A Visa/MasterCard theory of recessions

Statistical agencies employ data collectors who walk up and down aisles with hand-held computers gathering sticker prices for things like frozen french fries and bicycles. The data they collect gets amalgamated into an index and passed on to central bankers who use it as the basis for rate change decisions. It seems simple enough, but what happens if the source material has been corrupted? Might central bankers be reacting to mere shadows on the wall?

Here's how prices might go bad. Start with the U.S. and Canadian payments systems. For each credit card payment, a North American merchant must pay 1-2% in fees to the card networks Visa and MasterCard. Retailers in both countries have very different strategies for coping with this burden. In the U.S., retailers are permitted to offload network fees onto customers by asking them to pay a surcharge on each credit card payment. Because Canadian retailers are prohibited from surcharging customers, they react by marking up every sticker price in their store by a percent or two, the extra margin they collect sufficient to cover the card network fees. (Canadian retailers almost never offer cash discounts.) For a more complete explanation, see here.

This arcane difference in payments habits has the potential to result in a divergent evolution of prices, vastly different monetary policies, and an uncoupling of North American economic growth.

Consider what happens when the Visa and MasterCard networks decide to offer North American customers a universal 5% cash back reward. The networks fund this bonus by requiring merchants to submit a 5% fee on each card transaction. U.S. retailers cope with this levy by boosting the surcharge they apply on each card transaction to 5% or so, forcing the card-paying customer to bear the cost. Those Americans who pay with cash i.e. banknotes continue to get the sticker price, which stays constant. Without the ability to surcharge, Canadian retailers cope by boosting sticker prices by 5%, thereby indirectly passing the costs of the cash-back bonus onto the customer.

Marching up and down the aisles, U.S price collectorsdon't notice a thing. As a result, the U.S. consumer price index stays the same and the Fed doesn't lift a thumb. Canadian price collectors, however, find that prices have risen. Upon reception of this data, the Bank of Canada anxiously raises rates. This is because Bank officials believe that the rapidly rising price level indicates that the economy-wide rate of return (the natural rate of interest) has risen above the Bank's market rate, breeding inflation. A rate hike is necessary to bring the two rates back in lane, thus choking off the incipient inflation that seems to be developing. The natural rate hasn't budged, of course. All that has changed is the card networks' fee policy. Instead of bringing the market rate of interest in line with the natural rate, the Bank of Canada has been fooled into moving the market rate of interest above the natural rate.

If the card networks again increase the cash back reward, say to 10%, Canadian prices will rise even more. U.S. prices stay flat. The Bank of Canada once again confuses the effects a new cash-back policy with a rise in the natural rate of interest, tightening while the Fed stays pat.

Assuming that prices react rapidly and fluidly to central bank policy, then the Bank of Canada's tightening will simply drive consumer prices back down and restore equality between the natural rate of interest and the market rate. But if changes in monetary policy have effects on the real economy, then we've got problems. It could be that certain prices are sticky downward so that markets can't clear, the result being inventories of goods going unsold. Or perhaps the fact that debts are nominally denominated creates a Fisherian debt deflation. If so, then the Bank of Canada could end up unnecessarily driving Canada into a recession. The Federal Reserve, reacting to the very same set of stimuli, does not.

Now of course I'm exaggerating things. In real life such large increases in cash-back policy are unlikely. Nevertheless, we have seen a progressive increase in network fees over the years, enough to have probably inspired Canadian retailers to ratchet up sticker prices. As a result, Canadian CPI may be slightly over-stating actual inflation. On the U.S. side, consider that American retailers only recently gained the power to surcharge credit cards. As U.S. retailers roll out surcharge policies and reduce sticker prices, CPI will be pressured down. This may fool Fed officials into believing that the economy is slowing and draw them into an unnecessary rate cut when in realtiy all that has changed is credit card pricing habits. One wonders if the monetary authorities take into account these arcane features of our payment system when they set their monetary policies.

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This answers a question I asked more than a year ago.

On vacation since 2010

On a recent trip to Ottawa, I stopped by the Bank of Canada. The door was locked and the building empty. Odd, I thought, why would the Bank be closed in the middle of a business day? A security guard strolled up to me and told me that the entire staff packed up back in 2010 and left the country. He hadn't seen them since. Bemused I walked back to my hotel wondering how it was that with no one guiding monetary policy, the loonie hadn't run into either hyperinflation or a deflationary spiral.

Exactly 175 months passed between February 1996, when the Bank of Canada began to target the overnight rate, and September 2010, the date of the Bank's last rate change. Some 63 of those months bore witness to an interest rate change by the Bank, or 36% of all months, so that on average, the Governor dutifully flipped the interest rate switch up or down about four times a year. Those were busy years.

Since September 2010 the Governor's steady four-switches-a-year pace has come to a dead halt. Interest rates have stayed locked at 1% for 51 straight months, more than four years, with nary a deviation. I enclose proof in the form of a chart below. Not only has the Bank of Canada been silent on rates, it hasn't engaged in any of the other flashy central bank maneuvers like quantitative easing or forward guidance. In the history of central banking, has any bank issuing fiat money (ie. not operating under a peg) been inactive for so long?

Worthwhile Canadian chart: The Bank of Canada overnight rate target

Now the Bank of Canada will of course insist that you not worry about the lack of activity, its staff is still toiling away every day formulating monetary policy. But maybe the security guard was right. How do we know they haven't all been on an extended four-year vacation, hanging out in Hawaii or Florida? Who could blame them? Ottawa is awfully cold in the winter! With no one left at the Bank to flip the interest rate switch, that's why it remains frozen in time at 1%.

In theory, the result should be disastrous. With no one manning the interest rate lever, the price level should have either accelerated up into hyperinflation or downwards into a deflationary spiral. Why these two extreme results?

Economists speak of a "natural rate of interest". Think of it as the economy-wide rate of return on generic capital. The governor's job is to keep the Bank's interest rate, or the rate-of-return on central bank liabilities, even with the rate-of-return on capital. If the rate of return on central bank liabilities is kept too far below the rate on capital, everyone will want to sell the former and buy the latter. Prices of capital will have to rise ie. the purchasing power of money will fall. This rise will not close the rate-of-return differential between central bank money and capital. With the incentives to shift from money to capital perpetually remaining in effect, hyperinflation will be the result. Things work in reverse when the governor keeps the rate-of-return on central bank liabilities above the rate-of-return on capital. Everyone will try to sell low-yielding capital in order to own high-yielding money, the economy descending into crippling deflation.

In theory, there is no natural escape from these processes. The Bank needs to intervene and throw the interest rate lever hard in the opposite direction in order to pull the price level out of its hyperinflationary ascent or deflationary descent.

By the way, if this is all a bit boring, you can get a good feel for things by playing the San Francisco Fed's So you want to be in charge of monetary policy... game for a while. When you play, try keeping the interest rate unchanged through the course a game—you'll set off either a deflationary spiral or hyperinflation. Be careful, this game can get a bit addicting.

The upshot of all this is that with the Bank of Canada policy team on holiday and the policy rate stuck at 1%, any rise (or fall) in the Canadian natural interest rate is not being offset by an appropriate shift in the policy rate. Prices should be trending sharply either higher or lower.

However, a glance at core CPI shows that Canadian inflation has been relatively benign. Canada has somehow muddled through four years with no one behind the monetary rudder. How unlikely is that? Imagine Han Solo falling asleep just prior to entering an asteroid field only to wake up eight hours later to discover he'd somehow brought the ship through unscathed. We already know that the possibility of successfully navigating an asteroid field is approximately three thousand seven hundred and twenty to one—and that's with Han awake. If he's asleep, the odds are even lower. By pure fluke, each asteroid's trajectory would have to avoid a sleeping Han Solo's flight path in order for the Millennium Falcon to get through.

Success seems just as unlikely for the Bank of Canada. For us to have gotten this far with no one behind the wheel, the return on capital must not have changed at all over the last four years, the flat 1% interest rate thus being the appropriate policy. Either that or the return on capital zigged only to zag by the precise amount necessary to cancel out the zig's effect on the price level. However, I find it unlikely that the economy's natural rate of interest would stay unchanged for so long, or that its zig zagging was so fortuitous as to preclude a change in rates.

Alternatively, it could be that Canadians assume that the Bank is being vigilant despite the fact that the entire staff has skipped town. Even if a difference between the rate of return on capital and a rate of return on money arises thanks to normal fluctuations in natural rate of interest, Canadians might not take the obvious trade (buy higher yielding capital, sell low-yield money) because they think that the Bank will react, as it usually does, in the next period by increasing the rate of return on money. And with no one taking the trade, inflation never occurs. But is it safe to assume that people are willing to leave that much money on the table?

Another possibility is that the traditional way of thinking about monetary policy needs updating. I considered this possibility here. In short, when the return on Bank of Canada liabilities lags the return on capital, rather than a perpetual acceleration developing the price level stabilizes after a quick jump. This sort of effect could arise from central bank liabilities having some sort of fundamental value. Once the purchasing power of these liabilities falls low enough, their fundamental value kicks in, closing the rate-of-return differential between capital and money and preventing a hyperinflation from developing. So even with no one manning the Bank of Canada interest rate lever, the fundamental value of Bank of Canada liabilities provides an anchor of sorts, explaining why prices have been stable over the last few years.

I may as well come clean about the Bank of Canada. They haven't all gone to Hawaii. The real reason its HQ on Wellington Street was shut the day I visited is that it's being renovated. Rest assured the whole crew is hard at work at a temporary spot elsewhere. But does it make a difference? The monetary policy staff may just as well have gone to Hawaii in 2010. With the interest rate lever neglected and rates frozen at 1%, the evidence shows that prices would not have been sent off the rails, despite the fact that returns on capital surely jumped around quite a bit. It's all a bit odd to me.

A growing liquidity-premium on land

The Cider Mill, by Robin Moline

In general, the real price of land has been increasing all over the world, especially since the early 1990s. (Japan and Germany are the exception). The recent credit crisis hurt this trend in a few countries like Ireland, Spain, Netherlands, and the US, but in other countries like Belgium, Canada, Sweden, and Australia the secular rise in housing prices remains intact.

A popular explanation for the rise in land prices are the various versions of the secular stagnation thesis advocated by folks like Paul Krugman and Larry Summers. According to Krugman, if the natural rate of interest has become persistently negative—i.e. new capital projects are expected to yield a negative return—then investors will look to existing durable assets like gold or land that yield no less than a 0% return. The prices of these goods will be bid upwards, bubble-like. Or, as Summers puts it, if the return on capital is below the economy's growth rate, then intrinsically valueless ponzi assets may be recruited as stores of value to bridge the distance between an individual's present and the future. (Krugman and Summers's ideas are a bit hard to follow, but Nick Rowe has a bunch of helpful posts on these ideas).

In short, these theories explain the paradoxical conjunction of bubbles with a sluggish economy and low inflation.

I think that a better explanation for the rise in real land prices is the emergence of large liquidity premium on land. This premium isn't an irrational "bubble" phenomenon. Rather, over the last decade or two finance and real estate professionals have put in large amounts of time, sweat, and tears to improve the underlying infrastructure that facilitates the transfer of residential land. A few of these improvements include the optimization of the mortgage lending process by the adoption of automated underwriting systems, the development of mortgage scoring, higher loan-to-value ratios on mortgage loans, and the creation of the mortgage-backed securities market.

All these improvements mean that your parcel of land is not like your grandfather's parcel—it can be sold off, parceled up, rented out, collateralized, and re-hypothecated faster than ever. In short, land has become more like cash. Whereas in the past the purchase of a house made you dramatically less liquid, these days that same house impairs your liquidity position much less.

Like any other asset owner, land owners expect to enjoy three services: a pecuniary return such as capital appreciation, a non-pecuniary consumption yield, and liquidity services. In a world in which arbitrage ensures that all assets provide roughly the same return, any improvement in the liquidity services provided by land reduces the amount of capital appreciation people expect to earn on their land parcel (we'll assume the consumption return is constant). This reduction in expected capital appreciation comes about via a rise in land prices now relative to their expected future price. So the steady improvements in the liquidity services thrown off by land have created a stepwise rise in land prices. This rise might appear to be a bubble, but it's only the market's warm response to the finance industry's consistent upgrades to the mechanisms that facilitate transfers of land.

If you believe John Maynard Keynes, what we're seeing now is just a reversion to ancient times. In Chapter 17 of his General Theory, Keynes wrote: "It may be that in certain historic environments the possession of land has been characterized by a high liquidity-premium in the minds of owners of wealth..." He goes on to note that the high liquidity premiums formerly attaching to the ownership of land are now attached to money. It may be the case that in modern times these liquidity premia are detaching from traditional forms of money like deposits and returning to land, the evidence being the rise of land prices and decline in traditional deposit banking.

When a market bursts, the stagnation thesis has it that people have spontaneously switched from one bubble to a new one, or that the underlying features of the economy (i.e the negative natural interest rate) have changed. If land price increases are being driven by improvements in liquidity services rather than low-to-negative rates of return and resulting bubble-seeking behavior, than snap-backs may occur when the underlying architecture supporting that liquidity fails. Alternatively, different networks of finance professionals may be working hard to build up their own asset's liquidity, thus competing away the liquidity premium of the incumbent asset.

Here's an interesting data point: While almost every western nation experienced a housing price boom between the mid 1990s and 2008, Germany somehow missed the boat.

From the Economist's very useful housing price chart tool.

Was Germany somehow exempt from the stagnation that other Western nation's face? Perhaps Germans selected a different bubble asset than land? Or did the underlying mechanics governing the liquidity of the German market for residential land stay constant whereas those of most nation's improved?

We know that while MBS markets were deepening all over the world, German law did not permit MBS issuance until 1997, putting it far behind the mortgage slicing & dicing eight-ball. Rather, German residential real estate finance continued to be underpinned the centuries old pfandrief, or covered bond. While  the originator of an MBS can parcel away mortgages into a bankrupt-remote entity, the assets underlying a pfandriefe are required by law to stay on the issuer's balance sheet. The mortgages comprising MBS often have up to 100% loan-to-value ratios, but German law requires that pfandbriefe be backed by mortgage loans with a maximum of 60% of the home's "lending value" (lending value is more conservative than market value), which in practice means that Germans often have to put up 60-70% cash to buy a home. Such high requirements would surely stifle the liquidity of residential land, especially compared to places like Canada where permitted LTVs went from 80% to 100% in the space of ten years.

So while Keynes's liquidity premium may have migrated back to land in much of the western world, this doesn't seem to be the case in Germany. There are surely advantages to having avoided a rise in housing prices. On the other other hand, owning a liquid house rather than an illiquid one is a boon—it provides an individual with a fluid asset for dealing with an uncertain future. From this perspective, any attempt to stifle some asset's liquidity by limiting the finance industry's ability to innovate reduces the range of coping mechanisms that  a society is presented with.

P.S. I already wrote versions of this post. Here are these ideas applied to equity markets, here they are applied to bond markets. Same idea, different day, different market.

Questions for Bob Murphy and other Austrians on the inevitability of the bust

David Glasner had some recent posts (here and here) on Ludwig von Mises and Austrian Business Cycle Theory (ABCT). Bob Murphy pushed back here with a good rebuttal. But David's general point still stands: what necessarily forces a central bank that has adopted the practice of lending at a rate below the natural rate to ever cease this practice? Why does there have to be an inevitable bust?

I consider myself an Austrian in that one of my favorite economists is Carl Menger. I've also written a thing or two for the Mises Institute, my most recent being on Menger and Leon Walras and how the two would have differed on the phenomenon of high frequency trading. On the other hand, when it comes to macroeconomics, I remain a business cycle agnostic. I'm willing to be converted though. All you've got to do is answer a few questions of mine.

Say a central bank decides to reduce the rate at which it lends below the natural rate. Businesses can come to it for cheap loans -- and they do. Mises points out that as long as this differential exists it'll eventually lead to a "crack-up boom". The currency enters hyperinflation stage and, at its peak, people either turn to barter or dollarization occurs. Alarmed at this prospect, the central bank will probably increase rates in order to stave off the crack up.

But say the central bank and the currency users exists on a small island far from everywhere so dollarization can't happen. Say also that the police force is vigilant about preventing people from bartering. As a result, the currency issued by the central bank continues to be used, even during hyperinflation. The inevitable flight from money — the crack-up boom — can't occur. The currency perpetually falls.

So having assumed the crack-up boom away, why should the setting of market rates below the natural rate inevitably end in a bust? Sure, in the interim there might be a redirection of capital towards projects that are only profitable at low rates. In this context, a sudden increase in rates by the central bank back up to the natural rate might show some of these projects to be unprofitable. You've got a bust of sorts. But our central bank, released from the disciplining threat of a crack-up boom, steadfastly refuses to raise rates.

So if rates can be kept perpetually too low, and a crack-up boom can be averted, what causes the bust?

To start off, one explanation for a bust occurring is that when rates are kept too low, excess resources are allocated to interest-sensitive distant projects and not enough to less interest-sensitive near-term projects. At some point there's a realization that not enough capital has been allocated to present needs and all those future projects suddenly collapse in value. Thus a bust. What causes this sudden epiphany? As David Glasner asks, are workers dying of starvation?  It can't be higher interest rates that render these projects unprofitable since, as I've already pointed out, the central bank keeps rates permanently low.

Even if capital begins to flow into projects that are only profitable at low rates, wouldn't the prices of materials required by those projects be bid up relative to other prices, thereby putting a quick end to the profitability of these distant projects? Wouldn't the relative prices of material required for near term projects fall, thereby increasing the profitability of near term projects? How can any significant capital misallocation proceed given these rapid relative price adjustments?

If you can answer all my questions, then you'll have successfully converted me.

More on own-rates

The discussion on own-rates, the natural rate, and Sraffa cropped again.

Andrew Lainton blogged here, followed by Nick Rowe here, Daniel Kuehn here, and David Glasner here.

It seems to me that Nick and David are more or less on the same side of the aisle. I commented on Nick's post here, and Nick provided a helpful response. I commented on Glasner here, and he gave me some good feedback.

The natural rate of interest and the own-rate argument

The Austrian vs Keynesian end of the blogosphere often battle over the existence of a natural rate of interest. The Keynesian side typically points to Piero Sraffa's argument that there are many natural rates of interest, or own-rates, and therefore an Austrian sort of monolithic natural rate of interest simply doesn't exist.

Over the last few weeks I've participated in the comments here at Jonathan Finegold Catalan's blog and here at Daniel Kuehn's blog. Here is an older comment in this vein on "Lord Keynes" blog. Bob Murphy also has a paper (pdf) on this subject and has commented on the above blogs on this subject.

Sraffa, Hayek, natural interest rate, and own-rates of return

I commented on the blog Social Democracy for the 21st Century: A Post Keynesian Perspective in a post called Hayek’s Natural Rate on Capital Goods, Sraffa and ABCT.

Specifically, the issues in the above blog post are continued in one of my favorite David Glasner posts,  Sraffa v. Hayek.

I requote Glasner: "the rate of return from holding all assets net of their storage costs and their current service flows must be equal in equilibrium. If not, you’re not in equilibrium. So all you have to do is find an asset with no storage cost and no current service flow and calculate its expected rate of appreciation and you have the real natural rate of interest."

Liquidity options, liquidity premium, natural interest rate, TIPS, and inflation swaps

Commented on David Glasner's Once Again The Stock Market Shows its Love for Inflation:

The only problem here is the one that we talked about in a previous post (Unpleasant Fisherian Arithmetic) concerning the liquidity premium that assets carry. The reason for the rising TIPS spread could be (though not necessarily must be) that the liquidity premium on treasuries is shrinking relative to that of TIPS, and therefore TIPS are rising in price relative to Treasuries. This makes it hard to pass judgment on the hypothetical rate of return on capital.

 Anyways, you have already commented on this problem in your paper: “One possible cause of distortion in the yield on TIPS bonds and in the TIPS spread during the autumn 2008 financial crisis is that the yield on conventional Treasuries was depressed because of a liquidity premium. Even though the ex ante real interest rate was likely negative, because TIPS bonds were perceived as much less liquid than conventional Treasuries, TIPS bonds could not be sold unless they were discounted, so that their yields rose well above the (unobservable) ex ante real rate on holding real assets.”

 We were talking in the comments of the “Unpleasant Fisherian Arithmetic” post about how one could measure liquidity. I thought a bit about this. If there were a market for financial products, say options, that managed to price the pure value of an underlying asset’s liquidity premium, then you would be able to measure the value that the market placed on assets’ relative liquidity premiums and, from there, get a better idea for what portion of an assets total return is provided by an own-rate and what is provided by a liquidity premium. These sort of financial assets don’t exist, but if they did they would probably be sort of like credit-default swaps… more like liquidity-guarantee swaps.

Note that is follows from a previous comment I had concerning the impossibility of computing the natural rate of interest because liquidity interferes. See Unpleasant Fisherian Arithmetic

David responded:

Have you looked at how the Cleveland Fed tries to extract the inflation expectation from the TIPS spread?

I responded:

 I looked at it this morning. It seems to me that the Cleveland Fed is using alternative measures to extract inflation expecations given the problems posed by illiquidity in TIPS markets. They are including the inflation swaps market. In an inflation swap, one party pays a fixed interest rate, the other pays the inflation rate.

 Apparently swap markets didn’t suffer as much as TIPS markets did from liquidity problems in 2008, and for that reason the Cleveland Fed is using swap rates as one of their main indicators of inflation expectations.

 That being said, swaps are still traded contracts and bear some sort of liquidity premium, so it is still empirically impossible to back out a real rate without knowing what that premium is.

 For your records, here is the quote page for the 2 year USD dollar inflation swap spread: http://www.bloomberg.com/apps/quote?ticker=USSWIT5:IND

The Cleveland Fed discuss their methodology here. http://www.clevelandfed.org/research/workpaper/2011/wp1107.pdf