Financial Plumbing: Europe and the Fed's Interdistrict Settlement Account

One of this blog's most recurrently popular posts is a 2012 ditty entitled the Idiot's Guide to the Federal Reserve Interdistrict Settlement Account. The Interdistrict Settlement Account, or ISA, is a highly esoteric "plumbing" mechanism that lies at the centre of the Federal Reserve System. After a century of being ignored, it suddenly became a popular topic for discussion in late 2011 and 2012 as the breakup of the euro became a real possibility. Groping for a fix, European analysts turned to the world's other large monetary union, the U.S. Federal Reserve System, to see how it coped with the sorts of monetary problems that Europe was then experiencing.

Here's a short explanation of the ISA. Consider that there is no such thing as a unified Federal Reserve dollar. Rather, both the paper dollars that you hold in your wallet and the electronic reserves that a private bank holds in its vaults are the liability of one of twelve distinct Federal Reserve district banks. Thanks to the convention among these Reserve banks of accepting each others dollars at par, a 1:1 exchange rate between each of these twelve U.S. dollar brands prevails. This gives rise to the useful mental short cut of assuming that there is one homogeneous dollar brand. But to do so ignores the heterogeneity at the core of the system —we can imagine worlds, for instance, in which one district's dollars, say those of the St Louis Fed, are considered to be so inferior to the rest that the other Reserve banks will only accept "St. Louis's bucks" at a discount.

All inter-district flows between Reserve banks must be settled, which is where the ISA comes into the picture. The ISA is a ledger that tracks the various imbalances that accrue between Federal Reserve banks. Each April that imbalance is settled by a transfer of assets from debtor to creditor Reserve banks, so that if St. Louis is owing and San Francisco is owed, then bonds will flow from the former to the latter, reducing each district's respective ISA balance (or increasing it) to a sufficient level.

I'm happy to say that my ISA post was useful to a number of researchers, including Karl Whelan (pdf), Kevin H. O’Rourke and Alan M. Taylor, and most recently, Alexander Wolman (pdf), who all made reference to it in recent papers. I like to think that this demonstrates the second purpose of the econblogosphere. The first purpose, of course, is to swarm over polished work by those like Piketty and Reinhart/Rogoff searching for chinks in the armour. The second is to act as an advance scout of sorts. When a completely new problem crops up, a blogger can quickly pump out a few posts, establishing a beachhead from which the main army—academics with time, money, and resource—can begin to launch a larger-scale attack.

While scouts can provide useful hints on where to launch initial sorties, they will always make a few errors, and I want to draw attention to one error I made in my ISA post. I speculated that the Federal Reserve banks may not have bothered to settle the ISA in 2011. Given a visual inspection of the various imbalances that had arisen between several of the Reserve banks, it appeared that the Richmond Fed in particular had been allowed to carryover a large deficit while the New York Fed (FRBNY) was stuck with an outstanding credit. Luckily for the small group of folks interested in the ISA, Federal Reserve researcher Alexander Wolman has recently provided some clarity on this issue.

Wolman has written the definite explanation of how the ISA functions and it is well worth your time if you want to discover how this fascinating mechanism works. (In defense of my old Idiot's Guide, note that I did manage to incorporate the destruction of the Death Star scene into it — I doubt Alex's editors would let him get away with that). He also goes through the data to show how the ISA settled in April 2011. I had originally focused on the New York Fed's ISA balance as the basis for my suspicion that settlement may not have occurred—the FRBNY's ISA balance had not fallen by the proper amount over the settlement month. But if you look at the FRBNY's securities balance on its balance sheet, you'll see that it rose by $100-$150 billion, an amount sufficient to settle the debts that other Reserve banks owed it. If you care to explore more deeply, Alex deals with this on page 135 of his article. I'm tickled pink that he managed to "settle" this bit of trivia since it has been a recurring topics on this blog. (See here and here).

I should point out that the 2011 episode interested me because if non-settlement had occurred, then the ISA would impose very weak constraints on payments imbalances arising between the various district Reserve Banks. European analysts, who were looking to the U.S. for inspiration, needed to know whether the ISA imposed stern limits on imbalances or lenient ones.

Like the Fed, the ECB is composed of a number of member banks, or national central banks (NCBs). Each issues their own brand of Euro while accepting all other Euros at par, thereby ensuring a smooth 1:1 exchange between the various Euros. Unlike the Fed, the ECB has no settlement mechanism. Imbalances that arise between member banks can continue growing perpetually. This is what appeared to be happening between 2008 and 2012 as European depositors, wary of a break up the Eurozone, fled the GIIPS banking systems for safe havens like German and Dutch banks, resulting in the emergence of massive deficits and credits between the various member NCBs. The chart below illustrates the size of these imbalances, which have since shrunk.

Source: Euro Crisis Monitor, Osnabrück University

A number of analysts, led by Hans Werner Sinn, felt that a U.S.-style ISA settlement mechanism should be grafted on to the European payments system. In theory, this would impose strict discipline on NCBs and prevent imbalances from emerging. Many, including myself, felt that this sort of discipline might be a bad idea.

But a better rebuttal of the proposed European ISA is that the Federal Reserve ISA was never the stern mechanism that folks like Sinn made it out to be. Though my point about 2011 non-settlement is false, other features of the ISA provide for long settlement delays, including the "rediscounting mechanism" that I mentioned in my Idiot's Guide. However, the best person to learn from on this topic is economic historian Barry Eichengreen who, in the video that I've linked to below, provides a definitive historical overview of the ISA.

While the whole video is worth watching, I'm going to draw attention to a chart that Eichengreen shows at around minute 14-15 which I reproduce below.

Source: Federal Reserve Bulletin, 1922

During 1920 and 1921, large and persistent imbalances between Federal Reserve banks emerged, much like the imbalances that have plagued the Eurosystem since the credit crisis. It would seem that the Fed, just a young pup at the time, faced the very same problem that the ECB began to face just nine years after its debut and, much like the ECB, it chose to handle it by allowing for non-settlement. Eichengreen (and Mehl, Chitu & Richardson) has an upcoming paper that explores the long history of Reserve bank "mutual assistance", although for now you'll have to be content with the video.

The European payment imbalances debate (or Target2 debate) has long since died out. Germany's ever-growing creditor position halted in 2012 and has been shrinking ever since while debtors like Italy, Spain, and Greece have seen their negative positions return towards zero. No one talks about intra-Eurosystem imbalances or Euro breakup anymore, at least not on the blogosphere. But I have no doubt that somewhere in the ECB's deepest catacombs a group of European monetary architects are debating if, how, and when to import an ISA-style settlement mechanism into Europe. Let's hope that they are very careful in their approach and consider the softest possible solution.

Deep money, the coexistence puzzle, and the legal restrictions hypothesis

WWI Liberty bonds, which according to Neil Wallace circulated alongside Federal Reserve notes [source]

What follows are some thoughts on the coexistence puzzle as well as the folks who find it interesting.

There is plenty of hyperbole over the difference between freshwater and saltwater economists, but one peculiarity that surely distinguishes a freshwater economist from his saltier cousin is that they tend to be interested in the underlying motivations guiding monetary exchange, the so-called microfoundations of money. (Saltwater economists tend to be content with broad assumptions about monetary phenomena). Representatives of the microfounded approach, which includes the blogosphere's own David Andolfatto as well as Stephen Williamson—who has anointed his approach New Monetarism—like to refer to their models as "deep models of money".

One of the classic questions that continues to interest deep money types is the so-called coexistence puzzle. Zero-yielding financial assets like central bank-issued banknotes are "dominated" in terms of rate of return by interest-yielding financial assets created by governments. The puzzle that needs explaining is why these dominated instruments can continue to coexist with the instruments that do the dominating.

A quick answer is that a lower-yielding asset can coexist with the higher-yielding asset because the first is more liquid than the second. In an uncertain world, the stream of liquidity services that an asset provides over its lifetime is a valuable service. An asset that provides a little less income can still be demanded in the marketplace as long as it provides a little more liquidity. Deep money folks would say that my answer is a bit shallow. It avoids exploring both the qualities of the assets being used and the frictions that characterize the world in which those assets trade that might render one asset more liquid than the next.

Let's explore the setup of the coexistence problem in more detail. In a 1982 paper, deep money pioneer Neil Wallace defined the problem thusly; if the government were to issue small denomination bearer bonds, say in units of $5, $10, and $20, and these instruments were to yield interest, just like their larger denomination relatives, why would anyone carry 0% Federal Reserve notes in their wallets when they might own an interest-yielding replica instead? These two instruments shouldn't coexist—cash should be driven out of existence or, if they are to coexist, then bearer bonds should yield no more than the 0% rate on cash.

One aspect of the problem, Wallace noted, was that for some obscure reason, governments typically choose not to issue small denomination bearer bonds. The large denomination size of t-bills and t-bonds inhibits their use in trade, thus preventing at the outset any sort of direct competition between government bonds and zero-yielding cash.

However, Wallace pointed out that this doesn't explain why private issuers don't simply buy high denomination government bonds and create their own government bond-backed small denomination bearer notes. If they did so, Wallace believed that two things might happen. These private issuers, by virtue of paying interest on their notes (more specifically by issuing bearer bonds at a discount to face value and allowing them to appreciate in price till maturity, much like treasury bills) would drive inferior 0% yielding banknotes out of existence so that only interest-bearing notes circulate.

Alternatively, the public would allow privately-issued bearer bonds to circulate at par with existing currency. Par acceptance would mean that private bearer bonds no longer paid interest in the form of a steadily rising price. However, Wallace stumbled upon an interesting side effect of par acceptance: nominal rates on government bonds would have to fall to zero. Why? According to Wallace, arbitrage dictates that as long as the rate on long term government bonds is above zero, competing private issuers will flock to buy those term bonds with which to back their 0% bearer notes, putting upward pressure on bond prices and downward pressure on yields. It makes sense for banks to do so because they earn the spread between the 0% notes that they issue and the interest-yielding bonds they purchase. According to Wallace, the arbitrage window will only be shut when banks have driven long term rates close enough to zero that the the opportunity for excess profits disappears. In a free market, the term structure of interest rates disappears. All we have is a flat yield curve.

Here is Wallace: "Thus, my prediction of the effects of imposing laissez-faire takes the form of an either/or statement; either nominal interest rates go to zero or existing government currency becomes worthless."

Of course in the world we live interest-yielding bearer currencies have not kicked out 0% notes nor have private notes driven long term bond rates to zero. Wallace attributed this to various legal restrictions against banks from entering the small denomination bearer bond line of business. Take away these legal restrictions and he believed that his conclusions followed.

Even if we removed these legal restrictions, I'm not convinced by Wallace's arguments. Given free competition in note markets, I don't think that positive-yielding small denomination bearer bonds (issued either by a private bank or a government) must necessarily drive cash into exile, not do I think their coexistence means that the term structure of interest rates must be flat.

To start with, the necessity of calculating interest payments throws a wrench in the smooth transfer of a bearer asset, a point made by Larry White. Say that the bearer bonds are printed with a $10 face value but sold by the government at a discount to face so that their price appreciates over time until maturity, the capital gain being a stand-in for interest payments. Should someone wish to use their unmatured bearer bond to pay for something, they will have to calculate how much of a discount to face to apply to the bond. Such a calculation imposes a burden on the transactors since it will take time to crunch the numbers or require a costly technology to speed up the process. As White has noted, a $20 note held for one week at 5% interest would yield less than 2 cents. Is it really worth it for a banknote user to take the time and trouble to compute and collect such a small amount?

The interest rate feature of bearer bonds also precludes the simple summations that round numbers allow. An owner of a $10, $5, and $20 bearer bond doesn't have $35 in purchasing power. Rather, discounting the bonds will show that their purchasing power is composed of inconvenient sums like $9.33, $4.89, and $19.60. This makes it harder to know how much purchasing power is in one's wallet prior to going to market, thereby inhibiting the usefulness of bearer bonds as a liquid medium. Carrying around 0% currency which trades at its face value allows for certainty of purchasing power, a feature that may more than compensate for lack of a pecuniary yield.

Even worse, having inconvenient non-round bonds in one's wallet or till makes the process of obtaining or providing change a nightmare. If you buy a $10 bottle of wine with an unmatured bearer bond worth $11.56, what are the odds that the cashier will have a $1.56 bearer bond to give you as change? 0% cash may not offer interest payments, but at least the standardized even denominations in which it is available (combined with small change) allow for hassle-free transactions.

Lastly, all transactions in bearer bonds face capital gains taxes. That means on each exchange, the owner of bearer bonds must fish back into their records to find the original price at which they received the bond, determine the price at which it was sold, compute the profit, and then submit all this information to the tax authority. Payments made with 0% banknotes are not taxed, saving those who choose to transact with banknotes time and energy.

So in a nutshell, the previous factors may explain why interest-yielding small denomination bearer bonds will always be less liquid relative to 0% yielding cash, thus preventing the former from kicking the latter out of circulation.

If Wallace's first point is wrong and the payment of interest on banknotes doesn't drive existing 0% cash out of existence, what about his second prediction? Assuming that privately issued bearer bonds are accepted at par, what prevents profit-hungry banks from issuing 0% bankotes and accumulating interest-bearing bonds, eventually arbitraging bond rates down to zero?

As I've already illustrated, interest yielding instruments (especially large and ungainly ones like t-bills) will always be less liquid than cash. This gives rise to an un-arbitrageable wedge between the yield on cash and that on bonds, or a liquidity premium. Note-issuing private banks eager to earn more spread income may be able to temporarily push rates down through bond purchases. However, at these lower bond rates the marginal bond investor will be dissatisfied. They are now holding an asset that offers the same inferior liquidity return as before but less interest. These investors will sell their bonds, in the process pushing interest rate right back up to so that bonds once gain offer an attractive return on the margin. In short, bond-buying banks can't push long term bond rates down to zero because the rest of the liquidity-buying public won't let them.

But if long term rates won't budge when banks buy them, doesn't that mean that banks can continuously earn excess profits by perpetually issuing 0% notes and purchasing risk-free long term bonds? Free dollar bills left on the floor are, after all, the biggest no-no in economics. This ignores the fact that even if rates don't fall to zero, other costs will rise instead as banks compete to enjoy the spread. Larry White refers to this as non-price competition. It might include any number of costly strategies used to attract note-holders, including longer bank operating hours, more tellers, increased advertising expenses to make notes more trusted, and special engraving of notes to make one's bills more attractive relative to the competitions'. Thse mounting costs will soon counterbalance the fat spread income, thereby reducing the window for excess profits.

So contra Wallace, laissez faire doesn't reduce the risk-free bond yield curve to a flat line. Because liquidity differentials between bonds and notes will continue to exist free market or not, bond rates will always have to provide a sufficiently high nominal interest rate in order to attract holders.

What makes Wallace's conclusion about the yield curve in a free market interesting is its pleasing counter-intuitiveness. Many of the theories that deep money people come up with have this same quality, including one of my favorites: the irrelevance of open market operations, or what some call Wallace Neutrality. Stephen Williamson's odd theory that central bank's need to fight inflation by lowering rates, not increasing them, is in this same tradition, although in this case I think he's probably wrong.

Empirical evidence is the best way to test deep money theories. In the case of Wallace's legal restrictions theory, reality is not kind. For instance, we know that in the 18th and 19th centuries Scottish banks were not burdened by legal restrictions on the issue of notes, yet the Scottish yield curve was not a flat one. Indeed, interest bearing bills-of-exchange circulated freely with notes. Despite dominating notes, bills of exchange did not drive them to oblivion. Makinen and Woodward report on the coexistence of small-denomination interest-paying "bons" in 1920s France with the franc currency, and Wallace himself points to evidence that Liberty bonds circulated concurrently with Fed cash during WWI. (I should note that David Andolfatto is skeptical of these instances since they are commonly associated with periods of fiscal distress.)

As for some of the more modern deep money efforts like Stephen Williamson's, reality remains a hard customer. One wonders how Rudolph Havenstein's tight interest policy would have created the Wiemar hyperinflation, for instance. While I'm being tough on the deep money folk, I want to sign off on a positive note. Figuring out the underlying nature of monetary exchange is no doubt an important endeavor. Anyone who wants to learn more about monetary phenomena and central banking should probably be reading what the deep money people have to say.

From corporate bonds to a fiat CPI standard

Michigan Central Railroad 3.5% Bearer Bond with attached coupons, 1902

David Glasner is frustrated that there is no satisfactory theory of the value of fiat money, noting that "it's just a mess, a bloody mess, and I do not like it, not one little bit."

According to David, the core problem is the backward induction argument. Say that a valued fiat object provides no non-monetary services so that its price depends entirely on the expectation of future resale. This is a highly precarious situation since it it inevitable that someday no one will want to exchange for that fiat object. But if it is certain that no one will accept it at some point in the future, then why accept it in the first place? The explanation for the object's value rests on an "unlimited supply of suckers", as David puts it, hardly good fodder for a long term theory of asset prices.

David proposes tax acceptability as his way out of the problem, although he doesn't seem to be entirely convinced by this explanation. (I've never liked the tax-acceptability theory, as I wrote here. )

But there may be another solution to the backwards induction problem. I'm going to show that the market establishes the value of modern fiat money under a CPI standard in the exact same way that it establishes the value of a very familiar instrument; the standard corporate bond. Since corporate bonds are not subject to the backwards induction critique, then by analogy neither should fiat paper. What follows is a gradual progression from the one to the other with the aim of showing that if you can value a bond you can value a Federal Reserve note.

1. Start with a company, say Apple, that in addition to issuing corporate stock issues bonds. These are regular bonds. Each of them has a recurring quarterly claim on a nominal quantity of Apple income as well has the right to a final return of principal upon maturity. Should Apple be liquidated, bond holders get a first claim on whatever remains of the business. The market takes these terms and conditions into account and establishes a market price for the bonds. Pretty standard stuff.

2. A few years later Apple converts some of its bonds into bearer form, ie. they are printed on paper and transferable by hand, while leaving the rest unaltered. It issues these bearer bonds in both small denominations like 1/10, 1/4, 1, 5, and 10 units, as well as large 100 and 500 denominations. Attached to each bearer bond is a series of coupons. To receive interest, the bond owner detaches the coupon and brings it to Apple each quarter in return for a dollar payment.

Despite these changes, the market continues to value bearer bonds in the same way as the firm's regular bonds. Still pretty standard.

3. Next Apple ceases to periodically redeem its bearer bonds when they mature, converting them into perpetual bearer bonds. A perpetual is not as valuable as an equivalent series of redeemable Apple bonds, but the market can still establish a positive price for a perpetual debt instrument as easily as it can a fixed term bond.

4. Say that Apple begins to accept these perpetual bearer bonds as payment at Apple stores. Other merchants copy Apple. Bearer bonds become a highly liquid exchange medium. A liquidity premium develops, with Apple bearer bonds often trading at a higher price than Apple's regular bonds, despite the former being perpetual instruments. (Apart from the unusually large liquidity premium on bearer bonds, this is still pretty standard stuff.)

5. As the liquidity services thrown off by Apple's perpetual bearer bonds grows, Apple realizes that it can reduce the coupon rate it offers without losing too many investors. Apple eventually ceases paying any interest at all—owners of bearer bonds are sufficiently happy with the liquidity return provided by the bearer bonds that they do not require a pecuniary return. The bonds have effectively become "cash", or 0% yielding paper notes.

The market values these no-interest bonds in the same way they do the normal bonds. Both have first dibs come final liquidation of Apple. The difference is that whereas the regular bonds are fixed term, bearer bonds are perpetual; regular bonds pay interest while bearer bonds don't; and the bearer bonds carry a large liquidity premium whereas the regular bonds are illiquid.

6. The economy begins to spontaneously de-dollarize and Apple-ize. Merchants first set prices in terms of both "Apples" and dollars, and eventually just Apples. Debt contracts are redenominated into Apples. The market will continue to value both bearer and normal bonds in the same way as before.

7. Initially the Apple price level moves around according to the whims of the market. Later, Apple decides to stabilize prices by targeting a 0% rate of growth in the price of a basket of consumer goods, a CPI basket. One way it can do so is by varying the quantity of Apple bearer bonds in the economy via open market operations. If Apple increases the amount of bearer bonds via open market sales, then the liquidity premium on bearer bonds is reduced and the price level rises. If it engages in open market sales, the amount of bearer bonds is decreased, their liquidity becomes more valuable on the margin and the price level falls.

Alternatively, Apple can vary the 0% coupon rate on bearer bonds. If the purchasing power of Apple bearer bonds is rising, i.e. the economy is characterized by deflation, Apple can counteract this by reducing the coupon rate (to the point of even introducing a negative Gesell tax), thereby making bearer bonds less attractive and forcing the price level back up. By increasing the fixed coupon payment, it can do the opposite and prevent inflation.

8. Now Apple decides to let bearer bonds fall at 2% a year, or allow them to purchase 2% less of the consumer basket each year. As in step 7, it varies the coupon rate or conducts open market operations to counteract any forces that would prevent it from hitting its target.

We have now arrived at a modern fiat CPI standard. What was once a standard bond has been converted into a highly liquid perpetual bearer instrument with a 0% coupon (flexible upwards or downwards) that falls in value by 2% a year, and also happens to be the economy's medium of account.  This modified bond is the equivalent of the so called "fiat money" issued by the likes of the Fed and the Bank of Canada, or what is otherwise known as cash. Since the market can easily value Apple's regular bonds without falling prey to the David's backwards induction problem, then surely it can value Apple's modified bond after taking into account all the extra bells and whistles that have been added in steps 1 to 8.

(With apologies to Nick Rowe)

Labour Shares™: Beating capital at its own game

We all carry a variety of media of exchange in our portfolios, some more liquid than others. Deposits are pretty high on the liquidity scale, stocks and bonds a little less so, and our household's furniture is even less movable. The most sizable medium of exchange in our portfolios also happens to be our least liquid one: labor. Our capacity to use our brains and bodies to work is the primary currency that each of us own, although it isn't a particularly mobile one. Might things be different? Could labor be converted into a more effective medium of exchange that is capable of competing with highly fluid financial assets for preferred liquidity status?

Much of our lives are spent trying to make marginal improvements to the liquidity of our labour. We may choose to learn more skills so that we can participate in multiple markets, the more markets being open to us on any given day the more saleable our labour. Alternatively we may choose to learn one thing very well. While this leaves us with only one market in which to sell our labor, the quality of our work should differentiate itself enough such that the liquidity we enjoy within that one market outweighs the liquidity we choose to forgo by not participating in other labour markets.

Even with these liquidity enhancing strategies, labor remains a relatively hard sell compared to other media of exchange. This is problematic. Insofar as liquid media are the best hedges against an uncertain future—they can be rapidly mobilized to help plug leaks and patch holes—this means that labour, our largest medium of exchange, does a pretty bad job of protecting us from unpredictable events. It takes too much time and effort to sell the damn stuff. Amongst media of exchange, labour is the slow moving Titanic.

Which is why we fashion contractual crutches to convert illiquid labour into a more vendible product. Rather than go out into the marketplace each morning to find a new person who'll buy our labour, we usually make long term deals with buyers that require them to repeatedly purchase our services over a period of time. Having secured a repeated buyer of our services, we've converted a bad hedge against uncertainty into a better one, at least as long as the contract is in effect.

But there are ways to make labor even more liquid. To do so, we need to overcome the physical characteristics of labour that prevent it from being as good of a medium of exchange as, say, gold. Gold is divisible, portable, uniform, and durable. An ounce can be divided into smaller bits without any loss of value, it can be used by successive individuals without depreciating in quality, and it passes easily across time and space. Labor, on the other hand, can't be bottled up and stored, nor can it be passed on from buyer to buyer. Once expended on some task, labour is dissipated and ceases to be a conveyable medium. Labour is like an ice cream cone, it doesn't last very long.

A time-honoured way to encourage the liquidity of something is to securitize it. Take an illiquid mortgage, combine it along with others into a pool and splice that pool up into easily tradeable mortgage-backed securities. Or convert a sole proprietorship into a corporation, create shares that represent ownership, and list those shares on a marketplace, thereby converting illiquid ownership into liquid ownership. Exporting these ideas to the labour front, if people are capable of toiling away for fifty years, then why not create a series of claims on that labour and allow those claims to be sold off? In this science fiction world, these claims might be called 'labour shares'. While physical labour itself cannot be resold, the non-physical representation of that labour—labor shares—can be passed around indefinitely along long monetary chains.

This solves the resaleability problem that has historically impeded the liquidity of labour. After an employer has bought some of our labour shares and put us to work, should they have no further need for us they can trade away our shares to another employer rather than just firing us. Middle men might buy our shares and sell them on to other middle men, with the odd speculator jumping into the fray when they think they can buy low sell high. Financial engineers might combine our shares together with those of other similar workers, creating large pools of labour that can be bought all in one fell swoop by large employers. Our labour, once the Titanic of exchange media, has become a nimble instrument.

In this science fiction world, labour "does" more for its purchaser than in times past. As before it provides anyone who has bought it with a real pecuniary return (a labour share can be converted into work), but now it also provides an extra non-pecuniary return. Specifically, labor shares act as a stock of liquid media of exchange on par with an inventory of cash. A buyer of our labour, say a firm, now finds itself owning a fairly decent uncertainty hedge—should it be blindsided by some unforeseen event, the firm's owners can rest well knowing that the firm's managers can sell off either its cash or its accumulated labour shares, or some combination of the two, in order to help acquire the resources necessary to resolve the crisis.

Since labour now provides potential owners with a greater range of services than before it will command a premium over its previous price, or a liquidity premium. Anyone who provides labour will receive that premium, thereby earning more than they did before.

There are some ugly aspects to this science fiction world. It is certainly dehumanizing, treating humans like any other vendible commodity or asset. A market for labour shares might breed a highly itinerant workforce the members of which, much like Federal Reserve notes, would be constantly recycled from one side of the globe to the other. It also raises moral questions of personal agency. If we no longer want to toil for the employer who owns our labour shares, must we repurchase those shares—and our freedom—back from them?

The positive aspect of a world with liquidity shares is that in rendering itself more liquid, labor earns a greater share of the pie. Why should capital, after all, be rewarded the entire range of liquidity premia that society has to offer? Over the last few decades, financial engineers have made houses, equities, bonds, and all sorts of other assets ever more liquid. As a result the prices of these assets have steadily appreciated, a higher price being the market's reward for any asset that throws off growing quantities of liquidity services. That's great for the 0.01% who's wealth is primarily comprised of these assets; they enjoy ever growing capital gains (see chart below) and a larger slice of society's wealth. However, the majority of the world whose wealth is largely comprised of relatively illiquid labour potential has been left eating dirt.

The wealthiest 0.01% of society now owns 11% of society's wealth, up from just 2% in the 1970s.
Saez and Zucman, March 2014. [pdf]

Speed up the exchangeability of labor, on the other hand, and the reverse happens—labour grabs a larger liquidity premium for itself, thus appreciating in price and henceforth earning a larger share of society's total wealth.

Another advantage to a labour share scheme is that workers reduce their exposure to the discomforts of uncertainty. A worker's labour, represented by the full lifetime stock of liquidity shares in their portfolio, is more marketable than before, which means that they can more easily sell their labour to deal with potential disasters. This renders the future a little less frightening, the reduced contingency planning this entails allowing workers more time to enjoy the present.

Alternatively, rather than speeding up the liquidity of labour, maybe we should be slowing down the liquidity of all other things. That way labour, in the name of keeping up with the Joneses, never has to go down the somewhat ghoulish path of ever-accelerating liquidity. Various policies including a Tobin tax, the slowing down of equity markets in order to weed out HFTs, Glass Steagall style banking restrictions, and trade protectionism are all ways to help clog up the liquidity passageways. Enact these policies and mobile assets like stock and bonds lose their liquidity premia. The 0.01% who previously benefited from capital gains on rising housing, stock, and bond prices now suffer capital losses, and the labouring 90% will enjoy relative wealth gains.

The problem with these policies is that in constricting liquidity, we'd end up losing a major bulwark against felt uncertainty. Fretting and brow furrowing would increase, our lives worse off than before. The retort here is that perhaps liquidity should never have become our most important uncertainty hedge. In times past, self sufficiency, communities, families, and tribes were the institutions that we relied on to cope with a cloudy future. What made one's labour a great hedge against uncertain events, say a flood, was not that it could be rapidly sold off, but rather that together with other members of the community, our toil, sweat, and tears could be mobilized to plug dikes or rebuild houses. Implement policies like a Tobin tax and we may move back towards this world.

That may be true, by we've gone so many centuries down the liquidity path that its probably too late to reverse course. Labour shares, or something like it, might not just be science fiction; they could be the next step in the great liquidity race, especially if labour wants a larger share of resources. Perhaps the best way to cope with the ugliness created by an institution like labour shares, still very much in the imaginative stages, would be to innovate more humane ways to securitize labour. No-trade clauses or limited-movement clauses, for instance, might allow individuals to have some say in determining the destination to which they are dispatched. Unions may have a role to play in designing standards for labour shares that ensure that we don't bargain too much of our humanity away.

There is probably some upper limit to how liquid you can make something. Until that plateau is reached, financial engineers will keep making capital more liquid, and owners of capital will continuously enjoy the resulting price gains. Unless labour decides to liquidate itself, it could be facing many years of deteriorating wealth relative to the top 0.01%.