Monday, September 9, 2013

The rise and fall (and rise) of the hot potato effect

Don Randi Trio +1 at the Baked Potato, Poppy Records, 1971. [link]

In this post I'll argue that:

1. When it comes to financial assets, the hot potato effect is irrelevant.
2. The hot potato effect is born the moment we begin to talk about non-financial instruments
things you can touch and consume, like gold or cows or houses or whatnot.
3. Because central bank reserves are simultaneously financial assets and a tangible consumables, they are capable of generating a hot potato effect.
4. The moment that central bank money ceases to be valued as a consumer good, its hot potato effect dies.


Here's a short illustration of the hot potato effect that should serve as my definition of the term. Imagine that a gold miner finds several huge gold nuggets and quietly brings them to town to sell. The gold miner approaches the town's merchant with an offer to exchange gold for supplies, but at current prices the merchant is already happy with the size of his gold holdings. He will only take the the miner's gold if the miner is willing to buy supplies at a premium to the prevailing market price. The miner grumbles but sells the gold anyways. Now the merchant approaches the town's largest landowner with an offer to exchange gold for land, but the landowner is already content with the size of his gold holdings. He will, however, accept the offer if the merchant is willing to improve his price. The merchant accepts and the transaction is consummated.

Each subsequent townsperson will require a higher price to convince them to part with their goods and hold the newly mined gold. In this fashion the gold miner's nuggets work through the town's economy like hot potatoes, pushing up all gold-denominated prices.

With non-tangibles like financial assets, the hot potato effect is irrelevant. Say that our merchant decides to issue new stock or bonds into the town's economy by purchasing other stocks/bonds, gold, or by funding viable projects. The landowner takes the merchant up on his offer and tenders some gold, land, and shares in return for the merchant's newly-issued financial instruments. The merchant's financial instruments are fairly liquid and function as useful exchange media.

A few days later the landowner decides to sell these financial instruments and approaches the miner. The miner, who earlier experienced the hot potato effect, says that he'll only buy the financial instruments if the landowner will sell them for less gold. The landowner is about to consummate the transaction when the merchant barges in. The merchant offers to buy back the financial instruments at a smaller discount. After all, the merchant still owns the same land, shares, and gold that the landowner originally submitted for shares, and he can make a quick profit by repurchasing and retiring the landowner's stock with a smaller quantity of land/gold than was initially tendered. The miner reacts to the merchants competing offer by reducing the discount he required of the landlord, but each time he does so the merchant will match him with a better price. After much haggling between merchant and miner, the landowner will be able to sell his shares to one of them at a price very close to their original gold-denominated value.

Financial asset prices are driven not by the hot potato effect but by a "modern finance effect". The market value of a claim on an issuer is determined by the issuer's earning power and the risk of its underlying assets. If an individual tries to sell claims away like they were hot potatoes, profit maximizing arbitrageurs will step in and bring their price back up to their fundamental value, thereby annulling any hot potato effect.

Now back to central banks. Much like a merchant will buy back the instruments he has issued, a central banker commits to mobilize whatever bonds, gold, and other assets he holds in his vaults to repurchase every reserve he has ever issued. Like any other financial asset, the price of reserves is determined by underlying earnings power. Should a central bank issue new reserves by swapping them for bonds or gold, this issuance will not ignite a hot potato cycle of declining prices because arbitrageurs will compete to buy up any underpriced reserves.

The story doesn't end here. In addition to functioning as financial assets, central bank reserves also function as consumables. A bank that holds reserves enjoys a convenience yield: they can be sure that come some unforeseen event, they'll have adequate resources on hand to cope. Reserves are consumed in the same way that fire extinguishers are used up. While it is unlikely that either will ever be mobilized to deal with emergencies, their mere presence is consumed by their owner as a flow of uncertainty-shielding services over time.

Unlike fire extinguishers, reserves can be created instantaneously and at no cost. If fire extinguishers were like reserves, we'd conjure up any amount of them that we desired, their price would fall to zero, and everyone would enjoy their convenience for free. The marginal value that the market places on the consumability of reserves, however, never plunges to zero because a central bank keeps their supply artificially tight.

A central banker's ability to set off a hot potato chain of rising prices stems from the role of reserves-as-consumable, not their role as financial assets. Say that the banker offers to loosen the supply of scarce reserves. Existing consumers of reserves are already well-stocked with reserves at current prices. They will only accept the new issue by reducing the quantity of goods or other assets that they're willing to swap for reserves. Put differently, the price level must rise. This is the same mechanism by which the miner's gold nuggets were passed on hot-potato-like.

On the other hand, when a central banker further constricts the supply of already-scarce reserves, the marginal consumer of reserves will face a deficit in their reserve inventories, a hole that the consumer can only fill by offering larger quantities of goods/assets in return for reserves. Put differently, the price level must fall.

As a central bank issues ever larger amounts of reserves, the marginal value the market places on their consumability, or their marginal convenience yield, falls towards zero. As this happens, the hot potato effect becomes almost negligible—each subsequent issue of reserves increases the supply of what has already become a free good. The consumptive quality of central bank reserves is now akin to oxygen. Just like an increase in the amount of air has no effect on air's price—we already value it on the margin at zero— increases in the quantity of reserves are irrelevant. With the hot potato effect officially dead, we've arrived at Scott Sumner's case 5b, or Stephen Williamson's not-your-grandmother's-liquidity-trap.

With the death of the hot potato, the market's valuation of reserves is now solely governed by what I referred to earlier as the modern finance effect. Subsequent increases in the quantity of reserves via open market operations have no effect whatsoever on the price level. Anyone who sells reserves as if they were hot-potatoes will be corrected by arbitrageurs who return the price level to its fundamental value. This is a world in which Mike Sproul's backing theory precisely applies, or what Miles Kimball calls Wallace irrelevance/neutrality holds absolutely.

Reintroduce a shortage of central bank reserves and the marginal consumptive value, or convenience yield, of reserves will once again move above zero. The ability to harness the hot potato effect arises once again.

36 comments:

  1. JP, thanks for this article! I'm really mulling all this stuff over right now, and is directly related. I actually asked Scott if we're in case 5b right now and he replied "No, 5c." I'll take a look at that other article you referenced. Also, you probably noticed my thread w/ Mike Sproul on your previous post produced many interesting comments from Mike. Thanks again!

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    1. Also, I was imagining your whole miner, merchant, land owner story as some kind of folk Ballad. Perhaps Bob Dylan style.

      http://www.bobdylan.com/us/songs/lily-rosemary-and-jack-hearts

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    2. I agree with Scott that we're probably in case 5b. Mind you, 5b and 5c kind of blend in with each other, so its hard draw a hard line.

      Mike is a good teacher, don't hesitate to discuss stuff with him on my blog.

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    3. re: Scott: actually he said case 5c (not 5b... I suggested 5b)... but I agree w/ you they kind of blend, which was essentially his answer to Jared.

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    4. Oops. Yes, I agree with Scott that we're more in the 5c box than 5b.

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    5. BTW, re your "Leverage" article, I told him that lever #2 was a toss up between "Sproulian Lever," "Cullen's Bag-o-Dirt," and "Beckworth's Helicopter"

      Clearly "Sproulian Lever" is the best from a marketing perspective: being that "bag-o-dirt" and "helicopter" have less than positive connotations (for "helicopter," precisely because at least two others could lay claim!)

      http://ask-cullen.com/the-merit-of-negative-rates/

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    6. "Oops. Yes, I agree with Scott that we're more in the 5c box than 5b."

      Do you agree then that there's a bit of a paradox? That's it's possible to flatten the curve a bit to much and push yourself too close to 5b?

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  2. Also, does it go w/o saying that you don't think that MOE has an HPE (like Rowe and Woolsey contend)? Or is that a separate issue?

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    1. That depends on what definition Bill and Nick are using. These arguments are so sensitive to definitions, and there are at least 2 maybe 3 definition of "hot potato" floating around on the econ blogosphere. Given the definition I've used in this post, scarce central bank media of exchange does produce a hot potato effect, which would mean I agree with Bill and Nick. We would perhaps diverge when it came to bank deposits.

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    2. What do you say about bank deposits? No HPE? I think Nick would consider that MOE and thus subject to the HPE (i.e. Law of Reflux doesn't apply to bank deposits).

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  3. JP, have your views changed at all about the answer to this question I put to you previously?

    http://jpkoning.blogspot.com/2013/09/the-convenience-yield-as-epicentre-of.html?showComment=1378351463639#c5660292337080594540

    Do you still think that both cases A & B will result in "the price level will rise?"


    Also nice photo. I listened to a little of the Trio. Nice.

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  4. There's a bit in your story about the miner, merchant and landowner that doesn't sound right. When the landowner is trying to sell the merchant's instruments, I don't see why the merchant would necessarily want to buy these back at close to par value. He doesn't make a profit from buying them back; he's made the profit on a mark-to-market basis anyway. If the market for his instruments has indeed moved and he's anticipating issuing more in the future, then he's going to take a loss if he buys back at near par, then has to re-issue at a discount.

    Have I missed something?

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    1. The effect is very much like a firm that repurchases its own shares when it knows that they've fallen below fundamental value. Rather than investing in projects, the best use for its capital is to repurchase and retire its own shares. Doing so allows it to reap superior returns. In my story the merchant is so eager to repurchase shares because the landowner is selling them at below fundamental value, thereby providing the merchant with a superior avenue for his capital.

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    2. I agree that it can makes sense for companies to buy back their own shares or debt if their price is high enough. But that wouldn't normally mean they would always try to buy them back if they started trading above the issue price.

      I was wondering if I was overlooking the implication of your wording "gold-denominated value". Do you mean that these instruments may be exchanged with the merchant for a fixed amount of gold? At any time or at some specified future point? In that case, I can see how they might have a fixed value in terms of gold, subject to appropriate discounting. But then, I can't see why the landowner and the miner are negotiating some different price. Is this just a question of interest rates?

      Not that I'm that keen on the hot potato analogy. But I do think that growth of inside money can be inflationary, in certain circumstances, and I think you're suggesting otherwise.

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    3. Nick, I'm not implying that the shares are convertible into a fixed amount of gold. Perhaps I was a bit sloppy, but I was trying to invoke ceterus paribus. Nothing has changed with respect to the assets underlying the merchant's financial instruments since being issued to the landowner. They still have the same fundamental value. This militates against any hot potato effect.

      Can increases in the quantity of inside money be inflationary? Yes, insofar as inside money is similar to outside money and is valued not solely as a financial instrument but also as a consumable. The hot potato effect would work through the latter property. In my post I've assumed that the consumptive properties of the merchant's financial instruments aren't valued on the margin, so the hot potato effect can't occur.

      (Is the marginal value placed on the consumptive properties of bank deposits positive? I think this is unlikely because it would imply that bank deposits rise to a premium over underlying notes. If this happened there would be a huge incentive for banks to issue more deposits. Competition would drive to 0 the marginal value placed on the consumptive properties of deposits, and this would kill the hot potato effect.)

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    4. So, are you saying that deposits behave like the merchant's instrument? I.e., if people try and spend more, which might drive up prices reducing the value of the deposits, then banks will try to "buy back" those deposits first? How would they do that?

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    5. Yes. How would they do that? Deposits are convertible at par into notes, so technically banks always have a standing order out to repurchase deposits.

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    6. I don't see how banks can just decide to "buy back" deposits by exchanging notes. They don't just unilaterally repay deposits, do they? Do you mean, perhaps, that they cut their deposit rates to induce people to withdraw cash?

      So, is this saying that a natural response of banks to inflation is to cut their deposit rates?

      I'm not sure how much difference this would make in practice as there's obviously a limit to how much they can run down their deposit base, and that's going to cut in fairly quickly.

      I may have completely misunderstood you here (although the rest of your post all makes sense to me).

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    7. We know that the fundamental value of a deposit is $1, since that's the underlying medium into which it can be converted.

      If a deposit begins to trade below $1, say $0.98, then it makes sense for traders and other banks to buy the deposit for $0.98 and convert it into $1, earning a 2 cent profit. Or the issuer can conduct the arbitrage. Say there are $100 worth of deposits outstanding with a face value of $1 each, now trading at $0.98. The issuing bank has a portfolio of loans worth $100 on which it lent these deposits. If the banker sells $98 worth of loans to some other bank, buys back all the deposits for $98, then he's left with $2 worth of loans -- a risk free return.

      The overall point is that if tastes change and people decide that their portfolio holdings of good x are too large, then their efforts to all sell x so as to re-balance their portfolio will result in a hot potato effect. But if people believe that their portfolio holdings of financial asset x are too large, their selling will push the price of x below fundamental value. There are strong forces that counteract this.

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    8. I don't dispute anything you've described in your second paragraph. (Callable) deposits wouldn't trade below their par value, because they can be instantly converted. I'm just having trouble seeing how this relates to rising prices of non-financials. If prices of goods start rising, does this not lower the value of callable deposits and cash equally? I can't see why it should make anyone want to switch from one to the other.

      Where I think excess inside money might be inflationary is where people decide that they are holding excess financial assets generally, as opposed to excess of one particular asset. Assuming the people with assets are not themselves debtors, they have to try and get rid of this by spending. If this pushes up prices (of goods), then this will reduce the real value of fixed income assets and presumably increase the real value of equity. I would expect the prices of these assets to adjust to reflect this, but I'm not sure that it would lead to a general reduction in (nominal) debt.

      btw, I appreciate your responses on this - the only reason, I'm keeping on at this is that I really like your analysis.

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  5. Hello JP,

    In general I agree with the conclusion of your post that currently excess reserves are unable to initiate a hot potato effect. However, I don’t think your description of how the Fed controls reserves and with it the money base really fits what is going on. Banks and the Fed work as buyers and sellers. As in any trade you have to look at the motivations of both sides to determine when the trade will be made and at what price level. The Fed has two objectives:

    1. Ensure a smooth functioning of the money flow.
    2. Target inflation and employment through monetary policy.

    To address the first, the Fed implements a reserve ratio similar to a bank requiring you to have sufficient funds in your checking account to cover daily transactions. Further, a bank should have sufficient liquid capital that losses are covered and the bank does not suddenly go bankrupt which would undermine the stability of the banking system as a whole (see Lehman Bro.).

    The second point is addressed by its rate policy because low rates encourage lending while high rates encourage saving. With the quantitative theory of money that impacts total spending and prices.

    Now, let’s look at a banks incentive. That can be made short: A bank wants to make profit! It makes profit by earning interest on assets, increase in asset values and charging some fees while paying less in interest on liabilities and no losses in asset values (e. g. loan losses and interest rate changes).

    You say:” Unlike fire extinguishers, reserves can be created instantaneously and at no cost.… The marginal value that the market places on the consumability of reserves, however, never plunges to zero because a central bank keeps their supply artificially tight.”

    Pre-2008, all reserves did not earn interest while the assets the banks were selling did. Hence, adding reserves to its account has a cost to banks! Thus, it is not the Fed who keeps them scarce but the banks because a non-interest bearing reserve is not contributing to their earnings. They will therefore try to get rid off them by buying an interest-bearing asset in the interbankmarket. If too many reserves are chasing too few bonds interest rates will rise beyond the target level the Fed has set. Then, the Fed will sell treasuries from its holdings to get the rates back where it wants them. A bank can have a 50% reserve position; as long as it does not try to buy any other asset with it thereby driving rates up the Fed does not care. The bank’s owners, however, will surely be upset at some point. I think that shows how your next paragraph is not quite accurate:
    ” A central banker's ability to set off a hot potato chain of rising prices stems from the role of reserves-as-consumable, not their role as financial assets. Say that the banker offers to loosen the supply of scarce reserves. Existing consumers of reserves are already well-stocked with reserves at current prices. They will only accept the new issue by reducing the quantity of goods or other assets that they're willing to swap for reserves. Put differently, the price level must rise.”

    Simply put, the banks will never accept those additional reserves; the Fed cannot make them unless it changes the reserve ratio or pays interest on reserves as it does now.

    The picture that the Fed just can arbitrarily control the money base by “dropping” more reserves in the reserve accounts of banks is very misleading. As in any transaction, you need a willing buyer and a willing seller. And that is what the Fed and banks do, they don’t “donate” money to each other. The Fed fixes the price level not the amount of money/assets exchanged.

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    1. Sorry made a mistake; It should read: If too many reserves are chasing too few bonds interest rates will drop below the target level the Fed has set.

      Odie

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    2. Odie, none of my business I guess, but why don't you just put your name in and then any old URL, like www.google.com for example? That's under "Name/URL" in the pull down list. Then you wouldn't be "Anonymous."

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    4. Odie, you write:

      "Simply put, the banks will never accept those additional reserves; the Fed cannot make them unless it changes the reserve ratio or pays interest on reserves as it does now. "

      I disagree. Even w/ IOR = 0%, the Fed can buy assets on the open market. Somebody will sell for the right price offered by the Fed and that will result in ER stocks increasing. JP did not give me the impression that the CB just "drops" more reserves into the banks' reserve deposits.

      Have you read some of JP's other posts? If you haven't, you might want to take a look.

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    5. Aonon - I'm not sure where in my post I said that a central bank donates reserves to banks. It is a purchase/sale transaction.

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  6. JP,
    I'm trying to square this post with "permanence of the base". The "financial asset" view of reserves implies that they are also "impermanent". Is this necessarily the case?

    BTW, I like this post because it strips the base of its magical powers. It is the Fed's customers that determine the nature of the base (i.e. financial vs. consumable). The Fed is not in charge of this, except in so far as they influence that choice via interest rates.

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    1. Diego, I'm not sure what you mean by permanence via impermanence.

      "The Fed is not in charge of this, except in so far as they influence that choice via interest rates."

      The Fed can have an effect on the consumptive nature of reserves. By adjusting the scarcity of reserves, it varies their marginal consumptive value.

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  7. "Say that the banker offers to loosen the supply of scarce reserves. Existing consumers of reserves are already well-stocked with reserves at current prices. They will only accept the new issue by reducing the quantity of goods or other assets that they're willing to swap for reserves. Put differently, the price level must rise."

    I can see why the price of other assets might rise, but I can't see why the price of goods and services would necessarily rise.

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    1. James, I don't know the answer, but let me take a crack at it: Keep in mind that in this case I think JP is assuming we're not in a situation in which the marginal convenience yield for reserves is zero.

      Say that the [central] banker offers to loosen the supply of scarce reserves by purchasing bonds with reserves. The price of bonds rises immediately because the convenience yield for reserves is lessened, which drives up the price of bonds offering a pecuniary yield. Bond prices up means bond pecuniary yields go lower, which means both the pecuniary and non-pecuniary (convenience) yields on real goods and services looks better in comparison, thus their prices also rise (eventually... it might take a while if they are sticky).

      How's that? Sound plausible? So as long as there's a little convenience yield to wring out of reserves left (by increasing their quantity), then this can work. Hopefully that's correct.

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    2. Tom is right that we're assuming the marginal convenience yield is positive.

      Here's how I see it.

      When a central bank offers to loosen the quantity of scarce reserves, it effectively reduces the return on money relative to the both the pecuniary and non-pecuniary returns provided by all other goods/services and assets in the economy. Asset prices will quickly rise until they no longer provide a superior return relative to money. On the margin, agents will once again be indifferent between assets and money.

      But goods prices have not yet adjusted and therefore still provide superior returns relative to both money & flex-price assets. So while agents are indifferent along the asset:money margin, they are not indifferent on the asset:good or money:good margins.

      In the longer run, goods prices will rise enough such that indifference along all margins is restored. [link]

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    3. ... yeah, basically what I said! :D

      JP, I like your crisp professional explanation, but do you agree that my amateurish version of it was more or less the same? It seems basically the same to me, but perhaps I missed a something there.

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    4. Tom, you're right. We basically said exactly the same thing in our comments :)

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  8. JP, suppose for a moment that reserve requirements are 0% and that technological innovations make it possible for payment clearing by banks to be 1 (assuming banks have 0 risk)... in other words for payments to be cleared (assuming the banks all trust each other 100%) no actual reserves ever have to created. I'm making a distinction here between Fed deposits and reserves (reserves being Fed deposits at banks). Reserves would only be required in transactions between the Fed or government and private parties (banks acting as intermediaries for the most part).

    In such a setup, all private party transactions could be carried out w/o need of reserves: person x at bank A buys from person y, who banks at bank B, x's deposit is debited, y's deposit credited, and bank A simply takes on a loan of reserves from bank B for the amount of the purchase w/o any reserves ever becoming a liability of the Fed (I'm skipping the overdraft of A's reserve deposit, the crediting of B's deposit, the loaning of B's deposit back to A, and A's repayment of the overdraft).

    In such a situation, it seems the marginal convenience yield is 0, and thus there's no hot potato. True?

    Now suppose we add back in distrust between banks. Is that distrust (perceived risk) sufficient to restore the convenience yield and thus the hot potato?

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    1. 1st sentence should be

      "... for efficiencies in payment clearing by banks to be 1"

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