Friday, December 12, 2014

Short selling and monetary theory


Jacob Little, legendary short seller.
The Great Bear of Wall Street
1794 - 186
This is a guest post by Mike Sproul







To understand short-selling, start with three words: “Borrow and sell.” The short-seller in figure 1 borrows a share of GM stock from a stockholder and then sells that share of stock to a buyer for $60 cash. If GM subsequently drops to $50, then the short-seller can buy a share of GM on the open market for $50, repay that share to the stock-lender, and profit $10. But if GM instead rises to $70, then the short-seller loses $10, since he must pay $70 to buy the stock before repaying it to the stock-lender.                                                                    





As the short-seller borrows one share of GM, he hands his IOU to the stock-lender. This IOU promises to deliver a share of GM stock. (It would also promise to compensate the stock lender for any dividends missed as a result of lending the stock.) Since the IOU can be redeemed for a genuine share, the IOU will be worth the same as a genuine share. This means that the stock lender does not have much reason to care whether he holds the genuine stock or the IOU (unless he cares about losing his voting rights in the corporation).


Figure 2 shows a simpler way to sell short. The short-seller simply writes up an IOU and sells it directly to a buyer. This kind of short sale gives the same payoff as the “borrow and sell” short sale of figure 1. If GM falls to $50, the short-seller gets a $10 profit, while if GM rises to $70, the short-seller loses $10. This method of short selling is so simple that it can happen by accident. Suppose you're a stockbroker, and a client calls asking you to buy one share of GM for him. You answer, “OK, you got it”, and hang up, planning to deliver the actual stock later in the day. You have just gone short, and you stand to gain $1 for every dollar the stock falls, while losing $1 for every dollar it rises.


A still simpler way to go short is to make a bet with someone, as shown in figure 3. The terms of the bet are that for every dollar GM falls, the buyer pays the short seller $1, while for every dollar GM rises, the short seller pays the buyer $1. The payoffs from this bet are the same as the other two methods of short selling. The bet shown in figure 3 is like a futures trade: There is no actual delivery of GM stock, and gains and losses are settled periodically, including adjustments for dividends. In contrast, the trade in figure 2 is like a forward trade: There is a promise to deliver GM stock, and gains and losses accumulate until the position is closed out.

Some common misunderstandings about short selling:

1. Are these IOUs counterfeit shares? Do they dilute the underlying stock and reduce its value?

No, no, and no. And never mind what Overstock.com CEO Patrick Byrne says. The short seller who issues the IOU puts his name on that IOU, recognizes the IOU as his liability, and stands ready to deliver a genuine share to the holder of the IOU. These are not the actions of a counterfeiter. But suppose there are 1 million genuine shares of GM stock in existence, and that short sellers have collectively issued 2 million IOUs. In a sense, the quantity of GM shares has tripled, and you might expect the share price to fall to 1/3 of its former level. But don't forget that GM did not issue the IOUs, and they are not GM’s liability. They are the liabilities of the short sellers. The issuance of IOUs through short sales does not affect the number of genuine GM shares, nor does it affect GM’s assets, so it can't affect share price. If short selling somehow did put share price out of line with the firm's actual value, then arbitragers would pounce. There will occasionally be liquidity crises when markets break down, stocks are hard to borrow or hard to buy, and arbitrage can't play its usual role; but in normal conditions, arbitrage assures that short selling does not affect share prices. Besides, short selling itself helps to keep markets liquid, and makes these liquidity crises less likely to occur in the first place.

2. What is a naked short?

In figure 1, a naked short would occur if the short seller failed to deliver the genuine share to the buyer within 3 business days. If this happens, the “borrow and sell” short of figure 1 reverts to the “forward style” short of figure 2. The buyer ends up holding the short seller's IOU, rather than the genuine share. If the short seller fails to deliver the genuine share even after an extended period, then the two traders could still settle up with each other in cash or other securities. The “forward style” short of figure 2 would thus revert to the “futures style” short of figure 3. If worse comes to worst and the short seller defaults, then either the stock exchange will make good the loss, or the traders will get a costly lesson in placing too much trust in their fellow man. Sometimes the SEC will step in, and traders will get an even costlier lesson in placing too much trust in the government.

Note that in all three methods of short selling, the dollar payoffs to both traders are identical. This highlights the futility of the numerous restrictions that governments place on short selling in general, and on naked short selling in particular. In the first place, any legal restriction on one type of short selling will only cause traders to switch to a different kind that is not so easily restricted. In the second place, studies show that when governments do succeed in suppressing short sales, markets become less efficient.

3. Short selling and money

When you buy a house, you borrow dollars and then sell those dollars for a house. This makes you short in dollars, just like borrowing and selling GM makes you short in GM (figure 1). Alternatively, you might buy that house by handing your IOU directly to the house seller. This would put you in a “forward style” short position in dollars (figure 2). If you are well known and trusted, then your IOU can actually circulate as money. But normally a bank would act as a broker between borrower and lender, and the bank would issue its own IOU (a checking account) in exchange for your IOU. The bank's IOU will circulate more easily than your IOU, so we commonly talk as if the bank has created money. This is not quite right because the bank is not short in dollars on net. The bank went short in dollars as it issued its IOU, but it took an offsetting long position in dollars when it accepted your IOU. The bank is therefore neutral in dollars, while the borrower is short in dollars. This is why it makes sense to say that borrowers are the original issuers of money, while the banks only help out by putting their name on the money.

It's reasonable to think that short selling of money is governed by the same principles that govern short selling of stocks. Specifically, the fact that short selling of stocks does not affect stock price makes us expect that short selling of money will not affect the value of money. I think this view is correct, but it puts me at odds with every economics textbook I have ever seen. The textbook view is that as borrowers (and their banks) create new money, they reduce the demand for base money, and this causes inflation. This is where things get weird, because the borrowers, being short in dollars, would gain from the very inflation that they caused! Nobody thinks this happens with GM stock, but just about everyone thinks that it happens with money.

If the textbooks are right, then the value of the dollar is determined by money supply and money demand, and not by the amount of backing the Fed holds against the dollars it has issued. For example, if the Fed has issued $100 of paper currency, and its assets are worth 30 ounces of silver, then the backing value of each paper dollar is 0.30 oz/$. But if the money supply and money demand curves intersect at a value of 1 oz/$, then the dollar will supposedly trade at a premium of 0.70 oz/$ over and above its backing value of 0.30 oz/$.

This is where short sellers pounce. They could borrow 10 dollars and sell them for 10 oz. of silver, as in figure 4. As they borrow dollars, the short sellers issue dollar-denominated IOUs that promise to repay $10 worth of assets (ignoring interest). These IOUs can either be used as money directly, or they can be traded for a bank's IOU, which could then be used as money. The proliferation of these IOUs will, on textbook principles, reduce the demand for the Fed’s paper currency, causing it to fall in value, let's say to 0.9 oz/$. Now the short sellers can repay their $10 loan with only 9 oz. of their silver, earning an arbitrage profit of 1 oz. (Note that they don't repay their loan with currency, since buying currency with silver would drive the dollar back up.). The short sellers profited from the inflation that they caused. As the short selling continues, the dollar will continue to fall until it reaches its backing value of 0.3 oz/$, at which point short selling is no longer profitable. (Reality check: Currency traders don't usually deal in silver. A more realistic scenario would have traders borrowing dollars and selling them for British bonds (denominated in pounds). This would reduce the monetary demand for dollars and the dollar would lose value, at which point the traders would swap their British bonds for depreciated US bonds, which they would use to repay their dollar loans.)


So here’s the problem with textbook monetary theory: If you think that money's value is determined by money supply and money demand, and that money trades at a premium over its backing value, then you'd have a hard time explaining how money holds its value in the face of speculative attacks by short sellers. You’d also have to wonder why central banks bother to hold any assets at all. But if you think that asset backing determines money's value, there's nothing to explain. Money's value is governed by its backing, just like stocks, bonds, and every other financial security, and short selling will not affect its value.

Sunday, December 7, 2014

On vacation since 2010


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

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

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

Worthwhile Canadian chart: The Bank of Canada overnight rate target

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

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

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

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

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

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

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

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

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

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

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

Saturday, November 29, 2014

Gold's rising convenience yield


While I may have taken some jabs at the gold bugs in two recent posts, please don't take that to mean that I have it in for the metal itself. Gold is a fascinating topic with a history that is well worth studying. (See this, for instance). In that vein, what follows is some actual gold analysis.

Something weird is happening in gold markets. The future price of gold (its forward price) has fallen below the current gold price. Now in fairness, this isn't an entirely new phenomenon. Over the last year or two, the price of gold one-month in the future has traded below the current, or spot price, a number of times. However, this observation has grown more marked as both the three-month and six-month rates have also recently fallen below the spot price.

This degree of inversion is rare. Except for a brief flip in 1999 when near-term forward prices fell below zero for a day or two, future gold has almost always traded for more than current gold. See chart below, which illustrates the one-month to twelve-month forward price premium/deficit in annual percent terms:


Here's why this pattern has dominated:

Gold's forward price indicates the level at which a buyer and seller will contract to exchange gold at some point in the future. The seller must be compensated for a number of costs they will incur in holding the gold until the deal's consummation, including: 1) taking out a loan to buy the gold and stumping up interest expenses; and 2) paying to store and insure it in a vault. Together, these are called carrying costs.

The buyer of future gold needs to compensate the seller for these costs. Rather than paying the seller an up-front fee, the buyer builds a premium into the price they pay for future gold in-and-above the current spot price, say $5. The future seller of gold can use this $5 premium to cover their carrying costs, thereby coming out even in the end. So future gold trades above spot gold by the size of its carrying costs.

The current inversion of spot and future gold prices seems to break all these rules. The premium that sellers have traditionally required has not only shrunk to 0 but become a deficit. Put differently, sellers of future gold are no longer demanding a compensatory fee for storing and financing the metal. In fact, they seem willing to provide these expensive services at a negative price!

One explanation for the inversion is that with interest rates being so low, the costs of carrying gold have become negligible. This is only party correct. Minuscule carrying costs would imply a future gold price that is flat relative to the current gold price, when in actuality future prices are below present prices.

That leaves only one explanation for the inversion: there is some sort of hidden non-pecuniary benefit to holding the stuff. In futures-speak, this benefit is typically referred to as a commodity's convenience yield, a term coined by Nicky Kaldor in 1939. An analogy to oil markets may be helpful. Oil prices often invert because merchants see potential for future supply disruptions. Having oil on hand during these disruptions is immensely useful as it  spares our merchant the hassle of negotiating his or her way though an oil supply chain that may be severely crippled while ensuring that customer demand is smoothly met. So the convenience yield can be thought of as a flow of relief, or uncertainty-shielding services, provided to owners of inventories of a commodity. If that relief is sheer enough, than the convenience yield will be larger than the twin costs of financing and storage, resulting in inverted markets. (For an excellent explanation of the convenience yield in oil markets, check out this Steve Randy Waldman post).

That's what appears to be happening in gold. Gold merchants seem to be anticipating choppiness in the future supply and demand of the metal, and see growing benefits in holding inventories of the stuff in order to cope with this choppiness. The convenience yield on these inventories has jumped to a high enough level that it currently outweighs the costs of storing and financing gold, resulting in an inverted gold market.

Gold's convenience yield spikes every every few years due to market disruptions, with the last spike occurring during the 2008 credit crisis, the one prior to that in 2001, and the one before that in 1999 when central banks announced plans to limit gold sales. It just so happens that these earlier disruptions occurred when U.S. interest rates were already high enough that they continued to outweigh the metal's suddenly-augmented convenience yield. Inversions were brief and only on the 1-month horizon. Now that a disruption is occurring when interest costs are near zero, a more sharply inverted market is the result, dragging the 3 and 6-month horizons into negative territory. Going forward, all gold market disruptions could very well create sharp inversions of -1 to -2% in the 1 to 12-month horizons, insofar as we are living in an era of permanently low interest rates.

Is gold becoming money?

A number of gold bugs see the current inversion as something quite momentous. To understand why, you need to know that a gold bug's nirvana is when gold is once again 'money'. When something is money, it is highly liquid. The beauty of owning a highly liquid medium is that it can be mobilized to deal with almost any disruption to one's plans and intentions. Put differently, the convenience yield on stored money is very high. One measure of a paper dollar's convenience yield is the interest rate a government-insured certificate of deposit. Locking away cash for, say, 24 months means that the owner loses all the benefits of its liquidity. With 24-month certificates of deposit currently yielding 0.34% a year, the value of those forgone conveniences is 0.34%.

So when a gold bug's dream becomes reality and gold overtakes the dollar, yen, pound etc. as the world's most-liquid exchange medium, that is the equivalent of saying that gold is providing investors with the market-leading monetary convenience yield. And a permanently high convenience yield would result in a permanently inverted gold market (or at least a much flatter one).

Is the current inversion an indication that gold is becoming money? I don't think so. If the augmented convenience yield on gold was in fact rising due to gold's liquidity having surpassed that of fiat money, we'd expect this to be reflected not only in near-term forward prices but along the entire horizon of forward prices. Not only should the 3-month forward prices be inverted, but so should the 3-year forward price. Is this the case? Not really. If you've seen Crocodile Dundee, I'd suggest you go and check out this hilarious post by Bron Suchecki illustrating the extent of gold's inversion. If you haven't seen the movie (you should), check out the chart below.


The first data point is the spot price. Gold forward prices are inverted after that, but only over a narrow range of five or six-months. By mid-2015, forward prices return to their regular pattern of trading at a premium to current prices.

So no, gold is not becoming money. Rather, we are running into some short-term jitters, and merchants think that holding the stuff provides a few more ancillary benefits than before.

Could these short-term supply & demand problems crescendo into longer-term problems, resulting in inversion beyond 2015? I don't think so. Unlike oil and most other commodities, the supply of mined gold is never used up. Ounces that were brought out of the ground by the Romans are still in existence. This means that supply disruptions should never pose a significant problem in the gold market since gold necklaces and fillings can be rapidly melted down into bars and brought to market. While we care if Saudi stops all oil production or if the U.S. corn harvest is terrible,  if South Africa ceases to produce gold—meh.

This means that the convenience yield on inventories of gold will almost always be less than the convenience yield on stocks of oil, since the sorts of disruptions in the gold market will always be shorter and less extreme than in oil markets. Oil supply shocks can be so sharp and enduring that oil's convenience yield remains elevated for long periods of time. The result is an inverted oil market over the entire time horizon. Such inversions are fairly common events in oil markets (once again, see Bron's post).

Gold shocks can never be enduring, so the types of price inversions we'd expect will be fleeting and only appear in the near-term time horizon. Like the one we are seeing now. In sum, we've seen this all before, and no, it's not the end of the world.

Sunday, November 23, 2014

Not your father's price index: the Billion Prices Project

The price of 52 Samsung TVs gathered by the BPP, April 2008 - November 2009 (Cavallo)

In a previous post, I mentioned that the Billion Prices Project (BPP) contradicts the claims of those who believe that the government understates inflation data. The BPP crawls major US retailers' websites and scrapes them for price data, compiling an overall US Daily Index that is available on its website. The deviation between this index and the official CPI is minimal, as the above link shows.

The BPP isn't your father's price index—it shouldn't be viewed as a perfect substitute for the CPI. So use it wisely. What follows are a few details that I've gleaned from several papers on the topic of online price indexes as well my correspondence with Roberto Rigobon, one of the project's founders.

The most obvious difference between it and the CPI is in the datasets:

1) Online vs offline: The price data to generate the CPI is harvested by Bureau of Labour Statistics (BLS) inspectors who trudge through brick & mortar retailers. Rigobon and his co-founder Alberto Cavallo get their data by sending out lightning fast algorithms to scrape the websites of online retailers.

2) Wide vs Narrow: BLS inspectors compile prices on a wide range of consumer goods and services. According to Cavallo, only 60% of the items that are in the CPI are available online. The ability to track service prices online is particularly limited given the fact that most large retailers' websites only sell goods.

Let's get into some more specifics about what is included in the BPP, because there seems to be some confusion about this in the online discussion. Some commentators have mentioned that the BPP doesn't include gasoline prices. Rigobon informs me that this is wrong, gas prices are included in the US Daily Index. As for the cost of housing, my understanding is the BPP does track real estate data. It incorporates these prices using the same methodology as the BLS. So any deviation between the BPP and CPI should not be attributed to the BPP's lack of either gas prices or housing.

Lastly, despite the fact that service prices are under-represented online, the BPP's US Daily Index does include a number of services. According to Rigobon, the easiest ones to track are things like health insurance, transportation, restaurants, hotel, and haircuts. Others are hard to track, like the cost of public education. My understanding is that Rigobon and Cavallo may use proprietary methods to calculate service prices by referring to various goods' prices as proxies (see here). For instance, in this BIS comment on the BPP, it is noted that the price of education can be computed from prices of text books, uniforms, energy and construction materials, all of which represent 75% of cost of education.

3) Often vs rare: The BPP's algorithms trawl retailer websites every day. BLS inspectors stroll through the malls just once each month.

Another big difference is in the publication of the data:

4) Now vs later: The BPP is reported three days after the data has been gathered, and ten days for non-subscribers. CPI is reported with a long delay, usually the second or third week following the month being covered.

The next few differences are a little more technical:

5) Fixed vs Responsive: Both indexes measure entirely different consumption baskets. The BLS surveys U.S. households every few years in order to gather information about their spending habits. It uses this information to construct a fixed representative basket of goods & services consumed by Americans, and then proceeds to fill in the data each month. This survey approach results in a CPI basket that takes time to adjust to new products. Should a revolutionary device, say a universal mind reader, suddenly becomes popular, it won't be reflected in the CPI till the next survey.

Think of the BPP as capturing a dynamic market-determined consumption basket. The BPP basket is comprised of whatever goods retailers happen to be selling online that day in order to meet customer demand. Because retailers are constantly updating their websites, August 7's basket could be different from August 8's. This means that new goods will be quickly incorporated into Rigobon and Alvarez's inflation calculation. In other words, when universal mind readers do catch on, the BPP will incorporate this data way before the BLS will.

One of the most interesting differences is the difference in methodology:

6) Small vs Large Sample size: The BLS delicately samples offline prices whereas the BPP bulldozes through a large percentage of the entire population of online retailers' prices.

There are millions of goods sold in the US, and it would be cruel to force BLS inspectors to collect prices for all of them. To simplify the calculation, the BLS brain trust chooses individual products to serve as ideal representatives for given product categories. Take dishwashers. To represent the category, they might select the Whirlpool WTD-10 or some such model. A BLS data collector in New York City will go every month to a specific store, say Macy's on West 34th St, and grab that specific model's price. The repetitive use of the same product and location ensures that the New York City dishwasher price index is not corrupted by changes that have little to do with purchasing power. (The alternating collection of prices from Macy's on West 34th and Nordstrom's on Union Square might introduce price changes having little to do with inflation.)

Because their algorithms are whip fast and don't require salaries, Alvarez and Rigobon can afford to send them out each day to Macy's website to gather the price of every single dishwasher. They do this for each of the major online retailers, say Walmart, Target, and Best Buy. The final assemblage of prices represents something close to the entire population of online US dishwasher prices on every single day!

This segues into the thorny problem of adjusting for quality changes. They both use different techniques:

7) Statistical vs market-based quality adjustments: As I pointed out, the BLS samples one good to represent a given category rather than canvassing the full range of products within that category. This causes some difficulties in accounting for quality changes when that one good is replaced by another product.

Let's return to the Macy's example. Say Macy's stops stocking the Whirlpool WTD-10. On arriving at Macy's a few weeks later, our flummoxed BLS data collector has to find a replacement in order to keep the dishwasher price category up to date. Let's say she grabs the price of a General Electric XK-400 from across the aisle. The GE is priced $50 higher than the missing Whirlpool was during the inspector's previous visit. The problem is this: how does the BLS determine how much of that $50 increase is due to changes in quality and how much is due to changes in inflation? If the GE is the same in every way to the Whirlpool except its boasts a turbo wash option, then some portion of the $50 increase is due to the higher quality of the GE. But how much?

Because Cavallo and Rigobon's tireless algorithms regularly retrieve multiple product prices for each category rather than single monthly representatives, they can use the overlapping nature of the data to seamlessly splice in new products. Let's say that the expensive GE dishwasher is introduced to Macy's website. It is sold on the same page as the existing and cheaper Whirlpool for a few days at which point the latter is removed. On the day the GE first appears, the BPP ascribes its higher price to its superior quality. While the GE drives up the average price of dishwashers on Macy's dishwasher page, the purchasing power of a Macy's shopper hasn't been altered, rather, a given dollar buys more 'dishwashing services' than before. Only on day 2, after the GE's price has been retrieved a second time by the algorithms, is it allowed to start affecting the index, since any price change thereafter is considered to be due to inflation, not quality.

The assumption that the GE's premium is due entirely to quality is based on the idea that market prices are accurate measures of all that is known by producers and consumers about a given set of products.

Because CPI collectors have limited resources and typically only collect the price of one representative dishwasher, they usually can't rely on the overlap between dishwasher model prices to measure quality changes. One method they have developed to compute quality changes is hedonic regression. In brief, a dishwasher is conceptually broken up into a package of characteristics, including its size, time per run, energy efficiency, etc. When the Whirlpool is suddenly dropped by Macy's and the GE added, CPI data collectors try to determine what sorts of new characteristics have been incorporated in the GE and then use regression methods to determine the dollar value of that characteristic.

So to sum up, to calculate quality changes, the BPP piggy backs on the power of the market to price differences in quality. The BLS uses econometric methods (among other tools) to control for quality changes.

Here is a big one, the difference in ownership of the indexes:

8) Private vs public: The CPI is compiled by the BLS and funded by taxpayers, whereas Rigobon and Cavallo have incorporated a private company called Pricestats to compile the BPP US Daily index and its many other indexes. PriceStats work in partnership financial-giant State Street to distribute the data to paying subscribers.

Which leads into the last major difference:

9) Transparent vs opaque: There is loads of documentation on the CPI. If you have any questions, call up the BLS and a researcher will walk you through it—it's your right as a taxpayer. PriceStats can only reveal so much information because their methods are proprietary (although Dr Rigobon was kind enough to answer a number of my questions). I suspect they are hesitant to reveal too much of information because the retailers on which they have gathered data might view this as a potentially threatening action. Not so with the CPI.

So those are some of the features of each index. In the case of the BPP, the difficulty of getting public information on their methodology is probably the biggest bug, although the founders are forthcoming on general questions. Maybe if national statistics agencies start adopting BPP data collection methods, the transparency problem will be solved, since public agencies have no competitive reasons (and less legal ones) to hold back information on methodology. There seem to be rumblings in this direction: Statistics New Zealand says that they are in the early stages of a collaboration with with PriceStats to develop online price indexes (link).

For now the public is lucky to get access to the US Daily Index, even on a 10-day delay. When CPI numbers are reported, the bond market quakes. For hedge funds, getting a hint of what the upcoming government inflation print will be before anyone else is probably worth a lot of money. No doubt that's why they are willing to pay to subscribe to get PriceStat's numbers. These funds would probably prefer if the public were not privy to the US Daily Index as it reduces the information's value. The amount they'd be willing to pay PriceStats to yank the US Daily Index from the public domain would be a good indicator of the value the public gains by getting free access to it. It could be a substantial number.

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Back to initial reason for writing about the BPP; the gold bugs (Gulp, you thought I'd forgotten about you, right?). Your typical gold bug will sagely mention some esoteric price that has risen at an incredible rate over the last few years, like the price of shitaake mushrooms or a 1982 GI-Joe Snake Eyes collectors action figure (here is Peter Schiff using the Big Mac). A gold bug is convinced that their preferred data series is sufficiently strong evidence to justify declaring inflation to be stratospheric and the entire CPI null and void.


What makes gold bugs think that their one or two pet prices are a superior measure of the dollar's purchasing power than the BPP US Daily Index? Crickets. That sums up the gold bug response to the BPP's existence. If not crickets, then desperate attempts to change the subject.

Gold bugs don't like to talk about the BPP because they don't want to be dissuaded from their views—they find too much comfort in them. With the BPP continuing to move in line with the CPI, the gold bug community's cognitive dissonance is growing. At some point, the squirm-level will get large enough that they'll have to do something about it. No doubt the easiest route will be to come up with a fiction that discredits the BPP US Daily index. Well, hey gold bugs, here's a conspiracy theory you can use to save yourselves some painful cognitive dissonance... the Billion Prices Index went offline for a period of time, just when it appeared to be showing a break with the CPI index. When it went back online, the two started to converge. Could it be that Rigobon and Alvarez were brought into some FBI dungeon and re-programmed, the BPP moving more in line with the party line after they emerged? Yeah, that's it.

Saturday, November 15, 2014

Sign Wars


Does a lowering of a central bank's interest rates create inflation or deflation? Dubbed the 'Sign Wars' by Nick Rowe, this has been a recurring debate in the economics blogosphere since at least as far back as 2010.

The conventional view of interest rate policy is that if a central bank keeps its interest rate too low, the inflation rate will steadily spiral higher. Imagine a cylinder resting on a flat plane. Tilt the plane in one direction —a motif to explain a change in interest rates—and the cylinder, or the price level, will perpetually roll in the opposite direction, at least until the plane's tilt (i.e. the interest rate) has been shifted enough in a compensatory way to halt the cylinder's roll. Without a counter-balancing shift, we get hyperinflation in one direction, or hyperdeflation in the other.

The heretical view, dubbed the Neo-Fisherian view by Noah Smith (and having nothing to do with Irving Fisher), is that in response to a tilt in the plane, the cylinder rolls... but uphill. Specifically, if the interest rate is set too low, the inflation rate will jump either instantaneously or more slowly. But after that, a steady deflation will set in, even without the help of a counter-balancing shift in the interest rate. We get neither hyperinflation nor hyperdeflation. (John Cochrane provides a great introduction to this viewpoint).

Many pixels have already been displayed on this subject, about the only value I can add is to translate a jargon-heavy academic debate into a more finance-friendly way of thinking. Let's approach the problem as an exercise in security analysis.

First, we'll have to take a detour through the bond market, then we'll return to money. Consider what happens if IBM announces that its 10-year bond will forever cease to pay interest, or a coupon. The price of the bond will quickly plunge. But not forever, nor to zero. At some much lower price, value investors will bid for the bond because they expect its price to appreciate at a rate that is competitive with other assets in the economy. These expectations will be motivated by the fact that despite the lack of coupon payments, the bond still has some residual value; specifically, IBM promises a return of principal on the bond's tenth year.

Now there's nothing controversial in what I just said, but note that we've arrived at the 'heretical' result here. A sudden setting of the interest rate at zero results in a rapid dose of inflation (a fall in the bond's purchasing power) as investors bid down the bond's price, followed by deflation (a steady expected rise in its value over the next ten years until payout) as its residual value kicks in. The bond's price does not "roll" forever down the tilted plane.

Now let's imagine an IBM-issued perpetual bond. A perpetual bond has no maturity date which means that the investor never gets their principle back. Perpetuals are not make-believe financial instruments. The most famous example of perpetual debt is the British consol. A number of these bonds float around to this day after having been issued to help pay for WWI. When our IBM perpetual bond ceases to pay interest its price will quickly plunge, just like a normal bond. But it's price won't fall to zero. At some very low level, value investors will line up to buy the bond because its price is expected to rise at a competitive rate. What drives this expectation? Though the bond promises neither a return of principal nor interest payments, it still offers a fixed residual claim on a firm's assets come bankruptcy, windup, or a takeover. This gives value investors a focal point on which they can price the instrument.

So with a non-interest paying perpetual bond, we still get the heretical result. In response to a plunge in rates, we eventually get long term deflation, or a rise in the perpetual's price, but only after an initial steep fall.  As before, the bond's price does not fall forever.

Now let's bring this back to money. Think of a central bank liability as a highly-liquid perpetual bond (a point I've made before). If a central banker decides to set the interest rate on central bank liabilities at zero forever, then the purchasing power of those liabilities will rapidly decline, much like how the cylinder rolls down the plane in the standard view. However, once investors see a profit opportunity in holding those liabilities due to some remaining residual value, that downward movement will be halted... and then it will start to roll uphill. Once again we get the heretical result.

The residual claim that tempts fundamental investors to step in and anchor the price of a 0% yielding central bank liability could be some perceived fixed claim on a central bank's assets upon the bank's future dissolution, the same feature that anchored our IBM perpetual. Or it could be a promise on the part of the government to buy those liabilities back in the future with some real quantity of resources.

However, if central bank liabilities don't offer any residual value whatsoever, then we get the conventional result. The moment that the central bank ceases to pay interest, the purchasing power of a central bank liability declines...forever. Absent some residual claim, no value investor will ever step in and set a floor. In the same way, should an IBM perpetual bond cease to pay interest and it also had all its residual claims on IBM's assets stripped away, value investors would never touch it, no matter how low it fell.

So does central bank money boast a residual claim on the issuer? Or does it lack this residual claim? The option you choose results in a heretical result or a conventional result.

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What does the data tell us, specifically the many cases of hyperinflation? As David Beckworth has pointed out, the conventional explanation has no difficulties explaining the Weimar hyperinflation; the Reichsbank kept the interest rate on marks fixed at very low levels between 1921 and 1923 so that the price level spiraled ever upwards. Heretics seem to have difficulties with Weimar—the deflation they predict never set in.

Here's one way to get a heretical explanation of the Wiemar inflation. Let's return to our analogy with bonds. What would it take for the price of an IBM perpetual bond to collapse over a period of several years, even as its coupon rate remained constant? For that to happen, the quality of the bond's perceived residual value would have to be consistently deteriorating. Say IBM management invested in a series of increasingly dumb ventures, or it faced a string of unbeatable new competitors entering its markets. Each hit to potential residual value would cause fundamental investors to mark down IBM's bond price, even though the bond's coupon remained fixed.

Now assuming that German marks were like IBM perpetual bonds, it could be that from 1921 to 1923, investors consistently downgraded the value of the residual fixed claim that marks had upon the Reichsbank's assets. Alternatively, perhaps the market consistently reduced its appraisal of the government's ability to buy marks back with real resources. Either assumption would have created a consistent decline in the purchasing power of marks while the interest rate paid on marks stayed constant.

Compounding each hit to residual value would have been a decline in the mark's liquidity premium. When the price of a highly-liquid item begins to fluctuate, people ditch that item for competing liquid items with more stable values. With less people dealing in that item, it becomes less liquid, which reduces the liquidity premium it previously enjoyed. This causes the item's purchasing power to fall even more, forcing people to once again turn to alternatives, thus making it less liquid and igniting another round of cuts to its liquidity premium and therefore its price, etcetera etcetera. In Weimar's case, marks would have been increasingly replaced by dollars and notgeld.

So consistent declines in the mark's perceived residual value, twinned with a shrinking in its liquidity premium, might have been capable of creating a Weimar-like inflation, all while the Reichsbank kept its interest rate constant.

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That's not to say that central bank liabilities do have a residual value and that the heretical result is necessarily the right one. Both possibilities make sense, and both can explain hyperinflations. But to determine which is right, we need to go in and do some gritty security analysis to isolate whether central bank money possesses a fixed residual claim on either central bank assets or future government resources. Parsing the fine print in central bank acts and government documents to tease out this data is the task of lawyers, bankers, historians, fixed income analysts, and accountants. And they would have to do a separate analysis for each of the world's 150 or so central banks and currencies, since each central bank has its own unique constituting documents. In the end we might find that some currencies are conventional and others are heretic, so that some central banks should be running conventional monetary policies, and others heretic policies. 

In closing, a few links. I've taken a shot at a security analysis of central bank liabilities in a number of posts (here | here | here), but I don't think that's the final word. And if you're curious how the Weimar inflation ended, go here.

Tuesday, November 4, 2014

Gilded cage



This blog wouldn't be around if it wasn't for gold bugs.

Many moons ago my former-employer (and friend), the truest gold bug you'd ever meet, would lecture everyone in the office for hours about imminent hyperinflation, the wonders of the gold standard, and why gold should be worth $10,000. Fascinated, but unsure what to make of his diatribes, I started to read about the history of monetary systems, all of which would eventually provide grist for this blog.

A gold bug will typically have the following characteristics. 1) An abnormally-sized portion of their investing portfolio will be allocated to the yellow metal; 2) they believe in an eventual 'day of reckoning' when gold's price rises into the stratosphere, the mirror image of which is hyperinflation; 3) their investing case for gold is twinned with strong moral view on the decrepitude of the current monetary system and/or society in general; and 4) they are 100% sure that the monetary system's collapse will lead to the flowering of a new and virtuous system, a gold standard.

One thing I discovered fairly early on from my interactions with the gold bug community is that there's no point in debating a gold bug. In any debate, you should be able to ask your opponent what evidence they'd accept as proving their idea to be wrong. Gold bugs are loathe to submit such a list. After all, to do so would open up the possibility that they might have to precommitt themselves to changing their mind, which is the last thing they want to do. A gold bug's ideas are comforting to them. They've structured their entire mental landscape around these ideas, not to mention their entire life's savings and often careers around them.

Gold bugs have a powerful set of defense mechanisms to protect their ideas from outside threat. These mechanism, I'll call them 'mental bodyguards', will kill on sight any idea or bit of evidence that runs contrary to the gold bug schema, thus saving the gold bug from the discomfort, and potential danger, of having to weigh each new bit of data on its own merit.

For instance, consider the fact that central bank money was unmoored from the gold peg in 1968 (almost 50 years ago!). The monkeys behind the wheel should have caused hyperinflation by now and all those financial Noahs who were smart enough to jump into the gold boat before the fiat flood should be fabulously wealthy. But gold trades at just $1200 or so, not far above $850 levels set in 1980. Except for a few exceptions like Zimbabwe, hyperinflation hasn't happened.

Gold bugs can rationalize this contradiction because they possess a 'mental bodyguard' that absolves them of any responsibility for the timing of their predictions. Like the Millerite movement—which predicted the second coming of Jesus Christ on March 21, 1884, only to have to push the date to April 18 when nothing happened, and when that day passed uneventfully, bumped the event to October 22—gold bugs can keep pushing the day-of-reckoning further into the future without suffering any mental dissonance. Using an even more impressive bit of mental-Aikido they turn disconfirmation into a positive. The longer gold's meteoric rise is forestalled, say gold bugs, the more time it provides true believers with an opportunity to accumulate a larger stash of the stuff.

Another powerful mental body guard is the invocation of "them". Gold bugs invariably blame vague external and impersonal forces for wreaking havoc on the noble intentions of gold bugs and the upwards trajectory of the metal's price. They  may be the Federal Reserve, the plunge protection team, or a cabal of Jewish bankers (politically-correct gold bugs just blame Goldman Sachs). When gold falls in price it's always because of the the machinations of these oppressors, without which the metal would be worth $12,000 or $13,000 by now. (Yes, gold bugs like to refer to gold as "the" metal, presumably to differentiate it from all the plebeian metals)

Thanks to the them mental body guard, the inability of gold bug predictions to be borne out in reality is never due to any inherent weakness in the ideas themselves, but to outside interference. Doubts are conveniently refocused on something external like Ben Bernanke and the Fed, upon which gold bugs regularly bestow two minute hates.

Other mental bodyguards that prove useful in protecting the core gold bug ideology include the knee jerk discredit that gold bugs level at both the economics profession and economic data. Gold bugs screen out economists by deriding them as mainstream and therefore (obviously!) puppets of the system. The shoot-first assumption of guilt spares gold bugs from having to engage with these economists' potentially contradictory ideas on a level playing field. The same goes for inflation data, which they dismiss out of hand as being 'cooked'. And if you try mentioning the MIT Billion Prices Index to them, they hum loudly and put their fingers in their ears. (Although when there's any sort of divergence between the BPI and CPI, they suddenly start to make noise).

The awful returns that gold and especially gold shares have provided over the decades have impoverished many gold bugs as well as those unlucky enough to listen to them. Yep, I've seen the year-end statements. Yet somehow the gold bug meme continues to limp on. That's because gold bugs are less concerned about making money than upholding "the cause", as they like to refer to it. The cause is a vague combination of the promotion of a gold standard and a +$10,000 gold price, where simply holding gold through all downturns is an expression of support for that cause. Mere financial losses cannot keep them down.

Now I've been tough on the gold bugs in this post, but the fact is that gold bugs would probably say that both myself and any of their many accusers harbour mental body guards of our own. And the gold bugs probably wouldn't be entirely wrong. With so much time and energy having been invested in the various things we know and believe, a bit of cognitive dissonance is only natural. I'd argue that the gold bugs having walked much further out along that plank than their critics.

This post won't change the minds of any gold bugs—as I already pointed out, they've made up their minds long ago. But if you're a busy individual with some money to invest, and you're considering a gold bug advisor, remember that the fate of your investment may take second seat to the gold bug's devotion to the cause. Be wary.

Tuesday, October 28, 2014

Fear of illiquidity



There are thousands of fears, from arachnophobia to globophobia (fear of balloons) to zoophobia (fear of animals). What might the fear of market illiquidity look like?

Say that you are petrified that a day will come when markets will be too illiquid for you to convert your wealth into the things you need. There are two ways for you to buy complete peace of mind.

The first strategy involves selling everything you own now and buying checking deposits, the sine qua non liquid asset. Get rid of the house, the bonds, the stocks, the car, your couch, and your books. Use some of the proceeds to rent a house and a car, borrow books, and lease furniture. In renting back the stream of consumption benefits that you've just sold, your level of consumption stays constant. Negotiate the rental arrangements so that the lessor—the owner—cannot cancel them, and so that you can walk out of them at a moment's notice. Structuring things this way ensures that rental obligations in no way inhibit your ability to stay liquid. With your hoard of highly liquid deposits and array of rental agreements, you've secured a state of perfect liquidity. Relax. Breathe in. Enjoy your life.

The second way to perfectly hedge yourself from illiquidity risk would be to buy liquidity insurance on everything you own. For instance, an insurer would guarantee to purchase your house whenever you want to sell at the going market price. Same with your stocks, and bonds, your car and couches and your books. With every one of your possessions convertible into clean cold cash upon a moment's notice thanks to the insurer, you can once again relax, put your legs up, and lean back on the couch.

Since both strategies lead you to the same infinitely liquid final resting place, arbitrage dictates that the cost of pursuing these two strategies should be the same. Consider what would happen if the liquidity insurance route was cheaper. All those desiring a state of infinite liquidity would clamor to buy insurance, pushing the price of insurance higher until it was no longer the better option. If the checking deposit/rental route was cheaper, then everyone would sell all their deposits and rent stuff, pushing rental prices higher until it was no longer the more cost-efficient option.

Now I have no idea what liquidity insurance should actually cost. But consider this: liquidity option #1 is a *very* expensive strategy. To begin with, you'd be forgoing all the interest and dividends that you'd otherwise be earning on your bonds and stocks. Checking deposits, after all, offer no interest. Compounded over many years, that comes out to quite a bit of forfeited wealth. Second, you'd have to rent everything. And the sort of rent you'd have to negotiate would be costlier than normal rent. Last time I checked, most landlords require several months notice before a renter can be released from their rental obligation. But the rental agreements you have negotiated require the owner to accept a return of leased property whenever *you* want—not when they want. And that feature will be a costly one.

Since option #1 is so expensive, arbitrage requires that option #2 will be equally expensive. Let's break it out. Option #2, liquidity insurance, allows you to keep the existing flows of income from stocks and bonds as well as saving you from the obligation of paying high rent (you get to keep your house and all the other stuff). Not bad, right? Which means that in order for you to be indifferent between option #1 and #2, the cost of insurance must be really really high. If it wasn't, everyone would choose to go the insurance route.

So who cares ? After all, liquidity insurance doesn't exist, right? Wrong. Central banks are significant providers of liquidity insurance. They insure private banks against illiquidity by promising to purchase bank assets at going market prices whenever the bank requires it. This isn't full and complete liquidity insurance— there are a few assets that even a central bank won't touch—but it's close enough.

The upshot is that banks are well-protected from illiquidity. They get to keep all their interest-yielding assets and at the same time can rest easy knowing that the central bank insures that those assets will always be as good as cash. Consider what things would be like for private banks if the central bank were to get out of the liquidity insurance business. Now, the only way for bankers to replicate central bank-calibre liquidity protection would be for them to pursue option #1: sell their loan books and bond portfolios for 0%-yielding cash. But then they'd be foregoing huge amounts of income. They might not even be profitable.

With logic dictating that the cost of buying liquidity insurance needs to be pretty high, are modern central banks charging sufficiently stiff rates on liquidity insurance? I'm pretty sure they aren't. Regular insurers like lifecos require periodic premium payments, even if the event that said insurance covers hasn't occurred. But the last time I read a bank annual report, there was no line item for liquidity insurance premiums. It seems to me, and I could be wrong, that central banks are providing liquidity insurance without requiring any sort of quid pro quo. Feel free to correct me in the comments section.

Say that I'm right and that central banks are providing private banks with underpriced liquidity insurance. Central banks are ultimately owned by the taxpayer, which means that taxpayers are providing private banks with artificially cheap liquidity insurance. And that's not a fair burden to put on them. Nor is the underpricing of insurance a good strategy, since it results in all sorts of institutions getting insurance when they don't necessarily deserve it.

Does anyone know if central banks have any sort of rigorous model for determining the price they charge for liquidity insurance. Or are they just winging it? ... it sure seems like it to me.

Sunday, October 19, 2014

Fedcoin


Recent posts by Adrian Hope Baille and Sina Motamedi have got me thinking again about the idea of the Federal Reserve (or any other central bank for that matter) adopting bitcoin technology. Here's an older post of mine on the idea, although this post will take a different tack.

The bitcoin ethos enshrines the idea of a world free from the totalitarian control of central banks. So in exploring the idea of Fed-run bitcoin-style ledger, I realize that I run the risk of being cast as Darth Vader (or even *yikes* the Emperor) by bitcoin true believers. So be it. While I do empathize with the bitcoin ideal—I support freedom in banking—I rank the importance of bitcoin-as-product above bitcoin-as-philosophy. And at the moment, bitcoin is not a great product. While bitcoin has many useful features, these are all overshadowed by the fact that its price is too damn volatile for it to be be taken seriously as an exchange medium. This volatility arises because bitcoin lacks a fundamental value, or anchor, a point that I've written about many times in the past. However, there is one way to fix the crypto volatility problem...

Enter Fedcoin

Setting up the apparatus would be very simple. The Fed would create a new blockchain called Fedcoin. Or it might create a Ripple style ledger by the same name. It doesn't matter which. There would be an important difference between Fedcoin and more traditional cryptoledgers. One user—the Fed—would get special authority to create and destroy ledger entries, or Fedcoin. (Sina Motamedi gives a more technical explanation for how this would work in the case of a blockchain-style ledger)

The Fed would use its special powers of creation and destruction to provide two-way physical convertibility between both of its existing liability types—paper money and electronic reserves—and Fedcoin at a rate of 1:1. The outcome of this rule would be that Fedcoin could only be created at the same time that an equivalent reserve or paper note was destroyed and, vice versa, Fedcoin could only be destroyed upon the creation of a new paper note or reserve entry.

So unlike bitcoin, the price of Fedcoin would be anchored. Should Fedcoin trade at a discount to dollar notes and reserves, people would convert Fedcoin into these alternatives until the arbitrage opportunity disappears, and vice versa if Fedcoin should trade at a premium.

As for the supply of Fedcoin, it would effectively be left free to vary endogenously, much like how the Fed currently let's the market determine the supply of Fed paper money. This flexibility stands in contrast to the fixed supply of bitcoin and other cryptocoins. The mechanism would work something like this. Should the public demand Fedcoin, they would have to bring paper dollars to the Fed to be converted into an equivalent number of new Fedcoin ledger entries, the notes officially removed from circulation and shredded. As for banks, if they wanted to accumulate an inventory of Fedcoin, they would exchange reserves for Fedcoin at a rate of 1:1, those reserves being deleted from Fed computers and the coins added to the Fedcoin ledger.

Symmetrically, unwanted Fedcoin would reflux to the central bank in return for either newly-created cash (in the case of the public) or reserves (in the case of banks), upon which the Fed would erase those coins from the ledger. The upshot is that the Fed would have no control over the quantity of Fedcoin—it would only passively create new coin according to the demands of the public.

Apart from that, Fedcoin would be similar in nature to most other cryptoledgers. All Fedcoin transactions would be announced to a distributed network of listening nodes for processing and verification. In other words, these nodes, and not the Fed, would be responsible for maintaining the integrity of the Fedcoin ledger.

Why implement Fedcoin?

The main reasons that the Fed would implement Fedcoin would be to provide the public with an innovative and cheap payments option, and to provide the taxpayer with tax savings.

The public would enjoy all the benefits of bitcoin including fast transaction speeds, cheap transaction costs, and the ability to transact almost anywhere and with almost anyone as long as all parties to a transaction had a smartphone and the right software. At the same time Fedcoin's stability would immediately differentiate it from bitcoin. No longer would users have to fear losing 50% of their purchasing power prior to making a transaction.

Fedcoin's distributed architecture would be both complementary and in many ways superior to Fedwire, a centralized system which currently provides for the transferal of Fed electronic reserves among banks. I won't bother getting into the specifics: see this old post.

By introducing Fedcoin, the Fed would also lower its costs. While I haven't done the calculations, I have little doubt that running a distributed cryptoledger is far cheaper than maintaining billions of paper notes in circulation. Paper currency involves all sorts of outlays including designing and printing notes, collecting, processing and storing them, as well as constantly defending the note issue against counterfeiters. A distributed ledger does all this at a fraction of the cost. As Fedcoin begins to displace cash, and I think that this would steadily happen over time due to its superiority over paper, the Fed's costs would fall and its profits rise to the benefit of the taxpayer.

Fedcoin would have no impact on monetary policy

Fed officials might balk at giving the idea a shot if they feared that adopting a Fed cryptoledger would impede the smooth functioning of Fed monetary policy. They needn't worry.

The Fed currently exercises control over the price level by varying the quantity of reserves and/or the interest paid on reserves. The existence of cash doesn't get in the way of this process, nor has it ever gotten in the way. Bringing in a third liability type, Fedcoin, the quantity of which is designed to fluctuate in the same way as cash, would likewise have no impact on monetary policy. The Fed would continue to lever the return on reserves in order to get a bite on prices while allowing the market to independently choose the quantity of Fedcoin and cash it wished to hold.

Well, almost none: Interest on Fedcoin and the zero lower bound

Ok, I sort of lied in the last paragraph. While it happens only rarely, there are times when cash does get in the way of monetary policy, and so would Fedcoin if it were implemented. If the Fed needs to reduce rates on reserves to negative levels in order to hit its price and employment targets, the existence of cash impedes the smooth slide below zero. With reserves yielding -2% and paper notes yielding 0%, reserves would quickly be converted en masse into cash until only the latter remains. At that point the Fed would have lost its ability to alter rates—cash doesn't pay interest nor can it be penalized—and would no longer be capable of exercising monetary policy. This is called the zero-lower bound, and it terrifies central bankers.

Fedcoin has the potential to alleviate the zero lower bound problem. Here's how.

As Fedcoin adoption grows among the public, cash would steadily be withdrawn. And while it might not shrink to nothing—the public might still choose to use some cash—at least the Fed would have a good case for entirely canceling larger denominations like the $100 and $50.

Consider also that it would be possible for interest to be paid on each Fedcoin  (unlike bitcoin and cash), the rate to be determined by the Fed. And just as Fedcoin could earn positive interest, the Fed could also impose a negative rate penalty on Fedcoin. This would effectively solve the Fed's zero lower bound problem. After all, if the Fed wished to reduce the rate on reserves to -2 or -3% in order to deal with a crisis, and reserve owners began to bolt into Fedcoin so as to avoid the penalty, the Fed would be able to forestall this run by simultaneously reducing the interest rate on Fedcoin to -2 or -3%. Nor could reserve owners race into cash, with only low denomination and expensive-to-store $5s and $10s available.

So by implementing something like Fedcoin, the Fed could safely implement a negative interest rate monetary policy.

(Lastly, monetary policy nerds will notice that the displacement of non-interest yielding cash with interest-yielding Fedcoin is a tidy way to arrive at Milton Friedman's optimum quantity of money, or the Friedman rule.)

The big losers: banks

Fedcoin has the potential to tear down the private banking system. Interest yielding Fedcoin would be able to do everything a bank deposit could do and more, and all this at a fraction of the cost. As the public shifted out of private bank deposits and into Fedcoin, banks would have to sell off their loan portfolios, the entire banking industry shrinking into irrelevance.

One way to prevent this from happening would be for the Fed to make an explicit announcement that any bank could be free to create its own competing copy of Fedcoin, say WellsFargoCoin. Like the Fed, Wells Fargo would promise to offer two-way convertibility between its deposits/cash/Fedcoin and WellsFargoCoin at a rate of 1:1 to ensure that the price of its new ledger entries were well-anchored. The bank could then implement features to compete with Fedcoin such as higher interest rates or complimentary financial services. Even as Wells Fargo's deposit base steadily shrunk due to technological obsolescence, its base of WellsFargoCoin liabilities would rise in a compensatory manner.

The resulting lattice network of competing private bank crypto ledgers built on top of the Fedcoin ledger would work in a similar fashion to the current banking system. Wells Fargo would make loans in WellsFargoCoin and take deposits of FedCoin as well as competing bankcoins, say CitiCoin or BankofAmericaCoin. Intra-bank cryptocoin payments would be cleared on the books of the Federal Reserve with reserves transfers over the Fedwire funds system, although Fedcoin might eventually take the place of Fedwire. A change in the value of Fedcoin or reserves due to a shift in monetary policy would be transmitted immediately into a change in the value of all private bankcoins by virtue of  the convertibility of the latter into the former.

Nor would it be necessary to start with Fedcoin and then introduce bankcoins. Why not begin with the latter and skip Fedcoin altogether? Why aren't private banks at this very moment switching out deposits and replacing them with cryptoledgers?

KYC: Know your customer

'Know your customer' regulations would make implementation difficult, but not impossible.

With bitcoin, the location of a coin (its address) is public but the identity of the owner is not. However, laws require banks to gather information on their customers to protect against money laundering. As these laws are unlikely to change with the advent of new technology, banks would probably require anyone wanting to use bank cryptoledgers to have an account with a regulated bank. This would not be too onerous given that most Americans already have bank accounts.  However, it compromises anonymity, one of the key ideals of bitcoin, since each coin would be traceable by the authorities to a real person.

Perhaps there is still a way to preserve some degree of anonymity. Historically the Fed has always been spared from KYC rules since it has never had to document who uses cash. By grandfathering KYC exemption to Fedcoin, any user who wanted to preserve their anonymity could use Fedcoin rather than any of the multiple bankcoin ledgers, just like today they prefer to use anonymous Fed cash rather than bank accounts to transact.

In summary

So that's a rough sketch of Fedcoin—a decentralized, flexible, and well-backed payments system that grants one user, the Fed, a set of special privileges and responsibilities. Feel free to modify the idea in the comments section.

And just so we are keeping tabs, these are the institutions that Fedcoin could eventually make obsolete: bank deposits, banks (unless the latter are allowed to innovate their own bankcoins), the credit card networks Visa and Mastercard, bank notes, Fedwire, and even bitcoin itself, which would be unable to compete with a stable-value copy of itself.

Bitcoin true believers may not like this post, but perhaps they can take something constructive from it. Fedcoin is one of the potential competitors in the distant horizon. Now is the time for the rebels to figure out how to create a stable-price version of bitcoin, before Darth Vader does it himself. Otherwise they may someday find themselves closing down their bitcoin startups in order to write code for the Empire.




Note: My apologies to readers for my having succumbed to the constant temptation to adorn all blog posts with Star Wars references.

Sunday, October 12, 2014

The market monetarist smell test



I gave myself a quick whiff this week to determine if I pass the market monetarist smell test. This is by no means definitive, nor is this an officially administered MM® test.

To be clear, my preferred policy end point is market choice in centralized banking. In other words, you, me, and my grandma should be able to start up a central bank. But that's a post for another day. First-best option aside, here's my reading of a few market monetarist ideas.

Target the forecast

**** 5 stars

Big fan. Targeting the forecast would take away the ad hoccery and mystique that surrounds central banks. We want central bankers to be passive managers of yawn-inducing utilities, not all-stars who make front covers of magazines.

First, have the central bank set a clear target x. This is the number that the central bank is mandated to hit in the course of manipulating its various levers, buttons, and pulleys. Modern central banks sorta set targets—they reserve the right to be flexible. Bu this isn't good enough. To target the forecast, you need a really clear signal, not something vague.

Next, have the central bank create a market that bets on x. Either that, or have it ride coattails on a market that already trades in x. If the market's forecast for x deviates from the central bank's target, the central bank needs to pull whatever levers and pulleys are necessary to drive the market forecast back to target.

The advantage of targeting the market forecast is that the tasks of information processing and decision making are outsourced to those better suited for the task: market participants. Gone would be whatever department at the central bank whose task is to fret over incoming data to determine if the bank is on an appropriate trajectory to hit x. Gone too would be the functionaries whose job it is to carefully wordsmith policy statements. The job of Fed-watching—the agonizing process of divining the truth of those policy statements—would disappear, just like lift operators and bowling alley pinsetters have all gone on to greener pastures. Things would be much simpler. If the market bets that the central bank is doing too little, its forecast will undershoot the target and the central bank will have to loosen. Vice versa if the market thinks the central bank is doing too much.

Targeting the forecast is the "market" in market monetarism. It's elegant, workable, and efficient—let's do it.

NGDP targeting

*** 3 stars

Meh, why not?

If we're going to target the forecast, we need a number for the market to bet on. Using the same target that central banks currently use is tricky. Most central banks are dirty inflation targeters. They try to keep the rate of change in consumer prices on target, but reserve the right to be flexible. Central banks have been willing to tolerate a little more inflation than their official target, especially if in doing so they believe that they can add some juice to a slowing in the real economy. Alternatively, they may choose to undershoot their inflation target for a while if they want to put a break on excessively strong output growth.

An NGDP target may be a good enough approximation of a flexible inflation target. NGDP is real GDP multiplied by the price level. If a target of, say, 4% NGDP growth is chosen, and the real economy is growing at 3%, then the central bank will only need to create 1% inflation. But if output is stagnating at 0.5%, then it will create 3.5% inflation.

So NGDP targeting affords the same sort of flexible tradeoff between the price level and real output that dirty inflation targeting affords, while serving as a precise number for markets to bet on.

The quantity of base money

* 1 star

Market monetarists have a fixation on the quantity of base money. This is where the monetarism in market monetarism comes from. Specifically, market monetarists seem to think that a central bank's policy instrument is, or should be, the quantity of base money. The policy instrument is the lever that the Carneys and Draghis and Yellens of the world manipulate to get the market to adjust the economy's price level.

But modern central banks almost all pay interest on central bank deposits. The quantity of money has effectively ceased to be a key policy instrument. (The Fed was late, making the switch in 2008). Shifting the interest rate channel (the gap between the interest rate that the central bank pays on deposits versus the rate that it extracts on loans) either higher or lower has become the main way to get prices to adjust.

This doesn't mean that the base isn't important. Rather, the return on the base is the central bank's policy instrument—it always has been. This is a big umbrella way of thinking about the policy instrument, since the return incorporates both the interest rate paid on deposits and the quantity of money as subcomponents. Reducing the return creates inflation, increasing it creates deflation.

Market monetarists seem to think that the interest rate channel ceases to be a good lever once interest rates are at 0%. But this isn't the case. It's very easy for central banks to reduce the return on deposits by imposing deposit rates to -0.5% or -1.0%. Going lower, say to -3%, poses some problems since everyone will try to immediately convert negative yielding central bank deposits into 0% cash. But if a central bank imposes a deposit fee on cash, a plan Miles Kimball describes more explicitly here, or withdraws high face value notes so that only ungainly low value notes remains, which I discuss here, there's no reason it can't drop rates much further than that.

If anything, it's the contribution of quantities to the base's total return that eventually goes mute. In manipulating the quantity of central bank deposits, central banks force investors to adjust the marginal value of the non-pecuniary component of the next deposit. Think of this non-pecuniary component as package of liquidity benefits that imbue a deposit with a narrow premium in and above its fundamental value. Increasing the quantity of central bank deposits results in a shrinking of this premium, thereby pushing their value lower and prices higher, while decreasing the quantity of deposits achieves the opposite. At the extreme, the quantity of deposits can be increased to the point at which the marginal liquidity value hits zero and the premium disappears, at which point further issuance of central bank deposits has no effect on prices. Deposits have hit rock bottom fundamental value.

So in sum: yes to targeting the forecast, and I suppose that an NGDP target seems like a good enough way to achieve the latter, and to hit it let's just keep using rates, not quantities. Does this make me a market monetarist?

Of course there's more to market monetarism than that, not all of which I claim to understand, but this post is already too long. Nor am I wedded to my views—feel free to convince me that I'm deranged in the comments.



Incidentally, if you haven't heard, Scott Sumner is trying to launch an NGDP prediction market.