Sunday, January 26, 2014

Different goods are differently liquid

An evaporation in liquidity. September 13, 2012, at 12:25:27 to ~12:32 PM, eMini contract. From Nanex.

Steve Roth, who blogs at Asymptosis, recently posted a thoughtful critique of the idea of moneyness over at Cullen Roche's blog. (We've had a series of exchanges before on these questions). Even if my response can't sway Roth it should provide new readers of this blog with a rough overview of where I've been going with the idea of moneyness.

Let's start with definitions. Moneyness is a fancy word for liquidity. In short, it refers to the ease with which we expect to be able to trade something away for another item of value. Our expectations about liquidity are conditioned by an item's historical liquidity and modified by anything that we think could change it in the future, including new market mechanisms that might promote (or demote) that item's liquidity. All valuable goods & assets have varying levels of liquidity, or moneyness. Some will be easier to market when the need arises, others will require more effort.

Roth's first criticism, published on his blog last year, is that the
“moneyness” concept... seems to hinge on a single axis of “liquidity,” when in fact different units of exchange are differently liquid.
He goes on to give more detail at Roche's blog:
Suppose you have $10k in quarters. You can buy all the Snickers bars you want; there's a very liquid exchange market (quarters for snickers bars) out there. (Though need to tromp around to buy $10K worth of Snickers bars does seem to make it less “liquid”…)
But can you buy a car with those quarters? How about treasury bonds? No. Those quarters are completely illiquid relative to cars and treasury bonds.
Now think about treasury bonds. They're completely illiquid relative to both snickers bars and, but extremely liquid relative to fed bank deposits (reserve balances) — if you have 
I don't think I have to stretch this explanation out. Think about fed reserves/deposits — they’re (il)liquid relative to what other goods/assets?
So every financial asset — in fact every real good as well — has multiple liquidities, relative to every other asset/good.
I agree with Roth. Even the most liquid items are only tradeable along a few margins, or routes. The godfather of liquidity, a US dollar chequing deposit, can get you groceries or a car, but can't buy shares in IBM. A deposit at a brokerage can buy you IBM, but it can't get you a bag of groceries or a car. Roth's well turned phrase is worth repeating here, that different goods are "differently liquid", a point that I echo in Long Chains of Monetary Barter.

However, this doesn't mean that we can't arrive at a single combined measure for all of a good's different liquidities. All we need ask an individual is this:
"How much would I have to pay you in order for you to relinquish all rights to trade away your holdings of asset x for one year?" 
What we are extracting here is the individual's reservation price for x's liquidity. In this setup, the individual is allowed to continue to enjoy all the various pecuniary and non-pecuniary returns provided by x during a one year period, save for one return—its liquidity return. We are asking the individual to forgo each and every one of the good's multiple liquidities, or, put differently, the various margins along which x usually trades.

Whatever compensation the individual requires for giving up the right to trade away x along all routes is an indication of the foregone value that they ascribe to each of x's multiple liquidities. By dividing this price by x's total price, we can estimate what proportion of x's overall valuation our individual attributes to the liquidity component.

I think that this meets Roth's criticism, since in effect we are asking an individual to forgo each of an asset's multiple liquidities, all at once. We can go ahead and ask that individual the same question for each asset they own: how much would you have to be paid to forgo the combined multiple liquidities of a? and b? c? In the end, we'll have a list of all the individual's assets, along with the percentage contribution that each asset's liquidity provides to its total value. Having standardized our measurement of liquidity, we can now construct our individual's scale of moneyness for the coming year, ranked from least liquid to most liquid, the most liquid being that good who's liquidity contributes the largest chunk to its total value.

The upshot: the existence of multiple liquidities shouldn't prevent an individual from making private liquidity comparisons across different goods.

Which leads into Roth's next criticism, that estimates of liquidity differ across individuals. This presumably (Roth doesn't go into detail) hampers the effort to strip out a single measure of moneyness:
the liquidity of many assets depends on who you are. If you're a bank, your treasury bill is more liquid than if you're an individual, cause the bank can trade it for reserves and the individual can't. 
Again, I agree with Roth. Viewed from the eyes of a drug dealer, a chequing deposit is surely much less liquid than cash, while from the eyes of a typical nine-to-fiver, the opposite would be the case.

However, the charge of subjectivity shouldn't preclude us from extracting a market price for liquidity. After all, markets provide prices for diverse consumption goods like wheelchairs, which though an integral part of the life of an eighty-year old, from the perspective of a healthy twenty year old might be worthless. Milk is off-limits for the large portion of the population that is lactose intolerant while being popular with the rest—but markets are still capable of spitting out one price for milk. A particular good's liquidity, like a wheelchair or a carton of milk, is a consumption good the utility of which varies from individual to individual, yet in a competitive market these varying preferences should nevertheless interact together to create one market clearing price for these goods.

What follows is basic microeconomics. We can construct an individual's demand curve for x's liquidity by querying how much he or she would be willing to pay for those services at various prices. If we do this for all individuals and all assets, we can construct market demand curves for each asset's liquidity. Given a set of supply curves (supply is a totally different post), we can then submit this data to a Walrasian calculator to determine the market prices for these liquidities. These prices can be used to calculate the contribution made by liquidity to each asset's total market price, and from there we can proceed to construct the market's scale of moneyness, the asset with the most moneyness being that asset whose price is made up of the largest liquidity contribution.

The upshot is that the many differing personal scales of moneyness that Roth draws attention to can be reconciled by a market-wide moneyness scale. I hope that adequately answers Roth's points. One issue worth mentioning here is that we rarely get an opportunity to see living-breathing liquidity prices. As Nick Edmonds, who blogs here (and who should be on your reading list), points out:
I'm not sure that it is possible to extract out a market clearing price specifically for liquidity services, because it's assets that are traded not services. Each asset comes with a bundle of features yielding utility or disutility, not just the liquidity aspect.
Put differently, the difference between liquidity and a wheelchair is that liquidity doesn't stand alone as its own good but rather coexists as a service attached to an already produced good. Decomposing that service and its respective price from the rest is tricky.

Let me point out that fixed income markets do often provide accurate decompositions of the market price for liquidity. For instance, assume that FDIC-insured banks are offering chequing accounts yielding 0% and 1-year fixed term deposits yielding 2%. If we were to ask the market: "How much would I have to pay you in order for you to relinquish all rights to trade away your holdings of chequing accounts for one year?" ... the answer is 2%. So 2/100ths of the value of each chequing dollar is comprised of a 1-year liquidity return.

I've also spent some time trying to isolate the price of liquidity in equity markets, this post provides some detail.

But my best answer to Edmond's point is that this is a case of missing markets. We really don't have accurate prices for moneyness yet. One of the goals of this blog is to think about what these markets would look like, how you'd build them, and what they'd be useful for.

Thursday, January 23, 2014

Banknotes: IOUs or not?

The building that housed the original Swedish Riksbank, the earliest European issuer of banknotes

In my previous post on bitcoin, I noted offhandedly that I don't consider modern central bank-issued banknotes to be fiat but classify them as liabilities of the issuing bank. By fiat, I mean unbacked, intrinsically valueless, inconvertible, unenforced bits of paper. In the comments section, monetary operations whiz ATR (who blogs here) challenged me to clarify the nature of the IOU attached to paper currency, and whether that IOU had any value.

It would be cheating to point out that the world's 160+ central banks all list banknotes as a liability on their balance sheet. The deeper reason that I prefer to classify banknotes as liabilities (i.e. IOUs, promises, claims, or obligations) rather than fiat bits of paper is the "fine print". The best place to find the clauses governing the IOU nature of banknotes isn't on their face, but rather in the various acts and legal documents that govern a given central bank.

Section 16.4 of the Federal Reserve Act, for instance, specifies that:
Federal Reserve notes issued to any such bank shall, upon delivery... become a first and paramount lien on all the assets of such bank.
In the notes to the 2012 audited financial statements of the Federal Reserve system, section 3(k), it says:
To satisfy the obligation to provide sufficient collateral for outstanding Federal Reserve notes, the Reserve Banks have entered into an agreement that provides for certain assets of the Reserve Banks to be jointly pledged as collateral for the Federal Reserve notes issued to all Reserve Banks. In the event that this collateral is insufficient, the Federal Reserve Act provides that Federal Reserve notes become a first and paramount lien on all the assets of the Reserve Banks.
If we look at the Bank of Canada Act, Section 25 (1),
The Bank has the sole right to issue notes and those notes shall be a first charge on the assets of the Bank. 
Section 34.1 of the same Act says that: no case shall the affairs of the Bank be wound up unless Parliament so provides, but if provision is made for winding up the Bank the notes of the Bank outstanding are the first charge on the assets.
So in the case of the two central banks that I'm most familiar with, banknotes are ultimately claims on whatever stuff the central bank happens to have in its vaults. This means that on the occasion of the winding down of the Fed or the BoC, note holders are entitled to receive real assets, in the same way that a bond holder or stock holder would have a claim on a company's property, plant, & other assets upon the dissolution of that company. Banknote holders have an added bonus of being senior to other claimants, since notes provide a "first claim" in the case of the BoC, and a "first and paramount lien" in the case of the Fed.

Now the idea of shutting down either of these central banks sounds like either science fiction or a free banker's wet dream. What about the long period between then and now? Here are a few other indications of the IOU nature of banknotes. When a central bank chops some zeros off of its existing inflating notes, it doesn't leave its old issue stranded. Holders are entitled to bring their legacy notes in for conversion. Nor do central banks try to wiggle out of their obligation to redeem mutilated currency. When a note gets so worn that it becomes unusable, the central bank will replace it with a crisp new note. Lastly, when central banks merge (as in the case of the Euro) or are succeeded by another central bank (e.g. the Central Bank of Russia replacing Gosbank), holders of orphaned notes are given a window during which they can convert into new currency.

If central banks had no liability whatsoever for their note issue, then redenominations, mutilations, and successions would result in large capital losses to stranded note owners. That they don't would seem to indicate the opposite.

However, in the long waiting period until ultimate dissolution, the most important interim IOU provided by central banks is the promise of stability. The corollary of this in the old days was the obligation to redeem notes with some fixed amount of gold, or, during Bretton Woods, some quantity of dollars. Nowadays, central banks promise to ensure that the value of notes doesn't fall more than x% against a CPI basket. They guarantee to buy back IOUs in a sufficient quantity with the assets held in their vaults if the x% limit is exceeded, to the extent that a central banker might conceivably buy back and cancel every single IOU to enforce their promise.

Some central banks like the Reserve Bank of New Zealand encode this promise into their constituting act, along with stipulated penalties in case of non compliance. Other central banks provide this guarantee more informally, either in the form of accepted practice, tradition, or repeated verbal promises. Take the ECB, for instance, which uses the small quota of characters available on its Twitter account to state that its "main task is to maintain the euro's purchasing power."

Are these good liabilities? Not really. The promise of a payout upon central bank dissolution is a distant promise. In the meantime, the obligation to maintain price stability is subject to all sorts of political pressures to weaken the price target, as well as being held hostage to the skills of the central banker in hitting his/her target. Other central bank policy goals including employment and growth targets may interfere with the sanctity of the price stability IOU. The dubious nature of central bank IOUs isn't a new phenomena. Even in the gold standard/Bretton Woods days banknotes were constantly being devalued or rendered inconvertible.

Bad IOUs central banknotes may be, but IOUs they are nonetheless.

Saturday, January 18, 2014

Bitcoin's bootstraps

by Paul Conrad

When we talk about bitcoin, one thing we need to ask ourselves is this: can worthless things circulate and be accepted in trade? If so, how? And can this state of affairs continue indefinitely?

An intrinsically useless, unbacked, and costless fiat object might be accepted in trade, but only if it already has a positive price. A history of positive prices will generate sufficient expectations among potential acceptors that they will be able to trade that object on tomorrow. But how might our fiat object earn a positive price to begin with? If we reply that early adopters expected it to be widely accepted by others in trade, how did these early adopters ever form these expectations if that object didn't already have a positive price? We're dealing with a problem of circularity. There is no way to "break into" a dynamic that might generate a positive value for a fiat object. So logically, worthless things cannot trade in the market at a positive value.

However, fiat objects like dollars and yen do seem to have a positive value. Two types of economists, Austrians and MMTers, recognize the circularity dilemma that emerges when trying to explain the positive price of a useless fiat object. Both solve the circularity problem in different ways.

Austrians say that when early adopters first acquired the fiat object, it was not yet intrinsically useless, unbacked, or costless. Thanks to its original commodity nature, or perhaps its status as a backed financial asset, it already traded at a positive price. Even if that character is lost, the object suddenly becoming a fiat one, it may still be widely accepted in trade on the basis of people's memory of its pre-fiat price. Thus the circle can be broken into, and worthless bits of paper can legitimately have a positive value in trade. This is Ludwig von Mises's famous regression theorem.

MMTers solve the circularity problem by bringing in the tax authority. As long as some agency like the government imposes an obligation on people to pay taxes with these fiat objects, that will be enough to drive their positive value.

I should point out that I don't think we actually face a circularity problem with modern central banknotes since they aren't worthless bits of paper but rather exist as a liability of their issuer. But we do run into the problem with bitcoin. Here we have an unbacked, intrinsically useless, stateless fiat object trading at $950 or so, not to mention a legion of copycat coins trading at various positive prices. [1]

Austrians are all over the board on bitcoin. Because their solution to the circularity problem is to invoke the legacy commodity value of a fiat object, bitcoin poses some theoretical hurdles for them since it is by no means clear whether bitcoin ever had an original commodity value. Bob Murphy for one argues here that bitcoin may have earned its first foothold thanks to non-pecuniary ideological reasons. However, there seems to be no consensus among Austrians on that point. MMTers seem to genuinely dislike bitcoin since their preferred tax obligation story can't bear the load of explaining bitcoin's price. Here is L. Randall Wray who says that bitcoin is a test of the "infinite regress view of money", then gleefully points to its falling price as evidence that the taxed backed theory is the dominant theory (it later rebounded).

Let's move on from MMTers and Austrians. George Selgin recently came up with an interesting way to explain how bitcoin might have earned its all important original positive price:
Records show that a just a few persons took part in most early Bitcoin transfers, and especially in the larger-volume ones. My guess is that they all knew each other, and that those trades were more-or-less fictitious, with large values being traded and then traded back again, with the intent of enhancing the prominence of the positive-value equilibrium by drawing attention away from the much larger set of inactive Bitcoin markets. Bitcoin’s inventors, I’m now almost certain, were making conspicuous leaps onto their own bandwagon, so as to encourage others to do so, whether to express themselves or to profit by doing so. In short, a clever marketing strategy, including a little strategic sleight-of-hand, can substitute for history in putting a positive sign on the expected value of an otherwise useless potential exchange medium.
Here we have neat way to break into the circle. Have a group of insiders trade the fiat object amongst each other in order to generate an artificial history of positive prices, at which point outsiders will be willing to accept it in trade based on the expectation that others will repurchase it from them later.

Making "conspicuous leaps onto one's own bandwagon," as Selgin calls it, is a well worn tactic. In stock markets, the term wash trading refers to the illegal practice whereby an individual or group of schemers trade an illiquid, often worthless, stock back and forth among different accounts. The goal is to give the illusion of activity, thereby attracting innocent traders who would otherwise pass up the stock. A more colourful term for this is "painting the tape", which refers to the old ticker tape of yore.

Another way to paint the tape is to high close a stock. Using this technique, a trader or group of traders will buy a stock in the closing seconds of the day, pushing its price up. Since media outlets tend to focus on a stock's daily closing price, and stock charts depend on the daily close, high closing may be a cost effective strategy for traders to create and benefit from the positive price momentum that news of a high closing price engenders.

Auction markets, say in livestock or art, are sometimes populated with confederates—those who work in conjunction with a seller to provide fictitious bids so as to drive some object's price, say a dubious piece of abstract art, or a lame horse, far higher than it would otherwise be worth. Should the confederate's bid be the only bid, the worst that happens is that the schemers get their own painting or horse back, upon which they can try the same trick over again in the next auction. If their bidding excites someone else to add a bid, then they've succeeded in earning something for nothing.

In any case, all of these techniques can push a worthless object's price above zero, at which point that object may have generated enough of a history of positive prices that it will be valued by enough outsiders that it will join the mass of non-fiat objects in circulation. From nothing, our worthless item it has pulled itself up by its own bootstraps.

Which explains bitcoin's incredible volatility. A bootstrapped object can just as easily let go of its own straps and fall back to zero. Without some real use or backing, there's nothing to catch it on the way to $0. And at $0, there's no guarantee of re-bootstrapping bitcoin back to some positive price. As such, Bitcoin users justifiably expect incredible returns from bitcoin holdings in order to bear the risk of a zero-value equilibrium. Expected hyperdeflation is the carrot that must be proffered up for risky cryptocoins to be held. When those expectations of price appreciation aren't met, a large crash in the current price (relative to its future expected price) is necessary in order to tempt the next crop of speculators to hold it again. Thus bitcoin's pattern of incredible rises, or hyperdeflation, followed by 50% flash crashes, followed by the next round of hyperdeflation.

So if unbacked, useless, and costless objects can be imbued with a positive price via Selgin's painting-the-tape story, why isn't everyone doing it? But they are! Attracted by the potential for large gains, plenty of people are creating alt-coins, as I wrote here and here. In theory, their combined greediness should have the effect of swamping the market with fiat objects, driving their price towards the cost of production. The idea here is similar to the Somali shilling story, in which continual counterfeiting of old fiat shilling notes drove their price down to the cost of production, namely the costs of paper, printing, and shipment.

This hasn't happened yet with bitcoin, which is hovering at around $950. In my old post Milton Friedman and the mania in "copy-paste" cryptocoins, I hypothesized that the seeming inability of competitors to drive bitcoin prices down had something to do with the unassailable benefits that bitcoin enjoys as being the first mover, including superior security and liquidity. Tyler Cowen has some interesting thoughts on this. Bitcoin has a market cap of about $20 billion. As long as Bitcoin's entrenched advantages are so supreme that it would cost $20 billion to create a competitor, then there's no profit in tackling its niche. Cowen, however, thinks that the cost of mimicking bitcoin is far less than this. Rather than being in equilibrium, the cryptocurrency market is currently working itself via a process of "supply-side arbitrage" to a new equilibrium at which bitcoin will be worth far less.

On this same topic, Nick Rowe suggests that a BackedCoin might be one of the competitors capable of carrying of this feat. I agree with Cowen and Rowe —that's why I mostly sold out of bitcoin last year, and why I plan to eventually sell my litecoin. Of course, I'm the dummy who sold BTC back at $100, so my opinions should be taken with a grain of salt.

Where will the competition come from? Robert Sams makes a good argument for why bitcoin knock offs like litecoin, sexcoin, etc., though costless to produce, can't easily compete with bitcoin itself. The mining power that goes into maintaining the integrity of the various blockchains is in scarce supply. Merchants will always congregate to the blockchain with the most security, since that will be the coin that guarantees that the threat of double-spending is the smallest. While clones can be created with a few key strokes, good security can't be bought. Thus bitcoin's price can't be competed down to $0ish by alt-coins.

I think I buy Sams's point. However, he couches his argument within the existing universe of bitcoin and its clones. I'd make the argument that the crypto phenomena through which "supply-side arbitrage" will be carried out could be something entirely different than bitcoin, say Ripple or something we haven't yet seen. Ripple for one isn't constrained by the supply of existing mining power, or hashing, since the Ripple blockchain is maintained via consensus, not by hashing miners. Is this type of security cheaper? I'm no techie, so I won't speculate. But it is something different. And though it may take a while, at some point new and different will also be cheaper.

Another bonus of the Ripple system is that the crypto currency it creates are not bootstrapped assets, they are redeemable IOUs (let's not confuse Ripple IOUs and XRP!). In Rowe's UnbackedCoin vs BackedCoin world, Ripple IOUs are the equivalent of BackedCoin. It is their backing that should protect the exchange value of Ripple IOU from the threat of competition. This very same backing frees them from the hyperdeflation-crash-hyperdeflation patten that bootstrapped coins tend to display, stability being a desirable feature among  those who want to hold an inventory of media of exchange. As long as Ripple IOUs are just as transferable & secure as bitcoin and other alt-coins, this stability will be the edge that pushes them above the crypto competition.

So in sum, worthless assets can be kickstarted into circulation, say by a group of confederates who paint the tape in a way to attract outsiders. The riskiness of these bootstrapped assets requires that they yield incredibly high returns, or constant price appreciation. However, this state of affairs can't last forever since others will be eager to issue their own competing fiat objects, including superior non-volatile competitors. If I'm right, in the future bitcoin will be a smaller part of the cryptocoin world than it it now, whereas stable-value non-bootsrapped crypto assets, like Ripple IOUs, will be a larger part of that world.

[1] Bitcoin may not be entirely intrinsically worthless. I have floated the idea before that bitcoin has commodity value as a symbol of geek cred.

Saturday, January 11, 2014

Angolan macutes: Imaginary money

Economists are sometimes guilty of misrepresenting real-world liquid objects as living examples of the abstract variables populating their favorite monetary model. A good example of this is the incorrect reliance on Yap stones to illustrate the idea of fiat money by economists as varying as Keynes, Milton Friedman and James Tobin. Whereas fiat money is intrinsically useless, inconvertible, and unbacked, Yap stones certainly aren't, the anthropological evidence revealing that the stones had cultural and religious significance apart from their monetary value.

Similar in concept is the story of the macute, a unit of account used in Angola hundreds of years ago. Much like the exotic Yap stone, the existence of the macute (or macoute) came to the attention of Western thinkers as trade and conquest revealed ever large parts of the globe. Montesquieu was one of the first to describe the macute, noting:
The negroes on the coast of Africa have a sign of value without money. It is a sign merely ideal, founded on the degree of esteem which they fix in their minds for all merchandise, in proportion to the need they have of it. A certain commodity or merchandise is worth three macoutes; another, six macoutes; another, ten macoutes; that is, as if they said simply three, six, and ten. The price is formed by a comparison of all merchandise with each other. They have therefore no particular money; but each kind of' merchandise is money to the other. - Montesquieu, Esprit des Lois, 1748
Montesquieu's macute was later picked up by Sir James Steuart, an 18th century economist ranked just a notch or two below Adam Smith:
That money, therefore, which constantly preserves an equal value, which poises itself, as it were, in a just equilibrium between the fluctuating proportion of the value of things, is the only permanent and equal scale, by which value can be measured.

Of this kind of money, and of the possibility of establishing it, we have two examples: the first, among one of the most knowing; the second, among the most ignorant nations of the world. The Bank of Amsterdam presents us with the one, the coast of Angola with the other.

The second example is found among the savages upon the African coast of Angola, where there is no real money known. The inhabitants there reckon by macoutes; and in some places this denomination is subdivided into decimals, called pieces. One macoute is equal to ten pieces. This is just a scale of equal parts for estimating the trucks they make. If a sheep, e. g. be worth 10, an ox may be worth 40, and a handful of gold dust 1000. - An Inquiry into the Principles of Political Oeconomy, 1767
To Steuart and Montesquieu, the macute was an example of "ideal" money of account. The term money-of-account refers to the economy's pricing sign, or unit-of-account. It could be pounds (£), yen (¥), or dollars ($). Some real good typically defines this unit. For instance, the $ is the unit used to record prices in the US. The real good that defines the $ is base money issued by the Federal Reserve. In medieval times, prices were recorded in terms of £/s/d, with silver pennies being the defining real item (the "link coin"). To put this in the lingo of the econ blogosphere, the real good that defines the unit of account is the medium of account, a term popularized by Scott Sumner.

James Steuart's ideal money of account was a unit that, somewhat unusually, had no underlying real good defining it. It was a purely abstract accounting unit. There were prices in Steuart's economy, but no medium of account. Presumably Angolans were to keep the macute scale in mind, much like they might have a good sense for how long a foot was, or how much liquid a litre might contain. But at least with litres or feet there was a standard to which one might refer back to, say a metre stick or a measuring cup. Since the macute had no physical representation, goes the theory, it could only ever exist in people's heads.

Steuart and many others in his day believed in the necessity of an invariable scale of value. What was important to Steuart was the relative prices of real goods, not the price of some superfluous intervening good who's only job was to provide a measuring stick. If the money-of-account was a gold coin, for instance, then the "smallest particle of either metal added to, or taken away from any coin" would cause the entire price level to rise, destroying the ability of coins to measure the value of things. This would create macroeconomic difficulties:
any thing which troubles or perplexes the ascertaining these changes of proportion by the means of a general, determinate and invariable scale, must be hurtful to trade, and a clog upon alienation. This trouble and perplexity is the infallible consequence of every vice in the policy of money or of coin.
Fixing the money of account to a coin rather than allowing it to have an independent and abstract value caused distributional unfairness, since the relative interests of debtors and creditors were now at the disposal of anyone who could reduce the quality of coin,
not only of workmen in the mint, of Jews who deal in money, of clippers and washers of coin, but they are also entirely at the mercy of Princes, who have the right of coinage, and who have frequently also the right of raising or debasing the standard of the coin, according as they find it most for their present and temporary interest.
To those like Steuart, the advantage to society of an imaginary accounting unit like the macute was that, unlike physical coin, no prince or money clipper could ever debase it. It existed safely in the collective imagination where it could not be damaged, and therefore trade would no longer be held hostage to a fluctuating price level.

This idea spread. Around the time of Steuart, A.R.J. Turgot would also write of the macute as a purely imaginary unit:
The Mandingo negroes, who carry on a trade for gold dust with the Arabian merchants, bring all their commodities to a fictitious scale, which both parties call macutes, so that they tell the merchants they will give so many macutes in gold. They value thus in macutes the merchandize they receive; and bargain with the merchants upon that valuation. - Reflections, 1766
Macutes-as-ideal-unit would go on to be upheld a century later by John Stuart Mill:
This advantage of having a common language in which values may be expressed, is, even by itself, so important, that some such mode of expressing and computing them would probably be used even if a pound or a shilling did not express any real thing, but a mere unit of calculation. It is said that there are African tribes in which this somewhat artificial contrivance actually prevails. They calculate the value of things in a sort of money of account, called macutes. They say one thing is worth ten macutes, another fifteen, another twenty. There is no real thing called a macute: it is a conventional unit, for the more convenient comparison of things with one another. - Principles of Political Economy, 1848
As lovely as the idea of an imaginary macute was, it simply wasn't true. The macute was not so abstract as Montesquieu, Steuart, Turgot, and Mill would have liked it to be. William Stanley Jevons, for instance, scolded Montesquieu for misunderstanding the nature of money of account, since macutes served as "the name for a definite, though probably a variable, number of cowry shells, the number being at one time 2000." Lord Lauderdale accused Steuart of ignorance, noting that macutes were "pieces of net-work, used by the people of Angola for a covering." Like Lauderdale, John Ramsay McCulloch also found macutes to be bits of valuable cloth. Other writers declared that slaves were the missing medium-of-account used to describe the macute.

With the benefit of modern ethnographic accounts, we know that McCulloch and Lauderdale were right—macutes were neither imaginary, nor slaves, nor cowries, but cloth. In Power, Cloth and Currency on the Loango Coast, Phyllis Martin describes a coastal economy in which domestically produced cloth currency circulated. These libongo (pl. mbongo) were fourteen inch square pieces of cloth about the size of a hankerchief (see photo below). Mbongo had multiple uses. Not only could it be used in local markets to buy food and other consumption goods, but it could be made into clothes, wall hangings, bags, and floor coverings, and used for ceremonial purposes.

Kongo or Angola cloth, 17th century, raffia pile (source)

Martin also describes a traditional unit of account called a makuta (macute), defined as ten mbongo wrapped together in a strip. European trade brought foreign substitute cloth, and with that a decline in the purchasing power of the makuta, or inflation, resulted. As a result, copper coins came into increased use, although Martin finds that mbongo remained in circulation well into the eighteenth century. By the 1700s, around the time that Montesquieu was writing, the nature of the makuta unit of account had changed:
At Loango Bay traders used an abstract numerical unit of account based on a makuta, one mukuta being equal to 10. The unit may have developed from the older association of the mukuta with ten mbongo. Thus a slave-trader at Loango in 1701 wrote, "we bought men slaves from 3,600-4,000, and women, boys and girls in proportion." The goods to be exchanged were also valued in the numerical unit of account for example, a piece of "blue baft" or cotton cloth from India counted as 1,000, a piece of painted calico was 600, a small keg of powder was 300, and a gun was 300.40 
- Martin, Power, Cloth and Currency on the Loango Coast, 1986
What we have here is an example of "ghost money", not ideal money. An ideal money, having been divorced from any traded good, would have no commodity definition whatsoever. The mukuta (macoute) as described by Martin, however, was defined as a historically fixed, or "ghost" quantity, of mbongo. Though no longer prized as a highly liquid medium of exchange—copper coinage would have filled this place—mbongo were still desired for their non-monetary qualities. Thus any alteration in the real value of mbongo would continue to have an effect on all prices. It may have been this historically fixed "ghost" nature of macutes and their relative rarity in actual trade that confused Montesquieu into describing them as an ideal accounting unit.

In sum, macutes were not the ideal unit of Steuart and Montesquieu's imagination. Does that mean that ideal units of account can't exist? I'm hard pressed to come up with a logical explanation for how they might work. And I surely don't have any historical examples, the macute having been confined to the dustbin. I vote we toss the idea out, along with fiat money. Beware economists toting imaginary accounting units, abstract numeraires, and ideal money of account.

P.S. Indexed units of account like the Chilean Unidad do Fomento, which I wrote about here, are not imaginary units. Instead, I think they should be thought of as ghost monies.

Saturday, January 4, 2014

Does QE actually reduce inflation?

There's a counterintuitive meme floating around in the blogosphere that quantitative easing doesn't do what we commonly suppose. Somehow QE reduces inflation or causes deflation, rather than increasing inflation. Among others, here are Nick Rowe, Bob Murphy, David Glasner, Stephen Williamson, David Andolfatto, Frances Coppola, and Bill Woolsey discussing the subject. Over the holidays I've been trying to wrap my head around this idea. Here are my rough thoughts, many of which may have been cribbed from the above sources, though I've lost track from which ones.

Let's be clear at the outset. Inflation is a rise in the general price level, deflation is a fall in prices. QE is when a central bank purchases assets at market prices with newly issued reserves.

In equilibrium, the expected returns on all goods and assets must be equal. If they aren't equal then people will rebalance towards superior yielding assets until the prices of these assets have risen high enough to iron out their superior return (and away from low yielding assets until their prices have fallen enough so that their expected return is once again competitive with all other assets).

Central bank reserves are one of the many assets whose yield is included in this calculus of returns. The return on reserves can be decomposed into two specific categories of return: expected capital gains, or price appreciation, and a liquidity return, sometime referred to on this blog as a monetary convenience yield.

Regarding the first return, this is typically negative. People expect the purchasing power of central bank reserves to be lower in the future than in the present—they anticipate inflation.*

The liquidity return exists because reserves are highly marketable. The ability to quickly mobilize reserves to deal with unanticipated events yields a flow of liquidity services, specifically the alleviation of felt uncertainty. The expected return on these liquidity services outweighs the expected capital loss on reserves, providing reserve owners with a combined return that is competitive with other assets like cars, olive oil, education, t-bills or houses.

When a central bank conducts QE, the quantity of reserves in the economy increases so that they are less scarce. All else staying the same, the marginal value that people attribute to the flows of liquidity services provided by reserves declines. With their liquidity return having fallen, reserves now yield a lower overall return than competing assets.

Given these unequal returns, reserve owners will want to rebalance their portfolios into higher yielding alternatives. However, existing owners of these assets will be unwilling to accept this trade since the return they can expect to receive on reserves is no longer competitive with the return on the assets that they would be forgoing. Reserve owners will have to sweeten the deal by offering potential counterparties an improved return on reserves held. The way they can do this is to offer to sell their reserves at a reduced price today relative to their price tomorrow. In doing so, reserve owners are offering counterparties an improved potential for capital appreciation to counterbalance the diminished liquidity return on reserves.

Another way to describe this trade is that reserve owners must create some inflation, or a higher price level, in order to attract interested buyers. From this higher plateau, prices will rise at a much slower rate than before, or, put differently, the purchasing power of reserves will fall much slower than previously expected. The new expected price trajectory of reserves may even be a deflationary one—the market anticipating prices tomorrow to be lower than those today. In any case, only when the expected capital gain on reserves has been sweetened enough to sufficiently compensate would-be owners of reserves for bearing their diminished liquidity return will potential counterparties be willing to trade away their existing assets for reserves.

So back to our initial question: does QE reduce inflation? Not quite. By diminishing the liquidity return on reserves, QE reduces *expected* inflation. This change in expected inflation occurs via a leap in inflation in the present. Subsequent rounds of QE will continues to breed inflation and lower expected inflation until the liquidity return has been reduced to zero, at which point further QE will have no effect.


But let's introduce another wrinkle. What happens if other assets also carry a liquidity return? And let's assume that there are different kinds of liquidity returns, so that the liquidity services provided by one asset can't be easily substituted with the liquidity services of another. Thus, when the economy is flooded with reserves and their marginal liquidity return hits zero, the liquidity return on alternative assets needn't also decline to zero.

Let's take up where we left off. QE has reduced the liquidity return on reserves to zero and subsequent rounds of QE no longer cause inflation or reduce expected inflation. Let's assume that short term bills, specifically those issued by, say, Microsoft, provide a unique set of collateralizability services, and therefore yield a liquidity return > 0.

When our central bank purchases Microsoft bills, the supply of Microsoft collateral in the economy shrinks, which increases the liquidity return on Microsoft bills. The total return on Microsoft bills, the sum of their liquidity return and expected capital gain, is now superior to all other assets. This spawns a mass effort by investors to sell other assets for Microsoft bills. The only way that existing bill owners will agree to sell away their superior yielding Microsoft debt is if potential buyers offer to pay a higher price. As short term Microsoft bill prices are bid up, the expected capital gain on bills is reduced, counterbalancing the higher liquidity return. At some appropriately higher bill price, the total expected return on bills will be reduced to a level competitive with all other assets, restoring equilibrium.

This process, however, doesn't have any impact on inflation. All that is happening is that the relative price of a certain asset—the short term Microsoft bill—is rising.

Subsequent rounds of QE will further reduce the supply of short term Microsoft bills, increasing their liquidity return and eventually driving their price above par. At any price above par, capital returns on bills are effectively negative—bills, after all, never pay out more than their par value. People will continue to be attracted to a <0% yielding short term bill as long as it sports a sufficiently large liquidity return. The latter can outweigh the negative capital return, providing a total return that is competitive with other assets.

One problem with QE is that it drives the price paid for the liquidity service on Microsoft short term bills above the cost that Microsoft must incur in maintaining those liquidity services. People are effectively paying more to enjoy Microsoft liquidity services than they would in a competitive economy in which prices are pushed down to the cost of production. The artificially high price for bills that has been caused by QE incentivizes people to acquire a smaller flow of Microsoft liquidity services than they would otherwise prefer. This represents a deadweight loss to the economy, or what is termed an allocative inefficiency by economists. The surplus that consumers enjoy is smaller than it would be in a world in which large scale purchases of Microsoft bills had not pushed their liquidity return to artificially high levels.

This loss of allocative efficiency, however, does not equate to deflation. While QE involving Microsoft bills may not be ideal for the economy, it doesn't cause the price level to fall.

Given QE's effect on Microsoft bills, it would be odd if Microsoft did not choose to continually issue new short term bills until the marginal value of liquidity services yielded by bills was driven back down to the cost of maintaining those services. This would goose Microsoft's profits while simultaneously increasing the consumers' surplus, removing all of the inefficiency created by QE.

However, if the issuer of these unique collateralizable bills is the government, not Microsoft, things might be different. Because the government isn't profit-driven, it may be less motivated to issue new bills and reduce the allocative inefficiency created by QE. Is this a big deal? The excess of liquidity's price over cost is similar to any other monopolistic distortion, take for intance the diamond or potash oligopolies that price their products above cost. Situations like these are unfortunate, but I'm not so sure that they have large macroeconomic consequences. The benefit of not doing QE because one might create inefficiencies in a few lone markets for collateral are surely not as large as the benefits of doing QE in order to boost the economy's price level.

So the best I can do in my mental meandering is that QE either produces inflation or is irrelevant. It does not cause lower inflation or deflation. The by-product of any QE-inspired jump in inflation is lower *expected* inflation than before. A few inefficiencies may be created in various markets targeted by purchases, but as interesting as these inefficiencies are I don't see how they produce severe macroeconomic consequences.

*For the sake of simplicity I assume that reserves don't pay interest.