Tuesday, December 4, 2012

Why moneyness?

Here's why this blog is called Moneyness.

When it comes to monetary analysis, you can divide the world up two ways. The standard way is to draw a line between all those things in an economy that are "money" and all those things which are not. Deposits 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 etc etc.

Then you figure out what set of rules apply specifically to money and what set of rules apply to non-monies (and what applies to both). The quantity theory of money is a good example of a theory that emerges from this way of splitting up of the world. The quantity theory posits a number of objects M that belong in the relation MV=PY. Non M's needn't apply.

The second way to classify the world is to take everything out of these bins and ask the following sorts of questions: in what way are all of these things moneylike? How does the element of moneyness inhere in every valuable object? To what degree is some item more liquid than another? This second approach involves figuring out what set of rules determine an item's moneyness and what set determines the rest of that item's value (its non-moneyness).

Here's an even easier way to think about the two methods. The first sort of monetary analysis uses nouns, the second uses adjectives. Money vs moneyness. When you use noun-based monetary analysis, you're dealing in absolutes, either/or, and stern lines between items. When you use adjective-based monetary analysis, you're establishing ranges, dealing in shades of gray, scales, and degrees.

In general, the first way of dividing the world has been overrepresented in the history of monetary discourse. I'd weight its prevalence at around 90%. Take Keynes's General Theory. Almost the entire book uses the noun-based approach to monetary analysis, except for Chapter 17 (and a small bit in Chapter 23). It's only then that Keynes describes the idea of a liquidity premium that inheres in all assets:
the power of disposal over an asset during a period may offer a potential convenience or security, which is not equal for assets of different kinds, though the assets themselves are of equal initial value. There is, so to speak, nothing to show for this at the end of the period in the shape of output; yet it is something for which people are ready to pay something.
In my posts I try to do two things. First, I make my best effort to always speak in the under-represented language of moneyness, not money. Not that there's anything wrong in splitting the world into money and non-money. But any method of dividing the universe will determine what one sees. Reclassify the universe along different lines and a whole new world emerges. With most monetary economics having been conducted in terms of money, there's probably a lot we've never seen.

Secondly, I hope to remind people that while you can choose either of the two ways to classify the world, you need to be consistent when you use them. Don't switch arbitrarily between the two.

With that being said, here are a few posts that illustrate the idea of moneyness.

1. How bitcoin illustrates the idea of a liquidity premium
2. Shades of a liquidity premium peaking through in stock market prices
3. Adam Smith: taxes contribute to fiat's liquidity premium, they don't drive its value


  1. this blog is great! keep it up!

  2. I partly disagree.

    Sure, line up all the goods, with the least liquid at one end and the most liquid at the other end. It's a continuum, with only a difference in degree. But the race to be the medium of exchange is a winner-takes-all race. Nobody would use the second best when the best is available. Plus, winning the first race makes you even more liquid, so you win all subsequent races by an even bigger lead.

    1. Nick, you're switching between the two ways of classifying the world. I agree that in a money/non-money world, there is such a thing as "the" medium of exchange.

      Speaking in terms of moneyness, there is no such thing as "the" medium of exchange. Everything is a medium of exchange. Owning a more liquid asset surely provides advantages, which is why less liquid assets must provide compensatory pecuniary or consumptive returns. Marketers may try to increase their asset's relative position on the liquidity scale, but no single asset ever earns absolute liquidity.

    2. Hi JP!

      Aren't you mixing two concepts together, which are not really the same?
      Definition of "medium of exchange": "an intermediary used in trade to avoid the inconveniences of a pure barter system" (from wikipedia).
      Definition of liquidity: "Easy convertibility into cash".

      I think, "cash" here means "medium if exchange", so it can be bank deposit too. So, whether an asset will be used as medium of exchange, doens't follow from it's liquidity - treasury bonds for example are very liquid assets but can you buy a house with them? In exceptional circumstances the seller of the house could agree, but usually you have first to sell the bonds (which is really easy) and then use the proceeds to pay for the house.

    3. It's easy to get bogged down in definitions. Basically, I'm taking the words media of exchange and liquidity and giving them new meanings. But let's say we use your definitions instead to avoid confusion.

      My point is that people appraise assets (in part) based on the expected exchangeability of those assets for other assets. We'll call this property of an asset it's moneyness. In general, assets that are more widely exchangeable have more moneyness. Moneyness is a valuable feature of an asset, and it gets reflected in that asset's price as a liquidity premium. Because all assets have some degree of moneyness, they all carry premia, but the size of that premium varies.

    4. OK, but I'm unfortunately still confused, sorry. With exchangeability do you mean immediate exchangebility, so that the people can reasonably expect to exchange one asset for another directly.
      Isn't it so, that in the real world (in an overwhelming majority of cases) you can only exchange assets for money (whatever it is) and money for assets but not assets for assets. As in my example above you can't immediately exchange the treasury bonds for house (which is a real asset) but must put two money transactions in between. The same thing is true for, say, treasury bonds and stocks. So, in your definition the house, the bonds and the stocks have the moneyness of degree 0, while money (cash, bank deposits) have the moneyness of degree 1. But then the whole definition would be meaningless, so I'm probably missing something. Perhaps it would be easier, if you could come up with an asset with moneyness degree between 0 and 1 (0.5 for example).

    5. I'm trying to create a language for monetary phenomena that does not include the word money.

      A treasury bond can purchase a deposit at the Federal Reserve, or maybe a deposit at a private bank. It can also purchase a corporate bond in the repo market, or an Agency MBS. On the other hand, a bond can never purchase Federal Reserve banknotes and, vice versa, Federal Reserve banknotes can never purchase Treasury bonds. It's just not done. Nor can banknotes be used to buy corporate bonds. But treasury bonds can be used to acquire corporate bonds in the repo market.

      All I'm trying to illustrate is that in the example I've provided, one of the things you describe as money (a bank note) is less exchangeable than a thing you consider to be non-money, the treasury bond. Rather than arbitrarily classifying goods into money-or-not, we should try to get a measure for each asset's degree of moneyness.

      Is that useful?

    6. Ok, now. I think, I understand what you mean with "moneyness". It's a degree of exchangeability of (only financial?) assets into each other ?
      So, it's no surprise, that I didn't understand it at first, because in my layman's view money serves first and foremost as transactions medium in the goods market and the financial markets emerge after money already exists.
      Anyway, thanks for clarification.

  3. Am I right in thinking that the reason you care about moneyness is that you think that more moneyness=higher money premium?

    If so, then start with gold. People carry it around as money and so this monetary demand gives it a premium (30%, let's say). That premium motivates silver and copper and nickel producers to mint their metals into money. In some countries, silver will win out and become universal, while in others gold or copper or nickel (or salt, tobacco, or cows) will win out. This competition knocks gold's premium down to 20%.

    Next, people start trading with various asset-backed IOU's that promise to deliver 1 oz. of gold (or something of equal value) on demand. Eventually people carry no monetary gold at all and gold's premium is reduced to 0.

    As long as those gold IOU's are convertible into 1 oz (or equal value) then not only will gold have no premium, but the IOU's will have no premium either.

    Next, the gold IOU's become inconvertible into gold. The issuers still hold the same assets, and still maintain convertibility into those (non-gold) assets, but a few misguided souls (i.e., the entire economics profession) will see that they can't get actual gold for those IOU's, and they will conclude that the IOU's are unbacked. They will then conclude that the entire value of those IOU's is a monetary premium, even if the value of the IOU's never rose above the 1 oz. value dictated by their backing.

    1. Geez, you're really making me think here, Sproul.

      "People carry it around as money and so this monetary demand gives it a premium...Eventually people carry no monetary gold at all and gold's premium is reduced to 0."

      People also carry it around because they are middlemen in the jewelery/electronics industries and from their perspective, gold is a liquid piece of inventory. This too contributes to gold's liquidity premium.

      From the perspective of John Doe, some valuable item that he owns only ever loses a liquidity premium when it ceases to be possible for him to pass it on (here I am thinking about a bond John owns that is arbitrarily turned into a non-marketable bond by law, or say underwear after he's worn it once). From the perspective of all individuals, an item's economy-wide liquidity premium only ever disappears when all people in an economy can no longer pass on that item. In this case, gold would lose any value to middlemen as an inventory holding.

      If gold is less liquid then a gold IOU, then people will attach a higher liquidity premium to the IOU and therefore the IOU should have a higher price according to the logic I've set up. But as long as there is convertibility on demand, then arbitrage will keep that premium down to some minimum amount... probably no higher than the commissions and other costs of arbitraging.

      There are exchange-traded GOLD IOUs that don't offer instant convertibility. Central Fund is one. It often trades at a discount or premium to NAV. That could be a liquidity premium. Not going to go out on a limb and say for sure until I think about it.


      Thanks for the questions, I'm still debating these ideas in my mind and your feedback is helpful.