Monetary policy as a system of connected lakes (a post for John Hussman)

I always like reading fund manager John Hussman because he writes very well, but I feel like he's dug himself into a bit of an intellectual rut—a situation that happens to all of us. For a number of years now Hussman has been accusing the Federal Reserve of setting off a massive bubble in equity markets. But if you ask me, his claim really doesn't square with the observation that we haven't seen a shred of consumer price inflation over that same time frame. Let's explore more.

Hussman recently penned an admirable description of the hot potato effect, the process that is set off by an easing in central bank policy:

Initially, central banks focus on purchasing the highest-tier government securities (such as Treasury bonds in the case of the U.S. Federal Reserve). Central banks buy these interest-bearing securities, and pay for them by creating “base money” - currency and bank reserves. That base money takes the place of interest-bearing securities in the hands of the public, and someone then has to hold that amount of zero-interest money at every moment in time until it is actually retired by the central bank. 

Now, having traded their high-quality, interest-bearing securities to the central bank in return for zero-interest cash, a portion of those investors will simply hold the cash in the form of currency or bank deposits, but some investors will feel uncomfortable earning nothing on those holdings, and will try to pass the hot potatoes onto someone else. To do so, these investors now have to buy some other security that is lower on the ladder of credit quality, and more speculative. The sellers of those securities then get the zero-interest cash. Some of those sellers, unwilling to reach for yield in even more speculative securities, hold the cash, but some climb out to a further speculative limb. Ultimately, the process stops when yields on speculative securities have fallen low enough that investors are indifferent between holding zero-interest cash and holding low-yielding but more speculative securities. At that point, all of the new base money is passively held by somebody.

For those who didn't bother reading the above quotes, here's a quick summary. Start out with a market where everyone is happy with their holdings of cash and securities. New base money is suddenly introduced by the Fed. In an effort to rid themselves of the excess cash, people drive the prices of securities to a high enough level (or their yields low enough) that everyone is once again content with their portfolio of cash and securities. In other words, we get asset price inflation.

A nice way to think of this is to imagine a system of lakes connected by channels, the water level representing prices. When water is poured into one lake the system is disturbed. Water quickly flows out of the first lake through the various channels into the other lakes, the water level of each body of water rising until they are equal. The agitated water becomes stagnant again. Likewise, when the Fed creates and spends new money it quickly courses through the various asset market until the price of each security has risen to a point that all new money is willingly held.

Hussman uses the hot potato effect a lot in his writing. And while I like his description of the effect, it always seems incomplete. He's missed how a Fed-induced asset price inflation might be conveyed to consumer goods markets.

Securities are really just promises of future consumption. By buying Google shares now, we delay consuming stuff now and push it off to some future date. So when Hussman says that easy monetary policy is driving up securities prices, we can think of this as the price of future consumption rising relative to present consumption.

Prior to the monetary expansion, investors will have already chosen whatever balance between present and future consumption feels right to them. Assuming these preferences stay the same throughout, the Fed-induced rise in future consumption prices (ie. Hussman's asset price inflation) means that people are now getting more future consumption than they had originally bargained for. Using our lake metaphor,  the water level of the future consumption lake has risen above the present consumption lake.

Uncomfortable holding too much future consumption, people will begin to rebalance into present consumption—after all, it offers a better bang for the dollar. Consumer price inflation is stoked as everyone buy goods and services. This inflationary process stops only when yields on present consumption have fallen low enough that people are once again indifferent between future consumption and present consumption. Or, returning to our lake metaphor, water has to flow out of the future consumption lake into the present consumption lake until water levels are equal and the surface is once again calm.

Over the years, Hussman has made use of the hot potato effect to say that the stock market is in a massive bubble thanks to Fed easy monetary policy. But I don't buy this claim. If the Fed really was causing such an enormous disturbance in securities markets, we'd have seen some sort of spillover into consumer prices as investors rebalance out of future consumption into present consumption. However, inflation in the U.S. has been well below 2% for several years now.

If the Fed is to be accused of causing an asset bubble, Hussman needs a theory to explain why people have not been arbitraging the markets for future and present consumption. Why haven't we seen a roaring CPI? This seems like a tall order. From what I've read of his work, Hussman traces easy money to as early as 2009. So his theory needs to explain why Fed monetary policy could inflate asset markets for seven years without affecting goods markets.

One way to patch up the story would be to resort to the good ol' Shadowstats trick, or the idea that there is consumer price inflation, we just don't see it in official statistics. But that's a weak argument, and thankfully I don't see Hussman using it. Alternatively, maybe something is inhibiting the rebalancing process. Returning to the lake metaphor, if a network of locks are being used to connect the lakes, then the water level of one lake can rise far above the others insofar as movement between them is inhibited by a locking mechanism. Like the picture at top. Thus we might be able to get asset price inflation without consumer price inflation. But what force could possible be strong enough to hold back such a torrent? I'd love to hear. It's possible it's not Hussman who's in a rut, but myself.

Until Hussman gives a decent explanation, I'll stick to the theory that there never was a Fed-induced financial bubble in the first place. Despite what many fund managers might claim, Fed monetary policy really hasn't been very easy, and that's why we haven't seen any froth develop in consumer goods markets. We need a better explanation for rising asset prices than Hussman's irresponsible Fed theory.

Bank of Japan warms up the potato

Will the Bank of Japan's negative rates work?

Many people say no, among them Louis-Phillippe Rochon:

Sadly, they won't. They [negative rates] are based on a faulty understanding of our banking system. The reason banks do not lend is not because they are constrained by liquidity, but because they are unwilling to lend in such uncertain times.

Banks lend in the hope of getting reimbursed with interest. But banks are too pessimistic about the ability of the private sector to honour their debt, and so prefer not to lend. Having extra cash courtesy of the central bank imposing negative rates won't change the dark economic narrative. [link]

I disagree. Even if the lending channel is closed, a negative rate policy still sets off a hot potato effect that gets the Bank of Japan a bit closer to hitting its inflation targets and stimulating nominal GDP than without that same policy.

For the sake of argument I'll grant Rochon the point that negative rates might not encourage banks to lend. And as you'll read in the comments here, that would certainly have implications on the effectiveness of monetary policy. But even if we close the door on loans, the interest rate cut will simply find a different route into prices and the real economy.

The moment the BoJ reduces the rate on deposits it creates a hot potato; an asset with a below-market return that its owner is desperate to be rid of. Bank reserve managers will simultaneously try to sell off their BoJ deposits in order to get a better return in short term corporate and government debt. In aggregate, however, banks cannot get rid of reserves, which pushes the prices of these competing short-term assets up and their expected returns back in line with the return on balances held at the central bank, a process that continues until reserve managers are indifferent on the margin between owning BoJ deposits and short term corporate/government debt.

The hot potato doesn't stop here but continues to cascade through financial markets. At the margin, corporate and government debt will now be overvalued relative to other financial assets (like stocks), encouraging fund managers and other investors to bid up the prices of all remaining assets in the financial market until returns are once again in balance.

Up till now the the hot potato that I've been describing has been trapped in Japanese financial markets thanks to Rochon's blocked lending channel. Acting as a bridge into the real economy are the portfolios held by consumers. Japanese consumers own not only portfolios of financial assets but portfolios of consumption goods that yield an ongoing flow of consumption services. Think cars, shavers, tables, and vacations (the latter of which yield a recurring flow of memories). Likewise, financial assets yield an ongoing flow of consumption services since interest payments and the final return of principle can be measured in terms of consumption. When prices in financial markets rise and returns fall, a portfolio of financial assets now yields a smaller discounted quantity of future consumption services than a competing portfolio of consumption goods. In response, consumers will re-balance out of financial assets into undervalued consumption goods, causing consumer prices to rise. Or, if there is some stickiness in prices, the quantity sold experiences a boom.

And that's how the hot potato ignited by the Bank of Japan's negative rates gets passed into consumer prices and the real economy when the lending channel is closed.

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Another interesting critique of the effectiveness of negative rates has to do with the fact that in those nations that have already experimented with negative rates, the penalty has not been passed through to retail deposits. This could be a problem because if Japanese retail depositors are not going to be fined by banks, that nullifies the hot potato effect I described above. After all, consumers won't bother trying to re-balance out of the financial economy into the real economy if they can just hoard superior-yielding 0% deposits.

This failure to pass-through negative central bank rates will probably not be more than a short-term phenomenon. As the BoJ deposit rate get ever more negative, those banks that choose to prop up the rate sthey offer on retail deposits allow themselves to be the victims of arbitrage, consumers taking the positive end of the deal as they migrate into superior-yielding deposits. Borrowing at 0% to invest at -0.1% isn't a particularly profitable place for a bank to put itself in. The only way for a bank to rectify the situation is by the passing-through of negative rates to retail clients or the setting of limits on retail account sizes. The hot potato effect gets new life as investors flee bank deposits by purchasing underpriced consumer goods.

As Gavyn Davies points out, the Bank of Japan has set a tiered negative rate whereby the full effect of negative interest rates is not felt by banks; only a portion of deposits held at the BoJ will be docked the full 0.1% while the rest get off Scot-free. This BoJ (i.e. taxpayer) subsidy to banks helps offset any financial losses that banks incur by choosing to avoid passing through negative rates to retail customers, thus encouraging bank managers to keep retail deposit rates steady at 0%. .

But as the BoJ continues to cut rates, the size of the BoJ subsidy is unlikely to increase as fast as the size of the penalty imposed on banks as measured by the gap between the cost of maintaining 0% retail deposit rates and the revenues earned on negative-yielding central bank deposits & other short term money market assets. To plug these growing losses, and absent a compensating subsidy, banks will have no choice but to pass-through negative rates to retail clients or put a limit on retail account sizes. This in turn will give free rein to the hot potato effect.

Negative interest rates are like water, they'll always find a crack.

Rates or quantitites or both

Roaming around the econ blogosphere, I often come across what seems to be a sharp divide between those who think monetary policy is all about the manipulation of interest rates and those who think it comes down to varying the quantity of base money. Either side get touchy when the other accuses its favored monetary policy tool, either rates or quantities, of being irrelevant. From my perch, I'll take the middle road between the two camps and say that both are more-or-less right. Either rates, or quantities, or both at the same time, are sufficient instruments of monetary policy. Actual central banks will typically use some combination of rates and quantities to hit their targets, although this hasn't always been the case.

Just to refresh, central banks carry out monetary policy by manipulating the total return that they offer on deposit balances. This return can be broken down into a pecuniary component and a non-pecuniary component. By varying either the pecuniary return, the non-pecuniary return, or both, a central bank is able to create a disequilibrium, as Steve Waldman calls it, which can only be re-equilibrated by a rise or fall in the price level. If the net return on balances is sweetened, banks will flee assets for balances, causing a deflationary fall in prices. If the return is diminished, banks will flock to assets from balances, pushing prices higher and causing inflation.

The pecuniary return on central bank balances is usually provided in the form of a promise to pay interest, or interest on reserves.

The non-pecuniary return, or convenience yield, is a bit more complicated. I've talked about it before. In short, it's sorta like a consumption return. Because central bank balances are useful in settling large payments, and they are rare, banks find it convenient to hold a small quantity of them as a precaution against uncertain events. This unique convenience provided by scarce balances is consumed over time, much like a fire extinguisher's property as a fire-hedge is consumed though never actually mobilized. By increasing or decreasing the quantity of rare balances, a central banker can decrease or increase the value that banks ascribe to this non-pecuniary return.

Now some examples.

The best example of a central bank resorting solely to the quantity tool in order to execute monetary policy is the pre-2008 Federal Reserve. Before 2008, the Fed was not permitted to pay interest on reserves (IOR). This meant that the only return that Fed balances could offer to banks was a non-pecuniary convenience yield, a point that I described here. By adding to or subtracting from the quantity of balances outstanding the Fed could alter their marginal convenience, either rendering them less convenient so as to drive prices up, or more convenient so as to push prices down.

The Bank of Canada is a good example of a central bank that uses both a quantity tool AND an interest rate tool, though not always both at the same time. Since 1991, according to Mark Sadowski, the BoC has paid interest to anyone who holds overnight balances. This is IOR, although in Canada we refer to it as the deposit rate. In addition to paying this pecuniary return, BoC balances also yield a non-pecuniary return. Banks who hold balances enjoy a stream of consumptive returns, or a convenience yield, that stems from both the rarity of BoC balances and their exceptional liquidity.

The best way to "see" how these two returns might be decomposed is by looking at the short term rental market for Bank of Canada balances, or the overnight market. In Canada, this rate is called CORRA, or the Canadian overnight repo rate. A bank will only part with BoC balances overnight if a prospective borrower promises to sufficiently compensate the lending bank for foregone returns. Assuming that the Bank of Canada's deposit rate is 2%, a potential lender will need to be compensated with a pecuniary return of at least 2% in order to dissuade them from socking away balances at the BoC's deposit facility.

The lender will also need to be compensated for doing without the non-pecuniary return on balances. If the overnight lending rate, CORRA, is 2.25%, then we can back out the rate that a lender expects to earn for renting out the non-pecuniary services provided by balances. Since the lender of balances receives the overnight rate of 2.25% from the borrowing bank, and 2% of this can be considered as compensation for foregoing the 2% pecuniary return on balances, that leaves the remaining 0.25% as compensation to the lender for the loss of the non-pecuniary return.

So in our example, the pecuniary and non-pecuniary returns on BoC balances are 2% and 0.25% respectively, for a total return of 2.25%.

The Bank of Canada meets each six weeks, as Nick Rowe points out, upon which it promises to provide banks with a given return on settlement balances, say 2.25%, for the ensuing six week period. When it next meets, the Bank will  introduce whatever changes to this return that are considered necessary for it to hit its monetary policy targets. The BoC can modify the return by changing either the pecuniary component of the total return, the non-pecuniary component, or some combination of both.

Say it modifies only the non-pecuniary component while leaving their pecuniary return untouched. For instance, with the overnight rate trading at 2.25%, the BoC might announce that it will conduct some open market purchases in order to increase the quantity of balances outstanding, while keeping the deposit rate fixed at 2%. By rendering balances less rare, purchases effectively reduce the non-pecuniary return on balances. As a reflection of this shrinking return, the overnight rate may fall a few basis point, or it may fall all the way to 2%. Whatever the case, the rate at which banks now expect to be compensated for foregoing the non-pecuniary return on balances has been diminished. Banks will collectively try to flee out of overpriced clearing balances into assets, pushing up the economy's price level until balances once again provide a competitive return. This sort of pure quantity effect is the story that the quantities camp likes to emphasize.

The story told by the quantities camp is exactly how the BoC loosened policy between April 2009 and May 2010. At the time, the BoC injected $3 billion in balances *without* a corresponding decrease in the deposit rate. The overnight rate fell from 0.5% until it rubbed up against the 0.25% deposit rate. The lack of a gap between the overnight rate and the deposit rate indicated that the injection had reduced the overnight non-pecuniary return on balances to 0%. After all, if lenders still expected to be compensated for forgoing the non-pecuniary return on balances, they would have required that the overnight rate be above the deposit rate.

The BoC's decision to reduce the overnight non-pecuniary return on balances to 0% would have generated a hot potato effect as banks sold off lower-yielding BoC balances for higher-yielding assets, thus pushing prices higher. A change in quantities, not rates, was responsible for the April 2009 to May 2010 loosening.

Likewise, in June 2010, the BoC tightened by using quantities, not rates. Open market sales sucked the $3 billion in excess balances back in, thereby increasing the marginal convenience yield on central bank balances. The deposit rate remained moored at 0.25%, but the overnight rate jumped back to 0.5%, indicating that the overnight non-pecuniary return on balances had increased from 0% to 0.25%. This sweetening in the return on balances would have inspired a portfolio adjustment away from low-yielding assets into high-yielding central bank balances, a process that would have continued until asset prices had fallen far enough to render investors indifferent once again along the margin between BoC deposits and assets. Once again quantities, not rates, did all the hard work.

While the BoC chose to tighten in June 2010 by changing quantities, it could just as easily have tightened by changing rates. For instance, if it had increased the deposit rate to 0.5% while keeping quantities constant, then the net return on balances would have risen to 0.5%, the same return that was generated in the last paragraph's quantities-only scenario. This sweetening in the return on balances would have caused the exact same chain of portfolio adjustments and falling asset prices that the quantities-only scenario caused.

Alternatively, the BoC could have tightened through some combination of quantities AND rates. It might have increased the deposit rate from 0.25% to 0.4%, and then conducted just enough open market sales to increase the non-pecuniary return on balances from 0% to 0.1%, for a total combined return of 0.5%. The ensuing adjustments would have been no different than if tightening had been accomplished by quantities-only or rates-only.

Putting aside the period between April 2009 and June 2010, does the Bank of Canada normally execute monetary policy via rates or quantities? A bit of both, I'd say. At the end of a six week period, say that the Bank wishes to tighten. It typically tightens by announcing a 0.25% rise in its target for the overnight rate combined with a simultaneous 0.25% rise in the deposit rate. The overnight rate, or the rental rate on clearing balances, will typically rise immediately by 0.25%, reflecting the sweetened return on balances.

Did rates or quantities do the heavy lifting in pushing up the return on balances? Put differently, was it the threat that open market sales might increase the convenience yield on balances that tightened policy, or was it the improvement in the deposit rate? I'd argue that the immediate punch would have been delivered by the change in the deposit rate. CORRA, the rental rate on balances, jumped because overnight borrowers of BoC balances were suddenly required to compensate lenders for the higher pecuniary rate being offered by the BoC on its deposit facility. Quantities don't enter into the picture at all, at least not at first. The rates-only camps seems to be the winner.

However, as the ensuing six-week period plays out, market forces will push the rental rate on BoC balances (CORRA) above or below the Bank's target, indicating an improvement or diminution of the total return on balances. The BoC has typically avoided any incremental variation of the deposit rate to ensure that the rental rate, or return on balances, stays true to target over the six week period. Rather, it has always used quantity changes (or the threat thereof) to modify the non-pecuniary return on balances during that period, thereby steering the rental rate back towards target. First rates, and then quantities, conspire together to create Canadian monetary policy.

To sum up, the Bank of Canada's monetary policy is achieved, it would seem, through a complex combination of rate and quantity adjustments. The rates vs. quantities dichotomy that sometimes pops up on the blogosphere simplifies what is really a more nuanced story. Monetary policy can certainly be carried out by focusing on quantity adjustments to the exclusion of rate adjustments (as was the case with the pre-2008 Fed) or vice versa . However, modern central banks like the Bank of Canada use rates, quantities, and some combination of both, to achieve their targets.

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Note: The elephant in the room is the zero-lower bound. But the zero lower bound needn't prevent rates or quantities from exerting an influence on prices. On the rates side of the equation, the adoption of a cash-penalizing mechanism along the lines of what Miles Kimball advocates would allow a central bank to safely push rates below zero. As for the quantity side of the equation,  the threat of Sumnerian permanent increases in the monetary base may not be able to reduce the overnight non-pecuniary return on balances once that rate has hit zero, as Steve Waldman points out... but they can certainly reduce the future non-pecuniary returns provided by balances. Reductions in future non-pecuniary returns should be capable of igniting a hot potato effect, albeit a diminishing one, out of balances and into assets.

The rise and fall (and rise) of the hot potato effect

Don Randi Trio +1 at the Baked Potato, Poppy Records, 1971. [link]

In this post I'll argue that:

1. When it comes to financial assets, the hot potato effect is irrelevant.
2. The hot potato effect is born the moment we begin to talk about non-financial instruments — things you can touch and consume, like gold or cows or houses or whatnot.
3. Because central bank reserves are simultaneously financial assets and a tangible consumables, they are capable of generating a hot potato effect.
4. The moment that central bank money ceases to be valued as a consumer good, its hot potato effect dies.

Here's a short illustration of the hot potato effect that should serve as my definition of the term. Imagine that a gold miner finds several huge gold nuggets and quietly brings them to town to sell. The gold miner approaches the town's merchant with an offer to exchange gold for supplies, but at current prices the merchant is already happy with the size of his gold holdings. He will only take the the miner's gold if the miner is willing to buy supplies at a premium to the prevailing market price. The miner grumbles but sells the gold anyways. Now the merchant approaches the town's largest landowner with an offer to exchange gold for land, but the landowner is already content with the size of his gold holdings. He will, however, accept the offer if the merchant is willing to improve his price. The merchant accepts and the transaction is consummated.

Each subsequent townsperson will require a higher price to convince them to part with their goods and hold the newly mined gold. In this fashion the gold miner's nuggets work through the town's economy like hot potatoes, pushing up all gold-denominated prices.

With non-tangibles like financial assets, the hot potato effect is irrelevant. Say that our merchant decides to issue new stock or bonds into the town's economy by purchasing other stocks/bonds, gold, or by funding viable projects. The landowner takes the merchant up on his offer and tenders some gold, land, and shares in return for the merchant's newly-issued financial instruments. The merchant's financial instruments are fairly liquid and function as useful exchange media.

A few days later the landowner decides to sell these financial instruments and approaches the miner. The miner, who earlier experienced the hot potato effect, says that he'll only buy the financial instruments if the landowner will sell them for less gold. The landowner is about to consummate the transaction when the merchant barges in. The merchant offers to buy back the financial instruments at a smaller discount. After all, the merchant still owns the same land, shares, and gold that the landowner originally submitted for shares, and he can make a quick profit by repurchasing and retiring the landowner's stock with a smaller quantity of land/gold than was initially tendered. The miner reacts to the merchants competing offer by reducing the discount he required of the landlord, but each time he does so the merchant will match him with a better price. After much haggling between merchant and miner, the landowner will be able to sell his shares to one of them at a price very close to their original gold-denominated value.

Financial asset prices are driven not by the hot potato effect but by a "modern finance effect". The market value of a claim on an issuer is determined by the issuer's earning power and the risk of its underlying assets. If an individual tries to sell claims away like they were hot potatoes, profit maximizing arbitrageurs will step in and bring their price back up to their fundamental value, thereby annulling any hot potato effect.

Now back to central banks. Much like a merchant will buy back the instruments he has issued, a central banker commits to mobilize whatever bonds, gold, and other assets he holds in his vaults to repurchase every reserve he has ever issued. Like any other financial asset, the price of reserves is determined by underlying earnings power. Should a central bank issue new reserves by swapping them for bonds or gold, this issuance will not ignite a hot potato cycle of declining prices because arbitrageurs will compete to buy up any underpriced reserves.

The story doesn't end here. In addition to functioning as financial assets, central bank reserves also function as consumables. A bank that holds reserves enjoys a convenience yield: they can be sure that come some unforeseen event, they'll have adequate resources on hand to cope. Reserves are consumed in the same way that fire extinguishers are used up. While it is unlikely that either will ever be mobilized to deal with emergencies, their mere presence is consumed by their owner as a flow of uncertainty-shielding services over time.

Unlike fire extinguishers, reserves can be created instantaneously and at no cost. If fire extinguishers were like reserves, we'd conjure up any amount of them that we desired, their price would fall to zero, and everyone would enjoy their convenience for free. The marginal value that the market places on the consumability of reserves, however, never plunges to zero because a central bank keeps their supply artificially tight.

A central banker's ability to set off a hot potato chain of rising prices stems from the role of reserves-as-consumable, not their role as financial assets. Say that the banker offers to loosen the supply of scarce reserves. Existing consumers of reserves are already well-stocked with reserves at current prices. They will only accept the new issue by reducing the quantity of goods or other assets that they're willing to swap for reserves. Put differently, the price level must rise. This is the same mechanism by which the miner's gold nuggets were passed on hot-potato-like.

On the other hand, when a central banker further constricts the supply of already-scarce reserves, the marginal consumer of reserves will face a deficit in their reserve inventories, a hole that the consumer can only fill by offering larger quantities of goods/assets in return for reserves. Put differently, the price level must fall.

As a central bank issues ever larger amounts of reserves, the marginal value the market places on their consumability, or their marginal convenience yield, falls towards zero. As this happens, the hot potato effect becomes almost negligible—each subsequent issue of reserves increases the supply of what has already become a free good. The consumptive quality of central bank reserves is now akin to oxygen. Just like an increase in the amount of air has no effect on air's price—we already value it on the margin at zero— increases in the quantity of reserves are irrelevant. With the hot potato effect officially dead, we've arrived at Scott Sumner's case 5b, or Stephen Williamson's not-your-grandmother's-liquidity-trap.

With the death of the hot potato, the market's valuation of reserves is now solely governed by what I referred to earlier as the modern finance effect. Subsequent increases in the quantity of reserves via open market operations have no effect whatsoever on the price level. Anyone who sells reserves as if they were hot-potatoes will be corrected by arbitrageurs who return the price level to its fundamental value. This is a world in which Mike Sproul's backing theory precisely applies, or what Miles Kimball calls Wallace irrelevance/neutrality holds absolutely.

Reintroduce a shortage of central bank reserves and the marginal consumptive value, or convenience yield, of reserves will once again move above zero. The ability to harness the hot potato effect arises once again.

Do banks have a widow's cruse?

Elijah and the Widow of Zarephath

James Tobin wrote a paper back in 1963 called Commercial Banks as Creators of Money in which he pointed out that banks don't possess a widow's cruse. There has been a bit of a blog uproar over Tobin's paper (See Paul Krugman, Winterspeak, JKH, L. Randall Wray, Nick Rowe, Cullen Roche, Ramanan, Roger Sparks, and Steve Randy Waldman). My two bits will hone in on the widow's cruse aspect of the debate.

The phrase widow's cruse is defined as "an inexhaustible supply of something," which in turn is a reference to an obscure Bible story. Flip to I Kings 17:7–16 and there is a short passage in which the prophet Elijah asks a destitute widow to make him a loaf of bread. The Lord blesses the widow saying that the "jar of flour will not be used up and the jug of oil will not run dry until the day the Lord sends rain on the land."

What Tobin was referring to in his paper is that unlike the widow and her jug of oil, commercial banks aren't blessed with the ability to expand their liabilities indefinitely. When it comes to bank deposits, there is an "economic mechanism of extinction as well as creation, contraction as well as expansion."

Modern central bank's, on the other hand, do have such a cruse. Once central bank liabilities are created, there is no way for the economy to get rid of the excess. The hot potato analogy "truly applies", noted Tobin, because central bank money cannot be extinguished.

We know that the actions of any institution in possession of a widow's cruse will have major macroeconomic effects. With its cruse, a central bank can create excess media of exchange which, as it is passes from hand to hand, pushes up nominal income. An increase in quantities and/or prices is the only release valve for unwanted exchange media. A commercial bank, which has no cruse, might create an excess of deposits but this will not have any lasting influence on nominal income. After all, if the public doesn't desire new deposits, this excess will either quickly reflux back to the issuer, or it will displace competing deposits created by another bank and these deposits will reflux. To keep its deposits suspended in the economy will require a commitment of resources (say a superior interest rate). But resources are finite, unlike the widow's cruse.

Central banks didn't always have cruse. As David Glasner reminds us, when a central bank's liabilities, say those of the Bank of England, were convertible into gold, the Bank couldn't issue in excess of the public's desire for central bank notes. Unwanted notes would quickly return back to the Bank, inhibiting the Bank from having any macroeconomically important effects. The Bank of England, much like a modern commercial bank, could affect neither prices nor quantities via excess note issuance.

So what are the sufficient conditions for having a cruse? Consider that there are all sorts of financial instruments that can be expanded indefinitely. A company can continue issuing corporate stock, for instance, as long as it wants. To crib from Tobin, any expansion of corporate assets will generate a corresponding expansion of corporate liabilities, or in this case, equity. The mechanism for the creation of stock does not have an equivalent mechanism for the extinction and contraction of said stock. Without an instant-convertibility clause, stock is a perpetual instrument, much like modern central bank money. [For more along this line, see Money: is it immortal or does it die young?].

Despite its perpetual nature, I don't think that a stock-issuing company is blessed with a widow's cruse. An exogenous increase in the quantity of an individual company's stock will only affect relative asset prices; it won't change an economy's nominal income. To paraphrase Tobin, the burden of adaptation to an increase in the quantity of a corporate stock is not placed on the entire economy. This is because prices in an economy are not denominated in units of a given corporate stock, but in dollars, pounds, or whatever. Central bank money, on the other hand, is the economy's unit of account. The entire economy is burdened by the necessity of adapting to an increase in its supply.

So what does it take to have a widow's cruse? Two things. The liabilities of the issuer must be perpetual and non-convertible upon demand. Secondly, shops and markets must use those liabilities as a unit of account. Only when these two conditions will a widow's cruse have emerged. Commercial banks pass the latter but fail the former. Stock-issuing non-financial corporations pass the former but fail the latter. Only modern central bank money is both.

Google as monetary superpower — a parable

In trying to understand how modern monetary policy works, I find it useful to create parables, or alternate monetary worlds, and put them through the wringer. Hopefully I can learn a bit about our own world via these bizarro universes.

Let's say that in an alternate universe, people have decided to use Google stock (in bearer and digital form) as way to conduct most transactions. To top it off, all prices are set in fractions of a Google share. Shares get issued into the economy when Google pays employees with stock, makes corporate acquisitions, or purchases things from suppliers. Shares are removed when Google does buybacks.

Here are some questions we can ask of our Google priced world. What can Google do to cause the price level to rise? to fall? What do open market operations do, and what happens when Google "prints"?  Does Google QE have a large effect on the price level, or is it irrelevant? Once we've answered some of these questions, we can take what we've discovered over to our own universe in which Federal Reserves notes and deposits are monetary dominant and ask the same questions: what did QE1, QE2, and QE3 accomplish? What happens when the Fed "prints"? How does the Fed determine the price level? Let's explore our Google universe a bit and see what it has to teach us. [1]

In our alternate universe, people hold Google shares in bearer format in their wallets, or they own shares as electronic entries in a centralized database. Should you walk into a store to buy cigarettes, the sticker price might be 0.3 Googles. You can either hand over 3 Google bearer shares, each equal to 1/10th of a full share, or you might electronically debit your Google share account for the full amount.

Like any other share, a Google share is also a claim on the cash flows of the underlying business. Say that a week has passed and Google's shares have exploded in value due to higher margins announced at their quarterly earnings call. Now when you go to the store to buy cigarettes, they cost only 0.1 Googles. Alternatively, Google's prospects take a turn for the worse when it is sued for massive copyright infringement. Now when you go to buy cigarettes, a pack costs you 0.8 Googles. You get the point. A Google price level would be highly volatile, with all the thorny macroeconomic implications that such instability brings with it.

Google has come to recognize the public service that Google shares provide as both a medium of exchange and a unit in which other people post prices. It decides to take steps to ensure that Google shares neither rise too fast nor fall too much, or, put differently, that the general price level should be stable.

The manipulation of Google's returns shapes the price level 

One way Google can go about managing the price level is by varying the returns that shareholders enjoy. If the general price level is falling too fast, or, put differently, if Google shares are in a bull trend, CEO Larry Page may choose to suddenly announce that going forward, less earnings will flow to shareholders. By increasing the interest coupon on all Google-issued bonds, a larger share of profits will be diverted from the equity class to bondholders. In reaction to this announcement, Google's share price fall and, conversely, the price level begins to rise. This only makes sense. After all, in one fell swoop the present value of future Google shareholder income, often called fundamental value, has been reduced.

On the other hand, if inflation is the problem (i.e.if Google shares are collapsing), Larry Page might announce that henceforth bond coupons are to be cut, thus diverting more of the firm's profits back to shareholders. The share price will pull out of its bear trend -- after all, shareholders can expect a greater discounted flow of income than before -- and conversely, the price level will cease bounding upwards.

Larry Page has thus emerged as the economy's price-level setter. By either diverting profits away from or sluicing profits towards shareholders, Page holds the general price-level steady.

What do Google open market purchases do?

You'll note that I haven't mentioned money supply changes (ie. Google share supply changes) as the driver of the price level. Changes in the quality of Google shares -- their fundamental value -- and not the quantity of shares have been driving the price level up till now.

In fact, the classical example of an increase in the quantity of money -- broad open market purchases of assets -- needn't make much of a difference to our Google-determined price level. As long as Google consistently buys liquid and quality earning assets with newly printed shares and/or invests in decent projects that are neither over- nor underpriced, then all shareholders will retain the same claim on earnings that they did prior to the open market operations being conducted. Fundamental value remaining constant upon the completion of open market purchases, Google's share price will remain unchanged, as will the economy-wide price level.

This isn't to say that open market purchases are always neutral. One way for Google to use open market operations to affect the price level would be to issue new shares in such a way that upon completion, Google's per share earnings will have declined. We can call these sorts of transactions dilutive acquisitions. The best way to make a dilutive acquisition is to overpay for assets or buy worthless assets. Put in a bid for a collection of awful paintings, offer to pay a 50% premium to take out a company that already trades at fair value, or purchase a rail car full of carrots set to go bad the next day. Each of these transactions will permanently impair Google's per-share earnings base and destroy fundamental value. Google's share price will plummet to a new and lower floor as a result, the mirror image of which is a jump in the economy's price level.

On the flip side, Google can fight inflation by making a series of stock-financed accretive acquisitions. Buy up companies trading at undervalued prices and/or invest in projects with superior risk-adjusted yields. As a result of an accretive open market purchase, Google shareholders will enjoy an increase in per-share earnings. Should Google shares be in the midst of a bear trend (ie. inflation), a series of these accretive acquisitions will halt the bear and stabilize the price level.

This is an odd observation. We are accustomed to thinking of open market purchases, or money printing, as increasing the "money supply" and therefore causing inflation. This mental short cut is a result of a naive version of the quantity theory of money, a theory which posits a positive relationship between the money supply and the price level. But in the previous paragraph I've demonstrated how Google open market purchases increase the "money" supply yet cause deflation, not inflation. [2]

There is a lack of symmetry between overpaying to stop a deflation in the Google price level and underpaying to stop an inflation. One is easier to do than the other. To overpay for something, just go to any store and offer twice the sticker price for an item. No store owner will try to dissuade you. Google could offer to buy a few million shares of Microsoft at 20% above market value. They'd have no shortage of investors willing to take them up on that offer. On the other hand, try walking into the same store and offering to pay half the indicated sticker price, or watch Google try to wade into the market for Microsoft shares only to bid 20% under the current price. You're not going to be able to buy anything at the store, nor will Google get any offers for Microsoft.

The upshot of this asymmetry is that it's far easier for Google to stop a deflation with open market purchases  than to stop an inflation with open market purchases.

Google QE is irrelevant...

If Google announced its own version of QE or QE2, say $500 billion in upcoming treasury bond purchases, neither the announcement nor the actual purchases would be likely to affect the price level much. This is because the markets in which Google is buying assets are very deep and the announced purchases are being conducted at market prices. Google's risk-adjusted per share earnings, or fundamental value, will be the same both before and after QE.

In order to get the price level to rise or, equivalently, the value of Google shares to fall, rather than announcing QE of $x billion, Google should announce purchases of $x billion at a y% premium to the last market price. The losses incurred upon acquiring these assets at non-market prices would immediately drive the value of Google shares down, and the price level up. So the way to give QE bite is to be irresponsible and conduct purchases at silly prices.

...well, not entirely irrelevant: manipulating Google's liquidity premium 

Having just said that Google open market purchases are irrelevant if they target assets trading at market values, I'm going to backtrack a bit. This isn't entirely correct, because we need to include the idea of a Google liquidity premium.

Before Google shares ever became popular as exchange media, they were valued as mere equity claims. Rational traders would have ensured that the price of shares did not fluctuate far from their fundamental value, or the risk-adjusted net present value of cash flows thrown off by Google's underlying business. In this respect, Google stock was like any other stock, whether it be Apple, Cisco, or Exxon.

As Google shares became more widely used as exchange media, their price would have risen above fundamental value by a thin sliver called a liquidity premium. In essence, where before a Google share threw off a single pecuniary stream of cash flows, that same share now throws off not only the pecuniary stream but also a stream of non-pecuniary services related to its liquidity. All things staying the same, the addition of this extra non-pecuniary stream of services would have put a Google shareholder at an advantage relative to shareholders in other companies. After all, the quality of being moneylike, or having what I like to call "moneyness", is a desirable property in an asset. These excess returns would not have lasted long. The market would quickly bid up the price of Google stock until it offered a return commensurate with all other assets. The amount by which Google's price would have been bid up is what we call the liquidity premium.

The general price level thus contains within it two components. The first and original component is explained by Google's fundamental value. The rest of the price level is related to Google's liquidity, or a liquidity premium.

As already noted, QE, or open market operations at market prices, can't affect the first component. Both before and after QE, Google's per-share cashflow stay the same. But QE can affect the latter component, the liquidity premium. The increase in the supply of shares brought about by QE means that the marginal owner of Google exchange media finds their demand for liquidity satiated. What follows is the hot potato effect that market monetarists so dearly cherish. Those with an excess supply of Google exchange media will sell whatever shares (ie. cash) they no longer need, putting downward pressure on the price of shares and upward pressure on the price level. This is the classical quantity theory of money, in which an increase in the supply of media of exchange pushes the price level higher.

But the hot potato effect will not cause shares to fall by more than the value of their liquidity premium. If they fall by more, then share's will effectively be worth less than their fundamental value, a situation that won't last long as rational investors bid share prices back up. There is a floor below which more QE simply has no effect.

The depths to which Google's price falls because of QE depends on the size of the liquidity premium relative to fundamental value. The larger the liquidity premium, the more there is for QE to shrink, and the greater the price-level effect. I doubt that Google's liquidity premia will be very large, especially in open and competitive markets, so I don't think QE will push the shares down much or bring prices up too high. To get a massive rise in the price level, better for Google to announce QE at non-market prices. The effect would be a double whammy: not only would Google's liquidity premium shrink via the classical hot potato effect, but its fundamental value would deteriorate too.

Having explored our Google monetary universe, let's transfer what we've learnt to our own universe in which central banks such as the Federal Reserve are monetary dominant.

Making the analogy to the Fed: manipulating deposit rates to shape the price level  

Just as Google varies the price level by fiddling with the return on Google stock, the Fed can vary the price level by toying with the return that investors expect to enjoy on Fed-issued financial instruments. One obvious difference is that Google issues stock whereas the Fed issues deposits. But this is a difference of degree, not of kind. Both a deposit and a stock are instruments that provide a claim on their issuer. A deposit provides a safer fixed claim whereas a stock provides a riskier floating claim, but at the end of the day both instruments derive their value from their ability to act as titles to underlying businesses. The better the underlying business, the more valuable each respective claim will be.

If inflation is moving up too fast, the Fed can divert extra income towards depositors by increasing the interest rate it offers on deposits. This notching up of the interest rate enhances the life-time value of cash flows thrown off to owners of central bank deposits relative to other assets. This excess return will be quickly arbitraged away as investors compete to buy deposits, pushing their price up until they offer the same return as all other assets. This brings the general price level down, nipping inflation in the bud.

Vice versa, if the price level is deflating too fast (ie. if deposits are rising in value), the Fed can reduce the interest rate on deposits. This lowers the return on deposits relative to all other assets in the economy. Investors sell deposits until their price has fallen to a low enough level that they once again offer a competitive return. Thus the Fed terminates an incipient deflation.

Open market purchases by the Fed

Large open market purchases at market prices bring in a sufficient amount of earning assets to ensure that depositors will always receive the same risk-adjusted return that they enjoyed prior to the open market operations. There is thus no reason for the market to bid the price of deposits down when the Fed announces open market operations. Deposits are just as fundamentally sound as they were before.

On the other hand, if the Fed creates new deposits to purchase a collection of awful paintings, or offers to pay a 50% premium to take out a company already trading at fair value, or buys a rail car full of almost rotten carrots, the value of deposits will fall and the price level rise. This is because the Fed now owns less income-generating assets than before, thereby rendering it more difficult to make future interest payments to depositors. The risk-adjusted return on deposits -- their fundamental value -- has deteriorated. Investors will quickly bid down the price of Fed deposits until they once again offer a sufficient return to compete with other assets. A series of these dilutive purchases, much like Google's dilutive purchases, will put a halt to any deflation.

Manipulating the liquidity premium on Fed deposits

As in Google's case, open market purchases at market prices can't hurt the underlying fundamental value of Fed-issued deposits. But purchases will still have a bite on the price level by reducing the liquidity premium on Fed deposits.

I'll hazard a guess that the liquidity premium on Fed deposits is normally much higher than what Google would enjoy in our Google monetary universe. This is because unlike Google, the Fed can force banks to use deposits as an interbank settlement medium. By limiting the amount of deposits it issues and inhibiting the ability of competitors to provide alternatives, the Fed ensures that its deposits command a higher liquidity premium than they would in a free market. Thus, open market purchases and sales, even at market rates, will typically have significant effects on prices since a proportionally larger part of the price level is explained by deposit liquidity premia. In other words, the monetarist hot potato effect is large.

This has all changed since 2008. The Federal Reserve operates with a massive amount of excess deposits, or reserves. The supply of deposits is no longer special, artificially limited, or difficult to acquire. This means that the liquidity premium on deposits is probably much lower than before. So while open market purchases at market rates may have some effect on reducing prices, they can only narrow what was already a very thin liquidity premium. In other words, today's hot potato effect set off by QE is a feeble version of what it was before 2008.

To sum up...

The Google price level is determined by two elements: the underlying earnings power of Google's business as well as a liquidity premium arising from the superior ease of transacting with Google shares. Google monetary operations can change the price level by working on either of these two elements. I've hypothesized that the same rules apply to the Fed.

If we can take one lesson from our Google monetary universe, it's that mass open market purchasing schemes like QE probably have little bite because they don't change the fundamental value of Google or the Fed. QE has been conducted at close-to-market prices, and therefore brings an appropriate amount of assets onto the Fed's balance sheet to support the deposits created.

Nor do mass open market operations affect the liquidity premium much, since the current glut of Fed-issued deposits means that their liquidity premium is probably very small. In order for QE to significantly push down the return provided by deposits, and drive up prices, the Fed needs to do more than announce large asset purchases -- it also needs to announce that it will buy at wrong prices.

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[1] This blog post is pretty much a mashup of everything I've read over the last few years  from Nick Rowe, champion of the hot-potato effect, Mike Sproul, defender of the fundamental/backing theory of money,  Stephen Williamson, who likes to talk about liquidity premia, and Miles Kimball, who introduced the blogosphere to Wallace Neutrality.

[2] Everything I've said about Google open market purchases is just as applicable to open market sales. The classical quantity theory of money story is that open market sales reduce the supply of money, therefore causing deflation, or a fall in the price level. But if asset sales are conducted at the going market rate, then in Google's case, expected per-share earnings stays exactly the same as before and there is no reason to expect Google's share price to improve.

Google can use open market sales to affect the price level only if it sells assets at non-market prices. For instance, Google might conduct share buy backs when it perceives that its shares are underpriced. If Google execs have evaluated the situation correctly, then each open market sale will improve Google's financial situation and cause the share price to jump. On the other hand, Google can purposefully sell assets held in its portfolio at below-market prices in order to hurt fundamental value and cause inflation. 

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Updates:
03.08.2013 - added the reference to Miles Kimball in note 1
03.08.2013 - Changed "advantage relative to other shareholders" to "would have put a Google shareholder at an advantage relative to shareholders in other companies"
03.08.2013 - Added "moneyness" link.
21.08.2013 - exploded [added "in value"]
21.08.2013  - "open market purchases at market prices can't hurt the underlying financial viability" ... financial viability changed to fundamental value.

Money: is it immortal or does it die young?

Dreaming of Immortality in a Thatched Cottage - 1500s

Exogenous/endogenous money, reflux, hot potato money, helicopter money, inelastic vs elastic currency. These are all part of the colourful lexicon developed by monetary economists over the centuries to outline a general set of problems: how does money get emitted from source, and when, if at all, does it return to source?

We usually describe money as exogenous, hot potato, helicopter, or inelastic if it is emitted at the initiative of the issuer, and the issuer doesn't allow the public to exercise any initiative in returning this money back to source. Once it has been air-dropped into circulation from a helicopter, this kind of money becomes immortal, passing like a hot potato from person to person forever.

We describe money as elastic or endogenous when the money-using public exercises its own initiative in both drawing money out from an issuing source and pushing (refluxing) this money back to the source. This sort of money never strays far from its issuer, snapping back like a rubber band to be destroyed when it is no longer wanted. Rather than being a hot-potato zombie, elastic money lives fast and dies young.

There's a big debate among monetary economics about whether money is exogenous/hot potato/helicopter/elastic inelastic or if it is endogenous/elastic/refluxible. This debate goes all the way back to the banking-currency school battle of the early 1800s. Currency school advocates wanted to limit the note issuing power of private banks in order to prevent the overissue of notes, whereas members of the banking school believed such regulation unnecessary since in a competitive banking system, unwanted notes would simply reflux back to the issuer. The currency school won that debate, but the war continues.

I find it helpful to skirt around the skirmish and re-orientate the debate around finance, not monetary economics. This means that we've got to translate the language of monetary economists—hot potatoes, exogenous/endogenous, reflux, and the like—into the lexicon of financial instruments.

Let's head over to the stock market first. I'm going to hypothesize that the common stock is a thoroughly exogenous financial instrument. A firm decides when to issue new stock and at what price. Once stock has been issued, there's no way for an investor to automatically return the stock to the issuer. Stock wanders zombie-like through the financial world until the issuing firm is wound up, if ever. General Electric's original 1000 shares, for instance, have been hot-potatoing through financial markets since June 23, 1892.

Also found on stock markets are exchange-traded funds, or ETFs. Unlike stocks, though, I would say that ETFs are thoroughly endogenous financial instruments. Take the SPDR Gold Trust ETF. When investor demand for the Gold Trust heats up, ETF units will trade at a premium to their implied gold value. Large authorized-participants buy units from the ETF originator at par, paying with gold, and then sell these blocks to the public until the premium has disappeared. Vice versa when GLD units are at a discount to their real gold value. Now the authorized-participants buy units from the public at a depressed price and sell them to the ETF originator at par for gold. The result is that the quantity of outstanding units fluctuates quite widely, as the chart shows, but the price, specifically the premium/discount, stays constant. The public, through the intermediation of authorized-participants, sucks out whatever quantity of ETF units from the issuer that it desires, and then refluxes unwanted units back to it.

Unlike ETFs, bonds are exogenous financial instruments. Firms issue bonds when they need funding and these instruments stay outstanding until redemption date or firm instigated early-retirement. Until then, bonds pass hot potato-like from hand to hand in the secondary market.

Not all bonds are like this though. A retractible bond, or retractible debenture, is a different beast. Investors can choose to exercise the retractibility feature of this species of bond and force its issuer to buy it back. If we break down a retractable bond into its parts we see that it is a bond with an embedded put option. The put allows investors take the initiative and "reflux" the bond back to the issuer.

Retractability, or puttability, is a feature that gets often gets added to preferred shares and sometimes even common stock. The interesting thing about retractibility and puttability is that it turns what was once an exogenous hot potato asset into a semi-endogenous instrument. While investors can not "pull" retractible bonds or puttable stock out of an issuer, they can easily push, or "put", already-issued retractibles back to the issuer when those instruments are no longer desired.

How can we turn our semi-endogenous retractible bond or puttable share into a fully endogenous instrument? Let's consider another financial instrument, the gift card. Indigo, a bookstore up here in Canada, allows consumers to buy any quantity of gift certificates at the till. These gift certificates are puttable—their owner can immediately return the card for redemption. That the public can take the initiative in both buying unlimited amounts of gift cards and returning those coupons whenever they want qualifies them as fully endogenous. Not only is the "discount window"* for endogenous instruments like puttable gift certificates and ETF units always open, there is also a well-defined rule for pricing the emission of new units. Retractible bonds, which already have the put feature, would qualify as fully endogenous if their issuer were to set up a "window" with a set of rules so that investors could draw out new bonds on their own accord.**

Because endogenous and exogenous instruments are structured differently, they act in peculiar ways when market conditions change. When the demand for an exogenous instrument like GE stock increases, its price will quickly rise to meet that demand while its quantity stays fixed. When demand falls, the only way for investors to rid themselves of GE is to bid its price down until it reaches a real value at which the market willingly holds it. Things work differently with endogenous instruments. When the demand for an endogenous instrument like a coupon or gift certificate increases, its quantity quickly rises whereas its price stays fixed. When demand falls, investors can exercise their put option and send them back to their issuer. In sum, prices do all the work in exogenous adjustment whereas quantities do all the work with endogenous adjustment. Exogenous issuers can choose the quantity of their issue, but not the price, whereas endogenous issuers can choose the price but not the quantity.

So back to the great debate. Is money endogenous or exogenous? If money is defined as a certain narrow set of financial instruments (cash + deposits, M1, M2, whatever) then we need to appraise each instrument's structure to see whether its issuer provides an associated discount window and embeds a put option—or not. A quick glance through the instruments found on the narrowest lists of money (say M1) shows that almost all of these instruments have embedded put options and discount windows, so narrow money is primarily endogenous.

This is different from a few centuries ago when gold and silver constituted a significant share of the narrow money supply. Since the only way to get rid of an ounce of metal is to pass it on, gold, like stock, is exogenous and immortal, with the very same gold coin once used 5000 years ago still circulating today, though perhaps in bar form. Modern monetary economists are beginning to add exogenous assets like t-bills, bonds, and other AAA-rated debt securities to the list of money since these assets can be easily collateralized. In doing so, economists are slowly returning to a world in which a larger percentage of the assets on the list of money are exogenous.***

And finally, there's the moneyness, or liquidity, view. From this perspective, there is no limited list of money-items. Rather, all assets provide varying degrees of money-services. Put differently, moneyness is a vector which spans all assets. Because it inheres to a degree in all assets, moneyness is both endogenous and exogenous. After all, the universe of assets is comprised of both types of assets. A change in the demand for liquidity/moneyness results in a complex shift in prices and quantities. Liquid endogenous instruments are drawn out of issuers and less-liquid endogenous instruments refluxed back to issuers. Liquid exogenous instruments rise in price while less liquid exogenous instruments fall in price.
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*In modern days, the discount window refers to a central bank's ability to lend. In the old days, banks had actual "windows" behind which stood a bank officer who would accept securities in return for bank deposits or cash. A "discount" to its market value was applied to the securities, a sort of haircut that also provided the banks with income. See this image from the Philly Fed.

**A bank deposit is the quintessential endogenous instrument. There are multiple windows for buying a deposit -- one can either sell cash to get deposits, or sell personal IOU to get them, with each window offering different rules and rates. When deposits are no longer needed, one can "put" them back at any point by requesting cash or a return of one's personal IOU.

***With the emergence of Bitcoin, Ripple XRPs, and the other alt-currencies, we're seeing the return of exogenous monies with a vengeance.

Note: For more on reflux, I'd definitely recommend Mike Sproul's The Law of Reflux. For more on exogenous money, Nick Rowe is who you should be reading.

Hot or not?

The Rowe/Glasner/Sproul debate continues over hot potato-ish-ness of money. Here is Nick Rowe:

The hot potatoes simply pass from one hand to another. Unless they sell it back to the banks, to buy IOUs. But why would they want to do that? If I have opals I want to get rid of I will probably sell them at the specialised opal dealer, who will probably give me the best deal. If I have money I want to get rid of....well, everyone I deal with is a dealer in money. The bank is just one in a thousand. Why would we assume that the bank will always give me a better deal than the other 999?

Mike Sproul jumps in, but David doesn't, so instead I left a comment trying to anticipate what David would say:

You say hot potato, he says endogenous

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

David said something interesting:

So while I think that bank money is endogenous, I don’t believe that the quantity of base money or currency is endogenous in the sense that the central bank is powerless to control the price level.

I was curious about his claims that modern central bank (CB) money is not endogeneous and left some comments on his post trying to drill down on this issue. It seems to me that, much like old-fashioned gold standard CBs and modern private banks, many modern inflation-targeting CBs also have effective convertibility regimes, ie. they are governed by the redemption principle. This regime allows for arbitrage. In other words, David's classical theory of money applies just as well to modern CB money as it does to competitively-supplied banking money and central bank liabilities convertible into gold.

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

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

This hot potato vs not issue also came up at Lars Christensen's blog. I pointed out to him that I don't think that the distinction is a core one - its just a matter of how liabilities are structured.

I think we can agree that corporate stock is a hot-potato asset. Once issued, it circulates endlessly. Stocks can also be highly liquid -companies can issue new stock to buy services and many sorts of assets rather than using cash.

But if the corporation agrees to repurchase all its stock at $100 and sell unlimited stock at $105, then that stock is no longer hot-potato. Should the firm issue excess stock to buy services, that stock will quickly be returned for $100.

So much like stock, I’d say that central bank money is not necessarily either exogenous (hot potato) or endogenous. Like the stock example above, it depends on how the asset itself is structured and what options it provides its holders. 

So we're not talking about foundational differences here.

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

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