2024/04/25

Bitcoin mining in Ethiopia: the good, the bad and the ugly


In the last few months, media have been buzzing about Bitcoin mining in Ethiopia. For Bitcoiners, it is part of the story of Africa as the new frontier in the much desired geographic diversification of Bitcoin mining - a perspective I agree with. In mainstream Western media, it's sometimes framed as yet another example of China in Africa. That framing, while not inaccurate, I think casts a geopolitical shadow that obscures the national perspective. Others portray it as a desperate attempt by Africans for a "quick fix" to foreign currency shortages -- not false but a bit condescending and missing the bigger picture.  So, let's shine a bit more light on it from the Ethiopian point of view (Shadow, light... sorry I couldn't muster some "dark clouds" to complete the trifecta of clich├ęs!) 

Full disclosure: I'm a co-founder of  QRB Labs, the first company to introduce Bitcoin mining to the country.  We've been quietly working since 2021 to do this the "right way" against tremendous odds.  But this post is not our company's story.  It's a skin-in-the-game opinion about how this industry should evolve for the benefit of the country. To highlight the good it can do. But also the risk of bad, and ugly.

The Good

First let's talk about the positive. Energy in Ethiopia and Bitcoin mining are a match made in heaven. 

In Ethiopia, electricity generation capacity is growing very rapidly. From 2GW in 2020 to over 10GW in the next couple of years. The Grand Ethiopian Renaissance Dam (which I've written about before) is the biggest and most famous step in that growth, but there are many projects contributing to it. All of course phenomenally good. Indeed, practically nothing is better for economic growth and broadly improving lives than electrification.  For comparison, the average Ethiopian has 1/50th the electricity of an American. So, until we get to 100GW at least, another 1000% growth, increasing generation is unquestionably necessary. 

But there's a catch. It is extremely difficult and expensive to deliver that energy to users. In the case of Ethiopia, some estimate that  $10B of investment and years of hard work are needed for transmission and distribution to catch up to generation. In the meantime, up to half of the generated energy remains unused. Which means the investment in generation takes longer to pay for itself. Meanwhile how do you finance the transmission and distribution? It's a huge chicken and egg problem, and it's unavoidable when there is rapid growth.  

In more developed countries, capacity may not be doubling or quadrupling but a similar problem exists with solar and wind power. Huge investments in supply are needed, but the demand may not match up with the supply, since consumption peaks don't line up perfectly with the times when the sun shines or the wind blows.  Whether caused by the difference between the time of generation and consumption, or by the distance, this is the problem of "stranded energy".

Now what if there was a way to make money from stranded energy? In Ethiopia, this revenue could help accelerate electrification! That's where Bitcoin comes in:   

"the competitive dynamics of Bitcoin mining are such that it shifts in time and space to the lowest available cost of electricity. This occurs not just by deploying hardware to various locations, but also by turning miners on or off instantly. This flexible demand-side support makes mining the ideal customer to balance variable supply...."  from "The Dynamics of Bitcoin Mining" by yours truly.

Thus the energy demand profile of data centers that host high energy computations makes them the perfect customer for Ethiopia's stranded energy. Bitcoin even more so than other data applications because: 

  • Bitcoin mining is location agnostic. It doesn't matter if it runs in Antarctica or the Sahara as long as it's connected to the Internet. 
  • It's also time agnostic.  Each hash computation is independent of the previous one. You can mine 24 hours a day, 12 hours a day, at random times. Of course miners, in order to be profitable, must be very good at making the complex trade offs between between energy cost and hardware utilization. But they don't inherently need 24x7 power. 
  • Further, contrary to common perception, it doesn't actually need very much bandwidth. The entire blockchain is still barely more than half a terabyte! 
  • And equally importantly, it's all public data. The entire world can see all the inputs to the miners. So there's no data sovereignty, legal information jurisdiction or cyber security issue.
  • Mining is purely infrastructure for running computers. There's no link between the locations of the miners and the users of Bitcoin. So Bitcoin mining doesn't depend on local regulations about money and financial services, legality of "cryptocurrencies" etc. 
For traditional data centers hosting say streaming video, social media or corporate IT,  cheap electricity is nice to have, but they also require some combination of high bandwidth, low latency, and a compatible legal system for privacy, copyright, finance etc. These are all areas where it is presently tough for Ethiopia to compete globally -- to put it mildly. But Bitcoin mining has in principle no disadvantage running in Ethiopia. 

Further, Ethiopia's electricity generation mix is over 98% renewable. And the other 2% is largely off-grid. So for a data center in Ethiopia, the energy is pretty much 100% "green" hydroelectricity. This is very desirable for the Bitcoin community. Bitcoin arguably doesn't have to be green, any more than ice cream or football. In fact proof of work is one of the most noble uses of energy in the world. But Bitcoin has a lot of enemies who, as I have written about before on this blog. hypocritically or ignorantly use energy as an attack vector.  So "greening" mining is good for Bitcoin globally, and Ethiopia is perfect for that.

So there you have it.  The good is amazing.  Accelerating electrification for economic development of Africa. Geographic diversification and greening of Bitcoin mining.  That is literally the mission statement of QRB Labs. And also why Ethiopia and Bitcoin mining are truly a match made in heaven.

The Bad

But an electricity grid is a very complex beast. You can have too much energy in one place and too little in another at the same time.  When you have too much, it's  a waste. And where there's too little, consumers suffer outages which have negative economic and other consequences. In addition, both excess and shortage can cause costly damage to infrastructure. The best way to balance that is to manage the demand, through price and quantity allocation.

In the case of Ethiopia, while the people at the power company are dedicated to doing the right thing, historically it has not had the independence to manage pricing and demand as it needs to. By contrast, the airline, even though it is also state owned, has a long history of independence, allowing it to mange routes, schedules and prices on a purely commercial basis. This allows it to succeed in an extremely competitive and complex international industry.  But electricity prices have historically been dictated by politics.  Thus, when it comes to the relationship between the energy producer and Bitcoin miners, they don't have the full flexibility to achieve true win-win pricing.  Consumer utility pricing is understandably more difficult to change. But at the wholesale level, the producer should be allowed to make stranded energy cheap, and conversely to charge higher prices where there's lots of demand, whether it is from data centers, factories or households.  

Without modernized pricing from the supplier, the risk is that Bitcoin miners who don't particularly care about the long term of the country can rush in  with demand in the wrong places, and destabilize the grid. Not because they are particularly evil or greedy. But just like water flows to the bottom of a valley, Bitcoin miners will go to where they can get energy at a good price. In this almost perfectly competitive industry, the purest embodiment of survival of the fittest, the typical buyer can't afford to think for the seller.

The only solution is incentive compatible pricing. Rational, non-political, and based on supply and demand. Further, it is crucial that the pricing not be based on the industry, or what the energy is being used for. Electricity is fungible. So price discrimination by type of application never works well. If one industry  gets lower rates than another, it creates perverse incentives, where one will disguise itself as the other, and cause complexity in enforcement. This is also true for Bitcoin mining. Instead, energy should be commercially  negotiated based on quantity, location and time. Let the buyers find their niche. In a fair rational environment, Bitcoin demand will naturally stabilize and benefit the grid, and  monetize excess capacity to help long term electrification. And when the country's transmission and distribution infrastructure is fully developed, when industrial and consumer demand can use all of the electricity being generated, then Bitcoin miners will not be able to pay the same price as factories or households. We should be happy to declare mission accomplished and look for cheap power somewhere else.

Another potential Bad is that Bitcoin mining can easily get politicized in Ethiopia. People who don't understand the subtle win-win dynamics may complain that Bitcoin is taking power from the people. Or based on superficial nonsense about "cryptocurrencies", especially in a bull market, assume Bitcoin miners are rich and should pay high prices. Such interference risks killing the goose that lays the golden egg. If handled correctly, mining is a tough global competition for miners but an easy win for local energy producers. But mishandling could very quickly kill a historic source of revenue.

Initially, the government made the mistake of temporarily blocking Bitcoin mining equipment imports in 2022 while it tried to come up with new regulations. Then in 2023, it implemented rules about Bitcoin mining as "cryptography" rather than "energy". But in fact, mining involves no encryption in the conventional sense of trying to keep information secret. The computation is basically just a hash function with public inputs and public outputs. It's just a race between miners to get the output faster.  (Even transaction validation, which usually is not even on the miner but in the pool, only involves checking signatures which anyone can do -- no secrets). At one point we were even told that only foreign companies could participate in this industry, which is unconstitutional! Fortunately, over the last couple of months, these errors are getting understood and things are moving in the right direction.

The Ugly

An unfortunate side effect of taking the wrong regulatory approach is potential for corruption.  Bitcoin miners are not all idealistic. Even when they are so inclined, competition is so fierce there's always a temptation to look for legal short cuts. On top of that, many foreigners come with a "this is Africa" attitude. Translation: corruption is a natural feature of the landscape. So they try bulldoze their way in with bribery. If it doesn't work, they try the next place. If it works, they exploit it as fast as possible, and when it inevitably blows up, just pack up and move to the next hunting grounds.

For many countries, oil wealth turned into the infamous "resource curse", undermining governance and even being negative for economic development. In the worst cases, it goes beyond bribery to outright theft: taking the energy and not paying for it. This is a danger with Bitcoin for electricity-rich countries too. Kazakhstan, Angola, and some other countries have experienced this ugly side. Fortunately, there's no evidence of this occurring in Ethiopia yet, but it is perhaps the greatest theoretical danger.

The best way to avoid this is for the government to eschew regulatory micromanagement. Rather than trying to control it through hardware imports, or make it political, or treat it as cryptography, or have too many stakeholders at the table, it should allow this industry to naturally find a win-win buyer-seller relationship with energy. This means allowing flexible electricity capacity allocation and pricing.  

The government's focus should be on monitoring the bigger picture: that the energy security of the country is not compromised. So rather than trying to regulate the details of what miners do, the government should require the power company to regularly report on overall high and medium voltage demand by region, generation and transmission capacity, and provide assurances that supply and demand are sustainably managed across all industries and regions.

Conclusion

So there are a few ways things could go wrong. It's important to understand them. But part of me fears that I have given ammunition to the haters. I hope I've struck the right balance.  Reviewing this post, I see I've devoted a lot more words to the good than to the bad and ugly. And that is as it should be.  We face a historic opportunity for two things I care deeply about: Ethiopia and Bitcoin. May both live long and prosper!

P.S. This post is months overdue! And it's too long. To quote Mark Twain: “I didn't have time to write a short letter, so I wrote a long one instead.”

2023/11/11

Startups in Ethiopia: 5 obstacles the government should remove

"Addis, we have a problem."

According to one report, the total venture capital invested in Ethiopia in 2022 was $4M. Less than a single startup does on average in a "series A" VC round:
Lest you think this is an unfair comparison with the rich world, in Africa, there are 21 countries with a smaller population but larger amount of venture investing. There are 15 countries with a smaller GDP and more investment. Within Africa, while Kenya, Senegal and Ghana are punching above their weight, Ethiopia is so far below it literally falls out of the picture:
To be sure, total VC investment is not the most important metric. Only a tiny minority of companies ever need professional early stage investment. Still, the absence of venture capital is a symptom of the broader reality. Another indicator is that all of the companies in Ethiopia with more than $1B/year in revenue are state owned (Ethiopian Airlines, Commercial Bank of Ethiopia, Ethio Telecom and Ethiopian Petroleum Supply Enterprise, etc.). More than three decades after the end of communism, there's still not a single company that began as a startup and ended up very big. 

There are many problems, like the foreign currency regimewarpolitics fubar, and education, that go much beyond startups. Still, the GDP is growing! And you can't spend one day in Ethiopia without noticing huge opportunities for startups to address. There are so many things to do. So what is wrong when it comes to startups? Any entrepreneur in Ethiopia knows the answer first hand: Ethiopia is extremely unfriendly to startups.

Here are few examples, based on my experience, of obstacles the government could eliminate. I'm sure you could come up with a lot more. The key feature of my examples is that none of them require money or new technology or new powers to solve. They are just bureaucratic problems that in principle could be eliminated with the stroke of a pen.

Simplify company registration

To formally register a company you have to register the name at the Ministry of Trade. Then you to do a "Principal Registration". And third you have to do a tax registration.  While these are not the biggest problems, it could easily be made into a single step instead of three. 

Furthermore, in the registration process, the company address is a surprising complication. In most countries you can legally start a company with pretty much any valid address. It could be your house, your friend's apartment, a corporate agent or lawyer's office, a post office box, whatever.  Google started in a garage. Dell started in a college dorm. The vast majority of technology startups don't get a long term office until they have at least gotten some traction with a product or customers.  Nowadays, with the growth of remote work, it may be a long while before you need a traditional office. But in Ethiopia, you have to have a formal commercial lease in the company's name, and it can't be a residence. You have to make a legal long term real estate deal before you can do anything, even if the business doesn't actually need it nor can afford it.

Document authentication

Not only that, the lease has to be authenticated by the government. If the lease is signed by a building manager, you have to prove the manager has a power of attorney from the landlord. If the building has more than one owner, each owner must provide the power of attorney. If one of the owners is outside the country, the power of attorney must go through the "apostille" process, involving the ministry of foreign affairs of the other country, the Ethiopian embassy in the nearest country, and  the Ethiopian foreign ministry in Addis Abeba. The process takes weeks or months. 

The same process is required for many other company documents, like shareholder agreements, investment agreements, etc. It's hard for people from normal countries to even imagine this. It's absolutely insane.

In most countries, business agreements are mainly up to the parties involved. Whether they write their agreement from scratch, use templates,  hire lawyers, notarize etc. it's really up to the two parties to be as formal as they need. If there's a misunderstanding or dispute, the two parties negotiate a common understanding of what the agreement was and settle it. Very rarely, the dispute goes to court. But even then the court can interpret business agreements even if they weren't authenticated by the government. There's almost never any a priori authentication or approval by the government of a simple business agreement.

But in Ethiopia, one spends countless hours at the "Document Authentication and Registration Authority". This government office is often praised for being relatively well managed and efficient compared to most bureaucracies. So this is not a criticism of their performance. The issue is that too many other government functions require you to go there. Even the simplest deal that you could document on the back of a napkin has to be treated as if it's the last will and testament of Croesus. Why do so many business agreements have to be verified and approved by the government, even when the parties involved don't need that? This is ridiculously time and effort consuming. A burden that startups can ill afford. 

Business license 

A bigger issue is that every business requires a business license. In most countries, you can just register a company and get to work. You may need a license if you sell alcohol, or weapons, etc. You need a license to drive a car or to perform surgery.  But those are activities where there's a specific concern for the safety or health of others, and that justifies preemptive government control of that particular activity. Outside of those, in a normal country, by default things are allowed unless explicitly forbidden. In Ethiopia everything is forbidden unless explicitly allowed. You must get a license in a predefined category. If the right category doesn't exist, tough luck.  If you are expanding vertically, you need to get another license instead of just doing it. When you are doing something new, or growing, this is a real barrier.

Investment license 

There's a concept of "investment license". You need to ask permission from the government to invest! If you are used to a relatively free economy this is bizarre.  Why? There's already criminal law to prevent or punish specific things. Why should the act of investing in a completely legal activity require permission? Everyone will tell you investment licenses are very important in Ethiopia, but almost no one can explain why the concept exists. Like in the parable of the gorillas in a cage, that's just the way it's always been. 

If you are lucky enough to find a rare person who can explain it, you learn it was intended to encourage investment. And licensing was meant to regulate who can get tax breaks and other incentives. So it was supposed to be an optional positive incentive mechanism. But it has evolved into a barrier, you have to overcome it whether you want the incentives or not. Random government agencies routinely say: show me your investment license or else you can't do this or that.

To make matters worse, there are state and federal level investment licenses,  and maybe a dozen different commissions who give them. Which one do you go to? It is surprisingly difficult to get the answer.  It depends on whether you are classified as foreign or domestic investors, and on where your operations are. What if they are in more than one state? What if you are a person of Ethiopian origin but established abroad, are you domestic or foreign? It all depends. And making the wrong guess can be very dangerous. You have minimum investment amounts, in some cases it's US$150K, in others US$200K.  If you invest US$149K, could you be breaking the law? It is very hard to make sense of it all.

To get an investment license,  the company has to pass an audit by the ministry of revenue. Even if your company was founded yesterday and has zero revenue, you have to do this audit which can take weeks. In a normal country, you pay taxes once a year. If the government suspects the payment is incorrect, it does an audit after the fact. The principle is: If you cheat, you get caught and pay the penalties. In Ethiopia, investors are treated like they are cheating before they get started. Imagine if the police arrested you every morning because you might decide to commit a crime that day. And then you prove your future innocence and they let you go to work.

By the way, is the license for the company or for the investor or both? Most people can't even answer that.  It's very difficult to even find the right rules, let alone understand and obey them. 

Far from being a positive incentive mechanism, the investment license has become a Kafkaesque bureaucratic weapon. And when such a weapon is available, it creates a pockets of  bribe-seeking criminals in government.

Unrealized valuation increase may be taxed

Say you found a startup. You register the company with shares divided between you and your co-founders, with a nominal value like $1 per share. After some progress, an investor comes in with a $500K investment for new shares of the company at $10 per share. On paper, your founder shares increased in price from $1 to $10. But this gain is not "realized", no shareholders received any cash. The $500K goes to the company's expenses to help it grow. Of course, if there are salaries, every employee, founder or not, pays ordinary income tax. But no one pays capital gains taxes yet. It's only if the company succeeds and you sell your shares for more than the original price ($1 for founder, $10 for the investors) that you pay capital gains tax. If the company fails, there are no gains and no capital gains taxes. This is how it works in most places. 

In Ethiopia too, in theory, capital gains are only taxed when realized. But apparently the tax authorities sometimes demand that, when investors buy new shares for $10,  the company pay 30% tax on the capital gain from $1 to $10. And this payment is required up front. So $150K goes to the government, and the company only gets $350K to work with. Obviously no one wants to make an already risky investment where you lose 30% on day 1.

One solution is to simply not increase the share price. Keep it at $1. But that means the most basic mechanism of tech startups, which is that founders and employees get most of the value through their "sweat equity" doesn't work. 

What if you don't ask the government for permission? Investors could just do the stock purchase agreement and simply wire the money to the company? In the US, there is no government involvement, you just do it. It doesn't mean anything goes of course, you have to make sure your investors are accredited and that you are not misleading them or committing fraud. But all these are things that you can just do. There's no prior approval. In Ethiopia, that is very risky. If the investment money is given to the company without a government license, it may be treated as corporate income and taxed at 30%. Or worse, you could be accused of some kind of financial crime.

What is to be done?

Entrepreneurs love to take risks, to solve hard technical problems, build products, serve people, improve the world, make a small dent in the universe. And in Ethiopia, God knows there is so much to be done, it should be an entrepreneur's paradise. But what you end up working on are these pathetic artificial problems created by bad government. No one grows up dreaming of getting a license from the government or a letter from this bureaucrat or a stamp from that office. The striking thing when you talk to entrepreneurs in Ethiopia is how often you encounter dreams ground to dust.

But here's the silver lining. Solving these problems does not require any money. In fact, nothing here is asking for help or any favors from the government; every single idea here is about something the government should not do. Specifically 

  1. Delete the requirement for an office lease and combine the trade and finance ministry process into a single step. Let startups be startups. 
  2. Delete the requirement for document authentication for business agreements. The government has no business getting involved in private business agreements. 
  3. Abolish investment licenses. Convert the investment commissions into consulting bodies that the private sector can go to voluntarily for help. They should provide service and not have any power  to license, to permit or forbid. If that means tax incentives go away, so be it.  Don't let the tax tail wag the business dog. Real entrepreneurs don't do stuff for tax breaks. They do it because they want to do the thing.
  4. Abolish business licenses as the general case. Licensing should be limited to areas where there is a clear potential for harm to the public or third parties not involved in the business.  The government should be forbidden by law from imposing licensing requirements unless they can prove this potential harm.
  5. Eliminate pre-emptive audits, taxation, clearance etc. The tax authorities already have plenty of power to catch cheaters after the fact. There is no need to involve them in any aspect of gate keeping investment.

It's simple. But it is not easy. It requires a lot of courage and wisdom. The wisdom to understand that the government needs to do less and get out of the way. The courage and skill to implement reforms where special interests who benefit from inefficiencies will resist. DELETE is the missing key in Ethiopian bureaucracy.

P.S. Thanks to Tessema Getachew and Henok Assefa for feedback on a draft of this post. And to Addis Alemayehu and others for previous discussions (e.g. here and here).  All inaccuracies are my own. Comments and feedback welcome!

2023/06/03

The mother of all distortions: Ethiopia's foreign currency peg

Check your ideology at the door

Perhaps the biggest economic topic in Ethiopia today is foreign currency. Sadly, much of the discussion around it is low quality. Instead of reasoning from first principles, people drown in jargon and misunderstood theories: inflation, socialism, neoliberalism, colonialism, IMF,  China, bla bla bla. Whether the motivations are naivete or special interests, the result is many strongly held but incoherent beliefs. To navigate this, let's be guided by this (perhaps apocryphal) quote from the great physicist Richard Feynman: "If you can't explain something to a child, there's a chance you don't understand it well". So don't let any expert tell you: "it's too complex, don't try to understand, just believe my prediction". In that spirit, dear reader, please leave your isms and schisms at the door and join me in this ELI5 version of the problem of foreign currency in Ethiopia.

Notes: 
  1. In this post, we will talk about US Dollars as the "foreign" currency, but all of it applies equally to  Euros or any freely exchanged and widely used currency.
  2. Feedback is welcome. If there are factual errors, please let me know and I will correct them. If you have a solid counter-argument to any point made herein, feel free to comment here or contact me on Twitter, and I will respond and update the post (with credit!).

Two markets

How much is one US Dollar worth in Ethiopian Birr? Officially the price is pegged, currently at around 55 ETB per USD. But if an ordinary person, let's call him Abebe, simply goes to his bank and asks to buy 1 dollar for 55 birr, they will say no. There is a limited supply of dollars.  Ok how about 56, 57, ...? Nope. Now what if at the same time, another customer, let's call her Berhane, has a dollar and she's willing to sell it for 56? Naturally, the bank should be happy to buy that dollar at 56 and sell it to Abebe at 57. The buyer, the seller, and the bank would be happy. Problem solved! Actually no, by law, the bank is not allowed to do that. It must sell only to approved buyers at the official price and if that means those two customers go home unsatisfied, so be it. 

So what is the alternative? Abebe and Berhane could meet privately, find a mutually agreeable price and exchange. This is called the parallel market (also known as the "black" market).   Of course, even though it's a private transaction, just like when people buy and sell eggs or bread or whatever, information gets around and a market price emerges. These days it is apparently around 105 ETB per USD. No one is forcing this price, it's just a rough average of a lot of private transactions. In each case,  the buyer and seller get what they need. Problem solved! Actually no, by law Abebe and Berhane are not allowed to do that.

So we have two markets: the official one where the price is pegged by law, and relatively few people can transact.  And the "parallel" market where the price is voluntary but it is illegal.   

Mind the gap

Having two markets would be no big deal if they were reasonably close. Even in free market prices, there are gaps due to distance, convenience, time delays, etc.  But in this case, one price is almost double the other! This is an extreme gap by historical standards, a structural gap created by a legal barrier between the two markets. Let's examine how this barrier affects different people.  

There are two groups, buyers (who have birr and want dollars) and sellers (who have dollars and want birr). 

First consider the sellers. What brings dollars into Ethiopia? Roughly: 

  • Remittances: $6B/yr
  • Foreign investment: $4B/yr
  • Exports: $4B/yr
  • International aid: $3B/yr
  • Tourism: $0.4B/year
So anyone involved in those activities using the peg is getting 55 instead of 105. If an exporter sells coffee abroad, and brings back $1, they are getting half as many birr that trickle back to pay farmers, transportation etc. In other words, it's like there's a 50% tax on exports. Similarly if an investor wants to bring $1M into Ethiopia they are getting the equivalent of 50% tax on their investment before they even hire their first employee or lay the first brick.  Ditto for remittances, if a diaspora Ethiopian sends money to family in Ethiopia at the official rate, 50% tax. For visitors, it's like they are paying double for everything they consume in Ethiopia. Of course, it's not literally a tax. But with the peg, the only choice is to pay 50% or not do the activity at all. In other words it's just like a tax. And whenever something is taxed, at the margin, the tax can be the difference between an activity being feasible or not, which means the volume of that activity is less than it would be without the tax.

Now, having left ideology at the door, we won't assume taxes are automatically good or bad. Instead, let's ask what are the costs and benefits. We know the cost: it reduces legal exports, investment, remittances and to a lesser extent tourism. What or who does it benefit? 

The buyers of course. Those who get dollars at the pegged rate. To get legal dollars, you need a "letter of credit", which allows the bank to take your birr and give you dollars to use abroad. This permission goes to the government itself and to private imports prioritized by the government.

Debatable priorities and the problem of central planning

This leaves the Ministry of Finance the unenviable task of deciding the relative importance of hundreds or thousands of things, and deciding which ones should get higher priority for letters of credit, lower priority or none at all. Last October, the government decided to ban letters of credit for 38 items

 

The list includes oddly specific items like "Vimto", impossibly vague categories like "Different games", and hilarious ones like "Artificial and Human hairs" and "tiaras".  Comedy aside, some choices are really sad.  "Bicycles"! That one really broke my heart.  

Oil gets a double subsidy: first from foreign currency priority, and second from getting explicit subsidies of the price at the fuel pump.  Believe it or not, in Ethiopia which doesn't produce any oil, has a foreign currency crisis, and where less than 1% of the population has cars, the price of gasoline is half of the price in neighboring Kenya! Fuel subsidies may be one thing that is even crazier than the foreign currency nightmare, but let's leave that for another post.

Meanwhile, businesses are suffocating because they can't get foreign currency. If you make electrical equipment, you can't get the dollars to import copper, so you stop and wait. If you are constructing a building, you can't get dollars to buy steel, so you stop. Over 200 business ceased operations because of lack of foreign currencies. Manufacturers are getting less than 15% of the foreign currency they need for raw materials, according to the Ministry of Finance. A common sight around Addis Abeba is unfinished buildings, sitting half-built for months or years, a constant demonstration of wasted land, wasted capital, lost opportunities. If you talk to anybody in manufacturing, you will be overwhelmed with stories of dying companies.  Companies fail all the time of course, that's the nature of business. But the heartbreaking thing is they are not failing for business reasons. Imagine you  have the right idea, you invest lots of money, hire the right employees, make the right product, find the right customers.  You are willing to pay for inputs at market value, but, understandably, you don't want to go to the black market.  So you just sit and wait for permission to buy your inputs. And eventually close up shop. That is the tragic fate of many many businesses that could help the livelihood of  millions, dying because of this foreign currency policy.

Perhaps the starkest illustration of the failure of this central planning approach to prioritization is: "Lack of forex to import fertilizer threatens agricultural output". Nothing is more important than agricultural production, and the government understands that. So they planned ahead and allocated $1B for fertilizer,  much more than last year. But due to global market changes, the need is $1.2B. So here we are with a shortage of fertilizer.  

In short what we have is the classic "economic calculation problem" which forever plagues central planning. The problem is not that the planners have bad intentions, nor that they are not smart enough, nor that they don't have the right data, nor that they need more powerful computers. It's more fundamental. In a large economy, the full information to make the optimal allocations simply does not exist in one place at one time no matter how much you try. You cannot sit at a desk and decide for 100M people whether steel is more or less important than copper, or whether aspirin is more important than fertilizer. The information is distributed in the subjective values and decisions of thousands of different actors, and when they act locally on their specific problems, their collective intelligence is much greater than even the best possible central planner.

Inefficiency of indirect subsidies

Further, even if we assume the priorities are perfectly correct and everyone agrees, there is another basic problem. Who pays for them? The cost is of course being born by the sellers we identified above: exporters, people receiving remittances, etc. And the benefit goes to specific imports. Which raises the question: why should coffee exporters or remittances carry the cost of gasoline for car owners? Why shouldn't plumbers, teff farmers or real estate businesses share the burden? A society may decide the rich should subsidize the poor, or some things should have punitive taxes, etc. But implicitly making one sector pay for another specific sector is unfair and inefficient, and leads to many unintended consequences. If the society wants something to be subsidized, then it's better for the government to spend money directly on that thing, using money that it collects through normal explicit taxes. The optimal mix of taxes (VAT, duties, income tax, etc.) is a separate debate the society can have. But whatever the specific combination of taxes, explicit taxes are better than an implicit tax via currency controls.

Corruption

Another problem is that access to foreign currency becomes an exorbitant privilege, so there's an extreme incentive for corruption. Common sense says that when there's a magic way of doubling your money, there's bound to be some cheating. The people who are most adept at playing the privilege game will get more of it, while those who are politically naive  get less. To think otherwise is to ignore human nature.  Cronyism and corruption is rewarded and productive work is penalized. This is of course extremely damaging to the economic and moral health of the society.

The grey zone

Inevitably, many of those who can't get this privilege resort to the parallel market. Indeed, the black market has become mainstream. Increasingly this is not just individuals like Abebe and Berhane in our story above, but also in business. Research shows that prices of imported commodities are tracking the parallel market rather than the peg. Banks too are flirting with the black market, by adding transaction fees as high as 60% to bridge the gap. Even parts of government are resorting to the black market. For example, earlier this year, there was a huge public bus procurement scandal. The Addis Abeba city government paid 19 million birr per bus, which according to the peg, is about $350K. Critics screamed that those same buses cost less than $150K internationally, so surely someone pocketed the difference! But an alternative explanation soon emerged: the importer had to get their foreign currency at the parallel market rate. Using that rate, and adding the cost of shipping etc., the price seems more reasonable. Should you praise the importer for creative problem-solving (after all the city does need more public buses!), or condemn them for price gouging? You decide. It is a bit like the debate about "illegal" vs "undocumented" immigrants in the US, but much worse. Exploiter and exploited start to blur into an unhappy grey zone. Huge swaths of society are operating outside the law. The hypocrisy is staggering. People will publicly defend the peg and privately use the black market. That's not only legally risky for everyone involved, it's deeply corrosive to the rule of law. Ethiopia is becoming a mafia state.

The solution

The polite economist word for this nightmare is "distortion".  And while the consequences are very wide and complicated, there is a simple and narrow solution.  The government could simply revoke the law that says Abebe, Berhane and the banks are not allowed to exchange their USD for ETB at whatever price they agree to. That's what is meant by jargon like "float" or "unification", "liberalization",  etc.  Just let the two parties agree on a price. No other laws need to change. Any product that is illegal can remain illegal. Banking licenses don't need to change. Just decriminalize voluntary price. That's it.  

And, surprise! That is actually the current Ethiopian government's position.  Don't take my word for it. It said so in 2019:  Ethiopia: Central Bank announces floating exchange rate regime. And again in 2020: Ethiopia Plans New Key Rate, Floating Currency to Boost Economy. Even now in 2023, exchange rate unification remains the goal. But the policy is "gradual", and 4 years in, the peg remains and the gap is growing. So what are we waiting for? Why don't they just waive this magic wand today? 

The reasons for this inability to execute the change fall in two categories. First, this inefficiency benefits some special interests, even if it hurts the majority. And multi-billion dollar special interests, both within and outside government, are tough get rid of. The second set of reasons is many sincere but misguided fears, both within and outside the government, of what would happen with such a change. Let's examine them.

Inflation: the map and the territory

The most common fear is: if the currency is floated, inflation will go up. But this is due to a misunderstanding. Let's say the international price of copper is $0.10 per gram. And the local competition is such that  importers can't make more than 10% profit. If copper is a priority and importers get letters of credit allowing them to buy dollars at 55 ETB/USD, they can import it for 5.50 birr and sell it to you for 6 Birr. Ok great. But if the importers can't get foreign currency, what is the price? It's as if the price is infinity. You could go bankrupt while waiting for copper to be available. Or go to jail buying it from smugglers. Now suppose the importers can get dollars at a market rate legally, they will bring it in at a cost of 10 birr and sell it for 11. The naive academic might say there is inflation because the price went up from 6 to 11.  But people in the real world realize that 11 is less than infinity! Scarcity is a form of inflation. Focusing only on official prices while ignoring scarcity is mistaking the map for the territory, or mistaking the thermometer for the temperature. 

Of course inflation is a serious problem so it's easy to fall for this fallacy. But would you trust a doctor using a broken thermometer who says: if we fix the thermometer, you will develop a fever? No, you want a practical one who sees the thermometer is broken and that you already have a fever. So while academics and commentators talk about potential inflation, people who provide real goods and services know that the inflation they fear is already happening. 

Exchange rate

A closely related concern is that if the exchange rate is floated, then the currency will rapidly lose value. There are three versions of this worry.

Some think that, by some unexplained law of nature, the black market has to remain more expensive than the official market. So if the official market is floated and ETB/USD goes from 55 to 100, then the black market price will go to 200. That is nonsense The black market responds to supply and demand. If there is a functioning legal market, then there's no reason for anyone to pay a higher price and also take the risk of doing something illegal! It's just human nature, people prefer to pay less, and people don't like going to jail.

A more sophisticated version of this worry is the following: in the black market, both supply of and demand for foreign currency are suppressed, and if you legalize free exchange, the demand might increase more than the supply so the market price will be higher.  But this is also incorrect. Usually, when there's prohibition, supply is more suppressed than demand. Or to be technical, the elasticity of supply is greater than the elasticity of demand. Without prohibition, all else being equal, the price is lower.

Another variant of the same fear is based on historical examples. In a recent discussion on this topic this example came up: once upon a time, Sudan floated their currency. At the time of the change of policy, the USD on the black market was at 550 SDP. After the float, the market price rose to 600 SDP/USD.  So proponents of currency control claim that getting rid of it caused the SDP to lose 10% of its value. But they should note that in the preceding decade, the black market price of USD had risen 5000%! The currency was losing value very fast. And floating it, if anything, slowed it down. Similarly in the case of Ethiopia, I wouldn't say that if the exchange rate is allowed to float today, the price of foreign currency will go down tomorrow! Most likely it will continue to rise but it will slow down.  Here's a picture to illustrate the point (the dots represent real values of the black market as reported in news articles over the last 5 years): 

In short, the black market price is the free market plus a risk premium. If it is decriminalized, the risk premium goes away. So the black market is an upper bound on what the natural market price would be.  

Speculative attacks

A closely related fear is that if the currency is freely exchanged, international currency traders would swoop in and wreak havoc by "speculating". It is true that financial markets can be volatile but let's put that in perspective. That volatility is much less than the brutality of the practical forex market as currently experienced by Ethiopians today. The random shocks of getting or not getting a letter of credit are much worse. You can go for arbitrary length periods with an effective price of infinity and volume of zero! 

Sure, if the currency was freely traded, the National Bank of Ethiopia (the central bank) and the Ministry of Finance may make monetary or fiscal policy errors, reserves might run low, etc. But all that would be child's play compared to the devastation the current currency regime is inflicting on the real economy.  That said, the government can and should shore up reserves. Two obvious moves: stop fuel subsidies; sell off non-strategic and poorly-performing state enterprises (of which there are many).

Sequencing reforms

A related point often made by academics and commentators is: yes the parallel market should be decriminalized, but first the economy must be strengthened, productivity must increase etc. This argument is a bit like sitting in a burning house and saying: yes the fire is bad, but first let's invest in non-flammable furniture and curtains. It's missing the burning issue. The currency not being freely exchangeable is suffocating the very things that make the economy more productive.

Upside down tiger

Another argument given against free exchange is that some countries, like the so-called Asian Tigers and China, grew their economies while controlling their currencies. The irony is that in those cases, the control consisted of under-valuing their currencies, to promote exports and investments, while suppressing imports and domestic consumption. They essentially delayed the rise in standard of living in exchange for faster industrialization. But what we have in Ethiopia is the exact opposite: the peg over-values the currency, which subsidizes selected imports, while lowering investment, domestic production and exports! You might call this the "upside down tiger" de-industrialization strategy. No country has grown out of poverty this way. 

Brace for media impact

If the peg is abandoned, we can be almost sure that a lot of the commentariat will miss these two points:

  1. they will compare the new free market price to the old peg, instead of comparing it to the old black market price, falling for the map and territory fallacy;
  2. they will comment on the increase of foreign currency exchange rate, rather than the fact that the rate of increase declines.  

Even economics professors confuse a decline in the rate of change with an actual decline in the price! So what are the chances journalists and social media activists will be rational? Low. They will probably scream bloody murder.  And governments know that. Hence the "gradual" policy. To be blunt, the political cost of doing the right thing is very high.  

Deva!uyashun!1!?

It's amazing how many people think the strength or weakness of a currency is determined by a government simply deciding on a price. And they talk about "devaluation" as if it is a matter of just typing in a larger number. Their concept is: the bad guys will force African countries to use a larger number! Oh no, devaluation! We must fight the IMF! Neocolonialism! Bla bla bla. I'm very critical of the IMF and the current international financial order, but this conception of "devaluation" is complete nonsense. But it is political dynamite and a lot of energy is spent trying to defuse it. Here's how I would respond to it. If you think "government type big number = bad", then ask yourself do you believe that "type small number= good"? If it's that easy, do you think that, tomorrow, the Ethiopian government could set the peg at 50 ETB/USD instead of 55 ETB/USD and all imports would automatically be 10% cheaper? If they peg it at 0.01 ETB/USD would imports suddenly be 5000 times cheaper, and the average Ethiopian would afford a Ferrari? Of course not.

Root cause of currency strength or weakness

From a policy making perspective, the exchange rate is an effect not a cause. It's an output signal, not an input variable. The real price (which is approximated by the black market not the peg) is a reflection of a basic reality: how many dollars are coming, and how many dollars are going out. This is called the balance of payments. The birr gets weaker if the economy is not bringing in enough dollars. Exports and foreign investments are too little compared to the consumption of imports. And this imbalance can only improve if a) the economy produces more things the rest of the world wants, and b)  the country is more attractive for investment.

Now as we saw earlier, the first order victims of the peg overvaluing ETB are exporters, investors, and remittance recipients. The gap between the market and the peg is a de facto tax on them so it directly reduces their volume. Fewer dollars come in.  At the same time, it's a de facto subsidy of specific imports, which means more dollars go out. Which makes the currency weaker. Which increases the gap. That's the death spiral of a weakening currency.  The second order victims are manufacturers and producers more generally; even if they are not exporters, they help the balance of payments by creating products that would otherwise have to be imported. Plus they are part of making the society more productive which improves chances that the society will make stuff the rest of the world wants. Thus, by choking producers, the peg further increases the imbalance, another vicious cycle.

There is no solution that doesn't include facing reality. Recognize that 55 ETB is just not worth 1 USD. The peg doesn't make the currency stronger. A broken thermometer does not cure fever! The cure starts by getting rid of the peg, which will

  1. in the short term, eliminate the risk premium, improve availability of consumer goods, eliminate an unfair de-facto tax and subsidy, reduce corruption, and stop a major cause of socio-economic rot;
  2. and in the longer term, increase exports, foreign investments, and productivity of the society, which will help fix the structural weakness of the currency.

People voluntarily exchanging things at prices they agree on is not a neo-colonial imperialist capitalist evil that needs to be forbidden. It's what humans have always done naturally everywhere, including in Ethiopia.





2023/04/01

"Attention" and "Transformers" in Large Language Models

Everyone is talking about OpenAI's ChatGPT these days. Here's a very quick attempt to summarize the core idea behind large language models (LLMs) like GPT.

"Attention is all you need" (aka the transformer paper) published in 2017 by Vaswani et al from Google is still the mother of current LLMs, including GPT.  "Effective Approaches to Attention-based Neural Machine Translation", an earlier paper by Luong et al from Stanford, was also quite important.

These are sequence-to-sequence models, i.e. their job is mapping an input sequence of text into an output sequence of text. Applications include translation from one language to another, answering questions,  having a conversation, etc.

They use language embeddings (made famous by Word2vec in 2013 and later by BERT, both also from Google) as the basic encoding/decoding building blocks, i.e. mapping text to vectors of real numbers in an "embedding space".

The main new idea is in the architecture of the neural network between the input encoding and output decoding stages. The model uses the preceding terms in the current output sequence to decide which parts of the input sequence to pay more "attention" to for the next output term. A bit more precisely: the previous output is a "query" which gets used to generate a linear combination of "keys" from the input which maps to a linear combination of "values" also from the input. That in turn gets transformed into the next output term with a few more layers in a plain feed forward network (i.e. a bunch of layers of neurons, where each neuron is putting a linear combination of inputs into non-linear activation function). Each step has trainable weights.

There are also clever tricks besides "attention". One is positional encoding to represent the order so the same input term in a different position has different effects even though, unlike in recurrent neural networks,  in transformers the network just sees them as bag of words that could be in any order. Another is layer normalization to sort of keep the nonlinear outputs within a reasonable area in the embedding vector space.

This architecture, as far as I know, was not derived explicitly from the way human brains work. The "attention" analogy is really useful, but there are no principles saying this architecture is more fundamental to intelligence, or more natural, than many others. It just happens to produce remarkably good results when the weights are trained properly.

So that's the basic idea of contemporary LLMs. Of course in some sense, all computer neural networks are  just a bunch of matrix multiplications and ad-hoc activation functions. But you can't just connect a large number of mathematical "neurons" randomly in a network and hope it learns something.  The choice of architecture, i.e. how the "neurons" are connected, is key. On top of that, there is still an enormous amount of innovation/engineering to make the real world language models, not to mention turn them into a product like ChatGPT or Google Bard.

2022/07/27

Nile basin mechanism design

Part 1 made the case for GERD in the short and medium term. Now for the really big picture

The human population of the Nile basin will probably double in the next century. Even if the Nile's water flow increases (some climate change scenario models indicate that rainfall could actually increase in the Nile basin over the next 50-100 years), it seems inevitable that demand will grow faster. And as mentioned in part 1, 100% of the flow is already being consumed. But this doesn't have to cause conflict. Globally, 70% of water use is for agriculture. So that's where the adjustments would have to be. From a natural resource optimization point of view, just like it doesn't make sense to grow almonds in California, or cotton in Kazakhstan, growing cotton and wheat in Egypt is probably not the most efficient use of water. 

What do we mean by efficient? Imagine for a second the whole region was one country; if an allocation of water to different uses maximizes total benefit, i.e. there is no other allocation that has a larger total benefit, then that's an efficient outcome. To achieve this efficiency, obviously some water intensive agriculture should migrate to other regions. But of course, the Nile doesn't have one owner and we don't have perfect cooperation, so we can't expect individual players (a country or a farmer or a business) to sacrifice their immediate interest and give up some water use for the greater good.  Game theory teaches us that an efficient resource allocation is useless if it is not feasible. And feasible means it's an equilibrium where each party benefits more from sticking to it than from deviating unilaterally. 

What would such an equilibrium look like? It's not as simple as dividing it equally.  For example, one issue is that if two people get the same amount of water, but one of them doesn't actually need it, that's a waste, i.e. inefficient.  Even the notion of need, beyond bare survival, is subjective: you can argue about the relative merit of washing clothes, how often people should take a shower or bath etc. 

Fortunately, there is a way to turn subjective values into an objective agreement: a price. What pricing mechanism might work in this scenario? For example, in a hypothetical v2.0 of the CFA all the countries in the basin could agree on a uniform Nile water tax. Each country would be liable to pay the tax for its total usage yearly. Of course, it would be up to each government to determine how the cost is distributed in its society: as a tax explicitly passed on to water consumers, or paid by general government revenue, or something in between. Passing the cost on is not as hard as it sounds since in most places that matter (homes and factories with running water, and farms with irrigation) water usage can easily be metered or is already. And non-consumptive uses like electricity generation would naturally be neutral. 

To keep each other honest, the countries could easily agree on verifiable data sources. Egypt doesn't have to trust the metering in Ethiopia and vice versa, they could rely on aggregate measurements of the water balance, a lot of which can be done using currently existing satellite data that is freely available from neutral sources.

The revenue from this would be collected in a common fund and automatically redistributed to member countries in pre-set proportions. The proportions are negotiated in advanced and fixed, and of course that would be the hardest part of the whole deal. One basis for this negotiation could be a share proportional to the present fraction of the total Nile basin population in that country (not the total population, obviously as countries have different fractions of territory and population falling within the basin).  

Naturally the price would have to be adjustable, say yearly, with a protocol agreed to in advance, so it regulates annual usage at sustainable levels i.e. below 100% of flow volume with a safety margin. If total usage is too high, the price goes up. If a lot of water goes unused, the price goes down. And if the total usage stays well below the sustainability level for a long time, the price would keep going down all the way to zero. This too is not as difficult as it may seem, it's basically the same idea as a carbon tax to fight climate change but much easier: the set of players that need to agree is much smaller (it's "only" 10 countries not 200), the consequences of water are immediately felt by all participants every year (unlike climate change which plays out over longer periods), and the target quantity is much easier to compute (total flow is well known, unlike the effect of different levels of greenhouse gases in the atmosphere which requires complex models with lots of uncertainty). (As an aside, the carbon tax itself is much better than cap and trade or carbon offsets, as I wrote on this blog a long time ago). With a pricing mechanism like that, no need for arguments about cotton in Egypt or irrigation in Ethiopia. Instead we would see a graceful phasing out of sub-optimal uses of water, and maximize the benefit of this shared resource. 

Finally to further solidify the positive economics and minimize the negative politics of the system, the countries should facilitate investments and trade across the region. If for example investors from each basin country were free to invest in other basin countries in farming and industry while still supplying the outputs to their domestic market, there would be less political friction around the natural geographic distribution of agriculture and industrial production. 

There are many examples of more complex cooperative agreements between countries around the world today, so it doesn't seem infeasible for the Nile basin countries to reach this kind of equilibrium. And recall we have plenty of time to achieve this long term goal, as the short term issue of GERD itself is win-win as discussed in part 1. But the chances of achieving this outcome will be greatly enhanced if in the meantime, the region's economies grow and become better diversified  across farming, industry and services.  Which brings us back to the present. Electrification is the sine qua non of developing a diversified economy. And GERD is a big step in the right direction, one which is immediately beneficial to not just Ethiopia but also Sudan and Egypt. 

2022/07/25

The case for GERD

As the third filling of the Grand Ethiopian Renaissance Dam (GERD) goes ahead, we should expect what is now becoming an annual uptick in media coverage and geopolitical controversy.  I've been thinking of writing a version of this blog post ever since the project started more than 10 years ago, but always ended up assuming this is adequately covered elsewhere. Years later, I'm still surprised by the frequency of incorrect assumptions dominating the discussion.  Not just in the media, but also in countless conversations. So it sounds like there might be some value in exposing the basic facts.

Power

GERD will have the capacity to generate 6GW of power at peak. However, due to seasonal variations, the average is expected to be about 40% of the peak. So on average, it should generate about 80 million GJ or 20 billion kWh of energy per year. Electricity production in 2019 was about 15 billion kWh, so GERD will more than double the  country's capacity. 
Electricity generation by source, Ethiopia 1990-2019


Economic impact

What is the economic value of this additional energy? Note that we are not asking what is the cost to produce it, nor the price at which it is sold. We are asking what is the economic value of consumer and industrial uses that it enables.  One way to estimate that is to look at the relationship between energy and GDP.  From a widely cited paper, "Energy and Economic Growth: The Stylized Facts",  we can deduce that each Gigajoule of energy corresponds to about $100 of GDP:  
Double checking with another source, "Our World in Data", gives us about $0.40 of GDP for every kWH.  This data has the added benefit that it shows a similar relationship, not just across countries but also on the same country over time: 


The two datasets are in almost perfect agreement. And they imply GERD's impact will be about $8B/year, or an increase of about 7% of GDP.[1] 

Considering the cost of the dam is about $5B, a return of $8B per year is great. Of course it will take a couple of more years for it to reach it's maximum generation capacity,  many years to develop the transmission and distribution of all this additional power to 100M consumers, and even more years for industries to grow that will take advantage of it. So the full impact is still far down the road, and depends on quite a few things happening correctly (not the least of which is finding ways to sell the "stranded" generated energy to finance the development of the distribution infrastructure, a topic which I will expand upon in the future). Still, the long term benefit is so large that there is no question the dam is a phenomenally good investment by Ethiopia.

You can also view it with a "social impact" lens if you are so inclined. Can you think of many projects where a one-time investment generates 160% return per year for many many years, increasing income by 7% for more than 100M people, most of whom are among the poorest in the world? Indeed GERD is possibly the biggest and perhaps most effective poverty reduction effort in the entire world today.


Climate impact

Of course, hydroelectric power is 100% renewable, and outside of the materials used in construction, the on-going operations have zero greenhouse gas emissions. Less obvious but also important is the fact that this electricity will displace current sources of energy which are dirtier. For example, millions of people in Ethiopia today often cook with wood charcoal, which from an emissions perspective, is worse than oil, let alone gas, or clean electricity. The amount is tiny on the scale of global emissions and climate change, but still moving from burning wood to electricity is a positive transition from dirty energy to clean energy. Further, the wood comes from cutting trees. Thus, electrification helps combat deforestation, and trees take CO2 out of the atmosphere through photosynthesis. For a good discussion on the relationship between electrification, deforestation and climate, I recommend the book "Apocalypse Never",  which explains this same point in detail using an example from the Democratic Republic of Congo. (As an aside, I also recommend my  review of that book on this blog).  So GERD not only does not emit, it reduces other carbon emissions, and saves trees which take carbon out of the atmosphere, a triple win in terms of reducing anthropogenic climate change


Water balance

Increased rainfall?

An additional argument, articulated by Ugandan president Museveni in this video, is that saving trees helps rainfall, which is a positive for total water balance of the overall Nile basin (water balance is a crucial point of contention as we shall see below).  
   
This particular argument is debatable since forests increase rainfall but trees also consume water. Here's a good paper on the links between forest cover and rainfall.  So it's probably a stretch to argue that water balance will increase. But hey, trees do enough for us even if they are neutral in the water balance equation. The overwhelming consensus is that preserving forests as much as possible is good, and electrification happens to help that.

No reduction in flow

The bigger question regarding water balance is of course whether the dam itself will reduce water availability downstream. This is where there is the biggest misunderstanding. Egyptians are extremely fearful that the dam will reduce the flow of the Nile, and they view it as an existential threat. But the reality is that the GERD will not reduce the amount of water that gets to Sudan and Egypt:
  1. Electricity generation doesn't consume water. As water, pulled by gravity, flows through turbines, the kinetic energy of the water becomes electric energy, and all the water comes out on the other side and flows downhill from there as always. 
  2. When there is loss of water from a dam, it is because it has a reservoir, a lake. The larger the area of the lake, the larger the loss due to evaporation. Indeed at the High Aswan Dam in Egypt, located more than a thousand kilometers downstream from the GERD in a flatter and hotter area, the reservoir (Lake Nasser) is large and shallow, causing a significant loss of water to evaporation. The GERD however is situated in a gorge, so the lake it creates is much narrower and deeper (about 1,900 km2 for GERD vs 5,250 km2 for Lake Nasser). It's also in a cooler area. Thus the evaporation impact of GERD is much less than Aswan's. Further, the purpose of the reservoir is to regulate the flow, like a battery. In theory, if you have a reservoir upstream, you can reduce the size of a reservoir downstream. So if we naively forget political boundaries for a second, and assume Egypt, Sudan and Ethiopia were 100% cooperative, to manage the total flow optimally, they would achieve the same magnitude of regulation by reducing the volume of Lake Nasser by the volume of GERD lake. Since GERD has relatively lower evaporation, this would be a net reduction in evaporation. But to keep things in perspective, evaporation accounts for less than 2 billion out of about 90 billion m3 /year of water flow on the Nile, so it's a minor issue.
  3. A much larger fear for downstream people is that the GERD might enable additional consumptive uses, like irrigation for agriculture. This is a legitimate general concern of course, and fairness and efficiency in consumptive uses is important. However, in the case of the GERD, its location at the most downstream point in Ethiopia, near the point where the river exits to Sudan, means that it would be infeasible to use any of the water from that point for agriculture, as you would have to pump it uphill to reach farms within Ethiopia. This effectively guarantees that GERD cannot physically be used for irrigation or any consumptive activity in Ethiopia.  
For more on this, see the seminar on 'The economic impacts of large dams: a comparative analysis of the Nile and Colorado Rivers' . In particular the evaporation question and non-consumptive nature of GERD are addressed at 1:09:23 in the video

Bottom line: GERD will not decrease the net amount of water that reaches Egypt and Sudan. Regardless of what you think about the historical sharing of water, the fear that it can harm downstream people is just not supported by facts.


Floods and drought mitigation

In fact it's actually beneficial to them. As I tweeted some time ago, this excellent paper entitled 'Understanding and managing new risks on the Nile with the Grand Ethiopian Renaissance Dam' explains it:
  1. "Sudan will clearly be better off ... because GERD operations will smooth Blue Nile flows, eliminating flood losses, increasing hydropower generation, decreasing sediment load to the reservoirs and canals, and, most importantly, increasing water for summer irrigation in the Gezira Scheme and other irrigated areas along the Blue Nile".  To get a sense of the magnitude of this benefit, consider that flooding in 2020 caused over 100,000 homes to collapse and Sudan to declare a 3-month state of emergency.
  2. During droughts, it is expected that the existence of the GERD will cause "decreased water deficits to Egypt and increased water availability". 
It is also extremely important to note that, as the paper explains, these benefits to Egypt and Sudan do not depend on generosity and goodwill from Ethiopia. Keeping the flow steady by boosting it during droughts and throttling it during floods is also necessary from the self-interested electricity generating perspective of GERD, so it's a win-win-win proposition even without explicit cooperation.  In other words, long term incentives are aligned between Ethiopia, Sudan and Egypt, which should offer the strongest reassurance to back whatever political understanding is (hopefully) reached.


Filling

Now besides the long-term incentives, there is a separate question of what happens during the initial filling of the GERD reservoir, which started in 2020 and is expected to last 4 to 7 years. Filling the reservoir obviously must temporarily decrease the downstream flow. But here two facts should be understood. First, filling takes place in the rainy season (July and August) each year, where typically there is "too much" flow, so there should be no detrimental effect downstream.  Second, by chance, the first and second fillings took place during above average rainfall years 2020 and 2021. It's almost as if nature decided to be pro-GERD at this most critical time!
It's possible that the filling has already helped reduce the severity of floods in Sudan, although that effect may be limited by the fact that filling stopped as scheduled halfway through the rainy season (the Sudanese irrigation minister even complained that the filling didn't go fast enough to help).


Geopolitics

That is not to say Egypt and Sudan don't have any legitimate concerns. Future upstream uses of the Nile water could reduce their supply. The total water flow, while abundant, is currently almost 100% consumed: no Nile water actually reaches the Mediterranean Sea, except what's needed to push back salinity. So, even though GERD itself is a win-win-win,  in the bigger picture, the Nile water use is a zero sum game.  Currently, Egypt consumes 79%, Sudan 18%, and the rest of the countries combined less than 3%.

But there is international law and precedent on how to share rivers between multiple countries. The right way to deal with this case is the Nile Basin Initiative's Cooperative Framework Agreement  (CFA) which should be able to handle the issues of the next few decades at least. Uganda, Ethiopia,  Rwanda, Tanzania, Kenya, Burundi and South Sudan are on board. Sudan and Egypt initially joined, then "froze" their participation, but from what I gathered at the aforementioned seminar, Sudan has recently rejoined.  

The main problem is the recalcitrance of the Egyptian government. Given that their country consumes 79% of the Nile's water, perhaps they feel that acceptance of any upstream change jeopardizes this entitlement. The military government of Egypt has taken a hard line and it seems like they fear any compromise abroad might weaken their political power at home. This political trap has far reaching consequences for the region's stability and peace. Very unfortunate. Let's hope reason beats politics for once and things work out rationally, since GERD itself is actually beneficial to Egypt. 

Part 2 of this post explores the longer term sharing of the Nile beyond GERD.

P.S. This post is dedicated to my dear friend Ahmed Amr. A brilliant and hyper-informed Egyptian who during a conversation last year, was surprised by some of these technical facts.  Sadly Ahmed passed away from a long illness a few months ago. Ahmed, wherever you are, I hope you enjoy this post and I look forward to chatting with you again in the afterlife!

[1]Another way of getting economic impact is to multiply production by average price to get the direct value of the energy, and then apply a GDP "multiplier" which estimates the downstream GDP impact (electricity enables goods and services, which in turn enable other goods and services etc.) The problem as you can imagine is that multipliers are very inexact. In a tweet on this topic a couple of years ago, I used the a multiplier of 1.6 which I now realize is too low. I also incorrectly used peak power instead of average. Coincidentally the two inaccuracies cancelled out and the GDP estimate was about the same.

2022/06/03

The 4th wave of Bitcoin FUD

I just came across Why This Computer Scientist Says All Cryptocurrency Should “Die in a Fire”. I can't find any point in there that hasn't already been refuted many times. But it's relatively rare to find so many of them in one place, and it has been going around, so I thought I should make a little effort to rebut it. 

Security

Though not the most important aspect of the article, the "computer scientist" in the title is a not-too-subtle argument from authority, so it behooves us to take a look. The computer scientist in question is Nicholas Weaver, who I haven't heard of before, though from a brief look at his publications, I recognize some of his co-authors. It seems like his expertise is network security. So his most important contribution as an expert would be if he could find an actual technical security problem in Bitcoin. But of course he hasn't, in fact no one has successfully exploited Bitcoin. This is a rarely appreciated aspect of the network. Even though it's the world's largest honey pot, with literally several hundred billion dollars there for the taking, the entire codebase is open source, and all the data is on the public blockchain, no one has actually technically been able to "crack" Bitcoin. There is plenty of theft of Bitcoin of course, because people make mistakes with their keys etc. A scary bug was luckily fixed in the early days. Still no one has exploited the system itself. For any computer scientist, or anyone who has ever written software, this is very remarkable. As a network security expert,  you'd think Weaver would at least mention it. 

Maybe he has motivation for not saying anything positive? Indeed, apparently he's been declaring the death of Bitcoin so many times since 2013 that Weaver has earned a place in the Bitcoin Skeptic Hall of Fame.  It seems like he has dug himself into an anti-Bitcoin emotional trap which is hard to climb out of.

Bubbles

Credentialism aside, his actual criticism consists of economic arguments. He points to the price of Bitcoin in USD and "bubbles" where it rose from $10 to $100 then "crashed". Then to $1000 and crashed. Then to $20,000 and crashed. Then to $60,000 and crashed. And confidently asserts that there won't be a fifth bubble, that this time it's really dead.  But this only inadvertently points to the fact that he's been wrong so many times. Without any coherent explanation of why his previous predictions have failed, it's hard to believe him this time. A more honest view is to zoom out and look at it on a log scale, and notice that each "crash" bottoms out much higher than the previous one. So if one is going to reason purely from historical prices, then a reasonable observer would not confidently say that the last peak happens to be the final one before it goes to zero forever. That's like looking at a toddler learning how to walk and after the fourth time he falls down saying the kid will never walk. A more reasonable take is that if the Bitcoin price chart tells us anything, it's more likely the story of an emergent store of value.   Of course, chart analysis to predict future prices is generally a fool's errand, and even more so with this unique phenomenon. There are not many analogues in history -- we don't have exchange rates of gold from 2500 years ago. It's better to think about Bitcoin from first principles and think about long term adoption while avoiding short term price predictions.   

Adjacent crypto: altcoins, blockchains etc.

To make matters more confusing, most critics (and Weaver is no exception) put Bitcoin in a bucket with all the other cryptocurrencies, ICOs, NFTs etc. But almost all of the other stuff around "crypto" is junk, much of it unethical or even fraudulent.

Leaving aside the many outright frauds, the whole "altcoin" space reminds me a bit of the history of the Internet.  In the 1980s and 90s, TCP/IP had alternatives like ATM (Asynchronous Transfer Mode). A lot argued that the IP network wouldn't scale, or wouldn't offer good enough QoS, etc. They argued that the net would never be used for serious things like the phone network or television. It's true that there are various trade-offs in the design of TCP and IP, even some arbitrary choices. You can argue for different ones in hindsight. And things do evolve, albeit slowly. Witness IPv6 getting deployed in a backward compatible way over more than 2 decades, while IPv4 continues to chug along. Even ATM was absorbed as a short-lived layer 2 protocol under IP. But there's only one Internet. That's the so-called network effect. If the protocol is good enough, early enough, it becomes the standard.  

And that is where proponents and critics of "altcoins" are causing confusion and driving unjustified hostility to Bitcoin. Viewing Bitcoin as one of many "cryptocurrencies" masks a basic reality: Bitcoin is like the Internet of money and it is here to stay.

That said, I'm not against all other cryptocurrencies. For example a broader smart contract platform makes sense long term, and Ethereum may be the one for the ages. But there are significant technical hurdles remaining. And it's already so bloated very few people actually run a full Ethereum node. And that's all before the much delayed eth 2.0 migration, which if it succeeds may introduce a potentially fatal governance change called proof-of-stake. Building a "world computer" as it needs to be is much harder than what has been achieved to date. 

"Blockchain not Bitcoin" is another common theme among "crypto" hopefuls. But without a real reason for decentralization, a blockchain is just an expensive and slow database. Most of the envisioned applications for blockchains can be more easily achieved with traditional databases.

Bitcoin's proof-of-work ledger for sound commodity money is to date the only real world blockchain use case.

Energy and Proof-of-Work

Speaking of proof of work, energy use is the most common and dangerous vector of FUD against Bitcoin, and Weaver recycles the usual points. He claims that Bitcoin miners are "wasting tons of electricity". This topic is deep and generally misunderstood. Here's my attempt to distill it in my paper entitled "Dynamics of Bitcoin mining":

Does mining use too much energy?

This question assumes the system requires some amount of computation to be done and that it ”wants” to minimize the energy to achieve it. That is indeed how most systems work. But not Bitcoin. Proof-of-work does the reverse of that. The system ”wants” a certain value to be spent on energy, and the amount of computation adjusts to achieve it. Of course individual miners compete by being as efficient as possible, but the resulting collective behavior is to achieve a certain cost of energy with variable amounts of computation, not to perform a specific amount of computation with variable amounts of energy. 

This unusual combination – individual participants being efficiency-seeking but their collective behavior being efficiency-neutral – is very counter-intuitive and probably the root cause of much misguided hostility. It’s also worth emphasizing that the amount of energy doesn’t matter, only the cost. If the price of electricity relative to everything else in the world doubles, but nothing else changes, then Bitcoin would simply use half the amount of energy to achieve the same relative cost[...] The cost of energy is a feature not a bug, and ”waste” is impossible by design. All of the energy is ”work”. 

And where there’s no ”waste”, the question of energy use boils down to a moral judgement. Can you argue that heating in the winter, even if perfectly efficient, is not justified and people should move to warmer climates? What about air conditioning, or electric clothes dryers, or ice cream? When is any purposeful energy use justified? Morally, as long as access to and the price of energy is fair, what it’s used for should be accepted as a subjective choice. Bitcoin offers the possibility of inflation-resistant savings, low-cost long-distance value transfer, and censorship-resistant money. For its users, these are important benefits which are no less justified than most other uses of energy.

In the same interview, Weaver attacks the notion that Bitcoin "incentivizes green power", and goes on to misrepresent the incentives, and the supply and demand dynamics of electric power. I covered this too in the same paper:

Many sources of renewable energy are highly variable: solar and wind power depend on time of day and weather, hydroelectric power is seasonal, etc. In general, these ups and downs on the supply side do not line up perfectly with the demand for electricity. Further, even with the largest possible batteries, water reservoirs, etc., electric energy remains extremely difficult to store for later use at a large scale. Thus there is often a lot of ”stranded” energy when using renewable sources. Just like off-peak bandwidth in telecommunication networks, or empty seats on scheduled airline flights, the cost of production is already sunk, and so for the supplier, selling stranded power at any price is better than letting it go unused. [...] The competitive dynamics of Bitcoin mining are such that it shifts in time and space to the lowest available cost of electricity. This occurs not just by deploying hardware to various locations, but also by turning miners on or off instantly. This flexible demand-side support makes mining the ideal customer to balance variable supply, and as variability tends to affect renewable much more than fossil fuel sources, in effect, Bitcoin subsidizes the development of ”green” electricity.

Adoption

Finally, Weaver claims that Bitcoin will permanently fall apart Real Soon Now™, when it runs out of suckers. But there's really no basis for his claim. He doesn't give any reason why the number of suckers is a particular fraction of the world's population and why that limit has been reached now. Why didn't it run out after 1M people? Or 100M? Why not 8 billion people?  

Of course, the success of Bitcoin depends on widespread adoption. Why is gold used as money? You can try to explain it based on some key properties: it's impossible to synthesize, the supply is limited, it's fungible and can be shaped easily, it doesn't degrade... Those are useful, but we don't know if they are sufficient.  The emergence of a monetary good is a fascinating topic, one that most people don't understand and don't even realize that they don't know. ("The Origins of Money", an article which predates Bitcoin, is a good read). Ultimately, Bitcoin is just a Schelling point whose emergence is highly path dependent.That's just a fancy way of saying "we'll see", but every day that passes makes the ultimate success more likely, and it's been almost 5000 days already.