Thursday, November 29, 2012

Discussions of the medium-of-account could be more well-done


Nick Rowe, Scott Sumner, and most recently, David Glasner, all say that the US's current medium of account is the dollar. I disagree. I think that the current medium of account is CPI units. Here's why.

First, there's been some sloppiness with definitions in the links above, so let's define the term. The medium of account is whatever defines the unit of account. I think this a pretty standard definition. That's Bill Woolsey's definition here. David echoes this definition in his comment here.

Take an old-style central bank that holds 100% gold reserves in its vault. It chooses the word "dollar" to stand as the unit of account. The bank then goes on to define the dollar as equal to x grains of gold. Thus the medium of account is gold. Our central bank issues paper notes which are to be used as the medium of exchange. Shopkeepers post prices in terms of the unit of account, the dollar, and accept notes as payment. Some shopkeepers might even choose to post prices in grains of gold rather than the dollar unit of account. If they do, this won't affect the fact that gold remains the medium of account.

Inspired by the Bank of Canada, our 100% gold bank chooses to sell all its gold for bonds. Next it chooses to redefine the value of the dollar as an idealized basket of consumer goods that declines in size by 3% a year. It threatens to do open market operations in a manner that ensures that its definition sticks.

What has changed? Shopkeepers continue posting prices in the unit of account, the dollar. Notes issued by the central bank are still the medium of exchange. But the definition of the dollar, the medium of account, has changed from a quantity of gold to a gradually shrinking quantity of consumer goods.

Some shopkeepers might even post prices in terms of this imaginary basket of goods. When shoppers arrive at the till to pay, they obviously can't hand over CPI baskets. Rather, the shopkeeper will download the central bank's most recent CPI-to-dollar ratio and quote the customer their final price in terms of notes, the medium of exchange.

To sum up, in moving from a fully-reserved gold bank to a modern CPI targeter, all that's happened is that our central bank has changed the medium of account from gold to CPI. Nick has to understand where I'm coming from since I'm just using the same technique he used in this post.

Wednesday, November 28, 2012

We'll miss that Mark Carney squint


Mirroring Nick Rowe, here are some quick comments on the departure of Mark Carney from the Bank of Canada to the Bank of England.

Canadian monetary policy is set via an ongoing conversation between the Prime Minister, his/her agent the Minister of Finance, and the Governor of the Bank of Canada. This joint conversation happens because unlike Japan, Europe, or the US, the Finance Minister has the legislated power to fire the Governor of the BoC before his/her term is up. The minister must provide a public (and potentially embarrassing) explanation for doing so. As a result both minister and governor are incentivized to cobble policy jointly.

So whatever policy we've had in Canada since 2008, you can be sure that there's a bit of PM Harper and Finance Minister Jim Flaherty mixed in with the Carney. Did we ever really know the man? With Carney leaving but the other two sticking around, will there be much of a difference going forward?

As for the UK, Carney's term at the BoE runs for five years, but as far as I can tell there seems to be no ability to remove him from power before then. Without this leash, Bank of England watchers will be more likely to see an unadulterated version of  Carney than we ever saw here in Canada.

Tuesday, November 27, 2012

Explaining Stephen Williamson to the world (and himself)


Stephen Williamson catches a lot of flack on the net. Some is undeserved, some is deserved, but a big chunk is probably due to the fact that he and his fellow New Monetarists have a communications problem. People don't understand what they're up to. So here's my attempt to bring Steve down to earth and explain to the world the importance of the research being done by him and his colleagues. I'll go about this by adding a bit of historical context. After a quick tour of the history of monetary thought, readers will be able to see where in the greater scheme of things the New Monetarists fit. Now Steve doesn't know much about the history of economic thought - he thinks it's unimportant. So in a way, I'm explaining not just Steve to the world, but Steve to Steve.

Another liquidity-premium sighting - Harrison and Kreps


The word "moneyness" is synonymous with liquidity-premium. Both refer to that portion of an item's value that is derived from an individual's ability to sell it in the future.

I wrote about bitcoin's liquidity premium here, and here I talked about how QE affects the liquidity premium of the targeted asset.

Since it happens so rarely, it's always fun to see the idea of liquidity premiums pop up in academic literature. I was recently reading an old interview with Thomas Sargent in which he describes himself as “a Harrison-Kreps-Keynesian.” Here is Harrison and Kreps's paper (pdf), and here is the money quote:
We say that investors exhibit speculative behaviour if the right to resell a stock makes them willing to pay more for it than they would pay if obliged to hold it forever. This phenomenon will not occur in a world with one period remaining (as in the capital-asset-pricing model), in a world where all investors are identical, or in a world with complete and perfect contingency claims markets.
That's as good a description of a liquidity-premium as they come. Keynes was an early adopter of the idea of a liquidity premium, and presumably that's why Thomas Sargent is willing to call himself a Keynesian, at least in the Harrison-Kreps-Keynesian sense.  Another gem:
...investors attach a higher value to ownership of the stock than they do to ownership of the dividend stream that it generates, which is not an immediately palatable conclusion from a fundamentalist point of view... we suggest that this line of reasoning might lead to a "legitimate" theory of technical analysis.

Sunday, November 25, 2012

What gold's negative lease rate teaches us about the zero-lower bound

When people talk about gold, they usually talk about the gold price. But there are a few other key gold market metrics that often go unmentioned. The chart below stacks the gold price on top of the gold forward rate (GOFO), LIBOR, and the lease rate. The gold lease rate is an interest rate. Just as you can lend your cash to a bank at the bank's deposit rate, you can lend your physical gold to a bank at the lease rate.

Understanding GOFO and the lease rate is important not only for gold bugs, but for anyone who wants to get a good grasp of the phenomenon of interest rates. GOFO and the gold lease rate demonstrate that interest rates are not phenomena solely confined to paper assets. The ability for an investor to lease their gold and earn an interest return makes up part of gold's peculiar "own-rate". All commodities have own-rates. From our perspective as consumers, we rarely get to see these markets, but they do exist.



Go to this scribd link for a high res version if you want to understand how GOFO, LIBOR, and the lease rate interact.

One thing you may have noticed from the chart is that gold's three month lease rate (at bottom) is negative. Back in November 2011 the one month lease rate fell to a record low of -0.5%. Now anyone familiar with the idea of the zero-lower bound may find this surprising. Interest rates aren't supposed to be able to fall below 0%. If they do, people will simply redeem the underlying 0% yielding asset and store it themselves. Why keep gold on loan to a bank only to pay a -0.5% penalty when you can withdraw it and keep it under the mattress for free? Yet the market was willing to bear negative lease rates.

The reason for this oddity is that as the yellow metal's price rises, it becomes ever more attractive to robbers. One ounce to a robber at $300 is tempting, but not as tempting as that same ounce at $1750. So it costs more to insure gold. Secondly, storing gold is somewhat costly. Do you hide it under granny's bed, or do you buy a home safe for it? At which point do you rent a vault at a bank? Anecdotal evidence suggests that banks specializing in gold storage have been running out of space over the last few years, implying rising storage costs. In a nutshell, that's why people haven't withdrawn their gold as lease rates have turned negative. In keeping their gold on loan to the bank rather than bringing it at home, they avoid all the headaches of storage costs, insurance, and the fear of theft, yet still get exposure to gold price appreciation. The negative lease rate is the fee they pay in order to have someone else incur all these headaches.

Like the gold market, the currency market also has the capacity to bear a negative interest rate. If the rate on bank deposits falls to say -0.25%, depositors would likely keep their cash on loan to the bank since storing it at home or in a vault is costly. How low can deposit rates fall before people start to withdraw cash? -1%? -2%? Cash, after all, is thin and light, surely easier to store than gold. One way to prevent cash redemption at negative deposit rates is to make cash storage costly. If someone wants to withdraw $100,000 in cash, make them take it all in $5 bills. The high cost of storing low denomination bills will get anyone to reconsider withdrawal. I've discussed the idea of varying redemption denominations here.

So as the gold market shows, the zero-lower bound is a soft bound, not a hard one. As for all you gold bugs out there, I'll write more about negative lease rates sometime soon.

Saturday, November 24, 2012

Scott Sumner: Damned if markets are efficient, damned if they're not


Last week I wrote a post that attempted to dehomogenize Scott Sumner from Krugman. I left a similar but more precise comment on Bob Murphy's blog. Sumner seemed to endorse it. But there's something that doesn't make sense.

Open market operations can really only have an effect if markets are not efficient. Yet Sumner is a great believer in efficient markets (as commenter Max notes on RM's blog). See Scott here and here. How can Sumner reconcile those two positions?

First, some definitions. I'll define efficiency as the idea that financial assets trade in the market at the discounted value of their future cash flows. Any deviation from this value will be fleeting as investors arbitrage it away. Another word for discounted value is fundamental value.

Here's the logic for why open-market operations need an inefficient market to work.* Say reserves are currently plentiful and yield 0%. Twenty-year 2% bonds are trading in the market at their fundamental value of $115 and an implied interest rate of about 1%. If the Fed announces it's going to buy a bunch of 20-year bonds, how can it increase their price above fundamental value? Any attempt to bid bond prices above $115 will cause rational traders to quickly sell every bond they own to the Fed so as to take advantage of the overvaluation. Bond prices don't change, nor does the 1% yield. Same goes for stocks and other assets. QE-style open market operations can't get a "bite" on asset prices.

But as market monetarists like to point out, even in today's environment of plentiful reserves, open market operations do seem to have an effect on asset prices. See Lars Christensen's chart, for instance. So if purchases have demonstratively pushed up asset prices, that means traders aren't selling those assets at their fundamental value, and therefore markets aren't efficient.

Ok, here's a way for Scott to have his cake and eat it to - he can be a believer in efficient markets and accept the relevance of open market operations. Let's redefine the efficient price of a some asset to be composed of not only its fundamental value (the discounted value of future cash flows), but also a liquidity premium. Assets have differing liquidity premiums depending on the expected ease of buying or selling them. Marketable assets have large liquidity premiums and, as a result, their efficient price is higher than if they were illiquid. It's worthwhile for rational traders to own liquid assets because in an uncertain world, the ability to sell or hypothecate some asset provides a set of options that an illiquid asset doesn't.

Having redefined efficient, when the Fed announces it will buy 20-year bonds, their fundamental value still doesn't change. Instead, the liquidity premium on 20-year bonds rises. After all, with the Fed wading into the pool, these bonds have become much more liquid. As a result, the efficient price of 20-year bonds will rise. In this way, prices can rationally diverge from their fundamental value without the assumption of efficiency being dropped. That's why open market operations can have bite, even in an environment like ours.

*I get this from Eggertson and Woodford, who get it from Neil Wallace, who got it from the efficient market crowd, Miller, Modigliani, and the rest.

Thursday, November 22, 2012

Without proper balancing forces, Hans-Werner Sinn's "European ISA" will be destabilizing


(Disclaimer: this article is geeky. If you want to follow it, you should already know a bit about the European Target2 imbalances debate (here is a good intro) and have read my description of the US Interdistrict Settlement Account)

There is a tension involved in being a lender of last resort. Central banks are supposed to provide liquidity to solvent but temporarily illiquid institutions during a liquidity crisis. But they're not supposed to go as far as keeping bankrupt banks or governments alive. Hans-Werner Sinn’s proposal to import the Federal Reserve's Interdistrict Settlement Account (ISA) into the Eurosystem seems to me to be an attempt to impose on National Central Banks (NCBs) the discipline necessary to prevent them from crossing this almost transparent line.

But an ISA-type settlement mechanism in a European setting threatens to not only prevent NCBs from crossing the line; it could prevent them from fulfilling even their basic duty as lender of last resort. This would be dangerous. The very fear that an NCB is limited in acting as lender of last resort could lead to self-fulfilling runs on NCBs during crisis. Faced with the requirement of fulfilling its role of lender of last resort or meeting an ISA-type settlement requirement, it is likely that settlement will be sacrificed, resulting in an embarrassing loss of face and credibility to the Eurosystem as a whole.

Is the Federal Reserve’s ISA binding?

A large part of Sinn’s yearning for an ISA-style mechanism comes from the idea that “there is quite a penalty for District Feds that create and lend out more than their fair share of the monetary base. This is the reason why a TARGET-like problem has never arisen in the US to this day.” [source]

I disagree with him on his views on the ISA. While ISA settlement certainly imposes a constraint on district Reserve banks, it is a distant constraint. I call it distant because other “balancing” mechanisms (which I'll outline below) come prior to final settlement. As a result of these balancing mechanisms, district Reserve banks are unlikely to ever come close to settlement failure and therefore the ISA does not genuinely discipline them.

A hypothetical ISA settlement failure would happen if a district Reserve bank, in fulfilling its duty as lender-of-last resort, perpetually lent reserves to regional member banks facing crisis. If these newly-created reserves were to be moved to neighbouring districts, the district Reserve bank would be required to settle these capital outflows with ISA-permitted settlement media. In times past, gold was the settlement media, but nowadays it its System Open Market Account (SOMA) assets. All assets purchased by the Federal Reserve system in the open market are assigned to this account. Each district Reserve bank in turn receives an allocation of SOMA. Should the crisis be protracted and outflows continue, the district Reserve bank will eventually run out of SOMA assets and fail to settle its ISA debts.

But there is an important mechanism at work that prevents prolonged district Reserve bank loans to failing member institutions. In the US, insolvent banks are quickly shuttered and sold off by the Federal Deposit Insurance Corporation (FDIC). This is called bank resolution. Secondly, there are few regulatory barriers and certainly no cultural or linguistic boundaries to overcome when it comes to US bank mergers. A private bank in the Cleveland district can easily buy a weakened bank in the San Francisco district and vice versa.

Due to quick resolution and a relatively painless merger process, district Reserve banks need not lend to weak private member banks for extended periods of time. As a result, district Reserve banks don’t create the huge amounts of reserves that, when transferred to another district, might lead to an ISA settlement failure. Contrary to Sinn’s belief, the necessity of ISA settlement is only a distant constraint on district Reserve banks.

Potentially lethal problems with a European ISA

Sinn wants to graft an ISA-style mechanism onto the Eurosystem. The idea seems to be that if NCBs were to face a periodic day-of-reckoning that required the settlement of outstanding Target2 debts with real assets, then they would be dissuaded from incurring irresponsible debts in the first place.

I agree with Sinn on the idea of implementing some sort of Target2 settlement mechanism. Even Keynes, in devising his International Clearing Union, wrote:
Measures would be necessary to prevent the piling up of credit and debit balances without limit, and the system would have failed in the long run if it did not possess sufficient capacity for self-equilibrium to prevent this. Proposals for an International Currency (or clearing) Union, February 11, 1942
But there is a certain danger in implementing an ISA-style settlement mechanism without the same balancing mechanisms we see in the US. This danger arises because the settlement mechanism interferes with the lender of last resort role of NCBs. Acting as lender of last resort is a duty that all central banks must be left free to exercise. The famous line from Bank of England Director Harman on the quelling of the 1825 crisis comes to mind:
We lent it [pounds] by every possible means and in modes we had never adopted before; we took in stock on security, we purchased Exchequer bills, we made advances on Exchequer bills, we not only discounted outright, but we made advances on the deposit of bills of exchange to an immense amount in short, by every possible means consistent with the safety of the Bank, and we were not on some occasions over-nice. Seeing the dreadful state in which the public were, we rendered every assistance in our power.
As long as US-style balancing mechanisms exist   both a quick resolution mechanism and the ability to freely merge banks    it is unlikely that an NCB, in discounting freely, will create the incredible volume of reserves that might lead to a European ISA settlement failure. But my understanding of European banking is that bank mergers are not easy (see pdf). Nor has a proper European wide resolution protocol been established. Perhaps readers can elaborate on this.

So let's imagine that Sinn’s plan to implement an ISA-style settlement mechanism is adopted without the balancing mechanisms I've previously mentioned. The next time a crisis hits, the NCBs will discount freely, as they should. They'll have to do a lot of it, since problem banks aren't being resolved, nor are they being merged. There will probably be capital flight from one country to another. This will bring the intra-Eurosystem settlement mechanism into play, requiring the transfer of settlement asset from debtor NCBs to creditor NCBs.

The problem is that as an NCB gets closer to settlement failure, depositors will flee ever faster to other European NCBs. Depositors will do this because they anticipate that settlement failure will lead to temporary inconvertibility of that NCB’s euroliabilities better to get out while it's still possible, goes the thinking. This effect is perverse, since the very threat of settlement failure leads to the self-realization of settlement failure.

What does an NCB do when it hits Sinn’s settlement constraint? Does an NCB cease acting as the lender of last resort and settle? Or does it continue to lend and let settlement fail?

Relaxing the law is embarrassing

One of the lessons of monetary economics is that there are grave consequences to stepping aside as lender of last resort. Because of this, the most likely answer to the above question is that the law concerning Eurosystem settlement will be temporarily put aside to allow for continued lending.

There is a long tradition of setting law aside to allow for lender of last resort purposes. Peel’s Act of 1840 attempted to constrain credit creation by dividing the Bank of England into an Issue Department and a Banking Department. The Issue Department issued banknotes 100% backed by gold. The Banking Department issued deposits which were convertible into these notes. During a crisis, the Banking Department would be swamped with requests for notes. But Peel’s Act prevented the Issue Department from providing the Banking Department with bank notes. As a result, people grew even more anxious to withdraw existing notes from the Banking department, igniting a run. In order to save the Banking department from insolvency, during each crisis the government would issue a rather embarrassing public letter saying that the legal separation between the two departments was temporarily null. As a result, the Issue department could lend notes to the Banking department, and the crisis ended.

Much like the Bank of England of the 1800s, it would be embarrassing for the Eurosystem to adopt Sinn's ISA-style settlement mechanism only to have to publicly annul settlement each time a crisis hits and lender of last resort action is necessary. Far better to promote the emergence of strong balancing mechanisms like bank resolution and mergers, and only after that implement some sort of settlement mechanism. The former will dull the bite (and potential embarrassment caused by failure) of the latter.

PS. Karl Whelan is circulating a draft paper on Target2 and is looking for constructive criticism. I haven't commented on his paper in this post as I'm waiting for his final version. But drop by here to read & comment.

PPS. As a free banker, I don't support monopoly banking. I took off my free-banking hat to write this.

Wednesday, November 21, 2012

Central bank monetization doesn't have to be scary


David Beckworth has a good post pushing back against people who are pounding the Fed-is-monetizing-the-debt drums. His point was that there is no evidence of monetization. The Fed today holds roughly the same amount of government debt as a proportion of outstanding debt as it did in times past.

Accusations of monetization need to start out with proper definition of the term. To "monetize" means to turn into money. All banks engage in monetization, whether they be central banks or private banks. Banks monetize houses, debt, commodities and all sorts of other assets, issuing liquid liabilities in return. A credit card essentially monetizes your 30-day IOU. So to accuse a bank of "monetizing" is like accusing someone of breathing.

In conducting QE3 purchases, the Fed is currently monetizing government debt and agency-issued MBS. Is that bad? The Fed has to monetize something. Would people be happier if it was monetizing corporate bonds? Gold? Or do they simply want it to monetize at a slower rate?

There is a pejorative sense of the word monetize. It refers to a situation in which a bank monetizes an asset at a price that benefits the borrower. This is akin to a subsidy. In providing the subsidy, the bank grants the borrower (or issuer) more financing than the borrower otherwise deserves. When applied to the Fed, monetizing in its pejorative sense would seem to indicate that the Fed is subsidizing the government by pushing the government's borrowing rate below its fundamental rate, thereby allowing it to borrow even more. In other words, the price that the Fed is paying for government bonds is above their fundamental value.

Just because the Fed is monetizing government assets doesn't mean it is monetizing in the pejorative sense. As David points out, where's the proof?

Secondly, let's pretend that the Fed is monetizing government bonds in the pejorative sense. In providing this subsidy to the government, the Fed is earning less for itself. Say that this monetization continues until the Fed has negative capital. Typically, it is believed that a government implicitly guarantees to recapitalize the nation's central bank should it be insolvent. In this case, the government just returns to the Fed all the subsidies granted by the Fed. It's a wash, and monetization (in the pejorative sense) has had no net effects.

We need to be explicit about definitions and the relationship between the government and central bank when we talk about monetization.

Tuesday, November 20, 2012

The feeling of hyperinflation illustrated

I listened to a good Econtalk podcast last night with guest Steve Hanke. Few people in the world know as much as Steve does about hyperinflation. His catalogue of 56 hyperinflations (with Nicholas Krus) inspired me to do this chart. Most of us have been lucky enough not to have lived through hyperinflation. Here's what it might feel like if we did.


Sunday, November 18, 2012

How bitcoin illustrates the idea of a liquidity premium

On November 15 @ 5:37 PM, Wordpress.com tweeted that it would be accepting bitcoin as payment. Over the next twenty-four hours, the price of bitcoin steadily rose on Mt. Gox, the major bitcoin exchange. See chart below.


This is a great illustration of the idea of a liquidity premium.

All assets carry a liquidity premium. This premium will be smaller or larger depending on an asset's ability to be easily bought and sold, or its liquidity. The idea of liquidity is straight from Carl Menger, who figured things out back in 1872 (pdf). Keynes also knew this, read Chapter 17 of the General Theory. (This is one of those great examples of Austrians and Keynesians agreeing). Other words for liquidity include saleability and marketability. In short, the more marketable an asset, the larger its liquidity premium, which in turn means a higher price. Illiquid assets have small premiums and lower prices.

In announcing the acceptance of bitcoin, Wordpress has added yet another avenue for the use of bitcoin. And Wordpress is not just any old site. According to Alexa, Wordpress.com is the world's 22nd in terms of traffic. Bitcoin is now more liquid, and as a result, its liquidity premium has increased by about 75 cents.

Why is liquidity worth something? The future is uncertain. Knowing that an asset you own can be readily sold should the need arise provides you with a degree of comfort. Thus liquidity shields you from the displeasure of uncertainty, and since highly liquid assets do more shielding than illiquid ones, you'll have to pay a larger premium for that benefit.

  So with the Wordpress announcement, bitcoin has become a slightly better hedge against uncertainty.  What happens if other large venues start accepting bitcoin? Bitcoin up.

Saturday, November 17, 2012

The difference between Sumner and Krugman on liquidity traps


Daniel Kuehn and Robert Murphy wonder why Scott Sumner takes Paul Krugman to task on liquidity traps when they each seem to be saying the same thing - monetary expansion will get you out of a trap.

The phrase "monetary expansion" can mean many things. I think Krugman and Sumner have categorically different opinions concerning one specific sense of the phrase   quantitative easing's ability to have independent effects in a liquidity trap, .

When it comes to thinking about monetary policy, Krugman, Delong, Eggertson, Woodford, and other New Keynesians begin with a frictionless model populated by rational agents. No individual has the power to set prices and everyone can attain any quantity of assets at a given price. There is no limit on borrowing. With these assumptions and interest rates at zero, quantitative easing is powerless. That's because all asset prices are uniquely determined by the present value of their future cash flows. A central bank that threatens to buy bonds/stocks/gold so as to push their prices above their fundamental value will be unable to do so. All central bank purchases will be met with a wave of hedge funds sales (and short sales), thereby ensuring that the prices of these assets stay at their fundamental value. QE can't get any traction, so it's irrelevant.

On the other hand, Sumner, Nick Rowe, Miles Kimball, and others attribute an independent effect to quantitative easing. This is because they either explicitly or implicitly do not accept the assumptions of the frictionless model used by Krugman et al.

The market monetarist's departure from the assumptions of a frictionless model begins with the colourful idea of Chuck Norris walking into a room and telling everyone to get out. If they don't, he'll beat them up. Because his threat is credible, people file out of the room without Chuck Norris having to lay a finger on them. Now take a central bank that threatens to move up prices through large scale asset purchases. Hedge funds refusing to accept the threat will be pummeled by the central bank. Rather than resist, hedge funds cry uncle. Asset prices rise above their fundamental value because Chuck Norris says so. That's how QE gets traction.

So the difference between New Keynesians and market monetarists seems to rest on a few assumptions. In a frictionless model, hedge funds will undo the effects of central bank purchases. In a market monetarist model, hedge funds can't beat Chuck Norris and QE has bite. It'll be a long time before Krugman and Sumner agree on the specifics.

Sources:
Nick Rowe, Miles Kimball (here, here and here) , Michael Woodford (pdf), Paul Krugman (and here). See my old posts Don't fight the Fed and QE Zero.

Thursday, November 15, 2012

Bitcoin, alt-chains, and fiat money

An "alt-chain" is any alternative to the flagship cryptocurrency, bitcoin. New alt-chains pop up all the time. Terracoin debuted just last week, and the month before an alt-chain called PPcoin began.

Most alt-chains are similar to bitcoin. Indeed, some are identical. From what I've read, terracoin developers just took the bitcoin source code and copied it, modifying only the name. PPcoin makes some changes to bitcoin's methodology by adopting a different method for adding to the blockchain, the cryptocurrency's digital memory of transactions. But the concept is the same.

PPcoin and terracoin join a long list of alt-chains that have emerged since bitcoin became popular in 2011, including namecoin, litecoin, solidcoin, Ixcoin, IOcoin, liquidcoin, geist geld, solidcoin, devcoin, tenebrix, fairbrix, and more.

Below is a chart of the market capitalization of bitcoin and its largest alt competitors, as well as the date they debuted. You can see that bitcoin is both the largest in terms of market cap and the oldest. Market capitalization is calculated by taking the number of coins in existence and multiplying this by their value in $US. A number of alt-chains have been delisted from public cryptocurrency exchanges like vircurex and BTC-e, so I've been unable to get a market cap for them. But you can assume they're more or less worthless. As for the alt-chains that continue to be listed, only litecoin comes even close to bitcoin's market cap, and even then it's little more than a nugget in comparison. Note that the scale on the chart is logarithmic.


The emergence of bitcoin alternatives ties into the theory of fiat money. Fiat money is an intrinsically valueless token that serves as a medium of exchange. Central bank liabilities like US paper dollars are not fiat. Central banks hold assets that have been ring-fenced from their parent, the government. The paper issued by a central bank is backed by those assets. What makes bitcoin and its alt chains truly unique is that they're the world's first fiat monies. There is neither assets to back these coins, nor do they serve as useful commodities in a non-monetary setting.

Intrinsically valueless and replaceable tokens that trade at positive prices should quickly collapse in price. That's because there are significant arbitrage profits in generating copies of these fiat tokens and selling them. The emergence of so many alt chains is testimony to these competitive pressures. Just start your own alt-chain, call it something.coin, "pre-mine" 100,000 coins for yourself, make the chain public, and sell your coins to latecomers.

That bitcoin's price hasn't collapsed yet could be due to a number of factors. It would seem that brand name is important in the cryptocurrency market. People are hesitant to switch out of tried-and-tested bitcoin into new alt-chains. Secondly, liquidity is sticky. There are difficult-to-harness network effects involved in becoming a liquid item, so just creating something entirely similar to bitcoin (except in name) isn't sufficient to attract participants away from bitcoin. Creators of new alt-chains must also promote that coin's liquidity in order to take away from bitcoin's franchise. Lastly, things take time. My hunch is that bitcoin still has a positive value because proper competition will take a few years to truly develop. Let's see where we are in December 2013.

Monday, November 12, 2012

Data visualization: The US - From oil importer to oil exporter?

The US is currently importing significantly less crude oil and crude oil products than it did in 2005. Now if you were listening to the Presidential debates, then you probably heard Barack Obama take credit for this improvement. But the real driver has been improvements in technology, namely fracking and horizontal drilling. The chart below disaggregates the flow of petroleum into its constituent parts.


The US is certainly importing less crude oil than seven years ago. It is also now exporting significant quantities of refined crude products. The largest contributor to this shift comes from the distillate/diesel category. A lot of this diesel is going Rotterdam and from there to the rest of Europe. The switch from importing to exporting products isn't confined to diesel though, note how almost all the black arrows in the products section are now red.

Friday, November 9, 2012

Bitcoin (for monetary economists) - why bitcoin is great and why it's doomed


Bitcoin is a pretty complex institution. If you're a cryptoanalyst you'll have one explanation for bitcoin, if you're developer you'll have another. What follows is a useful way for monetary economists to think about bitcoin.

What I do in this post is explain how bitcoin compares to a central bank note and a bank deposit. The conclusion is that bitcoin does something truly revolutionary. It also has a lethal problem at its core.

Wednesday, November 7, 2012

Bimetallism redux

Isaac Newton, Master of the Mint
Miles Kimball's proposal for subordinating paper money to electronic money sounds to me a bit like abandoning bimetallism.

Beginning in 1717, Isaac Newton, Master of the Royal Mint, put England on a bimetallic standard. Under bimetallism, the pound sterling was defined as a fixed quantity of silver or gold. In other words, where before England's medium of account was a certain quantity of silver, the new medium of account was a certain quantity of both metals. The unit of account through all of this remained pounds. As the market prices of gold and silver varied due to technological advances and new discoveries, the fixed silver-to-gold ratio meant that one or the other would be undervalued relative to its actual market price. As a result, the entire nation's stock of circulating coin would either flip to gold (if gold was overvalued by the mint) or silver (if silver was overvalued). After all, why bring your silver to the Royal Mint in London when you might sell it for more overseas? The overvaluation of gold, which in England's case was accidental and not intended, quickly moved the nation from a mixed standard to a gold based monetary system.

Just as England once fixed the quantity of gold equal to a quantity of silver, the modern Bank of England declares a fixed relationship between a paper pound and an electronic deposit at the Bank. The relationship is 1:1. This fixed relationship causes significant problems at the zero-lower bound. Say interest rates on BoE deposits fall below zero. At this point, the entire nation's stock of circulating pounds will be converted into paper pounds. Why hold a -2% deposit when you can hold cash at 0%? Very quickly, England will have moved from a mixed deposit/currency standard to a straight paper currency standard. It's exactly like the old bimetallic flips of yore.

The way to solve the bimetallic switching problem was to periodically adjust the fixed ratio between gold and silver to approximate actual market rates. That way neither of metals would ever be undervalued and, as a result, England would have been able to stay on a mixed standard with both silver and gold coinage. Miles's proposal is very much the same. If you relax the 1:1 ratio between Bank of England deposits and Bank of England paper currency, then as rates fall you can prevent the flip to paper currency from happening. Say rate on deposits falls to -2%. The Bank can declare that paper currency is now only worth 0.98 of a deposit, nipping at the bud the incentive to switch into paper currency. With neither asset superior to the other, people will choose to hold the same mix of currency and deposits as before.

The other way to solve the switching problem was to simply get rid of bimetallism altogether. Define the pound in terms of only one metal and let the free market take care of dealings in the rest. This is Bill Woolsey's answer to the modern zero-lower problem (here and here). It's similar in nature to Miles's. Have the central bank cease all dealings in paper currency and define the pound only in terms of deposits at the BoE. Private banks will take over the business of issuing 0% paper money. When rates fall to zero, private banks will immediately contract their issues of outstanding paper currency to nothing since maintaining a stock of 0% liabilities when the assets that support them are also paying 0% is not profitable.

In either case, you can get below the zero-lower bound pretty easily. The long gone era of bimetallism isn't as dead as we think. Differentiating between currency and deposits is very much like differentiating between silver and gold.

Monday, November 5, 2012

Data visualization: The People's Bank of China balance sheet

David Glasner and Scott Sumner have posts on Chinese monetary policy. They both inquire about the People's Bank of China (PBoC) balance sheet. I've affixed a chart of it below.

Here's a quick rundown of how the PBoC balance sheet changes. The PBoC sets the yuan-to-dollar exchange rate at some rate below what it would in a free market. Chinese exporters thereby enjoy a subsidy. The law requires that the foreign currency that exporters earn overseas be repatriated and exchanged for yuan. The PBoC prints yuan (bottom green area) or provides deposits (bottom purple area), receiving this foreign exchange in return (top green area).

(scribd pdf)

By creating such large quantities of liquid currency and reserves, the PBoC will force the domestic price level  to rise. In order to prevent this inflation, the Bank must "sterilize", or mop up the liquidity it has created. It does this by issuing bonds (dark blue area at bottom) to domestic banks in exchange for currency and reserves (bottom purple and green). Thus liquid instruments are replaced by an illiquid instrument, bonds. The PBoC also forces banks to hold large quantities of required reserves (bottom purple area), which immobilizes what would otherwise be a fairly liquid instrument. In this way the rise in the domestic price level can be temporarily prevented. The PBoC could also sterilize by selling domestic assets (top pink, blue, or yellow areas) and retiring the currency and reserves it receives. But given that domestic assets held on the PBoC balance sheet haven't changed much over the years, it's likely that different means are being found to sterilize.

Saturday, November 3, 2012

Let the ECB capital key float

Bankers clear and settle with each other at a clearing house

Perry Mehrling had in interesting comment about how to settle the Eurosystem's Target2 imbalance problem.
If there were Eurobills, balances could be settled periodically by transfer of assets, just as is done in the Federal Reserve System. More precisely, if there were a System Open Market Account at the ECB, in which all of the national central banks held shares, settlement could be made by transfer of shares.
Perry is talking about adapting the structure of the Fed's Interdistrict Settlement Account to Europe. To understand the ISA, check out my Idiot's Guide to the Federal Reserve Interdistrict Settlement Account. In short, the 12 regional Reserve banks run up debts and credits to each other over the course of the year due to changes in payments flows. These debts and credits are settled each year by transferring securities that have been bought in open market operations from debtor Reserves banks to creditor Reserve banks.

The Eurosystem, on the other hand, doesn't require that the clearing debts wracked up by the various National Central Banks (NCBs) be settled. Which is odd. Not even Keynes's ICU would have allowed infinite debts, and Keynes was a forgiving sort of guy.

Perry's idea is that with the Eurosystem embarking on a program of Outright Monetary Transactions (OMTs), maybe the securities amassed will allow for a mechanism to settle intra-Eurosystem imbalances. Debtor NCBs like the Bank of Greece will have to transfer OMT securities to creditor banks like the Bundesbank. Perry specifically discusses the idea of having each NCB own shares in the OMT portfolio and have these shares transferable so as to facilitate settlement.

I like this idea and think it can be twinned with the already existing ECB capital key. What is the capital key?

All NCBs have an ownership stake in the overlying ECB. The relative amounts held by each are determined by the capital key. The key's weights are based on relative population and GDP. Germany for instance, has been given an 18.9% weighting in the capital key. Greece has been given a 1.96% weighting.

The ECB holds a unique set of assets on its balance sheet (see year-end 2011 statements). These have been transferred to it from the NCBs. First, it holds 16 million ounces of gold, worth around €21b. It also holds around €41 in forex reserves denominated in yen, dollars, and more. Lastly, it holds a few assets purchased during previous open market campaigns. Also worth considering is that the Eurosystem's total profits are paid out according to the capital key. This means that the profits yielded by assets held by the Bank of Greece don't necessarily get paid out to the BoG... they get amalgamated with all NCB profits and then allocated to each individual NCB according to the capital key. So having a big weighting in the capital key is definitely worth something.

Say that going forward all OMT purchases are conducted through the ECB and not the NCBs. That means that in addition to its gold and forex position, the ECB gets even bigger, and shares in the capital key are rendered more meaningful.

You can then institute a Fed-style settlement program by letting each NCB's weighting in the capital key float. Each year debtors get their share in the capital key lowered. Creditors get their's increased. That adds some quid pro quo to intra-Eurosystem balances. What happens if a central bank's representation in the capital key were to fall below zero because of persistent capital flight? Then the national government would have to recapitalize their respective NCB's contribution to the ECB so that it's portion of the key rises back to 0%. Or you could soft-pedal the whole thing and institute some sort of broad system of reforms a country has to initiate once it falls below 0%. Either way, the system is redesigned to have a tendency to equilibrate.

Is such a tendency necessary? I leave you with some words from Keynes's Proposals for an International Currency (or clearing) Union, February 11, 1942:
Measures would be necessary to prevent the piling up of credit and debit balances without limit, and the system would have failed in the long run if it did not possess sufficient capacity for self-equilibrium to prevent this.

Thursday, November 1, 2012

My synopsis of the MOE vs MOA debate


Bill Woolsey, Scott Sumner (here and here), and Nick Rowe and a debate that was fun to follow. It seems to me that they more or less end up on the same page. Here's my rough synopsis.

The argument seems to have started as a semantic battle over the definition of the word money. Scott holds that money is the medium of account (MOA), Nick and Bill say it's the medium of exchange (MOE). I say ignore this part of the conflict. Pretend the word money doesn't exist. Money. The semantics detract from the main points of the debate which, to me at least, is about how price rigidity, MOA, and MOE interact to cause recessions.