Thursday, July 3, 2014

To recapitulate...

I'm going on holiday and don't have enough time to write anything new. At the risk of being repetitive, here's a recapitulation of what is one of this blog's major themes: the idea of moneyness. Most of the component parts are spread out over a couple of dozen posts written over many months—here I'll try and piece the whole quilt together in one spot.

Money vs moneyness

The initial point comes from one of my first posts (as well as a later one). There are two ways of thinking about monetary phenomena. The standard way is to draw a line between all things in an economy that are "money" and all those things which are not. Deposits typically go in the money bin, widgets go in the non-money bin, dollar bills go in the money bin, labour goes in the non-money bin and so forth.

The second approach, the one this blog takes, begins with the idea that all things in an economy are money-like. The line we are interested in here is the extent to which the value of each thing is determined by its money-like qualities, or its moneyness, versus the degree to which its value is determined by its non-money like qualities, say its ability to be consumed. We might say that deposits have more moneyness than labour, and labour is more money-like than a second-hand speedo and so forth.

(This second approach isn't without precedent, see Keynes, Hayek, and Friedman.)

Why is moneyness a valuable attribute?

It's all in this post, but here's a quick recap. The greater an item's degree of moneyness, the easier it is for its owner to mobilize that item in trade should some unanticipated eventuality arise. This quality of being easily liquidated provides the owner of that asset with a flow of uncertainty-alleviating services over time, or insurance.

Because moneyness, like insurance, is a valuable property, people must choose on the margin whether to sacrifice moneyness for either consumption or interest. In deciding whether to trade an item with high moneyness for a consumption good with low moneyness, an individual must weigh the present value of the flow of uncertainty-shielding services provided by the former against the one-time zing provided by the latter. In considering a potential exchange between an item with high moneyness and an illiquid interest-yielding asset, the tradeoff is between uncertainty-shielding services and an ongoing pecuniary return.

The supply of moneyness

Moneyness is a valuable good, but it also must be produced at a cost.

Certain characteristics of a good allow it to become more money-like, including durability, verifiability, fungibility, and portability. Network effects may promote an item's degree of moneyness.

The moneyness of an object can be improved by manufacturing these characteristics. Gold, for instance, is rendered more money-like by incurring coinage costs in order to promote verifiability. Adding copper to a gold coin increases its durability. Network effects can be harnessed through marketing. As long as the expected returns of boosting an object's moneyness are higher than the costs, liquidity providers will happily bear the costs.

Whereas only banks and central banks create money, the cast of characteristics involved in supplying moneyness is quite varied. Investor relations teams manufacture it as do hedge fund managers like Cliff Asness and roll-ups like Valeant Pharmaceuticals.

Difficulties in measuring moneyness

It's all here. To summarize, people often use bid-ask spreads and the frequency distributions of various assets in trade as a way to measure an asset's moneyness. But this comes up short. Bid-ask spreads and frequency distributions are objective measures of liquidity. We want to know the price that the market ascribes to things like tight bid ask spreads, not the bid ask spread itself. Moneyness, like value, is a subjective quality, not an objective one.

The other problem is that the value of a good is usually derived from not only its moneyness, but also its 1) consumability and 2) its ability to yield pecuniary returns (like interest and capital gains). Stripping out the moneyness component from these others poses some thorny problems.

Here's how to do it

As I pointed out in this post, the trick is to poll people about how much they expect to be compensated if they are to forgo the ability to sell an asset for some a period of time, say one year, while still enjoying the pecuniary and consumption yields provided by that asset. The question goes something like this:
"How much would I have to pay you in order for you to relinquish all rights to trade away your holdings of asset x for one year?"
The price that an individual lists represents the value they ascribe to that asset's moneyness stripped of its other valuable attributes. It represents how much value they put on that asset's foregone bid-ask spread and other objective liquidity data.

On a larger scale, we want to create a moneyness market

The previous paragraph solves for each individual's assessment of moneyness, but we want to know the value that the market as a whole ascribes to a given asset's moneyness. In this post, I imagined what these markets would look like. We'd want to create a financial product that requires investors to set a price on how much they need to be paid if they are to relinquish the right to trade away asset x for a period of time. Buyers and sellers of these rights would establish a market price for the moneyness of all sorts of assets.

A few practical uses of moneyness and moneyness markets

Right now, equity analysts include an equity's moneyness in their valuation metrics, which is a big mistake. I go into this in plenty of detail here and here. If an analyst wants to accurately value an equity's price relative to its earnings, they need to have a measure of moneyness. That way they can strip out that part of an equity's price that is due to its moneyness and compare the non-monetary residual to earnings. A moneyness market would provide them with the missing data.

To properly value bonds and housing, we should probably do the same. See here and here.

And as I wrote here, financial assets like stocks are 2-in-1 deals meaning that you've got to buy an asset's moneyness along with its pecuniary return. Investors may prefer to have the one without the other. A moneyness market allows investors to split off and sell (or buy) each component separately, resulting in a more optimal allocation of moneyness and pecuniary returns.

Moneyness and monetary policy

Monetary policy is more of a sideline, but here are a few posts on the subject. A central bank issues liabilities with a high degree of moneyness. By increasing the quantity of outstanding liabilities, a central bank can reduce the marginal value that people are willing to pay for that moneyness, thereby lowering the purchasing power of central bank liabilities and increasing the price level. By tightening the supply of liabilities, it increases their marginal value, boosting their purchasing power and lowering the price level.

So in short, a central bank manipulates the moneyness of its own liabilities.

However, once it reduces the moneyness of its liabilities to zero across all time frames, a central bank can't create more inflation. This is the zero-lower bound from a moneyness perspective, which I go into here.

And in the future

I'm hoping to write a few posts on liquidity crisis and moneyness markets, and how moneyness markets can displace central banks as lenders of last resort (or at the very least help central banks improve).


  1. Have a great vacation JP!... and when you get back the world might be ready for another one of your great summary pieces (summarizing the views of a lot of different bloggers, and invariably introducing a few of your own thoughts on the subject as well). This time I'm talking about the discussion started by John Cochrane, which now has responses from David Glasner, Noah Smith, Nick Rowe and a comment from David Andolfatto.

    1. more from Krugman and Noah:

    2. Thanks Tom, will look at the links. I usually try to stay away from business cycle analysis, it's too vague and contentious.

    3. Oh, so you don't make awesome summary posts of every topic? ... ;^)

      (actually there was at least one more... I think Krugman or Noah or both)

    4. BTW, what's your secret for keeping the spam off your blog... er... other than the spam I put there, I mean? I love the fact that I don't have to do an eye test to post here, but my own experience with my own blog forced me to turn the eye test on to keep the garbage out. Do you just manually remove it?

    5. The blog catches about 99% of the spam that's submitted. Once or twice a week something gets by and I'll have to remove it.