Sunday, July 31, 2016

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.


  1. "Alternatively, maybe something is inhibiting the re-balancing process"

    I'll explore this path just a little. My gut feeling is that TWO processes are at work, hiding the inflation.

    The first is productivity. The movement from horses to tractors was a huge jump in per-person productivity. The jump from hand saw to power saw was another such jump. Productivity jumps have been extremely rapid beginning with the expansion of the use of electricity and the internal combustion engine. These productivity jumps should have REDUCED prices--they did not. Robotics continue the productivity jumps today. Productivity jumps are the first cause of hidden inflation.

    I would suggest that the second cause of hidden inflation is foreign imports. Foreign imports represent increased competition which can be expected to cause LOWER prices. These lower prices have never materialized despite massive imports (into the United States). Most will agree that imports have stabilized United States prices, but we could also make the argument that the imports have also hidden inflation. (We expected deflation, we realized stability).

    In terms of the series of lakes, it is if the locks were bypassed with a series of tunnels that accommodate the increased flows of water added at the top. Obviously the flows have increased and and we see increased levels at the bottom lake. The level of the intermediate lakes (which represent prices) have remained relatively stable (recently).

    The level of the bottom lake represents savers who hold the hot potatoes. This economic sector has the tools to hold what many find 'too hot to handle'. More hot potatoes is no problem for them, providing that certain conditions are met. This comment will not explore those conditions.

    So, concluding, are asset prices higher than they should be? In my mind, yes in terms of earning ability of the assets, no in terms of ratio of assets to the supply of money. I won't explore this contention either.

    Thanks for writing on this subject.

    1. Roger, thanks for the comment. Your point on productivity is well taken. It's actually the same argument that Austrian economists (among others) make to explain why the Fed-induced 1920s bull market was not accompanied by rising consumer inflation. I'm not sure how well it applies now as productivity growth has been very weak over the last decade or so.

  2. An equities bubble. We wish. Most places are still below levels of 2007 or even 2000. The S&P500 is only 20% above those years' highs.

    1. Hi James: I can sort of see Hussman's point that the S&P is overvalued on an earnings basis... I just don't think the Fed has anything to do with it.

    2. There's quite a big difference between saying something is overvalued and that it is in a bubble.

  3. An interesting metaphor and one that shows why the bank has such limited effectiveness. It affects the prices of assets only those with lower propensity to spend own anyway and prices have to increase considerably for only a modest effect. Worst case only 4% of this would end up as spending. Much more effective, more bang for the buck, is to feed consumer demand and let that demand flow up hill feeding investment by increasing the demand for and return on it. What fiscal can do so well, make water flow up hill. Some kinks in the metaphor.

    1. Water can't flow uphill. The iron law of monetary offset in an inflation targeting regime will always apply.

    2. Lord: Central banks have had limited effectiveness because QE was a weak tool. Using our metaphor, QE failed to introduce any water into the system, so water levels didn't need to rise.

      If instead the Fed bought some asset like gold at ever higher prices (as in here) or plunged interest rates deep into negative territory, then I have no doubt that the water level of all lakes would have risen.


  4. Saving, Asset-Price Inflation, and Debt-Induced Deflation


    The exponential growth of savings and debt takes the form mainly of loans to finance the purchase of real estate, stocks and bonds. These loans extract interest and amortization charges that divert revenue away from being spent on goods and services. The payment of debt service by the economy’s non-financial sectors interrupts the circular flow that Say’s Law postulates to exist between producers and consumers.

    Financial institutions re-lend their interest and other financial inflows as new loans to finance asset purchases. The result is that net savings do not increase for the economy as a whole. Meanwhile, lending out savings helps bid up asset prices, but does not necessarily promote new tangible investment and employment or increase real wages and commodity prices. In fact, new tangible investment and employment decline as investors find it easier to obtain price gains in stocks, bonds and real estate than to make profits by investing in factories and other tangible means of production. The effect is to divert savings and credit away from financing new direct investment, and hence from employing labor to produce more output.
    * “Saving, Asset-Price Inflation, and Debt-Induced Deflation,” in L. Randall Wray and Matthew Forstater, eds., Money, Financial Instability and Stabilization Policy (Edward Elgar, 2006):104-24. Dr. Hudson is Distinguished Research Professor, Department of Economics, University of Missouri at Kansas City (UMKC)

    1. Excellent link.

      Using the lake metaphor, it seems to me that the authors are positing that purchasing power can 'pool' up in indefinitely in the financial sector as income in the form of debt servicing is absorbed rather than being released.

      Everything in the 'financial sector' lake is owned by consuming individuals. When the water level rises (ie share prices move higher), their preferences for future consumption become slaked, and they will rebalance into present consumption, thus releasing purchasing power from asset markets. So I don't see how income can be indefinitely absorbed.

      Am I missing anything?

  5. Replies
    1. Here is Hussman's response. Any thoughts?

  6. Sorry, I think Hussmann is right
    Just the price of future consumption has gone up - not its real value, i.e. the "amount" of it.
    Those holding those claims are wealthier in terms of present consumption, but the amount of future consumption (as defined by PP conveyed by the cash flows of the assets) has not changed, for this you need productivity gains. And no evidence whatsoever points at increases in productivity.
    Hence, Under your assumptions, where there is no preference shift (unrealistic under these circumstances, more about that below)..not much would flow into present consumption, because consuming more today means foregoing future consumption which nobody wants (by definition). There is no other way to consume in the future but to wait until purchasing power from said claims is available....
    Now it is more realistic to assume that the relative price shift induces actors to CHANGE their preferences. Assetholders are tempted to consume more now, at the cost of consuming less later, by selling the asset (and thus forego its future cash flow)..In this case you would see an effect.
    On the other hand, it would make those who are "short" future consumption such as me wanting to save consume even less, as I need to pay more for those cash flow streams...
    The net effect depends on the circumstances

    1. Great point.

      Ok, how about this:

      Jack wants to consume an equal number of bananas both this week and ten years from now (there are just two time periods). He has $2.00 in his pocket. Say he can buy a risk-free banana IOU for $1 that will provide a banana ten years hence. He can also buy a banana to eat now for $1. This satisfies Jack as he gets an equal number of bananas now and in the future; specifically, 1.

      Rather than buying an IOU he can invest directly in tree that produces one banana ten years from now (and then dies). To grow that tree, he needs to buy one banana now for $1 and plant it in the ground. Although both the IOU and the tree cost the same, Jack prefers the IOU as it requires a bit less work.

      Just after Jack makes these transactions and before he eats his banana, the Fed introduces an easy money policy. We get Hussman's asset price inflation: the price of Jack's banana IOU triples to $3. The current price of bananas stays at $1.

      Jack sees an opportunity to improve his situation. He sells his IOU so that he now has $3 in cash. He still needs to match the banana in his hand with a future banana. He can do so by buying a banana for $1 dollar and planting it, leaving him with $2 remaining in his pocket. Because he likes an even ratio of present versus future consumption, he buys 1 more banana to consume this week and another to plant in order to secure an additional future banana. All his cash is now spent.

      Thanks to inflation, Jack ends up with 2 bananas now and 2 bananas in the future rather than just one now and one in the future. As everyone tries to make this same trade, the prices of bananas rises until there are no gains to be made.

      So asset price inflation does have to spread into consumer goods.

  7. Good example.
    However, you miss the fact that the process of growing a banana requires an additional factor of production - land. A banana 10 years from now is not the same good as a banana now it is a higher order good. For this transformation you by definition need a factor of production, i.e. you cannot assume it away (this even works if you try to store the banana for ten years, rather than planting it, which is the other alternative). Otherwise you would not need any labour input at all (you assume yourself that additional labour is needed).
    Land (or storage capacity) is a tradable asset and its value correlates with the price of the IOU (the risk free rate).
    If the price of the land increases in line with the IOU, not much changes, i.e. Jack is not induced to invest into real production, because the profit of producing has not changed. Which is exactly what we more or less see going on in the economy I would say.
    Now, in reality due to lag effects you might get some activity (in our 2 period setting there cannot be leads and lags), but after two decades of easy money, it is reasonable to assume the lags have been eliminated.
    Profits are a function of relative price levels.
    The absolute price level does not matter, its the realative price level that is important for investment decisions.

    1. "i.e. Jack is not induced to invest into real production, because the profit of producing has not changed."

      I disagree.

      Before inflation, the cost of producing future bananas (C) includes the price of purchasing a present banana (A) and the proper amount of land (B) to support the plant.


      Profit (P) will be the difference between the price of IOUs and C:

      P = IOU - C.

      In other words, you collect a profit by purchasing the necessary inputs and then selling an IOU (or futures contract), delivering the banana ten years from now as per your promise.

      Rearranging these two formulas, we get...

      1) P=IOU-(A+B)

      Say we get Hussman's asset price inflation. The prices of B and IOUs triple.

      2) P=3(IOU)-A-3(B)

      Profit at 2) is indeed higher than at 1) because A, the cost of bananas, has not risen high enough to counterbalance the rise in the price of IOUs and land.

      So asset price inflation does induce investment.

    2. I do not agree with your profit calculation, as it does not include all costs.

      Apart from Labour input (L), our actor also has to take business risk, i.e. he has to perform a production process between the two time periods. For when our actor exchanges the IOU for A and B, he is NOT done, i.e. he has to work – or at least (if we ignore Labour) wait and hope that the banana will grow. And there is discomfort in that.
      Yes, there is no price risk (IOU), but the banana might fail to grow, in which case he defaults on his obligation, etc.
      In the real world, the ultimate profit is only known at the end of the production process, and this should be modelled somehow.

      More technically: your P takes not into account that the profit is NOT deterministically known at t=0, which means that our actor not only needs to have the additional funds, but also be willing to take that risk (and work).

      Of course, you can assume away all risks, but then you are not talking about the same world like Mr. Hussmann, i.e. you cannot disprove his thesis in this way. After all, without uncertainty there is no need for entrepreneurial activity at all, as the Austrians have shown more than a century ago.

      Further, your conclusion rests on the fact that the price of the IOU and B rise by the same factor. Thus you get 3x(IOU-B) > (IOU-B) iff (IOU-B) >0. You get an automatic increase in profitability.

      In other words, you are implicitly assuming that the duration of the two assets is the same. Now, in a simple two-period setting this is obviously true, but in the real world it is far from certain. Indeed, a primary factor of production like land is usually considered to be one of the most interest sensitive assets, i.e. and one would expect land to increase faster than a finite sum of its output, which is what your IOU is. The net effect is by no means evident.
      For clarification: I am NOT saying there cannot be investment induced by asset inflation. Obviously, if Delta P > (E(Risk) + L) there will be investment, otherwise not. I have no doubt that one can construct an example that satisfies my minimum criteria mentioned above and get the desired result.

      Much depends on the sector we are talking about and the relationship between Labour input (assumed to be constant as we are not seeing much of wage inflation) and capital for the production process. For instance, if you can create high priced IOUs by just employing labour and no capital goods (the service economy), you will invest a lot – which is exactly what we are seeing (internet start-ups).
      But from showing that one specific sector will increase investment under certain circumstances, it does not follow that the economy overall will increase its investment activity which is what Hussman is talking about. And I am not sure that this can be done with an arithmetic model at all. (There are other, more abstract ways of approaching this problem).

      So asset price inflation does not necessarily induce investment activity. In fact, the empirical evidence does not support it at all.

  8. When the CB sells its money by buying assets, the total $ face value of all financial assets in the non bank sector remains the same. Changing your lake metaphor a bit it's like taking water out of one lake and pouring an equal amount in to another - with no connection between the two! The price level beimg the inverse of the water level. Overall there is no hot potato and no spillover into consumer markets. But each lake will show specific symptoms (one is emptier, the other fuller) while in aggregate these cancel out. The mistake Hussman makes imo is to believe that a flooded 'money' lake at the cost of a drought in the securities lake is more likely to lead to CP inflation than the opposite. If anything, the opposite will be the case because of the drain of interest flows from the non bank sector.

    1. Interesting, although I wouldn't go that far. Sounds like you're saying that central banks can't influence the economy wide price level at all. While QE did very little, I do think that central banks can do other things that influence prices, or the average level of the various lakes.

    2. On second thoughts, I may have overstated the case for relative changes in asset prices. It's probably more of a function of lower overall yield being reflected in higher prices for securities. And it is the interest rate channel that influences credit growth as well as exchange rates which both can have some effect on the price level of output. But I do think one has to look at the total of all 'savings lakes' to assess whether anything the CB does will have a direct effect on output prices or not. QE alone does not have a direct efect on income /output.

  9. Perhaps the root of the puzzle is that wealth is valued not only as defered consumption but also as insurance. Steve Randy Waldman wrote about that; he makes the case that for that role, it is relative and not just absolute levels of personal wealth that really count. So there is no limit to the appetite for wealth even once all appetite for current and future consumption has been satiated and also see
    Why Do the Rich Save So Much?
    Christopher D. Carroll

  10. I'm also very doubtfull about any hot-potato effect existing beyond any influence on short term interest rates and expectations for future short term interest rates. Even though the maths is beyond me, I thought this paper was interesting They make the case that all assets trend towards a price where borrowing money to fund holding of such assets just breaks even. So assets with volatile prices have to offer more return because margin calls and consequent forced "buy high, sell low" trading provide a cost drag. Money with no volatility fits into such a price structure as being a "fairly priced" asset. So adding more money into the system wouldn't induce a hot potato effect because it wouldn't effect the inherant "fair value" of other assets. Asset holders would simply increase the proportion of their portfolios that was held as money. To me the hot potato effect also seems wrong if you imagine an "inverse hot potato scenario" - if some huge private companies were listed on the stockmarket (eg imagine the Saudi oil reserves were listed on a stock market), then the total market value would increase and the public would transition to holding more stocks -prices wouldn't jig around based on a notional fixed percentage of portfolios needing to be accounted for by stocks.

  11. My impression is that what the Fed has done is to reduce short term interest rates and expectations for future short term interest rates. They may have created the "Hell" scenario described in . That scenario means an immediate boost to asset prices now together with a very long term reduction in asset returns from now on. It is simply a case of getting all of the future returns immediately rather than gradually. So pension fund managers will now consider that a bigger pension pot will be required in order to provide a future income and insurance companies will require more assets in order to cover future liabilities etc etc. This can already be seen as an increase in the cost of annuities So this will cause people to need to save more for the future and so have less spare for current consumption and so be deflationary for consumer prices.

  12. Is it possible that the distribution of assets is preventing the "wealth effect" you are talking about? I believe someone mentioned this above: the proportion of people actually holding financial assets is quite small, and any increase in asset prices is unlikely to alter this group's behaviour.

    At any rate, I am still confused as to the actual transactions that take place. If the CB exchanges reserves for ABS's, how can these reserves go on to affect anything? I was under the impression this excess stock of reserves sits in the accounts at the CB earning a small amount of interest, and that's the end of the process.

  13. why would people have to balance present consumption vs future consumption?

    not clear must happen, or at least not in short/medium term if ones receiving money dont need extra consumption. Or they consume it just bidding up prices of the assets they like and form bubbles just on those sectors (antique cars, art,...)
    when you change the interest rate to 0% the rest of assets have to get repriced.

    it more, it might be the case that asset price inflation might bring down CPI given normal consumers have less after rent, mortgage,... since it redirects bigger part of their salary to pay assets instead of consuming

    1. "it more, it might be the case that asset price inflation might bring down CPI given normal consumers have less after rent, mortgage,... since it redirects bigger part of their salary to pay assets instead of consuming"

      You make a good point.

      However, for every person who pays for assets (that are now more expensive) by reducing the proportion of salary spent on consumption, there is someone who already owns them and has enjoyed price appreciation. They'll be able to redirect a bigger part of their wealth towards consuming. So this particular effect on CPI should be cancelled out.

    2. The problems is that assets are owned by a very minor part of the population, and each day its accumulated by even less. So when assets go up a lot compared to gdp what is happening is a transfer of wealth from most to some. The great majority of asset owner are already wealthy and just won't consume more computers, bananas, cars,... so doesnt affect CPI. the areas where rich want to spend their money have seen no crisis (luxury brands, art, collector cars,...). So CPI doesnt cancel out in my opinion cause CPI measures every day items and if 90% has less wealth CPI can't increase just cause 10% consumes double of those items. To see CPI increase you would need to see money directly getting into the normal people that would directly consume everything they get pushing CPI higher.

    3. What about all the homes owned by the middle class? 401k plans?

      "So when assets go up a lot compared to gdp what is happening is a transfer of wealth from most to some."

      No, it's a wealth transfer from creditors to debtors, not from poor to rich.

      If you're interested in the redistributive effects of monetary policy, here's a paper:

    4. I agree is from creditors to debtors. 401k plans are not touched so won't accept CPI. Homes owned by middle class go up in value, but the only ones that can get that money is the ones that size down or move to cheaper area, and get the difference otherwise house appreciation dont matter. The fact is that most of the financial assets are not owned my most but by a few. Or even if owned by a big part say 50%, its still a tiny percent who owns most of them. So stocks going up doesnt mean 50% get a bump, it means 50% get some bump but specially 10% get a big bump, and 1% get a huge bump. where Im going is that it distributes the money to who has more, and normally those kind of people already have all their needs covered and consumption habits are not affected. My point at the end is that it seems it sucks more money out of the people that would use it and redirects it to those who won't use it.