Information Theory, Money, and the Oil Price Collapse

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Information theory is a branch of applied mathematics, electrical engineering, and computer science whose goal is to define, quantify, store, and communicate… information. Information theory found its genesis in Claude Shannon’s genius 1948 paper entitled “A Mathematical Theory of Communication”. Although not as well known in popular culture as he should be, Shannon is one of the most influential and impactful minds in human history. His contribution to human progress cannot go unnoticed in this age of information and fiber optic cables. He’s the father of the information age and the creator of an entirely new lens in which to see the world.

The mathematics behind information theory has been successfully applied to not just computing, but wireless communication, cryptography, neurobiology, ecology, statistical inference, pattern recognition, linguistics and some have been advocating for its use in economics. George Gilder, famed public intellectual and technologist, has been one of the more recent and fiercest advocates of the application of information theory to the beleaguered field of economics. His writings on the subject are extremely persuasive and are a must read for anyone remotely interested in economics.

The tools and schemas used for classical economic measurement and understanding were born out of Newtonian physics. Intellectuals like Adam Smith and the millions of economists that succeeded him attempted to apply the mathematics of physics to economic problems i.e. concepts such as general equilibrium and the second law of thermodynamics. Although Adam Smith personified a huge intellectual step in the conceptual development of economics there have been serious flaws in the application of physics to economics. The natural world described by Newtonian physics is a largely deterministic system that allows for very precise and accurate predictions. The world according to Newtonian physics is highly mechanistic and has no way of accounting for human creativity and a probabilistic future. Newtonian physics itself has since been replaced with a new physics of relativity led by Mr. Albert Einstein.

Adam Smith conceptualized the economy as some sort of great machine guided by an “invisible hand”, a natural thought to have during the dawn of the industrial revolution where machines were the new intellectual obsession. Keynesianism, the most influential economic philosophy of the last century, although breaking considerably from classical economics still kept Smith’s vision of an economic machine very much alive. The Keynesians to this day view the global economic system as some sort of machine that breaks down occasionally and the government and academia are the only institutions that can fix it. They use popular metaphors in their speeches and writings like “fix”, “stimulate”, or “jump-start the economic engine” as if the “economy” is as simple as a car and the government is the driver of that car. And not only is government the driver, it’s assumed the state is smart enough AND capable of fixing it when it breaks down. The false assumptions and leaps of faith in this train of thought are mind boggling.

The Austrian school of economics, led by Ludwig Von Mises and Friedrich Hayek, rejected the elaborate mathematics downloaded from Newtonian physics and refused to apply it to the crude subject of economic science. Hayek himself in his famous Nobel Prize speech in 1974 criticizes the scientism of the then Keynesian economic establishment:

“It seems to me that this failure of the economists to guide policy more successfully is closely connected with their propensity to imitate as closely as possible the procedures of the brilliantly successful physical sciences — an attempt which in our field may lead to outright error.”

In his speech he mentioned the word “information” 11 times highlighting its importance to making economic decisions. The Austrians have stressed over and over again for the past century that the lack of precise, accurate, specific, and timely information available to government institutions makes centralized economic planning not only ineffective but harmful. Unfortunately for Hayek and the Austrians, they’ve been bogged down and distracted by the war over general equilibrium with the Keynesians for decades now.

Information theory has really nothing to say about equilibrium and in contrast re-directs the discussion and asks what is information and what is the best way to communicate that information? If we look at the economy not as a physical machine such as a car that needs to be “jump-started” but rather an information system, we may start to yield some better insights into the optimum economic system. So if information is our focus let’s start with the key carrier of information in an economy: money. As they say, money talks.

At its core money is not a resource or a marketable commodity it is instead an information technology. Although in its earliest form, money took the form of gold or other goods that have value outside of exchange, money doesn’t have to be tangible to serve its purpose. In fact gold is way more valuable as an information technology (money) than it is as a metal. The price of gold is much higher than it would be if it were just a metal used in manufacturing and jewelry. Most of the price of gold is the price you pay for its use as an information technology (money). The factors that market analysts of gold look at most frequently have nothing to do with supply and demand of the physical commodity for actual material use but rather the financial conditions of the broader world economy. The material uses of gold are just icing on the price cake.

Since money is an information technology it serves its purpose best on the information superhighway, the internet. It was only a matter of time before the internet facilitated the creation of digital currencies like Bitcoin. So this begs the question: If money is an information technology, what information is it carrying?

Money holds this general message:

“This person or entity added value to society through their goods or services and are entitled to a proportional amount of goods and services”.

Money is in essence a social receipt or social gift card redeemable everywhere for anything. Although money is an asset for you it’s a liability for society at large. We accept money as compensation for our goods and/or services under the assumption that you may exchange that money for proportional value in the future for other goods and services when you deem appropriate. Money is the most pragmatic and effective proof that you added value to someone else in society and we in turn give you an immediately redeemable receipt as proof you contributed. Notice I said money is a “pragmatic and effective” proof, not a perfect proof. We all know that some earn money in nefarious ways or don’t “earn” it at all. This is a cost of the fiction of money but we tolerate it because its economic benefits greatly outweigh its costs.

If money carries information, financial markets and institutions are by analogy the channels in which information flows. According to information theory, a carrier of information and the channel in which information flows must each be low entropy or unsurprising. The less noise or distortion on the channel the more likely the full message being sent to the receiver will be received. You want your carrier and channel to be as predictable and stable as possible so that the signal sent by the messenger can be distinguished from the noise. This principle of low entropy carriers and channels is the principle on which our entire information economy has been built by companies like Qualcomm and IBM.

If we think of banks and financial markets as the channel in which money flows through from investors/savers (source) to entrepreneurs/borrowers (destination) and vice versa, anything that intervenes in the transmission of information would be considered noise or distortion.

The interest rate is the price of money. This is the most important price in a modern economy because everything is priced in money terms. If that initial measurement is distorted every other price is distorted. Producers and consumers alike will allocate resources sub-optimaly because of innacurrate pricing information about the real world.

Interest rates like any other price are a function of supply and demand and its price holds vital information. We distort interest rates at our own peril. High interest rates signal that banks and markets need to attract capital. Low interest rates signal to market participants there is a surplus of capital which encourages businesses and households to borrow and expand. When central banks such as the Federal Reserve intervene to bend interest rates to their will, they distort the signals or information that entrepreneurs, investors, savers, and consumers need to be aware of to make good decisions. By using different monetary tools to artificially lower interest rates central banks effectively trick entrepreneurs into thinking there are surplus savings in the financial system when in fact the opposite is true. They also bully investors into taking on riskier and riskier investments as they are starved for yield.

By distorting the price signals, central banks make unprofitable projects seem profitable which encourage entrepreneurs to take on projects and pump out more supply than future demand can afford. Unfortunately, for suppliers and their investors when that excess supply hits the market the demand they were counting on isn’t there to eat up that excess supply.

We can apply the following abstraction to the current collapse in oil prices. Let’s take a highly simplistic example of a hypothetical oil entrepreneur to highlight how central banks deceive entrepreneurs into taking on projects that won’t be profitable.

If an oil entrepreneur is prospecting an Eagle Ford Shale play and calculates that she will have a return on investment (ROI) of 12% but her cost of capital is 14%, that’s a negative net return. 12%-14%= (-2%). She won’t drill under these conditions and that potential supply of oil will never see markets. If instead the entrepreneur still forecasts her ROI to be 12% but her cost of capital is now 8% because of central bank activity that’s a positive net return on a previously unprofitable project. Any undergraduate business student would tell you to drill as quickly as you can. 12%-8% = +4%!

Unfortunately for the entrepreneur and her investors, that 8% is a false cost because she should be paying 14%. She and her investors will pay that cost in the future when they can’t get rid of inventory because of worse than expected demand. The interest rate at 8% tells the entrepreneur that there’s enough savings in the system to pay for that future supply of oil they are about to frack out of the ground. Unfortunately those real savings were never there and as a consequence that future demand won’t be there either.

This hypothetical carried out by thousands of other oil projects creates massive oversupply which leads to collapsing prices. This is exactly what has happened so far. Oil prices have collapsed over the past year because a tsunami of oil has hit markets with not enough demand to soak it up. Of course there are other factors that contribute to world oil prices from speculators to geopolitical manipulators but these cannot explain most of what’s going on in the price of oil because of the lack of consensus among the manipulators and the lack of long term bargaining power of the speculators. Looking at the collapse primarily through the lens of information theory will give you a much more complete picture of what’s happening and why it’s happening.

And not only have collapsing oil prices been hard on oil companies and their stakeholders; there are two huge opportunity costs that were lost during the financial heroin induced bull-market of the last few years.

First, instead of allowing interest rates to rise naturally to attract more real capital and encourage an already highly leveraged society to save more the Federal Reserve and other central banks have instead enabled more borrowing and consuming. More borrowing and consuming has made a financially unhealthy populace even sicker which we can see manifested in its support of the economically illiterate and angry campaigns of Bernie Sanders and Donald Trump who both want to introduce more noise into the system in their effort to make the system more “equal” or “great again”. And Hillary isn’t any better.

Secondly and more importantly, real financial, physical, and human capital was spent on sucking more and more fossil fuels out of the ground instead of using that capital for other projects that would have taken more time to develop and would have offered higher returns to their investors and society at large. Instead of the Federal Reserve manipulating the cost of capital which makes funding for an oil project at an 8% cost of capital possible that funding could have gone to a longer term investment in alternative energy at a higher hypothetical cost of capital if the Federal Reserve allowed interests rates to rise. A solar company with limited and immature competition may be able to stay profitable at a 20% cost of capital but definitely not the new fracking company trying to enter the incumbent infested oil industry. So not only did we waste resources on extra fossil fuels we can’t consume fast enough, potential real capital for alternative energy companies and other high value, long term projects throughout the economy were sucked up by a new oil rush enabled by easy money. There is only so much capital to go around at any given moment in time. It’s imperative that we have good information so we know as entrepreneurs, investors, and consumers where to invest our resources properly and prudently.

To top things off now that the price of oil has crashed it acts as a disincentive for society to innovate because the status quo is so cheap. Instead of smart money flowing into alternative energy where the capital investors actually have skin in the game, we have a lot of dumb money going into alternative energy, keeping the industry afloat in the form of government subsidies, research, and federally backed loans. Economic reality and exhaustive financial and resource management isn’t important to dumb money because it isn’t their money. Reality and prudence is important to those who actually take risk but not to those who don’t feel the pain of their decisions. I don’t think it’s controversial to say people are much smarter with their own money than other people’s money. Precious resources will undoubtedly be wasted on alternative energy firms that are politically connected and sophisticated.

What happens when a government initiative fails? You put more money into it. That’ll fix it. Just like our education system or health care system. Where do you get this new money? Well you just print it! Crisis solved. Don’t get your hopes up for an alternative energy revolution anytime soon.

Since the financial crisis of 2008 the Federal Reserve and other central banks have acted aggressively to “stimulate” economic activity by keeping interest rates as low as possible through different policy tools. They’ve succeeded in increasing “activity”, but activity isn’t valuable in of itself. There is a huge difference between taking steroids and flailing your arms back and forth and actually making sustainable health and fitness progress. The economy isn’t a car that can be jump started but rather a complex organic system dependent on the flow of accurate information. Central banks are distorting the channels we all need as consumers and producers to make good decisions.

Information helps us solve problems. When information is distorted problems aren’t solved and uncertainty is increased. The current confusion in the market is case in point. Global financial markets are anxious and confused because there is a lot more noise in the channel then there need be. To make matters even worse market participants are more focused on the noise(Janet Yellen press conferences) than market fundamentals.

Having said all that I’m optimistic about the future because of the incredible record of human beings solving problems through new ways of thinking and new ways of organizing. Bitcoin, other crypto-currencies, and blockchain technology will empower individuals and firms to work outside of the current financial system full of noise and distortion and will eventually change the system itself forever. Our modern communication system was built on the principle of low entropy carriers and channels. Its only a matter of time until our financial infrastructure is completely transformed using the same principles that built the internet.

Money and the price of money carry vital information. Let’s not let central authorities distort and change the information we need so desperately to make good financial decisions. In the United States we don’t let the government have a media monopoly for good reason and we shouldn’t let the government have a money monopoly either. Complete control of money is a very sophisticated form of censorship. It robs us of the very information we need to make good decisions as individuals and as a global community.

Dude bein a guy @Edgewallet, Security Platform and Crypto-Asset Wallet

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