Line in the sand

Over at the Free Banking blog, Kurt Schuler has two good posts on where to draw the line between money and other assets. While Schuler likes to differentiate between the monetary base (deposits at the central bank + currency) and other assets, he points out that there are a number of other popular spots to scratch out a line. The monetarists, for instance, settled on M2. I seem to recall that in America's Great Depression, Murray Rothbard let the cash surrender value of life insurance policies slip over the line into money supply territory. There are a thousand-and-one places to draw the line.

Schuler notes that rather than drawing a sharp line between money and other assets, one can also recognize a spectrum of "moneyness." Anyone who's read this blog knows that I'm amenable to this idea. Before we can ask where do we draw the line? we need to ask how do we draw the line?. Either treat money as a set of distinct goods, or treat each good as more or less money-like. By money-like, I'm referring to a good's role as a medium-of-exchange, not its role as a store-of-value or unit-of-account.

I've tried to convey these two approaches in the graphic below. I don't think either approach is better than the other, but we should be consistent. Depending which one you choose, you'll probably be able to see the economy from a different perspective, and different perspectives can be helpful.

Rothbard and the monetarists took the first approach. Between which discrete goods should the line be drawn? Should bank deposits make it past the line or not? How about shares?

Rather than placing a line between discrete groups of goods, the second approach draws a unique line across each individual good. This line demarcates each good's monetary qualities from its non-monetary qualities. All goods are money, but some are more money-like than others. Cattle (i.e. commodities), for instance, are simultaneously capital/consumption goods while also having monetary properties. Even beer (consumer goods) has a degree of moneyness since specialized producers, wholesalers, and retailers hold bottles in inventory for the purposes of resale.

In his discussion of moneyness, Schuler invokes the same classic 1956 W.H. Hutt paper that I've mentioned before. According to Hutt, money throws off a constant stream of services, the essence of which is availability. Just as an unused fire extinguisher provides its owner with constant comfort, the availability of money in one's wallet provides a steady flow of relief. Hutt described this idea as the yield from money held. But Hutt's is still an expression of absolute money, not moneyness, for his choice of words implies that only money-proper yields availability services and all other goods be damned. I find it useful to convert Hutt's expression from one of absolutes to one of degrees by rephrasing it as the money-yield from goods held. Beer, cattle, houses, stocks, banknotes, and bank deposits all throw off availability services, though the size of this stream varies according to each good's marketability, or liquidity. Because this service is valuable, a premium gets built into the price of a given good, or a liquidity premium.

Continuing his discussion of moneyness, Schuler also brings up the Divisia index, a technique of aggregating monetary assets championed by William Barnett. Rather than simply summing up quantities of so-called money, a Divisia index is a weighted monetary index. A component's contribution to the index is determined (in part) by its degree of monetary usefulness. How are monetary services computed? A liquid asset's interest rate is compared to the rate yielded by an illiquid zero risk benchmark bond. The more interest that is foregone in holding the given liquid asset implies that larger monetary services are being offered to compensate the asset holder. In other words, the lower its interest rate, the more money-like the asset, and the larger a component's contribution to the Divisia index.

This is a fascinating approach. Theoretically, I'd go even further than Barnett in extending the continuum of moneyness beyond financial assets to stocks, houses, cows, and beer. Here the computations get difficult. Barnett uses market-determined interest rates from debt markets to determine each Divisia component's monetary services. But the return from a stock comes primarily in the form of expected capital appreciation, not interest, so teasing out a stock's monetary services by comparing it to some illiquid interest-yielding benchmark bond would probably prove to be difficult. The same goes for houses, and it gets harder to compute moneyness the further we wade into markets for commodities and goods.

Even if we arrive at some aggregate amount of money services, I'm not yet sure what it would be useful for, and for whom. In thinking about degrees of moneyness, my preferred application would be  liquidity spreads rather than liquidity aggregates. Being able to see the risk premium of a given asset via credit default swaps is certainly useful, at least to financial market participants. One would imagine that knowing an asset's liquidity premium—how that premium fluctuates over time and how it compares to other assets' premia—would be just as helpful as knowing its risk premium.