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The Princeton

Financier SPRING 2014 Volume 3 | Issue 2

EDITOR-IN-CHIEF Eric Huang ‘16

MANAGING EDITORS dhruv bansal ‘17 Jeffrey Yan ‘16

LET TER FROM TH E EDITOR

DESIGN & LAYOUT You-you ma ‘16 Alan du ‘17

CONTRIUBUTORS Ryan Azarrafiy ‘16 Sankalp banerjee ‘16 dhruv bansal ‘17 Vivian Chen ‘17 Brendan hung ‘17 Jay Karandikar ‘17 Joseph Lee ‘17 jack rogers ‘16

PCFC Board PRESIDENT Darwin li ‘16

MENTORSHIP michelle molner ‘16

MARKETING you-you ma ‘16

COMMUNICATION & TECHNOLOGY John Su ‘16

INDUSTRY INSIGHT ryan azarrafiy ‘16 kevin w. chen ‘15 sherry zhang ‘15

FINANCE harold li ‘15

EDUCATION Jason nong ‘15

CLUB MANAGEMENT ben Huang ‘15 ALL CORRESPONDENCE MAY BE DIRECTED TO: The Princeton Financier 479 Frist Center Princeton, NJ 08544 pcfc@princeton.edu www.princetoncfc.com

I

n this spring 2014 issue of the Princeton Financier, we mirror the themes of the season by examining topics that have been hibernating from the public eye for some time while also taking a look at blossoming economic and industry changes that are just beginning to impact the financial world. As Princeton leaves behind a winter that has long overstayed its welcome, and we begin to see signs of green reemerging in the lawns and trees on campus, we are reminded of another type of “green” that has been largely absent from the public’s attention in recent times. The topic of green or renewable energy was widely discussed in the media and business world during the early to mid 2000’s, but the 2008 financial crisis shifted focus to economic issues. However, we still believe that renewable energy development is the key factor in determining the long-term future of the energy industry and deserves our utmost attention. Thus, in this issue, we feature a pair of articles on the catalysts and challenges behind the Middle East and North Africa region’s and China’s push for green energy. Spring is undoubtedly a time of change and growth, and this issue contains a number of articles that fit this theme. From the transition to Janet Yellen as the new Fed Chair to the rise of the disruptive cryptocurrency known as Bitcoin, 2014

has brought some radical changes that will undoubtedly impact the economic and financial worlds in the upcoming years. Additionally, this issue also features articles on China’s slowing economic growth and the slew of mergers in the U.S airlines industry in the past few years. Finally, I would like to express my enthusiasm and optimism for the changes and growth taking place within PCFC this semester. With an experienced but reinvigorated leadership, Princeton Corporate Finance Club’s goal remains to educate the Princeton community about all matters related to finance at large, but we are looking to do so through holding more interactive events and creating more relevant resources that the student body will be interested in delving into. The club has managed to garner additional support for this outreach from new corporate partners. This increased backing has allowed for the club to accomplish new, ambitious projects such as holding its first ever case competition in March. I, as the next editor-in-chief of the Financier, fully intend to contribute to this exciting era of expansion for PCFC by creating and publishing a magazine that brings relevant and professional stories to all those who are interested in learning more about finance. Thank you for your readership and ongoing support. ~ Eric Huang


The Princeton

Financier INSIDE: 4 8 12

Ready for Takeoff? Evaluating the Success of U.S. Airline Mergers by Dhruv Bansal China Slowdown: Rebalancing a Slowing Giant by Brendan Hung Developing Markets for Renewable Energy Feature Story A Changing Investment Landscape Energizing the MENA Region by Ryan Azarrafiy, Sankalp Banerjee, & Jack Rogers Going from Gray to Green: China’s Push Towards Renewable Energy by Vivian Chen

17 20 ABOUT PCFC

Janet Yellen: A Profile of the New Fed Chair by Joseph Lee Bitcoins: Digital Currency of the Future or Speculative Fad? by Jay Karandikar

The mission of the Princeton Corporate Finance Club is to provide an educational and networking platform for Princeton students interested in investment banking, private equity, venture capital, and the field of corporate finance at large. Established in March 2011, the Princeton Corporate Finance Club has quickly become a prominent club on the Princeton campus with over 400 student members and 30 officers working in seven divisions: Education, Mentorship, Industry Insight, Finance, Marketing, Communication & Technology, and The Princeton Financier. Our core values are fraternity, entrepreneurship, leadership, responsibility, integrity, professionalism, and mutual respect.


The U.S airline industry has been on a tumultuous ride the past decade. Flying high into the 21st century with improved technology, an expanding international presence, and dramatic increases in revenue, American airlines were slammed by the tragedy of 9/11 and the

by all six major airlines. Today the market has regained its interest in airline stocks as the industry consolidates and stabilizes. Investors’ zeal for airline stocks stems from predictions of drastically higher revenues despite a weak recovery and fierce competition between legacy

Investors’ zeal for airline stocks stems from predictions of drastically higher revenues despite a weak recovery and fierce competition. subsequent recession, posting cumulative losses of $40bn dollars between 2001 and 2005, according to the MIT Airline Data Project. The industry then went through incredible highs and lows, from years of record profits to dramatic bankruptcies THE PRINCETON FINANCIER | 4

carriers, such as American and United, and low cost carriers, such as Southwest and Jet Blue. Investors believe the recent wave of mergers has calmed the turbulent market, and will allow for current profits to persist. But not everyone shares this

enthusiasm. Warren Buffett spoke the conventional wisdom of many when he called the airline industry “a death trap for investors” last year. Fundamentally, the key question comes down to the following: do airline mergers really work? With the completion of the AmericanUS Airways merger in December, this question becomes more pressing than ever before. Background To answer this question, we must examine the deep-seated issues the airline industry faced at the turn of the century. Several major problems turned investments into risky gambles. First, airlines had and have among the highest fixed costs across all industries. Overheard costs can consume anywhere from eighty to over a hundred percent of revenue, depending on the year, according to the MIT Airline Data Project. These fixed costs stem from the huge range of services airlines are required


to provide, from airplane maintenance to IT services to sales management. Second, airlines’ margins depend heavily on the cost of fuel, which, like all commodities, can vary significantly depending on an extraordinary number of circumstances. Older airlines, with less efficient planes, are especially hard hit by high fuel prices. Third, airline labor costs are among the highest across industries, a controversial issue due to either high unionization rates or low productivity rates. Finally, airlines must make expensive longterm gambles. Airlines must purchase planes years in advance and thus have to predict what the most profitable plane will be five or ten years down the road. An exceptionally fickle market makes this a near-impossible task. Yet, airlines must do this regularly in order to keep up with the competition offering newer, more fuel-efficient planes that provide better services. Together, these challenges made the airline industry highly unstable. At the time, six airline carriers, now known as the legacy or network carriers, dominated the market: US Airways, United, Delta, Northwest, American, and Continental. Cyclical profits and soaring costs eventually forced bankruptcy for four out of six within five years of 9/11 and all six by the end of the decade. Adding to their woes, new airlines focused on maintaining low overhead costs entered the market. These airlines, dubbed low cost carriers, or LCCs, began to post steady profits and growth. Many of these, such as Southwest and Jet Blue, began to dominate regional markets. Clearly, something had to change. The Rise of the Merger Facing the seeming insurmountable task of achieving profitability, airlines began focusing on bringing stability to the market. One by one, the legacy carriers began to merge and acquire the others: Delta merged with Northwest Airlines in 2005, United merged with Continental Airlines in 2010, and finally, American Airlines merged with US Airways. Furthermore, although attention focused

on the mergers of the six legacy carriers into four, numerous smaller carriers also began merging to wield more clout. Republic Airways and Shuttle America merged in 2005, Republic Airways merged with Midwest Airlines and Frontier Airlines in 2009, and Southwest bought AirTran Airways in 2011. Does the Merger Pay Off ? Airline executives argued that such mergers benefited the market and their companies. They insisted that fewer options lead to more choices for passengers as the four major network airlines are now able to operate at every airport across the country. This means healthier, more stable competition. Mergers can also cut costs by allowing

The United-Continental Merger The United-Continental merger, completed in October 2010, was hailed for establishing the world’s dominant airline. The combined airline has the largest commercial fleet of any airline in the world and flies to more destinations than any other competitor, according to a recent article in the Economist. Almost immediately, however, the airline ran into difficulties. While attempting to convince investors to support the merger, the airline claimed that the deal would save $1.2bn by 2013. The airline fell well short of this goal, admitting in 2013 that, although the payoff was hard to quantify, it was nowhere near that figure. Furthermore, on-time performance suffered in the two years following the merger, plummeting

Facing the seeming insurmountable task of achieving profitability, airlines began focusing on bringing stability to the market. One by one, the legacy carriers began to merge.

for routes to be combined: instead of two half empty planes on two different airlines flying between destinations, one full plane can carry the entire load. This consolidation can be extended to the entire network of flights, as well as to IT services, where the incompatibility of competing airlines’ optimization systems has long been a major cost. The merger also would decrease the use of domestic hubs and would lead to a more decentralized structure that could respond more flexibly to market pressures. This would allow for airlines to capitalize on sudden demand and reshuffle in the case of sudden cutbacks.

to 64% by July of 2012, and frequent reservation system disruptions plagued the carrier.

While many analysts agree on these benefits, many also caution on blind exuberance. The mergers are fraught with perils. The following two cases depict both the benefits and pitfalls.

Further issues persist, most notably in labor contracts. Because airlines are so heavily unionized, every independent United union, from airplane maintenance workers to flight attendants, has had to hash out contracts with the Continental

Just as the airline started to post signs of improvement in 2013, including the fact that on-time performance had soared, that profits had increased, and that the reservation system had improved, the US Department of Transportation fined the airline $350,000 for taking too long to process refund requests. The airline squarely blamed the issue on the merger, revealing that the United electronic system had not been fully integrated with Continental’s.

THE PRINCETON FINANCIER | 5


unions and the company executives before the merger could be completed. Three years after the end of the merger, these talks are still ongoing. The only union to have completed talks is the pilots union. While finalizing permanent contracts, the airlines have been forced to operate on a temporary, new contract called the “metal contract.” This forces Continental flight attendants to fly on Continental planes and United flight attendants to fly on United planes. This impedes the optimization benefits that are supposed to accompany a merger; the combined carrier can’t move planes to certain markets where they would be more in demand without shifting the entire crew as well, creating a huge expense.

merger of two legacy carriers, Delta and Northwest in 2005, started off similarly in troubled waters. Like the merged United carrier, Delta had the worst on-time record in 2010 and generated profits well below expectations. But by 2012, Delta was outperforming all of its peer rivals, notably on a key measure of airline success: the passenger revenue per available seat mile. This measure indicates how much an airline is profiting off the current routes it runs as well as how efficient its routes are. United, suffering through the merger, posted an incremental 1.7% gain, while Delta posted a tremendous 7% increase. Analysts expect that, with the completion of labor negotiations, United too will begin to post increases in profitability and efficiency.

Like the merged United carrier, Delta had the worst on-time record in 2010 and generated profits well below expectations. But by 2012, Delta was outperforming all of its peer rivals.

Other touted benefits haven’t materialized either; the decentralization of the network, the disappearance of regional hubs, and the increase in options are all still future prospects, not current realities. In its anti-trust suit against the AmericanUS Airways merger, the Department of Justice argued that the United-Continental merger has raised fares up to 57% on some routes. This translates to larger profits, but some analysts argue that such profits are temporary as low cost carriers begin to compete on more routes with the legacy carriers. A Complex Recipe for Success Despite poor financial indicators, the United-Continental merger will likely not go down as a failure. The previous

THE PRINCETON FINANCIER | 6

History suggests that mergers increase profits and efficiency long-term after a tumultuous transition period. But questions remain. No evidence exists that the airline industry has broken away from its infamous cyclical profit trend. Low cost carriers continue to pose significant threats to the legacy carriers. The fact legacy carriers began to turn a profit despite a recession and a surge of low cost competitors is encouraging, but should be treated with caution. Companies coming out of bankruptcy filings are able to be more flexible, an advantage that translates to significant benefits in the airline industry. All four legacy carriers operating today underwent bankruptcy in the past decade. A key indicator will be whether the airlines can maintain this flexibility. Much of this flexibility

will depend upon how the airlines conduct their merger: whether they can successfully integrate their underlying computer systems, whether legacy carriers can use the merger to boost productivity per employee to the levels of low cost carriers, whether the labor contracts allow for enough flexibility with shuffling planes and routes around, and whether airlines can successfully invest profits into more modern, more efficient fleets with lower costs and greater amenities. Profitability of the entire airline industry also depends on responses to future challenges, most significantly due to decaying infrastructure among US airports. Numerous studies, from an analysis by MIT’s Aviation Project to the National Society of Civil Engineers, and experts, from former Secretary of Transportations to private industry analysts at Oliver Wyman, warn that the current infrastructure will not be able to support future demand, causing tremendous delays and incurring huge costs for both carriers and passengers. Thus investors should move with caution with respect to the American-US Airways merger and in regards to airline industry as a whole. While the industry does appear to be on track towards achieving stability and profitability, much work remains to be done. If past mergers serve as a lesson, the American-US Airways merger faces several tough years before fully integrating. Already, though, mergers have fundamentally altered the face of the airline industry, revitalizing the old legacy carriers and throwing into question the paradigm of the unprofitability of airlines. Whether these mergers bring a calm to a turbulent market remains to be seen: in the end, only time will tell.


What is Operations Research?

Applications

Theory

Game Theory

Simulation

Statistics

Business

MAT 378: Theory of Games ECO 418: Strategy and Information ECO 317: Economics of Uncertainty ORF 245: Introduction to Statistics ORF 350: Introduction to Big Data

Scheduling

ORF 407: Fundamentals of Queueing

ORF 409: Monte Carlo Simulation ORF 417: Dynamic Programming ORF 418: Optimal Learning ORF 401 - Electronic Commerce

Financial Engineering

ORF 335: Financial Mathematics ORF 435: Risk Management

Princeton Operations Research Society THE PRINCETON FINANCIER | 7

princetonors.weebly.com


Three decades of 10% average GDP growth has transformed China from a largely rural and poverty-stricken society into the largest trading nation and the second largest economy in the world. However, China’s GDP growth has fallen to 7.8% in 2012 and 7.6% in 2013. Developed countries, used to a 2% economic growth rate, would envy China’s strong development. But while a 2.4% slowdown may not seem significant, it amounts to over $200bn less of goods and services, an amount larger than three-quarter of the world’s economies. According to Raphael Bostic, a public policy professor at the University of Southern California, a major economic growth deceleration in China could result in a global recession: “China, for a long time now, has been an important driver of basically every country’s economy.

Any slowdown is going to ripple through and really have an adverse impact on the world’s economic performance.” China’s trade has grown to the extent that its economy has become interconnected with both the traditional economic powerhouses and many commodityexporting countries in Southeast Asia, Africa and South America. Thus, China’s economic development is critical not only for continued growth of the country, but also for that of other developed and developing nations as well. China’s Economic Growth Model In order to better understand the implications of China’s slowdown, it is important to first examine some shortcomings in its growth model.

Prior to the financial crisis, China maintained an export-driven economy, as its exports grew well over 20% year-overyear from 2002 to 2007. However, the weakening of the US economy coupled with the Eurozone debt crisis decreased global demand of Chinese goods. Furthermore, the manufacturing wage differential between the US and China has narrowed from 22 times in 2005 to 10 times in 2010. As wages continue to rise in China and stagnate in the US, the difference is projected to decrease to five times by 2015. China is quickly losing its comparative advantage as an exportbased nation that provides cheap labor. With China already holding an 11.1% share in the world’s total exports, it can no longer rely on exports as a source of growth. The Chinese government has acknowledged this as they began liberalizing the RMB in 2010. By slowly allowing the RMB to appreciate, China is gradually starting to favor domestic development and is thus starting to emphasize imports over exports. Net exports have declined from 8% of China’s GDP to just 2% as it became apparent that exports were not a viable long-term source of GDP growth. More recently, China’s growth has been driven by investment, which, staggeringly, makes up more than half of its economy. Following the 2008 crisis, the government

THE PRINCETON FINANCIER | 8


excessive fast growth and fed a worsening asset bubble.”

engineered a $586bn stimulus that lowered interest rates and led to a lending and investment boom. However, China cannot forever expect to fill new factories and occupy new houses. High rates of investments have been successful thus far largely because of the need to build transportation infrastructure and housing to accommodate urbanization. In 2011-2012 alone, China completed 3.8bn square meters of housing space– enough to house over 100mn people. Now, China’s high levels of investment have led them into a credit bubble. According to Charlene Chu, a senior director at Fitch in Beijing, overall credit has risen from $9tn to $23tn since late 2008. “They have replicated the entire US commercial banking system in five years,” she said. Furthermore, the ratio of credit to GDP has jumped by 75 percentage points to 200% of China’s GDP. In comparison, the credit to GDP ratio jumped just 40 percentage points in the US before the burst of the subprime bubble. “This is beyond anything we have ever seen before in a large economy. We don’t know how this will play out. The next six months will be crucial,” Chu remarks. With the rise of shadow banking (financial institutions that are not subject to regulatory policies ), China is increasingly exposed to an alarming credit expansion. A study by Morgan Stanley Research Group has revealed that Chinese corporates are the most leveraged globally. As shown in the figure above, state-owned enterprises in China now have a gross leverage (measured by debt over EBITDA) of over 2.0x. This

is significantly higher than the gross leverage in the US at about 0.5x and Europe at about 0.75x. Shadow banks, which hold extremely risky assets of up to $2tn, pose a serious threat to the stability of China’s monetary system. According to George Soros, the shadowbanking sector can be just as risky as the subprime residential mortgagebacked securities (RMBS) securities that devastated Wall Street in 2008. It remains to be seen whether the shadow banking system in China can withstand a fall in asset prices similar to that seen in the US. By extension, despite the fact that the central government holds $2.5tn of reserves in foreign currency, the government is no longer as strong as it was prior to the implementation of its stimulus package. Trying to stimulate the economy during the credit crisis would likely aggravate the debt concerns and lead to rampant inflation. As Nazi

Since investment, government expenditure, and trade cannot sustain China’s economic growth, China will have to depend on domestic consumption to fuel its growth. Fortunately, consumption appears to have picked up the baton as the driver of economic development in China. In fact, consumption is now the leading source of GDP growth in China. That said, consumption currently makes up only 35% of China’s GDP. Compared to the US, whose consumption makes up 69% of its GDP, this figure is extraordinarily low. With a population of 1.35bn people, there is enormous potential for domestic consumption. Consider a few statistics: China has over eight million new college graduates this year; the US has slightly over three million. Disposable income has tripled over the last eight years. In the past year, Taobao, an ecommerce giant, sold over one trillion RMB worth of goods, which easily surpasses the gross merchandise volume of Amazon and eBay combined. Taobao projects that they will reach a gross merchandise volume of over three trillion RMB by 2017. Signs are promising, but a delicate rebalancing of the economy is needed. Policy Changes Xi Jinping, the new Chinese President, has recognized the importance of allowing for slower growth to adjust the structure of its economy. In a written interview distributed by Xinhua

“China, for a long time now, has been an important driver of basically every country’s economy. Any slowdown is going to ripple through and really have an adverse impact on the world’s economic performance.” Germany and Soviet Russia have shown, government-driven economic growth becomes unfeasible over time. There is only so much that governments can do. Bill Adams, an economist at PNC Financial, warns, “The biggest mistake would be if China’s government targeted

news agency, Xi said that he would “rather bring down the growth rate to a certain extent in order to solve the fundamental problems” in the economy. The 60-point reform plan unveiled last November reflected this sentiment of steering away from investmentTHE PRINCETON FINANCIER | 9


led growth to a consumption-driven economy. Key points include relaxing the one child policy and reforming welfare systems, both moves that will likely increase the urban population and thereby simultaneously bolster both the labor and consumer markets. The plan also includes liberating market forces and improving corporate governance, which would make China an even more attractive destination for capital inflows. Yet, the new reforms would also dilute the government’s control in the economy. Whether this plan succeeds will depend on the willingness of Beijing to relinquish control of its State-Owned Enterprises. Furthermore, a rebalancing of the economy also comes with its risks. Soros warns that, “Structural reforms combined with fiscal austerity [can] push economies into a deflationary tailspin.” Deflation followed by a mass deleveraging would set China back significantly. As demand for consumption and investments decrease, incomes would also decline and cause a further reduction in aggregate demand. With slow recoveries in developed

It is therefore essential for Beijing to be cognizant of these risks and forego maintaining high growth rates in favor of healthier long-term development. Fortunately, there have been positive signs that Xi and his colleagues are mindful of avoiding Japan’s path and are instead striving to boost consumption in many key industries. Meanwhile, the country’s slowdown has taken a toll on the commodity sector. Between 2000 and 2012, China’s share of global steel demand increased from 16% to 44%; its share of nickel rose from 6% to 45%. This surge in demand has driven commodity prices to record highs. But with slowing growth, copper, iron and coal prices have all fallen 30-50% below their 2011 peaks. Worse yet, share prices are down 60%. The consequences may not be as severe as they appear, though. Chinese growth continues to expand more rapidly than any other commodity consumer. It is such a large consumer that even a 5% growth

Since investment, government expenditure, and trade cannot sustain China’s economic growth, China will have to depend on domestic consumption to fuel its growth. economies, a stagnant China could take years to rebound. Indeed, China faces the threat of following Japan’s footsteps. Like China, Japan in the 1980s had an export-led growth model via low cost labor and a devalued currency. Towards the end of the decade, Japan saw rampant inflation in housing prices and a sharp rise in its credit to GDP ratio. Furthermore, the size of the working-age population was also declining as people aged. The result of this has been a three decade period of stagnation that Japan is only recently starting to emerge from. Key Factors in Boosting Consumption THE PRINCETON FINANCIER | 10

in demand would raise copper production by 420,000 tons. Although iron ore and coal, commodities traditionally associated with investment-led growth, are likely to take a hit, commodities associated with a consumption-driven economy, such as petrol and palladium, are likely to fare well. In fact, despite automobile manufacturers closing factories and laying off thousands of workers in Europe and the US, Citroen, Ford and General Motors have all opened new factories in China over the past year. Car sales in China rose 14% last year compared to a 7% decrease in Europe. Carmakers are optimistic about the huge growth potential in China. Car

ownership, roughly 60 cars per 1000 people, is still well below the EU average of 500 cars. With only 15% of new cars being bought with credit, carmakers should be relatively less impacted by the impending credit crisis than the real estate market. Having exported €67bn worth of German machinery to China last year, German manufacturing companies continue to show confidence as well. In a survey of 500 German companies with operations in China, 47% responded that they expected business conditions to improve, while only 14% believed that they would worsen. Siegfried Russwurm, head of Siemens’ industry unit, stated: “China is not and probably will not be an area of strength for the next [few] quarters [ . . . ]but we are convinced that in the long run China is the place to be.” Luxury goods companies have also come to rely on China, which boasts the world’s second largest luxury market. Despite a 20% rise in sales to €23bn last year, this year’s forecast has declined to 6-8% growth. That said, China’s demand remains at a level higher than most other parts of the world. As seen with other sectors of the economy, even with more modest projected growths, companies are still inclined to expand and tap into China’s enormous potential market. Looking forward Despite its recent slowdown, China continues to be the biggest contributor of global economic growth. The fastest growing trade corridor has been between China and Africa, closely followed by China and ASEAN countries. With the US and Eurozone economies still recovering, it is important for the world to avoid a third setback, a recession led by emerging markets. Culturally, Chinese households are relatively more inclined to save than spend. However, China can no longer rely on investments and exports to propel growth. As the government starts to rebalance its economy in favor of a more sustainable model that is driven by consumption, investors are optimistic about the long-term growth potential in China. Most signs suggest that China will steer clear of trouble.


S A V E

T H E

D A T E

R E U N I O N S PA N E L M AY 3 0 , 2 0 1 4

ARE FINANCIAL INSTITUTIONS TOO BIG OR TOO BIG TO FAIL? 

Paul A. Volcker ’49 Former Federal Reserve Chairman, Founder of the Volcker Alliance

Richard J. Herring *73 Jacob Safra Professor of International Banking, Wharton School, University of Pennsylvania

Martin J. Gruenberg ’75 Chair, U.S. Federal Deposit Insurance Corporation

Donald S. Bernstein ’75 Partner and head of Insolvency and Restructuring Practice, Davis Polk & Wardwell LLP Moderator Cecilia Rouse, Dean, Woodrow Wilson School of Public and International Affairs Free and open to the public

4:00-5:30pm

Reception to follow Dodds Auditorium, Robertson Hall

Julis-Rabinowitz

Center for Public Policy and Finance

Under the direction of Markus Brunnermeier and Atif Mian, the Julis-Rabinowitz Center for Public Policy and Finance at the Woodrow Wilson School (JRCPPF) promotes research and teaching in financial markets and the macro economy with the aim of improving the design and implementation of public policies. To learn more about JRCPPF programs and research and internship funding opportunities please visit www.princeton.edu/jrc To learn more about the Program in Law and Public Affairs (LAPA) please visit http://lapa.princeton.edu THE PRINCETON FINANCIER | 11


Piece written on November 4, 2012

Alternative fuel sources, renewable energy, going green, carbon footprint, sustainability. These were the favorite buzzwords of the media and energy industry in the early 2000’s. However, in recent years, the green energy discussion has lost some of its widespread momentum, so we find it pertinent to examine how this industry has developed globally since its heyday. Renewables are currently on the cusp of becoming a key part of the world’s energy mix. While future advancements in technology will allow for more efficient energy production, the primary constraint to

achieving higher shares of renewables is the lack of political will to enact the necessary policies and measures. Overall, the rapid pace of policy adoption seen in the early-tomid 2000s has slowed in recent years, while global investment in renewable energy has also decreased in 2012 due to economic uncertainties and ongoing tensions in international trade. However, these financial issues have mostly impacted traditional and developed markets, while investment in renewable energy has expanded significantly in developing countries. Two of these developing markets for re-

AN EXCERPT FROM newable energy, the Middle East and North Africa (MENA) and China, have made significant commitments and investments towards expanding alternative energy sources in recent years. For the MENA region, a traditional fossil fuel exporter, the growth has been spurred primarily by increasing domestic energy demands while for China, both environmental and economic reasons have caused its government to make significant moves towards shifting from coal to renewables for supporting its rapid growth and development. The following two articles examine the push towards renewable energy for these developing economies.

~ By Eric Huang

A CHANGING INVESTMENT LANDSCAPE ENERGIZING THE MENA REGION by Ryan Azarrafiy, Sankalp Banerjee, and Jack Roger The history books state that the Spanish conquistadores of the fifteenth, sixteenth, and seventeenth centuries traveled to the Americas motivated by the Three G’s: God, Gold, and Glory. Had these explorers traveled to the south and east of their homeland, however, they may have found a fourth G that could have boosted their legacy to a new level: gas. For most of modern-day history,

the Middle East and North Africa region (MENA) has been known for its immense energy wealth. A study from The Oxford Institute for Energy Studies reported last month that the MENA region currently contains more than half of the planet’s discovered crude oil, in addition to more than a third of Earth’s natural gas reserves. While MENA exports a significant amount of its energy reserves to global demanders, the region’s energy consumption has also increased significantly over the

THE PRINCETON FINANCIER | 12

last fifty years. With regionally produced fossil fuels of ample supply and low cost, MENA has transitioned from a peripheral demand market for energy to an industrialized, populated region that has consumed energy faster than almost any other region over the last half century. While energy demand growth in the Persian Gulf states peaked during the 1970s, aggregate demand amongst Gulf nations (including Iran and Iraq) for primary energy has risen five-fold since the 1980s, which translates to the fastest


energy demand growth for any global region. Alternatives for domestic use have become necessary to maintain the region’s strong export-driven economy. This article explores the vast potential of renewable energy options, such as wind and solar energy, which could serve as valuable alternatives to fossil fuels in satisfying MENA’s energy demands. While oil and natural gas will undoubtedly maintain primacy in the region’s energy dependence, the pursuit of alternative forms of energy has the potential to save MENA, an ever-growing and industrializing region, from rising costs in order to sustain growth and prosperity. Recent Developments The MENA region includes countries such as Saudi Arabia, Bahrain, Iran, Iraq, Morocco, the UAE, and others. Understanding that renewable energy is to play an increasingly significant role in the economy, these countries have already begun taking steps to invest in alternative forms of energy, diversifying their interests in the energy sector. According to the Middle East Solar Industry Association, the MENA region could see up to $50bn investment in solar energy by 2020. Specifically, Saudi Arabia has gained considerable international press in the past month for its investment in the alternative energy sector. Currently, the Kingdom maintains a $576.8bn USD GDP, of which eighty percent is dependent on oil revenues. This being said, with export supplies dropping and growing internal demands, Saudi Arabian leaders are understanding more and more that it is necessary to begin investing in nuclear power and other renewable energy sources. The King Abdullah City for Atomic and Renewable Energy (KACARE) has been assigned by the Kingdom to create plans to produce 54 gigawatts of renewable energy by 2032, with a particular focus on solar energy. This has been regarded as one of the largest programs for solar energy growth in the world, and the Kingdom seems

poised to become a regional leader in solar energy production. It is clear that Saudi Arabia has recognized the need for renewable energy investment and has taken significant actions to enter the market and ultimately broaden the scope of the energy sector in the MENA region. Several companies also see great opportunities for renewable energy investment in the MENA region. In January of this year, Masdar, Abu Dhabi’s leading renewable energy company, announced that it will be collaborating with the European Investment Bank (EIB) to speed up the development of renewable energy projects in the MENA region. The agreement was signed during Abu Dhabi Sustainability Week, one of the largest gatherings on sustainability in the Middle East and a significant venue for cooperation in the region. Having provided more than 70bn euros in long-term energy investment over the last five years, EIB will enable Masdar to improve resources and move ahead with new renewable energy projects.

Investment initiatives like these will not only help reduce the risk involved in starting renewable energy projects but may also help catalyze further private sector involvement in the energy industry of the region. The MENA region has seen a considerable rise in renewable energy investment in the past few years and has very recently set forth projects to increase diversity in the energy sector. The Kingdom of Saudi Arabia hopes to spend $109bn on solar energy and nuclear power. The United Arab Emirates plans on allocating $102bn towards solar and alternative energy, and corporations such as Masdar and the European Investment Bank have become involved in the surge of alternative energy investment in the MENA region. The Future of Energy Investment While recent alternative energy efforts in Saudi Arabia and the UAE are promising, it is important to realize that consumer demand in the domestic market for electricity

The Kingdom seems poised to become a regional leader in solar energy production.

Aside from various private investments in the growing trend of renewable energy, funds and investment vehicles that are solely dedicated to alternative energy investment in the region are also being developed. For instance, in late 2013, Desertec Industrial Initiative (Dii) developed a $40.5mn fund for supporting renewable energy projects in MENA. The goal of the project is to capitalize on and help drive the energy transition to wind and solar power. Another up-and-coming fund includes the African Renewable Energy Fund, which closed on March 12, 2015 with $100mn of committed capital to support small to medium scale independent power producers.

in MENA is very different from the demand in Western Europe or North America. Whereas renewable energy development in Europe and the Americas has been catalyzed primarily by a desire to mitigate climate change, the importance of alternative energy investment in MENA can be better understood through an economic lens. In fact, many developing countries in MENA primarily consider alternative energy as a mechanism to satisfy their rapidly expanding consumer demand for energy. In Persian Gulf countries, for example, electricity demand regularly peaks in the afternoon, which coincides with the time of maximum sunlight availability. This means that solar energy could help fill in the

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growing electricity demand gap when it is needed the most-during peak hours. To the extent that non-fossil fuel energy sources are perceived as economic necessities, the future of alternative energy development in the region is bright. Perhaps the biggest perceived barrier to significant renewable energy development is the overwhelming dominance of fossil-fuel production in the region. However, the characterization of the Middle East and North Africa as an overwhelmingly oil-abundant area only tells part of the story. In reality, for many of the developing countries in MENA, a reliance on oil and natural gas reserves will not be enough to satisfy consumer demand. The

sector in these countries would allow governments to reorient their focus towards profitable oil and gas exports abroad. However, in order for MENA countries to unlock their immense potential for renewable energy, their political and regulatory conditions will have to become more businessfriendly. In Oman, for example, an intransigent legislative framework is inhibiting solar energy development, which keeps newer technologies out of the market for long periods of time. These restrictions drive the cost of renewable energy generation higher. Moreover, the threat of imminent political unrest continues to diminish the incentive for renewable energy investment in places such as

To the extent that non-fossil fuel energy sources are perceived as economic necessities, the future of alternative energy developement in the region is bright. International Finance Corporation, a World Bank subsidiary, predicts that the expensive nature of energy subsidies will force importers like Israel, Jordan, Lebanon, Morocco, Palestine, and Tunisia to put energy efficiency at the top of their priority lists. Its estimates put potential investment in the MENA region at $45bn, with $29bn coming from solar and $12bn from wind. Crucially, alternative energy development is also beneficial for countries that are currently net energy exporters. In order to satisfy domestic demand, net exporters like Saudi Arabia and Bahrain are currently forced to restrict foreign energy exports, resulting in lost revenue from selling oil at higher prices to other countries. Thus, by relieving some of their domestic energy demand, an advanced alternative energy private

Libya, Egypt, Algeria, and Iraq. Since the initial capital investment required for developing renewable energy technologies is often very high, increased risk due to geopolitical conflicts serves as a major disincentive for potential investors. Despite these significant hurdles, there is reason to believe that business conditions will improve as governments realize that it is in their best interest to allow for the development of alternative energy in the face of rising costs of water subsidies and conventional electricity generation. An aggressive governmental push towards green energy is already noticeable in Saudi Arabia, which currently features close to 1,500 green projects, including several initiatives for “green building”. Aside from the domestic political environment, the level of regional

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cooperation will be a major determinant in the success or failure of renewable energy in MENA. Regional cooperation can take the form of technology transfers or energy trading. In order to make green energy truly viable in the market, countries will have to embrace both. With regard to technology transfers, it is critical that a cooperative framework exists between countries with established renewable energy industries and newly producing countries. In the intermediate to long run, technology transfers will also allow countries which have recently entered the market to develop domestic manufacturing and R&D capabilities. A 2010 World Bank Study suggests that the creation of a “network” of regional technology transfers could also have positive economic spillover effects in construction, manufacturing, research, and other industries. Moreover, MENA countries must also take advantage of electricity trade as a part of their framework for regional energy cooperation. The Oxford Energy Report argues that this is largely feasible because of already existing infrastructure that has the potential to support this type of inter-grid trade. For instance, Egypt and Saudi Arabia have already agreed on plans to connect power grids that can facilitate trade by taking advantage of differences in peak electricity demand times. Ultimately, the potential for significant alternative energy development clearly exists in the Middle East. In the coming decades, it is safe to say that fossil fuels will continue to dominate the domestic market, but this does not mean that renewable energy will not find its place in the established energy industry. Regardless of whether it is developed in response to economic or environmental concerns, investment in viable green energy sources will play a crucial role in satisfying the demands of a rapidly developing region.


GOING FROM GRAY TO GREEN: CHINA’S PUSH TOWARDS RENEWABLE ENERGY AND CLEANING UP AIR POLLUTION by Vivian Chen

The Start to a Greener Future?

Current State of Renewable Energy

Many visitors to China’s large metropolises such as Shanghai and Beijing will not see a clear day during their entire trip to the country; the constant, thick gray smog retreats whimsically only by the blessings of strong wind or precipitation. While the country’s inhabitants have come to simply accept the incredible amount of air pollution as an unfortunate consequence of China’s spectacular economic growth, this issue is a major concern for those who keep a watch on the environmental impact of China’s fast-paced development. While this grave environmental challenge might pose setbacks for businesses hoping to carve a share in this market, it could present a great opportunity for firms and investors in environmental engineering and renewable energy.

Historically, China has fueled its rapid economic and industrial growth through the consumption of coal, but in recent years, there has been a strong push towards renewable alternatives. So while China still relies on coal for two-thirds of its primary energy needs, growth of coal demand is projected to slow in the upcoming years while development of renewable sources such as solar, wind, and hydropower continues to rapidly expand.

China’s cabinet has created a Five-Year plan that would invest 1.75tn yuan (approximately $290bn) in anti-pollution solutions between the years 2013 and 2017. About 37% of the 1.75tn yuan investment package would be spent on cleaning up industries whose dependence on inexpensive and inefficient energy pollutes the air, while another 35% would be put towards upgrading motor vehicles that emit pollutants in cities, with the remaining 28%, which translates to 490bn yuan, being used to develop and introduce new energy sources. It is understandable for one to ask whether this substantial investment is a genuine and reassuring step forward in China’s quest for cleaner energy or simply a coping strategy for the growing discontent among the affluent urbanites that have to live with the environmental consequences of their fast-paced prosperity. Where is the renewable energy industry in China headed?

As of 2013, China gets about 8% of its total primary energy from non-fossil sources. China’s 12th Five Year Plan, published in 2011, sets out goals of 11.4% of total primary energy from nonfossil sources by 2015 and 15% by 2020. The central government has shown a real

greater domestic solar deployment. China already has seven gigawatts (GW) of solar, but is attempting to dramatically scale up domestic deployment of solar, with a target of at least 35 GW installed by 2015. Hydropower is the country’s leading source of renewable energy, providing about 18% of China’s total electricity. Currently, China has 229 GW of installed hydropower, accounting for about a quarter of the world’s total hydropower. Interestingly, China is also the world’s biggest user of small-scale hydropower, about 65 GW. The official target for all hydropower is 290 GW by 2015. Wind is the second second largest source for renewable power in China, with 75 GW of installed capacity in 2012. The Chinese market for wind energy is

The Chinese market for wind energy is currently the fastest growing in the world, having increased over a hundredfold just in the past decade. commitment to reaching these goals with significant investments, including over $65bn invested in 2012. China’s commitment to promote renewable energy sources over the past few years can already be seen in some very impressive achievements. For example, China is currently the world’s largest producer and exporter of solar cells. In fact, in 2012, China manufactured 30% of all photovoltaic cells in the world. While much of this production has been focused on supplying the international market, recent difficulties have led to

currently the fastest growing in the world, having increased over a hundredfold just in the past decade. While China is already the largest producer of wind power in the world, the country has plans to double the number of turbines in the next six years, with goals of achieving 200 GW by 2020. China’s government is promoting renewable energy development through establishment of a legal framework that gives market-based incentives and direct subsidies. However there still remain major challenges such as connecting

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wind and solar farms in remote areas to the cities where the power is needed the most. Furthermore, there remains the issue of adapting China’s grid, accustomed to handling the predictable output of power stations burning coal, to the intermittency of renewables such as wind and solar. The government is using a variety of policies such as energy quotas, tax breaks, preferential loans, and other financial incentives to encourage investors to back renewable ventures. However many of the aforementioned incentives and development plans are primarily directed towards domestic, often state-controlled, power companies. How will the foreign renewable energy investor fare in this rapid-growth landscape that is China’s push towards development of alternative energy sources?

of renewables, and technology-specific drivers. While China fares similarly to the United States in terms of financing enterprises in renewable energy—even strikingly better in technology-specific drivers in wind and solar energy, it lags significantly behind in the area of ease of doing business, scoring only 45.9 compared to the United States’ 70.8. The rather colloquial term, “ease of doing business,” essentially refers to the issue of infrastructure, such as transportation, and problems with fairness and transparency in regulations and law enforcement. There is little doubt that emerging markets such as China present a lucrative opportunity for clean energy providers and investors, but they must be prepared to tackle the difficulty posed by the political, social, and economic infrastructure of these countries.

Potential Roadblocks

It is also important to note that “the ease of doing business” is inherently a macroeconomic parameter across all industries, and that the Chinese central authority’s enthusiastic support for the renewable energy sector brings a decided advantage. One example of government backing is a 50% tax break for solar manufacturers from October 2013 to December 2015, which was implemented to support the country’s ambitious plan to churn out 35 GW of solar energy by 2013. The country has also emerged as a leader in the installation of wind energy, with a plan to install 100 GW of wind capacity by the end of 2015. How does the country plan to incentivize domestic firms to utilize cleaner energy in the future? It is clear that China has dedicated significant resources to spurring the growth of renewable energy from both the supply and the demand side, which will ultimately result in a larger share for alternative energy sources in the country’s total energy consumption. China’s urgent demand for cleaner energy in light of the recent pollution problems, coupled with a steady stream of favorable policies by its central government, makes renewable energy a promising industry for investors and firms.

The story of a leading American solar panel manufacturer’s plans to build the world’s largest photovoltaic power plant in the Inner Mongolia region exemplifies the challenges that renewable energy companies face when attempting to gain entry to China’s markets. In late 2009, First Solar signed a memorandum of understanding with the Chinese government to build a two-gigawatt PV solar power plant in Ordos City, Inner Mongolia that when completed, would be capable of powering three million homes. However, four years after the initial announcement of this impressive project, First Solar has yet to begin construction on the site. The root of this inaction lies in the firm’s pending approval from the government to start the first phase of the project. Upon further examination, it becomes clear that First Solar is representative of foreign firms seeking to enter the Chinese market. In an annual industry report published in November 2013 by Ernst & Young, China ranks second in the Renewable Energy Country Attractiveness Index (RECAI), slightly behind the United States. The composite index is calculated from assessments of macroeconomic stability, ease of doing business, prioritization of renewables, bankability

Despite some evidence of progress in government efforts to incentivize investment in the renewable energy

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sector, there is a rather nuanced concern for foreign investors in firms. An article by Quartz coins China’s energy transition as “the Green Leap Forward,” a moniker which ominously alludes to the failed social and economic movement that wrought havoc in the country in the late 1960s. It voices concerns for foreign firms such as First Solar which will have to compete with China’s own state owned power generation enterprises. In fact, non-Chinese power plant developers and equipment suppliers currently own market shares amounting to less than 10% and 5%, respectively. For these reasons, successful foreign enterprises in China must often operate with the government-owned corporations through joint ventures. Another facet of China’s renewable energy sector is its exports of renewable energy products—those that do not affect domestic energy consumption patterns. Chinese producers have done phenomenally in exporting such equipment to Europe in recent years, which has led to accusations of Chinese companies dumping these products at distorted, subsidized prices. The related cases eventually resulted in the establishment of set quotas and fixed prices for renewable energy equipment— such as solar panels—imported from China. The task of enforcing this quota has been delegated to the Chamber of Commerce in China, and analysts predict that the said authority will most likely endorse large-sized domestic players, contributing to the already bleak economic landscape for foreign firms. The prospects for renewable energy in China present many promises, most notably the industry’s steadfast support from the central authority—including subsidies and government-funded projects. This government support is bolstered by the urgent demand for alternative energy sources as Beijing seeks to quell domestic discontent due to the environmental consequences of burning coal. Moving forward, it will be interesting to see how the industry tackles the political and social challenges faced in the industrial and regulatory landscape of China.


On January 6, 2014, the Senate confirmed that Janet Yellen was to succeed Ben Bernanke as chair of the Federal Reserve. The first woman chair and the first Democratic chair since Paul Volcker in 1979, Yellen and her openly reform-minded, Keynesian-oriented policies will bring a fresh new perspective to the Fed. Yellen’s Background and Stance Prior to nomination as chair, Yellen led a distinguished career in public finance and policy. She began her career with the Fed in 1994 when she was made a member of the Fed’s Board of Governors. Since then, she has served as the chair of Clinton’s Council of Economic Advisors and President and CEO of the Federal Reserve Bank of San Francisco. For the last four years, Yellen served as Vice-chair under Bernanke. Yellen’s stance has changed in regards to

monetary policy over the years. In her first congressional hearing, Yellen stressed that the injection of stimulus into the economy has spurred economic growth by reversing the direction of the crashing housing

favor higher interest rates as a means of maintaining lower inflation. Yellen has also recently predicted moderate growth until at least next year and has emphasized the need to look beyond the

Yet, Yellen has more commonly been known for her dovish stance on inflation, often stating, “monetary policy is not a panacea.” market and renewing investor spirit. Yet, Yellen has more commonly been known for her dovish stance on inflation, often stating, “monetary policy is not a panacea.” Doves generally care less about the consequences of inflation and prefer to keep interest rates low to spur economic growth and to reduce unemployment. Their counterparts, hawks, associate high inflation with recessionary pressure. They

unemployment rate when assessing the economy. These judgments imply that Yellen plans to keep interest rates low should the unemployment rate drop below the 6.5% threshold. Both Yellen and Bernanke are dovish on inflation and unemployment. However, Bernanke has been described as more of a cyclical dove, injecting the economy

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with government money for as long as possible, but only when the economy shows signs of regression. Yellen, as a Keynesian and a Democrat, likely believes that economic systems can be inefficient and thus government intervention is key, making her more of a structural dove. Unlike Bernanke, Yellen likely thinks the government should intervene in the economy at all times, not just during certain points in an economic cycle. As a dove, Yellen is not as inclined to react to economic downturns with increases in the Federal Reserve interest rate. However, economists from the research firm RDQ Economics predict she will focus on these issues differently. After heavily researching her papers, speeches, and various formulae, John Ryding and Conrad DeQuadros created the “Yellen Rule,” an equation that predicts the federal funds rates. The higher this rate is, the more expensive it becomes to borrow money. Because only the most credible institutions receive these shortterm loans, the federal funds rate can be thought of as setting the base that

variables p and U, demonstrate Yellen’s sensitivity to declines in unemployment. After studying her speeches, papers at University of California-Berkeley, and work at the Federal Reserve Bank of San Francisco and Vice-chair of the Fed, they found evidence for a hawkish attitude towards inflation. For example, if employment were to improve, they claim that it is possible that Yellen may call for a rapid rise in the federal funds rate. Furthermore, her recent statements imply that she sees inflation as not rising anytime soon, indicating her dovish desire to keep the federal funds rate low. Immediate Challenges Yellen will have several obstacles to overcome as she begins her first term as chair of the Fed. The economic conditions that Yellen now must address are drastically different from the ones in Bernanke’s time. During his two terms, the housing bubble burst, Lehman Brothers went bankrupt, and AIG had to be bailed out, among other economic disasters. It was evident in 2008 that the

The economic conditions that Yellen now must address are drastically different from the ones in Bernanke’s time. determines all other interest rates in the economy and a controller of inflation. r = 13 + 1.5*p -2*U r = federal funds rate p = Fed’s preferred measure of inflation, U = unemployment rate To show how the formula works, today’s inflation of 1.15% and an unemployment rate of 7.3% predict that the federal funds rate would be 0.13%. According to the economists Ryding and DeQuandros, the formula, and the coefficients on the

American economy was in tremendous turmoil; Bernanke had to take aggressive action to revive the economy from the deepest recession a chair has had to face since the Great Depression. Bernanke dropped the federal funds rate to a near 0% and spent over $700 billion bailing out banks and large corporations, extreme measures that surpassed all past anti-recession efforts. When the economy began to recover, every action Bernanke took was focused on ensuring the economy would not slide back into a depression. The Fed’s endeavor paid off. Currently, the unemployment rate

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is at a more moderate 6.6% and stock markets are approaching all time highs. Due to this moderate success, Bernanke has attempted to taper the quantitative easing policy by cutting purchases by $10 billion to $75 billion per month. In January of this year the Fed continued this trend and tapered back its policy by another $10 billion to $65 billion per month. No longer is the country in danger of falling into the grave depths of economic depression. Though the economy is no longer in recession, it is important that we continue to see signs of recovery. In a worrisome turn, growth stumbled during the months of December and January, but has quickly recovered during the end of the first quarter, 2014. In December, 74,000 non-farm payroll jobs were created, and in January, 2014 only 113,000 jobs were created, short of the expected 185,000. Yellen has acknowledged that the economy is still weak stating, “The recovery in the labor market is far from complete,” and, “the unemployment rate is still well above levels that [we monetary policymakers] estimate is consistent with maximum sustainable employment.” However, there is also a flip side. Bulls have stated that low January and December numbers were simply a correction from October and November’s surprisingly strong numbers, averaging 250,000 jobs per month. Furthermore, February’s nonfarm payroll jobs added totaled to 175,000, higher than the expected 130,000. Unemployment numbers have risen slightly (to 6.7% from 6.6%), but this was attributed to an increased number of discouraged workers reentering the labor force. Regardless of the analysis, one thing is for certain: nothing is certain. There is general consensus that economic conditions have been improving to a degree, but with mixed signals in the markets and employment numbers, Yellen will have to be careful in ensuring both the economy and markets are kept steady while tapering back some


of the government lending policies, as such actions can cause investors to lose confidence. Due to the quantitative easing initiatives of the Bernanke terms, Yellen will be knee deep in a balance sheet that has $4tn in assets. Timing will be essential for Yellen as she continues to combat a struggling economy and a huge deficit. Another matter to consider is the issue of inflation. The current goal of the Fed is to attain an inflation rate of 2%, a goal government officials have failed to meet in the past two years. Inflation that is too low puts the country’s economy in danger of deflation. This may cause households, expecting lower prices, to postpone purchases and companies to delay hiring and investing since demand for products would be expected to fall. In addition, higher inflation-adjusted interest rates will ensue, resulting in a difficult environment for economic growth. A Hopeful Future? So what are Yellen’s plans for her first few years at the head of the Fed? One of her ideas is known as “optimal control,” in which the Fed would raise and lower interest rates in a more scientific and analytical manner. Specifically, government economists would create and incorporate a macroeconomic model that would mathematically calculate the ideal path of the short-term interest rate, controlled by the federal funds rate, necessary to reach inflation goals and unemployment targets. In the current economic situation, Yellen would act to keep the federal funds rate low longer, ultimately resulting in increased employment and inflation rising above the Fed’s goal for a few extra years. Unfortunately, it is impossible for the Fed to be optimal when it comes to analyzing and predicting the future of the economy. Also, inflationary psychology, which causes consumers to buy quickly, expecting a rise in price from a lack of trust in the Fed to

control prices, makes “optimal control” unrealistic. Yellen, therefore, also considers a simpler rule, better known as the Taylor Rule, which sets the interest rate only based on the divergence of inflation and economic output from their targets. But the downside to this model is that it calls for rates to rise sharply after periods of economic weakness. There are clear advantages and disadvantages to both strategies.

during Bernanke’s term never reached the Fed’s goal, Bernanke was able to alleviate the financial turmoil and mend America’s economy with heavy intervention. Yellen will now have to face a low employment rate, low inflation rates, and the withdrawal of the stimulus package of bonds. Her past success as a government official and her recent position as Vice-Chair of the Fed demonstrate her knowledge and experience in macroeconomics. Yellen

Only time will tell exactly how Yellen will proceed to catalyze growth in the economy.

More generally, Yellen has shared her thoughts on how she would go about ensuring economic security through accommodative financial conditions, a strategy she helped develop. This involves supporting consumer spending, business investment, and housing construction as a means of adding more momentum to recovery. As long as labor markets and inflation steadily improve, she intends to continue the monthly $10 billion dollar cutting of Treasury securities and agency mortgage-backed securities purchases. Of course, she will continue to be wary of labor market and inflation as economists and other critics assess the efficiency of the government purchases.

seems determined toward job creation, demonstrating her desire to prioritize and combat unemployment. The country is hopeful that Yellen’s leadership and knowledge will bring about a change in the economy, one that will hopefully lead America back to a thriving, booming economy.

In order to avoid another credit crisis debacle, she likely does not intend to follow what Bernanke and his predecessor did: ameliorating the damages once the bubble inevitably crashed. Instead, Yellen’s plan is to actively prevent reckless spending by auditing bankers’ loan books. She also has not ruled out the use of higher interest rates, though her higher preference is clearly tighter regulation. Only time will tell exactly how Yellen will proceed to catalyze growth in the economy. Though the inflation rate

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Piece written on November 4, 2012

AN EXCERPT FROM

What Is Bitcoin? In 2009, Satoshi Nakamoto, whose identity remains unknown, wrote a paper called “Bitcoin: A Peer-to-

From those early days when bitcoin was more of a breakthrough in computer science, the digital currency has risen from a few cents a piece to over $1000 per bitcoin in 2013. Recently, bitcoin has

The idea was to have a currency that could be used by anyone with a computer and an Internet connection.

Peer Electronic Cash System,� which proposed a new virtual currency. The idea was to have a currency that could be used by anyone with a computer and an Internet connection. Satoshi Nakamoto designed the system in such a way that the users of the currency would themselves be the ones who ran the system.

become one of the most controversial and hyped topics lying at the intersection of finance and technology. How Does Bitcoin Work? Nakamoto designed bitcoin so that there is no central server that processes transactions; rather there exists a

THE PRINCETON FINANCIER | 20

decentralized network of computers all over the world that allows the currency to function. Each bitcoin user possesses a wallet, which gives them a bitcoin address, a unique identifier similar to an email address. Whenever the user wishes to transfer them to someone else, the owner sends a message to all of the computers on the network. These computers then collect all of the transactions into a unit of data called a block, while ensuring a user does not double-spend or spend more bitcoins than one has. The block chain is a sequence of blocks that is available to the public and contains every bitcoin transaction that has ever taken place. Any computer on the network that manages to add a block to the block chain is rewarded with a certain number of bitcoins. This process of adding a block to the block chain is called mining. The bitcoin protocol has a builtin mechanism that ensures that one block is added to the block chain approximately


once every ten minutes. Thus, new bitcoins are released at a fixed rate. The system is self-sustaining because people are rewarded for adding their computers to the network and verifying transactions. Also, it is important to note that the reward for mining decreases over time, so that only about 21 million bitcoins will ever be in circulation. Online exchanges exist to convert between bitcoin and traditional currencies, charging a small conversion fee just like traditional exchanges. Bitcoin vs. Traditional Currencies One major difference between bitcoin and traditional currencies is the fact that bitcoin is decentralized. This means that bitcoin cannot be controlled by any single entity, unless that entity was able to control over half of the bitcoin network, which is very unlikely. The rate at which bitcoins are released is completely determined by an algorithm which has been released to the public. In contrast, the U.S. Dollar is controlled by Federal Reserve, an entity that can print money at any rate. Thus, there is no bitcoin-related monetary authority whose announcements might disrupt the bitcoin markets. On the other hand this also means that there is no possibility for a central authority to step in and take whatever extraordinary measures it may deem necessary to regulate the price or handling of the currency. Another difference is that bitcoin users are essentially anonymous. This means that even though bitcoin transactions are tied to a particular bitcoin address, these addresses can be difficult to trace back to individuals if the user takes the proper precautions to ensure his or her privacy, such as using a different bitcoin address for each transaction. In this sense bitcoin is similar to physical cash, but preserves an even greater degree of privacy because the two parties involved in a transaction

do not have to meet physically and reveal their identities to each other. However this has also created issues since the anonymity and untraceable nature of the digital currency make it a prime candidate for illegal activities such as drug deals and money laundering. Bitcoin transactions are also irreversible. Credit card transactions, on the other hand, can be disputed by customers and subsequently reversed by credit card companies. Thus, merchants must take into account the fact that some percentage of their credit card transactions will be disputed and reversed. In fact, some smaller merchants only accept

investors are generally speculators who are hoping to make money on the assumption that the price of bitcoins will increase. However, as an investment, bitcoins can be very risky because its price is extremely volatile. For example, over the course of 2013, bitcoins’ value ranged from $13 to $1,200. Moreover, due to bitcoin’s rapid increase in price, some believe that it may be a bubble whose future depends solely on its widespread adoption as a legitimate currency. With no government backing or support, the risk of complete devaluation is non-trivial, prompting some economic experts such as former Federal Reserve Chairman Alan Greenspan to caution, “It has

Bitcoin has the potential to fundamentally change our conception of currencies. cash payments for precisely these reasons. However, this is often an inconvenience for customers. Bitcoin could offer a happy medium between cash and credit cards. Finally, bitcoin holdings cannot be frozen by a government. Since bitcoin is decentralized, there is no way for a government to dictate how the funds held in a particular bitcoin wallet will be dealt with by the bitcoin network. With funds held in traditional bank accounts, the government could force the bank to cease withdrawals from the account. Another challenge governments face is that the owner of the bitcoins might not be known. This is usually not a significant problem in the case of bank accounts. Bitcoin for Payments

Speculation

and

Currently, bitcoin has two primary types of users: investors and those who actually use it for its unique attributes as a currency. The

no have intrinsic value. You have to really stretch your imagination to infer what the intrinsic value of Bitcoin is.” Then there are those who believe that bitcoin will serve as the primary digital currency of the future, essentially acting as the U.S dollar for an economy that is more and more based on bits and bytes rather than physical nickels and dimes. A growing set of online and physical vendors who view it as an alternative to traditional payment systems have already taken advantage of bitcoins’ unique attributes. For example, Overstock.com and the Sacramento Kings are two vendors who have recently begun accepting bitcoin payments. As mentioned previously, since bitcoin transactions are irreversible, sellers do not have to worry about canceled transactions. Moreover, the conversion costs associated with using bitcoins are much lower than the transaction fees that credit card companies charge businesses. By using bitcoin instead,

THE PRINCETON FINANCIER | 21


vendors can retain a larger percentage of their revenue. For similar reasons, bitcoins could become very useful in the remittance market, allowing migrant workers to send money back home without paying large transaction fees that eat away at their hard-earned wages. Finally, bitcoin, as a digital currency, holds the unique potential of being programmable. This could be useful, for example, in limiting the ways a group of bitcoins Piece onpotentially November 4, 2012 canwritten be spent, eliminating corruption in poor and developing countries where often foreign aid is diverted into the pockets of corrupt political leaders. Supporters and Detractors The reaction to bitcoin from the financial industry has been mixed. According to Offit Capital Advisors LLC, a wealth-management firm, “Saying that a currency is a store of value implies that it is a

The reaction from world governments has also been mixed. Both the Bank of Finland and the People’s Bank of China have expressed skepticism that bitcoin meets the definition of a currency. China has gone even further and actually has prohibited financial companies from making transactions in bitcoin. In the U.S., regulators seem to be taking a more measured approach in considering bitcoin’s potential. For example, Ben Bernanke has stated that the Federal Reserve has no plans for regulating any virtual currencies. Bitcoin’s Future? There seems to be three plausible outcomes for the future of bitcoin. One possibility is that bitcoin will simply fall into disuse or will become extremely niche. Another possibility is that bitcoin will become so widespread that it will be a viable alternative to traditional currencies. In this scenario, people would store a substantial portion of

Only time will tell whether investing in bitcoin today will be more like investing in Apple in 1980 or investing in Dutch tulips in 1637. relatively stable value […] Without that stability, the costs of normal commerce far outstrip any creditcard or bank transaction fees. Bitcoin fails miserably on this important measure.” On the other hand, Barry Silbert, the leader of a brokerage called SecondMarket Inc., said, “There is very little debate, I think now in Wall Street, and certainly as it relates to Silicon Valley and venture capital, that Bitcoin technology and the protocol have the potential to radically disrupt and transform the financial-services space.” Some are skeptical of bitcoin’s future, while others are hopeful due to its potential.

their wealth as bitcoins and use them to for purchases and investments, and governments and corporations would universally accept bitcoins. In order for this to happen, the value of bitcoin would have to become relatively stable because otherwise it would not be able to function effectively as a currency. The third scenario is one in which bitcoin will become widely used as a payment system, but not as an alternative currency. Consumers would only store a small amount of their wealth as bitcoins in any given moment. They would use these to buy goods and services, and convert traditional money to bitcoins

THE PRINCETON FINANCIER | 22

as needed. Producers would receive bitcoins and immediately convert them to local currencies. In this way, the risk of fluctuating bitcoin prices is mitigated. Also, as mentioned previously, bitcoin is advantageous for a payment system, due to its low cost and irreversibility. Bitcoin is already seeing a small amount of use in this capacity. The Implications of Bitcoin Bitcoin has the potential to fundamentally change our conception of currencies. For example, currencies are usually regulated and managed by governments. The government performs important functions such as printing new money and protecting the integrity of the currency from counterfeits. With bitcoin, these analogous functions are performed by the computer network and protocol. However, there is a key similarity between many modern day currencies such as the U.S. dollar and bitcoins: both lack physical backing and thus their value is derived from faith in a system and general acceptance of worth between users. The dollar requires faith in the stability of the U.S. Government, while bitcoin requires faith in the bitcoin network. Given all of the excitement, skepticism, and fear surrounding bitcoin, the future of bitcoin is uncertain. Opinions on its prospects are sharply divided. The enthusiastic hopes of the early adopters are matched by the pessimistic forecasts of the skeptics. Only time will tell whether investing in bitcoin today will be more like investing in Apple in 1980 or investing in Dutch tulips in 1637.


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