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.