Saturday, April 21, 2012

You say hot potato, he says endogenous

David Glasner finally chimed in on the subject of endogenous money. I pretty much agreed with everything he said on the topic of bank money endogeneity. Basically, the financial system adjusts to a reduced demand  for bank money by destroying that money rather than keeping it in circulation and forcing all prices to adjust. The process by which this occurs is an arbitrage process. This is the classical theory of money that Glasner describes in his book Free Banking and Monetary Reform, and it applies equally to the modern banking system since banks make their deposits convertible into central bank money.

David said something interesting:
So while I think that bank money is endogenous, I don’t believe that the quantity of base money or currency is endogenous in the sense that the central bank is powerless to control the price level.
I was curious about his claims that modern central bank (CB) money is not endogeneous and left some comments on his post trying to drill down on this issue. It seems to me that, much like old-fashioned gold standard CBs and modern private banks, many modern inflation-targeting CBs also have effective convertibility regimes, ie. they are governed by the redemption principle. This regime allows for arbitrage. In other words, David's classical theory of money applies just as well to modern CB money as it does to competitively-supplied banking money and central bank liabilities convertible into gold.

As Nick Rowe points out here (and my post here), modern inflation-targeting central banks including the Bank of Canada, Australian Reserve Bank, and others, are not so different from old-fashioned gold standard CBs, the only difference being that rather than offering convertibility at a fixed rate into gold, modern CBs offer convertibility at  a floating rate into bonds (Nick calls this a CPI standard, I see it as floating rate bond-convertibility, same thing in the end). In between changes to that floating rate, those with access to the CBs "conversion window" - effectively those who can conduct open market operations with the CB - can engage in arbitrage between the external, or secondary market for bonds, and the private price set at the conversion window. This arbitrage mechanism withdraws money from the system or adds to it. Its existence renders modern CB money endogenous (or at least more endogenous than before). Using less exact terminology, once issued, modern (inflation-targeting) CB money never becomes a hot-potato. Increases in the public's demand for CB money draws it out of the system via open market operations while decreases in this demand push that money back into the CB via the same.

That being said, CB money can easily become hot-potato money. Should an inflation-targeting CB foresake its inflation targeting regime and cease offering daily withdrawal/deposit mechanisms (ie open market purchases and sales) priced using some sort of consistent rule, its liabilities have effectively become hot-potato, or exogenous. The modern Federal Reserve, which no longer targets the Federal funds rate by withdrawing/adding to reserves using open market purchases/sales of bonds, is a good example of this. There is no formal process which by the mountain of excess reserve balances might be withdrawn should the demand to hold them collapse, we only have indications from Ben Bernanke that some sort of draining process will occur. Over the last four years, the Fed has surely become a more "hot potato" central bank than the BoC, for instance. Thus David's classical theory surely applies more to the BoC than the Fed, although I'm not sure where he stands on this.

This hot potato vs not issue also came up at Lars Christensen's blog. I pointed out to him that I don't think that the distinction is a core one - its just a matter of how liabilities are structured.
I think we can agree that corporate stock is a hot-potato asset. Once issued, it circulates endlessly. Stocks can also be highly liquid -companies can issue new stock to buy services and many sorts of assets rather than using cash.
But if the corporation agrees to repurchase all its stock at $100 and sell unlimited stock at $105, then that stock is no longer hot-potato. Should the firm issue excess stock to buy services, that stock will quickly be returned for $100.
So much like stock, I’d say that central bank money is not necessarily either exogenous (hot potato) or endogenous. Like the stock example above, it depends on how the asset itself is structured and what options it provides its holders. 
So we're not talking about foundational differences here.

Lastly, while Nick Rowe's post From Gold Standard to CPI Standard is becoming one of my all time favorite Rowe posts, we like it for very different reasons, I think. Nick wanted to use the progression to show that if the old system was reserve-constrained, so is the current one. I'm using it to show that if the old system didn't emit hot potato money, neither does the new one.

Addendum: David Glasner follows up Nick Rowe’s Gold Standard, and Mine

Wednesday, April 11, 2012

Fisher Black's dream

Perry Merhling had an interesting quote from Fischer Black:
Thus a long term corporate bond could actually be sold to three separate persons. One would supply the money for the bond; one would bear the interest rate risk; and one would bear the risk of default. The last two would not have to put up any capital for the bonds, although they might have to post some sort of collateral
In the comments I pointed out that a fourth person can be added to the list - someone who bears the liquidity risk of that corporate bond in the secondary market. This would amount to a liquidity option. Essentially, the bearer of liquidity risk would allow the bond owner to sell that bond at some preset level in the bid-ask spread. For instance, the option could allow the bond owner to immediately sell their entire bond holdings at the upper end of the spread, or at the ask price. Normally, sellers can only sell quickly if they accept a price near the bid price, or lower end of the bid-ask spread. When illiquidity strikes and spreads widen, usually because buyers depart and there are less bids, an option to sell at the ask price rather than the bid price increases in value.

The evolving nature of central bank liabilities - from gold convertibility to bond convertibility

In his tradition of imagining alternative monetary systems, Nick Rowe asks if there is any fundamental theoretical difference between how monetary policy worked under the gold standard and how monetary policy works today for a modern inflation-targeting central bank. Nick uses a progression-style of reasoning in which he incrementally adds/subtracts elements to the original gold standard system to arrive at a modern inflation-targeting regime, or what he calls the CPI standard.

His point, and I agree with it, is that the two standards are not fundamentally different - rather, the same core mechanism underlies each system, with only a few modifications here and there. This runs counter to most people's intuition that the gold standard is a totally different beast from our modern system.

Although I criticized some of his points in the comments section, these disagreements stemmed from the fact that what interests me is not so much the evolution of monetary policy, but the evolution of the nature of a central bank liabilities. But this is really just the flip side of Nick's argument, since monetary policy is carried out via central bank liabilities, and updates to central bank monetary policy occur by tinkering with the structure of the liabilities issued by central banks. In essence, mine is the store of value approach to money, in which money is analyzed as a security. That's also why Nick didn't quite understand what I was saying, even though our final meeting place was the same.

Invoking Nick's method, the evolution of central bank liabilities goes something like this. Under a gold standard, the convertibility feature provided by central bank money - when it was exercised - was to be settled in gold by the central bank. The convertibility rate was some fixed quantity of gold. Everyone could directly go to the central bank and enjoy money's gold convertibility feature. Convertibility meant that in the secondary market, the public market for already-issued money, central bank money could purchase the same amount of gold for which it could be converted at the central bank.

Nowadays, the convertibility feature is still there, but it's been updated. Upon exercising central bank money's convertibility feature, the redemption medium is bonds, not gold. You can redeem notes for bonds via open market operations. The redemption rate is no longer fixed. Rather, it is adjusted to ensure that, in the secondary market for central bank money, that money's value relative to goods-in-general falls by 1-3% a year. Only a select few institutions can enjoy this redemption feature, but their participation is enough to ensure that central bank money falls at a 1-3% rate. The exclusivity of the modern redemption option is not entirely unique to our modern system, since even in the waning days of the gold standard central banks began to limit gold conversion to a few select institutions, usually other central banks.

If the Fed pegged to the loonie

Nick Rowe had an interesting post here. He asks how the Bank of Montreal would be different from the Federal Reserve if the Fed decided to peg it's currency to the Canadian dollar. I think the difference would be that BMO has access to Canadian Payments Association's LVTS (Canada's monopoly payments clearinghouse) and LOLR services provided by the Bank of Canada, whereas the Fed would have neither benefit.

More on the comparison of the Federal Reserve and ECB settlement mechanisms

Michiel Bijlsma and Jasper Lukkezen have a very good article on the Bruegel blog that deals with the question: why is there no Target2 debate in the US?