Classifying cryptocurrencies

Whenever biologists stumble on a strange specimen, they first try to see if it fits into the existing taxonomy. If it doesn't fall within any of the pre-existing categories, they sketch out a new one for it.

For people like myself who are interested in monetary phenomena and finance, Bitcoin and other cryptocurrencies like Dogecoin and Litecoin have presented us with the same challenge. How can we classify these strange new instruments?

Because they have the word 'currency' in them, the knee-jerk reaction has been to put cryptocurrencies in the same bucket as so-called fiat money, i.e. instruments like bank deposits and banknotes. But this is wrong. Bitcoin, Dogecoin, and other cryptocurrencies are fundamentally different from $100 bills or Citibank deposits. 

To see why, here is a chart I published last year at Sound Money Project:

I've located cryptocurrencies in the zero-sum outcome family. Banknotes and deposits are in a different family, win-win opportunities. The property that binds all zero-sum games together is that the amount of resources contributed to the pot is precisely equal to the amount that is paid out of the pot. Jack's ability to profit from his cryptocurrency is entirely dependent on the next player, Jill, stepping forward and taking them off him at a higher price. Likewise, the amount Jack wins from the lottery is a function of how much Jill and other players have contributed to the pot.

Compare this to a stock or a bond. As long as the firm’s managers deploy the money in the pot wisely, the firm can throw off more resources than the amount that shareholders and bondholders originally contributed.

People have been asking me to extend this classification to other assets. Below I've made a more extensive chart:

Similar to the first chart, I've put Bitcoin, Dogecoin, and other cryptocurrencies in the bets & hedges category along with insurance, futures & options, and various gambles such as lotteries. I describe the members of this family as sterile uses of wealth. Unlike more productive uses of wealth, which increase society's resources, bets and hedges transfer existing resources from one person to another.

I disagree with you, JP

No doubt others will disagree with my classification scheme. For instance, why not put cryptocurrencies in the consumer goods section? After all, aren't cryptocurrencies sort of like collectibles? Don't people primarily collect sports cards, old coins, and crocheted doilies because they expect these objects to rise in value, just like the people who buy cryptocurrencies?

Collectibles and other knick-knacks have sentimental, symbolic, ornamental, and ceremonial value. Even if they can't be sold (most knick-knacks can't), they are still valuable for the above reasons. Not so Bitcoin, Dogecoin, and Litecoin. Cryptocurrencies are pure bets on subsequent people accepting or buying them. If no one steps up, the tokens don't have any other redeeming features that can salvage their value.

Are cryptocurrencies like art? Leonardo da Vinci's Salvator Mundi sold for $450 million to a Saudi prince in 2017. Surely Salvator Mundi's consumption value isn't that high. It would seem that its value is entirely predicated on what the next aesthete will pay, in the same way that bitcoin's value hinges on whether another bitcoiner arrives.

Perhaps. But most art pieces aren't Leonardo's Salvator Mundi. The great mass of paintings that have been created over time are relatively cheap. Secondly, prices in high-end art markets may seem to be disconnected from the consumption value they provide, but that's only because these prices are being drive by the preferences and tastes of consumers who are far richer than most of us. It is this ability to consume the beauty and meaning of art that separates it from cryptocurrency.

What about categorizing cryptocurrencies as commodities? For instance, Bitcoin is often described as digital gold. Or consider George Selgin's reference to bitcoin as a synthetic commodity. Selgin's argument is that cryptocurrencies are commodity-like because they are scarce. And they are synthetic because, unlike commodities, they have no value apart from what other people will pay for them (i.e. they have no nonmonetary value).

I agree with Selgin's analysis. But because cryptocurrencies are synthetic—i.e. their purchasing power is entirely predicated on another person entering the game—I've put them in the bets & hedges category along with other zero-sum games, not the commodity family. Sure, the supply of cryptocurrencies is fixed, say like copper. But that only makes it a very special type of bet, not a commodity.

Blurred lines

The categories in my classification scheme do sometimes blur. At times the stock market becomes incredibly speculative. People start buying shares not because they expect the underlying business to produce higher cash flows, but because they expect others to buy those shares at a higher price, these buyers in turn expecting others to purchase it at a higher price. Thus buying stocks becomes for like betting on a zero-sum game than an effort to appraise the earnings potential of an underlying business.

The same applies to gold:

I'd argue that gold's price can be decomposed into two components 1) its value as a commodity and 2) the value of the lottery-like zero-sum game being played on top of its commodity value. Bitcoin lacks 1), it is purely 2). So it is sort-of like gold, but exactly like a lottery.

— JP Koning (@jp_koning) September 8, 2018

There is another type of blurriness. Notice that neither chart has a category for money. That's because I prefer to think of money as an adjective, not a category. More specifically, moneyness is a characteristic that attaches itself by varying degrees to all of the instruments in the chart above. A more money-like instrument is relatively more tradeable, or marketable, than a less money-like instrument.

So we can have money-like commodities, bonds with high degrees of moneyness, and heck, money-like lottery tickets. Even some types of banknotes will be more money-like than others. For example, you'll have much better luck spending fifty C$20 bills than you will one C$1000 banknote. Or take the example of choice urban land, which is a lot more saleable than property in the middle of nowhere. Lastly, spending bitcoins is probably much easier to do than spending Dogecoins.

For the last few centuries, the most money-like instruments have tended to be in the debt category. There are many reasons for this. Debt instruments are stable, they are light and thus convenient for transporting, they can be digitized and used remotely, they are fungible, they are difficult to counterfeit, and they can be efficiently produced.

All of you folks with some spare funds who are mulling a big cryptocurrency purchase: be careful. There are plenty of people on the internet who are aggressively marketing crypto as some sort of new society-transforming elixir, or tomorrow's money. But much of their marketing is unfounded. It is unlikely that Bitcoin or Dogecoin will ever attract the same degree of moneyness as the most popular debt instruments. Their zero-sum game nature will always interfere with their ability to attract usage as a medium of exchange. But I could be wrong.

While there are elements of cryptocurrencies that are really neat, they aren't fundamentally new. Rather, they fit quite nicely in the traditional 'bets and hedges' category. If you wouldn't bet all your savings in a zero-sum game like poker, neither should you do the same with cryptocurrencies. A bond or equity ETF is naturally productive, as is an investment in human capital. Consider them first.

Norbert's gambit

I executed one of the oddest financial transactions of my life earlier this week. I did Norbert's Gambit.

These days a big chunk of my income is in U.S. dollars. But since I live in Quebec, my expenses are all in Canadian dollars. To pay my bills, I need to convert this flow of U.S. dollars accumulating in my account to Canadian dollars.

Outsiders may not realize how dollarized Canada is. Many of us Canadians maintain U.S. dollar bank accounts or carry around U.S. dollar credit cards. There are special ATMs that dispense greenbacks. Canadian firms will often quote prices in U.S. dollars or keep their accounting books in it. I suppose this is one of the day-to-day quirks of living next to the world's reigning monetary superpower: one must have some degree of fluency with their money.

Anyways, the first time I swapped my U.S. dollar income for loonies I did it at my bank. Big mistake. Later, when I reconciled the exchange rate that the bank teller had given me with the actual market rate, I realized that she had charged me the standard, but massive, 3-4% fee. In an age where the equivalent fee on a retail financial transaction like buying stocks amounts to a minuscule $20, maybe 0.3%, a 3-4% fee is just astounding. But Canadian banks are an oligopoly, so no surprise that they can successfully fleece their customers.

So this time I did some research on how to pull off Norbert's gambit, one of the most popular work-a rounds for Canadians who need to buy or sell U.S. dollars. From a moneyness perspective, Norbert's gambit is a fascinating transaction because it shows how instruments that we don't traditionally conceive as money can be recruited to that cause. The gambit involves using securities listed on the stock market as a bridging asset, or a medium of exchange. More specifically, since the direct circuit (M-M) between U.S. money and Canadian money is so fraught with fees, a new medium--a stock--is introduced into the circuit (like so: M-S-M) to reduce the financial damage.

To execute Norbert's gambit, you need to move your U.S. dollars into your discount brokerage account and buy the American-listed shares of a company that also happens to be listed in Canada. For instance, Royal Bank is listed on both the Toronto Stock Exchange and the New York Stock Exchange. After you've bought Royal Bank's New York-listed shares, have your broker immediately transfer those shares over to the Canadian side of your account and sell them in Toronto for Canadian dollars. Voila, you've used Royal Bank shares as a bridging medium between U.S. dollar balances and Canadian ones.

These days, Norbert's gambit no longer requires a New York leg. Because the Toronto Stock Exchange conveniently lists a wide variety of U.S dollar-denominated securities, one can execute the gambit while staying entirely within the Canadian market. In my case, I used a fairly liquid Toronto-listed ETF as my temporary medium of exchange, the Horizon's U.S. dollar ETF, or DLR. I bought the ETF units with my excess U.S. dollars and sold them the very next moment for Canadian dollars.

Below I compare how much Norbert's gambit saved me relative to using my bank:

Using the ETF as a bridging asset, I converted US$5005 into C$6465, paid $19.90 in commissions, for a net inflow of $6,445.10 Canadian dollars into my account. Had I used my bank, I would have ended up with just $6265, a full $180 less than Norbert's gambit. That's a big chunk of change!

What is occurring under the hood? Norbert's gambit is providing a retail customer like myself with the same exchange rate that large institutions and corporations typically get i.e. the wholesale rate. Because there is a market for the DLR ETF in both U.S. dollar and Canadian dollar terms, an implicit exchange rate between the two currencies has been established. Call it the "Norbert rate". Large traders with access to wholesale foreign exchange rates set the Norbert rate by buying and selling the DLR ETF on both the U.S. and Canadian dollar side. If any deviation between the Norbert rate and the wholesale exchange rate emerges, they will arbitrage it away. Small fish like myself are thus able to swim with the big fish and avoid the awful retail exchange rate offered by Canadian banks.

This workaround is called Norbert's gambit after Norbert Schlenker, a B.C-based investment advisor who it to help his clients cut costs. Says Schlenker in a Globe & Mail profile:

"In 1986 I moved down to the States, and while I was there I needed to be able to change funds from U.S. dollars to Canadian and vice-versa, and I had a brokerage account in Canada. It came to me that I could use interlisted stocks to do this."

Thanks, Norbert!

But using stock as money isn't just a strange Canadianism. Back in 2014, I wrote about other instances of stocks serving as a useful medium-of-exchange. During the hyperinflation, Zimbabweans used the interlisted shares of Old Mutual to evade exchange controls, lifting them from the Zimbabwe Stock Exchange to London. Earlier, Argentineans used stocks (specifically American Depository Receipts) in 2001 to dodge the "corralito". But I never imagined I'd use this technique myself to skirt around Canada's banking oligopoly!

Moneyness = 22?

Courtesy of Kerry Taylor's twitter feed, here is a chart which was presented during a recent investing conference in Toronto. Apparently bitcoin has a moneyness score of 22 while cowry shells ring the bell at 15, both of them exceeding the moneyness of U.S. dollars at 13. The presentation that contains the chart was created by angel investor Sean Walsh and is available here.

Since my blog is called moneyness, and I've written quite a lot on this topic, I feel somewhat obligated to chime in. Let's start with the good bits about the chart. Instead of classifying items as money-or-not, we can appraise objects by their degree of moneyness. Because every valuable object or instrument is exchangeable, some more easily than others, everything lies somewhere on the money spectrum. The diagram below illustrates this idea. This way of looking at things can provide some insights that we don't normally get when taking the money-or-not approach, and its nice to see that folks like Walsh are using it. (For a longer explanation of moneyness, go here).

Now the not-so-good bits. Let's go and see what Walsh means by the term moneyness. On page 14 he lists six characteristics of money including scarcity, durability, divisibility, recognizability, fungibility, and tranportability. Walsh compiles an instrument's moneyness score by assigning a value from 0-4 for each characteristic and then summing this up. The maximum score is 24, with bitcoin losing just a point on durability and fungibility. He gives no explanation for how or why some instrument might get a 3 for, say, recognizability instead of a 4, so I guess we'll just have to assume he has a consistent method for rewarding points.

There are two reasons why I disagree with this approach. First, even if we accept Walsh's definition of moneyness and his choice of rankings for each instrument, his list of attributes is incomplete. It is missing one of the most important ones: price stability. When people accumulate balances in anticipation of spending needs, they expect those balances to hold their value for a few days, maybe weeks. If the medium's purchasing power is volatile, then there is a risk that the stuff in their wallets won't allow them to meet tomorrow's spending requirements, which means it isn't doing a very good job as a medium of exchange. Bitcoin probably has the lowest stability of the instruments in the chart. 

My second and more important criticism has to do with the way that Walsh measures moneyness. In a hard science like chemistry or geology, ranking each objects' physical characteristics might pass muster. For instance, geologists use the Mohs Hardness Test, a scale from 1-10 for testing the resistance of a mineral to being scratched. Walsh is running something like the Mohs Hardness Test, except for monetary instruments.

But economics involves humans. And in economics, we are not interested in the physical characteristics of the goods and services people buy, say how hard a mineral is, or how cushy a couch is, or how fast a car can go. Rather, we are interested in the subjective evaluation economic actors place on those objects and the manifestation of these preferences in the form of market prices.

So the way to accurately measure moneyness isn't to design the equivalent of Mohs Hardness Test for monetary instruments, but rather to find out what price people actually put on that moneyness. One way to do this is by asking how much compensation people would expect to earn if they were to give up an object's moneyness for a period of time. More specifically, say you are offered a deal to buy one bitcoin but are prohibited from selling that bitcoin for one year. How much less would you be willing to pay for this locked-in bitcoin than a regular bitcoin that you will probably hold for at least one year anyways? If a locked-in bitcoin is worth, say, $500 less to you than a regular bitcoin, that means that you place $500 on a regular bitcoin's one-year tradeability, or its moneyness.     

We can also think about moneyness in terms of interest rates. What rate would you need to earn on a locked-in bitcoin to compensate you for the nuisance of giving up its ability to be used as an exchange medium? 10%? 5%? The extra interest you expect on locked-in bitcoin is the degree to which you value a regular bitcoin's tradeability, or moneyness, over that time-frame.

The price of a dollar's moneyness is easy to measure. Someone who will have a spare $10,000 on hand for the next year can hold it in a government-insured chequing account and earn 0% or they can lock that amount into an insured term deposit and earn around 0.85% (I'm using Canadian numbers for non-cashable 1-year GICs). By locking in the $10,000, an individual's ability to mobilize these dollars as a medium for making payments has been effectively destroyed for 365 days. They cannot buy stocks or bonds with it, nor convert it into cash, nor purchase peaches, tables, labour, travel, etc. Their dollar are inflexible; they have no moneyness.

People are willing to accept this burden but only if they are compensated to the tune of 0.85%. Put differently, the 0.85% rate represents a large enough carrot that marginal depositors are roughly indifferent between holding money in a chequing account for a year or locking it in. So if $10,000 in a term deposit provides a pecuniary return of $85, then $10,000 dollars held in a 0%-yielding chequing account provides around $85 in non-pecuniary monetary services, or moneyness, over the course of the year.

We can also go through this process with gold. Head over to Kitco and you can see that the 12-month lease rate is at 0.2%. Say you are hoarding $10,000 in gold under your mattress. If you are willing to forfeit the ability to make any transactions with your $10,000 stash for one year, a bank will compensate you with $20 ($10,000 x 0.2%) for your pains. Put differently, $20 is the amount that the bank needs to provide the marginal gold hoarder to tempt them into giving up the moneyness of gold. (The implied moneyness of $20 is far less than the $85 a Canadian chequing account offers, contrary to Walsh's chart, which ranks gold above dollars. Note that I am ignoring storage costs.)

To carry out this measurement for bitcoin, we'd have to determine what sort of rates a large international bank provides to bitcoin term depositors. I doubt this measurement can be made since reputable banks don't deal in bitcoins. So bitcoin's moneyness is not 22. We have no real idea what it is.

Quibbling with the language of trade

The way we ascribe labels to things results in the creation of categories, and this in turn affects the construction of our mental landscapes—best to get the words and categories right from the start lest our thinking goes astray. In this post I quibble with some of the common words and categories we use to describe trade.

Walking out the front door last night, I told my wife that I was going to buy a few items at the grocery store. But as I trekked down the street, I asked myself why I hadn't chosen to tell her an alternate version: that I was going to the grocery store to sell my cash. The problem with this wording, I figured, was that if I was to be the one selling stuff in the upcoming transaction, then by process of elimination the grocery store could no longer be the seller in the deal but the buyer—of my cash. And that would be a weird way to view things.

Linguistic convention requires that there be a seller and a buyer in any trade. One side spends, the other receives. That separate terms are given to participants in an exchange implies that the two parties are irreconcilably different. By spending, buyers are doing something that stands in binary opposition to whatever it is that sellers are doing.

I don't think this dichotomization is a good way to characterize the intuition behind a transaction. All parties to any deal are essentially engaged in the same activity: trade. Escaping linguistic convention for a moment, let's put things this way: when I go to the grocery store I am a seller of coloured bits of paper, and the store is in turn spending its food to buy those bits. The binary opposition between buyers and sellers melts away since both myself and the store are simultaneously buyer and seller, spender and receiver. The exclusivity that previously characterized our positions no longer exists, rather, we are each engaged in mutual trade.

For the sake of simplification we should just drop all references to buyers, sellers, and spending. Instead, so-called buyers and sellers are best described as being equal counterparties to a swap. In last night's trip to the grocery store, the store and me were counterparties to a swap of paper notes for groceries.

It could be argued that the use of the terms 'buyer' and 'seller' are useful in that they capture the fact that one party to the trade is offering 'money' and the other asking for it. But the word 'money' is just as arbitrary. What is to fall into this category, what is to be excluded?

For instance, fan's of Arrested Development may remember the scene where Tobias and Lindsay walk into C.W. Swappigan's and trade a cocktail tray for mozzarella sticks. With neither item classified as money, is Lindsay the buyer or the seller? What is being spent: mozzarella sticks or a cocktail tray? We hem and haw when we try to describe this scene because we can't apply the language of buying/selling, spending/earning to situations involving the exchange of goods that are relatively illiquid. But these sorts of exchanges shouldn't be excluded from discussion just because we can't use regular language to describe them. Nor are they categorically different from exchanges that involve slightly more liquid goods. The language of swapping comes to the rescue: Lindsay and C.W. Swappigans are equal counterparties to a swap that involves two illiquid goods.

Classifying people as buyers or sellers is just as tricky when we start talking about exchanges of one currency for another. When you walk into a currency exchange shop to trade Canadian money for US money, are you the buyer or is the shopkeeper the buyer? Which one of you is spending? Again, the more universal language of swaps makes things easier: both you and the exchange shop are engaged in a swap of two highly-liquid items. Even if one item is slightly more liquid than the other (perhaps greenbacks are a shade more liquid than loonies), what separates the two of you in this trade isn't a Chinese wall of buyer vs seller, but simply a difference in the degree of liquidity (or not) of the items you are swapping.

And while I'm griping, why not exorcise the words borrower and lender? Like buyer and seller, the terms borrower and lender imply a stern barrier between two participants to a temporary trade when these participants are in fact undertaking the very same activity—trade. If we unbundle a transaction between a customer and a bank, what is happening? A consumer, the "borrower", is providing their personal IOU to the bank which in turn is offering its own IOU, a deposit, to the customer. While it is usually said that the customer borrows deposits from the lender bank, we might just as likely say that the customer is lending his or her IOU to the bank, and the bank is borrowing the customer's IOU.

So if we can boil a banking transaction down to a swap that reverses after a period of time, participants in this swap needn't be ring-fenced with their own unique noun. Rather, each can be simultaneously described with the same term: as counterparties.

But what about interest? Isn't the payment of interest a distinguishing enough feature that necessitates the terms debtor and lender? Interest emerges (in part) when parties agree to swap equally risky IOUs for a period of time, but one IOU is more liquid than the other. The counterparty that accepts the illiquid IOU while providing the liquid IOU, usually the bank, will ask for a fee, or a stream of interest payments, from the counterparty customer to compensate (the bank) for forgone liquidity. The other party to the trade, the customer, will be willing to pay an interest penalty as restitution for the superior liquidity return that the bank's IOU provides them. This doesn't change the fact that both bank and customer are engaged in a swap.

Things get tricky when a temporary swap involves exchanges of IOUs that are equally-liquid (and equally risky). Since no one forgoes liquidity over the course of this swap, interest doesn't arise. A good example of this is the repo market, where short term swaps of deposits for highly-liquid treasury bills occur at rates no different from 0%. The lender/borrower lexicon breaks down here since without interest we don't know which party is to earn which moniker. Is the bond owner the lender or the borrower? The deposit-taker?

Again, the clearer way to describe this situation is to default to more universal swap terminology. Both participants are counterparties to a swap of items of equal or varying liquidity profiles.

In sum, our language tries to find strict differences between participants in an exchange when there are none. There are no buyers nor sellers, no spenders, no lenders nor borrowers. Instead, we are all engaged in the same activity—trade. The things we own have varying degrees of liquidity and in endeavoring to swap them for things that are more, equally, or less liquid than that which we already own, we make efforts to grope towards a preferred final state of either greater or diminished liquidity.

To recapitulate...

I'm going on holiday and don't have enough time to write anything new. At the risk of being repetitive, here's a recapitulation of what is one of this blog's major themes: the idea of moneyness. Most of the component parts are spread out over a couple of dozen posts written over many months—here I'll try and piece the whole quilt together in one spot.

Money vs moneyness

The initial point comes from one of my first posts (as well as a later one). There are two ways of thinking about monetary phenomena. The standard way is to draw a line between all things in an economy that are "money" and all those things which are not. Deposits typically go in the money bin, widgets go in the non-money bin, dollar bills go in the money bin, labour goes in the non-money bin and so forth.

The second approach, the one this blog takes, begins with the idea that all things in an economy are money-like. The line we are interested in here is the extent to which the value of each thing is determined by its money-like qualities, or its moneyness, versus the degree to which its value is determined by its non-money like qualities, say its ability to be consumed. We might say that deposits have more moneyness than labour, and labour is more money-like than a second-hand speedo and so forth.

(This second approach isn't without precedent, see Keynes, Hayek, and Friedman.)

Why is moneyness a valuable attribute?

It's all in this post, but here's a quick recap. The greater an item's degree of moneyness, the easier it is for its owner to mobilize that item in trade should some unanticipated eventuality arise. This quality of being easily liquidated provides the owner of that asset with a flow of uncertainty-alleviating services over time, or insurance.

Because moneyness, like insurance, is a valuable property, people must choose on the margin whether to sacrifice moneyness for either consumption or interest. In deciding whether to trade an item with high moneyness for a consumption good with low moneyness, an individual must weigh the present value of the flow of uncertainty-shielding services provided by the former against the one-time zing provided by the latter. In considering a potential exchange between an item with high moneyness and an illiquid interest-yielding asset, the tradeoff is between uncertainty-shielding services and an ongoing pecuniary return.

The supply of moneyness

Moneyness is a valuable good, but it also must be produced at a cost.

Certain characteristics of a good allow it to become more money-like, including durability, verifiability, fungibility, and portability. Network effects may promote an item's degree of moneyness.

The moneyness of an object can be improved by manufacturing these characteristics. Gold, for instance, is rendered more money-like by incurring coinage costs in order to promote verifiability. Adding copper to a gold coin increases its durability. Network effects can be harnessed through marketing. As long as the expected returns of boosting an object's moneyness are higher than the costs, liquidity providers will happily bear the costs.

Whereas only banks and central banks create money, the cast of characteristics involved in supplying moneyness is quite varied. Investor relations teams manufacture it as do hedge fund managers like Cliff Asness and roll-ups like Valeant Pharmaceuticals.

Difficulties in measuring moneyness

It's all here. To summarize, people often use bid-ask spreads and the frequency distributions of various assets in trade as a way to measure an asset's moneyness. But this comes up short. Bid-ask spreads and frequency distributions are objective measures of liquidity. We want to know the price that the market ascribes to things like tight bid ask spreads, not the bid ask spread itself. Moneyness, like value, is a subjective quality, not an objective one.

The other problem is that the value of a good is usually derived from not only its moneyness, but also its 1) consumability and 2) its ability to yield pecuniary returns (like interest and capital gains). Stripping out the moneyness component from these others poses some thorny problems.

Here's how to do it

As I pointed out in this post, the trick is to poll people about how much they expect to be compensated if they are to forgo the ability to sell an asset for some a period of time, say one year, while still enjoying the pecuniary and consumption yields provided by that asset. The question goes something like this:

"How much would I have to pay you in order for you to relinquish all rights to trade away your holdings of asset x for one year?"

The price that an individual lists represents the value they ascribe to that asset's moneyness stripped of its other valuable attributes. It represents how much value they put on that asset's foregone bid-ask spread and other objective liquidity data.

On a larger scale, we want to create a moneyness market

The previous paragraph solves for each individual's assessment of moneyness, but we want to know the value that the market as a whole ascribes to a given asset's moneyness. In this post, I imagined what these markets would look like. We'd want to create a financial product that requires investors to set a price on how much they need to be paid if they are to relinquish the right to trade away asset x for a period of time. Buyers and sellers of these rights would establish a market price for the moneyness of all sorts of assets.

A few practical uses of moneyness and moneyness markets

Right now, equity analysts include an equity's moneyness in their valuation metrics, which is a big mistake. I go into this in plenty of detail here and here. If an analyst wants to accurately value an equity's price relative to its earnings, they need to have a measure of moneyness. That way they can strip out that part of an equity's price that is due to its moneyness and compare the non-monetary residual to earnings. A moneyness market would provide them with the missing data.

To properly value bonds and housing, we should probably do the same. See here and here.

And as I wrote here, financial assets like stocks are 2-in-1 deals meaning that you've got to buy an asset's moneyness along with its pecuniary return. Investors may prefer to have the one without the other. A moneyness market allows investors to split off and sell (or buy) each component separately, resulting in a more optimal allocation of moneyness and pecuniary returns.

Moneyness and monetary policy

Monetary policy is more of a sideline, but here are a few posts on the subject. A central bank issues liabilities with a high degree of moneyness. By increasing the quantity of outstanding liabilities, a central bank can reduce the marginal value that people are willing to pay for that moneyness, thereby lowering the purchasing power of central bank liabilities and increasing the price level. By tightening the supply of liabilities, it increases their marginal value, boosting their purchasing power and lowering the price level.

So in short, a central bank manipulates the moneyness of its own liabilities.

However, once it reduces the moneyness of its liabilities to zero across all time frames, a central bank can't create more inflation. This is the zero-lower bound from a moneyness perspective, which I go into here.

And in the future

I'm hoping to write a few posts on liquidity crisis and moneyness markets, and how moneyness markets can displace central banks as lenders of last resort (or at the very least help central banks improve).

Different goods are differently liquid

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

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

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

Roth's first criticism, published on his blog last year, is that the

“moneyness” concept... seems to hinge on a single axis of “liquidity,” when in fact different units of exchange are differently liquid.

He goes on to give more detail at Roche's blog:

Suppose you have $10k in quarters. You can buy all the Snickers bars you want; there's a very liquid exchange market (quarters for snickers bars) out there. (Though need to tromp around to buy $10K worth of Snickers bars does seem to make it less “liquid”…)

But can you buy a car with those quarters? How about treasury bonds? No. Those quarters are completely illiquid relative to cars and treasury bonds.

Now think about treasury bonds. They're completely illiquid relative to both snickers bars and, but extremely liquid relative to fed bank deposits (reserve balances) — if you have 

I don't think I have to stretch this explanation out. Think about fed reserves/deposits — they’re (il)liquid relative to what other goods/assets?

So every financial asset — in fact every real good as well — has multiple liquidities, relative to every other asset/good.

I agree with Roth. Even the most liquid items are only tradeable along a few margins, or routes. The godfather of liquidity, a US dollar chequing deposit, can get you groceries or a car, but can't buy shares in IBM. A deposit at a brokerage can buy you IBM, but it can't get you a bag of groceries or a car. Roth's well turned phrase is worth repeating here, that different goods are "differently liquid", a point that I echo in Long Chains of Monetary Barter.

However, this doesn't mean that we can't arrive at a single combined measure for all of a good's different liquidities. All we need ask an individual is this:

"How much would I have to pay you in order for you to relinquish all rights to trade away your holdings of asset x for one year?" 

What we are extracting here is the individual's reservation price for x's liquidity. In this setup, the individual is allowed to continue to enjoy all the various pecuniary and non-pecuniary returns provided by x during a one year period, save for one return—its liquidity return. We are asking the individual to forgo each and every one of the good's multiple liquidities, or, put differently, the various margins along which x usually trades.

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

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

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

Which leads into Roth's next criticism, that estimates of liquidity differ across individuals. This presumably (Roth doesn't go into detail) hampers the effort to strip out a single measure of moneyness:

the liquidity of many assets depends on who you are. If you're a bank, your treasury bill is more liquid than if you're an individual, cause the bank can trade it for reserves and the individual can't. 

Again, I agree with Roth. Viewed from the eyes of a drug dealer, a chequing deposit is surely much less liquid than cash, while from the eyes of a typical nine-to-fiver, the opposite would be the case.

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

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

The upshot is that the many differing personal scales of moneyness that Roth draws attention to can be reconciled by a market-wide moneyness scale. I hope that adequately answers Roth's points. One issue worth mentioning here is that we rarely get an opportunity to see living-breathing liquidity prices. As Nick Edmonds, who blogs here (and who should be on your reading list), points out:

I'm not sure that it is possible to extract out a market clearing price specifically for liquidity services, because it's assets that are traded not services. Each asset comes with a bundle of features yielding utility or disutility, not just the liquidity aspect.

Put differently, the difference between liquidity and a wheelchair is that liquidity doesn't stand alone as its own good but rather coexists as a service attached to an already produced good. Decomposing that service and its respective price from the rest is tricky.

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

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

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

Milton Friedman and moneyness

Steve Williamson recently posted a joke of sorts:

What's the difference between a New Keynesian, an Old Monetarist, and a New Monetarist? A New Keynesian thinks no assets matter, an Old Monetarist thinks that some of the assets matter, and a New Monetarist thinks all of the assets matter.

While I wouldn't try it around the dinner table, what Steve seems to be referring to here is the question of money. New Keynesians don't have money in their models, Old Monetarists have some narrow aggregate of assets that qualify as M, and New Monetarists like Steve think everything is money-like.*

This is a interesting way to describe their differences, but is it right? In this post I'll argue that these divisions aren't so cut and dry. Surprisingly enough, Milton Friedman, an old-fashioned monetarist, was an occasional exponent of the idea that all assets are to some degree money-like. I like to call this the moneyness view. Typically when people think of money they take an either/or approach in which a few select goods fall into the money category while everything else falls into the non-money category. If we think in terms of moneyness, then money is a characteristic that all goods and assets possess to some degree or another.

One of my favorite examples of the idea of moneyness can be found in William Barnett's Divisia monetary aggregates. Popular monetary aggregates like M1 and M2 are constructed by a simple summation of the various assets that economists have seen fit to place in the bin labeled 'money'. Barnett's approach, on the other hand, is to quantify each asset's contribution to the Divisia monetary aggregate according to the marginal value that markets and investors place on that asset's moneyness, more specifically the value of the monetary services that it throws off. The more marketable an asset is on the margin, the greater its contribution to the Divisia aggregate.

Barnett isolates the monetary services provided by an asset by first removing the marginal value that investors place on that asset's non-monetary services, where non-monetary services might include pecuniary returns, investment yields and consumption yields. The residual that remains after removing these non-monetary components equates to the market's valuation of that given asset's monetary services. Since classical aggregates like M1 glob all assets together without first stripping away their various non-monetary service flows, they effectively combine monetary phenomena with non-monetary phenomena—a clumsy approach, especially when it is the former that we're interested in.

An interesting incident highlighting the differences between these two approaches occurred on September 26, 1983, when Milton Friedman, observing the terrific rise in M2 that year, published an article in Newsweek warning of impending inflation. Barnett simultaneously published an article in Forbes in which he downplayed the threat, largely because his Divisia monetary aggregates did not show the same rise as M2. The cause of this discrepancy was the recent authorization of money market deposit accounts (MMDAs) and NOW accounts in the US. These new "monies" had been piped directly into Friedman's preferred M2, causing the index to show a discrete jump. Barnett's Divisia had incorporated them only after adjusting for their liquidity. Since neither NOW accounts nor MMDAs were terribly liquid at the time—they did not throw off significant monetary services—their addition to Divisia hardly made a difference. As we know now, events would prove Friedman wrong since the large rise in M2 did not cause a new outbreak of inflation.**

However, Friedman was not above taking a moneyness approach to monetary phenomenon. As Barnett points out in his book Getting it Wrong, Friedman himself requested that Barnett's initial Divisia paper, written in 1980, include a reference to a passage in Friedman & Schwartz's famous Monetary History of the United States. In this passage, Friedman & Schwartz discuss the idea of taking a Divisia-style approach to constructing monetary aggregates:

One alternative that we did not consider nonetheless seems to us a promising line of approach. It involves regarding assets as joint products with different degrees of "moneyness" and defining the quantity of money as the weighted sum of the aggregate value of all assets, the weights varying with the degree of "moneyness".

F&S go on to say that this approach

consists of regarding each asset as a joint product having different degrees of "moneyness," and defining the quantity of money as the weighted sum of the aggregate value of all assets, the weights for individual assets varying from zero to unity with a weight of unity assigned to that asset or assets regarded as having the largest quantity of "moneyness" per dollar of aggregate value.

There you have it. The moneyness view didn't emerge suddenly out of the brains of New Monetarists. William Barnett was thinking about this stuff a long time ago, and even an Old Monetarist like Friedman had the idea running in the back of his mind. And if you go back even further than Friedman, you can find the idea in Keynes & Hayek, Mises, and as far back as Henry Thornton, who wrote in the early 1800s. The moneyness idea has a long history.

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* Steve on moneyness: "all assets are to some extent useful in exchange, or as collateral. "Moneyness" is a matter of degree, and it is silly to draw a line between some assets that we call money and others which are not-money."

...and on old monetarists: "Central to Old Monetarism - the Quantity Theory of Money - is the idea that we can define some subset of assets to be "money". Money, according to an Old Monetarist, is the stuff that is used as a medium of exchange, and could include public liabilities (currency and bank reserves) as well as private ones (transactions deposits at financial institutions)."

** See Barnett, Which Road Leads to Stable Money Demand?

Friends, not enemies: How the backing and quantity theories co-determine the price level

Kurt Schuler was kind enough to host a Mike Sproul blog post, which I suggest everyone read.

I think Mike's backing theory makes a lot of sense. Financial analysis is about kicking the tires of a issuer's assets in order to arrive at a suitable price for the issuer. If we can price stocks and bonds by analyzing the underlying cash flows thrown off by the issuer's assets, then surely we can do the same with bank notes and bills. After all, notes and bills, like stocks and bonds, are basically claims on a share of firm profits. They are all liabilities. Understand the assets and you've understood the liability (subject to the fine print, of course), how much that liability should be worth in the market, and how its price should change.

Mike presents his backing theory in opposition to the quantity theory of money. But I don't think the two are mutually exclusive. Rather, they work together to explain how prices are determined. By quantity theory, I mean that all things staying the same, an increase in the quantity of a money-like asset leads to a fall in its price.

We can think of a security's market price as being made up of two components. The first is the bit that Mike emphasizes: the value that the marginal investor places on the security's backing. "Backing" here refers to the future cash flows on which the security is a claim. The second component is what I sometimes refer to as moneyness—the additional value that the marginal investor may place on the security's liquidity, where liquidity can be conceived as a good or service that provides ongoing benefits to its holder. This additional value amounts to a liquidity premium.

Changes in backing—the expected flow of future cash flows—result in a rise or fall in a security's overall price. Mike's point is that if changes in backing drive changes in stock and bond prices, then surely they also drive changes in the price of other claims like bank notes and central bank reserves. Which makes a lot of sense.

But I don't think that's the entire story. We still need to deal with the second component, the security's moneyness. Investors may from time to time adjust the marginal value that they attribute to the expected flow of monetary services provided by a security. So even though a money-like security's backing may stay constant, its price can still wobble around thanks to changes in the liquidity premium. Something other than the backing theory is operating behind the scenes to help create prices.

The quantity theory could be our culprit. If a firm issues a few more securities for cash, its backing will stay constant. However, the increased quantity now in circulation will satisfy the marginal buyer's demand for liquidity services. By issuing a few more securities, the firm meets the next marginal buyer's demand, and so on and so on. Each issuance removes marginal buyers of liquidity from the market, reducing the market-clearing liquidity premium that the next investor must pay to enjoy that particular security's liquidity. In a highly competitive world, firms will adjust the quantity of securities they've issued until the marginal value placed on that security's liquidity has been reduced/increased to the cost of maintaining its liquidity, resulting in a rise or fall in the price of the security.

This explains how the quantity theory works in conjunction with the backing theory to spit out a final price. In essence, the quantity theory of money operates by increasing or decreasing the liquidity premium, Mike's backing theory takes care of the rest.

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P.S. Kurt Schuler's response to Mike.

An ode to illiquid stocks for the retail investor

Today's go-to advice for the small retail investor is to invest in passive ETFs and index funds. These low cost alternatives are better than investing in high-cost active funds that will probably not beat the market anyway. There's a lot of good sense in the passive strategy.

Here's another idea. If you're a small investor who has a chunk of money that needs to be invested for the long haul, consider investing in illiquid stocks rather than liquid stocks, ETFs, or mutual funds. Pound for pound, illiquid stocks should provide you with a better return than liquid stocks (and ETFs and mutual funds, which hold mostly liquid stocks). Because you're a small fish, you won't really suffer from their relative illiquidity, as long as you're in for the long term. Here's my reasoning.

Take two companies that are identical. They begin their lives with the same plant & equipment and produce the exact same product. Say the risks of the business in which they operate are minimal. They will both be wound up in ten years and distribute all the cash they've earned to shareholders, plus whatever cash they get from selling their plant & equipment. The price of both shares will advance each year at a rate that is competitive with the overall market return until year 10 when the shares are canceled and cash paid out.

The one difference between the two is that for whatever reason, shares in the first company, call it LiquidCo, are far more liquid than shares in the second, DryCo. LiquidCo's bid-ask spread is narrower, it trades far more often, and when it does trade the volumes are much higher.

Given a choice between investing in two identical companies with differing liquidities, investors will always prefer the more liquid one. This is because liquidity provides its own return. Owning a stock with high volumes and low spreads provides the investor with the comfort of knowing that should some unforeseen event arise, they can easily sell their holdings in order to mobilize resources to deal with that event. The liquidity of a stock is, in a sense, consumed over its lifetime, much like a fire extinguisher or a backup generator is consumed, though never actually used. The problem with illiquid stocks, therefore, is that they provide their holders with little to consume.

As a result, the share prices of our two identical firms will diverge from each other at the outset. Since shares of LiquidCo provide an extra stream of consumption over their lifetime, they will trade at a premium to the DryCo shares. However, both shares still promise to pay out the exact same cash value upon termination. This means that as time passes, the illiquid shares need to advance at a more rapid rate than the liquid shares in order to arrive at the same terminal price. See the chart below for an illustration.

The logic behind this, in brief, is that illiquid shares need to provide a higher pecuniary return than liquid shares because they must compensate investors for their lack of a consumption return. This higher pecuniary return is illustrated by DryCo's steeper slope.

Here's where small retail investors come into the picture. Because the capital you're going to be deploying is so small, you can flit in and out of illiquid stocks far easier than behemoths like pensions funds, mutual funds, and hedge funds can. From your perspective, it makes little difference if you invest in LiquidCo or DryCo since your tiny size should allow you to sell either of them with ease. Your choice, therefore, is an easy one. Buy Dryco, the shares will appreciate faster! Thanks to your minuscule size, the market is, in a way, giving you a free ride. You get a higher return without having to sacrifice anything. In short, you get to enjoy a consumer surplus. [1]

Put differently, the consumption return provided by LiquidCo is simply not a valuable good to you as a small and nimble investor. By holding LiquidCo, you're throwing money away by paying for those services. Rather than enjoying a consumer surplus, you're bearing a consumer deficit by holding liquid shares, perhaps without even realizing it. [2]

This advice is of little use to large fish like mutual funds and hedge funds. These players never know when they will face client redemptions necessitating the liquidation of large amounts of stock. Investing in illiquid shares poses a very real inconvenience for them since they are likely to be punished if they try to sell their illiquid portfolio to raise cash to meet redemption requests. Paying the premium to own liquid shares may be the best alternative for a large player.

Because they dominate the market, large players are largely responsible for determining the premium of liquid shares over illiquid ones. Retail investors who directly invest in stocks have become a rare breed, typically opting for mutual funds or ETFs. As such, the premium doesn't reflect retail preferences at all, but the preferences of larger players. Liquid stocks are well-priced for institutional investors but mispriced for the retail investor.

Look over your portfolio. Are you mostly invested in liquid stocks? If so, you may be paying for a flow of liquidity-linked consumption that you simply don't need. Do you hold a lot of mutual funds and ETFs? Both will be biased towards liquid stocks. Mutual fund managers need the flexibility of liquid shares to meet redemptions, and ETFs are usually constructed using popular indexes comprised of primarily liquid stocks. If your liquidity position is overdetermined, it may be time to shift towards the illiquid side of the spectrum. The tough part, of course, is finding what illiquid stocks to buy. But that's a different story.

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[1] For this strategy to work in the real world, you really do need to be holding for the long term. My chart shows a steady upward progression. But in the real world, there will be hiccups along the way, and when these happen, illiquid stocks will tend to have larger drawdowns than liquid stocks, even though the underlying earnings of each firm will be precisely similar. As long as you don't put yourself in a position that you're forced to sell during temporary downturns, then you should earn superior returns over the long term.

[2] This is why I like the idea of liquidity options, or "moneyness markets". It makes sense for retail investor to buy LiquidCo if they can resell a portion of the unwanted non-pecuniary liquidity return to some other investor. That way the retail investor owns the slowly appreciating shares of LiquidCo and also earns a stream of revenue for having rented out the non-pecuniary liquidity return. This combination of capital gains and rental revenues should replicate the return they would otherwise earn on DryCo. See this post, which makes the case for "moneyness markets" for the value investor (and helpful comment from John Hawkins).

Medieval QE

Hand operated rolling mill, for putting the edge impression on to coins

I've been reading about the medieval monetary system lately. What a fascinating and complex mechanism, and a good reminder that we should not be using the word medieval as a synonym for primitive or unenlightened. Medieval coinage, I've come to discover, is also a highly confusing subject. A quote that John Munro attributes to Karl Helleiner seems apropos: "There are two fundamental causes of madness amongst students: sexual frustration and the study of coinage."

Studying odd, imaginary, or historical monetary systems is rewarding not only because of the aha! moment that understanding provides, but also because of what these systems reveal about our modern one. Readers may have noticed that for the last two months I've been posting rather obsessively on monetary policy, a topic I've typically avoided. Here's my attempt to combine monetary policy and medieval coinage into one post, hopefully as a useful way to consolidate all my points in an interesting way.

In medieval days, mints were generally owned by a prince. A mint-master was put in charge of coining silver bullion into coin (gold and copper were also coined, but for simplicity I'll focus on silver). The prince set the official rate at which the mint-master could convert raw silver into a specific coin. For instance, one pound-weight of silver might be coined into 240 silver pennies, each with 1/240th a pound-weight of silver in them. Under the principle of free coinage, anyone could bring raw bullion, plate, jewelry, and foreign coin to the mint to be converted into coin of the realm.

Coins were far more convenient in trade than raw silver because they saved transactors from the laborious process of weighing and assaying silver powder or ingots. Because of this superior marketability, coins usually traded at a premium to an equivalent amount of raw silver. A coin with 1 gram of silver therein, for instance, might exchange in the market at a price of 1.1 grams of pure silver bullion. Munro refers to this premium as the agio.

The existence of an agio represented a potential arbitrage opportunity for the public. A merchant need only buy raw silver, bring it to the mint to be coined, and leave with the same weight of silver, but now in coin form and capable of purchasing, say, 10% more goods. He could then buy more bullion with this new coins, repeating the process and earning a 10% risk-free return each time.

While coinage was free, it was not gratuitous. The mint-master required a certain amount of silver as payment for the use of his time, minting tools, and wages for his employees. Since silver was usually mixed with base metals like copper to produce the final coin, the mint-master also required compensation for supplying the baser metals. This fee was called brassage. The prince exacted a fee too, or a tax. This was called seigniorage.

These costs restricted the opportunities for arbitrage. If the brassage and seigniorage costs were higher than the agio, the public would avoid the mint altogether since the transaction would result in a loss in purchasing power. Better to keep their silver in bullion form or search for a mint that produced identical coin at less cost.
However, as long as the agio was more than brassage and seigniorage, citizens would continue to bring bullion to the mint and enjoy a small return.

This process had a natural limit. Much like the water-diamond paradox (which tells us that the usefulness of something does not necessarily equate to a higher price) the fact that coins were more useful than raw bullion in transactions didn't mean that people would always pay to enjoy that benefit. As the public flocked to the mint, a coin glut would develop. The marginal value that the market placed on coin-as-transactions-medium would deteriorate, driving the agio down to the twin costs of brassage and seigniorage. Put differently, an increase in coin supply would push the marginal value of coin towards the cost of production. Just as water is extremely useful but essentially free, the marketability value of coins -- though still useful -- could be had at no cost once the quantity of coin was sufficiently plentiful.

Let's bring this back to monetary policy. The initial agio of coin over silver is very much akin to the liquidity premium I've mentioned in previous posts. The existence of an agio, or liquidity premium, is justified by the convenience, moneyness, or non-pecuniary return on a medium-of-exchange. As the supply of coin is allowed to increase, all other things staying the same the market's marginal valuation of this non-pecuniary return will fall, as will the associated agio/liquidity premium.

A modern central bank keeps the supply of reserves artificially tight and restricts competition. In doing so, it creates a positive marginal non-pecuniary return on reserves (or a convenience yield, see here). This drives the market value of reserves above the price at which they would otherwise trade were they subject to competition. In other words, a central bank creates a permanent agio.

In order to execute monetary policy, central banks will typically massage this agio. By emitting a small amount of reserves or sucking them in, a central banker can alter the marginal valuation that the market places on the convenience of reserves. This pushes the agio higher or lower. Any change in the agio translates into an economy-wide change in the price level.

Bringing this back to a medieval setting, imagine that the prince ceases free coinage (much like how a modern central banker would restrict reserve supply and competition). From time to time the public might be allowed access to the mint, and in limited numbers, but usually the mint would be closed to business. The supply of coin, therefore, is henceforth restricted. The ensuing lack of transactions media will cause a large agio to emerge as the market value of coin rises relative to bullion. I'm assuming here that counterfeiting is too dangerous to justify. If not, counterfeiters will be motivated to establish black market mints once the agio significantly exceeds brassage.

The prince is now in the same position as a modern central banker. By bringing a bit of silver bullion to the mint, turning it into coin, and spending it, he can increase the quantity of coin in the economy and thereby decrease the marginal non-pecuniary return on coin. The agio would thereby shrink, pushing the market value of coin down, or the price level up.   After all, the economy's unit of account in the medieval period was determined by a given link coin, usually the penny, so any change in the penny's value resulted in an economy-wide change in prices.

Both the prince and a central banker face a limit to the effectiveness of expansionary monetary policy. Once a prince has issued enough coin to drive the agio down to zero via mass "coin quantitative easing", further coin emissions will have no effect on the price level. A coin will now be worth no more than its intrinsic silver value. Nor can it fall to a discount to its silver content, since the public would simply buy coin and melt it into bullion until the discount has been removed. As for a modern central banker, once QE has reduced the convenience yield provided by reserves across the entire curve to zero, then further reserve emission cannot push the price level down any further. The agio has disappeared. In the same way that coin falls to its silver content, reserves will have fallen to their intrinsic "backing" value -- and will go no lower.

The prince still has an alternative. He can engage in outright debasement. By reducing the intrinsic silver content in coin, the price level will once again start to rise. Likewise, a central banker might attack the intrinsic value of central bank liabilities by destroying assets, or purchasing assets at bloated prices, or engaging in helicopter drops. Princes did in fact tend to reduce the price level via debasement and not by manipulating the agio, although they usually did so as a way to earn higher revenue, not to help the economy. No doubt due to the irresponsibility of the prince's who preceded them, modern central bankers are legally prohibited from outright debasement. Manipulating the agio on reserves, or playing with the interest rate on reserves, are the only tools left to them.

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Most of the actual facts about medieval coinage in this post come from John Munro's Warfare, Liquidity Crises, and Coinage Debasements in Burgundian Flanders, 1384 - 1482 (RePEc) and The Coinages and Monetary Policies of Henry VIII (RePEc), among other papers. Munro shouldn't be blamed for mistakes in my theorizing, nor the analogy to modern central bank QE. 

The fed funds rate was never the Fed's actual policy lever

The lever on which a central bank pushes or pulls in order to keep its target variable (say inflation) on track is commonly referred to as the central bank's policy instrument. The policy instrument is the variable that is under the direct control of a central banker. The classic story is that the pre-2008 Fed conducted monetary policy via its policy instrument of choice—the federal funds rate. By pushing the fed funds lever up or down, the Fed could change the entire spectrum of market interest rates.

I think this is wrong. The fed funds rate was never the Fed's actual policy instrument. Now this isn't a novel claim. Market monetarists tend to say the same thing. According to folks like Nick Rowe, the quantity of money has always been the Fed's true policy instrument. The fed funds rate was little more than a useful shortcut (a communications device) adopted by the Fed to convey to the public what it intended to do.

I'm sympathetic to the market monetarist's position, although I'm not entirely in the same corner. I agree that the Fed's policy instrument was never the fed funds rate. But I'm going to go one further than the market monetarists and say that the Fed's real policy instrument prior to 2008 was always the non-pecuniary return on reserves.

What do I mean by non-pecuniary return? All assets are expected to provide a sufficient return to their holder. This expected return can be decomposed into a pecuniary and a non-pecuniary component. Financial assets, for instance, tend to provide only pecuniary returns. These come in the form of expected interest payments, dividends, and capital appreciation. Non financial assets like couches, books, and cutlery tend to provide only non-pecuniary returns. These non-pecuniary returns come in the form of future consumption (dated consumption claims), protection from uncertainty, status, etc. Complex assets like houses provide both pecuniary and non-pecuniary returns. We expect to enjoy the shelter provided by our house, and we simultaneously expect it to provide a capital gain when we sell it.

Note that another word for non-pecuniary return is convenience yield. I'll use the two interchangeably from here on in.

For the first time ever on Moneyness, an equation to help clear the waters:

Total expected return of an asset = expected non-pecuniary return + expected pecuniary return

In well-functioning markets, all assets provide the same total expected return. If some asset begins to throw off excess returns, people will buy it up till its price has risen to the point that the cost of acquiring that asset offsets its superior return. Vice versa with an asset that begins to throw off deficient returns.

Central bank reserves are like any other asset. They provide an expected return that can be decomposed into pecuniary and non-pecuniary components. Perhaps somewhat oddly for a financial asset, reserves have never provided a pecuniary return, at least not before 2008. This is because reserves failed to pay interest. (In fact, reserves have always provided a slightly negative pecuniary return. They are generally expected to fall in price, burdening holders with a negative capital gain).

Reserves, therefore, are only held because their non-pecuniary return, or convenience yield, is sufficiently large to compensate their owners for a lack of a pecuniary return. [From here on in, it goes without saying that I am talking about the pre-2008 Fed]. What is the nature of this yield? Reserves are the main instrument used for interbank payments and settlement. Should an emergency arise necessitating an immediate payment, a banker can always put his or her inventory of reserves to use. If a banker foregos holding an inventory of reserves, he or she will have to bear the risk of not being able to quickly obtain sufficient reserves for potential unforeseen payments requirements. Reserves are to a banker what a fire alarm is to a household— while neither provides an explicit pecuniary benefit, both assets provide their owners with ongoing protection from the uncertainty of future events. Bankers and households alike expect to "consume" this convenience over the life of the asset, earning the same total return they would on their other assets.

It is the convenience yield on reserves, and not the fed funds rate, that serves as the Fed's policy instrument. By manipulating the convenience yield—the non-pecuniary return provided by reserves—the Fed exercises monetary policy. When the Fed improves the convenience yield on reserves, reserves will provide a superior expected return relative to all other assets in an economy. Rational agents will bid the price of reserves up, and the price level down. When it hurts the convenience yield, reserves will provide an inferior expected return relative to all other assets in an economy. Rational agents will now cry the price of reserves down, and the price level up.

One way to alter the convenience yield on reserves is to change their quantity via open market operations. As the supply of reserves shrinks via open market sales, the marginal reserve provides an ever improving convenience yield. Rational agents will seek to earn an excess return on their portfolios by buying superior-yielding reserves and selling other assets. This causes a fall in the price level until reserves no longer provide superior returns. Conversely, as the supply of reserves is increased via open market purchases, the marginal reserve provides an ever shrinking convenience yield. Rational agents will try to rid themselves of inferior-yielding reserves, causing a decline in the price of reserves, the mirror image of which is a rise in the price level.

There's a second way to change the convenience yield on reserves. Keep the quantity fixed, but make reserves more convenient! Just like an auto manufacturer can improve the expected convenience yield of a car by adding more features—cup holders, AWD, safety air bags, inboard TV, you name it—the Fed can also improve the expected convenience yield on reserves by souping them up. One popular add-on has always been the required reserve stipulation. As a condition of participation in the payments system, a central bank may require member banks to hold a certain quantity of reserves contingent on the number of deposits that each member has issued to the public. Where before central bank reserves were valued primarily for their role in settlement, now reserves can also be held to fulfill the reserve requirement, enabling the bank to continue as a payments system member in good standing. Voilà, reserves are now doubly-convenient since they can perform two roles, not just one. Henceforth, any increase in reserve requirements improves the convenience yield on reserves and any decrease will hurt their convenience yield.

If the Fed's monetary policy instrument has always been the convenience yield on reserves and not short term interest rates, as is commonly supposed, why all the hoopla about the federal funds rate? Why do central banks talk so much about manipulating overnight interest rates?

The problem with doing monetary policy in terms of convenience yields is that convenience yields are not directly visible. We know that they exist, but we can't really see them. This leaves the Fed in a conundrum, because if it tries to communicate about monetary policy, it can only talk about raising or lowering the hidden convenience yield on reserves, but it can't go into any numeric depth on the issue.

But wait! There are indirect ways to measure convenience yields. One way is to ask people how much money they expect to earn if they forgo the convenience of some asset for a duration of time. The rent they expect to earn in compensation should "shadow" the convenience yield. The more convenient an asset becomes, the higher the rent the asset holder expects to be compensated with if they are to do without that asset for a period of time. The less convenient, the lower the rent.

The federal funds market is the rental market for reserves. Banks can either hold reserves and enjoy their convenience, or they can rent their reserves out to other banks, foregoing the convenience of reserves for a period of time but earning compensatory payments. These payments are the rental value of reserves, or the fed funds rate. The fed funds rate is driven by the convenience yield on reserves. So when reserves are made more convenient by the Fed, banks will expect to earn a higher fed funds rate as compensation from borrowers. When the fed funds rate falls, that means that reserves have been made less convenient.

So the fed funds market provides a numeric manifestation of the unobservable convenience yield on reserves. The Fed can use this manifestation as a stand-in for communicating with the public, describing monetary policy as-if it was directly manipulating the fed funds rate whereas in actuality the convenience yield is the Fed's true policy instrument. In the 1990s and 2000s, when the Fed announced changes in the fed funds rate target, it was doing nothing more than describing to the public how a change in the underlying convenience yield would appear to the superficial observer. As Nick Rowe says, interest rate targeting is not reality, its a way of framing reality.

The fed funds rate also serves the Fed's Open Market Committee as a useful sign post, or indicator, that provides information on the way to hitting its final price target. For each modification it makes in the convenience yield, the FOMC can measure how successful it has been by referring to how far the fed funds rate has moved in response. Alternatively, the FOMC can use the fed funds rate as a guide for stabilizing what would otherwise be an invisible and difficult to manage convenience yield. In general, the Fed has tried to keep the convenience yield on reserves flat for extended periods of time between meetings. Whenever the fed funds market blips up or down in the interim, the Fed can use these blips as indicators that it is not keeping the underlying convenience yield steady. Action, either OMOs or reserve requirement changes, will be used to bring the convenience yield on reserves back into its holding pattern.

But the key point here is that the federal funds rate is NOT doing the heavy lifting in monetary policy. The federal funds rate only responds passively to changes in the Fed's true policy instrument—the convenience yield on reserves. Fed-induced changes in the convenience yield create an instantaneous and simultaneous reaction in all markets, including the fed funds market, bond markets, stock markets, labour markets, goods markets, and commodity markets. The fed funds rate isn't the first price to react, nor is it the pivot around which the full network of other market rates move. That we use the fed funds market to measure the reaction of the economy to a change in the policy instrument rather than using, say, commodity markets, is merely for the sake of ease. The funds rate just happens to be the one that provides the most noise-free signal for how much the convenience yield has been manipulated.

...but not a perfect noise-free signal. The fed funds rate's ability to act at a good reflection of the underlying convenience yield comes to an end when it gets too low. Even as the Fed continues to reduce the convenience yield, the fed funds rate falls to 0% from where it refuses to budge, conveying the impression—an improper one—that the Fed's policy instrument is powerless. But further reductions in the convenience yield, and a higher price level, ARE still possible.

My point here is very similar to the one that Nick Rowe makes when he says that interest rates "go mute" at zero. This is an important point I never grasped intuitively till I began to think of Fed policy as the manipulation of convenience yields. The main difference between the two of us is that  Nick takes the "money" view, which looks at absolute quantities of money, while I take a "moneyness view", which means I'm interested in monetary convenience yields [on money vs. moneyness]. We arrive at the same final destination, though, albeit by different roads.

Plenty of things changed after October 2008. I suppose I could go into this in more detail, but this post is already too long. Suffice it to say that reserves ceased offering a present non-pecuniary return and began offering a pecuniary return. The latter is IOR (interest-on-reserves). The non-pecuniary return has shrunk because there is currently such a glut of reserves in the system that the marginal reserve no longer offers its owner a present convenience yield. All of these changes complicate the picture.

There's plenty more to say on all this stuff, but this post is heavy enough. Just keep in mind that thinking in terms of convenience yields and not the federal funds rate opens up a whole new world. The idea that the funds rate was ever the policy instrument should be confined to the trash bin. More later.