A CBDC, eh?

David Andolfatto recently wrote a helpful article about whether Canada needs a central bank digital currency, or CBDC. I agree with David that a CBDC is "not an essential initiative at this point in time."

The way I see it, there are two big elephants in the room when it comes to introducing a central bank digital currency. Both of them suggest we should slow down any effort to issue CBDC.

But before I get to that, what is a CBDC? In brief, a CBDC is a new payments option that would allow regular Canadians to interact digitally with our nation's central bank, the Bank of Canada. For example, instead of having to use your Royal Bank account or Visa card to buy stuff at the supermarket or on Amazon, you could pay with a central bank digital tool, perhaps a Bank of Canada app or card. The Bank of Canada has been exploring whether the idea of issuing a CBDC for several years now, but so far hasn't pulled the trigger.

Here are what I believe to be the two big risks to rolling out a Canadian CBDC.

The most important one is white elephant risk.

In mature democracies like Canada, the provision of retail non-cash payments is a mostly-solved problem. Decent access to payments is already provided by a panoply of bank accounts, financial  apps, and cards. These existing options for connecting to the payments system are very safe. The $1,000 we hold in a checking accounts to make payments, for instance, is protected by government deposit insurance.

So if the Bank of Canada were to issue a CBDC, it's not obvious to me that many of us would bother using it. It would be just one more safe payments account among a sea of safe options.

That leaves the central bank in the position of having spent large amounts of money building and maintaining a payments network that none of us really needed or wanted in the first place.

Getting rid of an expensive and lacklustre CBDC could be difficult. Central bankers may feel like their reputations are tied to their CBDC projects. This, combined with the fact that central bankers don't feel the sting of a bottom line, may allow these white elephants to limp on for a very long time.

At the moment, most Canadians don't interact with Bank of Canada products (apart from holding cash, usage of which is falling). We mostly view the central bank as a competent technocratic body that does complicated stuff with interest rates. A CBDC project would suddenly put the Bank of Canada in direct digital contact with Canadians. But if the CBDC were to become a white elephant, this proximity could backfire on the central bank. It'll be know as the agency that runs a bloated payment system that the public dislikes. We don't want the Bank's brand to be hurt. We want the Bank of Canada to be trusted and deemed competent.

The second risk is black elephant risk. A black elephant is an obvious risk that people avoid discussing ahead of time.

Most discussions about CBDC centre on the technological hurdles involved in building one. But they often ignore the pesky sociological difficulties of running payments systems.

Fickle customers want to be able to reverse payments when they aren't happy with the products they buy. Users are frequently swindled out of their money by fraudsters and will expect restitution. If Jack accidentally send $500 to Alice instead of the $50 that he intended to send, he will want $450 back. What if Alice disagrees?

This requires that central bank constantly arbitrate disputes.

That's not all. Criminals will try to use a CBDC to sell illegal products. The central bank will have to start policing what is illegal and what isn't. Controversial businesses, say white nationalist publishing houses or kinky porn sites, will line up to use it. That means getting embroiled in politics.  

These are the not the sorts of issues I want my central bankers to get bogged down in. The risk is that demanding CBDC users distract the Bank of Canada from the vital task of conducting monetary policy.

The Bank of Canada might try to outsource the governance of a CBDC to the private sector. But that begs the question: if the central bank doesn't want the burden of running a payments system, why is it trying to get in the game at all? Why not just stick with the status quo, which seems to be working?

In sum, if I had any suggestions for Canadian citizens on how they should appraise a Canadian CBDC, it would be this. Given the above white & black elephant risks, the Bank of Canada shouldn't lead, it should follow. Watch the first few trail-blazing central banks to see how their CBDC projects pan out. (The Swedes, who are aggressively purchasing a CBDC, are a good candidate). If the Swedish CBDC succeeds, copy it. If the Swedes fail, continue on as before. There's no advantage to being the first to market.

The difference between two colourful bits of rectangular paper

David Andolfatto had a provocative and open-ended tweet a few days back:

The difference between money and debt. pic.twitter.com/CSQuLzUJPU

— David Andolfatto (@dandolfa) April 26, 2019

We see two coloured pieces of paper, both with an old dead President on it. They each have a face value of $500. Both are issued by a branch of the government, the $500 McKinley banknote (at right) by the Federal Reserve while the $500 Treasury bond (at left) by the Treasury. Both are bearer instrument: anyone can use them.

So why do we bestow one of them the special term "money" while the other is "credit"? I mean, they seem to be pretty much the same, right?

The word money is an awful word. It means so many different things to different people that any debate invoking the term is destined to go off-track within the first fifty characters. So I'm going to try and write this blog post without using the term money. Why are the two instruments that David has tweeted about fundamentally and categorically different from each other?

One of them is the medium of account, the other isn't

Being a veteran of the monetary economics blogosphere, David's tweet immediately made me think of the classical debates between Scott Sumner and Nick Rowe about the the medium-of-exchange vs medium-of-account functions of assets like banknotes and deposits and coins. (For those who don't remember, here are some posts.)

As Scott Sumner would probably say, one of the fundamental differences between the two bits of paper is that the McKinley $500 Federal Reserve note has been adopted as the U.S.'s medium-of- account. The $500 Treasury bond  hasn't.

Basically, if Jack is selling his car for $500, this price is represented by the $500 note (and other sub-denominations like the $50, $20 etc), not a $500 bond. Put differently, the bill is used as the medium for describing the accounting unit, the $. The bond does not have this special status. Now it could be that Jack is willing to accept bonds as payment, but since he doesn't use bonds to describe his sticker prices, he'll have to do some sort of calculation to convert the price into bond terms. When something is the medium of account, the entire language of prices is dictated by that instrument.

So why has society generally settled on using banknotes and not the bonds as our medium of account?

First, let's learn a bit more about the bond in question. The image that David has provided us with isn't actually a bond, it's a bond coupon. A coupon is a small ticket that the bond owner would periodically detach from the larger body of the bond in order to claim interest payments. The full bond would have looked more like this:

This format would have hobbled the bond's usefulness as a medium of exchange. The bond principal of $100 is represented by the largest sheet of paper. Attached to it are a bunch of coupons (worth $1.44 each) that haven't yet been stripped off. To compute the purchasing power of the bond, the $100 principal and all of the coupons would have to be added up. Complicating this summation is the time value of money. A coupon that I can clip off tomorrow is more valuable than the one I can clip off next year.

So if Jack is selling a car, and Jill offers him a $500 Treasury bond rather than a banknote, he'll have to spend a lot more time puzzling out the bond's value. A $500 McKinley note, which pays 0%, is much easier on the brain, and thus less likely to hit some sort of mental accounting barrier. (Larry White wrote a paper on this a while back).

Another hurdle is that there are many vintages of $500 Treasury bonds. A $500 bond that has been issued last year will be worth more than one that has been issued ten years ago and has had most of its coupons  stripped off. Put differently, Treasury bonds are not fungible. Banknotes, on the other hand, don't come in vintages. They are perfectly interchangeable with each other. So in places like stores and markets where trade must occur quickly, banknotes are far more convenient.

Further complicating matters is capital gains tax. Each time the $500 Treasury bond changes hands its owner must go back into their records to find the original price at which they received the bond, compute the profit, and then submit all this information to the tax authority. The $500 note doesn't face a capital gains tax. Better to use hassle-free banknotes, and not taxable bonds, to make one's day-to-day purchases.

Which finally gets us to why notes and not bonds are the medium-of-account. Since banknotes are such a convenient medium of exchange, everyone will have a few on hand. And this makes it convenient to set our prices in terms of notes, not Treasury bonds.

Why is it convenient? Say that Jack were to set the price of the car he is selling at $500, but tells his customers that the sticker price is in terms of Treasury bonds. So the $500 Treasury bond will settle the deal. But which Treasury bond does he mean? As I said earlier, at any point in time there are many vintages of $500 bonds outstanding. The 1945 one? The 1957 one? So confusing!

Jack's customers will all have a few notes in their wallet, having left their bonds locked away at home. But if Jack sets prices in terms of bonds, that means they'll have to make some sort of foreign exchange conversion back to notes in order to determine how many note to pay Jack. What a hassle!

If Jack sets the sticker price in terms of fungible notes he avoids the "vintages problem". And he saves the majority of his customers the annoyance of making a forex conversion from bond terms back into note terms. Since it's better to please customers than anger them, prices tend to be set in terms of the most popular payments instrument. Put differently, the medium-of-account tends to be married to the medium-of-exchange.

Alpha leaders vs beta followers

There is another fundamental difference between the two pieces of paper. Say that the Treasury were to adopt a few small changes to the instruments it issues. It no longer affixes coupons to Treasury bonds. And rather than putting off redemption for a few years, it promises to redeem them on demand with banknotes at any point in time. This new instrument would look exactly like the McKinley note. Without the nuisances of interest calculations, Treasury bond transactions should be just as effortless as the those with Federal Reserve notes.

But a fundamental difference between the two still exists. Since the Treasury promises to redeem the bond with banknotes, the Treasury is effectively pegging the value of the Treasury bond to the value of Federal Reserve notes. However, this isn't a reciprocal relationship. The Federal Reserve doesn't promise to redeem the $500 note with bonds (or with anything for that matter).

This means that the purchasing power of the bond is subservient to that of the banknote. Or as Nick Rowe tweets, "currency is alpha leader, bonds are beta follower."

Bonds promise to pay currency. Currency does not promise to pay bonds.
There's an asymmetric fixed (future) exchange rate between bonds and currency. Issuers of bonds peg to currency; issuers of currency do not peg to bonds.
So currency is alpha leader, bonds are beta follower.

— Nick Rowe (@MacRoweNick) April 26, 2019

This has much larger implications for the macroeconomy. In the long-run, the US's price level is set by the alpha leader, the Federal Reserve, not by the beta follower, the Treasury.

The Treasury could remove the peg. Now both instruments would be  0% floating liabilities of the issuer. Without a peg, their market values will slowly diverge depending on the policy of the issuer. For instance, a few years hence the $500 Treasury bond might be worth two $500 Federal Reserve notes. We could imagine that in certain parts of the U.S., custom would dictate a preference for one or the other as a medium of exchange. Or maybe legal tender laws nudge people into using one of them. And so certain regions would set price in terms of Treasury bonds while others will use Federal Reserve notes as the medium of account.

The Treasury's monetary policy would drive the price level in some parts of the U.S., whereas the Fed's monetary policy would drive it in the rest. This would be sort of like the 1860s. Most American states adopted Treasury-issued greenbacks as the medium of exchange during the Civil War, but California kept using gold coins issued by the US Mint. And thus prices in California continued to be described in terms of gold, and held steady, whereas prices in the East inflated as the Treasury printed new notes. (I wrote about this episode here.)

In conclusion...

So in sum, the two instruments in David's tweet are fundamentally and categorically different because one is the medium of account and the other isn't. Treasury bonds just aren't that easy to transact with, so people don't carry them around, and thus shopkeepers don't set sticker prices in terms of Treasury bonds. But even if the Treasury were to modify its bonds to be banknote look-alikes, they are still fundamentally different. Treasury paper is pegged to notes, but not vice versa.

This peg can be severed. But for convenience's sake, one of the two instruments will come to be used as the medium-of-account within certain geographical areas. And thus in its respective area, the issuer of that medium-of-account will dictate monetary policy.

Why the American taxpayer might prefer a large Fed balance sheet

David Andolfatto and Larry White have been having an interesting debate on the public finance case for having a large (or small) Federal Reserve balance sheet. In this post I'll make the case that American taxpayers are better off having a large Fed balance sheet, perhaps not as big as it is now, but certainly larger than in 2008.

To explain why, we're going to have to go into more detail on some central banky stuff.

The chart below illustrates the growth of the Fed's balance sheet. Prior to the 2008 credit crisis, the Fed owned around $900 billion worth of assets (green line), these being funded on the liability side by $800 billion worth of banknotes (red line), a slender $10-15 billion layer of reserves (blue line), and a hodgepodge of other liabilities. The Fed now owns an impressive $4.5 trillion in assets. These are funded by around $1.5 trillion worth of banknotes and $2.3 trillion worth of reserves. So the lion's share of the increase in the Fed's assets is linked to the expansion in reserves, which have ballooned by around 25,000%.


There's a problem with the above chart. It shows reserves clocking in at just $10 billion prior to 2008, but it's important to keep in mind that this *understates* the quantity of reserves issued by the Fed. Prior to 2008, the Fed would typically lend out tens of billions worth of reserves to banks during the course of the day, these amounts being paid back before evening. These loans are referred to as "daylight overdrafts." Because the above chart uses end-of-day data, it omits daylight overdrafts, thus making the balance sheet look smaller than it actually was.

How big did the Fed's balance sheet actually get during the course of a day thanks to overdrafts? Prior to the 2008 credit crisis, daylight overdrafts typically peaked at around $150 billion. So if we recreate the chart using intraday Fed data, the pre-2008 balance sheet would be around $800 billion + $150 billion, or 20% larger than if we use end-of-day data. And rather than a relatively flat pattern, we see a pulsing pattern. I've drawn out the chart by hand to give a sense for how the balance sheet would have looked, although its not to scale and doesn't use real data.

So why does the Fed offer daylight overdrafts? One of the business lines in which a commercial bank participates is the processing of payments on behalf of its clients to other banks, these recipient banks in turn crediting sent funds to their clients. To make these interbank payments, banks use deposit accounts at the central bank, or reserves.

In the U.S., legally-stipulated reserve requirements force banks to hold small quantities of central bank reserves overnight. So when the U.S. banking system opens in the morning for business, a bank will typically already have some funds in their reserve accounts that can be used to make client payments. However, the ability of this small layer of required reserves to carry out the nation's payments will soon be swamped—after all, the quantity of transactions conducted on a single day using reserves is massive, currently clocking in at $3 trillion.

In theory, banks might choose to hold an excess quantity of reserves overnight (i.e. more than the legally mandated minimum) in preparation for the next day's payment cycle. However, the Fed has historically kept the overnight interest rate on reserves at 0%, far below the market overnight interest rate. So no bank wants to hold reserve overnight if they can avoid it. If they did, their profits would suffer.

To ensure that banks have the ability to carry out the nation's business come morning, the Fed has typically provided the necessary reserves via daylight overdrafts. When the banks close for business in the evening, the Fed then sucks the reserves it has lent to banks back in. Alex Tabarrok once fittingly described banks as inhaling credit during the day, "puffing up like a bullfrog" —only to exhale at night.

As I mentioned earlier, before the credit crisis hit Fed-granted daylight overdrafts used to rise as high as $150 billion over the course of the day. Since 2008, the quantity of daylight overdrafts has declined quite dramatically. See the chart below:

source

Why have banks stopped applying for overdrafts? In 2008 the Fed began to pay interest to any bank that held reserves overnight. Rather than "exhaling at night," it suddenly made sense for banks to hold reserves till the next morning. This new demand for overnight balances was not met by daylight overdrafts, which must be paid back by the end of the day. Rather, a new permanent supply of reserves began to emerge thanks to the Fed's policy of quantitative easing. Under QE, the Fed created reserves and spent them to purchase bonds, these reserves staying outstanding as long as the Fed did not repurchase them, potentially for decades. The upshot is that banks are now quite happy to hold huge amounts of Fed-issued reserves on a permanent basis. As such, they no longer need to make use of daylight overdrafts to carry out the nation's payments. 

So let's bring the conversation back to the taxpayer. As you should hopefully see by now, the debate between keeping a big balance sheet and returning to its pre-2008 size is closely intertwined with the following question: do we want our central bank to provide daylight overdrafts or not? Because if we are to go back to 2008—i.e. to a period when overnight reserves were "scarce," as Larry White describes it—then by definition we are advocating daylight overdrafts.  

I'd argue that taxpayers might prefer that the Fed not provide daylight overdrafts. To begin with there is the question of credit risk. If a bank that has been granted an overdraft were to fail during the course of business, the Fed would be out of pocket. Since the central bank is ultimately owned by the taxpayer, that means taxpayers could take a big hit when a bank fails.

The Fed could protect itself by requiring banks provide collateral as security for access to Fed overdrafts. Now when the offending bank goes under, the Fed has a compensatory asset in its possession that it can use to make good on the loan, thus sparing the taxpayer. However, the protection afforded the Fed by collateralized daylight overdrafts comes at the expense of the nation's deposit insurance scheme, the Federal Deposit Insurance Corporation, or FDIC. To ensure that depositors of a failed bank are made whole, FDIC typically sells off the bank's assets. If the Fed has taken one of those assets for itself as collateral for a daylight overdraft, FDIC will have one less bank asset at its disposal and may have to dip into taxpayer funds to make up the difference. The overall risk faced by the taxpayer has not been reduced.

By maintaining the status quo—i.e. a large quantity of reserves—the taxpayer gets more protection from bank failures. Banks must buy reserves, or tokens, ahead of time to ensure that they can meet the payments needs of their clients. So the Fed acts as a seller, not a creditor, and therefore does not expose taxpayers to risk of bank failures. At the same time, FDIC does not face the prospect of having risk shifted onto it should the Fed seize collateral from a failed bank with unpaid daylight overdrafts.

Now the preceding discussion might seem to tilt me towards David Andolfatto's position of keeping a large balance sheet, albeit for different reasons than him. Not entirely. While a large quantity of reserves will be sufficient to insulate the taxpayer from bank failures, it needn't be as large as the current $2.5 trillion in outstanding reserves. As I pointed out earlier, prior to the 2008 credit crisis the Fed would typically grant around $150 billion in daylight overdrafts. This was sufficient to facilitate ~$2.7 trillion in payments (see data here). So each dollar in reserves was able to support 18x that value in payments. The Fed currently processes around $3.1 trillion in payments, a task that could probably be discharged with ~$200 billion in daylight overdrafts, assuming that the 18x ratio still prevails. So as long as the Fed were to keep at least $200 billion of the $2.5 trillion in reserves outstanding, that amount should be sufficient to replace the need for daylight overdrafts.

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Sources:

1. How the High Level of Reserves Benefits the Payment System and Settlement Liquidity and Monetary Policy Implementation, both by Bech, Martin, and McAndrews
2. Divorcing Money from Monetary Policy by Keister, McAndrews and Martin
3. Turnover in Fedwire Funds Has Dropped Considerably since the Crisis, but It’s Okay by Garratt, McAndrews, and Martin

Central banks deposits for you and me

The Bank of England recently announced that it will end a 300-year tradition of allowing employees to keep chequing accounts at the Bank. You can see an example of a cheque above, which is marked with the sort code 10-00-00. Traditionally, folks like you and me have only been able to get a piece of the central bank's balance sheet by holding banknotes. Central bank deposit accounts, which are far more convenient, have been limited to banks and other financial institutions. But the BoE provides a rare example of regular people, specifically employees, being permitted to directly own fully transferable central bank deposits, at least until recently.

The BoE's termination of this seemingly archaic practice is especially interesting in the context of growing efforts to crack open central bank balance sheets to those who have traditionally been hived off from them. A concrete step in this direction is the Federal Reserve's overnight reverse repurchase facility, which allows money market mutual funds to hold overnight balances at the Fed. More ambitious (but less concrete) is the Bank of England's Ben Broadbent, who describes the idea of a central bank adding more counterparties-

"perhaps a wide range of non-bank financial companies, say.  It might mean something more dramatic:  in the limiting case, everyone – including individuals – would be able to hold such balances."   

Echoing Broadbent, BoE Deputy Governor Minouche Shafik has spoken of the need to rethink "about to whom we give access to the advantages of central bank money with its unique qualities of finality of settlement." The idea here is to allow non-banks involved in fintech direct access to the Bank's real time gross settlement system, as Mark Carney goes on to illustrate here.

Turning to the blogosphere, John Cochrane has recently written about having all money backed by the government in order to end bank runs. And in the same vein, here is David Andolfatto's idea of allowing TreasuryDirect balances to be tradeable, thus providing individuals and firms with a safe place to keep cash other than the banking or shadow banking system.

This democratization of central banking sounds like a novel idea. Nosing deeper into the Bank of England's history, however, we learn that it was not just employees who could hold Bank of England deposits; most people could. Some of them were quite famous. An interesting anecdote from the 1700s has Sarah, Duchess of Marlborough, asking her bankers at the Bank of England to provide her with a freebie, namely some pens because she 'could get none that were good.' [1]

Moving forward a century, we learn that upon opening for business in 1855 the Bank of England's Western branch tended to attract small businessmen and private individuals "of modest means" as clients, including the accounts of the University of London, a Regent Street hatter, and a Sackville Street clothier—all on its first day of operations. Later that year the household of Queen Victoria left its private bank in order to do business with the Western branch. By all accounts, the Bank of England seems to have had excellent service:

"Staff were expected to recognize customers on sight and have a good, clear hand for writing up passbooks. Two porters were always on duty at the main entrance, clad in the pink livery of the Bank of England with silk top hats, and even the cashiers wore top hats when serving at the counter." [2]

The Bank of England kept up a retail presence well into the 1900s. But as public service came to be regarded as the Bank's main role, the aggressiveness of its commercial and retail businesses was reduced and it transitioned into a purely bankers' bank. The Western branch would be sold in 1930 to the Royal Bank of Scotland. [3]

By 1963 the Bank of England's services to the public were limited to a small number of accounts for existing customers. Presumably as they died, these accounts were closed. The most recent example of the Bank of England allowing non-banks to set up accounts comes from 2003, when Bank officials decided to provide Huntingdon Live Sciences, a drug company facing threats from animal rights activists, with a BoE account because commercial banks refused to offer their services.

So while it may seem that the Bank of England's Broadbent and Shafik are introducing a modern approach to central banking, the practice of allowing private individuals and non-financial businesses to directly hold central bank balance sheet space (in a non-cash form) is actually an old one. What lessons can we take from this historical example?

Many people believe that an open central bank balance sheet has the potential to render our traditional banking system extinct. Banks are special. They provide the world's most popular exhange media—deposits—as an offshoot of their primary business, lending. But as Robert Sams points out, if individuals are allowed to own safe central bank deposits directly there may no  longer be a reason for them to hold risky bank accounts. Demand for bank deposits falling to zero, banks will have to fund their loans to the public with regular bonds or equity, even as payments are re-routed through the books of the central bank. Fractional reserve banking as we know it is dead.

Depending on who you ask, the replacement of fractional reserve banking with so-called narrow banking, or 100% reserve banking, can be either good or bad. I'll leave that discussion for another day. Whatever the case, Bank of England history illustrates that private bank deposits can coexist with an open central bank balance sheet. Given the choice between keeping accounts with the safe Western branch or a risky private bank, individuals did not collectively flock to the former.

No doubt this was partly due to the two things, the Bank of England's policy of charging for servicing unprofitable accounts and of not paying interest on deposits. Its competitors, on the other hand, did pay interest. In essence, private banks had to retain customers by offering better services.

Which brings us back to the Bank of England's recent decision to close employee accounts. Given the Bank's stated intention of opening up its balance sheet, wouldn't it have been an opportune time to open up its retail banking business to all of England rather than shutting it down? The Bank maintains that it had been having trouble competing with services like online banking being offered by private banks. But as history shows, since a central bank offers something private banks can't —safety—it needn't be as competitive in the services it provides. Alternatively, it could be that the Bank will be following a different strategy of opening itself up, say through a distributed ledger or something like PositiveMoney's Digital Cash Accounts. Whatever the case, don't be fooled by the technological terminology; if the Bank were to open itself up, this would be more of a returning to the fold than a bold new future.

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[1] Bank of England: first report, session 1969-70 (link)
[2] Western Branch of The Royal Bank of Scotland - The Story of a Bank and its Building (pdf)
[3] Branches of the Bank of England, 1963 (pdf)

Why hasn't Canadian Tire Money displaced the Canadian dollar?

Canadians will all know what Canadian Tire Money is, but American and overseas readers might not. Canadian Tire, one of Canada's largest retailers, defies easy categorization, selling everything from tents to lawn furniture to hockey sticks to car tires. Since 1958, it has been issuing something called Canadian Tire Money (see picture above). These paper notes are printed in denominations of up to $2 and are redeemable at face value in kind at any Canadian Tire store.

Because there's a store in almost every sizable Canadian town, and the average Canadian make a couple visits each year, Canadian Tire money has become ubiquitous—everyone has some stashed in their cupboard somewhere. Many Canadians are quite fond of the stuff—there's even a collectors club devoted to it. I confess I'm not a big fan: Canadian Tire money is form of monetary pollution, say like bitcoin dust or the one-cent coin. I just throw it away.

It's the monetary oddities that teach us the most about monetary phenomena, which is why I find Canadian Tire money interesting. Here's an observation: despite the fact that it is ubiquitous, looks like money, trades at par, and is backed by a reputable issuer, Canadian Tire money doesn't circulate much. Stephen Williamson, a Canadian econ blogger, had an entertaining blog post a few years back recounting unsuccessful efforts to offload the coupons on Canadians. Sure, from time to time we might encounter the odd bar or charity that accepts it, or maybe a corner-store in Wawa. But apart from Canadian Tire stores, acceptability of Canadian Tire money is the exception, not the rule.

Why hasn't Canadian Tire money become a generally-accepted medium of exchange? One explanation is that Canadian law prevents it. Were the government to remove the strict rules that limit the ability of the private sector to issue paper money, bits of Canadian Tire paper would soon be circulating all across the nation, maybe even displacing the Bank of Canada's paper money.

A second hypothesis is that even if the law were to be loosened, Canadian Tire would remain an unpopular exchange medium. Some deficiency with Canadian Tire money, and not strict laws, drives their lack of liquidity. Nick Rowe, another Canadian econ blogger (notice a theme here?), once speculated that this had to do with network effects. Canadians have long since adopted the convention of using regular Bank of Canada-issued notes, and overturning that convention by accepting Canadian Tire money would be too costly. David Andolfatto (not another Canadian econ blogger!), would probably point to limited commitment as the deficiency. IOUs issued by Canadian Tire simply can't be trusted as much as government money, and so they inevitably fail as a medium of exchange.

In support of the first view, which is known in the economics literature as the legal restrictions hypothesis, Neil Wallace and Martin Eichenbaum (yep, another Canadian) recount an interesting anecdote. Back in 1983, competitor Ro-Na (since renamed RONA), a major hardware chain, started to accept Canadian Tire coupons at face value. I've found an old advertisement of the offer below:

RONA advertisement in La Presse, 1983 (source)

Eichenbaum and Wallace say that this is evidence that Canadian Tire money isn't just a mere coupon but readily serves as a competitive medium of exchange among Canadians. After all, if a major store like RONA accepted the coupons, then their acceptance wasn't just particular—it was general.

The story doesn't end there. Here is an interesting 1983 article from the Montreal Gazette:

The article mentions how in retaliation Canadian Tire sought an injunction against RONA to prevent it from accepting Canadian Tire money. We know this tactic must have been somewhat successful since RONA does not currently accept said coupons. Eichenbaum & Wallace slot this into their legal restrictions theory, noting that the injunction was probably motivated by Canadian Tire's desire to comply with legal prohibitions on the private issuance of currency, a damaging law suit helping to inhibit general use of their coupons. Remove these legal restrictions, however, and Canadian Tire would probably not have sued RONA, and usage of Canadian Tire coupons as a medium of exchange would have expanded. Presumably if Tim Horton's took up the baton from RONA and accepted Canadian Tire money, and then Couche-Tard joined in, you'd end up with a new national currency.

So we have two competing theories to explain Canadian Tire money's lack of acceptability. Which one is right? Let's introduce one more story arc. Zoom forward to 2009 when Canadian Tire lawyers sent a notice to a NAPA car parts dealer asking him to stop accepting Canadian Tire money. The reason cited by Canadian Tire: trademark infringement. As the article points out, Canadian Tire Money constitutes intellectual property, and if companies do not sufficiently police their trademarks against general usage, they may lose control of them. For instance, over the years Johnson & Johnson has had to vigorously defend its exclusive rights to the name "Band-Aid." If it hadn't, it might have lost claim to the name in the same way that Otis Elevator lost its trademark on the word "escalator" because the word fell into general use. That the 1983 RONA challenge probably had less to do with currency laws than trademark infringement damages Eichenbaum &Wallace's argument.

The last interesting Canadian factoid is the observation that a number of community currencies circulate in Canada. Salt Spring dollars, a currency issued by the Salt Spring Island Monetary Foundation, located off the coast of British Columbia, is one of these. Other examples include Calgary Dollars and Toronto Dollars. According to Johanna McBurnie, Salt Spring dollars are legal because they are classified as gift certificates. If so, I don't see why the use of Canadian Tire money as a medium of exchange wouldn't fall under the same rubric. This puts the final nail in Wallace & Eichenbaum's argument that restrictions on circulation of competing paper money have prevented broad usage of Canadian Tire paper. Rather, if laws are to blame for the minimal role of Canadian Tire Money's as currency, then it is the company's desire to protect its trademark that is at fault.

That local IOUs like Salt Spring dollars can legally circulate but lack wide acceptance (even in the locality in which they are issued) means we need something like the Nick Rowe's network effects or David Andolfatto's limited commitment to  explain why incumbent paper money tends to exclude competing paper money from circulation. Which isn't to say that Canadian Tire money would never circulate. As Larry White and George Selgin have pointed out, private paper money has circulated along with government paper money in places like Canada. But the bar for Canadian Tire money is probably a high one.

Deep money, the coexistence puzzle, and the legal restrictions hypothesis

WWI Liberty bonds, which according to Neil Wallace circulated alongside Federal Reserve notes [source]

What follows are some thoughts on the coexistence puzzle as well as the folks who find it interesting.

There is plenty of hyperbole over the difference between freshwater and saltwater economists, but one peculiarity that surely distinguishes a freshwater economist from his saltier cousin is that they tend to be interested in the underlying motivations guiding monetary exchange, the so-called microfoundations of money. (Saltwater economists tend to be content with broad assumptions about monetary phenomena). Representatives of the microfounded approach, which includes the blogosphere's own David Andolfatto as well as Stephen Williamson—who has anointed his approach New Monetarism—like to refer to their models as "deep models of money".

One of the classic questions that continues to interest deep money types is the so-called coexistence puzzle. Zero-yielding financial assets like central bank-issued banknotes are "dominated" in terms of rate of return by interest-yielding financial assets created by governments. The puzzle that needs explaining is why these dominated instruments can continue to coexist with the instruments that do the dominating.

A quick answer is that a lower-yielding asset can coexist with the higher-yielding asset because the first is more liquid than the second. In an uncertain world, the stream of liquidity services that an asset provides over its lifetime is a valuable service. An asset that provides a little less income can still be demanded in the marketplace as long as it provides a little more liquidity. Deep money folks would say that my answer is a bit shallow. It avoids exploring both the qualities of the assets being used and the frictions that characterize the world in which those assets trade that might render one asset more liquid than the next.

Let's explore the setup of the coexistence problem in more detail. In a 1982 paper, deep money pioneer Neil Wallace defined the problem thusly; if the government were to issue small denomination bearer bonds, say in units of $5, $10, and $20, and these instruments were to yield interest, just like their larger denomination relatives, why would anyone carry 0% Federal Reserve notes in their wallets when they might own an interest-yielding replica instead? These two instruments shouldn't coexist—cash should be driven out of existence or, if they are to coexist, then bearer bonds should yield no more than the 0% rate on cash.

One aspect of the problem, Wallace noted, was that for some obscure reason, governments typically choose not to issue small denomination bearer bonds. The large denomination size of t-bills and t-bonds inhibits their use in trade, thus preventing at the outset any sort of direct competition between government bonds and zero-yielding cash.

However, Wallace pointed out that this doesn't explain why private issuers don't simply buy high denomination government bonds and create their own government bond-backed small denomination bearer notes. If they did so, Wallace believed that two things might happen. These private issuers, by virtue of paying interest on their notes (more specifically by issuing bearer bonds at a discount to face value and allowing them to appreciate in price till maturity, much like treasury bills) would drive inferior 0% yielding banknotes out of existence so that only interest-bearing notes circulate.

Alternatively, the public would allow privately-issued bearer bonds to circulate at par with existing currency. Par acceptance would mean that private bearer bonds no longer paid interest in the form of a steadily rising price. However, Wallace stumbled upon an interesting side effect of par acceptance: nominal rates on government bonds would have to fall to zero. Why? According to Wallace, arbitrage dictates that as long as the rate on long term government bonds is above zero, competing private issuers will flock to buy those term bonds with which to back their 0% bearer notes, putting upward pressure on bond prices and downward pressure on yields. It makes sense for banks to do so because they earn the spread between the 0% notes that they issue and the interest-yielding bonds they purchase. According to Wallace, the arbitrage window will only be shut when banks have driven long term rates close enough to zero that the the opportunity for excess profits disappears. In a free market, the term structure of interest rates disappears. All we have is a flat yield curve.

Here is Wallace: "Thus, my prediction of the effects of imposing laissez-faire takes the form of an either/or statement; either nominal interest rates go to zero or existing government currency becomes worthless."

Of course in the world we live interest-yielding bearer currencies have not kicked out 0% notes nor have private notes driven long term bond rates to zero. Wallace attributed this to various legal restrictions against banks from entering the small denomination bearer bond line of business. Take away these legal restrictions and he believed that his conclusions followed.

Even if we removed these legal restrictions, I'm not convinced by Wallace's arguments. Given free competition in note markets, I don't think that positive-yielding small denomination bearer bonds (issued either by a private bank or a government) must necessarily drive cash into exile, not do I think their coexistence means that the term structure of interest rates must be flat.

To start with, the necessity of calculating interest payments throws a wrench in the smooth transfer of a bearer asset, a point made by Larry White. Say that the bearer bonds are printed with a $10 face value but sold by the government at a discount to face so that their price appreciates over time until maturity, the capital gain being a stand-in for interest payments. Should someone wish to use their unmatured bearer bond to pay for something, they will have to calculate how much of a discount to face to apply to the bond. Such a calculation imposes a burden on the transactors since it will take time to crunch the numbers or require a costly technology to speed up the process. As White has noted, a $20 note held for one week at 5% interest would yield less than 2 cents. Is it really worth it for a banknote user to take the time and trouble to compute and collect such a small amount?

The interest rate feature of bearer bonds also precludes the simple summations that round numbers allow. An owner of a $10, $5, and $20 bearer bond doesn't have $35 in purchasing power. Rather, discounting the bonds will show that their purchasing power is composed of inconvenient sums like $9.33, $4.89, and $19.60. This makes it harder to know how much purchasing power is in one's wallet prior to going to market, thereby inhibiting the usefulness of bearer bonds as a liquid medium. Carrying around 0% currency which trades at its face value allows for certainty of purchasing power, a feature that may more than compensate for lack of a pecuniary yield.

Even worse, having inconvenient non-round bonds in one's wallet or till makes the process of obtaining or providing change a nightmare. If you buy a $10 bottle of wine with an unmatured bearer bond worth $11.56, what are the odds that the cashier will have a $1.56 bearer bond to give you as change? 0% cash may not offer interest payments, but at least the standardized even denominations in which it is available (combined with small change) allow for hassle-free transactions.

Lastly, all transactions in bearer bonds face capital gains taxes. That means on each exchange, the owner of bearer bonds must fish back into their records to find the original price at which they received the bond, determine the price at which it was sold, compute the profit, and then submit all this information to the tax authority. Payments made with 0% banknotes are not taxed, saving those who choose to transact with banknotes time and energy.

So in a nutshell, the previous factors may explain why interest-yielding small denomination bearer bonds will always be less liquid relative to 0% yielding cash, thus preventing the former from kicking the latter out of circulation.

If Wallace's first point is wrong and the payment of interest on banknotes doesn't drive existing 0% cash out of existence, what about his second prediction? Assuming that privately issued bearer bonds are accepted at par, what prevents profit-hungry banks from issuing 0% bankotes and accumulating interest-bearing bonds, eventually arbitraging bond rates down to zero?

As I've already illustrated, interest yielding instruments (especially large and ungainly ones like t-bills) will always be less liquid than cash. This gives rise to an un-arbitrageable wedge between the yield on cash and that on bonds, or a liquidity premium. Note-issuing private banks eager to earn more spread income may be able to temporarily push rates down through bond purchases. However, at these lower bond rates the marginal bond investor will be dissatisfied. They are now holding an asset that offers the same inferior liquidity return as before but less interest. These investors will sell their bonds, in the process pushing interest rate right back up to so that bonds once gain offer an attractive return on the margin. In short, bond-buying banks can't push long term bond rates down to zero because the rest of the liquidity-buying public won't let them.

But if long term rates won't budge when banks buy them, doesn't that mean that banks can continuously earn excess profits by perpetually issuing 0% notes and purchasing risk-free long term bonds? Free dollar bills left on the floor are, after all, the biggest no-no in economics. This ignores the fact that even if rates don't fall to zero, other costs will rise instead as banks compete to enjoy the spread. Larry White refers to this as non-price competition. It might include any number of costly strategies used to attract note-holders, including longer bank operating hours, more tellers, increased advertising expenses to make notes more trusted, and special engraving of notes to make one's bills more attractive relative to the competitions'. Thse mounting costs will soon counterbalance the fat spread income, thereby reducing the window for excess profits.

So contra Wallace, laissez faire doesn't reduce the risk-free bond yield curve to a flat line. Because liquidity differentials between bonds and notes will continue to exist free market or not, bond rates will always have to provide a sufficiently high nominal interest rate in order to attract holders.

What makes Wallace's conclusion about the yield curve in a free market interesting is its pleasing counter-intuitiveness. Many of the theories that deep money people come up with have this same quality, including one of my favorites: the irrelevance of open market operations, or what some call Wallace Neutrality. Stephen Williamson's odd theory that central bank's need to fight inflation by lowering rates, not increasing them, is in this same tradition, although in this case I think he's probably wrong.

Empirical evidence is the best way to test deep money theories. In the case of Wallace's legal restrictions theory, reality is not kind. For instance, we know that in the 18th and 19th centuries Scottish banks were not burdened by legal restrictions on the issue of notes, yet the Scottish yield curve was not a flat one. Indeed, interest bearing bills-of-exchange circulated freely with notes. Despite dominating notes, bills of exchange did not drive them to oblivion. Makinen and Woodward report on the coexistence of small-denomination interest-paying "bons" in 1920s France with the franc currency, and Wallace himself points to evidence that Liberty bonds circulated concurrently with Fed cash during WWI. (I should note that David Andolfatto is skeptical of these instances since they are commonly associated with periods of fiscal distress.)

As for some of the more modern deep money efforts like Stephen Williamson's, reality remains a hard customer. One wonders how Rudolph Havenstein's tight interest policy would have created the Wiemar hyperinflation, for instance. While I'm being tough on the deep money folk, I want to sign off on a positive note. Figuring out the underlying nature of monetary exchange is no doubt an important endeavor. Anyone who wants to learn more about monetary phenomena and central banking should probably be reading what the deep money people have to say.

Is it irrelevant when a central bank goes in the red?

There's been a steady hum of articles that either worry about the Fed's potential QE-related capital losses or entirely discount them. Are central bank losses irrelevant or important? In this post I'll make the case that we should not discount losses as meaningless.

Let's say that year over year a central bank operates at a loss. It is unable to fund ongoing operations from cashflow, and to compound problems, the central bank is already operating with a bare bones staff and can't slim down.

One way to plug the funding gap is to get a capital injection. Who would do the injecting? The government, of course. This answer comes easily, since economists tend to build models that assume the consolidation of the government and its central bank. By tying them together with a nice red bow, the math and logic are made much simpler. Thus a central bank can easily run at a loss since it is really just a department within a larger consolidated entity.

Let's adopt the perspective of an investment analyst who has money on the line. Any investor knows that networks of parents and subsidiaries should never be treated as one entity. Parent companies often let subsidiaries hang out to dry, looting them of good assets and transferring bad ones in, or refusing to commit capital for the maintenance of a subsidiary's plant and equipment in order to allocate capital back to the mothership. Parents purposefully damage certain subsidiaries so as to maximize the overall welfare of the group. Those who suffer are minority shareholders and bondholders of the damaged subsidiaries... and that's why wise minority investors never make the mistake of assuming their interests are consolidated with those of the parent.

Just as parent-subsidiary relationships can be tenuous, there's no reason for investors expect the existence of a 100% guarantee of government support for its central bank. Minority investors in the Fed—anyone who holds Fed paper and deposits—must always be wary of the possibility of either being looted or being left to hung out to dry by the sovereign.

How plausible is this deconsolidated view? We in the West tend to look at everything with Fed or ECB-tinted glasses, but there are more than a hundred central banks in our world. Consider the case of the Central Bank of Philippines (CBP), for instance. According to Lamberte (2002), the CBP was harnessed by the government in the 1980s to engage in off-balance sheet lending and to assume the liabilities of various government-controlled and private companies. All of this was to the benefit of the government as it lowered the deficit and kept spending off-budget. Later on these loans proved to be worthless, leaving the central bank holding the refuse. This has shades of Enron, which used various conduits and SPVs to hide its mounting losses.

The CBP was replaced in 1993 by the newly chartered Bangko Sentral ng Pilipinas (BSP). The BSP took over the CPB's note and deposit liabilities, as well as its foreign reserves and other valuable assets (the bad assets were allocated elsewhere). The government had promised to contribute 50 billion pesos in capital to the BSP, but only paid P10 billion in 1993. The remainder owed was not forthcoming. After some seventeen years, the government finally added another P10 billion in 2011, but this still leaves P30 billion in unfunded obligations to the central bank. The BSP has been left out in the cold by its parent.

So who cares if the government refuses to inject capital into a loss-making central bank? How could that possible have any macro effect?

Well, if a central bank can't fund itself from operations, nor by financing, then it needs to sell its own assets to raise cash. So it starts selling off a few bonds here and there, using the proceeds to pay the governor's salary. Or maybe it prints off a few fresh dollars and uses those to pay staff.

As I've pointed out before, one feature of a central bank is that blowfish-like, it can suck in all of the liabilities it has issued by redeeming them for assets. This potential for redemption is one of the key forces that props up the value of central bank paper. Without it, dollars and pounds would be mere paper bits of paper. The ability to suck in and blow out liabilities is also essential to monetary policy, in particular the maintenance of price stability. Central banks use open-market purchases and sales of assets to enforce their inflation targets.

If it sells too many assets to fund itself, or prints to much cash to pay salaries, the central bank's ability to act like a blowfish and suck in its outstanding liabilities is inhibited. To compensate investors for the increased risks of non-redemption arising from central bank losses, central bank notes and deposits need to offer a higher return. This return manifests itself by a quick fall in the purchasing power of money, or inflation. From this much lower plateau, the value of central bank's liabilities will be expected to appreciate, thereby providing enough capital gains to compensate investors for increased redemption risk. But this threatens the central banks price stability targets and breeds a general lack of faith in the central bank's power. Central bank losses can have consequences.

This interesting bit from the Bangko Sentral ng Pilipinas's 2011 Annual Report captures these ideas. The bank is commenting on the losses it experienced in 2011:

Because its mandate is typically specified as the maintenance of price and financial stability, a central bank is tasked to stabilize the economy in the presence of macroeconomic shocks. Such stabilization efforts typically involve costs to the central bank... In this regard, the full capitalization of the BSP is being pursued to allow the BSP to operate fully without being constrained by balance sheet weaknesses or operating losses... The full capitalization of the BSP needs to be ensured to enhance the viability and credibility of its various policy tools. It may be noted that a central bank’s sound capitalization is critical for the effective pursuit of its mandate as well as for political economy and credibility considerations.

In sum, the threat of central bank losses isn't something that can be glossed over. There is never a 100% guarantee that a parent government will recapitalize its central bank, which means that a central bank could be forced to dilute its asset base in order to fund operations, inhibiting its ability to ensure price stability.
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PS: Funny enough, as I was writing this, David Andolfatto posted on this topic yesterday. Here is David: 

In many of our models, we assume passive support from the Treasury to support whatever needs to be done to keep inflation in check. But how realistic is this? What if that support does not materialize? And moreover, suppose that the Fed is no longer permitted to use IOR as a policy tool? What if inflation and inflation expectations start to rise? What then?

In questioning the consolidated Fed-Treasury entity, I think David and me are saying roughly the same thing.

How Irish pubs helped cure a shortage of safe assets

By way of David Andolfatto's comment on my earlier post on safe assets, I stumbled onto a talk by John Moore and Nobuhiro Kiyotaki called Evil is the Root of All Money, which in turn invokes a 1978 paper by Antoin Murphy called Money in an Economy Without Banks: The Case of Ireland (pdf link). For anyone interested in the conjunction of history of economic thought and economic history, Murphy is a great resource. I definitely suggest his The Genesis of Macroeconomics.

Murphy's paper describes an interesting episode in Irish financial history. From May 1 to November 17, 1970, all banks in Ireland went on strike. This meant that Irish bank deposits were indefinitely frozen. Despite being deprived of a large chunk of their safe and liquid assets, the Irish populace managed to soldier on with little economic difficulty—according to Murphy, retail sales were barely affected by the bank closures.

Ireland filled the void vacated by frozen deposits by using uncleared cheques as a circulating medium. Cheques are normally accepted with the intention of quickly cashing or depositing them. During the strike, an Irish family could now sign and spend a cheque at the grocer for food, and the grocer in turn could pass off that family's cheque to the local pub for a beer, who in turn was free to spend it onwards. Thus cheques boomeranged around the economy, even though they could not be cleared and no one knew when the banking system would reopen.

The genius of this system is that it resorted to an unused asset to create the new circulating medium: personal credit. Says Murphy:

In a normal banking system cheques are readily acceptable because it is believed that they are drawn against known accounts and will be cleared quickly. During the bank disputes they were drawn, not against known credit accounts or allowed overdraft limits, but against the value of other uncleared cheques and/or the transactor’s view as to his creditworthiness.

The tight-knit nature of Irish society allowed for an informal credit-rating network which, according to Murphy, was underpinned by Irish public houses. At the time, there was one pub for every 190 adults. The information that various retail outlets had about their customers allowed them to verify the ability of individuals to stand by their credit. This system had a degree of sophistication, since cheques were not universally accepted but rather were graded by risk.

This illustrates one of the ideas that I was (perhaps ineptly) trying to explain in my previous post. Just as the Irish quickly fabricated safe and liquid assets when their existing ones disappeared, wouldn't a modern shortage of safe assets be remedied in a few weeks, maybe months? What is blocking the same set of powerful market forces that quickly resupplied the Ireland with safe assets from operating today? Won't a rise in existing safe asset prices provide the economy with the desired level of safety? An excess demand for safe assets just doesn't sound like it can be a chronic problem to me.

In any case, give the Murphy paper a read. It has some gems in it.

I must be a dummy for not understanding the shortage of safe asset argument

I've never understood the global shortage of safe asset meme. I'm willing to be educated.

I know that Ricardo Caballero and Gary Gorton have written about the safe asset shortage problem. In the blogosphere it pops up in David Beckworth and David Andolfatto, and the folks at FT Alphaville can't talk about much else.

First, there seems to me to be definitional issues. What is a safe asset? Beckworth, for instance, describes them as "those assets that are highly liquid and expected to maintain their value." But liquidity and riskiness are separate concepts. There are many financial instruments that are very liquid yet risky—take the S&P mini futures contract, the most liquid futures contract in the world. There are many low-risk instruments that are illiquid—a 5 year non-cashable Canadian GIC being a good example. How are we to reconcile these oppositions into one definition?

Second, it seems to me that the concept of a safety is misspecified. How do we go about classifying safety? Is it a spectrum, or are there discrete categories of safety? If a spectrum, how are we supposed to measure degrees of safety or the lack thereof? Where do we get this safety data? Next, how do we get economy-wide gradiations of safety data?

If, on the other hand, assets are to be categorized into discrete buckets of safe and non-safe, how can anyone possibly know what asset goes in each bucket? Take a vote? Whatever Gorton says? Best 4 out of 7 rock paper scissors? At what point did Italian debt go from the safe into the non-safe bucket? Or the Zim dollar? The whole process seems ad hoc and impossible to empirically verify.

But ignore all these epistemological points for now.

Let's deal first with the word shortage. If society faces a shortage of safe financial assets, won't the prices of those safe assets immediately rise and thereby remedy the shortage?*  If so, where's the problem?

Imagine a basic economy in which gold is the only safe asset and everything else is risky. There's a sudden demand for safety which means that a shortage of gold simultaneously appears in individuals' portfolios. What happens? The shortage can't be filled by gold production, supply is more or less fixed. So the gold price immediately triples. There's now enough gold to satisfy everyone's demand for safe assets.

A big part of the safe asset shortage meme seems to apply specifically to collateral. In our simple economy, if for some reason the gold market is broken, just convert risky assets into safe collateral by requiring a slightly bigger haircut than before. This is RebelEconomist's point here. Next, recruit formerly uncollateralized risky assets like pianos and grandfather clocks into serving as collateral and slap a bigger hair cut on them. Do this until the demand for collateral is met. End of story.

What does a shortage in financial asset markets even look like? I've seen shortages at Toys R Us when some new item arrives and the store manager hasn't properly anticipated demand. Lineups and unhappy customers are the result. But has anyone ever seen a lineup at the bid-ask spread for AAPL? The idea is odd. If you want to buy AAPL now, just take whatever is on offer at 601. Then take whatever is on offer at 602. Then 603. Repeat until you've bought every share that has ever been issued. The same with t-bond markets. Your demand will never go unsatisfied. No shortage here.

But maybe I'm putting too much weight on the word shortage. Maybe the problem is not a shortage per se, but the underlying increase in preferences for safety. If  people's taste for risk changes, market prices adjust to a new equilibrium in order to satisfy those tastes. Why must this new distribution of prices be considered an aberration? Does the safe asset problem apply equally when people express their demand for more safety by purchasing fire extinguishers, guns, and home alarm systems? Would we then be talking about a shortage of safe consumables?

And lastly, back to the epistemological issue. I don't think we can get proof that we've got too few safe assets because we haven't properly specified the concept of safety, which means we don't have good data. Without good data, we can't be confident in any pronouncements concerning safe asset shortages.

So tell me why I'm a dummy.

[Update: David Beckworth responds]

*put aside the idea that some of those assets are "money", and therefore may be sticky.

What would destroying a central bank's assets do?

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

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

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

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

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

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

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

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

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

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

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

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

The root of all money

William Stanley Jevons, who coined the term "double coincidence of wants"

A while back I had an interesting conversation with David Andolfatto on his post Evil is the Root of All Money. This is surely one of the more catchy phrases developed by monetary economists, who tend to the less-flowery end of the literary scale. David fleshes out a model that shows how untrustworthiness, or evil (what is called a lack of commitment in the NME literature), can lead to the emergence of money.

David finds this interesting because his model doesn't need the absence of a double-coincidence of wants to exist in order to motivate a demand for money. The double-coincidence problem - the unlikelihood that two producing individuals meeting at random would each have goods that the other wants - has historically been the explanation of choice for the emergence of monetary exchange. After all, if one person doesn't want another's goods, she can still transact by accepting some third commodity that is itself highly liquid and therefore likely to be easily passed on come the next transaction.

I think David is pushing a catchy phrase too far. While I agree that a lack of double coincidence of wants is not necessary to explain monetary exchange, neither is a lack of commitment necessary to explain monetary exchange.

Imagine a world with no evil, and no, this isn't a John Lennon song. Individuals in that economy are 100% trusted to pay their promises, i.e. full commitment exists. But people are widely dispersed and suffer from the double-coincidence of wants problem. It will make sense to trade amongst each other using transferable personal promises. Each promise guarantees to pay out some quantity of goods produced by that individual upon that promise being presented for redemption. Because promises are far cheaper to hold and transport than actual goods, these promises, and not goods, will circulate along long transactional chains. When a promise is accepted by someone who actually desires the given good, that  promise will be "putted back" to the promisor, the good will be delivered, and the promise canceled. Thus you get monetary exchange... without the evil.

One real-life example of such as system would be the bills of exchange market that existed during the medieval ages up to the early 1900s. See this paper, for instance. Start on page 23 when the discussion on transferability, assignability, negotiability, and endorsement begins if you want a flavour for the bills of exchange system.

Microfoundations

I had an interesting conversation about microfoundations at David Andolfatto's blog.

David's post comes on the heels of a number of other posts by various bloggers. See here, here, here, here, here, here, and here. Here is David:

A narrow view of "microfoundations" is reflected in the idea that the methodology of microeconomic theory (specifying individual preferences, information sets, endowments, constraints, together with an equilibrium concept) can and should be brought to bear on macroeconomic questions. This is in contrast to an earlier methodology that specified and estimated behavioral relations at the aggregate level. (One can legitimately weigh the pros and cons of these (and other) methodologies.)

 Not many macro models are "microfounded" in a pure sense. Almost all models make at least some assumptions that may be viewed as ad hoc and provisional (subject to further investigation). I think of an ad hoc assumption as a restriction on behavior that is inconsistent with other aspects of the model, like maximizing behavior.

...just take a look at one of the dominant paradigms in macroeconomic theory--the New Keynesian framework. As anyone who is familiar with the paradigm knows, it is built around models that embed ad hoc assumptions reflecting the alleged costs associated with nominal wage and price adjustments in auction-like settings

...By the way, I like to take a broader view of "microfoundations;" or, rather, the search for microfoundations. Microfoundations does not, in my mind, mean stopping at preferences and technology, or anywhere else, for that matter. It simply means seeking a deeper understanding. 

I like this broader view. At some point, perhaps, microeconomics will find its own microfoundations in behavioral economics and psychology, which in turn will be microfounded in neuroscience, which in turn...

This post from Leigh Caldwell describes this idea.

Asset shortages, scarcity of safe collateral

Have commented on a few blogs that bring up the meme of collateral shortages.

Commodity money: It's back! (and it sucks) at Macromania
Is the Fed our savior in financial regulation? at Marginal Revolution
Why the Global Shortage of Safe Assets Matters at Macro and Other Market Musings

The idea of a scarcity of shortage of safe assets is nonsensical to me.

I just don't think this can be a real issue. If the quantity of "safe assets" somehow collapses, then the prices of remaining "safe assets" will rise to meet the market's demand for safe collateral and stores of value. You can't have shortages in financial markets. Do you think you can?

and

The idea that there can be a shortage of good collateralizable financial assets sounds fishy to me. Prices for those assets will simply rise until their price is sufficient to meet the demand for good collateral. The same with an excess demand for money - prices will simply fall to meet that demand.