Monetary policy as a system of connected lakes (a post for John Hussman)

I always like reading fund manager John Hussman because he writes very well, but I feel like he's dug himself into a bit of an intellectual rut—a situation that happens to all of us. For a number of years now Hussman has been accusing the Federal Reserve of setting off a massive bubble in equity markets. But if you ask me, his claim really doesn't square with the observation that we haven't seen a shred of consumer price inflation over that same time frame. Let's explore more.

Hussman recently penned an admirable description of the hot potato effect, the process that is set off by an easing in central bank policy:

Initially, central banks focus on purchasing the highest-tier government securities (such as Treasury bonds in the case of the U.S. Federal Reserve). Central banks buy these interest-bearing securities, and pay for them by creating “base money” - currency and bank reserves. That base money takes the place of interest-bearing securities in the hands of the public, and someone then has to hold that amount of zero-interest money at every moment in time until it is actually retired by the central bank. 

Now, having traded their high-quality, interest-bearing securities to the central bank in return for zero-interest cash, a portion of those investors will simply hold the cash in the form of currency or bank deposits, but some investors will feel uncomfortable earning nothing on those holdings, and will try to pass the hot potatoes onto someone else. To do so, these investors now have to buy some other security that is lower on the ladder of credit quality, and more speculative. The sellers of those securities then get the zero-interest cash. Some of those sellers, unwilling to reach for yield in even more speculative securities, hold the cash, but some climb out to a further speculative limb. Ultimately, the process stops when yields on speculative securities have fallen low enough that investors are indifferent between holding zero-interest cash and holding low-yielding but more speculative securities. At that point, all of the new base money is passively held by somebody.

For those who didn't bother reading the above quotes, here's a quick summary. Start out with a market where everyone is happy with their holdings of cash and securities. New base money is suddenly introduced by the Fed. In an effort to rid themselves of the excess cash, people drive the prices of securities to a high enough level (or their yields low enough) that everyone is once again content with their portfolio of cash and securities. In other words, we get asset price inflation.

A nice way to think of this is to imagine a system of lakes connected by channels, the water level representing prices. When water is poured into one lake the system is disturbed. Water quickly flows out of the first lake through the various channels into the other lakes, the water level of each body of water rising until they are equal. The agitated water becomes stagnant again. Likewise, when the Fed creates and spends new money it quickly courses through the various asset market until the price of each security has risen to a point that all new money is willingly held.

Hussman uses the hot potato effect a lot in his writing. And while I like his description of the effect, it always seems incomplete. He's missed how a Fed-induced asset price inflation might be conveyed to consumer goods markets.

Securities are really just promises of future consumption. By buying Google shares now, we delay consuming stuff now and push it off to some future date. So when Hussman says that easy monetary policy is driving up securities prices, we can think of this as the price of future consumption rising relative to present consumption.

Prior to the monetary expansion, investors will have already chosen whatever balance between present and future consumption feels right to them. Assuming these preferences stay the same throughout, the Fed-induced rise in future consumption prices (ie. Hussman's asset price inflation) means that people are now getting more future consumption than they had originally bargained for. Using our lake metaphor,  the water level of the future consumption lake has risen above the present consumption lake.

Uncomfortable holding too much future consumption, people will begin to rebalance into present consumption—after all, it offers a better bang for the dollar. Consumer price inflation is stoked as everyone buy goods and services. This inflationary process stops only when yields on present consumption have fallen low enough that people are once again indifferent between future consumption and present consumption. Or, returning to our lake metaphor, water has to flow out of the future consumption lake into the present consumption lake until water levels are equal and the surface is once again calm.

Over the years, Hussman has made use of the hot potato effect to say that the stock market is in a massive bubble thanks to Fed easy monetary policy. But I don't buy this claim. If the Fed really was causing such an enormous disturbance in securities markets, we'd have seen some sort of spillover into consumer prices as investors rebalance out of future consumption into present consumption. However, inflation in the U.S. has been well below 2% for several years now.

If the Fed is to be accused of causing an asset bubble, Hussman needs a theory to explain why people have not been arbitraging the markets for future and present consumption. Why haven't we seen a roaring CPI? This seems like a tall order. From what I've read of his work, Hussman traces easy money to as early as 2009. So his theory needs to explain why Fed monetary policy could inflate asset markets for seven years without affecting goods markets.

One way to patch up the story would be to resort to the good ol' Shadowstats trick, or the idea that there is consumer price inflation, we just don't see it in official statistics. But that's a weak argument, and thankfully I don't see Hussman using it. Alternatively, maybe something is inhibiting the rebalancing process. Returning to the lake metaphor, if a network of locks are being used to connect the lakes, then the water level of one lake can rise far above the others insofar as movement between them is inhibited by a locking mechanism. Like the picture at top. Thus we might be able to get asset price inflation without consumer price inflation. But what force could possible be strong enough to hold back such a torrent? I'd love to hear. It's possible it's not Hussman who's in a rut, but myself.

Until Hussman gives a decent explanation, I'll stick to the theory that there never was a Fed-induced financial bubble in the first place. Despite what many fund managers might claim, Fed monetary policy really hasn't been very easy, and that's why we haven't seen any froth develop in consumer goods markets. We need a better explanation for rising asset prices than Hussman's irresponsible Fed theory.

Helicopter money, Canadian-style

Proponents of helicopter money have been getting a lot of press lately, but I don't really get what all the excitement is about. I live in Canada, and no nation is closer to implementing helicopter money than mine. But if I work through the basic steps involved in implementing Canadian helicopter money drops, I'm underwhelmed. As far as I can tell, deploying loonie-filled CH-147 Chinooks just doesn't do anything that other government tools don't already achieve.

Helicopter money means using the nation's central bank to fund government spending. If a government wants to spend money, it typically auctions bills and bonds to the public and uses the money to fund programs, all the while paying interest on the debt it has issued. Cue the helicopter money advocates: why not have a central bank create money from scratch and gift it to the government for spending? This certainly seems to be a more stimulative approach than regular debt-funded government spending. The added bonus is that the government gets to provide extra services to people without having to pay interest on bonds.

As I said earlier, Canada is the closest nation to implementing helicopter money. This is because the Bank of Canada is permitted to credit the government's account with newly printed money by direct purchases of Federal government bonds at government debt auctions. Canada is unique in this regard; the U.S., Europe, U.K., Japan and most other central banks have set up a fence between the nation's central bank and its executive branch that prevent the latter from financing the former. Central banks can acquire government debt, but they can only do so by buying from the private sector in the second hand market for bonds, i.e. *after* the public has first acquired government debt. This means that central bank can't create new money for the government; they can only create new money for the public, specifically banks.

Ok, so what—the Bank of Canada has no fence. While it can provide new money directly to the government,  this money is free, right? After all, in order to get its hands on the funds the government still has to provide a bond to the Bank of Canada and pay interest on that bond.

But this ignores the fact that the Bank of Canada is owned by the Federal government and therefore pays all its profits to the government in the form of dividends. Thus any interest that the Federal government pays to the Bank is simply returned to the government. So the lack of a fence between the two institutions really does mean that the Bank of Canada can gift the Federal government with free money. The Bank buys new government bonds at government bond auctions, creates fresh money for the government, and re-gifts all interest it receives back to the government.  

Not only does Canada lack a fence between central bank and government, but it has been making extensive use of this feature for the last five years. In 2011, the government announced a measure called the Prudential Liquidity Management Plan (PLMP), the goal of which was to increase Federal government cash reserves by an amount sufficient to cover at least one month of net projected cash flows, or around $35 billion. The Bank of Canada was to directly supply around $20 billion of this amount.

To understand how it went about this, consider that the Bank usually buys around 15% of each government bond auction. It does so in order to maintain the size its existing portfolio of government bonds. After all, bonds are always maturing and need to be 'rolled over' if the funds are to stay invested. By raising the proportion of new Government of Canada bonds that it directly purchases at government securities auctions from 15% to 20%, the Bank of Canada's rate of purchases began to exceed the rate at which bonds matured, thus leading to a steadily growing balance in the Government's account at the Bank of Canada. That's right; cue helicopter money.

The arrow on the following chart illustrates what the 5% increase in participation did to the liability side of the Bank of Canada's balance sheet:

Note how the Federal government's deposits (in red) have grown quite considerably as a result of the PLMP. By the way, if you are interested in more details on the PLMP, I've blogged more fully about it here and here.

Canada hasn't fully gone down the path to helicopter money. To qualify as helicopter money, the funds must not only be created but also be spent. While the Bank of Canada has loaded up the helicopters, the Federal government has not yet allowed any of the $20 billion to be rained down on Canadians. That is understandable since the PLMP was always supposed to be a rainy day fund.

But let's say it did deploy the helicopters. Imagine that next month Justin Trudeau, Canada's new Prime Minister, decides to spend the $20 billion in PLMP funds held at the BoC by mailing a $1000 check to every adult Canadian. Would anything out of the ordinary happen?

The heli drops complete, Canadians will deposit these checks in the banking system, either saving the funds or spending the funds. Whatever the case, the $20 billion that had previously been held in the government's account at the Bank of Canada does not disappear. It flows out of the government's account at the Bank of Canada and into the accounts that private banks maintain with the central bank. In the chart above, the entire red area would be replaced by a large jump in the green area.

The Bank of Canada pays interest to depositors at a rate that is quite close to the rate that the Federal government pays on treasury bills. Interest payments made to banks reduce the Bank of Canada's profits, which means that the dividend flowing to the Federal government is much smaller than if the helicopter drop had not been deployed.

In the end, the government ends up in the same position as it would have if it had funded its mailing of cheques with traditional bond financing. Consider the traditional way of doing things. Trudeau issues $20 billion worth of T-bills to the market at 0.5%, paying interest of around $100 million yearly. Canadians all get nice fat checks. If Trudeau instead routes his efforts through the Bank of Canada, it is the Bank that ends up paying $100 million in interest each year to private banks given a deposit rate of 0.5%. This in turn reduces government revenues by $100 million because interest costs reduce the size of the dividend that the Bank of Canada is able to pay. Either way—traditional financing or helicopter money—we get to the same ending point; Canadians get $20 billion to spend and the Trudeau government faces a cost of $100 million.

So there seems to be no difference between Justin Trudeau providing cheques to Canadian via helicopters or the regular bond-financed route. Why then are so many people quite keen on helicopter money? I'm not sure, but it could be that the advocates already know that helicopter money isn't special. Instead, helicopter money is just a way to get increased government spending without calling it government spending. Add a veneer of central bankishness to anything and it becomes sterile and boring, effectively removing any political charge that new spending brings with it.

Or maybe not, I could be missing some good reasons for why helicopter money is a truly unique tool. Feel free to correct me in the comments section, although please illustrate using Canada as your example; it's always easiest to work off of real world data.

Hyperinflation 2.0?

If you haven't heard, protests are breaking out in Zimbabwe and unpaid civil servants are going on strike. This sort of thing hasn't happened in many years.

It's possible to trace at least some of the motivation for these developments to monetary mischief. Over the last twenty years, no nation has suffered more problems with its money than Zimbabwe has. Everyone remembers the hyperinflation and subsequent dollarization in late 2008. The most recent episode has seen a nation-wide bank run break out as Zimbabweans queue at ATMs to withdraw U.S. dollars, the local currency.

Remember last year's Greek bank run? I'd argue that Zimbabwe's bank run is similar. If you recall, Greek depositors were worried that—in the event of a Greek exit from the Eurozone—their deposits would be redenominated from euros to a Greek version of the euro or even a new drachma. Better to cash out in good euros before getting stuck with something worse. Line-ups grew outside Greek banks until authorities had no choice but to shut the system down.

Like Greece, there is a decent chance that Zimbabwean bank deposits might be made payable in funny money, namely a Zimbabwean version of the U.S. dollar rather than the actual U.S. banknotes. This may explain why Zimbabweans have been desperately queuing up at bank machines—they want to cash out before the worst case scenario happens.

To understand what I mean by 'Zimbabwean version of the U.S. dollar', we need to take a quick tour of the Zimbabwean banking system. A nation's central bank usually runs the plumbing that connects local banks. These banks keep accounts at the central bank—in Zimbabwe's case the Reserve Bank of Zimbabwe (RBZ)—and use balances held in these accounts to clear and settle among each other. These accounts, along with central bank-issued banknotes, constitute a nation's supply of base money, the quantity of which determines its price level. When Zimbabweans spontaneously stopped using the local currency, the Zimbabwean dollar, in late 2008, RBZ accounts (and cash) became worthless. The RBZ-managed plumbing system had imploded.

Zimbabweans still needed to bank, however, so local banks soon began offering U.S. dollar accounts to clients. A new plumbing system was re-erected overseas; instead of maintaining clearing accounts at the now defunct Reserve Bank of Zimbabwe, local banks held U.S dollar accounts at banks in Europe and the U.S., otherwise known as nostro accounts. They used these offshore accounts to settle interbank Zimbabwe payments. [1]

To understand how this offshore plumbing system worked, say Joseph (who lives in the capital Harare) writes a cheque to Robert (who lives in Bulawayo). Joseph's local bank might settle the cheque thousands of miles away by having its New York bank wire funds to the nostro account of Robert's bank, which might be based in London. Circuitous, right?

As for cash, say Joseph wants to withdraw $100,000 in U.S. banknotes from his Zimbabwe bank account. His bank would request its New York bank to debit its nostro account by $100,000 and then ship the $100,000 in banknotes to Zimbabwe. Joseph now has a suitcase full of Ben Franklins.

This offshore plumbing system worked pretty well. However, it didn't take long for the RBZ to re-insinuate itself into the works by offering local banks U.S. dollar accounts. These accounts allowed the local banks to use the RBZ's re-christened real-time gross settlement system (RTGS) to settle interbank payments rather than using the offshore plumbing system. After having lost its printing press, the RBZ had got back into the monetary printing game. It had created a Zimbabwean version of the U.S. dollar.

My understanding is that as time passed the RBZ forced local banks to "repatriate" their clearing accounts from the overseas system and deposit them at the RBZ. In effect, local banks were told to wire U.S. funds from their foreign-based nostro accounts into an RBZ account held at a European/American bank. In turn, the local bank was credited with an equal quantity of U.S. dollar deposits on the RBZ's own books. Voila, local banks had gone from holding U.S. dollars in relatively safe foreign banks located in places like London to holding the domestic RBZ version of the dollar. I can't imagine that bank managers were terribly fond of this forced switch given the RBZ role in igniting the 21st century's first hyperinflation.

Let's see how this new system works. Now when Joseph wants $100,000 in cash, Joseph's bank—call it the Commonwealth Bank of Zimbabwe—has two choices. Use its foreign nostro account as before. Or it can ask the RBZ to debit the Commonwealth Bank RTGS account and provide the proper number of U.S. banknotes. The RBZ in turn sources the cash by requesting its foreign bank to debit the RBZ account—now plump with confiscated dollars—and send the cash to Zimbabwe by plane. The RBZ's overseas dollar accounts in effect "back" the dollar deposits that the RBZ has issued to local banks.

On paper this sort of system should work fine... as long as the RBZ doesn't abscond with the funds in the foreign bank accounts. Unfortunately, this may be exactly what happened. The RBZ had effectively gone from being bankrupt to having amassed large amounts of U.S. funds overseas. This proved tempting, and according to former finance minister Tendai Biti the regime began dipping into the RBZ's foreign stash to pay for expensive junkets and to finance public sector salaries. The upshot it that there may not be enough U.S. funds in the RBZ's foreign accounts to back its promises to local banks.

This means that now when Zimbabweans go to their banks to get U.S. cash, the banks—which before had no problems meeting these requests via their nostro accounts—are hamstrung. They have U.S. dollar accounts at the RBZ but the RBZ is unable to draw on its depleted overseas accounts to get the requested cash. The lineups that have developed are the public's attempt to squeeze out whatever spare dollars remain in the system, an attempt that is rendered much hard given the withdrawal limits that have been instituted to slow down the run.

Zimbabweans are already starting to see a divergence between the price of an electronic dollar and a paper dollar. Various media reports say the practice of "cash burning" has re-emerged for the first time since the hyperinflation of 2007-08. Anyone who needs to convert deposits into cash, frustrated by long lines at ATMs and withdrawal limits, can instead approach an informal dealer who offers to buy their deposits at a discount of 10-20% of their cash value (see here and here). Think of the 'cash burning' discount as the market value of an RBZ-backed bank deposit. If the regime has indeed wasted all the money in its nostro accounts, this discount will only widen.

The theory that the regime has absconded with the RBZ's overseas funds is consistent with a flurry of official proclamations over the last month or two. If the RBZ is indeed bankrupt, it would make sense for the ruling regime to adopt the same strategy that Greece did last year; implement capital controls to trap as many U.S. dollars in the banking system as possible, thus limiting the damage and buying time for the government to rebuild the balance sheets of both the RBZ and the local banks before reopening for business. This would probably require some sort of loan from China or elsewhere. Under this scenario, Zimbabwean deposit holders could very well have to take a large haircut.

As in Greece, the RBZ has started to ring-fence the system by instituting daily withdrawal limits (of around $100); enough to allow Zimbabweans to get by but not enough to hurt the banking system. To coax people into accepting electronic dollars rather than paper dollars, the central bank has suddenly decreed much lower fees on bank payments and transfers. The government has also invoked the Bank Use Promotion and Suppression of Money Laundering Act, which punishes citizens and business if they refuse to deposit their money in banks. More radically, it has imposed severe import restrictions on a broad variety of goods from furniture to beans to fertilizer, a policy that presumably prevents cash leaking over the border. Together, all these regulations seem designed to help stuff as many U.S. banknotes back into the RBZ as possible.

Alternatively, it's possible the Zimbabwe government cribs from the Argentina play book and sets up a corralito, or coral, followed by a redenomination of dollar accounts into the local unit. Unlike Argentina, which had pesos, Zimbabwe is fully dollarized and doesn't have its own paper currency in which to redenominate deposits. But so-called bond notes (which I wrote about last month), an issue of paper money set to debut this fall in denominations of $2, $5, $10 and $20, may be a step in the Argentinean direction. Rather than meeting conversion requests by providing U.S. dollars, the RBZ will be able to print off any quantity of bond notes it deems necessary. In this way U.S. dollar claims on Zimbabwean banks will cease to be payable in actual dollars but in the RBZ's peculiar brand of U.S. banknotes, probably worth far less than the real thing.

It seems perverse that Zimbabwe could see another hyperinflation while on the very dollar standard that was meant to immunize it from a hyperinflation scenario, but I'm starting to worry this could happen. Consider that Robert John Mangudya, the head of the RBZ, claims that retailers are beginning to put two different price tags on one product, a higher one for electronic payments and a lower one for cash. If the RBZ-issued electronic dollar continues to inflate then electronic dollar sticker price will rise but the U.S. paper dollar price will stay constant. This second set of prices would at least provide some modicum of price stability to the nation.

Not so fast. Mangudya warns that the central bank will prosecute any retailer that sets two prices. If retailers comply and set only one price for their wares, that effectively undervalues U.S. banknotes and overvalues RBZ-issued U.S. electronic dollars. Gresham's law will take hold as shoppers use only bad electronic dollars to pay for things while hoarding their good, and undervalued, paper dollars in their wallets. Unwilling to be the dupes and accumulate overvalued and unwanted electronic dollars, retailers will have no choice but to jack up their prices, essentially adopting the RBZ U.S. e-dollar as the standard unit of account, or unit in which they set prices. With U.S. dollars no longer being used as a medium of exchange and unit of account, price stability in Zimbabwe will cease to exist.

One hopes that rumors that the regime has absconded with the RBZ's funds are false and that the current bank run and potential inflation is just a temporary spate of animal spirits. But in my experience, most sustained bank runs are underpinned by something real.


[1] I get much of this information from here.