We'll miss that Mark Carney squint

Mirroring Nick Rowe, here are some quick comments on the departure of Mark Carney from the Bank of Canada to the Bank of England.

Canadian monetary policy is set via an ongoing conversation between the Prime Minister, his/her agent the Minister of Finance, and the Governor of the Bank of Canada. This joint conversation happens because unlike Japan, Europe, or the US, the Finance Minister has the legislated power to fire the Governor of the BoC before his/her term is up. The minister must provide a public (and potentially embarrassing) explanation for doing so. As a result both minister and governor are incentivized to cobble policy jointly.

So whatever policy we've had in Canada since 2008, you can be sure that there's a bit of PM Harper and Finance Minister Jim Flaherty mixed in with the Carney. Did we ever really know the man? With Carney leaving but the other two sticking around, will there be much of a difference going forward?

As for the UK, Carney's term at the BoE runs for five years, but as far as I can tell there seems to be no ability to remove him from power before then. Without this leash, Bank of England watchers will be more likely to see an unadulterated version of  Carney than we ever saw here in Canada.

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.

Another liquidity-premium sighting - Harrison and Kreps

The word "moneyness" is synonymous with liquidity-premium. Both refer to that portion of an item's value that is derived from an individual's ability to sell it in the future.

I wrote about bitcoin's liquidity premium here, and here I talked about how QE affects the liquidity premium of the targeted asset.

Since it happens so rarely, it's always fun to see the idea of liquidity premiums pop up in academic literature. I was recently reading an old interview with Thomas Sargent in which he describes himself as “a Harrison-Kreps-Keynesian.” Here is Harrison and Kreps's paper (pdf), and here is the money quote:

We say that investors exhibit speculative behaviour if the right to resell a stock makes them willing to pay more for it than they would pay if obliged to hold it forever. This phenomenon will not occur in a world with one period remaining (as in the capital-asset-pricing model), in a world where all investors are identical, or in a world with complete and perfect contingency claims markets.

That's as good a description of a liquidity-premium as they come. Keynes was an early adopter of the idea of a liquidity premium, and presumably that's why Thomas Sargent is willing to call himself a Keynesian, at least in the Harrison-Kreps-Keynesian sense.  Another gem:

...investors attach a higher value to ownership of the stock than they do to ownership of the dividend stream that it generates, which is not an immediately palatable conclusion from a fundamentalist point of view... we suggest that this line of reasoning might lead to a "legitimate" theory of technical analysis.

What gold's negative lease rate teaches us about the zero-lower bound

When people talk about gold, they usually talk about the gold price. But there are a few other key gold market metrics that often go unmentioned. The chart below stacks the gold price on top of the gold forward rate (GOFO), LIBOR, and the lease rate. The gold lease rate is an interest rate. Just as you can lend your cash to a bank at the bank's deposit rate, you can lend your physical gold to a bank at the lease rate.

Understanding GOFO and the lease rate is important not only for gold bugs, but for anyone who wants to get a good grasp of the phenomenon of interest rates. GOFO and the gold lease rate demonstrate that interest rates are not phenomena solely confined to paper assets. The ability for an investor to lease their gold and earn an interest return makes up part of gold's peculiar "own-rate". All commodities have own-rates. From our perspective as consumers, we rarely get to see these markets, but they do exist. I've illustrated them in the following chart:

Go to this scribd link for a high res version if you want to understand how GOFO, LIBOR, and the lease rate interact.

One thing you may have noticed from the chart is that gold's three month lease rate (at bottom) is negative. Back in November 2011 the one month lease rate fell to a record low of -0.5%. Now anyone familiar with the idea of the zero-lower bound may find this surprising. Interest rates aren't supposed to be able to fall below 0%. If they do, people will simply redeem the underlying 0% yielding asset and store it themselves. Why keep gold on loan to a bank only to pay a -0.5% penalty when you can withdraw it and keep it under the mattress for free? Yet the market was willing to bear negative lease rates.

The reason for this oddity is that as the yellow metal's price rises, it becomes ever more attractive to robbers. One ounce to a robber at $300 is tempting, but not as tempting as that same ounce at $1750. So it costs more to insure gold. Secondly, storing gold is somewhat costly. Do you hide it under granny's bed, or do you buy a home safe for it? At which point do you rent a vault at a bank? Anecdotal evidence suggests that banks specializing in gold storage have been running out of space over the last few years, implying rising storage costs.

In a nutshell, that's why people haven't withdrawn their gold as lease rates have turned negative. In keeping their gold on loan to the bank rather than bringing it at home, they avoid all the headaches of storage costs, insurance, and the fear of theft, yet still get exposure to gold price appreciation. The negative lease rate is the fee they pay in order to have someone else incur all these headaches.

Like the gold market, the currency market also has the capacity to bear a negative interest rate. If the rate on bank deposits falls to say -0.25%, depositors would likely keep their cash on loan to the bank since storing it at home or in a vault is costly. How low can deposit rates fall before people start to withdraw cash? -1%? -2%? Cash, after all, is thin and light, surely easier to store than gold. One way to prevent cash redemption at negative deposit rates is to make cash storage costly. If someone wants to withdraw $100,000 in cash, make them take it all in $5 bills. The high cost of storing low denomination bills will get anyone to reconsider withdrawal. I've discussed the idea of varying redemption denominations here.

So as the gold market shows, the zero-lower bound is a soft bound, not a hard one. As for all you gold bugs out there, I'll write more about negative lease rates sometime soon.

Scott Sumner: Damned if markets are efficient, damned if they're not

Last week I wrote a post that attempted to dehomogenize Scott Sumner from Krugman. I left a similar but more precise comment on Bob Murphy's blog. Sumner seemed to endorse it. But there's something that doesn't make sense.

Open market operations can really only have an effect if markets are not efficient. Yet Sumner is a great believer in efficient markets (as commenter Max notes on RM's blog). See Scott here and here. How can Sumner reconcile those two positions?

First, some definitions. I'll define efficiency as the idea that financial assets trade in the market at the discounted value of their future cash flows. Any deviation from this value will be fleeting as investors arbitrage it away. Another word for discounted value is fundamental value.

Here's the logic for why open-market operations need an inefficient market to work.* Say reserves are currently plentiful and yield 0%. Twenty-year 2% bonds are trading in the market at their fundamental value of $115 and an implied interest rate of about 1%. If the Fed announces it's going to buy a bunch of 20-year bonds, how can it increase their price above fundamental value? Any attempt to bid bond prices above $115 will cause rational traders to quickly sell every bond they own to the Fed so as to take advantage of the overvaluation. Bond prices don't change, nor does the 1% yield. Same goes for stocks and other assets. QE-style open market operations can't get a "bite" on asset prices.

But as market monetarists like to point out, even in today's environment of plentiful reserves, open market operations do seem to have an effect on asset prices. See Lars Christensen's chart, for instance. So if purchases have demonstratively pushed up asset prices, that means traders aren't selling those assets at their fundamental value, and therefore markets aren't efficient.

Ok, here's a way for Scott to have his cake and eat it to - he can be a believer in efficient markets and accept the relevance of open market operations. Let's redefine the efficient price of a some asset to be composed of not only its fundamental value (the discounted value of future cash flows), but also a liquidity premium. Assets have differing liquidity premiums depending on the expected ease of buying or selling them. Marketable assets have large liquidity premiums and, as a result, their efficient price is higher than if they were illiquid. It's worthwhile for rational traders to own liquid assets because in an uncertain world, the ability to sell or hypothecate some asset provides a set of options that an illiquid asset doesn't.

Having redefined efficient, when the Fed announces it will buy 20-year bonds, their fundamental value still doesn't change. Instead, the liquidity premium on 20-year bonds rises. After all, with the Fed wading into the pool, these bonds have become much more liquid. As a result, the efficient price of 20-year bonds will rise. In this way, prices can rationally diverge from their fundamental value without the assumption of efficiency being dropped. That's why open market operations can have bite, even in an environment like ours.

*I get this from Eggertson and Woodford, who get it from Neil Wallace, who got it from the efficient market crowd, Miller, Modigliani, and the rest.

Without proper balancing forces, Hans-Werner Sinn's "European ISA" will be destabilizing

(Disclaimer: this article is geeky. If you want to follow it, you should already know a bit about the European Target2 imbalances debate (here is a good intro) and have read my description of the US Interdistrict Settlement Account)

There is a tension involved in being a lender of last resort. Central banks are supposed to provide liquidity to solvent but temporarily illiquid institutions during a liquidity crisis. But they're not supposed to go as far as keeping bankrupt banks or governments alive. Hans-Werner Sinn’s proposal to import the Federal Reserve's Interdistrict Settlement Account (ISA) into the Eurosystem seems to me to be an attempt to impose on National Central Banks (NCBs) the discipline necessary to prevent them from crossing this almost transparent line.

But an ISA-type settlement mechanism in a European setting threatens to not only prevent NCBs from crossing the line; it could prevent them from fulfilling even their basic duty as lender of last resort. This would be dangerous. The very fear that an NCB is limited in acting as lender of last resort could lead to self-fulfilling runs on NCBs during crisis. Faced with the requirement of fulfilling its role of lender of last resort or meeting an ISA-type settlement requirement, it is likely that settlement will be sacrificed, resulting in an embarrassing loss of face and credibility to the Eurosystem as a whole.

Is the Federal Reserve’s ISA binding?

A large part of Sinn’s yearning for an ISA-style mechanism comes from the idea that “there is quite a penalty for District Feds that create and lend out more than their fair share of the monetary base. This is the reason why a TARGET-like problem has never arisen in the US to this day.” [source]

I disagree with him on his views on the ISA. While ISA settlement certainly imposes a constraint on district Reserve banks, it is a distant constraint. I call it distant because other “balancing” mechanisms (which I'll outline below) come prior to final settlement. As a result of these balancing mechanisms, district Reserve banks are unlikely to ever come close to settlement failure and therefore the ISA does not genuinely discipline them.

A hypothetical ISA settlement failure would happen if a district Reserve bank, in fulfilling its duty as lender-of-last resort, perpetually lent reserves to regional member banks facing crisis. If these newly-created reserves were to be moved to neighbouring districts, the district Reserve bank would be required to settle these capital outflows with ISA-permitted settlement media. In times past, gold was the settlement media, but nowadays it its System Open Market Account (SOMA) assets. All assets purchased by the Federal Reserve system in the open market are assigned to this account. Each district Reserve bank in turn receives an allocation of SOMA. Should the crisis be protracted and outflows continue, the district Reserve bank will eventually run out of SOMA assets and fail to settle its ISA debts.

But there is an important mechanism at work that prevents prolonged district Reserve bank loans to failing member institutions. In the US, insolvent banks are quickly shuttered and sold off by the Federal Deposit Insurance Corporation (FDIC). This is called bank resolution. Secondly, there are few regulatory barriers and certainly no cultural or linguistic boundaries to overcome when it comes to US bank mergers. A private bank in the Cleveland district can easily buy a weakened bank in the San Francisco district and vice versa.

Due to quick resolution and a relatively painless merger process, district Reserve banks need not lend to weak private member banks for extended periods of time. As a result, district Reserve banks don’t create the huge amounts of reserves that, when transferred to another district, might lead to an ISA settlement failure. Contrary to Sinn’s belief, the necessity of ISA settlement is only a distant constraint on district Reserve banks.

Potentially lethal problems with a European ISA

Sinn wants to graft an ISA-style mechanism onto the Eurosystem. The idea seems to be that if NCBs were to face a periodic day-of-reckoning that required the settlement of outstanding Target2 debts with real assets, then they would be dissuaded from incurring irresponsible debts in the first place.

I agree with Sinn on the idea of implementing some sort of Target2 settlement mechanism. Even Keynes, in devising his International Clearing Union, wrote:

Measures would be necessary to prevent the piling up of credit and debit balances without limit, and the system would have failed in the long run if it did not possess sufficient capacity for self-equilibrium to prevent this. Proposals for an International Currency (or clearing) Union, February 11, 1942

But there is a certain danger in implementing an ISA-style settlement mechanism without the same balancing mechanisms we see in the US. This danger arises because the settlement mechanism interferes with the lender of last resort role of NCBs. Acting as lender of last resort is a duty that all central banks must be left free to exercise. The famous line from Bank of England Director Harman on the quelling of the 1825 crisis comes to mind:

We lent it [pounds] by every possible means and in modes we had never adopted before; we took in stock on security, we purchased Exchequer bills, we made advances on Exchequer bills, we not only discounted outright, but we made advances on the deposit of bills of exchange to an immense amount in short, by every possible means consistent with the safety of the Bank, and we were not on some occasions over-nice. Seeing the dreadful state in which the public were, we rendered every assistance in our power.

As long as US-style balancing mechanisms exist —  both a quick resolution mechanism and the ability to freely merge banks  —  it is unlikely that an NCB, in discounting freely, will create the incredible volume of reserves that might lead to a European ISA settlement failure. But my understanding of European banking is that bank mergers are not easy (see pdf). Nor has a proper European wide resolution protocol been established. Perhaps readers can elaborate on this.

So let's imagine that Sinn’s plan to implement an ISA-style settlement mechanism is adopted without the balancing mechanisms I've previously mentioned. The next time a crisis hits, the NCBs will discount freely, as they should. They'll have to do a lot of it, since problem banks aren't being resolved, nor are they being merged. There will probably be capital flight from one country to another. This will bring the intra-Eurosystem settlement mechanism into play, requiring the transfer of settlement asset from debtor NCBs to creditor NCBs.

The problem is that as an NCB gets closer to settlement failure, depositors will flee ever faster to other European NCBs. Depositors will do this because they anticipate that settlement failure will lead to temporary inconvertibility of that NCB’s euroliabilities — better to get out while it's still possible, goes the thinking. This effect is perverse, since the very threat of settlement failure leads to the self-realization of settlement failure.

What does an NCB do when it hits Sinn’s settlement constraint? Does an NCB cease acting as the lender of last resort and settle? Or does it continue to lend and let settlement fail?

Relaxing the law is embarrassing

One of the lessons of monetary economics is that there are grave consequences to stepping aside as lender of last resort. Because of this, the most likely answer to the above question is that the law concerning Eurosystem settlement will be temporarily put aside to allow for continued lending.

There is a long tradition of setting law aside to allow for lender of last resort purposes. Peel’s Act of 1840 attempted to constrain credit creation by dividing the Bank of England into an Issue Department and a Banking Department. The Issue Department issued banknotes 100% backed by gold. The Banking Department issued deposits which were convertible into these notes. During a crisis, the Banking Department would be swamped with requests for notes. But Peel’s Act prevented the Issue Department from providing the Banking Department with bank notes. As a result, people grew even more anxious to withdraw existing notes from the Banking department, igniting a run. In order to save the Banking department from insolvency, during each crisis the government would issue a rather embarrassing public letter saying that the legal separation between the two departments was temporarily null. As a result, the Issue department could lend notes to the Banking department, and the crisis ended.

Much like the Bank of England of the 1800s, it would be embarrassing for the Eurosystem to adopt Sinn's ISA-style settlement mechanism only to have to publicly annul settlement each time a crisis hits and lender of last resort action is necessary. Far better to promote the emergence of strong balancing mechanisms like bank resolution and mergers, and only after that implement some sort of settlement mechanism. The former will dull the bite (and potential embarrassment caused by failure) of the latter.

PS. Karl Whelan is circulating a draft paper on Target2 and is looking for constructive criticism. I haven't commented on his paper in this post as I'm waiting for his final version. But drop by here to read & comment.

PPS. As a free banker, I don't support monopoly banking. I took off my free-banking hat to write this.

Central bank monetization doesn't have to be scary

David Beckworth has a good post pushing back against people who are pounding the Fed-is-monetizing-the-debt drums. His point was that there is no evidence of monetization. The Fed today holds roughly the same amount of government debt as a proportion of outstanding debt as it did in times past.

Accusations of monetization need to start out with proper definition of the term. To "monetize" means to turn into money. All banks engage in monetization, whether they be central banks or private banks. Banks monetize houses, debt, commodities and all sorts of other assets, issuing liquid liabilities in return. A credit card essentially monetizes your 30-day IOU. So to accuse a bank of "monetizing" is like accusing someone of breathing.

In conducting QE3 purchases, the Fed is currently monetizing government debt and agency-issued MBS. Is that bad? The Fed has to monetize something. Would people be happier if it was monetizing corporate bonds? Gold? Or do they simply want it to monetize at a slower rate?

There is a pejorative sense of the word monetize. It refers to a situation in which a bank monetizes an asset at a price that benefits the borrower. This is akin to a subsidy. In providing the subsidy, the bank grants the borrower (or issuer) more financing than the borrower otherwise deserves. When applied to the Fed, monetizing in its pejorative sense would seem to indicate that the Fed is subsidizing the government by pushing the government's borrowing rate below its fundamental rate, thereby allowing it to borrow even more. In other words, the price that the Fed is paying for government bonds is above their fundamental value.

Just because the Fed is monetizing government assets doesn't mean it is monetizing in the pejorative sense. As David points out, where's the proof?

Secondly, let's pretend that the Fed is monetizing government bonds in the pejorative sense. In providing this subsidy to the government, the Fed is earning less for itself. Say that this monetization continues until the Fed has negative capital. Typically, it is believed that a government implicitly guarantees to recapitalize the nation's central bank should it be insolvent. In this case, the government just returns to the Fed all the subsidies granted by the Fed. It's a wash, and monetization (in the pejorative sense) has had no net effects.

We need to be explicit about definitions and the relationship between the government and central bank when we talk about monetization.

The feeling of hyperinflation illustrated

I listened to a good Econtalk podcast last night with guest Steve Hanke. Few people in the world know as much as Steve does about hyperinflation. His catalogue of 56 hyperinflations (with Nicholas Krus) inspired me to do this chart. Most of us have been lucky enough not to have lived through hyperinflation. Here's what it might feel like if we did.

How bitcoin illustrates the idea of a liquidity premium

On November 15 @ 5:37 PM, Wordpress.com tweeted that it would be accepting bitcoin as payment. Over the next twenty-four hours, the price of bitcoin steadily rose on Mt. Gox, the major bitcoin exchange. See chart below.

This is a great illustration of the idea of a liquidity premium.

All assets carry a liquidity premium. This premium will be smaller or larger depending on an asset's ability to be easily bought and sold, or its liquidity. The idea of liquidity is straight from Carl Menger, who figured things out back in 1872 (pdf). Keynes also knew this, read Chapter 17 of the General Theory. (This is one of those great examples of Austrians and Keynesians agreeing). Other words for liquidity include saleability and marketability. In short, the more marketable an asset, the larger its liquidity premium, which in turn means a higher price. Illiquid assets have small premiums and lower prices.

In announcing the acceptance of bitcoin, Wordpress has added yet another avenue for the use of bitcoin. And Wordpress is not just any old site. According to Alexa, Wordpress.com is the world's 22nd in terms of traffic. Bitcoin is now more liquid, and as a result, its liquidity premium has increased by about 75 cents.

Why is liquidity worth something? The future is uncertain. Knowing that an asset you own can be readily sold should the need arise provides you with a degree of comfort. Thus liquidity shields you from the displeasure of uncertainty, and since highly liquid assets do more shielding than illiquid ones, you'll have to pay a larger premium for that benefit.

  So with the Wordpress announcement, bitcoin has become a slightly better hedge against uncertainty.  What happens if other large venues start accepting bitcoin? Bitcoin up.