Buoyant Ireland

Nick Rowe is pessimistic, and points to one of the dreariest articles I've read to date on the Europe situation.

I noticed that Ireland seems to be doing much better than the other peripherals. See the chart below. Its stock market is relatively strong, having outperformed markets in Greece, Italy, and Spain while keeping up to the German DAX. At the same time, Ireland isn't seeing capital outflows anymore. While Greece, Spain and Italy's TARGET2 balance is deteriorating, Ireland's has been improving for over a year. (Note that data is to end of April).

(click here for expanded version)

What are the Irish doing differently? Is Ireland presaging how the other peripherals might be stabilized, or are they just lagging behind?

Note: For one explanation of the difference, see this Allied Irish Bank report (pdf).

Tipsy TIPS spreads

David Glasner noticed a very interesting anomaly yesterday. In short, 5-year TIPS rates seem to be rising while 10-year TIPS have been falling. He encouraged his readers to do some investigating to find out why. See my findings below.

Sproul v Glasner

Some comments on their theoretical differences here.

I think Mike Sproul and David Glasner would agree on 95% of monetary economic propositions, only disagreeing on how fiat money gets its value. David thinks there are two reasons for fiat money to have value: either people are irrational, or fiat money provides a real service - discharging of taxes. The latter is a chartal description of money. Mike has a "backing theory" of fiat money, which I think is broad enough to include the tax-discharge argument. I like Mike's because it is a more general theory. But I don't think the two are very far apart.

To tell them apart, ask this question. "If the US government ceased accepting Federal Reserve-issued liabilities to settle taxes and, say, required gold instead, would the US dollar lose its value?"

I think David and most chartalists would have to say yes. Without the ability to redeem it for taxes owed, the US dollar would be worthless. I think Mike would say no, because as liabilities of the Fed, even fiat money has some sort of claim on Fed assets, and this is enough to give it value.

TIPS: How to decompose the liquidity premium from the inflation-risk premium

Lars Christensen talks about the idea of setting a floor under inflation-linked bonds in order keep inflation expectations at some minimum level. It`s an interesting idea. Here is my comment:

Interesting idea, Lars. One problem here is that the TIPS spread (I’ll use US lingo if you don’t mind) measures not only expected inflation but also the relative illiquidity of TIPS relative to Treasuries. It measures, in part, a liquidity premium.

TIPS might fall to the central bank’s minimum buying price not because inflation expectations have fallen, but because the liquidity of TIPS relative to Treasuries has declined. This change in liquidity could be purely incidental. ie. it could be due to some unimportant technical change unique to Treasury markets. The result would be that the central bank buys up TIPS because it believes inflation expectations have fallen, when in actuality it is the liquidity premium that has changed. According to your rule, the money supply automatically increases, though perhaps it shouldn’t have.

In short, you have to find some way to decompose that portion of the spread between TIPS and Treasuries that is due to the liquidity premium and that which is due to inflation expectations.

It there were publicly traded “liquidity-options” on TIPS, you’d be able price the value of the liquidity premium and use that to back out that portion of the TIPS spread due purely to inflation expectations. Then you could apply your rule more precisely.

In a 2009 speech, FRBNY President William Dudley talks about the illiquidity premium and inflation-risk premium of TIPS here.

Greece is no Argentina

Paul Krugman compares Greece to Argentina. Devaluation in Argentina surely helped, and so would it in Greece. But there's a problem. See my comment:

The comparison to Argentina is a poor one. Argentina's central bank was a fully-operational currency issuer when it lifted its peg, and the peso already circulated along with dollars.

Greece's central bank is currently in-operational as a currency issuer; drachmas simply don't exist.

Should the Bank of Greece try to relaunch itself, will its drachma liabilities be voluntarily accepted as mediums of exchange? Probably not, for the same reason its bonds are worthless. Like the Greek government, the BoG simply has no credit. Compounding this is the fact that already-existing euros circulate in paper form, and the fact that so many Greeks have accounts in German banks they can use for payments. Given this broad array of payments choices, the free drachma will be stillborn.

Nor can drachmas be forced into circulation. A country that can't enforce tax laws can't enforce legal tender laws. No, the drachma won't be reappearing any time soon.

Krugman assumes that the euro is like a glove. You can put it on and take it off easily. In actuality the Euro is more like a Chinese finger-trap. It's easy to put on, but once you're in, getting out is well night impossible. As attractive as devaluation is, that's not the core issue. There simply is no way to get from here to there.

Greece will either stay in the Eurosystem, or will try to leave and end up with euro anyways. The latter is informal euroization.

On the problem of ensuring the acceptability of a new fiat money, see George Selgin.

GDP totalitarianism: Krugman's mischaracterization of Japan's plight as "star performance"

Paul Krugman points to Japan's apparent resurgence in GDP and asks: "There seems to be some kind of lesson here about macroeconomics, but I can’t quite put my finger on it …"

My comment:

The lesson here is that one needs to be careful when trying to understand natural disasters using flow-based identities like Y=C+I+G. The latter fails to account for large draw-downs in national wealth due to, say, tsunamis. Using a stock identity, and stock related data like national net worth, will be more helpful in this situation.

For a proper accounting treatment of Japan's experience, Krugman should refer to the 722 page UN System of National Accounts Manual (pdf). Krugman wants to use the production accounts for his analysis, which are represented as flows. He should be using the wealth account, in particular new worth, which is a stock. The tsunami will have resulted in a large fall in Japan's net worth. This is elementary, so I don't know why a Nobel-prize winning economist wouldn't know this.

I agree with Nick Rowe that GDP has a totalitarian grip on our way of economic thinking.

The free banking alternative to the centralized provision of lender of last resort services

Inspired by Perry Mehrling and Fischer Black:

I think I'd take your future ideal financial model even further (slide 9). The C5 in your model provides what you call liquidity puts. I see no reason why these liquidity puts need be provided by a central bank. In the future, financial products called liquidity options - the option to buy or sell some asset (say Apple stock) at a guaranteed point in the bid-ask spread - would be popular financial products traded on organized exchanges. Just as Apple CDS allow investors to split off Apple credit risk and distribute it across the economy, so would Apple liquidity options split away the liquidity risk of transacting in Apple stock in the secondary market and evenly distribute this risk to those willing and capable of holding it.

A private liquidity options market has some advantages over a monopoly last resort system. Liquidity would be competitively priced and no longer supplied in an opaque manner. Central banks would either vacate the market for liquidity services or price their liquidity products off the private liquidity options market. Subsidies to or penalties on institutions anxious for liquidity insurance would be a thing of the past.

If central banks were to cease providing liquidity options, their sole role in the future would be as managers of the clearing and settlement system. The provision of paper money can be easily fulfilled by private banks. I guess central banks would also have to manage the price level.

The above is a free-banking view of the world. The lender-of-last resort role is transferred from central banks to private markets. It is distilled into just another financial product.

Thinking in terms of stocks: From Fisher to Fischer

In an older post, Scott Sumner had an interesting comment:

The most recent inflation rate in Greece is 1.7%, whereas Spain has 1.9% inflation. I don’t know about you, but I find those figures to be astounding. That’s not deflation, and yet Tyler’s clearly right that they are being buffeted by powerful deflationary forces. I’d make several observations:

1. This shows the poverty of our language. Economics lacks a term for falling NGDP, even though falling NGDP is arguably the single most important concept in all of macro, indeed the cause of the Great Depression. So we call it “deflation” which is actually an entirely different concept. I wouldn’t be the first to find connections between the poverty of our language and the poverty of our thinking.

Did the Canadian government subsidize the big banks? The problem with pricing liquidity

Nick Rowe had a good comment on the CCPA's recent allegation that Canada's big banks were subsidized by taxpayers. In the comments I pointed out the difficulty of determining whether a subsidy or penalty had been paid to the banks because we lack a way to properly price and therefore compare the provision of liquidity services.

In effect, a government program called the Insured Mortgage Purchase Program (IMPP) announced it would buy $125 billion worth of insured NHA-MBS from the banks. It eventually bought $69 billion worth. In an alternative world, the same result is arrived at when

NHA-MBS liquidity options are sold by private actors to holders of NHA-MBS. These options allow NHA-MBS holders to sell all MBS back to the option writer at any time at a liquidity-protected price (some favourable point in the bid-ask spread). In a liquidity crisis bid-ask spreads increase, so the value of these options would quickly rise. The CMHC/IMPP provided MBS holders with a liquidity option, but we'll never know if they required MBS holders to pay the market price for this option.

Hey Nick, am I making any sense here?

Escaping the zero-lower bound by only printing $20s

Scott Sumner had a good post on the difficulties of escaping the zero-lower bound when you speak in the language of interest rates. Here he is:

Krugman was way ahead of the profession in 1998 when he emphasized that monetary policy wasn’t about the current setting of the policy instrument, but rather the expected future path. But he didn’t take that far enough. That implies that the current instrument setting is primarily a signaling device. And that means you really need an instrument that doesn’t become mute when you most need it to speak loud and clear. In other words, nominal interest rates are the worst possible instrument. 

In the comments I proposed one way to escape the zero-lower bound:

The Fed simply has to set a negative federal funds rate or IOR, and to prevent everyone from holding their savings in 0% interest cash, impose a compensating burden on cash holders by issuing only $20 bills and lower. This will impose significant inconveniences on cash holders, mainly storage costs, and let the fed funds rate remain below 0.

One problem with this policy would be its negative effect on the $ brand. US $100 and $50 bills are prized all over the world. Cease issuing them, and people might permanently switch to Euros. This would cause the proportion the Fed's zero-interest liabilities to permanently shrink relative to its floating interest liabilities (reserves). That's fine when interest rates are negative or near zero. But when they start to rise, so will the Fed's interest costs, thereby shrinking the Fed's profits and the dividend it pays each year to the government. In other words, less seniorage. Zero-interest cash is a great funding source.

Adam Smith: taxes contribute to fiat's liquidity premium, they don't drive its value

David Glasner had an article called Wicksteed on the Value of Paper Money.

David discusses the idea that it is the imposition of taxes by government, payable in fiat money tokens, that gives fiat money its value. This is chartalism, the very same idea that MMTers trumpet as their unique addition to economic discussion. This is one theory for why fiat money has value. Another is Mike Sproul's backing theory in which, just as a mutual fund's assets give its units value, a central bank's assets support the value of its liabilities. When it comes to explaining modern money, I'm partial to the latter. I'm not averse to the MMT explanation, but only as science fiction. I don't think any real monetary system has actually worked in this way.

David mentions that Adam Smith advocated the taxes-drive fiat money theory. Incidentally, Randall Wray says the same in his book Understanding Modern Money. I disagree. To make a long story short, in Smith's world, fiat money was any issue of paper money which was temporarily unredeemable and therefore circulated at a discount. In forcing people to pay taxes with this money, the sovereign created a built-in liquidity premium. But the tax obligation did not give the paper money it's original value - the probability of future redemption did. Here's the a better explanation that I left on David's blog:

I’ve read Smith pretty carefully on this. The offhanded comment comes after he talks about money that is no longer instantly convertible but redeemable at some future point in time. He uses as his example Scottish notes for which the option clause has been invoked and US colonial paper which is only redeemable after a few years.

Given deferred redemption, “such a paper money would, no doubt fall more or less below the value of gold and silver, according as the difficulty or uncertainty of obtaining payment was supposed to be greater or less, or the greater or less distance of time at which payment was exigible.”

The point being that Smith thought such money was valued according to its discounted probability of being redeemed at par.

Smith then brings up the point about taxes. 

“The paper of each colony being received in the payment of the provincial taxes, for the full value for which it had been issued, it necessarily derived from this use some additional value, over and above what it would have had, from the real or supposed distance of the term of its final discharge and redemption.”

Thus acceptability in payment of taxes added a liquidity premium to colonial paper. But it didn’t give that paper its original value. I read Smith as providing a chartal theory of the liquidity premium, and not an explanation for a positive value of fiat money.