Sunday, December 8, 2013

Milton Friedman and moneyness

Steve Williamson recently posted a joke of sorts:
What's the difference between a New Keynesian, an Old Monetarist, and a New Monetarist? A New Keynesian thinks no assets matter, an Old Monetarist thinks that some of the assets matter, and a New Monetarist thinks all of the assets matter.
While I wouldn't try it around the dinner table, what Steve seems to be referring to here is the question of money. New Keynesians don't have money in their models, Old Monetarists have some narrow aggregate of assets that qualify as M, and New Monetarists like Steve think everything is money-like.*

This is a interesting way to describe their differences, but is it right? In this post I'll argue that these divisions aren't so cut and dry. Surprisingly enough, Milton Friedman, an old-fashioned monetarist, was an occasional exponent of the idea that all assets are to some degree money-like. I like to call this the moneyness view. Typically when people think of money they take an either/or approach in which a few select goods fall into the money category while everything else falls into the non-money category. If we think in terms of moneyness, then money is a characteristic that all goods and assets possess to some degree or another.

One of my favorite examples of the idea of moneyness can be found in William Barnett's Divisia monetary aggregates. Popular monetary aggregates like M1 and M2 are constructed by a simple summation of the various assets that economists have seen fit to place in the bin labeled 'money'. Barnett's approach, on the other hand, is to quantify each asset's contribution to the Divisia monetary aggregate according to the marginal value that markets and investors place on that asset's moneyness, more specifically the value of the monetary services that it throws off. The more marketable an asset is on the margin, the greater its contribution to the Divisia aggregate.

Barnett isolates the monetary services provided by an asset by first removing the marginal value that investors place on that asset's non-monetary services, where non-monetary services might include pecuniary returns, investment yields and consumption yields. The residual that remains after removing these non-monetary components equates to the market's valuation of that given asset's monetary services. Since classical aggregates like M1 glob all assets together without first stripping away their various non-monetary service flows, they effectively combine monetary phenomena with non-monetary phenomena—a clumsy approach, especially when it is the former that we're interested in.

An interesting incident highlighting the differences between these two approaches occurred on September 26, 1983, when Milton Friedman, observing the terrific rise in M2 that year, published an article in Newsweek warning of impending inflation. Barnett simultaneously published an article in Forbes in which he downplayed the threat, largely because his Divisia monetary aggregates did not show the same rise as M2. The cause of this discrepancy was the recent authorization of money market deposit accounts (MMDAs) and NOW accounts in the US. These new "monies" had been piped directly into Friedman's preferred M2, causing the index to show a discrete jump. Barnett's Divisia had incorporated them only after adjusting for their liquidity. Since neither NOW accounts nor MMDAs were terribly liquid at the time—they did not throw off significant monetary services—their addition to Divisia hardly made a difference. As we know now, events would prove Friedman wrong since the large rise in M2 did not cause a new outbreak of inflation.**

However, Friedman was not above taking a moneyness approach to monetary phenomenon. As Barnett points out in his book Getting it Wrong, Friedman himself requested that Barnett's initial Divisia paper, written in 1980, include a reference to a passage in Friedman & Schwartz's famous Monetary History of the United States. In this passage, Friedman & Schwartz discuss the idea of taking a Divisia-style approach to constructing monetary aggregates:
One alternative that we did not consider nonetheless seems to us a promising line of approach. It involves regarding assets as joint products with different degrees of "moneyness" and defining the quantity of money as the weighted sum of the aggregate value of all assets, the weights varying with the degree of "moneyness".
F&S go on to say that this approach
consists of regarding each asset as a joint product having different degrees of "moneyness," and defining the quantity of money as the weighted sum of the aggregate value of all assets, the weights for individual assets varying from zero to unity with a weight of unity assigned to that asset or assets regarded as having the largest quantity of "moneyness" per dollar of aggregate value.
There you have it. The moneyness view didn't emerge suddenly out of the brains of New Monetarists. William Barnett was thinking about this stuff a long time ago, and even an Old Monetarist like Friedman had the idea running in the back of his mind. And if you go back even further than Friedman, you can find the idea in Keynes & Hayek, Mises, and as far back as Henry Thornton, who wrote in the early 1800s. The moneyness idea has a long history.

* Steve on moneyness: "all assets are to some extent useful in exchange, or as collateral. "Moneyness" is a matter of degree, and it is silly to draw a line between some assets that we call money and others which are not-money."

...and on old monetarists: "Central to Old Monetarism - the Quantity Theory of Money - is the idea that we can define some subset of assets to be "money". Money, according to an Old Monetarist, is the stuff that is used as a medium of exchange, and could include public liabilities (currency and bank reserves) as well as private ones (transactions deposits at financial institutions)."

** See Barnett, Which Road Leads to Stable Money Demand?


  1. Reminds me of the great Robert Solow quote: "Everything reminds Milton Friedman of the money supply. Well, everything reminds me of sex, but I try to keep it out of my papers." I guess Friedman was more of a money as an adjective kind of guy than Solow was.

  2. The biggest problem I have with the idea of moneyness is the size of the moneyness premium. Gold and silver would have had a big moneyness premium 100 years ago, but it's probably zero today. Bitcoin's value seems to be 99+% moneyness premium, but the moneyness premium on central bank-issued paper notes looks pretty close to zero. And since modern banking allows virtually any commodity (land, wheat, etc) to be coined into money, it seems like the competition between rival moneys would quickly compete away any moneyness premium.

    1. The moneyness premium is the present value of future monetary services thrown off by an asset. Assets also provide flows of investment services like interest which, when discounted, can also be represented as a premium, an investment premium. Barnett's idea is to remove the investment premium, leaving only the moneyness premium. If, as you say, the moneyness premium must be competed away to zero, then those same forces should be just as capable of driving the investment premium to zero. Why doesn't competition should force the price of all assets to 0? The reason that investment premium don't get competed down to 0 is the same reason that moneyness premia don't get competed down to 0.

    2. JP:

      A chicken throws off a stream of eggs, and the price of the chicken is the PV of that stream. Competition in the chicken market sets the price (investment premium) of a chicken at the intersection of the chicken supply and demand curves. Competition won’t push the investment premium of a chicken to zero. If people start carrying chickens around as money, then the demand for chickens will rise, and chickens will develop a moneyness premium, but this moneyness premium can easily be competed to zero if people start trading with chicken certificates instead of actual chickens.

      The supply curve of chicken certificates is horizontal, since they can be produced costlessly and instantly in infinite quantities (unlike physical chickens). So no matter how much the moneyness demand for chickens shifts around, the moneyness premium of a chicken stays at zero.

    3. "but this moneyness premium can easily be competed to zero if people start trading with chicken certificates instead of actual chickens... The supply curve of chicken certificates is horizontal, since they can be produced costlessly and instantly in infinite quantities (unlike physical chickens)."

      The generation of the monetary services provided by chicken certificates is not costless -- it requires an intial outlay and ongoing capital expenditures to build and maintain the network effects that keep a liquid asset liquid. In order to produce a marketable asset, one must spend money on marketing! Not just word of mouth and advertisements, but a physical network of redemption booths (ie ATMs) may be one of the costs of promoting marketability. In the case of a publicly-traded firm, they'll higher an IR department to go out and evangelize about the firm's stock so as to promote its liquidity. On the margin, the liquidity premium will not fall to zero -- it will fall to the cost of generating the infrastructure and marketing necessary to drive the premium.

    4. Those costs are normally 5% or less. Taking that as given, the moneyness premium can't be bigger than 5%.

    5. Probably way smaller than that when talking about assets like gold, bonds and equities. Maybe bigger when we're talking about monopolistically-supplied assets like central bank reserves.

  3. Divisia data is on FRED, also.

    This second link subtracts the divisia from the stock measurement. It's easy to see how small the moneyness premium is in the current low interest rate environment.

    1. Interesting. You can also see the big spike in M2 back in 1983, while Divisia hardly moved.

    2. Also interesting is how they've moved together since 2008 or so. At the zero-lower bound, most assets provide the same 0% investment return, which means they no longer provide differing liquidity returns on the margin. So at the ZLB, the simple sum aggregate is a good representative of the Divisia index, since the Divisia weightings are all equal.

    3. Hi John, I must have used the wrong reply button. My comment @12:58 PM was directed at you. Cheers.

  4. Re:second link. It's also interesting that moneyness seems to be declining into the 2000 and 2008 recessions. I wonder whether all asset premia were declining or 10% of assets lost all their moneyness rather rapidly. I'll have a closer look at the papers referenced on FRED. Cheers for the interesting link.

    1. Hey JT, FRED has the Data for a wide variety of aggregates, including one termed "ALL assets" which I'm not exactly sure what it includes though I assume it means that all bonds are included. Looking at them together might help give a little insight into your question.

      It might be more interesting actually to compare the divisia index to the total stock value index for each different aggregate.

      Your intuition was good that the premia act differently with different assets. Giant growth in M1 moneyness in the mid-'90s as M2 moneyness stayed flat... meaning the broader aggregates must have had declining moneyness. And very intersting stuff happening in '83 as JP said, especially with MZM.

      I'm sure there is a more rigorous way to look at this but I think this paints a pretty picture so far.

  5. wot about New Classicals? Don't hear much about them these days.

  6. The Housing Bubble can thus be seen to pop in two parts: 1) 2005-6 peak price, max top speculative value, yet still available for equity take outs, then 2) 2008, with a fast drop in price and banks no longer lending on bubble equity.

    The "moneyness of housing", or Mh, money in housing, was huge and then rapidly became tiny. This "moneylike" contraction in the real world is not well captured by current metrics.

  7. The Dispensation Economics Manifest presents Fifteen Corollaries, that is Fifteen New Things, are coming through the Economy of God ....

    Corollary #3 presents that a new seigniorage, that is a new moneyness is coming as authoritarianism replaces liberalism; the world will move from the seigniorage of investment choice, to the seigniorage of diktat.

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