Wednesday, November 20, 2013
Friends, not enemies: How the backing and quantity theories co-determine the price level
Kurt Schuler was kind enough to host a Mike Sproul blog post, which I suggest everyone read.
I think Mike's backing theory makes a lot of sense. Financial analysis is about kicking the tires of a issuer's assets in order to arrive at a suitable price for the issuer. If we can price stocks and bonds by analyzing the underlying cash flows thrown off by the issuer's assets, then surely we can do the same with bank notes and bills. After all, notes and bills, like stocks and bonds, are basically claims on a share of firm profits. They are all liabilities. Understand the assets and you've understood the liability (subject to the fine print, of course), how much that liability should be worth in the market, and how its price should change.
Mike presents his backing theory in opposition to the quantity theory of money. But I don't think the two are mutually exclusive. Rather, they work together to explain how prices are determined. By quantity theory, I mean that all things staying the same, an increase in the quantity of a money-like asset leads to a fall in its price.
We can think of a security's market price as being made up of two components. The first is the bit that Mike emphasizes: the value that the marginal investor places on the security's backing. "Backing" here refers to the future cash flows on which the security is a claim. The second component is what I sometimes refer to as moneyness—the additional value that the marginal investor may place on the security's liquidity, where liquidity can be conceived as a good or service that provides ongoing benefits to its holder. This additional value amounts to a liquidity premium.
Changes in backing—the expected flow of future cash flows—result in a rise or fall in a security's overall price. Mike's point is that if changes in backing drive changes in stock and bond prices, then surely they also drive changes in the price of other claims like bank notes and central bank reserves. Which makes a lot of sense.
But I don't think that's the entire story. We still need to deal with the second component, the security's moneyness. Investors may from time to time adjust the marginal value that they attribute to the expected flow of monetary services provided by a security. So even though a money-like security's backing may stay constant, its price can still wobble around thanks to changes in the liquidity premium. Something other than the backing theory is operating behind the scenes to help create prices.
The quantity theory could be our culprit. If a firm issues a few more securities for cash, its backing will stay constant. However, the increased quantity now in circulation will satisfy the marginal buyer's demand for liquidity services. By issuing a few more securities, the firm meets the next marginal buyer's demand, and so on and so on. Each issuance removes marginal buyers of liquidity from the market, reducing the market-clearing liquidity premium that the next investor must pay to enjoy that particular security's liquidity. In a highly competitive world, firms will adjust the quantity of securities they've issued until the marginal value placed on that security's liquidity has been reduced/increased to the cost of maintaining its liquidity, resulting in a rise or fall in the price of the security.
This explains how the quantity theory works in conjunction with the backing theory to spit out a final price. In essence, the quantity theory of money operates by increasing or decreasing the liquidity premium, Mike's backing theory takes care of the rest.
P.S. Kurt Schuler's response to Mike.