Wednesday, February 3, 2016

Does the Fed lack the technical means to dive into negative rate waters?

The Federal Reserve may be in a bit of a bind.

With the Bank of Japan reducing rates to -0.1%, many commentators are calling on the Fed to reverse its policy of rate normalization and follow Japan into negative territory.  The problem is this. Thanks to the rules laid out in the Federal Reserve Act, the Fed may lack the technical means to dive into negative rate waters. Let me restate this in different terms. If the Federal Reserve were to reduce the rate at which it pays interest on reserves (IOR) to -0.25% or so, the overnight rate may not follow very far. Monetary policy is useless, or at least less effective than it would otherwise be.

Not only would monetary policy lose some of its potency when IOR falls below 0%, but an unapproved fiscal transfer from the Fed to another set of government institutions could occur. This is because negative IOR has the potential to provide a large subsidy to a narrow range of governments sponsored-entities that are allowed to keep 0%-yielding deposits at the Fed. At deeply negative rates, this subsidy could get very large, turning the Fed's substantial profits into large losses. The result, a steady fall in its share capital, might undermine Fed independence and the credibility of monetary policy.**

Why these odd effects? As Nick Rowe says in this delightful post, in a world with negative interest rates everything old is new again, only it's a mirror image. And in a world of negative U.S. rates, the mirror image of the Fed's leaky floor is a sticky ceiling. And just like the leaky floor (more on this later) dragged the overnight rate down to 0% when IOR was positive, the sticky ceiling effectively pulls the overnight rates back up to 0% when IOR is negative. To see why this would happen, we need to take a quick tour of the legal and technical history behind IOR.

Until October 2008 the Fed was legally prohibited from paying interest to banks. Any bank manager who left reserves on deposit at the Fed earned 0%. This changed with the passage of the  Financial Services Regulatory Relief Act of 2006 which bolted Section 19(b)(12) onto the Federal Reserve Act allowing banks to "receive earnings to be paid by the Federal Reserve Bank." As a direct result of 19(b)(12), the Fed has been paying interest of 0.25% for a number of years, a rate that was recently increased to 0.5%.

Not only did Section 19(b)(12) provide the Fed with the ability to pay interest on reserves, it also gives it the technical means to pay negative rates on reserves. Now there is some controversy whether the wording in Section 19(b)(12) authorizes a negative rate; for instance, it mentions the paying of earnings to banks, not the payment of negative earnings:
...and here is Stephen Williamson on the issue.

Ex-Fed official Narayana Kocherlakota points out that various members of the Fed Board of Governors, including William Dudley and Stanley Fischer, have already hinted at negative rates as a potential tool, the implication being that the Fed has high confidence in a certain interpretation of the Act that would legally justify the move, otherwise they would not have spoken. Don't forget that Fed general counsel Scott Alvarez will have to sign off on the question of legality. Alvarez is the one who allowed a truck to be driven through Section 13.3 during the credit crisis, legalizing the bailout of Bear Stearns and AIG via Maiden Lane.

Let's assume that there is no legal controversy and the Fed sets negative IOR of -0.25% tomorrow. That's where the Fed's real problems start. Because as I said at the outset, the overnight rate won't follow IOR down in lock-step, it may even stick to the 0% ceiling. On top of this is the aforementioned subsidy provided to those institutions that have access to interest-free deposits at the Fed, namely the government-sponsored entities Freddie Mac, Fannie Mae, and the Federal Home Loan Banks (I'll describe this subsidy later).

As I said at the outset, the sticky ceiling problem is the opposite of the well known leaky floor problem. Over the last few years the various U.S. overnight rates have traded below IOR. These leaks are odd since IOR is supposed to set a lower bound to the overnight rate. After all, why invest your funds at 0.05% overnight when you can get 0.25% at the Fed? We can blame the leakage on our three government-sponsored entities (GSEs): Freddie, Fannie, and the Federal Home Loan Banks. These GSEs are allowed to keep accounts at the Fed but are prohibited from collecting interest. Rather than earn nothing, the GSEs have been lending their reserves overnight to banks who have access to IOR. These banks have been engaging in arbitrage whereby they borrow GSE funds at 0.05%- 0.15% and invest them at 0.25%, a nice gig if you can get it.

From whence this prohibition on interest? 19(b)(12), the same bit of legalese that authorizes IOR, emphasizes that only "depository institutions" can receive interest, and since Freddie, Fannie, and the Federal Home Loan Banks are not depositories, they do not qualify (this article speculates why).

Which means that if the Fed is going to stretch Section 19 authority for payment of interest  to allow for the payment of negative interest rates, then the GSE prohibition on receiving positive interest means that they will likewise be exempt from paying negative interest.

The ultimate effect of all this is that if and when the Fed decides to brings IOR to -0.25%%, the overnight rate is going to do a flip—rather than trading below IOR it will start to trade above it. Why the inversion? In positive rate land the IOR exemption meant that it really sucked to be the GSEs. But in negative rate land it's great to be a GSE. When all other banks must endure a -0.25% penalty, an exemption from IOR becomes an asset, not a liability. Banks, sensing a way to improve their returns, will compete to purchase 0% shelter from the GSEs. Say they offer to lend funds to the GSEs in the overnight market at  -0.17%, an 8 basis point improvement to IOR of -0.25%. GSEs would be hard-pressed to not accept this gift. After all, they'd be borrowing at -0.17% in order to lend to the Fed at 0%, which means 17 basis points in risk free profit. Taken to the extreme, a profit-maximizing Fannie, Freddie, and the Federal Home Loan Banks will compete to borrow the entire $3.3 trillion in reserves held at the Fed, driving overnight rates back up towards 0%. No matter how deep the Fed brings IOR into negative territory, the overnight rate stays stuck at a shallow level thanks to the GSEs.

You may recognize that the sticky ceiling problem is just another (perhaps weaker) version of the good old zero-lower bound problem, but in the role of 0% cash as antagonist, 0% deposits held at Fannie, Freddie, and the Federal Home Loan Banks have been substituted.

Now it could be argued that GSE arbitrage will force the overnight rate within a hair of negative IOR. For instance, if  IOR is at -0.25%  the overnight rate might trade at -0.24%. If so, the problem is less about monetary policy impotence and more about the massive subsidy being granted to the GSEs. These institutions have a large incentive to hoover all the reserves held by non-GSEs in order to earn risk free returns. Rather than earning 0.25% on reserves held by banks, the Fed will get 0%. And since the Fed's profits--what economists call seigniorage--typically flows to the taxpayer via the Treasury, taxpayers would be subsidizing Fannie, Freddie, and the Federal Home Loan Banks to the tune of millions, a fiscal transfer lacking the appropriate Congressional approvals.*

If the GSEs take the free gift, this will have very real effects on the Fed's financial health.  With IOR at -0.25% the steady rolling-over the Fed's assets will result in a decline in their yields, maybe even negative returns. As the spread between the return on assets and cost of liabilities shrinks, the Fed's seigniorage will drop dramatically. In  normal times, a certain portion of this seigniorage goes to rebuilding any impairments to the Fed's capital base while the rest flows through the Treasury to the taxpayer, either in the form of reduced taxes or services. With a 0% loophole being offered to the GSEs, the Fed risks running permanent operating deficits which in turn will lead to a steady erosion in its capital base. If the equity writedowns gets too large this may reduce the Fed's credibility in the eyes of the market, thus reducing the effectiveness of monetary policy.**

The Fed will have to plug this hole if it doesn't want to find itself neutered and/or subsidizing the GSEs. Maybe Fed officials can cap the amount of reserves that the GSEs are allowed to borrow, or use moral suasion to get the GSEs to drop out of the market. Better yet, maybe Fed Chair Janet Yellen can ask Congress to change 19(b)(12) so that, like all other banks, GSEs get to receive IOR (and are forced to pay it). Alternatively, maybe the laws can be altered so that the GSEs are prevented from keeping deposits at the Fed to begin with.

The legal option is a good idea for two reasons. First, it means that negative IOR effectively sets the overnight rate, restoring the pass-through from negative rates into financial markets and the real economy. It also removes the subsidy to the GSEs and the potential for large hits to share capital. Secondly, it fixes the Fed's leaky floor problem at positive rates of IOR. The Fed has already set up an overnight reverse repo agreement (ON RRP) facility to borrow from those ineligible to receive IOR, the idea being to keep a sterner floor under overnight rates. But as Marvin Goodfriend writes, ON RRP
violates the minimal intervention principle of central banking by turning the Fed into a financial intermediary operating directly on a large scale beyond the banking system with the potential to distort short term credit allocation and enable disruptive flight-to-quality flows during periods of financial distress.
Far less obtrusive to fix the leak with a quick change to legislation than fully arming a new battle station.

In closing, if the Fed wants to go negative, it may have some technical details to worry about. Fed officials no doubt already know this. If they don't, the blame can be attributed to their all-out focus on so-called normalization. By throwing all their organizational capital into the creation of a mechanism for keeping rates on an upward trajectory (the ON RPP), the Fed has diverted resources and attention away from the design of a complementary mechanism necessary for a downward rate trajectory. In hindsight, perhaps the Fed should have been tasking half its lawyers, accountants, financial architects, and media personnel to the rate normalization project, and the other to the negative rate project. Time to play catch-up?

Due to the difficulty of this subject matter, I've altered this post a few times since initially publishing it. The general idea has remained the same.

* In my original post, this paragraph didn't appear but was in the footnotes. I think it's important enough to bring up to the body of the text.
** Added on January 4.
*** Since originally posting this, I've softened my position on the sticky ceiling. I originally thought that the overnight rate would stay stuck at 0%, but I now feel it is likely to move closer to negative IOR. It would remain above IOR, however, so the idea of a sticky ceiling, while muted, is still relevant.

Monday, February 1, 2016

Bank of Japan warms up the potato

Will the Bank of Japan's negative rates work?

Many people say no, among them Louis-Phillippe Rochon:
Sadly, they won't. They [negative rates] are based on a faulty understanding of our banking system. The reason banks do not lend is not because they are constrained by liquidity, but because they are unwilling to lend in such uncertain times.
Banks lend in the hope of getting reimbursed with interest. But banks are too pessimistic about the ability of the private sector to honour their debt, and so prefer not to lend. Having extra cash courtesy of the central bank imposing negative rates won't change the dark economic narrative. [link]
I disagree. Even if the lending channel is closed, a negative rate policy still sets off a hot potato effect that gets the Bank of Japan a bit closer to hitting its inflation targets and stimulating nominal GDP than without that same policy.

For the sake of argument I'll grant Rochon the point that negative rates might not encourage banks to lend. And as you'll read in the comments here, that would certainly have implications on the effectiveness of monetary policy. But even if we close the door on loans, the interest rate cut will simply find a different route into prices and the real economy.

The moment the BoJ reduces the rate on deposits it creates a hot potato; an asset with a below-market return that its owner is desperate to be rid of. Bank reserve managers will simultaneously try to sell off their BoJ deposits in order to get a better return in short term corporate and government debt. In aggregate, however, banks cannot get rid of reserves, which pushes the prices of these competing short-term assets up and their expected returns back in line with the return on balances held at the central bank, a process that continues until reserve managers are indifferent on the margin between owning BoJ deposits and short term corporate/government debt.

The hot potato doesn't stop here but continues to cascade through financial markets. At the margin, corporate and government debt will now be overvalued relative to other financial assets (like stocks), encouraging fund managers and other investors to bid up the prices of all remaining assets in the financial market until returns are once again in balance.

Up till now the the hot potato that I've been describing has been trapped in Japanese financial markets thanks to Rochon's blocked lending channel. Acting as a bridge into the real economy are the portfolios held by consumers. Japanese consumers own not only portfolios of financial assets but portfolios of consumption goods that yield an ongoing flow of consumption services. Think cars, shavers, tables, and vacations (the latter of which yield a recurring flow of memories). Likewise, financial assets yield an ongoing flow of consumption services since interest payments and the final return of principle can be measured in terms of consumption. When prices in financial markets rise and returns fall, a portfolio of financial assets now yields a smaller discounted quantity of future consumption services than a competing portfolio of consumption goods. In response, consumers will re-balance out of financial assets into undervalued consumption goods, causing consumer prices to rise. Or, if there is some stickiness in prices, the quantity sold experiences a boom.

And that's how the hot potato ignited by the Bank of Japan's negative rates gets passed into consumer prices and the real economy when the lending channel is closed.


Another interesting critique of the effectiveness of negative rates has to do with the fact that in those nations that have already experimented with negative rates, the penalty has not been passed through to retail deposits. This could be a problem because if Japanese retail depositors are not going to be fined by banks, that nullifies the hot potato effect I described above. After all, consumers won't bother trying to re-balance out of the financial economy into the real economy if they can just hoard superior-yielding 0% deposits.

This failure to pass-through negative central bank rates will probably not be more than a short-term phenomenon. As the BoJ deposit rate get ever more negative, those banks that choose to prop up the rate sthey offer on retail deposits allow themselves to be the victims of arbitrage, consumers taking the positive end of the deal as they migrate into superior-yielding deposits. Borrowing at 0% to invest at -0.1% isn't a particularly profitable place for a bank to put itself in. The only way for a bank to rectify the situation is by the passing-through of negative rates to retail clients or the setting of limits on retail account sizes. The hot potato effect gets new life as investors flee bank deposits by purchasing underpriced consumer goods.

As Gavyn Davies points out, the Bank of Japan has set a tiered negative rate whereby the full effect of negative interest rates is not felt by banks; only a portion of deposits held at the BoJ will be docked the full 0.1% while the rest get off Scot-free. This BoJ (i.e. taxpayer) subsidy to banks helps offset any financial losses that banks incur by choosing to avoid passing through negative rates to retail customers, thus encouraging bank managers to keep retail deposit rates steady at 0%. .

But as the BoJ continues to cut rates, the size of the BoJ subsidy is unlikely to increase as fast as the size of the penalty imposed on banks as measured by the gap between the cost of maintaining 0% retail deposit rates and the revenues earned on negative-yielding central bank deposits & other short term money market assets. To plug these growing losses, and absent a compensating subsidy, banks will have no choice but to pass-through negative rates to retail clients or put a limit on retail account sizes. This in turn will give free rein to the hot potato effect.

Negative interest rates are like water, they'll always find a crack.

Friday, January 29, 2016

A monetary policy sound check

It's healthy to ask others for a sound check every now and then. I'm going to give a short description of how I see the monetary policy transmission process working, then readers can tell me how far off I am. Hopefully this sound check will bring some more rigour to my thought process.

Briefly, the story from start to end it goes like this...

1. A central bank reduces interest rates.

2. After a delay, consumer prices will be higher than they would have been without the rate cut.

Here's some more detail on how I get from 1 to 2.

A) In the first moment after the rate cut, banks find themselves earning a smaller return on balances held at the central bank than on competing short term/safe financial assets (like government bills and commercial paper). Central bank balances are overpriced, government bills and commercial paper are underpriced.

B) To maximize their profits, banks all try to sell their overpriced balances, driving the prices of government bills and commercial paper up and their expected returns down. The relative mispricing has been fixed; returns on central bank balances are once again equal to returns on other short-term/safe financial assets. What about other financial assets?

C) In the next moment the reaction spreads to the rest of the financial universe. Financial market participants (many of whom don't have an account at the central bank) observe that the returns on government bills and commercial paper in their portfolios have been reduced relative to returns on other financial assets. They try to sell their bills & paper and buy underpriced risky assets like stocks, gold, and bitcoin, driving the prices of these instruments higher and returns lower until the arbitrage window is closed.

D) Very quickly, these adjustments brings the expected returns on all financial assets into balance with each other. What about goods markets?

E) In the next moment the reaction spreads beyond financial markets. Investor begin to notice that the returns on the financial assets in their portfolios have suddenly become inferior to the return they can expect on consumer goods and services. Investors try to re-balance by selling their financial assets and buying underpriced consumer goods.

F) Unlike financial prices, goods prices may be slow to adjust. This means that the window for enjoying artificially underpriced consumer goods stays open for a period of time. With people flocking to enjoy free lunches, the quantity of consumer goods and services sold speeds up relative to the pace that would have prevailed without a rate cut. We get a boom.

G) At some point, shops increase prices and close the arbitrage window. We've now arrived at 2 and the story is complete.

You may notice that I didn't include bank lending in my sound check. That's because I'm not convinced that bank loans are vital to the monetary transmission process. That being said, we can introduce an optional step between F and G.

i) To take advantage of underpriced consumer goods, investors may take on bank debt in order to buy more goods than they might otherwise have afforded, so the quantity of debt increases.

But even if people choose not to take on additional debt, or for some reason the banks decide to hold back lending, the arbitrage process ignited by a rate cut will still play itself out with an increase in consumer prices being the final result. The key role banks play in the transmission process is at A & B, the effort to sell reserves for alternative safe assets, not at the i) level. And no matter how sick a bank is, it won't forgo arbitrage at the A & B level.

So the purpose of the Bank of Japan's recently-announced negative interest rate policy is not to make Japanese banks lend more. The point is to set off an arbitrage process out of Bank of Japan deposits and into goods & services through a series of other intervening assets, eventually leading to higher prices.


Previous posts on the transmission process:

Robin Hood Central Banking
Toying with the Monetary Transmission Mechanism

Monday, January 25, 2016

The social function of equity deposits

One more post on equity deposits.

My last post described a dirt cheap (and hypothetical) way for long-term investors to get exposure to equities. Briefly, an investor commits a certain amount of money to a one-year term deposit that promises an equity index-linked return. The manager of this equity deposit (ED) invests that money in an appropriate number of shares in the companies that make up the index, then lends these shares out to borrowers for one year at a fixed rate. At the end of the year the stocks on loan are recalled, sold, and the investor's deposit is repaid. The interest earned on stock loans is shared with the depositor, boosting their returns.

It's worth pointing out that ETFs already lend out shares, but unlike an ED they can only do so on an overnight basis. So an ETF can't harvest the extra term premium on long-term loans.

EDs have a broader social purpose than just saving a few bucks. Here's a quick list:

1. Equity deposits would reduce the dead weight loss currently being incurred by long-term investors.

The investing world currently discriminates against long-term investors by requiring them to invest in securities that are tailor-made for short-term traders. Stocks, ETFs, and mutual funds enjoy a permanent trading window--the ability to cash out of the stock market in a millisecond. Long-term investors who have precommitted to the stock market for ten or twenty years simply don't need this feature. Unfortunately, not only do they not have a choice (all securities have these windows), but they must pay the fees involved in the maintenance of said window. This is an an efficient allocation of resources, or what economists call a dead weight loss.

Equity deposits are tailor-made for the long-term investor. By removing the trading window, long-term investors no longer have to pay for a feature that caters to traders, thus lowering investors' costs and improving their returns. The world is made more efficient.

2. Borrowers of stock are missing a market. Equity deposits would fill this gap.

Anyone who wants to borrow dollars from a bank can do so overnight or on a long-term basis. It's not the same when it comes to other financial instruments. Anyone who wants to borrow stock can only do so overnight. An equity deposit provides the missing market.

The reason for this gap is that institutional owners of stock like ETFs and mutual funds face the possibility that they might be besieged at any moment by redemption requests. This means that they can only lend out stock on a short term basis to borrowers, usually overnight. Because owners of equity deposits have committed to a fixed holding period, the manager of an ED is free to lend underlying stock out on a long-term fixed rate basis. Borrowers should be willing to pay an ED manager a premium rate of interest for the certainty its fixed products provide.

Which leads into points 3, 4, and 5...

3. Equity deposits would improve market liquidity and reduce price volatility.

The job of a market maker is to facilitate trading in a security by maintaining tight spreads between the bid and ask price. Market makers need an inventory of securities to do their job, and they will often borrow to ensure that supply. Because most shares are lent out on an overnight basis, this source of liquidity is flighty. Stock can be recalled without warning and lending rates can get ratcheted up suddenly. A manager of an ED can offer market makers a guaranteed supply at a fixed price, thus reducing the uncertainty involved in market making. Hopefully this will help make for a thicker and tighter market.

4. Equity deposits would improve price discovery.

Arbitrageurs need to borrow stock to put on the short leg of their strategies. Because most equity loans can be recalled at any moment and lending rates can change daily, it can be difficult to know ahead of time the return of a certain the strategy. Equity deposits provide a stable long-term supply of stock for arbitrageurs at a fixed lending rate, thus helping to ensure that the arbitrage process keeps prices in line.

5. Equity deposits provide a useful risk management tool.

Hedgers may need to borrow stock and sell it to hedge some other position they hold, thus offsetting risk. Long-term fixed interest rate loans may offer the hedger more peace of mind than a series of overnight loans that might be reset at higher interest rates without warning.

In closing, ETFs and index mutual funds have become more than just vehicles for retail investors to get passive market exposure. They have also become intermediaries between overnight lenders and borrowers of stock, even if most retail investors in ETFs do not actually realize that they have become lenders. An equity deposit mimics the passive market exposure provided by an ETF while extending the lending business from an overnight basis to what should be a more profitable long-term basis.

It is generally accepted that stock lending brings stability to the marketplace. But as we know from the financial crisis, overnight markets are run-prone. Long-term stock lending via an ED solves the run problem; it seems like an incremental way to create a more robust system.

Monday, January 11, 2016

Even cheaper than an ETF

John Bogle, father of passive investing

With fees as low as 0.10%, passively managed ETFs are one of the cheapest ways to get exposure to equities. Not bad, but here's a financial product that would be even cheaper for investors: an equity deposit. I figure that equity deposits would be so cost efficient that rather than charging a management fee, investors would be paid to own them.

To understand how equity deposits would work, I want to make an analogy to bank deposits. Think of an equity ETF as a chequing account and an equity deposit, or ED, as a term deposit. In the same way that chequing deposits can be offloaded on demand, an ETF can be sold whenever the owner wants, say on the New York Stock Exchange or NASDAQ. Equity deposits, like term deposits, would be locked in until their term was up up. Issued in 1-month, 3-month, 1-year, 3-year, and 5-year terms, EDs would replicate a popular equity index like the S&P 500.

Given that both ETFs and EDs track the same index, and both provide the same dividends, the sole difference between the ETF and the ED is their liquidity. A commitment by an investor to an ED is irrevocable (at least until the term is up) whereas an ETF allows one to change one's mind.  ETFs represent liquid equity exposure; EDs are illiquid equity exposure.

An investor might buy an ED rather than an ETF for the same reason that they might prefer term deposits to a chequing account; they are willing to sacrifice liquidity for a yield. For a trader with a holding period of a few minutes or hours, an ED would be an atrocious instrument. On the other end of the spectrum, long-term buy-and-hold investor would be perfect candidates for substitution from ETFs into EDs. Come hell or high water, investors following a buy and hold strategy have pre-committed themselves to owning equities till they retire. As such, they don't need the permanent liquidity window that ETFs provide. Now if that window were provided free of charge, then investors may as well buy ETFs. But liquidity doesn't come without a cost, as I'll show below. Which means that long-term investors who own ETFs are paying for a worthless feature.

Better for a buy and hold investor to slide a portion of the portfolio that has already been dedicated to ETFs into higher yielding 5-year EDs, rolling these over four or five times until they retire. In doing so, investors get a higher return while forfeiting liquidity, a property they put no value on anyways.

How is it that an ED can provide a higher return than an ETF? Here's how. Once investors' funds have been irrevocably deposited into a 5-year vehicle, the manager buys the stocks underlying the S&P 500. Next, the manager offers to lend this stock to various market participants, either short sellers looking to make a quick buck or market makers who want to replenish inventories. These loans, which are quite safe due to the fact that the borrower provides collateral, earn a recurring stream of interest income which the ED manager shares with the ED investor. This return should be high enough to more-than counterbalance management expenses such that on net, ED investors end up earning an extra 0.25% or so each year rather than paying 0.10-0.50%.

But wait a minute, why don't ETFs do the same thing? Why don't they lend stock and share the income with ETF investors? Actually, they already do. And in some cases, ETF managers are already providing investors with more in lending income than they are docking them to manage the ETF. See the screenshot below from an iShares quarterly report:

The iShares Russell 2000 ETF, which has a net asset value of around $25 billion, provided investors with $34.58 million in stock lending income in the six months ended September 30, 2015, well in excess of advisory fees of $27.85 million.

So yes, ETFs can and do earn stock lending income, but my claim is that an ED manager following an equivalent index would be able to earn even more from lending out stock. To understand why, we need to think about how stock lending works. Stock loans are usually callable, meaning that the lender, in this case the ETF, can ask for a return of lent stock whenever they want. Callability is terribly disadvantageous to the borrower, especially a short seller, as they may have to buy back and return  said stock when they least want to, say during a short squeeze. In order to protect themselves, a short seller will always prefer a non-callable stock loan, say for 1-year, then a callable one, and will be willing to pay a higher interest rate to enjoy that protection.

ETFs and mutual funds are not in the position to provide non-callable stock loans because ETF and mutual fund units can be redeemed on demand by investors. For instance, if performance lags a mutual fund manager may start to experience large redemption requests. To meet those demands, the manager needs the flexibility to recall lent stock and quickly sell it. As for ETFs, units can be redeemed when authorized participants submit them to the ETF manager in return for underlying stock. So an ETF manager is limited in their ability to lend out stock on a long term basis lest they are unable to fulfill requests from authorized participants. Because ETFs and mutual funds can only lend on a callable/short-term basis they must content themselves with a correspondingly low return on lent stock.

As one of the only actors in the equity ecosystem with a long-term pool of pre-committed stock-denominated capital, an ED manager is in the unique position of being able to make non-callable term stock loans. Put differently, redemption of EDs is distant and certain, so only an ED structure allows for the perfect matching of long term assets with long-term liabilities. This means EDs should enjoy superior stock lending revenues, more than offsetting the costs of running the ED.

Say that an ED can beat an ETF by around 0.5% a year thanks to its superior stock lending returns. That doesn't sound like much, but compounded over a long period of time it grows into a large chunk. For instance,  If you invest $2000 each year for 25 years in an ETF that earns 8%, you end up with $157,900. Place those funds in an ED that returns 8.5% and you end up with $170,700. That's a pretty big difference.

EDs don't exist. But if they did I'd probably sell a significant number of my ETFs and buy EDs. I could imagine putting 20% of my savings in a 5-year S&P 500 ED, for instance. What about you?

PS: Feel free to torture test this idea in the comments
PPS: It is very possible that this product already exists.
PPPS: The devil is in the legal details.

Related posts:

An ode to illiquid stocks for the retail investor 
A description of the moneyness market 
If your favorite holding period is forever 
Beyond Buffett: Liquidity-adjusted equity valuation 
Liquidity as static 
No eureka moment when it comes to measuring liquidity

Sunday, January 3, 2016

What makes money special, the lawyer's edition (with a guest appearance by bitcoin)

Juan Galt recently introduced me to one of bitcoin's biggest problems. Bitcoin is not money, at least not according to the law.

Economists like to say that money is unique because it is a medium of exchange, store of value, and unit of account. Lawyers and judges have a different story to tell about money's uniqueness. Unlike goods, money can't be 'followed.' When a good is exchanged, its entire history goes with it. This history may be checkered. Say that a car has been stolen at some point in its past and then sold, and the police discover this fact. The current owner—though having purchased the car innocently—is required to return it to its rightful owner. The law 'follows' goods.

With money things are different. Each time a monetary instrument is transferred, its history is wiped clean. As long as the recipient accepts the money in good faith, the original owner of stolen dollars cannot make a claim for those dollars.

This peculiar legal treatment of money, dubbed money's liability limitation by Steve Randy Waldman, ensures fungibility. When all members of a population can be perfectly substituted for each other, than we say that they are fungible. If each monetary unit's unique history becomes a datum that merchants must take into account before selling a good, then fungibility no longer prevails. One unit may be worth more than another because its history is more pristine.

Fungibility is important because it promotes the smooth functioning of a monetary system. If merchants have to analyze each piece of money they are offered to ascertain its legitimacy, long lineups will develop. Exchange grinds to a halt.

So why not extend the status enjoyed by current forms of money to bitcoin? What follows is a quick tour through the history of how jurists have rationalized the legal treatment of other forms of money, including coins, banknotes, and bills of exchange. This should provide us with enough grist to analyze bitcoin's current legal status.


Let's start with coins. The basic principle of nemo dat quod non habet governs property; no one can give away that which they do not have. According to early common law jurists, coins were exempt from nemo dat because they couldn't be followed. The inability to follow coins arose from the fact that they were homogeneous. In the words of the jurists of the day, 'money has no earmark.' Whereas one pig could be differentiated from another thanks to the practice of earmarking—cutting out a distinct piece from a pig's ear—coins could not be earmarked, and therefore could not be differentiated.

Thus there was no way for a victim to lay claim to lost or stolen coins. With no way to prove that the coins in the accused's pockets had not already been there, mixed coins could not be sufficiently distinguished to establish title. James Fox, for instance, cites a 1614 case in which a gambler, Warde, "thrusts" his coins into the stack of another gambler, Aeyre, perhaps hoping to get a tell from of his opponent. Aeyre refuses to give the coins back. The judge upholds Aeyre's rights to the entire stash since money has no earmark, and therefore nemo dat does not apply. Once mixed, who ever possesses the pile of coins has the best title.

Interestingly, the only way to preserve ownership of coins in the medieval era was to keep them in a bag. Since they could now be identified by the distinctiveness of their container, like any other good they were subject to nemo dat. Had Aeyre's coins been bagged, he could have easily mixed them with Warde's without losing title to them.

The fact that coins had no earmark meant that each piece's distinct past was irrelevant. While this was awkward for poor Aeyre, society was made better off by this decision. Coins became much more fungible than they otherwise would have been, and this would have dramatically promoted their use in trade, greasing the wheels of commerce in general.


Let's move on to paper credit, namely bills of exchange and banknotes. While bills of exchange developed in the 12th or 13th century, the first notes would not have appeared in England until the 17th century. Though English common law was useful for land disputes, it had not yet developed the expertise to deal with commercial disputes. Indeed, common lawyers' expertise with commercial matters was so limited that Josiah Child, an English trader, complained that he could only make his lawyers understand "one half of our case, we being amongst them as in a Foreign Country."

Rather than resorting to common law, problems arising from the usage of negotiable instruments like bills were governed by lex mercatoria, or merchant's law, a private form of commercial law or custom that had been developed by European merchants over the preceding centuries. Market courts, operated by the merchants themselves, guaranteed a decision the day after a complaint, a necessity given the mobile nature of commercial life.

According to Lowry, the close-knitted nature of the merchant class began to unravel by the end of the seventeenth century, making merchant law less enforceable. As commercial cases were increasingly brought to common law courts, jurists had to decide how to treat these new financial innovations.

Lex mercatoria had always accepted the principle that, as in the case of coins, bills of exchange could not be followed. Since those who accepted bills of exchange didn't have worry about whether they had been stolen or not, this would have made trade in bills of exchange extremely fluid. However, the stance taken by lex mercatoria was an anathema to common law logic. Unlike coins, which couldn't be followed due to their lack of earmark, both bills of exchange and banknotes did have earmarks. Whereas coins were issued in uniform denominations, bills of exchange were usually made out in non-standard ones, say $101.50, making for easy identification. Bills were also signed by a unique debtor and a range of consignees. As for banknotes, these had serial numbers on them. Without the homogeneity of coins, there seemed to be no way to save the these relatively new financial instruments from the harsh strictures of common law nemo dat. Goods they were to be, not money.

It was Lord Mansfield, an English jurist, who took on the task of incorporating lex mercatoria into English common law (Adam Back notes a similar case in Scotland). Take Miller v Race, Mansfield's definitive ruling on banknotes in 1758. The note in question had been issued by the Bank of England "to William Finney or bearer on demand" and subsequently mailed to a third party by Finney. Along the way it was stolen and used to buy room and board at an inn, the innkeeper Miller innocently accepting the note. Finney, upon learning of the robbery, asked Race, an employee at the Bank of England, to stop payment of the note, upon which Miller the innkeeper sued Race. If the bill was treated as a regular good, then Finney would have prevailed. However, Mansfield ruled that despite the note having been stolen, Miller had the best title and was allowed to keep it.

In justifying his ruling, Mansfield dismissed as "quaint" the old earmark principle for not following money. Instead, he appealed to the common mercantile practice of the day. Banknotes, wrote Mansfield, are:
not goods, nor securities, nor documents for debts, nor are so esteemed; but are treated as money, as cash, in the ordinary course and transactions of business, by the general consent of mankind, which gives them the credit and currency of money to all intents and purposes. The are as much money as guineas themselves are, or any other current coins that is used in common payment as money or cash. 
The true reason that money cannot be followed, said Mansfield, is upon "the currency of it; it can not be recovered after it has passed in currency." Thus had Finney sued the robber before he had spent the stolen note, he would have succeeded in claiming title since the note had not yet passed into currency. But once Miller accepted it, the note was "in currency" and thus out of nemo dat's reach. In subsequent rulings, Mansfield extended this same protection to bills of exchange, cheques, bonds, and exchequer bills. Any contrary decision would "incommode" trade and commerce, wrote Mansfield. Thus the customs of merchants were transcribed into common law.


So both lex mercatoria and the common law tradition that superseded it accepted the principle that in order to protect commerce, highly liquid instruments should not be subject to nemo dat.  Given this precedent, why not extend this same broad amnesty to modern monetary innovations like bitcoin, Fedcoin, or other digital bearer tokens?

One reason could be that bitcoin hasn't proven itself yet. Whereas bills of exchange and banknotes had been widely accepted for decades, even centuries prior to Mansfield's ruling, bitcoin is less than a decade old. It fails the my-grandmother-uses-it-test or, in Mansfield's words, lacks the "general consent of mankind." People seem more intent on hoarding the stuff than trading it around in the "ordinary course of business." Unfortunately there is a chicken-and-egg dynamic at play here; how can bitcoin gain enough consent to be granted amnesty by the law if it needs amnesty to gain consent in the first place?

Lacking common law amnesty from nemo dat, an alternative would be to modify bitcoin so that it is completely anonymous. Although the real world identity of a bitcoin owner remains unknown, the blockchain is a publicly-distributed ledger that reveals the history of every single bitcoin. A modification that were to remove the ability to see the ledger's history would restore true anonymity. In the same way that coins were originally exempt from nemo dat because they were physically impossible to follow, modern law would not be able to trace any given bitcoin because there would be no means to do so. While true anonymity is typically the dream of a small group of privacy advocates, in this case the motive for anonymity is a commercial one; without fungibility, mass market adoption might never happen. My understanding is that extensions such as Zerocoin or Zerocash would be able to achieve this sort of true anonymity.

The third route is to roll with the punches and accept non-fungibility. If merchants must search each bitcoin's past, they will innovate solutions to cope. One innovation would be to set up a system for grading bitcoin so as to save on transaction time. Tokens that pass a test of authenticity would be accepted at par whereas low grade bitcoin, that which has a soiled history, would pass at a large discount to pure bitcoin. I believe that a few bitcoin grading services have emerged, including Mint Exchange, which sells freshly-mined bitcoin (which are unburdened by a history) at a premium to regular bitcoin.


Let's explore the third route a bit more. There is precedent for non-fungible monetary systems. During the so-called Wildcat banking era in the early to mid 1800s, U.S. privately-issued banknotes of the same denomination (say $1) were often  accepted at varying discounts to par. A $10 note from a the Bank of Talahassee might only be worth 98% that of a $10 note from the Bank of Fargo.

While banking regulations prevented note-issuing banks from establishing branches beyond state borders, nothing kept their notes from circulating outside of their home state. However, for notes to be settled in gold, they had to be returned to the issuing bank. Given the large distances involved and lack of transportation infrastructure, this could be an expensive process. To recoup this cost a merchant would typically accept local notes at par while applying discounts to non-local notes. The discount acted as a fee that covered the merchant's transportation costs. And since each bank's brand of notes involved different transportation costs, there were a bewildering number of discounts.

To solve the non-fungibility problem, a new profession emerged, that of a banknote analyst. In addition to providing merchants with information on how to spot counterfeit bank notes, an analyst would publish a weekly banknote reporter that advertised the market price of each banknote that circulated in a particular city, say Philadelphia. Gary Gorton provides a visual feel for what one looks like. Philadelphian merchants who subscribed would, upon being proffered a particular note by a customer, consult their reporter and apply the proper discount. I've explained in more depth how this process worked here and here.

While a Wildcat-era sorting mechanism for bitcoins would help merchants cope with the fungibility problem, any sort of grading process would also impose an extra set of costs on the bitcoin system, making it less competitive with banknotes and deposits. The lack of uniformity of U.S. banknotes was recognized to be enough of a problem that the 1864 National Banking Acts required all banks to accept notes at par (it would have been better to allow banks to establish branches across state lines, of course. See George Selgin here).

Uniformity would also be the most efficient solution for bitcoin, but lacking a central authority that can enforce par acceptance, bitcoin may have to endure a period of non-fungibility before the law deems the cryptocurrency popular enough to earn amnesty from nemo dat. That's a low bar to set, but if bitcoin is as good as its proponents say, it should be a bar that can be limbo-ed.


S. Todd Lowry: "Lord Mansfield and the Law Merchant: Law and Economics in the Eighteenth Century" (1973) [link]
Benjamin Geva: "The Payment Order of Antiquity and the Middle Ages" (2011)
Kenneth Reid: "Banknotes and their Vindication in Eighteenth-Century Scotland" (2013) [link]
David Fox: "Banks v Whetston" in Landmark Cases in Property Law (2015)
Tim Swanson: Unable to dynamically match supply with demand (2015)
Nick Szabo: From Contracts to Money (2006)

Saturday, December 26, 2015

'Tis the season for large cash withdrawals

A recent tweet from Matthew Yglesias made me smile:

Inspired, I've updated my December 2012 Merry Cashmas chart showing the annual Christmas and New Year's cash demand spike. See below.

Tipping might certainly be one reason for the annual cash spike, but I'd bet if you look at data from Europe where tipping is not a tradition you'll still see a jump.  Because we can't anticipate all the random events that will arise when we travel long distances to meet our loved ones, we purchase insurance in the form of larger cash holdings. Thus you can see a consistent seasonal spike in currency in circulation in the weeks before Christmas. Those amounts falls heavily in January. Having returned to our regular schedules, insurance against uncertainty is no longer necessary so we redeposit our cash at the bank.

The U.S. Christmas spike has gotten less marked over the years, most likely because of increasing usage of U.S. banknotes in non-Christian countries and by criminals. But you can still pick it out on the chart.

A few differences between my December 2012 post and this one...

Whereas the 2007-2014 period (the light blue line) opened with stagnant U.S. cash demand, the 2015-2022 period (the black line) has shown a return to 1990 growth rates. People want U.S. dollars again.

Why is this? Well, it has nothing to do with interest rates being near their lower bound. Rather, consider that the U.S. dollar had become quite unpopular as a world transactions medium during the 2000s thanks to its steady decline in value relative to other currencies, especially the euro. Once the euro crisis hit in 2011, that changed. Since then, the U.S. dollar has appreciated relative to almost every currency in the world. Along with this, its cachet outside the U.S. has returned. I go over all these factors in this post.

This may be my last post in 2015, so once again, thanks to all my readers, lurkers, haters, and commenters.

My most popular blog posts this year according to number of page views were:

1. The final chapter in the Zimbabwe dollar saga?
2. Why bitcoin has failed to achieve liftoff as a medium of exchange
3. Freshwater macro, China's silver standard, and the yuan peg
4. Sweden and Peak Cash
5. The ZLB and the impending race into Swiss CHF1000 notes
6. A Lazy Central Banker's Guide to Escaping Liquidity Traps
7. Euros without the eurozone
8. Zimbabwe's new bond coins and the demonetization of the rand

...of which, I'd say my Lazy Central Banker's guide is the most important. For some reason no one liked Why Big Fat Greek Bank Premiums, despite the fact that I think I pretty much nailed it. And as usual, I wrote my share of material that, at the time, seemed stellar to the author but upon rereading a few months later, t'was dreck.

My main blog referrers in 2015 were Mark Thoma, FT Alphaville, Marginal Revolution, Chris Dillow, and David Andolfatto. Thanks!

Thursday, December 24, 2015

Was Bretton Woods a real gold standard?

John Maynard Keynes and Harry Dexter White, who contributed to the design of the Bretton Woods system

David Glasner's piece on the gold standard got me thinking about the Bretton Woods system, the monetary system that prevailed after WWII up until the early 1970s.

There are many differences between Bretton Woods and the classical gold standard of the 1800s. My claim is that despite these differences, for a short period of time the Bretton Woods system did everything that the classical gold standard did. I'm using David's definition of a gold standard whereby the monetary unit, the dollar, is tied to a set amount of gold. This linkage ensures that there can never be an excess quantity of monetary liabilities in circulation—unwanted notes will simply reflux back to the issuer in return for gold. When most people criticize Bretton Woods, they say that it lacked such a linkage.

A narrowing redemption mechanism

For a gold standard to be in effect, a central bank's notes and deposits have typically been tied down to gold via some sort of redemption mechanism. In the days of the classical gold standard, central banks didn't discriminate; the right to redeem was universal. Whether black or white, big or small, male or female, you could bring your notes or deposits to a central bank teller and have them be converted into an equivalent quantity of gold coin. Any unwanted notes and deposits quickly found their way back to the issuer.

After 1925, the world adopted a narrower redemption mechanism; a gold bullion standard. Economist and trader David Ricardo had recommended this system a century before as a way to reduce the resource costs of running a gold standard. Gold coins were withdrawn from circulation, and rather than offering to redeem notes and deposits in coin, the monetary authorities would only offer bulky gold bars. This excluded most of the population from redemption since only a tiny minority would ever be wealthy enough to own a bar's worth of notes.

It might seem that this narrowing of the redemption mechanism compromised the gold standard. After all, if too many dollars were created by a central bank, and these fell into the hands of those too poor to redeem for bullion bars, than the excess might remain outstanding rather than refluxing back to the issuer.

But consider what happens if a free secondary market in gold is allowed to operate. Unable to send excess notes to the central bank, less wealthy gold owners can sell them in the free market. This would drive notes to a discount relative to their official price, at which point large dealers will buy them and bring them back to the central bank for redemption in bars, earning arbitrage profits. The free market price is thus kept in line with the central bank's redemption price. So as long as the wealthy and not-so wealthy are joined by a market in which they can exchange together, then a narrower redemption mechanism needn't impinge on the proper functioning of a gold standard.

Anyone who has toyed around with ETFs will know what I'm talking about. Despite the fact that a gold ETF limits direct redemption to a tiny population of investors (so called authorized participants), the price of the ETF will stay locked in line with the market price of gold. Authorized participants earn profits by arbitraging differences between the ETF and the underlying, thus maintaining the peg on behalf of all ETF owners. You don't need many of them; just a few well-heeled ones.

When authorized participants don't do their job

The U.S. narrowed the gold redemption mechanism even further when, in 1934, Roosevelt limited redemption to foreign governments. As long as foreign governments and the public were joined by a market, then excess notes could be sold to these governments and returned to the U.S. for gold at the official price. The free market price and the U.S.'s official price would converge and a gold standard would still be in effect.

Things didn't work that way. After it entered WWII, the U.S. continued to buy and sell gold to governments at $35, but gold traded far above that level in so-called free gold or premium markets in Zurich (see chart below), Paris, Beirut, Macau, Tangiers, Hong Kong, and elsewhere. The existence of premium markets continued through the 1940s and well into the 1950s.

While private dealers have incentives to engage in arbitrage, national governments are driven by political motives. Governments no doubt could have earned large profits by buying gold from the U.S. at $35, shipping it home, and selling it in their domestic free gold markets at $45 or $50, but they chose not to, most likely to avoid raising the ire of American officials.

The monetary system in the 1940s and 1950s was a malfunctioning ETF. For various reason the authorized participants (ie. foreign governments) were not arbitraging differences between the price of the ETF and the underlying, and the ETF was therefore wandering from its appropriate price.

With the redemption mechanism compromised, the supply of U.S. monetary liabilities in circulation could exceed the demand, the result being that the market price of dollars sagged to a discount to their official price. Bretton Woods, with its multiple prices for gold, was not a gold standard, at least not yet.

The London gold market

It was only in 1954 that the so-called "free gold" price in Zurich and elsewhere finally converged with the official price of $35. This happened more by accident than purposeful arbitrage conducted via the redemption mechanism. On the supply side, the Soviets were bringing large supplies of "red gold"  to sell on free markets while the South Africans were diverting more gold away from official buyers in order to earn wider margins. At the same time, the end of the Korean War was reducing safe haven demand.

Source: The Economist

Once parity between free gold prices and the U.S. official price was established, the London gold market reopened for business. London had always been the largest gold market in the world, far eclipsing Paris, Zurich, and the rest. Its re-opening had probably been delayed for face-saving reasons. Given that the Brits and the Americans effectively ran the world's monetary system, they could safely ignore premium markets in Zurich and Paris. But the existence of a British gold price in excess of the official price would have been embarrassing. Upon the market's reopening, British authorities limited the ability of locals to buy on the market (they could freely sell) but put no restrictions on the ability of foreigners to participate in the London gold market.

From the time it opened in 1954 to 1960 the London price was well-behaved, staying locked in line with the official price. In October 1960, however, speculators took over control of the London gold market and sent the price of gold to an intraday high of $40, well above its official price of $35. Rather than arbitraging the market by buying from the U.S. Treasury at $35 and selling in London at $40, foreign central banks stepped aside.

The London gold pool

The authorities' response to the 1960 gold crisis is what finally turned Bretton Woods into a real gold standard, at least in my opinion. While the U.S. had ignored premium markets in the 1940s and early 50s, they couldn't ignore a premium market in their own backyard. At the behest of the U.S., the London gold pool was formed. Under the management of the Bank of England, the pool assembled a gold war chest with contributions from the U.S., U.K., Germany, Holland, France, Italy, Belgium, and Switzerland. Whenever gold rose above $35.20, the pool sold gold on the London market in order to keep the price steady. When it fell to $34.80, it bought in order to support the price. The existence of the pool was never officially declared, but everyone knew it was in operation and had the task of setting the London gold price.

This effectively created a functioning gold standard. Before, the only mechanism connecting the public's excess dollars with the U.S.'s gold was the somewhat unpredictable predilection of foreign governments to buy that excess and exercise the right to return it for redemption. Now the public could deal directly with the U.S. government by selling on the London gold exchange to the U.S.-led London gold pool, which guaranteed a price of at least $35.20.

And as the chart below shows, the pool worked pretty well for the next few years, keeping the price of gold in a narrow range. However, the devaluation of the British pound in 1967 and the departure of the French from the gold pool shook confidence in the $35 peg. The system imploded in March 1968 when a steady jog into gold accelerated into an all out run. Rather than continue to bleed gold to speculators, the London gold pool disbanded and the price of gold in London shot up to over $40, well above the official price of $35.20.

But from 1961 to 1968, the world pretty much had a gold standard. Or, put differently, thanks to the opening of the London gold market and the arming of the London gold pool, the world's monetary system between 1961 and 1968 did pretty much everything that the  gold standard of the 1800s did. After 1968, the U.S. dollar slid back into its earlier Bretton Woods pattern of having more than one price in terms of gold; the $35 official price and the "free" London price. This was no gold standard. When Nixon famously dismantled the already-narrow redemption mechanism in 1971, most of the damage had already been done.

Saturday, December 19, 2015

The desert dollar industry

January 1, 2021

Jessie Smith, who owns a dusty motel in Beowawe, Nevada, had to turn away customers yesterday. No vacancy, Smith told the recent arrivals, the first time she has uttered those words since she bought the motel twenty years ago.

These days, the desert is swimming in cash... literally. Over the last six months, a booming business in illegal cash storage has sprung up in Nevada, New Mexico, and Arizona where analysts estimate that $30 billion worth of $100 notes have been hidden. By day, smugglers drive deep into the desert, SUVs loaded down with suitcases full of Ben Franklins. Once they've found an ideal spot, they wait till the sun goes down and frantically dig a hole, only to drive away the next morning with nothing but the cache's GPS coordinates and a drone or two to guard it. When asked about the sorts of people staying at her motel these days, Smith shrugs. "I don't ask who they are and they pay cash."

This is life in the Great Deflation. What began as a steady disinflation early last decade (a decline in the global rate of inflation) slowly turned into all out deflation by the turn of the decade. In response, central bankers around the world simultaneously increased their inflation targets from 2% to 4% and fully re-loaded their quantitative easing programs. To their embarrassment, consumer prices only continued to decline, crescendoing into what the press has dubbed hyperdeflation; annual global price declines of 2-3%. The Fed is currently in its fifth round of QE and, along with most central banks, has kept its key interest rate at the effective lower bound of -1.25% since 2019. To no avail.

Consensus among central bankers is that -1.25%, and not 0%, is the lowest interest rate that the public will endure before converting deposits into 0%-yielding cash. This level emerged as the consensus when the Swiss National Bank reduced rates to -1.5% back in 2018. A stampede into Swiss banknotes ensued. When the Bank dialed the rate back to -1.25%, the Swiss public re-deposited notes back into their bank accounts. Since then, no central banker has dared reduce rates below this magic level. If they did, they'd risk losing control of monetary policy (as if they haven't already) as well as causing a run on the banking system.

But wait. The world's newest monetary experiment is about to be unveiled...

Throughout 2019 and 2020 the world's monetary architects have been steadily dismantling effective lower bounds in many large economies, giving central bankers, until now stuck at -1.25%, the ability to reduce interest rates deep into negative territory. Many say that the world is on the cusp of something so new that we don't even have a word for it. The opposite of disinflation (disdeflation?), the dawning phenomenon of gradually declining deflation is being dubbed by the econblogosphere the Great Reflation. Some are forecasting that we'll soon be moving back up to -2 or -1% deflation... maybe even zero.

The Europeans started to dismantle their lower bound in 2019. They did so by having the ECB cancel all 500, 100, and 50 notes, leaving only the lowly 20 to circulate as the eurozone's highest denomination bill. And when a new 20 euro note was issued in January of last year, the ECB doubled its surface area from 72x133 mm to a cumbersome 108x200 mm. A standard suitcase now only fits half as much raw value, thus burdening noteholders with extra storage and handling costs. Even when folded in half, a single 20 note no longer fits snugly into a pocket. Which means that when the ECB drops rates into deeply negative territory (which it is expected to do at its next meeting), the European public probably won't bother converting deposits into clunky cash.

The U.S. was soon to follow. Unlike Euro notes, American bills are 70% cotton. So when the Fed first floated the possibility of removing $100 and $50 denominations from circulation last year, the cotton lobby exerted enough pressure that Fed officials decided to rethink their strategy. Instead of withdrawing $100s and $50s, the Fed asked Congress to make mass cash storage illegal. As of July 2020, any member of the public caught holding more than $1000 in bills risks having their stash confiscated, with corporations and financial institutions facing cash limits of their own. In theory, this should allow the Fed to set deeply negative interest rates.

Which explains why Nevada's deserts are being punched full of holes. The $1000 limit, combined with the possibility of deeply negative rates next year, means that storage of 0%-yielding paper has the potential to be incredibly profitable. To combat the so-called desert dollar industry, the U.S. Secret Service's counterfeit currency team has been retasked with patrolling vast empty patches of desert. So far their raids have had mixed success; smugglers have been diverting their hoardes across the border into Mexico or Canada. New legislation is being tabled to restrict cash exports and should be passed later this month. In any case, the significant costs that smugglers face in evading the Secret Service means that the Fed should be able to safely bring rates to -3% or so at its next meeting without facing mass flight into paper dollars.

Despite having dismantled its lower bound, the Fed held back from a rate cut at its recent policy meeting. Why? There is a growing faction in the Fed that says that reducing interest rates could very well prove disastrous. Not only would a cut not stoke inflation, it could exacerbate the existing hyperdeflation. To replace hyperdeflation with inflation, you need to raise interest rates, not drop them, claim members of this faction. Ratchet the interest rate up to 3% and arbitrage dictates that a gentle inflation will be restored. After all, if the Fed is compensating investors with a 3% return on its highly-liquid risk-free liabilities, then those investors will be content with an expected decline in the purchasing power of those liabilities, say a 1-2% inflation.

Once a taboo idea, the ongoing inability on the part of central banks to reign in deflation has brought this sort of turn-the-wheel-left-to-go-right thinking into vogue. Not only are central bankers finding it increasingly difficult to understand their traditional interest rate tool—it may not do what they always thought it did—but bond traders have been thrown into confusion. For years, the ECON 101 courses they learnt in college taught them that a reduction in interest rates leads to higher prices, not lower ones. Now they're not sure.

Jessie Smith, however, is 100% sure where she casts her lot; whichever direction keeps the cash flowing into Nevada. She's hoping that the Fed plunges rates to -5% next year, which would only increase her customers' incentives to store cash. As for a hike back into positive territory, the thought makes her shudder. Why hold 0% cash when you can earn 2 or 3% in the bank? Nevada's desert, now full of cash, would rapidly return to normal, and Smith's hotel would go back to having vacancies again.