Shades of a liquidity premium peaking through in stock market prices

In my other life, I analyze the stock market. I always find it interesting when the stock market reveals its often hidden monetary nature. The common assumption is that monetary analysis should be confined to a narrow range of coins, dollar bills, central bank reserves, and bank deposits. But this ignores the fact that all valuable things in an economy have a degree of liquidity, including stocks.

A stock's price can be decomposed into a "fundamental" component and a liquidity component. Fundamental value arises from a stockholder's right to receive any distribution of the assets of a corporation. The liquidity component is the premium on top of fundamental value that arises from the owner's ability to easily sell that stock. Knowing that a stock can be easily sold provides the owner with a degree of comfort that would otherwise be lacking if the stock was less saleable, or not saleable at all. This "comforting service" is built into the stock's price as a liquidity premium.

While in theory we can determine a stock's monetary nature by subtracting its fundamental value from its price, in practice this is almost impossible to do. Computing fundamental value is more art than science. Nevertheless, we can get indirect evidence of the existence of a liquidity premium by comparing different share classes issued by the same company. In Canada, it's common for large family-owned corporations to issue non-voting and voting shares. The family controls the company by holding 51% of the voting shares while the public holds the balance of the voting and all the non-voting shares. Both voting and non-voting shares rank pari passu, meaning they receive the same claim on the company's assets.

Given these properties, we'd expect the market price of voting shares to be equal-to or greater-than the price of non-voting shares. After all, since everything else about the two classes is equal, having a vote can only add to the value of a share.

The chart below shows the voting and non-voting share price of a major publicly-traded Canadian retailer. Below the price is the premium/discount on the non-voting shares. At the bottom are relative volumes traded.

Now it's evident from the chart that our hypothesis doesn't hold. For long periods of time, the non-voting shares of our retailer have traded above the voting shares. What might explain this? One reason is that non-voting shares are far more liquid than the voting shares. Just look at the much higher trading volumes in the non-voting shares. From 2008 to 2010, shareholders valued the liquidity bonus of non-voting shares more highly than the element of corporate control provided by voting shares. In other words, the perceived benefits provided by the liquidity of the non-voting shares caused their liquidity premium to balloon to the extent that non-voting share prices rose above voting share prices.

Why doesn't the non-voting share premium get arbitraged away? Well, the comfort that liquidity provides is a very real service, not a mistaken bit of irrationality that can be ironed away. A highly-liquid share is like a fire extinguisher - even if it's not being used, just having it there makes you feel better. So while buying cheap voting shares and short-selling expensive non-voting shares may seem like a risk-free arbitrage, it isn't. After all, if the market decides to put an even higher value on the liquidity services provided by the non-voting shares, then non-voting's liquidity premium will grow even more and the trade will lose money.

While risk-free arbitrage can't shrink a stock's liquidity premium, there are indirect forces that ensure the premium stays thin. The larger a firm's liquidity premium, the lower its cost of capital. After all, if you need to raise money, having a larger liquidity premium means that you needn't issue as many shares. Because a low cost of capital is a boon, firms will try to replicate the success of competitors who have attracted a large liquidity premium. They may do so by pursuing similar lines of business or marketing their shares to the same group of shareholders. This will have the effect of drawing trading activity away from shares with large liquidity premiums to those without, thereby destroying the underpinnings of that large premium.

All of this plays into the ongoing bitcoin discussion between Mike Sproul and I. While Bitcoin might have some negligible fundamental, or non-monetary, value due to its value as a curio, its liquidity premium is surely huge. There is no way to arbitrage this premium away directly, but over time competitors will peck away at it, causing bitcoin's price to deteriorate back to its fundamental value, which I'd guess is <$1.

What would destroying a central bank's assets do?

Gavyn Davies's post Will central banks cancel government debt? dovetails nicely with the recent fundamental value of fiat money debate. [For commentary on this debate, see Nick Rowe, Paul Krugman, David Glasner, Stephen Williamson here, here, and here, David Andolfatto, Brad DeLong, and Noah Smith]

Let recap the debate first before turning to Gavyn's post. Noah Smith pointed out that since fiat money is fundamentally worth nothing (its future value = 0), then all financial assets are worth zero. Financial assets, after all, are mere promises to receive fiat money. Now back up a second. As I pointed out here, modern central bank money is not fundamentally worthless. Were it to fall to a small discount to its fundamental value, Warren Buffet would buy every bit of money up. Central bank money has a fundamental value because even if it can no longer be passed off to shopkeepers, there are assets in the central bank's kitty. Modern central bank money provides a conditional claim on those assets. David Andolfatto and Stephen Williamson also note the importance of central bank assets.

I got this idea from Mike Sproul. Back in the day, Mike used to start huge comment wars on the Mises blog when he brought up the topic of central bank assets "backing" its liabilities. In fact, here's the post where I first ran into Mike talking about this interesting feature of central bank money. Geez, I sound pretty ornery.

Nick Rowe also brings up central bank assets in his contribution. It's a rendition of his old classic, From gold standard to CPI standard (which I commented on here). In his new post, Nick explains how a modern central bank holds hypothetical CPI baskets in its basement, promising to redeem the liabilities it issues with those CPI baskets at a declining rate 2% every year.

Bill Woolsey gives a similiar story to Nick's in this comment on David Glasner's blog. Bill's point is that if a central bank provides a credible commitment to repurchase and cancel its liabilities should the demand for them evaporate, then central bank money will have value. As he points out, this commitment is only credible as long as the central bank holds (or can get a hold of) the necessary assets to commit to those buy backs.

The point of all this is that central bank assets are important. They are the key for understanding why modern central bank money is different from pure fiat money, why central bank money's future value > 0, and why financial assets (like corporate bonds) that pay out central bank money are not fundamentally worthless. Which brings us back to Gavyn's post.

Gavyn describes a radical idea to reduce UK sovereign debt whereby the Bank of England, the nation's central bank, would cancel part of the government bonds that they've acquired via quantitative easing. By canceling debt held at the BoE, the government's debt-to-GDP ratio comes down. No one in the private sector loses out, since they don't hold any of the canceled debt. The central bank loses out but its loss is counterbalanced by the government's gain such that if you aggregate both under the title "public sector", nothing has happened.

Let's look at this with our previous discussion in mind. With less assets on the BoE's balance sheet, the fundamental value of BoE money would have deteriorated. Why? Should the monetary demand for pounds disappear so that all that remains is fundamental value, the BoE will have fewer assets remaining to commit to repurchases so as to prop up the value of the pound.

Now, it could be that the debt cancellation really means that a formal debt on the asset side of the central bank's books has been replaced by an implicit promise that the government will come to the aid of the central bank during a run on a central bank's liabilities. In that case, holders of BoE money will quickly realize that there is an unwritten and unrecognized asset on the central bank's balance sheet. As a result, the fundamental value ascribed to the central bank liabilities would be damaged somewhat less than a scenario in which the debt was canceled outright. But damaged they would be since implicit guarantees are not as good as real assets.

One reason to make a central bank independent is to cordon off a fixed set of assets that can be used to provide a permanent basis for the fundamental value of central bank money. In this respect, a central bank is like a special purpose vehicle. SPVs are subsidiaries to which a parent company has transferred specific assets. The vehicle has been structured to prevent the parent from tampering with the assets after the fact. The SPV issues its own liabilities to other investors using these ring-fenced assets as backing. A central bank, much like an SPV, has been hived off from its parent, the government, and as a result the holders of its liabilities, the public, can be sure that they have claim to a secure set of assets. If an SPV suddenly had its assets removed by its parent with no guarantee of replacement, the liabilities issued by that SPV would suffer. Same with the liabilities of a central bank.

Gavyn worries that the destruction of central bank assets would unleash inflation. He also points out that there are people who are worried about deflation, and they would welcome a destruction of central bank assets. Whichever way you stand, the point here is that central bank money has a fundamental value. The proof of this would be what Gavyn describes: a scenario in which the value of central bank money declines as central bank assets are destroyed.

Update: Britmouse and Nick Rowe have blog posts on these issues too.

Hot or not?

The Rowe/Glasner/Sproul debate continues over hot potato-ish-ness of money. Here is Nick Rowe:

The hot potatoes simply pass from one hand to another. Unless they sell it back to the banks, to buy IOUs. But why would they want to do that? If I have opals I want to get rid of I will probably sell them at the specialised opal dealer, who will probably give me the best deal. If I have money I want to get rid of....well, everyone I deal with is a dealer in money. The bank is just one in a thousand. Why would we assume that the bank will always give me a better deal than the other 999?

Mike Sproul jumps in, but David doesn't, so instead I left a comment trying to anticipate what David would say:

Sproul v Glasner

Some comments on their theoretical differences here.

I think Mike Sproul and David Glasner would agree on 95% of monetary economic propositions, only disagreeing on how fiat money gets its value. David thinks there are two reasons for fiat money to have value: either people are irrational, or fiat money provides a real service - discharging of taxes. The latter is a chartal description of money. Mike has a "backing theory" of fiat money, which I think is broad enough to include the tax-discharge argument. I like Mike's because it is a more general theory. But I don't think the two are very far apart.

To tell them apart, ask this question. "If the US government ceased accepting Federal Reserve-issued liabilities to settle taxes and, say, required gold instead, would the US dollar lose its value?"

I think David and most chartalists would have to say yes. Without the ability to redeem it for taxes owed, the US dollar would be worthless. I think Mike would say no, because as liabilities of the Fed, even fiat money has some sort of claim on Fed assets, and this is enough to give it value.

Adam Smith: taxes contribute to fiat's liquidity premium, they don't drive its value

David Glasner had an article called Wicksteed on the Value of Paper Money.

David discusses the idea that it is the imposition of taxes by government, payable in fiat money tokens, that gives fiat money its value. This is chartalism, the very same idea that MMTers trumpet as their unique addition to economic discussion. This is one theory for why fiat money has value. Another is Mike Sproul's backing theory in which, just as a mutual fund's assets give its units value, a central bank's assets support the value of its liabilities. When it comes to explaining modern money, I'm partial to the latter. I'm not averse to the MMT explanation, but only as science fiction. I don't think any real monetary system has actually worked in this way.

David mentions that Adam Smith advocated the taxes-drive fiat money theory. Incidentally, Randall Wray says the same in his book Understanding Modern Money. I disagree. To make a long story short, in Smith's world, fiat money was any issue of paper money which was temporarily unredeemable and therefore circulated at a discount. In forcing people to pay taxes with this money, the sovereign created a built-in liquidity premium. But the tax obligation did not give the paper money it's original value - the probability of future redemption did. Here's the a better explanation that I left on David's blog:

I’ve read Smith pretty carefully on this. The offhanded comment comes after he talks about money that is no longer instantly convertible but redeemable at some future point in time. He uses as his example Scottish notes for which the option clause has been invoked and US colonial paper which is only redeemable after a few years.

Given deferred redemption, “such a paper money would, no doubt fall more or less below the value of gold and silver, according as the difficulty or uncertainty of obtaining payment was supposed to be greater or less, or the greater or less distance of time at which payment was exigible.”

The point being that Smith thought such money was valued according to its discounted probability of being redeemed at par.

Smith then brings up the point about taxes. 

“The paper of each colony being received in the payment of the provincial taxes, for the full value for which it had been issued, it necessarily derived from this use some additional value, over and above what it would have had, from the real or supposed distance of the term of its final discharge and redemption.”

Thus acceptability in payment of taxes added a liquidity premium to colonial paper. But it didn’t give that paper its original value. I read Smith as providing a chartal theory of the liquidity premium, and not an explanation for a positive value of fiat money.