Setelinleikkaus: When Finns snipped their cash in half to curb inflation

On the last day of 1945, with World War II finally behind it, Finland's government announced a new and very strange policy.

All Finns were required to take out a pair of scissors and snip their banknotes in half. This was known in Finland as setelinleikkaus, or banknote cutting. Anyone who owned any of the three largest denomination Finnish banknotes — the 5000 markka note, the 1000, or the 500 — was required to perform this operation immediately. The left side of the note could still be used to buy things, but at only half its value. So if a Finn had a 1000 markka note in their wallet, henceforth he or she could now only buy 500 markka worth of items at stores. As for the right side, it could no longer be spent and effectively became a bond (more on this later).

Source: Hallitus kansan kukkarolla, by Antti Heinonen

Setelinleikkaus was Finland's particular response to the post-War European problem of "monetary overhang," described in a 1990 paper by economists Rudi Dornbusch and Holger Wolf. After many years of war production, price controls, and rationing, European citizens had built-up a substantial chest of forced savings, or involuntary postponed consumption, as Dornbusch & Wolf refer to it. With WWII now over, Europeans would soon want to begin living as they had before, spending the balances they had accumulated on goods and services. Alas, with most factories having been configured to military purposes or having been bombed into dust, there wasn't nearly enough consumption items to make everyone happy.

It was plain to governments all across Europe what this sudden making-up of postponed consumption in a war-focused economy would lead to: a big one time jump in prices.

This may sound familiar to the modern day reader, since we just went through our own wartime economy of sorts: the 2020-21 battle against COVID and subsequent return to a peacetime economy. The supply chain problem caused by the COVID shutdowns combined with the big jump in spending as lockdowns expired, spurred on by a big overhang of unspent COVID support cheques, led to the steepest inflation in decades. 

According to Dornbusch and Wolf, European authorities fretted that the post-WWII jump in prices could very well spiral into something worse: all-out hyperinflation, as had happened after the first World War. Currencies were no longer linked to gold, after all, having lost that tether when the war started, or earlier, in response to the Great Depression. 

To prevent what they saw as imminent hyperinflation, almost all European countries began to enact monetary reforms. Finland's own unique reform — obliging their citizens to cut their stash of banknotes in two — would reduce the economy's stock of banknotes to just "lefts," thereby halving spending power and muting the wave of post-wartime spending. After February 16, 1946 the halves would be demonetized, but until then the Finns could continue to make purchases with them or bring them to the nearest bank to be converted into a new edition of the currency.

As for the right halves, they were to be transformed into a long-term investment. Finns were obligated to bring each right half in to be registered, upon which it would be converted into a Finnish government bond that paid 2% interest per year, to be repaid four years later, in 1949. It was illegal to try and spend right halves or transfer their ownership to anyone else (although it's not apparent how this was enforced).

In theory, turning right halves into bonds would shift a large part of the Finnish public's post-war consumption intentions forward to 1949, when the bonds could finally be cashed. By then, the economy would have fully transitioned back to a civilian one and would be capable of accepting everyone's desired consumption spending without hyperinflation occurring.

To our modern sensibilities, this is a wildly invasive policy. Had setelinleikkaus been proposed in 2022-23 as a way to dampen the inflationary effects of the reopening of COVID-wracked economies, and we all had to cut our dollar bills or yen or euros in half, there probably would have been a revolt.

With the benefit of hindsight, we know that setelinleikkaus didn't work very well. Finland continued to suffer from high inflation in the years after the war, much more so than most European countries did.

Why the failure? As Finish economist Matti Viren has pointed out, the reform only affected banknotes, not bank deposits. This stock of notes only comprised 8% of the total Finnish money supply, (Finns being  uncommonly comfortable with banks) so a major chunk of the monetary overhang was left in place.

Another glitch appears to have been the public's anticipation of setelinleikkaus. According to
former central banker Antti Heinonen, who wrote an entire book on the subject, banks began to advertise their services as a way to avoid the dangers of the upcoming monetary reform (see images below). So Finns deposited their cash prior to the final date, the monetary overhang to some degree evading the blockade.

Finnish bank advertisements warning of the upcoming note cutting
Left: "Bank accounts are fully secured in the banknote exchange."
Right: "Depositors are protected."
Source: Hallitus kansan kukkarolla, by Antti Heinonen (Translations via Google Translate)

If the Finnish experiment was a dud, other European responses to the post WWII overhang — either  redenominations, temporarily blocking of funds, or all-out write offs of bank accounts — were more successful. Germany's monetary reform of 1948, which introduced the Deutschmark and was later dubbed the "German economic miracle", is the one that captures the most attention, but here I want to focus on a lesser known reform.

Belgium's Operation Gutt, named after Belgium's Minister of Finance, Camille Gutt, was the earliest and perhaps the most dramatic of the post-war monetary operations. Taking place over four days in October 1944, Belgium contracted its entire money supply, both banknotes and deposits, from 165 billion to 57.5 billion francs. That's a two-thirds decline! You can see it illustrated in the chart below, along with the monetary reform enacted by the Dutch the following year, inspired by the Belgians.

A chart showing the incredible contraction of Belgium's money supply in 1944
Source: Federal Reserve Bulletin, October 1946 (red arrow is my emphasis)

It's not just the size of Operation Gutt that is striking to the modern eye. It's also the oddity of the tool being used. Today, we control inflation with changes in interest rates, not changes in the quantity of money. To soften the effect of the global COVID monetary overhang, for instance, central banks in the U.S., Canada, and Europe began to raise rates in 2022 from around 0% to 4-5% in 2024. 

By making it more lucrative for everyone to save and less attractive to borrow, central bankers were trying to reduce our propensity to spend our COVID support payments, and with less spending, prices wouldn't get pushed up as fast. This reliance on interest rates as our main tool of monetary policy is a relatively new phenomenon. In times past, central banks tended to lean heavily on changes in the supply of money, which may explain why in 1945, their main response — in Europe at least —  was to obliterate the public's money balances rather than to jack up interest rates to 25% or 50%.   

It's worth exploring in some more detail how Operation Gutt was designed. On October 9, 1944, Belgian bank depositors had 90% of the money held in their accounts frozen, leaving just 10% in spendable form.

As for holders of banknotes, there was no Finnish-style cutting. Rather, Belgians had four days, beginning October 9, to bring all their banknotes to the nearest bank, only the first 2,000 francs qualifying for conversion to newly printed versions. All notes above that ceiling got blocked in a separate account (along with excess deposits), some of which would be released slowly over the next few years—while the rest would remain frozen forever, subject to whether the owner was deemed to have been a collaborator who got rich during the occupation. (Finland's setelinleikkaus also had this same "cleansing" motivation.)

In 1944, a line forms at the National Bank of Belgium to exchange notes.
Source: National Bank of Belgium on Flickr

In this sense, the post-WWII European monetary reforms were not only designed to reduce inflation, but also had a moral basis. Think of them as progenitors to India's 2016 demonetization, which was designed to catch so-called "black money," although it failed to do so.

Did Operation Gutt work? Incredibly, the decimation of two-thirds of the money supply in just a few days did not cause an immediate fall in Belgian prices. According to Belgian economic historians Monique Verbreyt and Herman Van der Wee, the Belgian retail price index stood at 260 the month of the reform, but had risen to 387 by September 1945. So it would seem that the whole operation failed. This surely draws into question the quantity theory of money, one of the basic tenets of monetary economics. A decline in the money supply, all things staying the same, is supposed to cause a fall in prices. Here is a glaring case in which it didn't.

However, the National Bank of Belgium (NBB), the country's central bank, strikes a more constructive tone. In a recent retrospective on Operation Gutt, the NBB describes the reform as a gamble that paid off over time, eventually inspiring the "Belgian Economic Miracle", a period of low inflation and fast growth lasting from 1946-1949. By contrast, France did not embark on its own monetary reforms, the NBB takes pains to point out, and it thereby "paid the consequences of post-World War II inflation well into the 1960s." Belgium's inflation rate was also much lower than Finland's in the four or five years after the war. 

Which gets us back to Finland. Unlike the Belgian central bank, Finland's central bank — Suomen Pankki — notably avoids almost all mention of its post-war reform on its website. According to Matti Viren, setelinleikkaus led to "distrust towards the authorities and economic policy for decades," so there may be some sheepish reticence on the part of the central bank to draw attention to it.

But setelinleikkaus and Operation Gutt aren't just archaic monetary policy dead-ends. One day I suspect they'll be back. Not just as a special tool for responding to emergencies, but as a day-to-day policy wrench, albeit in a new and refined form. 

Cash, which is awkward to immobilize for policy reasons, will be gone in a decade or two, leaving the public entirely dependent on bank deposits and fintech balances which, thanks to digitization and automation, can be easily controlled by the authorities. To rein in a jump in inflation, central bankers will require commercial banks and companies like PayPal to impose temporary quantitative freezing on their clients'  accounts, but unlike Finland's 1945 blockade, the authorities will be able to rapidly and precisely define the criteria, say by allowing for spending on necessities — food, electricity, and gas— while embargoing purchases of luxury cars and real estate.

The future version of setelinleikkaus won't be clumsy, it'll be a precise and surgical inflation-fighting tool, albeit a controversial one.

Fedwire transactions and PT vs PY

Milton Friedman's alleged license plate, showing the equation of exchange

The excruciatingly large revisions that U.S. first quarter GDP growth underwent from the BEA's advance estimate (+0.1%, April 30, 2014) to its preliminary estimate (-1.0%, May 29, 2014) and then its final estimate (-2.9%, June 25m, 2014) left me scratching my head. Isn't there a more timely and accurate measure of spending in an economy?

One interesting set of data I like to follow is the Fedwire Fund Service's monthly, quarterly, and yearly statistics. Fedwire, a real time gross settlement interbank payment mechanism run by the Federal Reserve*, is probably the most important financial utility in the U.S., if not the world. Member banks initiate Fedwire payments on their own behalf or on behalf of their clients using the Fedwire common currency: Fed-issued reserves. Whenever you wire a payment to another bank in order to settle a purchase, you're using Fedwire. Since a large percentage of U.S. spending is transacted via Fedwire, why not use this transactions data as a proxy for U.S. spending?

Some might say that using Fedwire data is an old-fashioned approach to measuring spending. Irving Fisher wrote out one of the earliest versions of the equation of exchange, MV=PT, where T measures the "volume of trade" or "real expenditure" and P is the price at which this trade is conducted. Combined together, PT amounts to the sum of all exchanges in an economy. More specifically, Fisher's T included all exchanges of goods where his chosen meaning for a good was broadly defined as any sort of wealth or property. That's a pretty wide net, including everything from lettuce to publicly-traded equities to land.

Practically speaking, Fisher wrote that it was "utterly impossible to secure data for all exchanges" and therefore his statistical approximation of T was limited to the quantities of trade in 44 articles of internal commerce (including pig iron, rice, hogs, boots & shoes), 23 articles of import and 25 of export, sales of equities, railroad freight carried, and letters through the post office. This mishmash of items included everything from wholesale goods to securities to and consumption goods. Using Fedwire transactions to track total spending is very much in the spirit of Fisher, since any sort of transaction can be conducted through the interbank payments system, including financial transactions.

Nowadays we are no longer taught the Fisherian transactions version of the equation of exchange MV=PT but rather the income approach, or MV=PY. What is the difference between the two? Y is a much smaller number than T. This is because it represents GDP, or only those goods and services that are qualified as final, where "final" indicates items bought by a final user. T, on the other hand, includes not only the set of final goods and services Y but also all spending on second hand goods, stocks and bonds, existing homes, transfer payments, and more. Whereas GDP measures final goods in order to avoid double counting, T measures final and intermediate goods, thus counting the same good twice, thrice, or even more if the good changes hands more often than that.

A good illustration of the difference in size between Y and T is to chart them. The total yearly value of Fedwire transactions, which are about as good a measure of PT that we have (but by no means perfect), exceeds nominal GDP (or PY) by a factor of 40 or so, as the chart below shows. Specifically, nominal GDP came in at $17 trillion or so in 2013 whereas the total value of Fedwire transactions clocked in at $713 trillion.

So why do we focus these days on PY and not Fisher's PT? We can find some clues by progressing a little further through the history of economic thought to John Keynes (is it a travesty to omit his middle name?). In his Treatise on Money, Keynes was unimpressed with Fisher's cash transactions standard, as he referred to it, because PT failed to capture the most important human activities:

Human effort and human consumption are the ultimate matters from which alone economic transactions are capable of deriving any significant; and all other forms of expenditure only acquire importance from their having some relationship, sooner or later, to the efforts of producers or to the expenditure of consumers.

Keynes proposed to "break away from the traditional method" of tabulating the total quantity of money "irrespective of the purposes on which it was employed" and focus instead on the narrow range of trade in current consumption and investment output. Keynes's PY measure (the actual variables he chose was PO where O is current output) would be a "more powerful instrument of analysis than their predecessor, when we are considering what kind of monetary and business events will produce what kind of consequences."

And later down the line, Milton Friedman, who renewed the quantity theory tradition in the 1950s and 60s, had this to say about the shift from PT to PY:

Despite the large amount of empirical work done on the transactions equations, notably by Irving Fisher and Carl Snyder ( Fisher 1911 pp 280-318, Fisher 1919, Snyder 1934), the ambiguity of the concept of "transactions" and the "general price level", particularly those arising from the mixture of current and capital transactions—were never satisfactorily resolved. The more recent development of national income accounting has stressed income transactions rather than gross transactions and has explicitly and satisfactorily dealt with the conceptual and statistical problems of distinguishing between changes in prices and changes in quantities. As a result, the quantity theory has more recently tended to be expressed in terms of income rather than of transactions

So there are  evidently problems with PT, but what are the advantages? Assuming we use Fedwire transactions as the proxy for PT (and again, Fedwire is by no means a perfect measure of T, as I'll go on to show later) the data is immediate and unambiguous. It doesn't require hordes of government statisticians to laboriously compile, recompile, and check, but arises from the regular functioning of Fedwire payments mechanism. There are no revisions to the data after the fact. And rather than being limited to periods of time of a month or a quarter, there's no reason we couldn't see Fedwire data on a weekly, daily, or even real time level of granularity if the Fed chose to publish it.

Even Keynes granted the advantages of PT data when he wrote that the "figures are available promptly without the necessity for any special calculation." In Volume II of his Treatise, he took U.S. "bank clearings" data (presumably Fedwire data), and tried to remove those transactions arising from financial activity by excluding New York City, the nation's chief financial centre, thus arriving at a measure of final spending that came closer to PY.

What are the other advantages of PT? While PT counts second-hand and existing sales, might that not be a good thing? Nick Rowe, writing in favour of PT, once made the point that it's "not just new stuff that is harder to sell in a recession; it's old stuff too. New cars and old cars. New houses and old houses. New paintings and old paintings. New furniture and antique furniture. New machine tools and old machine tools. New land and old land." As for the inclusion of financial transactions, anyone who thinks asset price inflation or deflation is an important property of the economy (Austrians and Austrian fellow travelers no doubt) may prefer PT over PY since the latter is mute on the subject.

I'd be interested to hear in the comments the relative merits and demerits of PY and PT. Why don't the CNBC talking heads ever mention Fedwire, whereas they can spend hours debating GDP? Why target nominal GDP, or PY, when we can target PT?

For now, let's explore the Fedwire data a bit more. In the figure below I've charted the total value of Fedwire transactions (PT) for each quarter going back to 1992. I've overlaid nominal GDP (PY) on top of that and set the initial value of each to 100 for the sake of comparison.

It's evident that the relative value of Fedwire transactions has been growing faster than nominal GDP. However, the financial crisis put a far bigger dent in PT than it did PY. Only in the last two quarters has PT been able to break to new levels whereas nominal GDP surpassed its 2008 peak by the second quarter of 2010. Is the financial sector dragging down PT? Or maybe people are spending less on used goods and/or existing homes?

Fedwire data is further split into price and quantity data. Below I've plotted the number of transactions, or T, completed on Fedwire each quarter. On top of that I've overlaid real GDP, or Y. The initial value of real GDP has been set to 16.6 million, or the number of transactions completed on Fedwire in 1992.

After growing at a relatively fast rate until 2007, the number of transactions T being carried out on Fedwire continues to stagnate below peak levels. In fact, last quarter represented the lowest number of transactions since the first quarter of 2012, a decline that coincided with the atrocious first quarter GDP numbers.

Finally, below I've plotted the average value of Fedwire transfer by quarter. On top of that I've overlaid the GDP deflator. To make comparison easier, I've taken the liberty of setting the initial value of the deflator at the 1992 opening value for Fedwire transaction size.

As the chart shows, the average size of Fedwire transfers really took off in 2007, peaked in late 2008 then stagnated until 2013, and has since re-accelerated upwards. In fact, we can attribute the entire rise in the quarterly value of transactions on Fedwire (the second chart) to the growth in transaction size, not the quantity of transactions. Fedwire data is telling us that inflation of the PT sort has finally reemerged.

A few technical notes on the Fedwire data before signing off. As I've already mentioned, Fedwire provides a less-than complete measure of PT. To begin with, it doesn't include cash transactions (GDP does, or at least those that have been reported). This gap arises for the obvious reason that cash transactions aren't conducted over Fedwire. Nor do cheque transactions appear on Fedwire, or at least they do so only indirectly. Check payments are netted against each other and canceled, with only the final amounts owed being settled between banks via Fedwire, these settlements representing just a tiny fraction of the total value of payments that have been conducted by check over any period of time.

The same goes for securities transactions. Fedwire data underestimates the true amount of financial transactions because trades are usually netted against each other by an exchange's clearing house prior to final settlement via Fedwire. The transfer of reserves that enables the system to settle represents a small percent of the total value of trades that have actually occurred.

Another limitation is that Fedwire data doesn't include wire payments that occur on competing payment systems. Fedwire isn't a monopoly, after all, and competes with CHIPS. I believe that once all CHIPS payments have been cleared, final settlement occurs via a transfer of reserves on Fedwire, but this final transfer is a fraction of the size of total CHIPS payments. And finally, payments that occur between customers of the same bank are not represented in the Fedwire data. This is because these sorts of payments can be conducted by a transfer of book entries on the bank's own balance sheet rather than requiring a transfer of reserves.

I'm sure I'm missing other reasons for why Fedwire data undershoots PT, feel free to point them out in the comments. Do Fedwire's limitations cripple its value as an indicator PT? I think there's still some value in looking at these numbers, as long as we're aware of how they might come up short.

Some links:
1. Canadian Large Value Transfer System Data, the Canadian equivalent to Fedwire
2. A paper exploring UK CHAPS data,the British equivalent to Fedwire: Income and Transactions Velocities in the UK

* 'Real time' means that payments are immediate and not subject to delay, while 'gross settlement' indicates that payments are not grouped together for processing but submitted individually upon being entered. Fedwire gets its name from the beginning of the last century, when payments were carried out over the wires, or the telegraph system. 

Scott Sumner vs. the Real Bills Doctrine

This is a guest post by Mike Sproul. Mike's last guest post is here.

Scott Sumner and I have argued about the backing theory of money (aka the real bills doctrine) quite a bit over the years, starting in 2009 and continuing to the present. (link 1, link 2, link 3, link 4, …) Scott rejects the backing theory, while I favor it. I think that printing more money is not inflationary as long as the money is adequately backed, while Scott thinks that printing more money causes inflation even if it is adequately backed. Our discussions in the comments section of his Money Illusion blog extend well over 50 pages, so I’m going to try to condense those 50+ pages into two key points that cover the main arguments that Scott and I have had over the backing theory. (That’s John Law on the right. He was an early proponent of the real bills doctrine, oversaw a 60% increase in French industry in the space of two years, and was the architect of the western world’s first major hyperinflation and stock market crash.)

The key points:
1. Scott thinks that the liabilities of governments and central banks are not really liabilities.

For example:

“In what sense is cash a liability of the Fed? I thought once we left the gold standard the Fed was no longer required to redeem dollars?” (July, 2009)

“Dollar bills are not debt. The government is not required to redeem them for anything but themselves. That's not debt.” (August, 2009).

It would be cheating if I were to point out that the Federal Reserve’s own balance sheet identifies Federal Reserve notes (FRN’s) as the Fed’s liability, and that a large chunk of the Fed’s assets are classified as “Collateral Held Against Federal Reserve Notes”. Scott already knows that. It’s just that he thinks that the accountants are wrong, and that FRN’s are not a true liability of the Fed or of the government.

Scott’s argument is based on gold convertibility. On June 5, 1933, the Fed stopped redeeming FRN’s for a fixed quantity of gold. On that day, FRN’s supposedly stopped being the Fed’s liability. But there are at least three other ways that FRN’s can still be redeemed: (i) for the Fed’s bonds, (ii) for loans made by the Fed, (iii) for taxes owed to the federal government. The Fed closed one channel of redemption (the gold channel), while the other redemption channels (loan, tax, and bond) were left open. For example, suppose that 10% of FRN’s in circulation were originally issued in exchange for gold, 20% of FRN’s were originally issued on loan, another 30% were given to the federal government, which spent them on office buildings, and the remaining 40% of FRN’s were issued in exchange for bonds. That would mean that 90% (=20+30+40) of circulating FRN’s could be redeemed through the loan, tax, and bond channels alone. Only after those channels were used up and closed would it matter whether the Fed re-opened the gold channel. Assuming that the Fed still cared about maintaining the value of the dollar, the Fed would finally have to start using its gold to buy back the remaining 10% of FRN’s in circulation. But as long as the loan, bond, and tax channels remain open, the mere suspension of gold convertibility does not make FRN’s cease to be the liability of the Fed or of the government.

So Federal Reserve Notes are a true liability, whether or not they are gold-convertible. And like any liability, they are valued according to the assets backing them, just like the backing theory says. In the case of a gold-convertible currency, this is not disputed by Scott or anyone else. For example, as long as the Fed maintained gold convertibility of the dollar at $1=1 oz, it would not matter if the Fed held assets worth 100 oz as backing for $100 in FRN's, or 300 oz worth of assets as backing for $300 in FRN's. The quantity of convertible FRN's can be increased by any amount without affecting their value, as long as they are fully backed. Once we understand that both convertible and inconvertible FRN's are a true liability of the Fed, it is easy to see that the quantity of inconvertible FRN's could also be increased by any amount, and as long as the Fed's assets rose in step, there would be no effect on the value of the dollar. (There is a comparable result in Finance theory: that the value of a convertible call option is equal to the value of an inconvertible call option.)

2. Scott thinks that if the central bank issues more money, then the money will lose value even if the money is fully backed.

For example:
“ That’s where we disagree. I think open market operations have a huge impact on the price level, even if they involve the exchange of assets of equal market value.” (April 2012)

“ I understand what the backing theory says, I just don’t think it has much predictive power. Nor do I think it matches common sense. If you increase the monetary base 10-fold, prices will usually rise, even if the money is fully backed.” (July, 2009)

The problem with supposing a 10-fold increase in the monetary base is that we must ask how and why the money supply increased. If the new money was not adequately backed, then I agree that it would cause inflation. So if every dollar bill magically turned into ten dollar bills, or if helicopters showered us with newly-printed dollar bills, or if the Fed issued billions of new dollar bills in exchange for worthless bonds or worthless IOU’s, then Scott and I would both expect inflation. It’s just that I would expect inflation because the quantity of Federal Reserve Notes was outrunning the Fed’s assets, while Scott would expect inflation because the quantity of FRN’s was outrunning the quantity of goods being bought with those FRN’s.

But if the Fed issued billions of new dollars in exchange for assets of equal value, then I’d say there would be no inflation as long as the new dollars were fully backed by the Fed’s newly acquired assets. I’d also add a few words about how those dollars would only be issued if people wanted them badly enough to hand over bonds or other assets equal in value to the FRN’s that they received from the Fed.

This is where things get sticky, because Scott would once again agree that under these conditions, there would be no inflation. Except that Scott would say that the billions of new dollars would only be issued in response to a corresponding increase in money demand. So while I’d say that there was no inflation because the new money was backed by the Fed’s new assets, Scott would say that there was no inflation because the new money was matched by an increase in money demand. It seems that for every empirical observation, he has his explanation and I have mine. We are stuck with an observational equivalence problem, with neither of us able to point to an empirical observation that the other guy's theory can't explain.

But what if the Fed lost some or all of its assets while the quantity of FRN’s stayed constant? The backing theory would predict inflation because the Fed would have less backing per dollar, and the quantity theory would predict no inflation, since the same number of dollars would still be chasing the same amount of goods. It looks like we finally have a testable difference in the two theories. But here again, it’s easy for both Scott and me to get weaselly. If inflation happened in spite of Scott’s prediction, he could answer that money demand must have fallen. If my expected inflation failed to materialize, I could answer that the government stands behind the Fed, so any loss of assets by the Fed would be compensated by a government bailout. Empirical testing, it turns out, is hard to do. But at least I can claim one small victory: Scott is clearly wrong when he says that the backing theory doesn't have much predictive power. It obviously has just as much predictive power as Scott's theory, since every episode that can be explained by Scott's theory can also be explained by my theory.

Scott is also wrong to claim that the backing theory doesn't match common sense. Clearly, it makes perfect sense. Everyone agrees that the value of stocks and bonds is determined by the value of the assets backing them, and the backing theory says, very sensibly, that the same is true of money. Actually, it's when we start to use our common sense that the backing theory gains the advantage over the quantity theory. There are many aspects of the quantity theory that defy common sense, but I'll focus on four of them:

(i) The rival money problem. When the Mexican central bank issues a paper peso, it will get 1 peso’s worth of assets in return. The quantity theory implies that those assets are a free lunch to the Mexican central bank, and that they could actually be thrown away without affecting the value of the peso. This free lunch would attract rival moneys. For example, if US dollars started being used in Mexican border towns, then the Mexicans would lose some of their free lunch to the Americans. As the dollar invaded Mexico, the demand for pesos would fall, and the value of the peso would fall with it. More and more of the free lunch would be transferred from Mexico to the US, until the peso lost all value. If the quantity theory were right, one wonders how currencies like the peso have kept any value at all.

(ii) The counterfeiter problem. If the Fed increased the quantity of FRN’s by 10% through open-market operations, the quantity theory predicts about 10% inflation. If the same 10% increase in the money supply were caused by counterfeiters, the quantity theory predicts the same 10% inflation. In this topsy-turvy quantity theory world, the Fed is supposedly no better than a counterfeiter, even though the Fed puts its name on its FRN’s, recognizes those FRN’s as its liability, holds assets against those FRN’s, and stands ready to use its assets to buy back the FRN’s that it issued.

(iii) The currency buy-back problem. Quantity theorists often claim that central banks don’t need assets, since the value of the currency is supposedly maintained merely by the interaction of money supply and money demand. But suppose the demand for money falls by 20%. If the central bank does not buy back 20% of the money in circulation, then the quantity theory says that the money will fall in value. But then it becomes clear that the central bank does need assets, to buy back any refluxing currency. And since the demand for money could fall to zero, the central bank must hold enough assets to buy back 100% of the money it has issued. In other words, even the quantity theory implies that the central bank must back its money.

(iv) The last period problem. I’ll leave this one to David Glasner:

“For a pure medium of exchange, a fiat money, to have value, there must be an expectation that it will be accepted in exchange by someone else. Without that expectation, a fiat money could not, by definition, have value. But at some point, before the world comes to its end, it will be clear that there will be no one who will accept the money because there will be no one left with whom to exchange it. But if it is clear that at some time in the future, no one will accept fiat money and it will then lose its value, a logical process of backward induction implies that it must lose its value now.”

Taken together, I think these four problems are fatal to the quantity theory. Scott is welcome to bring up any problems that he thinks might be similarly fatal to the backing theory, but it will be a tough job. It’s easy to make the quantity theory fit the data. It’s harder to reconcile it with common sense.

---

Addendum: Scott Sumner responds.And Mike Freimuth comments. Over at Scott's blog, Mike Sproul writes a rejoinder to Scott. And now David Glasner has chimed in.

Short Squeezes, Bank Runs, and Liquidity Premiums

This is a guest post by Mike Sproul. Many of you may know Mike from his comments on this blog and other economics blogs. I first encountered Mike at the Mises.com website back in 2007 where he would eagerly debate ten or twenty angry Austrians at the same time. Mike was the first to make me wonder why central banks had assets at all. Here is Mike's website. 

On October 26, 2008, Porsche announced that it had raised its ownership stake in Volkswagen to 43%, at the same time that it had acquired options that could increase its stake by a further 31%, to a total ownership stake of 74%. The state of Lower Saxony already owned another 20% stake in VW, so Porsche's announcement meant that only 6% of VW's shares were in “free float”, that is, held by investors who might be interested in selling.

Porsche's buying had inflated the price of VW stock, and investors had been selling VW short, expecting that once Porsche's buying spree ended, VW shares would fall back to realistic levels. Short sellers had borrowed and sold 12.8% of VW’s outstanding stock, but with free float now down to 6%, short sellers owed more shares than were publicly available. If the lenders of those shares all at once demanded repayment of their shares, then there would be 12.8 buy orders for every 6 shares available. In what was called “the mother of all short squeezes” share price rose until the short sellers went broke.

A short squeeze is bad news for financial markets, largely because the fear of short squeezes deters short selling, and thus inhibits the normal arbitrage processes that keep securities correctly priced. If I may make a suggestion to the owners of the world's stock exchanges, there is a simple way to prevent short squeezes from happening on your exchange: Allow cash settlement of all short positions, just like in futures trading. If the most recent selling price of VW was 250 euros, and if short sellers suddenly find no shares available, then allow those short sellers to pay 250 euros in cash (plus some small penalty) to the lenders of the shares, rather than having to return an actual share of VW. This would prevent the stampede to buy VW, and would assure that VW’s price would not skyrocket to crazy levels. (As a measure of short-squeeze mis-pricing, it is worth noting that VW briefly became the world's most valuable company at the height of the short squeeze.)

Short squeezes on stock exchanges are mercifully rare. Unfortunately they are not quite as rare in the banking world, where they go by the name of bank runs. Just as a short squeeze pushes short sellers to hand over more shares of VW than can be obtained on the market, a bank run pushes banks to hand over more currency than can be obtained on the market. And just as short squeezes can be mitigated by allowing cash settlement, so can bank runs be mitigated by allowing banks to settle their obligations in forms other than currency. Clearinghouses and other banking associations can issue loan certificates or scrip for use in clearing checks, or even for public use as currency. Some creativity might be required in the issuance of money substitutes, but in return banks are spared from having to sell their assets at distress prices, while the community is spared from the effects of a bank panic.

What I find most interesting about short squeezes and bank runs is that they are a clear case of market failure, where financial instruments are obviously trading above the value of the assets backing them. During a short squeeze, value is no longer determined by backing, but by the forces of supply and demand. I don't think that economists pay enough attention to this point. The price of financial securities is normally determined by the underlying assets, while the price of commodities is determined by supply and demand. When economics textbooks explain supply and demand, they speak of the supply and demand for apples and oranges or other commodities. They rarely if ever speak of the supply and demand for stocks and bonds, because stocks and bonds are not objects of consumption, and they are not produced using scarce resources. There is no production function and no consumption function, hence there are no supply or demand curves. When we examine a bond that promises to pay $105 in 1 year, we find the price of that bond by dividing 105/(1+R). If R=5% and we tried to sketch supply and demand curves for that bond, we would draw a pair of meaningless curves that were both horizontal at $100. This is what makes short squeezes so strange. The price of VW stock is supposed to be determined by backing, and not by the supply and demand for VW shares. But during a squeeze, supply and demand take over, and stocks trade at a premium relative to their backing. The same might be true of money during a bank run.

This is a problem that JP and I have batted around a bit. I usually argue that arbitrage prevents money from trading at a premium relative to its backing, while JP usually argues that money can trade at a small premium. I can never pin him down on the size of the premium, but he doesn't argue much when I throw around a figure of 5%. Well, here we have VW stock trading at a premium of 500%. Might such a premium be possible for money?

Apparently not. We never see comparably large premiums on currency during bank runs. Gerald Dwyer and Alton Gilbert (Bank Runs and Private Remedies, May/June, 1989) examined American banking panics that occurred between 1857 and 1933, and found that the largest paper currency premium (relative to certified checks) ever observed during bank panics was 5%. The average paper currency premium during bank panics was much lower, only about 1%. Other measures of a currency premium, such as a rise in the value of money relative to goods in general (i.e., deflation), are also in the modest range of 1-5%. Why the enormous gap, from a 1% premium on currency to a 500% premium on VW stock? My best explanation is that banks can get creative in devising alternate forms of payment, while the traders in VW stock simply did not have the time or the legal means to devise alternate forms of payment. Thus the market in VW stock failed catastrophically, while banks facing a run are able to muddle through.

The result of the banks' muddling with money substitutes is that even during stressful events like bank runs, the value of money is, at most, only 5% higher than its fundamental backing value. This makes sense, because any premium over backing value gives an arbitrage opportunity to investors. If the fundamental backing value of each dollar is 1 oz. of silver, and if the dollar somehow trades at 1.05 oz., then the issuer of that dollar earned a free lunch of .05 oz. This free lunch would attract issuers of rival moneys, and rival moneys would keep being created until each dollar traded at its fundamental value of 1 oz.

The idea that money is worth no more than the assets backing it is consistent with finance theory, and with the backing theory of money, but it contradicts the quantity theory of money. The quantity theory asserts that modern fiat money has no backing, that it is not the liability of its issuer, and that its entire value is therefore a monetary premium. Which of the two theories gives a better fit to real-life moneys? When we look around for moneys that fit the quantity theory, that have no backing and are not anyone's liability, we find very little. Just bitcoin and a few orphaned currencies like the Iraqi Swiss Dinar. When we look around for moneys that fit the backing theory, that are the recognized liability of their issuer, and are backed by their issuer's assets, we find every other kind of paper and credit money that has ever existed. I conclude that the backing theory beats the quantity theory.

The three lives of Japanese military pesos

1942 Japanese Invasion Philippines Peso with a JAPWANCAP Stamp

In his reply to Mike Sproul, Kurt Schuler brings up the question of the determination of the value of a very peculiar kind of money: military currency. Curious, I investigated one example of such money, Japanese-issued "invasion money" in Philippines both during and after World War II. As best I can tell, the mechanism by which the value of these military notes has been mediated has gone through three different phases, each of them teaching us something interesting about money.

In January 3, 1942, a few weeks after successfully invading Philippines, the Japanese Commander-in-Chief announced that occupying forces would henceforth use military-issued currency as legal tender. Notes were to circulate at par with existing Philippines "Commonwealth" Pesos. Since this military scrip was not directly convertible into existing pesos, the trick to get it to circulate at par can probably be found in the tersely titled proclamation Acts punishable by death which, among seventeen acts that could result in loss of life, listed the thirteenth as:

(13) Any person who counterfeits military notes; refuses to accept them or in any way hinders the free circulation of military notes by slanderous or seditious utterances.

This is a great example of a Warren Mosler fiat money. According to Mosler, the state's requirement that citizens discharge their tax obligation with a certain intrinsically worthless medium on pain of being shot in the head is sufficient to give that medium a positive value. Likewise, requiring citizens to use the same medium in the course of regular payments and accept it to discharge debts, all on pain of death, would probably have promoted a positive value for intrinsically worthless paper.

Over time, those bits of "forced" paper will enjoy constant purchasing power as long as the issuer withdraws excess currency or adds it when desired. This is the quantity theory of money.

By 1943, however, it seems that the Japanese occupying forces, now being pushed back by the Allied forces, were desperately issuing excess notes to pay for operations. The Filipino monetary system proceeded to run smack dab into Gresham's law. The unit of account, the peso, was defined in terms of two different media—original pesos and military pesos. This meant that debtors could choose to discharge their debts with either. However, if one was perceived to be more valuable than the other, this superior medium would be hoarded and the inferior one used to pay off the debt. Legacy pesos had completely disappeared from circulation by 1943—only war pesos were being used to discharge debts and pay for goods, a decent indicator that the value of Japanese invasion pesos had fallen below that of original pesos. Bad money had chased out the good. (See [1] and [2] for evidence of Gresham's law)

Through 1944 and 1945, the war peso would endure extreme inflation. 10P had been the largest denomination in 1942. The military introduced 100P, 500P, and 1000P notes in subsequent years. In Neil Stephenson's Cryptonomicon, a wide-ranging historical/science fiction novel filled with monetary themes, there's an interesting passage in which Japanese soldier Goto Dengo describes the use of military scrip, probably sometime in 1943 or 1944:

The owner comes over and hands Goto Dengo a pack of Lucky Strikes and a book of matches. "How much?" says Goto Dengo, and takes out an envelope of money that he found in his pocket this morning. He takes the bills out and looks at them: each is printed in English with the words THE JAPANESE GOVERNMENT and then some number of pesos. There is a picture of a fat obelisk in the middle, a monument to Jose P. Rizal that stands near the Manila Hotel.
The proprietor grimaces. "You have silver?"
"Silver? Silver metal?"
"Yes," the driver says.
"Is that what people use?" The driver nods.
"This is no good?" Goto Dengo holds up the crisp, perfect bills.
The owner takes the envelope from Goto Dengo’s hand and counts out a few of the largest denomination of bills, pockets them, and leaves.
Goto Dengo breaks the seal on the pack of Lucky Strikes, raps the pack on the tabletop a few times, and opens the lid.

Japanese invasion currency, already being well on its way to being repudiated, would become completely worthless upon Japan's unconditional surrender in 1945.

Well, not entirely valueless. The second chapter in the life of military scrip begins with The Japanese War Notes Claimants Association of the Philippines, or JAPWANCAP. Formed in 1953 on behalf of Filipinos left holding stranded quantities of worthless Japanese invasion money, JAPWANCAP's mission was to hold both the US and Japanese government's liable for the redemption of war currency (the US had also issued counterfeit Japanese military currency). So while pesos had been valued prior to the war's end upon pain of death, and their value regulated by limiting the quantity outstanding, those same pesos were now valued on the margin as a liability of their issuer. Given the possibility of redemption, an old invasion note was worth more than zero.

Was JAPWANCAP successful? While the case was heard in a United States Court of Claims in 1967, it was thrown out on a technicality, the statute of limitations having had passed. Put simply, the court would not hear a claim that had not been filed within six years of that claim first being accrued, and in JAPWANCAP's case many more years than that had already passed.

This makes one wonder, if Filipinos in 1953 were already convinced that Japanese invasion pesos were the liability of the issuer, and therefore redeemable in some quantity of yen or dollars, did that same motivation also lead them to originally accept new military pesos in 1942? To what degree was the initial acceptance of pesos driven by the threat of force (& subsequent changes in value regulated by their quantity), and to what degree was their value dictated by their status as a liability of a well-backed issuer? That's a question we can never be entirely sure of. But while the force/quantity theory story fits the facts, the liability story does too. The military peso's inflation, for instance, can be attributed to the rising quantity of money, but also to the increasing likelihood of Japan losing the war, a loser's liability's being worth far less than a winner's.

Which brings us to the third chapter in the evolution of Japanese military pesos. Nowadays you can buy the notes on eBay for a few bucks. Their value is no longer dictated by gunpoint, nor by their liability nature, but their existence as a unique commodity, much like gold, bitcoin, or some rare antique.

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To learn more, here is a paper called "Financing Japan’s World War II occupation of Southeast Asia"

Note: I will be posting sparsely over the next two months, probably once every two weeks.

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.

Google as monetary superpower — a parable

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

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

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

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

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

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

The manipulation of Google's returns shapes the price level 

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

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

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

What do Google open market purchases do?

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

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

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

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

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

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

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

Google QE is irrelevant...

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Open market purchases by the Fed

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

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

Manipulating the liquidity premium on Fed deposits

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

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

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

To sum up...

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

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

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

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

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

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

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

Why moneyness?

Here's why this blog is called Moneyness.

When it comes to monetary analysis, you can divide the world up two ways. The standard way is to draw a line between all those things in an economy that are "money" and all those things which are not. Deposits 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 etc etc.

Then you figure out what set of rules apply specifically to money and what set of rules apply to non-monies (and what applies to both). The quantity theory of money is a good example of a theory that emerges from this way of splitting up of the world. The quantity theory posits a number of objects M that belong in the relation MV=PY. Non M's needn't apply.

The second way to classify the world is to take everything out of these bins and ask the following sorts of questions: in what way are all of these things moneylike? How does the element of moneyness inhere in every valuable object? To what degree is some item more liquid than another? This second approach involves figuring out what set of rules determine an item's moneyness and what set determines the rest of that item's value (its non-moneyness).

Here's an even easier way to think about the two methods. The first sort of monetary analysis uses nouns, the second uses adjectives. Money vs moneyness. When you use noun-based monetary analysis, you're dealing in absolutes, either/or, and stern lines between items. When you use adjective-based monetary analysis, you're establishing ranges, dealing in shades of gray, scales, and degrees.

In general, the first way of dividing the world has been overrepresented in the history of monetary discourse. I'd weight its prevalence at around 90%. Take Keynes's General Theory. Almost the entire book uses the noun-based approach to monetary analysis, except for Chapter 17 (and a small bit in Chapter 23). It's only then that Keynes describes the idea of a liquidity premium that inheres in all assets:

the power of disposal over an asset during a period may offer a potential convenience or security, which is not equal for assets of different kinds, though the assets themselves are of equal initial value. There is, so to speak, nothing to show for this at the end of the period in the shape of output; yet it is something for which people are ready to pay something.

In my posts I try to do two things. First, I make my best effort to always speak in the under-represented language of moneyness, not money. Not that there's anything wrong in splitting the world into money and non-money. But any method of dividing the universe will determine what one sees. Reclassify the universe along different lines and a whole new world emerges. With most monetary economics having been conducted in terms of money, there's probably a lot we've never seen.

Secondly, I hope to remind people that while you can choose either of the two ways to classify the world, you need to be consistent when you use them. Don't switch arbitrarily between the two.

With that being said, here are a few posts that illustrate the idea of moneyness.

1. How bitcoin illustrates the idea of a liquidity premium
2. Shades of a liquidity premium peaking through in stock market prices
3. Adam Smith: taxes contribute to fiat's liquidity premium, they don't drive its value

Explaining Stephen Williamson to the world (and himself)

Stephen Williamson catches a lot of flack on the net. Some is undeserved, some is deserved, but a big chunk is probably due to the fact that he and his fellow New Monetarists have a communications problem. People don't understand what they're up to. So here's my attempt to bring Steve down to earth and explain to the world the importance of the research being done by him and his colleagues. I'll go about this by adding a bit of historical context. After a quick tour of the history of monetary thought, readers will be able to see where in the greater scheme of things the New Monetarists fit. Now Steve doesn't know much about the history of economic thought - he thinks it's unimportant. So in a way, I'm explaining not just Steve to the world, but Steve to Steve.