Friday, August 9, 2013

Market monetarists and "buying up everything"

Market monetarists have a reductio ad absurdum that they like to throw in the face of anyone who doubts the ability of central banks to create inflation. It goes like this; "So, buddy, you deny that central bank purchases can have an affect on the price level? What if a central bank were to buy up every asset in the world? Wouldn't that create inflation?" Since it would be absurd to disagree with their point, the buying up everything gambit usually carries the day.

In this post I'll bite. I'm going to show how a money issuer can buy up all of an economy's assets without having much of an effect on the price level.

Let's return to my Google parable from last week. You don't have to read it, but you should. If you don't have the time, here's a brief summary. In an alternate world, Google stock has become the world's most popular exchange media and all prices are expressed in terms of Google shares. Google conducts monetary policy by changing the return it offers shareholders, thereby ensuring the price level is stable. The reason I'm using a Google monetary world rather than our own is that it cuts through all the accumulated baggage associated with our central bank-dominated monetary discussion. A new set of lenses may let us see a bit more clearly.

Say that financial assets trade at or near fundamental value, where fundamental value is the present value of returns to which assets are a claim. Deviations from fundamental value are fleeting since investors will either buy undervalued assets or short overvalued ones.

Google announces that it wants to double the price level, or, alternatively, to cut the value of Google shares in half. It will go about this by purchasing financial assets until this target has been met. [One niggling detail here is that Google's charter prevents it from consciously overpaying for assets. More on this later]

Google starts printing huge amounts of new shares and injecting them into the economy by buying stocks, bonds, commercial paper, derivatives, and whatnot. Their wallets flush with new Google cash, individuals start to spend away unneeded cash balances, putting downward pressure on Google's share price, and upward pressure on prices. Google's mandated doubling of the price level seems well on its way to being fulfilled.

But something halts the decline. The moment that anxious sellers push Google shares below fundamental value, investors step in and buy all shares offered. No matter how long Google's buying rampage continues, and how large the supply of Google cash in the economy, these investors mop up all unwanted shares. This has the effect of putting a floor under the price of the stock, and vice versa places a ceiling on the amount of inflation that can be created. Thanks to the investment demand for its shares, Google can buy up all the world's assets while hardly causing an increase in the price level.

The reason that investors willingly set a floor beneath Google's stock price is that Google is buying up assets at market prices, as stipulated by its charter. In buying at these prices, Google's fundamental value will never change, no matter how many shares it prints. Say that equity in our Google universe tends to trade at a risk-adjusted multiple of 10x earnings (i.e. a share is worth ten times current per-share earnings). Since Google is prohibited from paying more than 10x risk-adjusted earnings for the assets it acquires, and is itself valued at the same 10x earnings multiple, its fundamental value after each acquisition remains the same. In other words, Google has the same per-share earnings throughout its purchasing campaign. When anxious transactors try to rid their wallets of the excess exchange media created by Google "printing", -- say they drive Google shares towards 9x earnings -- savvy investors will immediately jump in and buy the undervalued stock, enjoying a free lunch until they've pushed Google's price back up to its fundamental value of 10x earnings.

So contra the market monetarist claim, the economy's reigning monetary superpower can print and buy up all the world's financial assets -- yet not cause inflation.

There are a few simplifications I've made here. Acquirers incur transaction costs. Commissions must be paid to investment bankers, for one. Secondly, there really is no such thing as "one market price". Financial assets trade in a range called the bid-ask spread. If Google always buys at the higher ask price rather than patiently waiting to be filled at the lower bid price, then it will consistently lose small amounts on each transaction. This means that after each acquisition, Google's fundamental value will have declined by a few beeps, and investors will bid Google shares down a bit. But this transaction effect is small, nor is it equivalent to the effect that market monetarists are talking about when they refer to central bank power over the price level.

Now back to the real world. Whatever general rules of finance that apply to Google's highly liquid financial media apply just as ably to the Fed's highly liquid financial media. See my previous post on this. So take out every mention of Google share in the above text and substitute it with Fed deposit and the same conclusions can be drawn.

Lastly, just like Google's charter prevents it from overpaying, the Federal Reserve Act specifies that the Fed must buy all assets in the open and liquid market, effectively preventing the Fed from overpaying for assets. So our analogy is more appropriate than one might initially assume.

PS. I'm not saying that central banks can never push up the price level via mass purchases. I'm saying that given a certain set of constraints, a central banker can buy up every single asset in the economy without having much of an effect on the price level. It is interesting that this constraint, embodied in our hypothetical Google's charter, approximates to the rules that actually govern the Fed and other central banks -- namely that assets must be bought at market prices. Remove this constraint and it would be very easy for either Google or a central bank to push up the price level, as my previous post showed.


  1. Google may have trouble reducing the value of its stock for the reason given but does that apply to the fed ?

    Surely the $ derives its value not from the feds fundamental value but rather from peoples' beliefs about the feds desire and ability to maintain the currency at a certain rate, plus the demand to hold cash. I see no reason why the fed at any time could not commit to half the $'s value just by credibly promising to print new $ bills and exchanging them for assets until the new rate was reached.

    1. As I showed in my previous post, the ability of Google or the Fed to maintain the currency at a certain rate is modified by each institution's underlying fundamental value, specifically the investment demand this value inspires. The demand to hold Google shares or Fed notes as cash adds a liquidity premium to either instrument. The upshot: Fed exchange media functions by the same set of rules than Google exchange media. So if Google has trouble creating inflation given the limitations I've set, so will the Fed.

    2. I just read your earlier post. I'm not sure I understand it fully.

      It sounds like you are saying that the value of the $ is determined both by the feds fundamental value and by a liquidity premium in addition to that. Its fundamental value is determined by its ability to pay interest to holders of $s. As long as the fed buys assets that maintain its ability to continue to pay interest its fundamental value (and the value of the $) can never be driven beyond a certain level. This fundamental value would seem to be related to IOR and its level compared with other returns in the economy.

      Is that a correct understanding ?

      If so, then why can't the fed just reduce interest rates to 0 so that liquidity premium became the only reason to hold $ and the more assets it purchased the lower the $s value would be ?

    3. "Its fundamental value is determined by its ability to pay interest to holders of $s."

      I would say that the fundamental value of a Fed liability is a function of its ability to pay current interest, future interest, and its final break-up value.

      If the Fed stops paying interest today, the liability will still have a fundamental value because 1. in scenarios in which everything else is paying -1%, a 0% yielding asset is a fine asset to own, 2. the interest rate the Fed pays might be increased back up in the future, and 3. the final break-up value of the Fed, its liquidation value, sets a lower bound below which the liability's price won't fall.

      That's why lowering rates to 0 doesn't reduce the motivation for holding dollars to the mere enjoyment of a liquidity premium.

  2. Central banks pay market prices, yes, but they don't necessarily offer a competitive rate of interest on their liabilities. And money holders can't force the CB to liquidate and deliver all the assets to them. If the risk-free money market rate is 5% and the CB is only offering 0%, the equilibrium demand for money will be limited.

    Can a central bank get out of a "liquidity trap" by buying stuff? In theory yes, because the more stuff the CB buys, the more leveraged it becomes. And at some point its liabilities will be seen as risky, which will push up the equilibrium rate of interest.

    But I've seen anyone, anywhere suggest the above as a way that QE could work (if taken to crazy extremes). It's just too far outside the box, I guess.

    1. "And money holders can't force the CB to liquidate and deliver all the assets to them."

      Neither can minority shareholders or non-voting shareholders force a company to be liquidated. But that doesn't mean that minority and non-voting shares have no fundamental value. [Thank god, because I own some ;)...] No, non-voting and minority shares have fundamental value because in the case of a liquidation (an event over which they have no control), appropriate assets will be delivered to them. The same goes for claims on the Fed.

      "...but they don't necessarily offer a competitive rate of interest on their liabilities... If the risk-free money market rate is 5% and the CB is only offering 0%, the equilibrium demand for money will be limited."

      So what?

    2. "No, non-voting and minority shares have fundamental value because in the case of a liquidation (an event over which they have no control), appropriate assets will be delivered to them. The same goes for claims on the Fed."

      The premise is that the Fed is doubling the price level. That means the claims are cut in half. It's irrelevant that the Fed could satisfy a greater claim. That just means it has more capital.

    3. Max, you've always got insightful things to say but you're not getting through to me right now. Give it another shot.

  3. So what stops the Fed from buying up the national debt and "retiring" it?

    1. The Federal Reserve Act prevents the Fed from not having an asset for each and every liability. Were the Fed to buy national debt and extinguish it, it would be orphaning its liabilities and be in violation of the Act.

    2. couldn't the Treasury in theory buy all its debt from the Fed with things like million/billion/trillion dollar coins (or US notes) for example? Then the Fed would have assets to put on its balance sheet in place of the bonds.

      Or they could just change the Federal Reserve Act to do what Michael Byrnes suggests, of course. What effect might that have?

    3. In theory, the Act could be changed to allowe Fed purchases of my grandmother's dirty stockings, but in reality the Act doesn't allow such a thing. Go give it a read, you'll see that it's very specific.

    4. The Act doesn't allow the Fed to buy "a collection of awful paintings", or "a rail car full of almost rotten carrots" either but that doesn't stop you discussing it.

      What's your view on the legality of the Treasury minting any-denomination platinum coins and depositing them at the Fed?

  4. I think the MM's claim the portfolio balances effect leads to inflation. Something about preferred habitat leading to a wealth effect leading to higher nominal spending and inflation. This, at least, is rooted squarely in a financial friction: market segmentation. The problem is they rarely rigorously defend this friction except for pointing to empirical tests of dubious worth. Theoretically, they really can't come up with reasons why arbitrage fails. Or, at least, I've never heard them.

    In any case, the Fed issuing IOR-paying reserves buy assets is the same as Treasury issuing T-bills to finance a sovereign wealth fund. I never heard anyone say the latter is inflationary.

    On the other hand, public sector spending on goods and services, financed at a central bank-induced negative real rate, has a long tradition of causing inflation.

    1. Good points.

      I don't think I've ever seen Scott Sumner talk about portfolio balance effects, but I could be wrong about that. David Beckworth has in the past.

    2. "I think the MM's claim the portfolio balances effect leads to inflation".

      Scott Sumner apparently denies that things like portfolio rebalancing effects are required for there to be an effective 'transition mechanism' for monetary policy. He seems to believe that people will simply believe a central bank's promise to create inflation and thus bring about that inflation themselves by automatically putting all prices up, or something. It doesn't seem to matter to him that there isn't necessarily a concrete way in which the CB can actually cause inflation itself other than through this 'expectations' or 'blind faith in CB powers' channel.

  5. True, Sumner seems to think reserves are inherently "special" and not T-bill substitutes.

    So much magic assigned to "the base". But the Fed only creates value from its unique attributes: a monopoly over bank reserves and irredeemable liabilities. Either 1) there is bank demand for additional reserves; or 2) there is a lemons problem in the banking system. Outside of this, the Fed is just intermediating maturities or credit. This balance sheet can be exactly replicated by Treasury or a hedge fund. Nothing "special" about the assets or liabilities.

    1. Yes, there is less that is special about "the base" than is commonly supposed. I'll go even further than you and say that I don't see irredeemability as a unique feature of Fed claims since perpetual bonds and equity are also irredeemable.

      One important thing that does make Fed notes and deposits unique -- and here I think Sumner is right -- is that the economy's prices are set in terms of Fed dollars. No other asset in the economy, neither gold nor t-bills nor cowries shells, is used by storekeepers/traders/banks/etc to express prices.

    2. Seems to me Reserves are only the unit of account when banks make them so (i.e. when they convert them to currency or use them for payments).

    3. ...and banks will only make central bank reserves the index for bank deposits when the broad public desires them. When citizens of a nation start to choose dollars over the local pricing unit (partial dollarization) the liabilities of the central bank become steadily less unique as their role as unit of account is displaced.

  6. Money's fundamental value derives from the liquidity discount between fair price and market price of an asset.

    If you have infinite liquidity, the liquidity premium that money enjoys goes to zero - its value tends to zero and prices surge. The reason why monetary injections can fail to create inflation is not because of money's fundamental value but transmission failure or failure insetting expectations.

    The transmission intermediaries (banks) might be susceptible to default risk (systemic leverage too high), doubtful recovery rates (deflating collateral) or plain poor AD. But very little of it has got to do with some magical "fundamental" value of money. Value of money is what it is (with a term structure). In such transmission-failure cases, the CB could do helicopter drops (addresses AD), selective asset purchases (collateral) or recapitalization (leverage) and support issuance-based fund-raising for corporates by widening the collateral acceptable for repos.

    Forward guidance on top of that is supposed to smooth out consumption during the monetary therapy period (ie "setting expectations"/forward guidance is actually about reducing uncertainty).

    Not all of it works, of course, because the diagnosis of the problem is usually not correct. But CBs do have the tools to reflate economies. And none of it takes any radical new thinking beyond what Japan has already done and is doing - ie reducing term-risk, finetuning the yield-curve and forward guidance.

    Wallace-neutrality based arguments against monetary policy's futility don't work because liquidity transformation is a major (if not the biggest) transmission mechanism.

    1. Welcome to my blog.

      I agree that if you have infinite liquidity, the liquidity premium on money goes to zero, as does the premia on bonds, bills, houses, MBS, and other marketable assets. In a world where everything is perfectly liquid, monetary phenomena disappear.

      But if the liquidity premium on the 10 year Treasury, the most repo-able collateral in the world, disappears, its price doesn't fall to 0. Though repoability is no longer valued on the margin, the 10 year remains a claim on its issuer, and that should be sufficient to give it a positive market price, though that price will be somewhat lower than before. The same goes for the debt issued by a central bank. When the liquidity premium that banknotes and deposits enjoy disappears, like the 10 year these instruments remain claims on the issuer, and the market will see it fit to endow them with a positive price.

      The transmission mechanism in my Google share example doesn't require banks. Say that Google wants a higher inflation target, so they pay silly prices for assets. All that is required for transmittal is intelligent agents who notice the decline in fundamental value intentionally engineered by Google's CEO. These agents act on that information by shorting overvalued Google and buying up undervalued assets with the proceeds, thereby enjoying excess returns. They rinse and repeat until they've driven up the price level.

    2. "But if the liquidity premium on the 10 year Treasury, the most repo-able collateral in the world, disappears, its price doesn't fall to 0"

      Which is a result that relies on the assumption of there existing an arbitrage opportunity between a 10y UST and a perfectly replicable portfolio made of nothing but future cashflows in dollars. If no-arbitrage exists between a UST and such a setup, then the value of claims on the Treasury are zero, indeed.

      A bit of an arbitrage-pricing theory primer would help clarify my point:

      1. There are some assets (or "contingent claims" like US Treasuries) in the world whose payoffs are perfectly replicable by some combination of future cashflows involving just dollars (this is static replication - if we want dynamic replication, we say there exists *some* deterministic portfolio-allocation strategy that allows for even stochastic price movements of an asset to be perfectly replicated by pure dollar cashflows). But let's stick with static replication for now to make things simpler - similar arguments hold for dynamic replication as well. Let's call this category of assets Category A.

      2. There are some assets which, no matter what magic you perform, are not replicable with dollar-based cashflows. For example, Google's shares - they are a claim on revenues earned by Google which are a component of the value gained by advertisers for whose ads Google is able to supply "eyeballs". No matter what combination of swaps, money-market funds, bonds etc you concoct, you will *not* be able to present advertisers with a utility-proposition which is equivalent to their ads being seen by users (which is the essential service Google provides). Let's call the category of such assets Category B.
      (In the Arrow-Debreu world this is known as an incomplete market - and it requires some prices to be taken at face-value for the market to reach equilibrium via no-arbitrage - we call such state-prices as "fundamental values/returns")

      Most assets in the world we see - houses, cars, food, stocks etc - fall into Category B - i.e., they are not perfectly replicable with money ("But we pay for them with money!" - you say - I'll come to that later). And to be honest, even US Treasuries also fall into that category becaue not only are they a claim on future cashflows of the Treasury, they are also a claim on the Treasury's ability to pay those claims (which they may not be able to due to purely legal/operational reasons rather than financial ones - something known as a technical-default) - ie a claim on the hazard-rate/credit-quality of the US government - which is a quantity independent of the interest-rates on dollars in the market (hence a CDS *does* trade on the US government with non-zero spread).

      So - what happens when you pump an infinite amount of dollars into the market? The value of things in Category A goes to zero (but wait, didn't UST's or even T-bills surge when QE began? Well, as I said, USTs really belong to Category B - and it's their non-zero "safety" premium combined with a low-interest yield curve which led to that surge)

      What happens to things in Category B? Their prices surge leading to inflation as their "fundamental" risk/return profiles remain the same while the risk-free rate goes down.

      Now what about dollars themselves? They fall into Category A - so even though people holding banknotes have claims on the Fed, the Fed has complete freedom to pay those claims in dollars themselves. So, the "fundamental" value of money doesn't even come into the picture at all.

      Lastly, to clarify the "But we pay for tomatoes with money!"-bit - yes we do, but it's because the market for tomatoes, potatoes and money comes into an equilibrium when the supply of money is finite.

      Apologies for the long comment - but I hope it clarifies things a bit.

    3. "even US Treasuries also fall into that category becaue not only are they a claim on future cashflows of the Treasury, they are also a claim on the Treasury's ability to pay those claims."

      "the Fed has complete freedom to pay those claims in dollars themselves."

      We could simply have the Treasury be the issuer of dollars, ie. just consolidate the Fed within the Treasury, and that means dollars are ultimately "a claim on the Treasury's ability to pay those claims."

      So what does the Treasury promise to pay? In setting an inflation target, it promises to buy back all outstanding claims in order to ensure that their price doesn't fall below target. They effectively promise to pay the holder of Treasury dollar liabilities a fixed amount of CPI goods (although they settle their obligation by open market sales of bonds, not actual CPI goods).

      If you de-amalgamate the Fed from the Treasury, I don't see things as being any different. It would be somewhat arbitrary say that some line is being crossed when the Fed becomes the issuer of central bank liabilities and not the Treasury.

      So I'd say money falls into Category B, just like Treasury debt.

      But you really haven't given any examples of what else falls in category A apart from Fed dollars, so I am having troubles understanding what you mean by your distinction.

    4. Yes - so if money and Treasuries were completely replicable with each other, inflating the supply of one would automatically bring down the value of both claims.

      The only reason that doesn't happen in the real world is because Treasuries and money *are* different - though both could be used as numeraires without breaking any arbitrage condition.

      You are completely right when you say that it is not possible for a central bank to achieve arbitrary levels of inflation when the notes it issues have some fundamental value besides liquidity. And, in the current setup of things, Treasuries *do* have a fundamental value besides liquidity (the future revenues of the US government).

      The point of our disgareement is then, whether money has any fundamental value at all besides liquidity - which I say it doesn't - and that's totally debatable (you might say the paper it's printed on or due to some market frictions, "money" has some value - in which case you can't increase its supply forever and expect inflation).

      As for assets belonging purely to Category A, there are none besides dollars themselves (by design).

    5. "The point of our disgareement is then, whether money has any fundamental value at all besides liquidity..."

      Yes, that's the crux of it, and I was trying to draw this out with my Google parable. You say central bank notes & deposits are pure balls of liquidity, I say that they are claims that an issuing central bank will be expected to repurchase with future revenues. And that they also have a liquidity premium on top of fundamental value. Whichever it is, the implications for policies like QE are probably large.

    6. Central bank liabilities are also the only thing that can be used to pay taxes to the Treasury. Isn't that a fundamental value?

    7. I pay taxes with my bank account, not Fed notes or deposits.

      But if it was the case that the only way to offset a tax liability was to pay with these instruments, then yes, that would constitute their fundamental value.

    8. you pay your taxes with a bank deposit, but then your bank has to pay the Treasury on your behalf with central bank deposits. Debiting your bank deposit is only the first step. The payment is completed when your bank's reserve account is debited.

  7. JP Koning has asked me to transfer my tweets here:

    Google example confuses equity vs. debt. Central banks buy assets with liabilities, not equity.

    If purchased assets appreciate, value of central bank liabilities does not change, central bank equity appreciates instead.

    If purchased assets lose value, central bank liabilities lose value, while equity value is preserved

    1. Welcome Vaidas,

      On your final point, don't you mean to say that if purchased assets lose value, equity depreciates while central bank liabilities don't change? If not, what am I missing?

    2. Suppose the central bank increases dividend payouts when assets appreciate, and does not reduce them when assets lose value. This is a very natural strategy that you are missing.

    3. Sure, but dividends are paid out after interest, so debt will always be protected to the downside relative to equity.

    4. Nominal vs. real.

      Protection of liabilities vs. equity is a nominal protection.
      Strategy of paying non-decreasing dividends is a real strategy.

      In case of central banks, protection of liabilities is trivial and it means that you have to pay zero interest, and you can't write off your liabilities.

      If you do a forward-looking valuation of central bank liabilities, purchases of risky assets will automatically reduce the value of liabilities, if central bank follows a dividend paying strategy that preserves the real value of dividends, and pays out extra profits in case of asset appreciation.

  8. Chris PapadopoullosAugust 13, 2013 at 4:26 PM

    Hi JP

    (I'm new to you're blog). I think there's a logical inconsistency in your argument (unless I've misunderstood, which is more than likely). Consider the three statements:
    1. Google creates and sells more shares.
    2. The price of shares relative to other goods doesn't decline.
    3. The value of google doesn't increase.

    If 2 of the statements are true, the other cannot be, yet you're argument seems to require all three to occur. Now where might I have gone wrong?

    1. Welcome, Chris.

      I'm not quite getting it. Why can't all three be consistent with each other?

    2. Chris:

      In #3, do you mean the aggregate value of ALL google shares? In that case #3 is wrong. But the price per share would normally not increase as a result of google creating and selling new shares.

  9. Great piece JP! While some might think the Fed has the power of Archimedes-or Promsethus who rolls his boulder up a hill-Bernanke is certainly not one of them. He certainly thought the Federal Reserve Act placed limits on him back in September 2008 which is why he told Paulson the TARP had to go through Congress for two reasons:

    1. The Fed lacked the tools to fix the financial crisis by itself

    2. Small d-democratic legitimacy required it go through the fiscal authorities-Congress.

    See page 328

  10. Was thinking more about moneyness and "buying up everything". I wonder if the benchmark is not "market value" but moneyness value. Use haircuts or bid-ask spreads as an example since they represent the ability to convert to money. QE of Tsys has no effect because repo haircuts and bid-ask spreads are so small (1%,0.05%, respectively). The stimulative effect of market-value purchases of MBS is higher (5% and 0.2%). Houses even higher (25% and 15%).