 6/22/2015An Economy with Personal Money32 Table 1: Non-cooperative Equilibria in the sell-all model Players on each side Money bid for ow ned goo d Money bid for oth er goo d Bid ow ned /bid oth er Sum of bid s Money uns pen t PriceUnits of ow ned goo d bou ght Units of oth er goo d bou ght Allocative Effici ency 22653.511573.72 1.6861 4227.23 1772.77 21.14 125.54 74.46 96.68 5*2213.791810.88 1.2225 4024.67 1975.33 20.12 110.0189.9999.50 102102.921902.62 1.1053 4005.54 1994.46 20.03 105.0095.0099.87 many2000.00 1.00004000.002000.0020.00100.00 *Money endowment (M) = 6,000 units per trader Goods endowment = (200,0) for one member and (0,200) for the member of each pair of traders.

33. 6/22/2015An Economy with Personal Money33 Allocation of Money Fig. 1: Money spending balanced between goods A and B CGE predicts equal amount spent on two goods With 5+5 subjects, non-cooperative equilibrium predicts 55 percent of the money being spent to the owned good (22 percent more than the other good) Table 2 and Figure 1 data are weakly consistent with this prediction The results appear to be closer to CE than to non-cooperative equilibrium

34. 6/22/2015An Economy with Personal Money34 Figure 1

35. 6/22/2015An Economy with Personal Money35 Table 2: Percentage of total spending invested in A and B (Separated by those endowed with Good A and with Good B) Spendin g for A by A- holders Spendin g for A by B- holders Spendin g for B by A- holders Spendin g for B by B- holders Own - good - bias* own-good- bias (as %age of other good)** T1, run 154.6%46.0%45.4%54.0%8.6%18.9% T1, run 249.3% 50.7% 0.0% T1, run 350.8%49.5%49.2%50.5%1.3%2.7% T2, run 151.6%47.0%48.4%53.0%4.5%9.9% T2, run 252.3%50.4%47.7%49.6%1.9%4.2% *Own-good-bias: the percentage spent for the own good minus the percentage spend for the other good. **The final column presents this bias as percentage of the spending for the other good

36. 6/22/2015An Economy with Personal Money36 Symmetry of Investment Smaller investment /larger investment in the two goods (0-1) Period-wise averages charted in Figure 2 Symmetry ranges from.7 to.95, slightly higher than the average of.65 in sell-all treatment in HSS (2007) experiment Why?

37. 6/22/2015An Economy with Personal Money37 Figure 2

38. 6/22/2015An Economy with Personal Money38 Credit Limit Actually Used Varied widely over range 30-90 percent for individual periods of individual sessions and over 30-70 percent for individual periods averaged across sessions (Figure 3) Little stability Suggest continuum of non-cooperative equilibria

39. 6/22/2015An Economy with Personal Money39 Figure 3

40. 6/22/2015An Economy with Personal Money40 Link Between Money Printed (Percent of Credit Limit Used) and Earnings of Individuals No detectable link The economy offers no advantage to those who print more Also, no disadvantage to those who print less The clearinghouse mechanism adjusts the exchange rates among money issued by various players appropriately

41. 6/22/2015An Economy with Personal Money41 Figure 6: Points Earned Relative to Money Issued (Pooled Data for 5 sessions)

42. 6/22/2015An Economy with Personal Money42 Allocative Efficiency Actual number of points earned/Maximum possible points (i.e. CGE) Observations in range 96.9 to 99.3 (Figure 4) Most traders invested equal amounts in the two goods Session 1 has lowest symmetry and efficiency With efficient decisions from the beginning, little opportunity to “learn” over time Low cross sectional dispersion of earnings

43. 6/22/2015An Economy with Personal Money43 Figure 4

44. 6/22/2015An Economy with Personal Money44 Figure 6 (MI sessions added)

45. 6/22/2015An Economy with Personal Money45 Goods Delivered under Option to Default When subjects were given the option of defaulting on their promise to deliver all units of the goods they were endowed with Actual delivery depended on default penalty Figure 5: Higher the default penalty, lower the rate of default Average delivery of 94, 60 and 26 percent with penalty of 5, 2.5 and 0 per unit

46. 6/22/2015An Economy with Personal Money46 Figure 5

47. 6/22/2015An Economy with Personal Money47 Efficiency under Option to Default Percent of maximum payoff actually earned (Figure 4, 6) As penalty drops, default rates rise, and efficiency drops (91, 71 and 67 respectively for penalty of 5, 2.5, and 0) Drop in efficiency does not seem to stop the default rates from rising Efficiency of MI economies falls sharply with higher penalty because such agents do not adjust their behavior to the level of penalties (Figure 6)

48. 6/22/2015An Economy with Personal Money48 Owned Good Bias Under Moral Hazard Theory predicts spending bias towards the “other” good with option to default Figure 7 and Table 2: data supports this prediction As the default penalty drops, subjects spend less on the owned good (8, 39 and 47 percent higher with penalty of 5, 2.5 and 0) Patterns stable over 20 periods of sessions Symmetry measure reflects these biases (Figure 8)

49. 6/22/2015An Economy with Personal Money49 Figure 7: Period-wise Share of Money Bid for Owned-Goods in Presence of Option to Default Black line: Share of spending on own good; Grey line: Spending on other good

50. 6/22/2015An Economy with Personal Money50 Figure 8

51. 6/22/2015An Economy with Personal Money51 Figure 9

52. 6/22/2015An Economy with Personal Money52 Figure 10

53. 6/22/2015An Economy with Personal Money53 Appendix A: Average earnings per period as percentage of maximum vertical-axis: points earned, horizontal-axis: period Results per run for T1 and T2

54. 6/22/2015An Economy with Personal Money54 Minimally Intelligent Agents Total spending ~U(0,6,000); split randomly between Goods A and B Efficiency 79% (4/5 th of the gain from autarky to CGE from random behavior) Average spending 3000 Average symmetry 0.39 –Humans with symmetric behavior (0.80) almost 100% efficient

55. 6/22/2015An Economy with Personal Money55 Discussion and Extensions Modeling calls for ruthless simplification and abstraction from “details” Some subtle “details” may change the outcomes They can be identified through successive empirical observations of varying environments As a starting point, we use a simple and symmetrical environment to compare the empirical observations with theoretical predictions Significant deviations suggest revision of theory

56. 6/22/2015An Economy with Personal Money56 Formation of Reputation In Treatment 2 (with option to default), anonymity of default did not permit individuals to develop a reputation Whether reputations may provide an adequate mechanism to deter default and promote efficiency remains to be examined Design of future experiments with roles for reputation and expertise (e.g., non-delivery) –Social context problem in laboratory

57. 6/22/2015An Economy with Personal Money57 Conclusions Theoretical analyses of strategic market games indicate that economy can approximate competitive outcomes with individually issued credit lines alone (without fiat or commodity money) This model abstracts away from transactions costs, intertemporal credit, possibility of default (forcing all traders to have perfect reputation for trustworthiness) through a perfect clearinghouse mechanism for enforcement (no accounting problems of intertemporal trade) Treatment 1 in the lab economy mimics these conditions postulated in the model economy (and tells us little about what would happen when these conditions are violated)

58. 6/22/2015An Economy with Personal Money58 Conclusions What happens with strategic option to default? (Treatment 2)? High enough penalties are needed to ensure high delivery rates and efficiency

59. 6/22/2015An Economy with Personal Money59 Conclusions In the meantime, results reveal considerable power of market structure in producing efficient outcomes when reputation is not an issue Under such (perfect) circumstances, the claim that government money is not needed for efficient exchange is supported analytically as well as experientially Future experiments to be carried out under weaker conditions In the free banking era in the U.S., different bank notes sold at different discount rates depending on their individual reputation and acceptability

60. Thank You