Turkey, Iran, and "gold for gas"

What should we make of the so-called "gold for gas" trade between Turkey and Iran?

Turkey depends on Iranian natural gas to produce a large part of its electricity. In normal times, the Turkish natural gas monopoly BOTAS probably would have paid for Iranian natural gas with euros or dollars. The transaction would have been settled through euro- or US-denominated accounts that both BOTAS and the the National Iranian Gas Company (NIGC) held at a bank in Europe. That's my guess, at least.

It's become dangerous for Iranian companies to keep accounts in Europe lest they be frozen. So the NIGC has probably opened an account at a Turkish bank like Halkbank, a large government-owned institution. BOTAS likely keeps an account there too. When natural gas gets delivered across the border, Halkbank settles the trade by crediting NIGC's account and debiting BOTAS's account.

What the heck does the NIGC do with all the Turkish lira it accumulates at Halkbank from gas sales? There's only so much Turkish stuff that Iranians need to buy. Converting it into dollars or euros and sending it to Europe is probably risky, if not impossible. One avenue open to the NIGC is to go to Istanbul's Grand Bazaar and buy gold with its stash of lira deposits, then ship this gold back to Iran. This explains the huge outflows of gold from Turkey starting in early 2012.

So assuming I've got the mechanics right, claims to the existence of outright gold-for-gas trade between Turkey and Iran are exaggerated. Turkey's natural gas purchases continue to be settled via the banking system, not by barter. The gold end of the trade is just the second leg of the round-trip.

Oddly, the value of gold flowing from Turkey to Iran represents far more than the value of natural gas flowing in to Turkey, implying that something else is at work. One explanation is that Turkey buys a lot of Iranian crude oil too. A temporary waiver granted by the US allows Turkish banks to settle Iranian oil trades. I'd bet that a lot of the deposits earned by Iranian institutions from oil sales are also being sold for gold at the Grand Bazaar.

Secondly, a large chunk of India's oil trade is settled in Turkey. Since 2011, Indian oil refiners have been opening euro-denominated accounts at Halkbank. They've used these accounts to credit the accounts of Iranian companies and banks, thereby paying for Indian oil imports. How useful are Turkish-domiciled euros? Can Iranian firms easily transfer them elsewhere in order to buy stuff? Probably not. My guess is that most international banks are hesitant to accept Turkish euros, especially if they're linked to Iranian trade. Buying gold and repatriating it may be the best way for Iranian companies get their hands on purchasing power.

Insofar as obeying US sanctions, there's nothing illegal in any of this. Turkey is allowed to buy as much natural gas from Iran as it wants, and the US waivers granted to Turkey and India allow oil trades to be cleared by Halkbank and other banks without sanction (see my previous post). Converting deposits into gold and shipping it back to Iran is hardly a dodge – it's a fallback towards an inferior medium of exchange. For Iran, in a world of bad payments options, gold is the least bad.

Nevertheless, various US senators want to put the kibosh on what they refer to as the "gold game". The idea here is to punish banks that settle Iranian natural gas trades by excluding them from the US banking system. Faced with this threat, Halbank and other Turkish banks would likely refuse to deal with NIGC and, as a result, the Turkey-Iran natural gas trade would collapse. Now, such an extreme outcome would be highly unlikely since Turkey depends on natural gas for electricity and Turkey is a US ally. Most likely the US would grant Halkbank some sort of waiver allowing it to keep accounts for NIGC as long as these accounts were monitored to prevent NIGC from purchasing gold.

Indeed, if you read the fine print of the Menendez-Kirk-Lieberman Sanctions on Iran document, it is stipulated that banks engaging in Iranian natural gas transactions will be exempted from being cut off from the US banking system "so long as the purchasing country holds the payment for Iran in an account to be drawn on for permissible trade." What qualifies as permissable trade will probably not include gold. If Menendez et al. passes into law, it'll probably reduce the outflow of Turkish gold. But if NIGC and BOTAS decide to skirt the banking system altogether and deal directly in gold and gas, then you'll really see the start of the "gold-for-gas" game.

From a "moneyness" perspecitve, here are my thoughts. The monetary blockade has increased the liquidity of gold, thereby building a larger premium into the gold price. Any return to a more normal situation ie. Iran clearing trades again via the USD clearing and settlement system, will hurt gold's moneyness and lower the gold price.

What is a non-monetary economy?

The response to the above question will usually be a barter economy. But I want to show you that this is a tougher question than it seems. The answer depends on whether you're starting from a money view of the world or a moneyness view. (See Why Moneyness? in which I explain these ideas).

1. The money view, which is the standard view, begins by classifying all things in an economy into either money (M) or non-money. Any economy that has M in it is a monetary economy. All exchange in a monetary economy is achieved by trading non-money into M and back into a different non-money. When there is no M, then a non-monetary economy is said to exist. In a non-monetary economy, exchange occurs by trading non-money for non-money, our word for this being barter. So a non-monetary economy is a barter economy.

2. Things are different from a moneyness perspective. An isolated household living in a cave values their inventory of goods solely for its use-value—how each good satisfies the household's needs. The household's goods become liquid the moment that it realizes that other people are willing to exchange for them. Their inventory is now worth more to them than before because it provides them with a greater range of options. As once-isolated households trade with each other, goods will be graded according to their relative liquidities. Depending on its ranking, each good earns a smaller or larger premium over use-value. ie. a liquidity premium. Liquidity/moneyness don't exist in a world without trade. We call such a state autarky.

So depending on one's method of classifying the world, a non-monetary economy can be either a barter economy or an autarkic economy.

This conclusion may seem somewhat odd at first. Take what we would typically consider to be a barter economy, say a world in which people barter deer for beaver. This setup is actually monetary in nature, insofar as both deer  and beaver earn a monetary premium for their potential to be bartered. In other words, its possible to start monetary analysis way before we ever exit from so-called barter.

$42.22: Not quite the meaning of life, but a number worth remembering

One of the more archaic features of the US monetary system is that the price of gold continues to be set at $42.22. Ever wondered why that is? This post will work through some monetary history to show why, unlike most countries, the US doesn't mark the gold price to the market price of $1750 or so. I'll give a quick hint. Marking the gold price to market wouldn't be a mere cosmetic change—rather, it would require the Federal Reserve to hand over hundreds of billions of free money to the President. Here's how it all works.

The Fed currently holds 261 million ounces of gold. At the archaic price of $42/oz, this stash is valued at a mere $11 billion. With modern day gold trading at $1750, the market value of 261 million oz is actually $457 billion. Doesn't that mean that the Fed would show a huge mark-to-market gain if gold were revalued?

No. If you read the fine print, the Fed doesn't actually own gold ounces. Rather, it owns gold certificates that have been issued to it by the Treasury. There is a long history behind this. At the end of 1933, the Fed owned some 195 million ounces comprised entirely of physical gold. Valued at the then official price of $20.67, this stash would have been worth around $4 billion. The Gold Reserve Act, passed on January 30, 1934, required the Fed to transfer all of this gold to the Treasury in return for $4 billion worth of gold certificates.

Here's the kicker. Unlike most gold certificates, the ones issued by the Treasury to the Fed were not payable in a fixed quantity of physical gold. Rather, a $10,000 gold certificates simply promised to pay to the bearer $10,000 worth of gold.

Let's trace what happened the very next day. On January 31, 1934 the official price of gold was increased by the authorities from $20.67 to $35 per ounce. The Fed's certificates, which the day before had provided a claim to $4 billion worth of gold held at the Treasury, still provided the same $4 billion claim. But with gold having been revalued, $4 billion worth of gold certificates was now the equivalent of a mere 115 million ounces, far less than the day before when these same certificates could lay claim to 195 million ounces.

So by tweaking the gold price, the Treasury had "transferred" itself some 80 million ounces (195m less 115m) from the Fed. Valued at $35/oz, this 80m oz amounted to $2.8 billion. Using its newly-acquired 80 million ounces as collateral, the Treasury printed up fresh gold certificates, brought these certificates to the Fed, and had the Fed issue it $2.8 billion in newly printed currency.

Back in 1934, $2.8 billion was a lot of money. The Treasury would go on to use these funds to create the Exchange Stabilization Fund (ESF), a reserve fund that the Treasury uses to this day to circumvent congressional oversight over spending.

Let's zoom forward in time. The US revalued gold from $35 to $38 in May 1972, and again in February 1973 to $42.22. This is the price which stands today.

Just as in 1934, the benefits of a modern revaluation would accrue entirely to the Treasury. At the official price of $42.22, the Fed’s $11 billion worth of gold certificates currently lay claim to 261 million ounces of gold ($11b divided by $42.22). Say the official gold price was increased to $1750. The Fed’s certificates would still be worth $11 billion in gold, but these certificates would now represent a claim on a measly 6.3 million ounces of gold, far less than the current 261 million ounces.

After our hypothetical revaluation, around 255 million ounces (261m less 6.3m) sitting in Treasury vaults would be free and unencumbered. The Treasury might choose to just sit on its new treasure trove. But most likely it would proceed directly to the Fed without passing go, deposit $450 billion worth of gold certificates (255m oz. x $1750), and receive in return a massive $450 billion stash of Federal Reserve notes or deposits.

This odd result has created what I think is one of the more amusing equilibriums in monetary politics. Hard money types would like nothing more than to see their favorite asset, gold, revalued. But they don't actively pursue the idea because of the expansionary effects a revaluation would have on the Fed's balance sheet. Easy money types would like nothing more than to see the government get billions in free cash, but don't like the idea of the barbaric metal getting a leg up. The upshot is that gold stays valued at its archaic price of $42.22.

The always tedious US debt ceiling season is upon us, so don't expect this blog to be the only one to point to gold revaluation or other various loopholes as a way to hack the limit. The folks at MMR, I see, have come up with an odd trillion dollar platinum coin idea. In any case, by drawing attention to either of these loopholes don't assume that I'm recommending them.

The great monetary injection debate of 2012

1563, Bruegel the Elder
"Therefore is the name of it called Babel; because the Lord did there confound the language of all the earth"

This post is written for people in 2013 or 2014 who decide to have a debate on the importance (or not) of monetary injection points. This debate already transpired in early December 2012 across multiple blogs. Rather than starting from scratch, here's a bibliography.

The debate kicked off with Scott Sumner's response to this article by Sheldon Richman. From then on, in no particular order, are these posts:

Scott Sumner
It really, really, really doesn’t matter who gets the money first—part 2
You can start talking about Cantillon effects as soon as central banks start buying bananas
A voice of reason from the comment section
If I buy T-bonds, their price rises. If the Fed buys T-bonds, their price (usually) falls

Bob Murphy
Scott Sumner and I Have a Failure to Communicate
Resolution of the Sumner/Richman Showdown
You Might Be Talkin to a Market Monetarist If…
I Have a Deal for JP Koning, Scott Sumner, and Nick Rowe
Clarification on Cantillon Effects
Bill Woolsey Replies on Cantillon Effects
One More on Cantillon for 2012

Nick Rowe
Cantillon effects and non-SUPER-neutrality = does fiscal policy matter?
Defending Hayek against the Austrians

Bill Woolsey
Sumner on Injection Effects
Injection Effects and the Quantity Theory
Selgin on Cantillon Effects

Steve Horwitz
Sumner, Murphy, Richman, and Cantillon Effects

George Selgin
Sumner v. Cantillon

David Glasner
Those Dreaded Cantillon Effects

Daniel Kuehn
On Cantillon Effects
It's the rational expectations, stupid

JP Koning
Richard Cantillon on Cantillon Effects

Gene Callahan
Golden Meteors and Cantillon Effects

Kurt Schuler
Cantillon effects in Africa

If I've missed any other blogs, please post them in the comments section.

What was the final conclusion from all this debate? I haven't the foggiest clue. Unfortunately there's no final arbiter on blog wars. But since this is my blog, I'll go ahead and attach my final thoughts.

I'm only going to respond to the exact comment from Richman that set the debate off:

First, the new money enters the economy at specific points, rather than being distributed evenly through the textbook “helicopter effect.” Second, money is non-neutral. Since Fed-created money reaches particular privileged interests before it filters through the economy, early recipients—banks, securities dealers, government contractors—have the benefit of increased purchasing power before prices rise. Most wage earners and people on fixed incomes, on the other hand, see higher prices before they receive higher nominal incomes or Social Security benefits. Pensioners without cost-of-living adjustments are out of luck.

Say the Fed announces that rather than buying bonds from traders as it normally does, tomorrow it will inject new money by purchasing goods in shops. Upon the injection announcement, savvy traders will quickly bit up financial asset prices to offset the anticipated money injection. Goods prices, on the other hand, do not immediately get updated because shopkeepers don't pay much attention to Fed announcements. So even though shops will be the first to receive the new money tomorrow, shop keepers cannot purchase a larger real quantity of IBM or Google shares—these prices having already adjusted. So the uneven distribution created by new money has little to do with where money is injected. Even if shopkeepers receive the money first, it is the owners of flex-priced assets like IBM shares who will enjoy increased purchasing power—at least until all prices in the economy have adjusted to the new equilibrium.

[Updated with new links]

Aggressive US monetary policy... in Iran

Whenever we think of US monetary policy we usually think of the Fed. There's another side to US monetary policy, and its probably just as significant.

Being part of the worldwide US dollar clearing & settlement system means having access to the world's most liquid payments medium: the US dollar-denominated bank deposit. As long as a nation's banks are connected to this network, goods that are produced in that nation will be infinitely more saleable. On the other hand, being cut off from it means that the same goods will be a lot tougher to move. The Iranian monetary blockade illustrates the US Treasury's ability to use banishment from the USD network, or the threat thereof, to exert incredible influence over the world.

Network view of cross-border banking, IMF, Minoiu and Reyes (2011) PDF

To see how this works we've got to understand how the worldwide US dollar deposit clearing system functions. Let's start at the periphery of the network. An Iranian bank (call it "Persian Bank") lets Iranians keep USD deposits and transfer them amongst each other. These trades clear on the books of Persian Bank. The US Treasury is powerless to prevent Persian Bank from doing a local USD business.

What happens if an Iranian customer want to receive USD from a French company to pay for Iranian oil?

To facilitate this transaction, Persian Bank needs to set up a what is called a correspondent banking relationship with a non-Iranian bank at the centre of the network. A Persian Bank exec flies to London and opens a USD account at "London Bank", a large multinational bank. As long as our French company's bank  – we'll call it "Paris Bank" – also has a USD account at London Bank, then the entire transaction can be conducted on London Bank's books. Paris Bank simply tells London Bank to transfer the appropriate quantity of USD deposits from its account to Persian Bank's account. Back in Iran, Persian Bank credits the USD account of the Iranian customer. At the same time, Paris Bank debits the USD account of the French company. The oil can now be sent.

Here's how the monetary blockade works. The US Treasury issues an ultimatum to London Bank. There's nothing that we can do to stop you from clearing USD trades on your books for Iranian banks, the Treasury says, but if you do so, you'll have to close your accounts at "New York Bank", a large US institution.

London Bank is in a pickle. The reason it keeps an account at New York Bank is so that it can transact the US side of its business. Assume that US importers keep their accounts at New York Bank and debit these accounts to pay for imported goods. London Bank's account at New York Bank allows it to settle trades between US importers and its European exporting clients. If London Bank is forced to close its New York Bank account, it can't partipate in US trade anymore.

For London Bank, the choice is easy. It will cease dealing with Iranian banks altogether since the cost of losing US business is far larger than the cost of losing Iranian business. The upshot is that in threatening to banish London from the US, the US Treasury can force London to banish Iran from the worldwide USD network.*

The removal of Iranian banks from the international USD clearing system has meant that it's infinitely tougher for Iranians to sell their crude. To get around the banking blockade, we here stories about Iran reverting to barter. But this has been insufficient to prevent Iran's economy from entering what seems to be recessionary territory.

This certainly jives with monetary theories of the business cycle. Milton Friedman, for instance, wrote that the Great Depression was caused by the Fed providing insufficient liquidity to the banking system. Rather than conduct massive open marker operations, it tightened. As the Depression worsened, we saw the emergence of barter and alternative payment schemes. Even Irving Fisher became an advocate of these systems, publishing Stamp Scrip in 1933. Because it has been caused by a lack of liquidity, Iran's recession is very much a monetary one. It will only get out of the recession if it is able to derive alternate payment schemes that make Iranian products as liquid as before, or if the US lets it back into the worldwide US dollar clearing & settlement network.

*the actual ultimatum given by the US Treasury is not an all-or-none ultimatum. As long as countries show some evidence of having reduced Iranian oil imports, the US Treasury grants a temporary waiver that allows banks in importing nations to continue to settle oil transactions made by Iranian banks. To date, all importers of Iranian oil have complied by reducing imports. This means that the Treasury hasn't had to act on its threat of sanctioning banks that do business with Iranian banks.

Richard Cantillon on Cantillon Effects

There's a dustup between market monetarists and Austrians over Cantillon effects. See Nick Rowe, Scott Sumner, Bill Woolsey, and Bob Murphy. What are Cantillon effects? One definition is the effect that a change in the money supply has on the real economy due to where money is injected. Rereading Cantillon, I think its better to define the effect he is writing about as the influence that a change in the money supply has given that people are incapable of anticipating that change.

Cantillon wrote in a world in which huge discoveries of gold in the Americas had steadily increased the price level. We know that if people perfectly anticipate the arrival of new gold, all prices will immediately rise. Cantillon thought somewhat differently. According to him, the initial discovery of gold would go unnoticed by people:

It is also usually the case that the increase or decrease of money in a state is not perceived because it comes into a state from foreign countries by such imperceptible means and proportions that it is impossible to know exactly the quantity which enters or leaves the state.

Il arrive aussi d'ordinaire qu'on ne s'apperçoit pas de l'augmentation ou de la diminution de l'argent effectif dans un Etat, parcequ'il s'écoule chez l'Etranger, ou qu'il est introduit dans l'Etat, par des voies & des proportions si insensibles, qu'il est impossible de savoir au juste la quantité qui entre dans l'Etat, ni celle qui en sort.

In his paper on Richard Cantillon, Michael Bordo echoes this:

In Cantillon’s work, the dynamic path of adjustment of relative prices, output, the interest rate, and specie flows depends on the expectations of agents in the various markets. This emphasis on expectations presages much of modern monetary theory. It is unclear exactly how expectations are formed in his scheme but the frequent examples of agents catching on slowly suggests that they are formed adaptively. Moreover, the repeated examples of people being fooled suggests that the availability and cost of information is an important aspect of Cantillon’s scheme. Such an emphasis antecedes modern macro theories of disequilibrium.

Cantillon then goes on to describe how unanticipated gold inflows would first be spent on food, forcing up food prices and the earnings of farmers. Farmers in turn employ more land, forcing up land prices. While all prices have now adjusted to the change in the money supply, during the adjustment period landowners are relatively disadvantaged since the price of their product is the last to increase.

While we don't have to agree with Cantillon's ordering of effects, it seems uncontroversial to assume that if expectations only adapt slowly, then there will be some sort of distributional effect during the adjustment period to an unanticipated change in the money supply. There can certainly be debate over the size and consistency of this effect. Austrians, for instance, build a business cycle theory out of it. Others consider the effect to be ephemeral.

On the other hand, if rational expectations are assumed from the start, then the location of gold's injection point is moot since everyone perfectly anticipates the repercussions and adjusts. In talking about injection points under rational expectations, it seems to me that market monetarists are having a totally different conversation than Austrians, who are interested in injection points under imperfect expectations. Is this just a debate over the nature of expectations? I see that Bryan Caplan has made the same point.

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

Shades of a liquidity premium peaking through in stock market prices

In my other life, I analyze the stock market. I always find it interesting when the stock market reveals its often hidden monetary nature. The common assumption is that monetary analysis should be confined to a narrow range of coins, dollar bills, central bank reserves, and bank deposits. But this ignores the fact that all valuable things in an economy have a degree of liquidity, including stocks.

A stock's price can be decomposed into a "fundamental" component and a liquidity component. Fundamental value arises from a stockholder's right to receive any distribution of the assets of a corporation. The liquidity component is the premium on top of fundamental value that arises from the owner's ability to easily sell that stock. Knowing that a stock can be easily sold provides the owner with a degree of comfort that would otherwise be lacking if the stock was less saleable, or not saleable at all. This "comforting service" is built into the stock's price as a liquidity premium.

While in theory we can determine a stock's monetary nature by subtracting its fundamental value from its price, in practice this is almost impossible to do. Computing fundamental value is more art than science. Nevertheless, we can get indirect evidence of the existence of a liquidity premium by comparing different share classes issued by the same company. In Canada, it's common for large family-owned corporations to issue non-voting and voting shares. The family controls the company by holding 51% of the voting shares while the public holds the balance of the voting and all the non-voting shares. Both voting and non-voting shares rank pari passu, meaning they receive the same claim on the company's assets.

Given these properties, we'd expect the market price of voting shares to be equal-to or greater-than the price of non-voting shares. After all, since everything else about the two classes is equal, having a vote can only add to the value of a share.

The chart below shows the voting and non-voting share price of a major publicly-traded Canadian retailer. Below the price is the premium/discount on the non-voting shares. At the bottom are relative volumes traded.

Now it's evident from the chart that our hypothesis doesn't hold. For long periods of time, the non-voting shares of our retailer have traded above the voting shares. What might explain this? One reason is that non-voting shares are far more liquid than the voting shares. Just look at the much higher trading volumes in the non-voting shares. From 2008 to 2010, shareholders valued the liquidity bonus of non-voting shares more highly than the element of corporate control provided by voting shares. In other words, the perceived benefits provided by the liquidity of the non-voting shares caused their liquidity premium to balloon to the extent that non-voting share prices rose above voting share prices.

Why doesn't the non-voting share premium get arbitraged away? Well, the comfort that liquidity provides is a very real service, not a mistaken bit of irrationality that can be ironed away. A highly-liquid share is like a fire extinguisher - even if it's not being used, just having it there makes you feel better. So while buying cheap voting shares and short-selling expensive non-voting shares may seem like a risk-free arbitrage, it isn't. After all, if the market decides to put an even higher value on the liquidity services provided by the non-voting shares, then non-voting's liquidity premium will grow even more and the trade will lose money.

While risk-free arbitrage can't shrink a stock's liquidity premium, there are indirect forces that ensure the premium stays thin. The larger a firm's liquidity premium, the lower its cost of capital. After all, if you need to raise money, having a larger liquidity premium means that you needn't issue as many shares. Because a low cost of capital is a boon, firms will try to replicate the success of competitors who have attracted a large liquidity premium. They may do so by pursuing similar lines of business or marketing their shares to the same group of shareholders. This will have the effect of drawing trading activity away from shares with large liquidity premiums to those without, thereby destroying the underpinnings of that large premium.

All of this plays into the ongoing bitcoin discussion between Mike Sproul and I. While Bitcoin might have some negligible fundamental, or non-monetary, value due to its value as a curio, its liquidity premium is surely huge. There is no way to arbitrage this premium away directly, but over time competitors will peck away at it, causing bitcoin's price to deteriorate back to its fundamental value, which I'd guess is <$1.

Discussions of the medium-of-account could be more well-done

Nick Rowe, Scott Sumner, and most recently, David Glasner, all say that the US's current medium of account is the dollar. I disagree. I think that the current medium of account is CPI units. Here's why.

First, there's been some sloppiness with definitions in the links above, so let's define the term. The medium of account is whatever defines the unit of account. I think this a pretty standard definition. That's Bill Woolsey's definition here. David echoes this definition in his comment here.

Take an old-style central bank that holds 100% gold reserves in its vault. It chooses the word "dollar" to stand as the unit of account. The bank then goes on to define the dollar as equal to x grains of gold. Thus the medium of account is gold. Our central bank issues paper notes which are to be used as the medium of exchange. Shopkeepers post prices in terms of the unit of account, the dollar, and accept notes as payment. Some shopkeepers might even choose to post prices in grains of gold rather than the dollar unit of account. If they do, this won't affect the fact that gold remains the medium of account.

Inspired by the Bank of Canada, our 100% gold bank chooses to sell all its gold for bonds. Next it chooses to redefine the value of the dollar as an idealized basket of consumer goods that declines in size by 3% a year. It threatens to do open market operations in a manner that ensures that its definition sticks.

What has changed? Shopkeepers continue posting prices in the unit of account, the dollar. Notes issued by the central bank are still the medium of exchange. But the definition of the dollar, the medium of account, has changed from a quantity of gold to a gradually shrinking quantity of consumer goods.

Some shopkeepers might even post prices in terms of this imaginary basket of goods. When shoppers arrive at the till to pay, they obviously can't hand over CPI baskets. Rather, the shopkeeper will download the central bank's most recent CPI-to-dollar ratio and quote the customer their final price in terms of notes, the medium of exchange.

To sum up, in moving from a fully-reserved gold bank to a modern CPI targeter, all that's happened is that our central bank has changed the medium of account from gold to CPI. Nick has to understand where I'm coming from since I'm just using the same technique he used in this post.