Monday, December 31, 2012

Not a big fan of the metallist vs chartalist debate on the origins and nature of money


There is a century's old debate between metallists and chartalists on the origin of money. The metallist view is that the first spark of money emerged through barter and matured when the use of precious metals as money was discovered. The chartalists disagree. According to them, the use of credit preceded the use of precious metals as money.

At its core, the metallist/chartalist debate is a battle over the definition of the word money. In a moneyness world, there is no such thing as money. All we have are numerous media of exchange with varying ranges of liquidity. Whether moneyness first gets attached to credit or precious metals is really not important.

Imagine that a hunter encounters a trapper. The hunter has a deer. The trapper wants the deer but isn't sure what to offer. On the one hand, he can exchange the two rabbits in his belt for the deer. On the other he can offer his credit. In offering to exchange away his credit, the trapper is simply capitalizing his future earning power and bringing it forward for use in trade. Metallists and chartalists put tremendous importance on this first choice of credit versus rabbits, since one or the other will represent the so-called origins of money.

From a moneyness perspective, there are more interesting forces at play. Say that the trapper learns that the hunter will accept either his credit or his rabbits. The trapper next arrives at the realization that both items now have a degree of liquidity, or moneyness. He begins to attach a liquidity premium to both, for not only are the trapper's inventory of rabbits useful to him as food, but they can also be resold to the hunter, thereby providing the trapper with an extra range of liquidity services. The same goes for his credit. The trapper's future earning power is one of his key possessions. Now that it is tradeable, his future earnings power provides an extra margin of liquidity services. Over time the trapper will learn which one of his trade items is more liquid  and will favor that item with a larger liquidity premium. A monetary economy has now emerged in which traded goods are appraised according to their degree of liquidity and carry varying liquidity premiums.

If we split the world into money and non-money, then debates over the what items make it into the money category will often be heated. The origins debate gets especially intense because it tries to define modern money by looking back to its so-called debut. Taking inspiration from gold's barter origins, modern day metallists want a pure real/commodity based money. Modern day chartalist, who advocate state-issued inconvertible paper, look back to money's credit origins to support their view that the essential nature of money is credit.

From a moneyness perspective, the money-or-not debate is distracting. The origins of liquidity and liquidity premia is complex and probably not subject to study. There never was a single dominant instrument that could claim the mantle of money, only multiple goods and forms of credit, each with different degrees of moneyness. As for the metallists and chartalists, a pox on both their houses.

Thursday, December 27, 2012

The final draft on Fed-Treasury overdrafts

Marriner Eccles
There is an idea floating around on the internet that the US Treasury can finance itself indefinitely by borrowing directly from the Federal Reserve. All the President need do, goes the story, is order the Fed to credit the Treasury's account with fresh money, and voilà – the Treasury can spend willy-nilly. This is called the Treasury's overdraft facility.

In actuality, the above operations are impossible since the Treasury is legally prevented from borrowing directly from the Fed. The result is that the Treasury can only spend by ensuring that it has already obtained funding through the collection of taxes or the issuance of securities in the open market. The overdraft facility is a myth.

But this wasn't always the case. Marriner Eccles's March 1947 hearing before the House of Representative's Committee on Banking and Currency is a great source of US monetary history. In it we learn that from 1914 to 1935, the Federal Reserve had the power to lend directly to the Treasury by purchasing newly created government debt. This was called direct-purchase authority, and it amounted to a Treasury overdraft privilege with the Federal Reserve. This overdraft facility found legal expression in section 14(b) of the act, which permitted the Fed to "buy and sell, at home or abroad, bonds and notes of the United States, and bills, notes, revenue bonds, and warrants with a maturity from date of purchase of not exceeding six months." The interpretation of this bit of legalese was that the Fed needn't limit purchases of government debt to the open market, it could buy directly from the government.

As I pointed out in an earlier post, section 16 of the Federal Reserve Act prohibited the Fed from using government securities as collateral for note backing until the passage of the first Glass Steagall Act in 1932. So even though the Fed could lend directly to the Treasury during this early period, its ability to do so was significantly crimped by the ineligibility of government bonds as backing.

We learn from the Eccles document that in 1935, the Federal Reserve Act was modified to prevent the Fed from making direct purchases of Treasury-issued securities. This was done by inserting a provision into section 14(b) of the Act requiring all purchases of government debt to be carried out in the open market. As a result, the overdraft privilege ceased to exist.

The overdraft facility was re-instituted in March 27, 1942, only a few months after the US entered World War II. The War Powers Act provided the Fed with the temporary authority to directly buy up to $5 billion of government securities from the Treasury. Specifically, the new wording of section 14(b) allowed the Fed to purchase
any bond, note, or other obligation which are obligations of the United States, or which are fully guaranteed by the United States as to principal and interest, may be bought and sold without regard to maturities either in the open market or directly from or to the United States, but all such purchases and sales shall be made in accordance with the provisions of section 12 (a) of this Act and the aggregate amount of such obligations acquired directly from the United States which is held at any one time by the 12 Reserve banks shall not exceed $5,000,000,000.
This was only a temporary power, which is why we find Fed Chairman Marriner Eccles visiting Congress in 1947. He was lobbying Washington to make the overdraft facility a permanent part of the Fed's arsenal. Eccles justified the overdraft by pointing out that it might save the taxpayer money. After all, overdrafts provided the Treasury with cheaper temporary funding than the open-market did. We know he was unsuccessful in his efforts to make the authority permanent, since this 2006 Government Accountability Office (GAO) document notes that:
Intermittently between 1942 and 1981, Treasury was able to directly sell (and purchase) certain short-term obligations to (and from) the Federal Reserve in exchange for cash. Congress first granted this cash draw authority temporarily in 1942, allowed it to lapse several times, and extended it 22 times until 1979, when it modified some of the terms and added controls.
We also learn from the GAO document that in 1981 Congress allowed the overdraft authority – referred to as "draw authority" – to permanently expire. Thus ended 39 years of Treasury overdrafts. The GAO report provides some interesting statistics on this period. Between 1942 and 1981, the Federal Reserve held Treasury certificates purchased directly from the Treasury on just 228 days, mostly during times of war. So while overdrafts were permitted, they weren't used often, and not for long periods of time. The largest amount  of certificates issued by the Treasury to the Fed on a single day was $2.6 billion in 1979. By 1979, $2.6 billion didn't amount to much, but in 1942, with the Fed's liabilities amounting to $25 billion, an extension of a $5 billion overdraft would have dramatically increased the Fed's balance sheet.

Below is a handy chart I've pinched from the GAO report which illustrates the use of the overdraft facility over time.


Note the large interwar gaps when draw authority was never used.

Section 14(b) of the modern Federal Reserve Act, amended in 1981, includes a strict "open market" provision that limits Fed purchases to "any bonds, notes, or other obligations which are direct obligations of the United States or which are fully guaranteed by the United States as to the principal and interest may be bought and sold without regard to maturities but only in the open market". This change is indicative of the broader trend to independent central banking. In a 1978 subcomittee meeting on the Fed's draw authority, Congressman George Hansen expressed this sentiment quite well:
This authority is a leftover from the days of explicit Fed support for Treasury financing, when monetary policy was clearly subordinated to the Treasury's aim of cheap deficit financing. I hope we are all agreed that monetary policy should not be thus subordinated, and that we can do without the mechanisms through which the Treasury called the shots for Federal Reserve open market operations.
And that's where we are today. The Treasury can't finance itself directly via the Fed. Yes, there may be indirect routes, but that's another post. Anyone who operates under the assumption that the direct route exists are assuming a monetary structure that became extinct in 1981.

Wednesday, December 26, 2012

Corporations are currency issuers, governments are not

Corporate stock: a perpetually inconvertible currency

In this post I play around with the distinction between a currency user and a currency issuer.

Modern Monetary Theory (MMT) draws a line between currency issuer and currency user. Households and businesses are currency users. They can "run out of money" and become insolvent. Central banks, on the other hand, are currency issuers. Issuers can never run out of money and, as such, face no solvency constraint. As long as the government is not legally separated from the nation's central bank, it too enjoys the benefits of being a currency issuer. After all, the government can always have the central bank issue liabilities to pay for all governmental obligations. The only constraint on a currency issuer is inflation, not solvency. For if a central bank's liabilities inflate to worthlessness, they can no longer be used to meet either the government's or the central bank's obligations.

While MMT associates currency issuance with the state and currency use with the private sector, this needn't be the case. Private businesses can be thought of as currency issuers facing an inflation constraint, whereas governments are almost always currency users facing a solvency constraint.

My translation of these MMT ideas is that the key to escaping the solvency constraint is this: can the institution under consideration issue perpetual inconvertible liabilities? If so, the institution can never become insolvent and qualifies as a currency issuer. The beauty of perpetually inconvertible liabilities is that they never expire, nor can their holder take the initiative and force the issuer to redeem them for some underlying asset. Lacking any revenues whatsoever, an institution can function indefinitely as long as its perpetually inconvertible liabilities have some positive value and can be sold to obtain resources. If these liabilities inflate to nothing, the issuer loses its ability to function.

Consider central banks first. Say that a central bank issues perpetual liabilities convertible into gold. This central bank is not a currency issuer, for if the gold is not forthcoming, the central bank will be rendered insolvent. Modern central banks, on the other hand, are safe from the solvency constraint because they no longer issue perpetual liabilities convertible into gold. Rather, modern central bank liabilities are inconvertible. The central bank can simply spend these liabilities into the economy, thereby financing its continued existence. Only when these liabilities are worth zero will the bank have breathed its last.

Modern corporation can also issue perpetual inconvertible liabilities. This is called equity. Much like a central bank, modern corporations face no solvency constraint because they can always meet their obligations with new equity issuance. Only when a corporation's equity has inflated away to nothing i.e. the price of the stock they issue is worth zero, have corporations finally hit the wall. Fledgling companies with no revenues and large expenses can function for many years by constantly issuing perpetual inconvertible equity.

Unlike businesses, individuals can't issue equity in themselves. Society has rendered it taboo to alienate shares in one's self, even if this is done in a voluntary manner. People can only issue personal IOUs that must be paid back at some point in time, or debt. Because individuals can't issue perpetual inconvertible liabilities they face a solvency constraint and therefore qualify as currency users.

Modern governments are very much like individuals. They can't issue equity. Nor can modern governments rely on their central bank to meet governmental obligations. The practice of independent central banking puts a strict divide between state and central bank, rendering it illegal for the central bank to use its perpetual inconvertible liabilities to finance the government and shelter it from the solvency constraint.

In sum, the line between a user facing a solvency constraint and an issuer facing an inflation constraint is defined by the ability to "print" perpetual inconvertible liabilities. Both corporations and modern central banks have the ability to issue these instruments and therefore face only an inflation constraint. Governments and households, on the other hand, are prohibited from issuing these instruments and therefore qualify as currency users that face solvency constraints.

Monday, December 24, 2012

Merry Cashmas

Christmas is upon us, and so is the seasonal spike in the demand for cash. This Christmas bump relates to the previous post on liquidity and uncertainty. Christmas isn't just about buying presents – it's also about traveling to distant places to meet up with family and friends. We realize that we can't anticipate all eventualities along the way. To insure ourselves against these uncertainties we carry a bigger wad of cash. This liquid wad provides a very real service by comforting us, even if we never end up having to use it.

It's illuminating to plot the Christmas spike in cash in order to compare it over decades. See below. The data I'm using is the weekly currency component of M1 from the Federal Reserve.


We can eyeball a few trends from the chart. First, we see a consistent seasonal spike in currency in circulation in December and climaxing around New Year's Day. Cash falls heavily in January as people and businesses redeposit it at the bank.

While the Christmas bump was very pronounced in the 1970s and 80s, it appears to have grown more muted over time. In recent Christmases, say 2011, it is difficult to pick out the spike at all, although if you look carefully you'll spot it. It's not just the Christmas bump that has declined, the general rate of increase in cash outstanding over each period has slowed. This is evident in the gradually flattening slope of each line. People don't need cash as much as they used to. Credit cards and direct payments provide good alternative forms of liquidity.

It's also interesting to see a monthly saw-toothed pattern in the data, particularly in the older periods. Around the middle of each month cash outstanding peaks, falling until the beginning of the next month. My guess is that this is some sort of paycheck effect. People deposit paychecks at the beginning of the month, then build up a buffer of cash to pay for that month's necessities and incidentals, this buffer steadily being drawn down over the latter half of the month. This saw-toothed pattern has all but disappeared in the data. Cash just isn't as important as it once was for payments.

It's worthwhile noting that come Christmas the Fed doesn't "blow" this cash out into the economy. Rather, people "suck" it out of the Fed. In anticipation of a spike in the demand for cash by consumers and businesses, private banks decide to hold more cash in their vaults. Banks build this buffer by converting reserves in their bank account held at the Fed into cash, with Brinks trucks moving this paper from Fed to bank. Before the credit crisis of 2008, a general withdrawal of cash would have required the banking system to rebuild their reserves in order to meet statutory minimum reserve requirements. The Fed would have offered to buy treasury bills from the banking system in order to provide those reserves. Nowadays banks hold so many excess reserves that if they convert some of these into cash, they don't need to buy more reserves in order to meet statutory requirements.

Friday, December 21, 2012

Uncertainty and the demand for liquidity


In between my more practical posts, once every week or so I'll do something on the idea of moneyness. Economists have known for a long time that the concepts of uncertainty and money are intimately intertwined. George Costanza knows this too. He holds a bunch of cash to deal with all eventualities... until his wallet blows up. I'll show how we can just as easily replace money with moneyness in this two-step with uncertainty.

Uncertainty is an uncomfortable feeling one endures when thinking about an unforeseeable future. One of the ways to shield oneself from uncertainty is to devote a certain portion of one's portfolio to "money" – dollar bills, bank deposits, and such. Because these money items are liquid, it will be relatively easy for their holder to offload them in the future should some unanticipated eventuality arise. Holding money therefore alleviates discomfort about the future. This is the same sort of service that a fire extinguisher provides. Though someone may never need their extinguisher, it comforts its owner by its mere presence. On the margin, individuals are always comparing the present value of the stream of "security and comfort" that money provides to the consumption goods or durable assets that money can buy.

The link between uncertainty and the demand for money has a long heritage. We can find this idea early on in the Marshallian tradition, for instance. In 1917 Arthur Pigou, a student of Marshall, wrote that any person would be anxious to hold money "to secure him against unexpected demands, due to a sudden need, or to a rise in the price of something that he cannot easily dispense with." On the margin, people could either hold money, spend it on consumption, or exchange it for a capital asset. "These three uses," wrote Pigou, "the production of convenience and security, the production of commodities, and direct consumption, are rival to one another." (The Value of Money, 1917)

In 1921, Fred Lavington explicitly described this very same link between uncertainty and money.
the stock of money held by a business man serves not only to effect his current payments but also as a first line of defence against the uncertain events of the future. (The English Capital Market, 1921)
More explicitly, said Lavington, money provides its owner with a
return of convenience and security. His stock [of money] yields him an income of convenience, for it reduces the cost and trouble of effecting his current payments ; and it yields him an income of security, for it reduces his risks of not being able readily to make payments arising from contingencies which he cannot fully foresee. The investment of resources in the form of a stock of money which facilitates the making of payments is then in no way peculiar; it corresponds to the investment by a merchant in the office furniture which facilitates the dispatch of business, to the investment of the farmer in agricultural implements which facilitate the cultivation of his land, and indeed to investment generally. 
Like Pigou, Lavington emphasized the marginal choice between holding money, spending it on consumption, and investing it.
Resources devoted to consumption supply an income of immediate satisfaction; those held as a stock of currency yield a return of convenience and security; those devoted to investment in the narrower sense of the term yield a return in the form of interest. In so far therefore as his judgment gives effect to his self-interest, the quantity of resources which he holds in the form of money will be such that the unit of resources which is just and only just worth while holding in this form yields him a return of convenience and security equal to the yield of satisfaction derived from the marginal unit spent on consumables, and equal also to the net rate of interest.
The most famous adopter of this idea was Keynes, a friend of Pigou's and, oddly enough, Lavington's teacher.
Because, partly on reasonable and partly on instinctive grounds, our desire to hold Money as a store of wealth is a barometer of the degree of our distrust of our own calculations and conventions concerning the future... The possession of actual money lulls our disquietude; and the premium which we require to make us part with money is the measure of the degree of our disquietude. (The General Theory of Unemployment, 1937)
The link between uncertainty and money isn't confined to the Marshallian and Keynesian traditions. Erich Streisler (1973) quotes Carl Menger in Geld:
The amount of money which is used in actual payments constitutes only a part, and indeed a relatively small part, of the cash necessary to a people, and . . . another part is held (in order that the economy may function without friction) in the form of various reserves as a security against uncertain payments, which in many cases in fact are never realized.
William Hutt, an Austrian "fellow traveler", described the prospective yield from money in a 1952 paper called the Yield from Money Held. According to Hutt, the value of money assets was "affected by reason of their being demanded for their 'liquidity,' i.e. for the medium of exchange services that they can perform." These monetary services that money assets provide are prospective – even though money isn't being used, much like a fire engine when there were no fires, it isn't lying idle. "The essence of all these services is availability," wrote Hutt.

Modern Austrian Hans Herman Hoppe provides a very sharp linkage between uncertainty and money holdings.
the investment in money balances must be conceived of as an investment in certainty or an investment in the reduction of subjectively felt uneasiness about uncertainty. ('The Yield from Money Held' Reconsidered, 2009)
Nor is the Auburn side of the Austrian school the only to note linkage. Steve Horwitz, a free-banking Austrian, also gives expression to the link between money and uncertainty:
The connection between Hutt and Menger lies in recognizing that the availability services that money provides flow from it being the most saleable good. To be available to be exchanged for anything at any time requires that the good have the degree of saleability that Menger describes. The nature of Hutt's availability services is that they are a subjective return to holding an item that others also subjectively value a great deal, thus permitting the item to be easily exchangeable. When one chooses to hold wealth in the form of money, one is simply purchasing these availability services. (A Subjectvist Approach to the Demand for Money, 1990)
We also find the link between uncertainty and money among monetarists. In their 1971 paper The Uses of Money, Brunner and Meltzer noted that in a world of perfect certainty, information is available for free. This effectively eliminates the main reasons for the existence of money. However, by relaxing the assumption of certainty, “transactors possess very incomplete information about the location and identity of other transactors, about the quality of the goods offered or demanded, or about the range of prices at which exchanges can be made.” Rather, they must acquire information about these characteristics. Because knowledge acquisition takes time and energy, individuals may alternatively:
search for those sequences of transactions, called transaction chains, that minimize the cost of acquiring information and transacting. The use of assets with peculiar technical properties and low marginal cost of acquiring information reduces these costs. Money is such an asset.
David Laidler, also a monetarist, describes the money as a "buffer against costly consequences of market uncertainty and inflexibility".
If money holding is a cheap and reliable buffer, then agents will find that it pays to remain relatively uninformed about the processes affecting the variability of their net receipts, and will be relativley unwilling to undertake any costly measures that might render them either more predictable or controllable. If, on the other hand, money holding itself is a costly or unreliable source of insulation from such uncertainty, then the expenditure necessary to acquire and utilise extra information is more likely to be made. (Taking Money Seriously, 1990)
It's clear from this wide variety of quotes that many economists have considered money holdings to be uncertainty-alleviating. It's not a big step to replace the concept of "money" with "moneyness". The idea here is that by selling less-liquid items for more-liquid items, individuals can increase their protection from uncertainty. All assets can be ranked on a scale according to their liquidity/moneyness, and as a corollary, by their ability to "lull our disquietude".

On the margin, people are constantly comparing the package of services provided by each asset in an economy, where each package consists of the real services the asset provides, its pecuniary returns (interest, capital gains, or dividends), and finally the extent to which that asset's moneyness shields the holder from uncertainty. This means that in trying to defray their worries about a cloudy future, people seek out the quality of moneyness rather than a specific instrument called money. This quality, or property, is never fully concentrated in one hypothetical asset called "money" but can be found unevenly distributed over the economy's entire range of goods.

To get up to speed, here are two previous posts dealing with the idea of moneyness
1. Why moneyness?
2. What is a non-monetary economy?

Tuesday, December 18, 2012

How to stop a hyperinflation

Hjalmar Schact and Montague Norman

If you were in charge of a central bank during hyperinflation, what would you do to stop it? Here's a brief but detailed account of how the German hyperinflation was halted in November 1923.

What is so unusual about the end to the German hyperinflation was its suddenness. Within days of a series of monetary reforms implemented in mid November 1923, price rises came to a dead stop. You have to put this into context to properly appreciate it. A loaf of bread, which cost 30,000 marks on August 30, 1923, rose to 300,000 by mid-September, fifteen million marks by mid-October, and 165 billion marks by early November. And suddenly it stabilized.

There were two not-entirely unrelated reforms implemented that month that halted the inflation:

1. the creation of a new unit of account called the rentenmark.
2. the stabilization of the existing unit of account, the paper mark.

The Rentenmark

With the Reichsbank's paper marks having lost all credibility, in August 1923 legislation was introduced in the German parliament to open a new bank of issue. After some discussion, on October 17 the Rentenbank was created. The Rentenbank was to institute a brand new unit-of-account called the rentenmark. A rentenmark unit was to be defined as one gold mark, or 1⁄2790 kg pure gold. The gold mark was the country's old unit-of-account which had been forsaken during the war. The bank would issue notes called rentenmarks which were to trade at their defined gold amount.

The catch was this. Historically when a nation's unit-of-account (like pounds or dollars) was defined in terms of certain quantity of gold, the currency issued by that nation's central bank was made convertible into gold. If inconvertible, then the currency risked floating away from its defined gold value. But the rentenmark was not convertible into gold.

How then was the definition of the rentenmark as 1⁄2790 kg pure gold to be enforced in the marketplace? It's a complex but interesting mechanism. Four percent of the value of all German private agricultural land and industrial property was to be mortgaged, these "forced" mortages handed over to the Rentenbank as capital. The name given to these mortages was Rentenbriefe. Rentenbriefe represented a first lien on property owners, and each bond paid a 6% coupon stated in gold marks ie. interest and principle payments were indexed to gold. Furthermore, all rentenmarks were convertible into rentenbriefe at a rate of 500 to 1. Rentenbriefe, it should be noted, were not convertible into gold.

To sum up this unusual structure, circulating rentenmarks were to be convertible into rentenbriefe, which in turn represented a quantity of German land and property expressed in gold ounces. Rentenmarks, it seems, were a land-backed currency.

Horace Greely Hjalmar Schact, who many of us have read about in the excellent book Lords of Finance, was appointed to run the new Rentenbank. The notes debuted on November 16 and were immediately embraced by the German populace, trading for goods and services at their defined gold value. In his book The Economics of Inflation, Constantino Bresciani Turroni called this "miracle of the Rentenmark".  A currency defined in terms of gold with no actual gold-backing and only land-backing had been successfully floated. The solidity of the rentenmark need only be remarked upon by the fact that by Jan 1924, only 1,600 rentenmarks had been presented to the bank for conversion into rentenbriefe.

The stabilization of the paper mark

The German state now had two units of account, each with a related media of exchange. The rentenmark, defined in terms of gold, was stable, but the paper mark continued to hyperinflate, even after the rentenmark's debut. On November 13 one dollar bought 3.9 trillion paper marks, 6.7 trillion marks on the November 17, and 13 trillion by the end of the month.

To help stabilize the paper mark, that November the government was officially banned from funding itself through the Reichsbank, restoring to the central bank a much-needed degree of independence from the government.

At the same time, the Reichbank changed its commercial lending policy. It had been incredibly profitable to borrow from the Reichsbank during the hyperinflation because its lending rate was kept artificially low. Businesses and speculators borrowed marks to buy stocks, goods, or dollars, and after the mark had lost much of its value, bought them back to cover their loans several weeks later. Even though the lending rate was eventually increased to 90% in September 1923, businesses and speculators were in no way dissuaded from borrowing from the Reichsbank since – at the speed at which depreciation was occurring – only a rate in the thousands would prevent them from profitably borrowing, shorting, and later buying back marks to repay their loan.

As part of its new lending policy, all new advances were now to be indexed to the value of the mark in forex markets. Thus, should a business borrow a million paper marks from the Reichsbank, and the mark depreciated vis-à-vis the dollar, come maturity three weeks later the business would be required to pay back the million marks plus some penalty for depreciation. This dramatically increased the cost of borrowing from the bank.

Lastly, the Reichsbank's policy of accepting privately-created "notgeld" at par was ended. During the hyperinflation, severe currency shortages had encouraged corporations, towns, and municipalities to issue private currency alternatives, or notgeld. The Reichsbank gave these currencies legitimacy by accepting them at the bank's clearinghouse at the same rate as all other paper marks. By ceasing to accept notgeld, these alternative media suddenly lost a large part of their moneyness.

On November 20, Schact formally defined the paper mark against the US dollar. One dollar was to be equal to 4.2 trillion marks. The market simply didn't believe the Reichsbank could defend this definition. A few days later the mark's value had fallen so that it required 13 trillion marks to buy one dollar. To return the paper mark to its defined value, Schact and the Reichsbank proceeded to pull the rug out from under the market. Schact can explain it best:
The speculators, however, did not believe that the Reichsbank would be able to hold this rate of exchange rate for any length of time, and bought dollar after dollar on time bargains at a much higher rate of exchange... This speculation was not only hostile to the country's economic interests, it was also stupid. In previous years such speculation had been carried on either with loans which the Reichsbank granted lavishly, or with emergency money which one printed oneself, and then exchanged for Reichsmarks.
Now, however, three things had happened. The emergency money had lost its value. It was no longer possible to exchange it for Reichsmarks. The loans formerly easily obtainable from the Reichsbank were no longer granted, and the Rentenmark could not be used abroad. For amongst the stipulations governing the issue of the Rentenmark, there was one which forbade the surrender of Rentenmarks to foreigners. For these reasons the speculators were unable to pay for the Dollars they had bought when payment became due. They were forced to sell the Dollars back, and the Reichsbank was not prepared to pay more than the official rate of 4.2 billion Marks to the Dollar. The speculators made considerable losses. A bare ten days later the rate of exchange of 4.2 billion fixed by the Reichsbank had re-established itself. (The Magic of Money)
To sum up, short sellers needed to buy back paper marks to cover their shorts, but there were no sellers except for the Reichsbank. According to Adam Fergusson in When Money Dies (pdf), speculators lost up to 60% of their capital and “took off for Paris and went to work on the franc.” The upshot is that by the end of November, just fifteen days after the initial reforms were floated, Germany had two stable units of account, the rentenmark and paper mark. And that, folks, is how you end a hyperinflation.

Sunday, December 16, 2012

Chartalism = the McDonald's coupon theory of money


While chartalism is usually associated with the state and its ability to tax, there's no reason that this must be so. In fact, I like to think of chartalism as stateless. I call this the McDonald's coupon theory of money.

What I'm specifically addressing here is the chartalist idea that paper notes issued by the state have value because the state imposes a liability on its citizens that can only be discharged by the use of this paper.

McDonald's Corporation can do the same thing if it imposes an obligation on the burger-eating community to pay for all Big Macs with McDonald's-issued coupons. One coupon buys one Big Mac, say. In order to pay their "tax" and get a burger, Big Mac fans have to somehow acquire these coupons ahead of time.

McDonald's pays for a portion of its supplies by printing and issuing these coupons as payment. So one way that Big Mac fans can get their hands on coupons is by providing services to McDonald's... say cleaning floors or selling them pickles. Another way fans can get coupons is by approaching someone else who is already a supplier to McDonald's and offering them gold, silver, or some other media in exchange for coupons. An active secondary market would probably develop for these coupons.

McDonald's is required to spend enough coupons into existence so as to meet the very real demand people have to settle their obligation to buy Big Mac's with coupons.

Because McDonald's and Big Mac fans are everywhere, it's likely that these coupons will begin to circulate broadly. For instance, corner stores may begin to accept McDonald's coupons in payment for stuff, as will hotels and other merchants. They'll be willing to do so because they know they can pass the coupon off as change to a Big Mac fan at some later point in time. If not, they themselves may want to use it to buy a Big Mac. McDonald's coupon become ever more liquid, their degree of moneyness increases, and they emerge as a globally-useful medium-of-exchange.

Now burger lovers needn't submit to the McDonald's "tax". Burger King still allows customers to buy a Whopper without having to secure a coupon ahead of time. But if Burger King, Wendy's, A&W, and other burger joints institute a similar coupon-mechanism, then burger lovers will have to submit to some sort of coupon-tax.

In any case, I hope you can see why chartalism needn't be explicitly intertwined with the state. We can imagine worlds without states that have circulating chartal media-of-exchange. This is a world of private coupon monies. Theorizing in this way makes monetary discussion easier since it removes the political aspect of the debate, rendering it purely technical.

While I can imagine chartal worlds, I don't think the real world is particularly chartal. Coupons exist, but they rarely circulate outside of a very proscribed range. Here is one example of a circulating chartal money, in which Zimbabweans started to widely use gasoline coupons during the Zim$ hyperinflation. Chartal monies certainly become more prevalent during times of monetary stress.

Nor do I think modern central bank liabilities are chartal coupon monies. In my hypothetical example, McDonald's spent coupons into existence. Modern governments can't fund themselves by issuing coupons, they can only spend after having taxed or issued bonds. Nor are people obligated to use central bank notes or deposits to discharge government obligations – they can, and typically do, use other media. The upshot of this is that if governments announced that they'd only accept gold in payment of taxes from here on in, central bank liabilities would continue to be a valuable and popular medium of exchange. Not so our hypothetical McDonald's coupons. If McDonald's ceased accepting coupons for Big Macs, they'd be worthless.

PS. Just because I am saying that modern central bank money is not chartal doesn't mean that I think we can ignore the state in understanding how modern money gets valued in the marketplace. I think that acceptance of particular media of exchange by the state helps drive the liquidity premia of those media. See this old post.

Friday, December 14, 2012

A history of the pound sterling's medium-of-account

Shillings issued during Queen Elizabeth's reign

There are plenty of rumours that Mark Carney will implement some sort of NGDP targeting regime when he arrives at Threadneedle Street. If so, this will mark the seventh medium-of-account used to define the pound sterling since the pound's establishment in the early part of the last millennium. This storied list of media-of-account includes silver, silver/gold, gold, the US dollar, the Deutsche Mark, CPI, and perhaps NGDP.

First, some definitions. The pound sterling is a unit-of-account. Think of it as a word, a unit, or a brand name. The unit-of-account is generally defined in terms of some other good. This other good is called the medium-of-account. Some quantity x of the medium-of-account equals the unit-of-account. (See this older discussion of the definition of the word medium-of-account.)

1. Silver

The pound's first medium-of-account was silver.  A pound sterling was defined as 5,400 grains of 92.5% fine silver. We don't use grain measurements much these days, but a grain was legally defined as the weight of a grain seed from the middle of an ear of barley. So whatever weight of silver equated to 5,400 grain seeds defined the pound sterling.

The pound's 5,400 grains of silver was subdivided into a smaller unit of account, the shilling. Twenty shillings made a pound, each shilling equal to 270 grains. Over the centuries, monarchs redefined the unit-of-account by increasing the amount of shillings in each pound. For instance, Henry V divided the pound unit into 30 shillings, not 20, while Henry VII increased the amount of shillings in a pound to 40. This allowed the monarchy to issue more shilling coins from the same 5,400 grains of silver. By Queen Elizabeth I's time, a shilling only had 93 grains of silver, down from 270 grains a few centuries before. This meant that instead of coining just 20 shillings from 5,400 grains of silver, Elizabeth could issue 62 shillings from that amount.

2. Silver & gold - bimetallism

Gold coins called "guineas" were issued in 1663. Each guinea containing 118.6 grains of pure gold. While the value of the guinea was allowed to float relative to silver, this policy changed in 1696 when the monarchy declared one guinea equal to 22 shillings. Since 5,400 grains of silver was defined as 62 shillings, and 22 shillings was now defined as 118.6 grains of gold, the shilling was now dually-defined. Enter bimetallism, a system in which both silver and gold were the medium-of-account. The dual definition would be slightly modified by Sir Isaac Newton so that a guinea equaled 21.5 shilling in 1698 an 21 shillings in 1717.

3. Gold

In 1816, the bimetallic standard officially ended. The pound continued to be defined in terms of a quantity of gold grains and silver grains, but silver was confined to serving as the medium-of-account on payments below two pounds. For all practical purposes, gold had taken over the task of serving as the pound's medium-of-account. From 1816 to 1931, the pound would be defined as 113 grains of pure gold.

4. US dollar

After going off the gold standard in 1931, the pound had no publicly-disclosed medium-of-account until 1940, when it was redefined as US$4.03. While the USD served faithfully as the pound's medium-of-account, the specific amount of USD used in this definition changed three times over the next decades. In 1949 the pound dropped to $2.80 and in 1967 to $2.40. After Nixon closed the gold window in 1971, the ensuing Smithsonian Agreement redefined the pound upwards to $2.6057. This definition would only last for a few months when in June 1972 it became impossible to defend that rate. The dollar ceased to be the pound's medium-of-account.

5. Deutsche mark

In October 1990, John Major entered the European Exchange Rate Mechanism by defining the pound as 2.95 deutsche marks. As a result, the deutsche mark was now the pound's medium-of-account. The Bank of England was allowed to let the pound diverge from this underlying definition by a band of +/-6.5%, but the pound fell out of this band in September 1992 due to massive speculation by the likes of George Soros.

6. CPI

Since September 1992, the pound unit-of-account has been defined in terms of the consumer price index (CPI). In short, the medium-of-account is now the CPI basket, and an ever-shrinking basket at that. For the first few years, the pound was defined such that it bought a basket that declined in size by 1-4% each year. After 1997, the rate of decline was made more precise, 2.5% each year. The Bank of England is held accountable should the pound-denominated liabilities it issues fail to fall in the line with the ever shrinking medium-of-account.

7. NGDP?

If a switch is made to NGDP targeting, then the pound's medium-of-account will be updated from a variably-sized CPI basket to a varying NGDP basket. A pound sterling will be equal to a trillionth (or so) of UK nominal output. One could do so even more formally by adopting an NGDP futures market. Here is Scott Sumner describing such a scheme as "analogous to a gold standard regime, but with NGDP futures contracts replacing a fixed weight of gold as the medium of account."

You'll notice there are plenty of large gaps in the above history where the pound had either no public definition or was undefined altogether. Perhaps it's not necessary to always have a medium-of-account. Changes in the medium-of-account tend to be acrimonious and attract intense public attention. The bimetallism debates defined the 1896 US election, as evinced by the famous cross of gold speech. The drive to adopt NGDP as a medium-of-account seems no less controversial, at least if the debate  in the blogosphere is any sign.

Thursday, December 13, 2012

Turkey, Iran, and "gold for gas"

Grand Bazaar in Istanbul

What should we make of the so-called "gold for gas" trade between Turkey and Iran?

Turkey depends on Iranian natural gas to produce a large part of its electricity. In normal times, the Turkish natural gas monopoly BOTAS probably would have paid for Iranian natural gas with euros or dollars. The transaction would have been settled through euro- or US-denominated accounts that both BOTAS and the the National Iranian Gas Company (NIGC) held at a bank in Europe. That's my guess, at least.

It's become dangerous for Iranian companies to keep accounts in Europe lest they be frozen. So the NIGC has probably opened an account at a Turkish bank like Halkbank, a large government-owned institution. BOTAS likely keeps an account there too. When natural gas gets delivered across the border, Halkbank settles the trade by crediting NIGC's account and debiting BOTAS's account.

What the heck does the NIGC do with all the Turkish lira it accumulates at Halkbank from gas sales? There's only so much Turkish stuff that Iranians need to buy. Converting it into dollars or euros and sending it to Europe is probably risky, if not impossible. One avenue open to the NIGC is to go to Istanbul's Grand Bazaar and buy gold with its stash of lira deposits, then ship this gold back to Iran. This explains the huge outflows of gold from Turkey starting in early 2012.


So assuming I've got the mechanics right, claims to the existence of outright gold-for-gas trade between Turkey and Iran are exaggerated. Turkey's natural gas purchases continue to be settled via the banking system, not by barter. The gold end of the trade is just the second leg of the round-trip.

Oddly, the value of gold flowing from Turkey to Iran represents far more than the value of natural gas flowing in to Turkey, implying that something else is at work. One explanation is that Turkey buys a lot of Iranian crude oil too. A temporary waiver granted by the US allows Turkish banks to settle Iranian oil trades. I'd bet that a lot of the deposits earned by Iranian institutions from oil sales are also being sold for gold at the Grand Bazaar.

Secondly, a large chunk of India's oil trade is settled in Turkey. Since 2011, Indian oil refiners have been opening euro-denominated accounts at Halkbank. They've used these accounts to credit the accounts of Iranian companies and banks, thereby paying for Indian oil imports. How useful are Turkish-domiciled euros? Can Iranian firms easily transfer them elsewhere in order to buy stuff? Probably not. My guess is that most international banks are hesitant to accept Turkish euros, especially if they're linked to Iranian trade. Buying gold and repatriating it may be the best way for Iranian companies get their hands on purchasing power.

Insofar as obeying US sanctions, there's nothing illegal in any of this. Turkey is allowed to buy as much natural gas from Iran as it wants, and the US waivers granted to Turkey and India allow oil trades to be cleared by Halkbank and other banks without sanction (see my previous post). Converting deposits into gold and shipping it back to Iran is hardly a dodge – it's a fallback towards an inferior medium of exchange. For Iran, in a world of bad payments options, gold is the least bad.

Nevertheless, various US senators want to put the kibosh on what they refer to as the "gold game". The idea here is to punish banks that settle Iranian natural gas trades by excluding them from the US banking system. Faced with this threat, Halbank and other Turkish banks would likely refuse to deal with NIGC and, as a result, the Turkey-Iran natural gas trade would collapse. Now, such an extreme outcome would be highly unlikely since Turkey depends on natural gas for electricity and Turkey is a US ally. Most likely the US would grant Halkbank some sort of waiver allowing it to keep accounts for NIGC as long as these accounts were monitored to prevent NIGC from purchasing gold.

Indeed, if you read the fine print of the Menendez-Kirk-Lieberman Sanctions on Iran document, it is stipulated that banks engaging in Iranian natural gas transactions will be exempted from being cut off from the US banking system "so long as the purchasing country holds the payment for Iran in an account to be drawn on for permissible trade." What qualifies as permissable trade will probably not include gold. If Menendez et al. passes into law, it'll probably reduce the outflow of Turkish gold. But if NIGC and BOTAS decide to skirt the banking system altogether and deal directly in gold and gas, then you'll really see the start of the "gold-for-gas" game.

From a "moneyness" perspecitve, here are my thoughts. The monetary blockade has increased the liquidity of gold, thereby building a larger premium into the gold price. Any return to a more normal situation ie. Iran clearing trades again via the USD clearing and settlement system, will hurt gold's moneyness and lower the gold price.

Wednesday, December 12, 2012

What is a non-monetary economy?


The response to the above question will usually be a barter economy. But I want to show you that this is a tougher question than it seems. The answer depends on whether you're starting from a money view of the world or a moneyness view. (See Why Moneyness? in which I explain these ideas).

1. The money view, which is the standard view, begins by classifying all things in an economy into either money (M) or non-money. Any economy that has M in it is a monetary economy. All exchange in a monetary economy is achieved by trading non-money into M and back into a different non-money. When there is no M, then a non-monetary economy is said to exist. In a non-monetary economy, exchange occurs by trading non-money for non-money, our word for this being barter. So a non-monetary economy is a barter economy.

2. Things are different from a moneyness perspective. An isolated household living in a cave values their inventory of goods solely for its use-value—how each good satisfies the household's needs. The household's goods become liquid the moment that it realizes that other people are willing to exchange for them. Their inventory is now worth more to them than before because it provides them with a greater range of options. As once-isolated households trade with each other, goods will be graded according to their relative liquidities. Depending on its ranking, each good earns a smaller or larger premium over use-value. ie. a liquidity premium. Liquidity/moneyness don't exist in a world without trade. We call such a state autarky.

So depending on one's method of classifying the world, a non-monetary economy can be either a barter economy or an autarkic economy.

This conclusion may seem somewhat odd at first. Take what we would typically consider to be a barter economy, say a world in which people barter deer for beaver. This setup is actually monetary in nature, insofar as both pigs and wheat earn a monetary premium for their potential to be bartered. In other words, its possible to start monetary analysis way before we ever exit from so-called barter.

Monday, December 10, 2012

$42.22: Not quite the meaning of life, but a number worth remembering


One of the more archaic features of the US monetary system is that the price of gold continues to be set at $42.22. Ever wondered why that is? This post will work through some monetary history to show why, unlike most countries, the US doesn't mark the gold price to the market price of $1750 or so. I'll give a quick hint. Marking the gold price to market wouldn't be a mere cosmetic change—rather, it would require the Federal Reserve to hand over hundreds of billions of free money to the President. Here's how it all works.

The Fed currently holds 261 million ounces of gold. At the archaic price of $42/oz, this stash is valued at a mere $11 billion. With modern day gold trading at $1750, the market value of 261 million oz is actually $457 billion. Doesn't that mean that the Fed would show a huge mark-to-market gain if gold were revalued?

No. If you read the fine print, the Fed doesn't actually own gold ounces. Rather, it owns gold certificates that have been issued to it by the Treasury. There is a long history behind this. At the end of 1933, the Fed owned some 195 million ounces comprised entirely of physical gold. Valued at the then official price of $20.67, this stash would have been worth around $4 billion. The Gold Reserve Act, passed on January 30, 1934, required the Fed to transfer all of this gold to the Treasury in return for $4 billion worth of gold certificates.

Here's the kicker. Unlike most gold certificates, the ones issued by the Treasury to the Fed were not payable in a fixed quantity of physical gold. Rather, a $10,000 gold certificates simply promised to pay to the bearer $10,000 worth of gold.

Let's trace what happened the very next day. On January 31, 1934 the official price of gold was increased by the authorities from $20.67 to $35 per ounce. The Fed's certificates, which the day before had provided a claim to $4 billion worth of gold held at the Treasury, still provided the same $4 billion claim. But with gold having been revalued, $4 billion worth of gold certificates was now the equivalent of a mere 115 million ounces, far less than the day before when these same certificates could lay claim to 195 million ounces.

So by tweaking the gold price, the Treasury had "transferred" itself some 80 million ounces (195m less 115m) from the Fed. Valued at $35/oz, this 80m oz amounted to $2.8 billion. Using its newly-acquired 80 million ounces as collateral, the Treasury printed up fresh gold certificates, brought these certificates to the Fed, and had the Fed issue it $2.8 billion in newly printed currency.

Back in 1934, $2.8 billion was a lot of money. The Treasury would go on to use these funds to create the Exchange Stabilization Fund (ESF), a reserve fund that the Treasury uses to this day to circumvent congressional oversight over spending.

Let's zoom forward in time. The US revalued gold from $35 to $38 in May 1972, and again in February 1973 to $42.22. This is the price which stands today.

Just as in 1934, the benefits of a modern revaluation would accrue entirely to the Treasury. At the official price of $42.22, the Fed’s $11 billion worth of gold certificates currently lay claim to 261 million ounces of gold ($11b divided by $42.22). Say the official gold price was increased to $1750. The Fed’s certificates would still be worth $11 billion in gold, but these certificates would now represent a claim on a measly 6.3 million ounces of gold, far less than the current 261 million ounces.

After our hypothetical revaluation, around 255 million ounces (261m less 6.3m) sitting in Treasury vaults would be free and unencumbered. The Treasury might choose to just sit on its new treasure trove. But most likely it would proceed directly to the Fed without passing go, deposit $450 billion worth of gold certificates (255m oz. x $1750), and receive in return a massive $450 billion stash of Federal Reserve notes or deposits.

This odd result has created what I think is one of the more amusing equilibriums in monetary politics. Hard money types would like nothing more than to see their favorite asset, gold, revalued. But they don't actively pursue the idea because of the expansionary effects a revaluation would have on the Fed's balance sheet. Easy money types would like nothing more than to see the government get billions in free cash, but don't like the idea of the barbaric metal getting a leg up. The upshot is that gold stays valued at its archaic price of $42.22.

The always tedious US debt ceiling season is upon us, so don't expect this blog to be the only one to point to gold revaluation or other various loopholes as a way to hack the limit. The folks at MMR, I see, have come up with an odd trillion dollar platinum coin idea. In any case, by drawing attention to either of these loopholes don't assume that I'm recommending them.

The great monetary injection debate of 2012

1563, Bruegel the Elder
"Therefore is the name of it called Babel; because the Lord did there confound the language of all the earth"

This post is written for people in 2013 or 2014 who decide to have a debate on the importance (or not) of monetary injection points. This debate already transpired in early December 2012 across multiple blogs. Rather than starting from scratch, here's a bibliography.

The debate kicked off with Scott Sumner's response to this article by Sheldon Richman. From then on, in no particular order, are these posts:

Scott Sumner
It really, really, really doesn’t matter who gets the money first—part 2
You can start talking about Cantillon effects as soon as central banks start buying bananas
A voice of reason from the comment section
If I buy T-bonds, their price rises. If the Fed buys T-bonds, their price (usually) falls

Bob Murphy
Scott Sumner and I Have a Failure to Communicate
Resolution of the Sumner/Richman Showdown
You Might Be Talkin to a Market Monetarist If…
I Have a Deal for JP Koning, Scott Sumner, and Nick Rowe
Clarification on Cantillon Effects
Bill Woolsey Replies on Cantillon Effects
One More on Cantillon for 2012

Nick Rowe
Cantillon effects and non-SUPER-neutrality = does fiscal policy matter?
Defending Hayek against the Austrians

Bill Woolsey
Sumner on Injection Effects
Injection Effects and the Quantity Theory
Selgin on Cantillon Effects

Steve Horwitz
Sumner, Murphy, Richman, and Cantillon Effects

George Selgin
Sumner v. Cantillon

David Glasner
Those Dreaded Cantillon Effects

Daniel Kuehn
On Cantillon Effects
It's the rational expectations, stupid

JP Koning
Richard Cantillon on Cantillon Effects

Gene Callahan
Golden Meteors and Cantillon Effects

Kurt Schuler
Cantillon effects in Africa

If I've missed any other blogs, please post them in the comments section.

What was the final conclusion from all this debate? I haven't the foggiest clue. Unfortunately there's no final arbiter on blog wars. But since this is my blog, I'll go ahead and attach my final thoughts.

I'm only going to respond to the exact comment from Richman that set the debate off:
First, the new money enters the economy at specific points, rather than being distributed evenly through the textbook “helicopter effect.” Second, money is non-neutral. Since Fed-created money reaches particular privileged interests before it filters through the economy, early recipients—banks, securities dealers, government contractors—have the benefit of increased purchasing power before prices rise. Most wage earners and people on fixed incomes, on the other hand, see higher prices before they receive higher nominal incomes or Social Security benefits. Pensioners without cost-of-living adjustments are out of luck.
Say the Fed announces that rather than buying bonds from traders as it normally does, tomorrow it will inject new money by purchasing goods in shops. Upon the injection announcement, savvy traders will quickly bit up financial asset prices to offset the anticipated money injection. Goods prices, on the other hand, do not immediately get updated because shopkeepers don't pay much attention to Fed announcements. So even though shops will be the first to receive the new money tomorrow, shop keepers cannot purchase a larger real quantity of IBM or Google shares—these prices having already adjusted. So the uneven distribution created by new money has little to do with where money is injected. Even if shopkeepers receive the money first, it is the owners of flex-priced assets like IBM shares who will enjoy increased purchasing power—at least until all prices in the economy have adjusted to the new equilibrium.

[Updated with new links]

Saturday, December 8, 2012

Aggressive US monetary policy... in Iran

Whenever we think of US monetary policy we usually think of the Fed. There's another side to US monetary policy, and its probably just as significant.

Being part of the worldwide US dollar clearing & settlement system means having access to the world's most liquid payments medium: the US dollar-denominated bank deposit. As long as a nation's banks are connected to this network, goods that are produced in that nation will be infinitely more saleable. On the other hand, being cut off from it means that the same goods will be a lot tougher to move. The Iranian monetary blockade illustrates the US Treasury's ability to use banishment from the USD network, or the threat thereof, to exert incredible influence over the world.

Network view of cross-border banking, IMF, Minoiu and Reyes (2011) PDF

To see how this works we've got to understand how the worldwide US dollar deposit clearing system functions. Let's start at the periphery of the network. An Iranian bank (call it "Persian Bank") lets Iranians keep USD deposits and transfer them amongst each other. These trades clear on the books of Persian Bank. The US Treasury is powerless to prevent Persian Bank from doing a local USD business.

What happens if an Iranian customer want to receive USD from a French company to pay for Iranian oil?

To facilitate this transaction, Persian Bank needs to set up a what is called a correspondent banking relationship with a non-Iranian bank at the centre of the network. A Persian Bank exec flies to London and opens a USD account at "London Bank", a large multinational bank. As long as our French company's bank   we'll call it "Paris Bank" also has a USD account at London Bank, then the entire transaction can be conducted on London Bank's books. Paris Bank simply tells London Bank to transfer the appropriate quantity of USD deposits from its account to Persian Bank's account. Back in Iran, Persian Bank credits the USD account of the Iranian customer. At the same time, Paris Bank debits the USD account of the French company. The oil can now be sent.

Here's how the monetary blockade works. The US Treasury issues an ultimatum to London Bank. There's nothing that we can do to stop you from clearing USD trades on your books for Iranian banks, the Treasury says, but if you do so, you'll have to close your accounts at "New York Bank", a large US institution.

London Bank is in a pickle. The reason it keeps an account at New York Bank is so that it can transact the US side of its business. Assume that US importers keep their accounts at New York Bank and debit these accounts to pay for imported goods. London Bank's account at New York Bank allows it to settle trades between US importers and its European exporting clients. If London Bank is forced to close its New York Bank account, it can't partipate in US trade anymore.

For London Bank, the choice is easy. It will cease dealing with Iranian banks altogether since the cost of losing US business is far larger than the cost of losing Iranian business. The upshot is that in threatening to banish London from the US, the US Treasury can force London to banish Iran from the worldwide USD network.*

The removal of Iranian banks from the international USD clearing system has meant that it's infinitely tougher for Iranians to sell their crude. To get around the banking blockade, we here stories about Iran reverting to barter. But this has been insufficient to prevent Iran's economy from entering what seems to be recessionary territory.

This certainly jives with monetary theories of the business cycle. Milton Friedman, for instance, wrote that the Great Depression was caused by the Fed providing insufficient liquidity to the banking system. Rather than conduct massive open marker operations, it tightened. As the Depression worsened, we saw the emergence of barter and alternative payment schemes. Even Irving Fisher became an advocate of these systems, publishing Stamp Scrip in 1933. Because it has been caused by a lack of liquidity, Iran's recession is very much a monetary one. It will only get out of the recession if it is able to derive alternate payment schemes that make Iranian products as liquid as before, or if the US lets it back into the worldwide US dollar clearing & settlement network.

*the actual ultimatum given by the US Treasury is not an all-or-none ultimatum. As long as countries show some evidence of having reduced Iranian oil imports, the US Treasury grants a temporary waiver that allows banks in importing nations to continue to settle oil transactions made by Iranian banks. To date, all importers of Iranian oil have complied by reducing imports. This means that the Treasury hasn't had to act on its threat of sanctioning banks that do business with Iranian banks.

Wednesday, December 5, 2012

Richard Cantillon on Cantillon Effects


There's a dustup between market monetarists and Austrians over Cantillon effects. See Nick Rowe, Scott Sumner, Bill Woolsey, and Bob Murphy. What are Cantillon effects? One definition is the effect that a change in the money supply has on the real economy due to where money is injected. Rereading Cantillon, I think its better to define the effect he is writing about as the influence that a change in the money supply has given that people are incapable of anticipating that change.

Cantillon wrote in a world in which huge discoveries of gold in the Americas had steadily increased the price level. We know that if people perfectly anticipate the arrival of new gold, all prices will immediately rise. Cantillon thought somewhat differently. According to him, the initial discovery of gold would go unnoticed by people:
It is also usually the case that the increase or decrease of money in a state is not perceived because it comes into a state from foreign countries by such imperceptible means and proportions that it is impossible to know exactly the quantity which enters or leaves the state.
Il arrive aussi d'ordinaire qu'on ne s'apperçoit pas de l'augmentation ou de la diminution de l'argent effectif dans un Etat, parcequ'il s'écoule chez l'Etranger, ou qu'il est introduit dans l'Etat, par des voies & des proportions si insensibles, qu'il est impossible de savoir au juste la quantité qui entre dans l'Etat, ni celle qui en sort.
In his paper on Richard Cantillon, Michael Bordo echoes this:
In Cantillon’s work, the dynamic path of adjustment of relative prices, output, the interest rate, and specie flows depends on the expectations of agents in the various markets. This emphasis on expectations presages much of modern monetary theory. It is unclear exactly how expectations are formed in his scheme but the frequent examples of agents catching on slowly suggests that they are formed adaptively. Moreover, the repeated examples of people being fooled suggests that the availability and cost of information is an important aspect of Cantillon’s scheme. Such an emphasis antecedes modern macro theories of disequilibrium.
Cantillon then goes on to describe how unanticipated gold inflows would first be spent on food, forcing up food prices and the earnings of farmers. Farmers in turn employ more land, forcing up land prices. While all prices have now adjusted to the change in the money supply, during the adjustment period landowners are relatively disadvantaged since the price of their product is the last to increase.

While we don't have to agree with Cantillon's ordering of effects, it seems uncontroversial to assume that if expectations only adapt slowly, then there will be some sort of distributional effect during the adjustment period to an unanticipated change in the money supply. There can certainly be debate over the size and consistency of this effect. Austrians, for instance, build a business cycle theory out of it. Others consider the effect to be ephemeral.

On the other hand, if rational expectations are assumed from the start, then the location of gold's injection point is moot since everyone perfectly anticipates the repercussions and adjusts. In talking about injection points under rational expectations, it seems to me that market monetarists are having a totally different conversation than Austrians, who are interested in injection points under imperfect expectations. Is this just a debate over the nature of expectations? I see that Bryan Caplan has made the same point.

Tuesday, December 4, 2012

Why moneyness?


Here's why this blog is called Moneyness.

When it comes to monetary analysis, you can divide the world up two ways. The standard way is to draw a line between all those things in an economy that are "money" and all those things which are not. Deposits go in the money bin, widgets go in the non-money bin, dollar bills go in the money bin, labour goes in the non-money bin etc etc.

Then you figure out what set of rules apply specifically to money and what set of rules apply to non-monies (and what applies to both). The quantity theory of money is a good example of a theory that emerges from this way of splitting up of the world. The quantity theory posits a number of objects M that belong in the relation MV=PY. Non M's needn't apply.

The second way to classify the world is to take everything out of these bins and ask the following sorts of questions: in what way are all of these things moneylike? How does the element of moneyness inhere in every valuable object? To what degree is some item more liquid than another? This second approach involves figuring out what set of rules determine an item's moneyness and what set determines the rest of that item's value (its non-moneyness).

Here's an even easier way to think about the two methods. The first sort of monetary analysis uses nouns, the second uses adjectives. Money vs moneyness. When you use noun-based monetary analysis, you're dealing in absolutes, either/or, and stern lines between items. When you use adjective-based monetary analysis, you're establishing ranges, dealing in shades of gray, scales, and degrees.

In general, the first way of dividing the world has been overrepresented in the history of monetary discourse. I'd weight its prevalence at around 90%. Take Keynes's General Theory. Almost the entire book uses the noun-based approach to monetary analysis, except for Chapter 17 (and a small bit in Chapter 23). It's only then that Keynes describes the idea of a liquidity premium that inheres in all assets:
the power of disposal over an asset during a period may offer a potential convenience or security, which is not equal for assets of different kinds, though the assets themselves are of equal initial value. There is, so to speak, nothing to show for this at the end of the period in the shape of output; yet it is something for which people are ready to pay something.
In my posts I try to do two things. First, I make my best effort to always speak in the under-represented language of moneyness, not money. Not that there's anything wrong in splitting the world into money and non-money. But any method of dividing the universe will determine what one sees. Reclassify the universe along different lines and a whole new world emerges. With most monetary economics having been conducted in terms of money, there's probably a lot we've never seen.

Secondly, I hope to remind people that while you can choose either of the two ways to classify the world, you need to be consistent when you use them. Don't switch arbitrarily between the two.

With that being said, here are a few posts that illustrate the idea of moneyness.

1. How bitcoin illustrates the idea of a liquidity premium
2. Shades of a liquidity premium peaking through in stock market prices
3. Adam Smith: taxes contribute to fiat's liquidity premium, they don't drive its value

Saturday, December 1, 2012

Shades of a liquidity premium peaking through in stock market prices


In my other life, I analyze the stock market. I always find it interesting when the stock market reveals its often hidden monetary nature. The common assumption is that monetary analysis should be confined to a narrow range of coins, dollar bills, central bank reserves, and bank deposits. But this ignores the fact that all valuable things in an economy have a degree of liquidity, including stocks.

A stock's price can be decomposed into a "fundamental" component and a liquidity component. Fundamental value arises from a stockholder's right to receive any distribution of the assets of a corporation. The liquidity component is the premium on top of fundamental value that arises from the owner's ability to easily sell that stock. Knowing that a stock can be easily sold provides the owner with a degree of comfort that would otherwise be lacking if the stock was less saleable, or not saleable at all. This "comforting service" is built into the stock's price as a liquidity premium.

While in theory we can determine a stock's monetary nature by subtracting its fundamental value from its price, in practice this is almost impossible to do. Computing fundamental value is more art than science. Nevertheless, we can get indirect evidence of the existence of a liquidity premium by comparing different share classes issued by the same company. In Canada, it's common for large family-owned corporations to issue non-voting and voting shares. The family controls the company by holding 51% of the voting shares while the public holds the balance of the voting and all the non-voting shares. Both voting and non-voting shares rank pari passu, meaning they receive the same claim on the company's assets.

Given these properties, we'd expect the market price of voting shares to be equal-to or greater-than the price of non-voting shares. After all, since everything else about the two classes is equal, having a vote can only add to the value of a share.

The chart below shows the voting and non-voting share price of a major publicly-traded Canadian retailer. Below the price is the premium/discount on the non-voting shares. At the bottom are relative volumes traded.


Now it's evident from the chart that our hypothesis doesn't hold. For long periods of time, the non-voting shares of our retailer have traded above the voting shares. What might explain this? One reason is that non-voting shares are far more liquid than the voting shares. Just look at the much higher trading volumes in the non-voting shares. From 2008 to 2010, shareholders valued the liquidity bonus of non-voting shares more highly than the element of corporate control provided by voting shares. In other words, the perceived benefits provided by the liquidity of the non-voting shares caused their liquidity premium to balloon to the extent that non-voting share prices rose above voting share prices.

Why doesn't the non-voting share premium get arbitraged away? Well, the comfort that liquidity provides is a very real service, not a mistaken bit of irrationality that can be ironed away. A highly-liquid share is like a fire extinguisher - even if it's not being used, just having it there makes you feel better. So while buying cheap voting shares and short-selling expensive non-voting shares may seem like a risk-free arbitrage, it isn't. After all, if the market decides to put an even higher value on the liquidity services provided by the non-voting shares, then non-voting's liquidity premium will grow even more and the trade will lose money.

While risk-free arbitrage can't shrink a stock's liquidity premium, there are indirect forces that ensure the premium stays thin. The larger a firm's liquidity premium, the lower its cost of capital. After all, if you need to raise money, having a larger liquidity premium means that you needn't issue as many shares. Because a low cost of capital is a boon, firms will try to replicate the success of competitors who have attracted a large liquidity premium. They may do so by pursuing similar lines of business or marketing their shares to the same group of shareholders. This will have the effect of drawing trading activity away from shares with large liquidity premiums to those without, thereby destroying the underpinnings of that large premium.

All of this plays into the ongoing bitcoin discussion between Mike Sproul and I. While Bitcoin might have some negligible fundamental, or non-monetary, value due to its value as a curio, its liquidity premium is surely huge. There is no way to arbitrage this premium away directly, but over time competitors will peck away at it, causing bitcoin's price to deteriorate back to its fundamental value, which I'd guess is <$1.