Grexit: An Escape to More of the Same

The upcoming Greek election has renewed interest in the idea of Grexit. This option is often presented to the Greek public as desirable given that it would restore an independent monetary policy to the nation.

Beware, this is dangerous advice. The euro isn't a glove that you can take on and off, it's a Chinese finger trap; once in, it's tricky to get out. Even if Greece were to formally leave the euro, odds are that it would remain unofficially euroized, leaving it just as bereft of an independent monetary policy as before. The real trade off in a Grexit-or-not scenario is between formal membership in the euro with some say in monetary policy, no matter how small, or informal membership without any say whatsoever.

The optimists, say someone like Hans-Werner Sinn, advise the Greeks to leave the euro and adopt a new currency. The value of this new drachma would immediately collapse. As long as prices in Greece are somewhat sticky, Greek goods & services will become incredibly competitive on world markets, spawning an export/tourism-led recovery. By staying on the euro, however, Greece forfeits the exchange rate route to recovery. Instead, Greece's competitiveness can only be restored via a painful internal devaluation as wages and prices adjust downwards.

While the optimists tell a good story, they blithely assume a smooth switch from the euro to the drachma. Let's run through the many difficult steps involved in de-euroization on the way to an independent monetary policy. All euro bank deposits held at Greek banks must be forcibly converted into drachma deposits, and speedily enough that a bank run is preempted as Greeks desperately try to evade the corral by moving euros to Germany. At the same time, the Bank of Greece, the nation's central bank, needs to issue new drachma bank notes, the public being induced to use these drachmas as a medium of exchange.

Now even if Greece somehow pulls these two stunts off (I'm not convinced that it can), it still hasn't guaranteed itself an independent monetary policy. To do so, the drachma ₯ must also be adopted as the unit of account by the Greek public. Not only must financial markets like the Athens Stock Exchange begin to publish stock prices in drachmas, but supermarkets must be cajoled into expressing drachma sticker prices, employees and employers need to set labour contracts in terms of drachmas, and car dealership & real estate prices need to undergo drachma-fication.

Consider what happens if drachmas begin to ciruclate as a medium of exchange but the euro remains the Greek economy's preferred accounting unit. No matter how low the drachma exchange rate goes, there can be no drachma-induced improvement in competitiveness. After all, if olive oil producers accept payment in drachmas but continue to price their goods in euros, then a lower drachma will have no effect on Greek olive oil prices, the competitiveness of Greek oil vis-à-vis , say, Turkish oil, remaining unchanged. If a Greek computer programmer continues to price their services in euros, the number of drachmas required to hire him or her will have skyrocketed, but the programmer's euro price will have remained on par with a Finnish programmer's wage.

As long as a significant portion of Greek prices are expressed in euros, Greece's monetary policy will continue to be decided in Frankfurt, not Athens. Should the ECB decide to tighten by lowering interest rates, then Greek prices will endure a painful internal deflation, despite the fact that Greece itself has formally exited the Euro and floated a new drachma.

We know that a unit of account switch (not to mention successful introduction of drachma banknotes) will be hard for Greece to pull off by looking at dollarized countries in Latin America. To cope with high inflation in the 1960s and 70s, the Latin American public informally adopted the U.S. dollar as an alternative store of value, medium of exchange, and unit of account. Even after these nations' central banks had succeeded in stabilizing their own currencies, however, dollarization proved oddly persistent. This is referred to as hysteresis in the economics literature. Economists studying dollarization suggest that network externalities are the main reason for hysteresis. When a large number of people have adopted a certain standard there are significant costs involved in switching over to a competing standard. The presence of strong memories of past inflation may also explain dollar persistence.

In trying to de-euroize, Greece would find itself in the exact same shoes as Latin American countries trying to de-dollarize. Greeks have been using the euro for 15 years now to price goods; how likely are they to rapidly switch to drachmas, especially in light of the terrible performance of the drachma relative to other currencies through most of its history? Those few Latin American countries that have successfully overcome hysteresis required years, not weeks. If Greece leaves the euro now, it could take decades for it to gain its own monetary policy.

As an alternative illustration of the power of network externalities, consider the multi-year plans made by Slovakia (pdf, fig 2) prior to switching over to the euro, or the Czech Republic's timeline when it makes the changeover. Each step must be broadly communicated and telegraphed long ahead of time so as to ensure that all members of a nation are properly coordinated, thus ensuring the network effects engendered by the incumbent currency can be overcome. These euro changeover plans weren't adopted a few days before the switch, but often as much as a decade before.

In sum, I fail to understand how Greece can ever expect to enjoy the effects of a drachma-induced recovery if the odds of drachma-fication or so low, especially given the sudden nature of a Grexit. At least if it stays part of the euro, Greece has a say in how the ECB functions thanks to the Bank of Greece's position in the ECB Governing Council. And at least Greece's inflation rate and unemployment rate will be entered into the record as official data worth considering by ECB monetary policy makers. For just as the Federal Reserve doesn't consider Panamanian data when it sets monetary policy (Panama being a fully dollarized nation), neither would the ECB care about Greek data if Greece were to leave the euro, though still be euroized.

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Basil Halperin responds.

No, Swiss National Bank shareholders are not pulling the strings

Swiss National Bank share certificates

Gavyn Davies blames the Swiss National Bank's corporate structure for the floating of the Swiss franc. Paul Krugman intimates the same, as does Cullen Roche. Here is Davies:

But the SNB is 45 per cent owned by private shareholders, many of whom are individuals, who receive dividends from the SNB. The rest is owned by the cantons, which have been complaining recently about insufficient cash transfers from the SNB.

Davies goes on to say that the influence of shareholders, combined with the peg, means that the SNB is particularly concerned about balance sheet losses. The idea seems to be that currency pegs often result in large balance sheet fluctuations, forcing a suspension of shareholder dividends.

I disagree, as a quick peek at the details shows:

1) The dividend to which Davies attributes so much importance is minuscule. In aggregate it comes out to just CHF 1.5 million per year, or US$1.7 million. Private shareholders, who own just 40.3% of the SNB's shares, are entitled to around 700,000 CHF per year in total. And these crumbs are shared among 2,219 private shareholders, most of whom hold ten shares or less. Are we to assume that these private interests care so much about the possible forfeiture of this trickle of cash (and just for a year or two) that they'd bother marshaling the significant effort required to influence Tommy Jordan, Chairman of the SNB, to drop the fixed exchange rate? Not a chance. These are nickles and dimes we're talking about.

2) Even if the shareholders organized themselves and tried to pressure Jordan, why would Jordan care? Jordan is Chairman of the three member Governing Board, which calls the SNB's monetary policy shots. He is appointed by the Federal Council, Switzerland's federal government, not by shareholders. Nor can the shareholders get him fired, as a quick reading of the National Bank Act reveals. Jordan can only be removed from office by the Bank Council. And while shareholders can elect five members to the Bank Council, the Federal Council, Switzerland's federal government, chooses the other six members, thus monopolizing the process. The upshot is that SNB shareholders have been neutered and exercise no control whatsoever over Tommy Jordan's thought process.

3) As for the interests of the Cantons, Tony Yates deals with them here.

I'm not sure why everyone is making such a big fuss of the SNB's corporate structure—it's hardly unique among central banks. The Federal Reserve, for instance, is 100% owned by private banks. We never worry about U.S. banks having an undue influence of U.S. monetary policy for the same reason we shouldn't worry about SNB shareholders having an influence on SNB policy—their power has been legislatively usurped by the government, as a quick reading of the Federal Reserve Act will show.

The deeper question is this: should the SNB (or any other central bank for that matter) take into account potential losses on its asset portfolio? In general, I think that the quality of a central bank's assets *should* be a factor that every central banker considers. If a central bank's assets have permanently ceased to yield enough income to cover the bank's salaries and expenses, then the central bank will have to cover this operating deficit by printing new money. Inflation will rise above target, forcing the central bank to sell assets in order to tighten the money supply. While this momentarily solves the inflation problem, it only further crimps the bank's supply of income-yielding assets and its ability to cover operating costs. A progressively slippier slope of ever more inflationary money printing to cover bills ensues.

This won't be a problem as long as the nation's government promises to recapitalize the central bank once problems emerge, thus topping it up with the resources to pay salaries and restore its inflation targets. Slippery slope avoided. But as I learnt a few years ago when reading a classic paper by Peter Stella, governments have been known to leave their central banks stranded. The Philippines' Bankgo Sentral is the best example of a central bank, the recapitalization it was promised by the government having been perpetually delayed. And as Stella points out, the central bank of Costa Rica has made losses for close to two decades consecutively, impeding the central bank’s ability to achieve low inflation. Prudence dictates a central banker be aware of the risk of being stranded.

All that being said, the SNB is really not at the point of having to be concerned about its operating position. The Bank's recent (and potential) losses are paper losses, not real ones. Bank expenses--including banknote printing, personnel, and overhead--still come out to just several hundred million francs a year, while its investments are providing billions worth of francs in interest and dividends. With Tommy Jordan's CHF 865,000 salary and all other expenses easily being covered, there's no slippery slope here. In sum, it is highly unlikely that the unhitching of the euro was motivated either by shareholder concerns or SNB worries about the effect of losses on its portfolio.

Links: 
Central Banks That Trade on the Stock Market
Does the Swiss National Bank need equity? - Speech by Thomas Jordan, 2011 (HT Vaidas Urba)

The ZLB and the impending race into Swiss CHF1000 bank notes

Two things worth noting:

1. As many of you know by now, the Swiss National Bank (SNB), Switzerland's central bank, just reduced the rate that banks earn on deposits held at the SNB by half a percentage point to -0.75% (from -0.25%). The SNB had only recently instituted a negative deposit rate, having reduced it to -0.25% from 0% this December. The SNB will also be targeting a 3-month LIBOR rate of -1.25% to -0.25%, down from the previous range of -0.75% to +0.25%


2. The SNB issues the world's largest paper bearer note denomination, the hefty CHF 1000 note (pictured above). It's worth around US$1143.

The first is significant because as yet, no central bank has ever brought rates this deep into negative territory. The ECB's current deposit rate is set at -0.2% while Denmark's central bank, the Danmarks Nationalbank (DNB), applied a negative deposit rate of -0.2% on deposits that banks placed with the DNB in 2012. Neither of these top the SNB's ultra-low -0.75% rate.

The second point is significant because neither the ECB nor the DNB issue a note that approaches the real value of the CHF 1000.

Why is the conjunction of these two observations important? In short, we get to observe in real time how tightly the so-called zero-lower bound (ZLB) binds. When a central bank reduces the rate it pays on central bank deposits below 0%, arbitrage dictates that all other short term interest rates will follow along, including rates on government t-bills and insured bank deposits. However, one asset interferes with this adjustment: cash. Cash carries an implicit yield of 0%. If deposits or t-bills are being penalized at a rate of 0.25% per year, there are significant incentives for everyone to convert these assets into zero-yielding paper equivalents in order to avoid the 0.25% penalty. Not only will commercial banks all convert their deposits at the central bank to cash, but the public will clear out their bank accounts in order to hold paper. The upshot is that interest rates can't fall below 0% lest the  entire country turn into a 100% cash economy.

In practice, the 0% bound isn't a tight one since paper currency incurs storage and transportation costs whereas electronic deposits don't. What this means is that a depositor will grudgingly accept a slightly negative deposit rate in order to avoid having to bear the inconveniences of ungainly cash. So the zero lower bound actually lies a bit lower than 0%, let's say -0.4%. However, reduce rates far enough below that and the dash to cash beings.

This is where the CHF 1,000 note comes into the picture. The larger the denomination of paper currency issued by a central bank, the lower the storage and transportation costs. Take CHF 1,000,000 worth of CHF 20 notes. That's 50,000 paper notes. The costs incurred in counting, double counting, checking for counterfeits, packaging, loading into an armoured car, unloading into a vault, paying storage costs on that vault, and finally insuring the hoard will be quite high. Now imagine CHF 1,000,000 worth of CHF 1000 notes. That amount to just 1,000 slim paper notes, a fiftieth of the amount. Handling and storage costs come out to much less. The point being that thanks to the CHF 1,000 note, the zero lower bound binds a bit more tightly in Switzerland than anywhere else in the world.

What I'd expect over the next few months is a mad dash out of deposits into these colourful bits of paper. Luckily, the SNB provides data on its note denominations, which I've charted below going back to 1990.

The value of CHF 1000 denomination notes in circulation. Source: SNB

You can see that in general, the value of CHF 1,000 notes outstanding has grown quite quickly since 1990 and now comprises around 61% of the entire value of the Swiss note circulation. While that tally retreated a bit in 2014, it should start to grow at an above-trend rate in 2015 now that negative rates are in effect. The actual process will go something like this; the Swiss public will ask to convert their bank deposits into CHF 1000 notes, the banks being obliged to provide these notes by going to the SNB and converting their SNB deposits into cash.

If this process doesn't occur, the implication is that the costs of holding 1000 notes are even higher than 0.75% a year, thus giving the SNB even more breathing room to reduce rates.

I'd expect ongoing conversion into 1000 notes to impose a significant burden on the SNB, threatening both the banking system's deposit base and the effectiveness of monetary policy. There are a number of fixes that the Swiss might consider to offset this burden. First, the SNB can bump interest rates back up in order to stem the mania for 1000 notes, hardly an alternative if it is trying to get inflation back up to  its target. Alternatively, the Bank may decide to call in and demonetize the CHF 1000 notes, forcing everyone to accept five CHF 200 notes in its place (an idea discussed here). Since the 200 incurs more carrying costs than the 1000, the conversion into cash will be forestalled and the lower bound will have effectively been loosened downwards. Lastly, the Swiss might consider adopting a crawling peg between cash and deposits, as advocated by Miles Kimball.

The next and last option is the most interesting. When the public asks the banks for CHF 1000s, and the banks ask the SNB for 1000s, the SNB can just say no. In doing so, the SNB will have frozen the quantity of 1000s in circulation.

What will happen next will amount to an instance of Gresham's law. Since a CHF 1000 note is better than five CHF 200 notes due to its lower carrying costs, and 200s can no longer be converted on demand into 1000s thanks to the SNB's freeze, the 1000 should trade in the market at a premium to its face value, say CHF 1012 or 1013. However, legal tender laws typically stipulate that a note cannot discharge debts at more than its face value, thereby resulting in the forced undervalution of the 1000 note in trade. As a result, the Swiss public and its banks will hoard their 1000s rather than spending them, preferring instead make payments and settle debts with lower denominations notes. Thus we get a modern version of Gresham's law, whereby 'good' CHF 1000 notes are driven out of circulation 'bad' lower-denomination CHF notes. Think of it as an unofficial demonetization of the 1000.

Ultimately, I think that this last solution is the easiest and lowest cost alternative for the Swiss to fix their impending problem of mass paper storage at the negative interest rates. It's a temporary fix, however. A permanent solution will require outright demonetization of large denomination notes, or something like Miles Kimball's plan.

Cracks in the zero-lower bound

Shibboleth, by Doris Scalcedo

John Cochrane writes an interesting post that makes the case that removing or penalizing cash would not remove an economy's 0% lower bound. Briefly, the zero lower bound problem arises when a central bank tries to reduce the interest rate on central bank deposits below zero. Because cash always yields a superior 0% yield, everyone will race to convert their deposits into cash, thus preventing a negative interest rate from ever emerging. By removing cash, this escape route is plugged and a central bank can safely guide rates to -4 or -5%.

Cochrane's point is that even if cash is removed, there are a number of alternative 0% yielding 'exits' to which people will flee, the effect being that rates will be inhibited from falling much below 0%. The examples he provides includes prepayment of taxes, bills, and mortgage payments, and the hoarding of gift cars or stored value cards like subway passes. In a follow-up post, he mentions a strategy of rolling over cheques.

There are two points I want to make:

1. Even with alternatives, a central bank can still create inflation

Scott Sumner points out that even in a cashless world at the zero lower bound, the existence of these alternatives cannot impede a central bank from driving up inflation. This is because the other alternative assets that Cochrane discusses are not media of account. To be a medium of account is to be that good which defines the $ unit that appears on a retailer's website and their aisles. What this means is that the the sorts of dollars that a retailer has in mind when setting sticker prices are those issued by the nation's central bank (in a cashless world, this would be central bank deposits). Retailers aren't using gift card dollars or stored value card dollars as the 'reference dollar' for their sticker prices.

Keep in mind that the use of central bank deposits as the medium of account does not preclude retailers from accepting gift cards in payment at the till. However, if they accept them, they'll probably apply some sort of reduction/addition to a good's advertised sticker price. If we assume that gift cards have become quite liquid in the absence of cash, I think it's conceivable that retailers would offer a reduction (ie. take gift cards at a premium) since gift cards would be a better asset than a deposit; in addition to being useful as media of exchange, they yield 0% rather than negative yielding deposits. We could imagine a range of different gift card premia developing based on their perceived quality, with cashiers consulting some sort of electronic guide to calculate the final bill.

In any case, Sumner's point is that as the central bank reduces rates into negative territory, sticker prices will all rise, despite the fact that alternative media exist that can be used to make payments. I think he's dead right.

2. Alternative escape routes will be resolved by simple product alterations, not a legal revolution

Cochrane's posts emphasize that in a negative rate world, all sorts of odd financial loop holes will be exploited in order to earn superior 0% returns. I think he's right on this. However, Cochrane seems to believe that that the government will have to upend 'centuries of law' in order to plug these alternative 0% instruments. I am more sanguine than him. If someone is exploiting a loophole in order to earn a superior 0% return, someone else is bearing that negative return. Institutions forced to bear the negative impacts of these loopholes will have an incentive to quickly evolve simple strategies to plug them, thus precluding any need for either Cochrane's rather dramatic 'legal revolution' or the heavy hand of the government.

Take Cochrane's first 'escape', gift cards. Consider a retailer that issues 0% gift cards in various denominations like $50s and $100s. Assume that in a world without cash, these cards have become relatively liquid. The central bank suddenly pushes rates to -5%. People who own negative yielding bank deposits will flock to buy the retailer's gift cards (assume that both instruments are equally risky) with the goal of immediately improving their expected return from -5% to 0%. The retailer, however, is left holding a -5% asset while owing a 0% liability, an awful position to be in. To remove the burden of this negative spread, our retailer need only reduce the return on newly-issued gift cards to -5%, say be introducing a redemption fee of 5%. A gift card worth $100, when redeemed, now only buys you $95 worth of stuff. Either that or just stop issuing the things. The loophole is closed and the problem solved.

The same goes for Cochrane's other 0% exit, prepayment if bills. A firm that allows for prepayments is accepting a 0% liability on itself; it effectively owes x dollars worth of some service or item. So we are back to our gift card example above, since gift cards are basically prepayments. Impose an appropriately sized fee on those who want to prepay and the problem is solved. Banks have always charged prepayment penalties on mortgages, car loans, and business loans, so this is nothing revolutionary in turning to this solution.

The next of Cochrane's 0% exits is a string of constantly renewed personal cheques. Rather than cashing a personal check, a cheque holder waits for that cheque to go 'stale', usually after 6-months, and then asks the issuer to issue a new one, rinsing and repeating as often as necessary. As physical bearer instruments, cheques (much like cash) cannot be made to pay negative interest, which allows the holder of a cheque to earn a perpetual 0% return. The unfortunate issuer of the cheque is left bearing a 0% liability in a world where their assets are yielding just -5%. This problem will quickly be resolved by people no longer writing checks. There is a less extreme alternative. Banks, unwilling to lose revenues from their cheques businesses, will simply increase cheque cancellation fees. Before a stale check is re-issued, it must be canceled, which traditionally incurs a cancellation fee. If the person running the scheme is required to pay an appropriately sized fee to carry over the cheque, the scheme can be rendered no more profitable than owning a -5% deposit.

Cochrane also points to Kenneth Garbade and Jamie McAndrews's scheme whereby depositors can purchase certified cheques from banks and thereby evade negative rates. According to Garbade and McAndrews, commercial banks "might find their liabilities shifting from deposits (on which they charge interest) to certified cheques outstanding," with this shift imposing significant costs on banks since certified cheques are less stable than deposits. If such a shift were to occur, banks would find themselves bearing a negative spread (liabilities yielding 0% while assets yielding -5%), a position they would be quick to remedy. One option would be to cease the issuance of certified cheques altogether. Alternatively, banks have always charged a fee for certified cheques. They could simply increase this fee to the point that the cost of holding a certified cheque is brought in line with the negative deposit rate. Once again, problem solved.

This fee strategy shouldn't be unfamiliar. It is the mirror image of the strategy adopted by U.S. commercial banks when interest rates were capped during the inflationary 1960s and 70s. Unable to reward depositors with sufficiently high interest rates, banks evaded the ceilings by offering implicit interest in the form of under-priced banking services, say by reducing fees on certified cheques. In our modern era in which deflation is pushing rates towards an equally artificial 0% barrier (in this case arising from the circulation of personal and certified cheques rather than a government imposed cap), all those services that a bank had been underpricing or pricing at market will now be adjusted upwards so that they are overpriced.

In sum, no revolutions here, just markets adaptation via boring old fee changes.

In closing, Cochrane has much more legitimate worries about two other problems: Big Brother and the disproportionate effect on the poor if cash is removed. Agreed, these are big issues. Now it could be that the emergence of cryptocurrencies such as bitcoin solves the Big Brother problem so that there is no role left for cash in preserving anonymity. Let's put bitcoin aside though. The simple answer to both of Cochrane's concerns is that we don't need an outright ban on cash to remove the 0% lower bound. Just adopt Miles Kimball's proposal for a crawling peg between cash and deposits. Kimball's peg is designed in a way that it would impose the same penalty on cash as that incurred by deposits. This would allow central banks to push rates to zero without mass flight into cash, all the while preserving the institution of cash for the poor and those requiring anonymity. (I've written in support of Kimball's plan here and here)

There is also my lazy man's route toward getting below the lower bound (here, here, here). I call it lazy since it's not nearly as complete as Kimball's solution, nor as complicated. Simply withdraw high denominations of bills like $100s, $50s, and $20s. When a central bank sends rates to -3% or -4%, people will balk at fleeing from deposits into $1s, $5s, and $10s since low denominations are very inconvenient to store. That way the poor still get to use cash and the zero lower bound can be breached.

Cashing up the system

David Beckworth had a very interesting pair of posts outlining how QE would only have had a meaningful effect on the economy if the associated monetary base growth was permanent.

One addendum I'd add on the topic is that even permanent expansions of the monetary base can have no effect on the economy. The best example of this is the "cashing up" of the Reserve Bank of New Zealand (RBNZ) in 2006, an event that doesn't get the attention that it deserves in monetary lore.

Banks typically hold deposit balances at their central bank in order clear payments with other banks. Because New Zealand's clearing and settlement system was suffering signs of stress in the mid-2000s including delayed payments, hoarding of collateral, and increased use of the RBNZ standing lending facilities, the RBNZ decided to 'flood' the system with balances to make things more fluid. This involved conducting open market purchases that bloated the monetary base (comprised of currency plus deposits) from around NZ$6 billion in mid-2006 to just under NZ$14 billion by December of that year. See chart below.

 (Note that the RBNZ's problems began far before the credit crisis and were due entirely to the peculiar structure of the clearing system, not New Zealand's economy.)

This 'cashing up' of New Zealand's monetary system was fast, large, and permanent, so New Zealand should have experienced extremely high inflation, right? Actually, New Zealand's inflation rate was very reasonable and even declined a bit that year.

Why is that? As long as central banks are allowed to provide interest payments to depositors, permanent increases in the monetary base needn't have much of an effect on the economy. Like most modern central banks, the RBNZ pays interest to commercial banks that keep balances on deposit at the central bank. So even if a central banker permanently amps up the supply of balances, banks will not all simultaneously try to offload this excess supply and hyperinflation does not follow. This is because the deposit rate 'carrot' that is dangled in front of banks helps offset their urge to get rid of the excess. In fact, even as it was cashing-up the system the RBNZ increased its deposit rate by 5 basis points five times between July and October 2006 for a total increase of 25 basis points, a slight tightening of monetary policy. This brought the return on central bank balances to a level competitive with other assets like government treasury bills. Instead of panicking as the monetary base permanently exploded by 150%, New Zealand's banks shrugged and calmly accepted the new balances.

When central banks don't pay interest on deposits then a permanent increase in the base will typically have a large effect on the economy. Without an interest rate carrot to make deposits competitive with other assets, banks that are faced with large excess balances will race to get rid of them, causing a large spike in the price level. With the U.S. Federal Reserve only earning the legal right to pay interest in 2008, there are now no major central banks (to my knowledge) that lack their own deposit rate carrot. And all of them set that rate to be roughly competitive with the rate on other short term assets like treasury bills, specifically a few basis points below the rate on competing assets.

Just to make sure I've made my point, with the deposit rate on central bank balances being (almost) competitive with other assets, a permanent doubling in the supply of money will only cause significant inflation when combined with a large cut to the deposit rate. Keep that rate unchanged and the same doubling will only have a marginal effect on the economy. A doubling in the supply of money would actually be deflationary if combined with a large enough rise in the central bank's deposit rate. In short, central bank decisions about the deposit rate can override whatever permanent changes are made to the money supply.

Beckworth makes the case that the Federal Reserve's quantitative easing was never more than a temporary measure, and therefore had no meaningful effects on the economy. I agree with him that QE didn't have much of an effect, but not necessarily because it was temporary. Let's say that QE was not a temporary phenomenon but rather more akin to a permanent New Zealand-style 'cashing up' of the system. If so, would QE's effects on the economy have been more marked? Given the precedent set by New Zealand in 2006, I don't think so. Throughout the Fed's three QEs, the rate offered on Fed balances (generally referred to as interest on reserves, or IOR) was very competitive with the rate on other government-issued short term assets, and therefore banks would have been unlikely to feel any need to rid themselves of their rapidly growing pool of balances. So while I agree with Beckworth that the Fed's 'dirty little secret' is that QE was muted from the start, I don't think that this powerlessness necessarily hinges on QE being temporary—after all, permanent increases can fall on deaf ears, depending on the level at which the central bank's deposit rate is set. New Zealand is living proof of this.


PS. This isn't a gotcha post. Beckworth has mentioned this stuff before.

PPS. I'm not sure whether he'll agree with the following, though. Take the RBNZ again. It's 2006  and the Bank is paying a competitive rate on central bank balances. When it cashes up the system, the RBNZ simultaneously announces a regime change; it will now target 4-6% inflation rather than 1-3% inflation. It also says that the permanent increase in the supply of balances (and subsequent increases if necessary) will be sufficient to ensure this target is reached. The threat of a lower deposit rate will not be used to enforce the target, the rate being left unchanged. Will the RBNZ manage to hit its new target? I say no. Despite a regime change and a commitment to permanent open market operations, the Bank won't succeed in doubling inflation. This is because the unchanged deposit rate will be set too high, interfering with the RBNZ's ability to carry out its promise. 

References:
Review of the Reserve Bank of New Zealand's Liquidity Management Operations - A consultation paper, March 2006 [link]
Doubling Your Base and Surviving. Anderson, Gascon, Liu [link]
RBNZ 2007 Annual Report [Link]

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...and on a totally unrelated note, Happy New Year!

These were my top five visited posts in 2014, as measured by Google.

1. Fedcoin
2. Draghi's fake zero-lower bound and those pesky €500 notes
3. Is the value premium a liquidity premium?
4. Gilded Cage
5. Gresham's law and credit cards

Fedcoin, which I think the internet overrated, got picked up by Ycombinator, while Draghi's fake zero-lower bound and Is the value premium a liquidity premium (both much better than Fedcoin) were tweeted by Joe Weisenthal, spreader of ideas extraordinaire. Gilded Cage demonstrates the fact that people tend to prefer posts that attack individuals or groups of people and, finally, Gresham's law and credit cards is just plain awesome  ;)

Two of my favorite posts that went pretty much under the radar screen were Fear of Liquidity and Liquidity Everywhere. Ignoring the fact that these titles sound like adverts for diapers, do give them a read.

Thanks to all you who comment on this blog. It's always fun to read your thoughts, they get me thinking about the next post.

JP

Robin Hood central banking

Robin Hood, N.C. Wyeth, 1917

There were plenty of reports in the press this year accusing central banks of behaving like King John, stealing from the poor to help the rich. Rich people's wealth tends to be geared towards holdings of stocks and bonds whereas the poor are more dependent on job income. By pushing up the prices of financial assets, central bank quantitative easing helped rich people while leaving the poor in the dust.

There are a lot of problems with the King John critique of quantitative easing.

First, a good argument can be made that QE had almost no effect on prices. Insofar as purchases were considered temporary by market participants, then the newly created money would not have been spent on stocks and whatnot, its recipients preferring to keep these balances on hand in order to repay the central bank come the moment of QE-reversal. If so, the large rise in equity prices since 2009 is due entirely to changes in the fundamentals and animal spirits, not QE.

But let's say that QE was not irrelevant and can be held responsible for a large chunk of the rise in equity prices over the last few years. Even then, the real economy, and therefore the poor, would have been equal beneficiaries of QE. As I pointed out in my previous post, financial markets are not black holes. Newly-created money, insofar as there is an excess supply of the stuff, cannot stay 'stuck' in financial markets forever. For every buyer of a financial asset there is a seller, and that seller (or the next seller after) will choose to do something 'real' with the proceeds, like buying a consumption good, investing in real capital, or hiring an employee—the sorts of purchases that benefit the poor. So if QE succeeded in pushing up financial markets (thus helping the rich), then the real economy (and the poor) must have benefited just as much. The King John argument doesn't hold much water.

But wait a minute. If both financial markets and the real economy were equally inflated by QE, then why have wage increases been so tepid relative to equity prices? One explanation is that wages are sticky whereas financial prices are quick to adjust. The relative wealth of the poor, comprised primarily of the discounted flows of wage income, stagnates, at least until wages start to catch up at which point it is the turn of the the relative wealth of the rich to decline.

Can we right this short-term wrong? Even if we try to convert central banks from being King John central banks into Robin Hood ones, things wouldn't change. Say we change where central banks inject new money. Instead of conducting QE with a select group of banks, central banks now purchase directly from the populace. And instead of buying financial assets, they bid for stuff that regular folks own, like cars, houses, and wedding rings. The moment Robin Hood QE is announced, the same effect occurs as when King John QE is announced: the prices of financial prices will be the first to jump. This 'injustice' occurs even though the counterparties to Robin Hood QE are all too poor to play the stock market and the items being purchased from them are not financial assets. Consider that a impoverished recipient of new funds may use them to purchase something at a grocery store, and the owner of that store may in turn use the proceeds to buy new inventory, and the farmer producing that inventory could use the funds to buy seed, etc etc. Someone along this line will eventually purchase shares. However, stock markets participants don't wait for this excess money to flow into stock markets before marking up prices; they adjust their offers ahead of time upon the expectation of excess money being used to purchase stocks. Robin Hood QE or not, the relative wealth of the rich is the first to rise thanks to flexible financial prices, at least until sticky wages start to catch up. This isn't the fault of central bankers, and there's no way they can restructure their operations to promote short-term equality in wealth.

How long can this short-term inequality last? I can't see it lasting longer than a year. Maybe two. But we've seen so many years of QE now that I don't think we can attribute the gap between the rates of increase in stock prices and wages to stickiness. The most likely explanation is the one in my third paragraph: on the whole, QE has done very little to affect prices, whether they be financial or not. Wages have been stagnant because QE is irrelevant, or at least close to it, and the S&P 500's rise from around 700 to 2090 has been by-and-large achieved of its own accord. Without QE, where might the S&P be? Maybe 2060, or 2065?

Central banks aren't like King John, nor is there anyway we can turn them into Robin Hoods.

Speculative markets are not black holes

Marc Faber is a very knowledgeable guy, but thumbing through a copy of his most recent Gloom, Boom, & Doom Report, I stumbled on a pretty big error. Here is Faber:

"All the liquidity that central banks have created isn't flowing into the real economy but remains in asset markets (mostly financial markets) buying and selling currencies, bonds, stocks, real estate, art, entire companies, etc. For example, most corporations find it advantageous to buy back their own shares (in order to boost their share prices) instead of investing in new plant and equipment... Or take wealthy individuals as another example. Most of them invest in stocks, bonds, funds or real estate; very few of them go out and build businesses. Private equity funds do the same: instead of building new businesses, they tend to buy existing assets." 

and later on:

"I believe that as long as savings and newly created fiat money flow into booming and speculative asset markets, real economic activity will remain depressed."

Faber is repeating a very old fallacy that goes something like this: new money and credit can stay tied up in financial markets indefinitely. This unproductive absorption of capital by speculators in turn prevents the real economy from benefiting. New buildings and factories go unbuilt, consumer goods go unsold, and cutting- edge technology goes undeveloped because the stock market 'sucks up' all the money.

Marc Faber styles himself as an Austrian economist, so he should know that Fritz Machlup, an Austrian 'fellow-traveller', dealt with this particular fallacy in his 1940 book The Stock Market, Credit and Capital Formation (pdf).

In a nutshell, newly-created money (or already existing money) that flows into stock and bond markets does not enter a financial black hole. For every buyer there is a seller. By definition, money will flow away from the market on which it is spent just as quickly as it enters it.

Here is the argument in more depth. Say that Frank (for lack of a better name) invests fresh money in a new issue of corporate shares. These funds don't fall into an abyss. Rather, the issuing company now owns them and uses them to build a factory. Faber would approve since machinery is being created from scratch.

But even if Frank uses the new money to buy already-issued shares rather than newly-issued shares, these funds don't get sucked into a vortex. They are now held by the seller of the used shares, Tom. And the moment Tom uses these funds to buy a car or invest in his home business, they are released into the real economy.

Of course, Tom might simply reinvest the funds earned on the sale in another stock or bond. But this changes nothing since an entirely new seller, Sally, comes into ownership of the funds. Like Tom, Sally might choose to invest it in real capital or on consumption, the real economy enjoying the benefits. Or she might choose to reinvest in the stock market, selling to Harry, and so on and so on. But even if the next ten or twenty recipients of Frank's newly-created money all choose to reinvest those funds in equities, the stock market is nothing akin to a black hole. At some point along the chain the money will inevitably arrive in the account of an investor who chooses to dispatch it to the so-called real economy by either purchasing consumption goods, services, or some sort of industrial good. Though the chain along which this money might travel can include many people along the way, when it finally exits only a few financial heartbeats will have passed.

So in sum, contra Faber money and credit cannot be held up inside speculative markets. It doesn't take long for it to be spent into the real economy.

For those who like to keep track of these things, the 'financial black hole' myth is related to the 'idle cash on the sidelines' myth, dealt with ably by John Hussman many years ago. In the 'sidelines' story, money sniffs its nose at the market and stays at the edge of the dance floor only to have a sudden change of heart, subsequently flooding the stock market. But as Hussman points out, when you put your cash on the sidelines to work in the stock market, it becomes someone else's cash on the sidelines. Both the black hole and sidelines stories are wrong because money doesn't disappear when it is spent. Rather, there is a seller who is left holding the stuff.

Short selling and monetary theory

Jacob Little, legendary short seller.
The Great Bear of Wall Street
1794 - 186

This is a guest post by Mike Sproul







To understand short-selling, start with three words: “Borrow and sell.” The short-seller in figure 1 borrows a share of GM stock from a stockholder and then sells that share of stock to a buyer for $60 cash. If GM subsequently drops to $50, then the short-seller can buy a share of GM on the open market for $50, repay that share to the stock-lender, and profit $10. But if GM instead rises to $70, then the short-seller loses $10, since he must pay $70 to buy the stock before repaying it to the stock-lender.                                                                    

As the short-seller borrows one share of GM, he hands his IOU to the stock-lender. This IOU promises to deliver a share of GM stock. (It would also promise to compensate the stock lender for any dividends missed as a result of lending the stock.) Since the IOU can be redeemed for a genuine share, the IOU will be worth the same as a genuine share. This means that the stock lender does not have much reason to care whether he holds the genuine stock or the IOU (unless he cares about losing his voting rights in the corporation).

Figure 2 shows a simpler way to sell short. The short-seller simply writes up an IOU and sells it directly to a buyer. This kind of short sale gives the same payoff as the “borrow and sell” short sale of figure 1. If GM falls to $50, the short-seller gets a $10 profit, while if GM rises to $70, the short-seller loses $10. This method of short selling is so simple that it can happen by accident. Suppose you're a stockbroker, and a client calls asking you to buy one share of GM for him. You answer, “OK, you got it”, and hang up, planning to deliver the actual stock later in the day. You have just gone short, and you stand to gain $1 for every dollar the stock falls, while losing $1 for every dollar it rises.

A still simpler way to go short is to make a bet with someone, as shown in figure 3. The terms of the bet are that for every dollar GM falls, the buyer pays the short seller $1, while for every dollar GM rises, the short seller pays the buyer $1. The payoffs from this bet are the same as the other two methods of short selling. The bet shown in figure 3 is like a futures trade: There is no actual delivery of GM stock, and gains and losses are settled periodically, including adjustments for dividends. In contrast, the trade in figure 2 is like a forward trade: There is a promise to deliver GM stock, and gains and losses accumulate until the position is closed out.

Some common misunderstandings about short selling:

1. Are these IOUs counterfeit shares? Do they dilute the underlying stock and reduce its value?

No, no, and no. And never mind what Overstock.com CEO Patrick Byrne says. The short seller who issues the IOU puts his name on that IOU, recognizes the IOU as his liability, and stands ready to deliver a genuine share to the holder of the IOU. These are not the actions of a counterfeiter. But suppose there are 1 million genuine shares of GM stock in existence, and that short sellers have collectively issued 2 million IOUs. In a sense, the quantity of GM shares has tripled, and you might expect the share price to fall to 1/3 of its former level. But don't forget that GM did not issue the IOUs, and they are not GM’s liability. They are the liabilities of the short sellers. The issuance of IOUs through short sales does not affect the number of genuine GM shares, nor does it affect GM’s assets, so it can't affect share price. If short selling somehow did put share price out of line with the firm's actual value, then arbitragers would pounce. There will occasionally be liquidity crises when markets break down, stocks are hard to borrow or hard to buy, and arbitrage can't play its usual role; but in normal conditions, arbitrage assures that short selling does not affect share prices. Besides, short selling itself helps to keep markets liquid, and makes these liquidity crises less likely to occur in the first place.

2. What is a naked short?

In figure 1, a naked short would occur if the short seller failed to deliver the genuine share to the buyer within 3 business days. If this happens, the “borrow and sell” short of figure 1 reverts to the “forward style” short of figure 2. The buyer ends up holding the short seller's IOU, rather than the genuine share. If the short seller fails to deliver the genuine share even after an extended period, then the two traders could still settle up with each other in cash or other securities. The “forward style” short of figure 2 would thus revert to the “futures style” short of figure 3. If worse comes to worst and the short seller defaults, then either the stock exchange will make good the loss, or the traders will get a costly lesson in placing too much trust in their fellow man. Sometimes the SEC will step in, and traders will get an even costlier lesson in placing too much trust in the government.

Note that in all three methods of short selling, the dollar payoffs to both traders are identical. This highlights the futility of the numerous restrictions that governments place on short selling in general, and on naked short selling in particular. In the first place, any legal restriction on one type of short selling will only cause traders to switch to a different kind that is not so easily restricted. In the second place, studies show that when governments do succeed in suppressing short sales, markets become less efficient.

3. Short selling and money

When you buy a house, you borrow dollars and then sell those dollars for a house. This makes you short in dollars, just like borrowing and selling GM makes you short in GM (figure 1). Alternatively, you might buy that house by handing your IOU directly to the house seller. This would put you in a “forward style” short position in dollars (figure 2). If you are well known and trusted, then your IOU can actually circulate as money. But normally a bank would act as a broker between borrower and lender, and the bank would issue its own IOU (a checking account) in exchange for your IOU. The bank's IOU will circulate more easily than your IOU, so we commonly talk as if the bank has created money. This is not quite right because the bank is not short in dollars on net. The bank went short in dollars as it issued its IOU, but it took an offsetting long position in dollars when it accepted your IOU. The bank is therefore neutral in dollars, while the borrower is short in dollars. This is why it makes sense to say that borrowers are the original issuers of money, while the banks only help out by putting their name on the money.

It's reasonable to think that short selling of money is governed by the same principles that govern short selling of stocks. Specifically, the fact that short selling of stocks does not affect stock price makes us expect that short selling of money will not affect the value of money. I think this view is correct, but it puts me at odds with every economics textbook I have ever seen. The textbook view is that as borrowers (and their banks) create new money, they reduce the demand for base money, and this causes inflation. This is where things get weird, because the borrowers, being short in dollars, would gain from the very inflation that they caused! Nobody thinks this happens with GM stock, but just about everyone thinks that it happens with money.

If the textbooks are right, then the value of the dollar is determined by money supply and money demand, and not by the amount of backing the Fed holds against the dollars it has issued. For example, if the Fed has issued $100 of paper currency, and its assets are worth 30 ounces of silver, then the backing value of each paper dollar is 0.30 oz/$. But if the money supply and money demand curves intersect at a value of 1 oz/$, then the dollar will supposedly trade at a premium of 0.70 oz/$ over and above its backing value of 0.30 oz/$.

This is where short sellers pounce. They could borrow 10 dollars and sell them for 10 oz. of silver, as in figure 4. As they borrow dollars, the short sellers issue dollar-denominated IOUs that promise to repay $10 worth of assets (ignoring interest). These IOUs can either be used as money directly, or they can be traded for a bank's IOU, which could then be used as money. The proliferation of these IOUs will, on textbook principles, reduce the demand for the Fed’s paper currency, causing it to fall in value, let's say to 0.9 oz/$. Now the short sellers can repay their $10 loan with only 9 oz. of their silver, earning an arbitrage profit of 1 oz. (Note that they don't repay their loan with currency, since buying currency with silver would drive the dollar back up.). The short sellers profited from the inflation that they caused. As the short selling continues, the dollar will continue to fall until it reaches its backing value of 0.3 oz/$, at which point short selling is no longer profitable. (Reality check: Currency traders don't usually deal in silver. A more realistic scenario would have traders borrowing dollars and selling them for British bonds (denominated in pounds). This would reduce the monetary demand for dollars and the dollar would lose value, at which point the traders would swap their British bonds for depreciated US bonds, which they would use to repay their dollar loans.)

So here’s the problem with textbook monetary theory: If you think that money's value is determined by money supply and money demand, and that money trades at a premium over its backing value, then you'd have a hard time explaining how money holds its value in the face of speculative attacks by short sellers. You’d also have to wonder why central banks bother to hold any assets at all. But if you think that asset backing determines money's value, there's nothing to explain. Money's value is governed by its backing, just like stocks, bonds, and every other financial security, and short selling will not affect its value.

On vacation since 2010

On a recent trip to Ottawa, I stopped by the Bank of Canada. The door was locked and the building empty. Odd, I thought, why would the Bank be closed in the middle of a business day? A security guard strolled up to me and told me that the entire staff packed up back in 2010 and left the country. He hadn't seen them since. Bemused I walked back to my hotel wondering how it was that with no one guiding monetary policy, the loonie hadn't run into either hyperinflation or a deflationary spiral.

Exactly 175 months passed between February 1996, when the Bank of Canada began to target the overnight rate, and September 2010, the date of the Bank's last rate change. Some 63 of those months bore witness to an interest rate change by the Bank, or 36% of all months, so that on average, the Governor dutifully flipped the interest rate switch up or down about four times a year. Those were busy years.

Since September 2010 the Governor's steady four-switches-a-year pace has come to a dead halt. Interest rates have stayed locked at 1% for 51 straight months, more than four years, with nary a deviation. I enclose proof in the form of a chart below. Not only has the Bank of Canada been silent on rates, it hasn't engaged in any of the other flashy central bank maneuvers like quantitative easing or forward guidance. In the history of central banking, has any bank issuing fiat money (ie. not operating under a peg) been inactive for so long?

Worthwhile Canadian chart: The Bank of Canada overnight rate target

Now the Bank of Canada will of course insist that you not worry about the lack of activity, its staff is still toiling away every day formulating monetary policy. But maybe the security guard was right. How do we know they haven't all been on an extended four-year vacation, hanging out in Hawaii or Florida? Who could blame them? Ottawa is awfully cold in the winter! With no one left at the Bank to flip the interest rate switch, that's why it remains frozen in time at 1%.

In theory, the result should be disastrous. With no one manning the interest rate lever, the price level should have either accelerated up into hyperinflation or downwards into a deflationary spiral. Why these two extreme results?

Economists speak of a "natural rate of interest". Think of it as the economy-wide rate of return on generic capital. The governor's job is to keep the Bank's interest rate, or the rate-of-return on central bank liabilities, even with the rate-of-return on capital. If the rate of return on central bank liabilities is kept too far below the rate on capital, everyone will want to sell the former and buy the latter. Prices of capital will have to rise ie. the purchasing power of money will fall. This rise will not close the rate-of-return differential between central bank money and capital. With the incentives to shift from money to capital perpetually remaining in effect, hyperinflation will be the result. Things work in reverse when the governor keeps the rate-of-return on central bank liabilities above the rate-of-return on capital. Everyone will try to sell low-yielding capital in order to own high-yielding money, the economy descending into crippling deflation.

In theory, there is no natural escape from these processes. The Bank needs to intervene and throw the interest rate lever hard in the opposite direction in order to pull the price level out of its hyperinflationary ascent or deflationary descent.

By the way, if this is all a bit boring, you can get a good feel for things by playing the San Francisco Fed's So you want to be in charge of monetary policy... game for a while. When you play, try keeping the interest rate unchanged through the course a game—you'll set off either a deflationary spiral or hyperinflation. Be careful, this game can get a bit addicting.

The upshot of all this is that with the Bank of Canada policy team on holiday and the policy rate stuck at 1%, any rise (or fall) in the Canadian natural interest rate is not being offset by an appropriate shift in the policy rate. Prices should be trending sharply either higher or lower.

However, a glance at core CPI shows that Canadian inflation has been relatively benign. Canada has somehow muddled through four years with no one behind the monetary rudder. How unlikely is that? Imagine Han Solo falling asleep just prior to entering an asteroid field only to wake up eight hours later to discover he'd somehow brought the ship through unscathed. We already know that the possibility of successfully navigating an asteroid field is approximately three thousand seven hundred and twenty to one—and that's with Han awake. If he's asleep, the odds are even lower. By pure fluke, each asteroid's trajectory would have to avoid a sleeping Han Solo's flight path in order for the Millennium Falcon to get through.

Success seems just as unlikely for the Bank of Canada. For us to have gotten this far with no one behind the wheel, the return on capital must not have changed at all over the last four years, the flat 1% interest rate thus being the appropriate policy. Either that or the return on capital zigged only to zag by the precise amount necessary to cancel out the zig's effect on the price level. However, I find it unlikely that the economy's natural rate of interest would stay unchanged for so long, or that its zig zagging was so fortuitous as to preclude a change in rates.

Alternatively, it could be that Canadians assume that the Bank is being vigilant despite the fact that the entire staff has skipped town. Even if a difference between the rate of return on capital and a rate of return on money arises thanks to normal fluctuations in natural rate of interest, Canadians might not take the obvious trade (buy higher yielding capital, sell low-yield money) because they think that the Bank will react, as it usually does, in the next period by increasing the rate of return on money. And with no one taking the trade, inflation never occurs. But is it safe to assume that people are willing to leave that much money on the table?

Another possibility is that the traditional way of thinking about monetary policy needs updating. I considered this possibility here. In short, when the return on Bank of Canada liabilities lags the return on capital, rather than a perpetual acceleration developing the price level stabilizes after a quick jump. This sort of effect could arise from central bank liabilities having some sort of fundamental value. Once the purchasing power of these liabilities falls low enough, their fundamental value kicks in, closing the rate-of-return differential between capital and money and preventing a hyperinflation from developing. So even with no one manning the Bank of Canada interest rate lever, the fundamental value of Bank of Canada liabilities provides an anchor of sorts, explaining why prices have been stable over the last few years.

I may as well come clean about the Bank of Canada. They haven't all gone to Hawaii. The real reason its HQ on Wellington Street was shut the day I visited is that it's being renovated. Rest assured the whole crew is hard at work at a temporary spot elsewhere. But does it make a difference? The monetary policy staff may just as well have gone to Hawaii in 2010. With the interest rate lever neglected and rates frozen at 1%, the evidence shows that prices would not have been sent off the rails, despite the fact that returns on capital surely jumped around quite a bit. It's all a bit odd to me.