Friday, May 20, 2016

Those new Japanese safety deposit boxes must all be empty

Remember all the hoopla about Japanese buying safety deposit boxes to hold cash in response to the Bank of Japan's decision to set negative rates? Here is the Wall Street Journal:
Look no further than Japan’s hardware stores for a worrying new sign that consumers are hoarding cash--the opposite of what the Bank of Japan had hoped when it recently introduced negative interest rates. Signs are emerging of higher demand for safes—a place where the interest rate on cash is always zero, no matter what the central bank does.
Well, three month's worth of data shows no evidence of unusual cash demand. As the chart below illustrates, the rate at which the Bank of Japan is printing the ¥10,000 note shows no discontinuity from its pre-negative rate rise. In fact, demand for the ¥10,000 is far below what it was in the 1990s, when interest rates were positive.

I should remind readers that the Bank of Japan, like any central bank, doesn't determine the quantity of banknotes in circulation; rather, the public draws those notes into circulation by converting deposits into notes. So this data is a pure indicator of Japanese cash demand.

The lack of interest in switching into yen notes should come as no surprise given the experience of other nations that have set negative interest rates. Data from Sweden, Denmark, and Switzerland has consistently shown that it takes more than just a slight dip into negative territory before the dreaded "lower bound," the point at which the public converts all their deposits into banknotes, is encountered.

For instance, despite the setting of a -0.5% repo rate by Sweden's Riksbank, Swedish cash in circulation continues to decline. I won't bother to provide a chart, you can go see the data here.

As for the Danes, the growth rate in Danish cash demand continues to hover near its long term average of 3.7%/year. This despite the fact that the Danmarks Nationalbank, the nation's central bank, is setting a deposit rate of -0.65%. I've charted it out below:

Definitely no lower bound in Denmark, at least not yet.

Finally, we have Switzerland where the Swiss National Bank has maintained a -0.75% rate since December 2014. Back in February, the WSJ and Zero Hedge were making a fuss out of the sudden jump in the demand for the 1000 franc note, in effect blaming the build up on the lower bound. I wrote a rebuttal at the time, Are Swiss fleeing deposits and hoarding cash, pointing out that the demand for Swiss francs is often driven by safe haven concerns. The observed increase in 1000s might therefore have very little to do with the SNB hitting the effective lower bound and everything to do with worries about falling equity prices, China, deteriorating credit quality, and more.

With many of these concerns subsiding in 2016, one might expect the safe haven demand for 1000 franc notes to be falling again. And that's exactly what we see in the chart below; the Swiss are accumulating notes at a decelerating pace, even though the SNB has not relaxed its negative deposit rate one iota.

What these charts all show is that the effective lower bound to central bank deposit rates has not yet been engaged, even after many months in negative territory. You can be sure that the global community of central bankers is watching this data too; it is telling them that, should the need arise, their respective interest rates can be pushed lower than the current low-water mark that has been set by the SNB and Danmarks Nationalbank at -0.75%, say to -0.85% or even -1.0%.

There are a few factors that might be dampening the demand for paper notes. Remember that the Swiss and the Japanese have installed cash escape inhibitors; mechanisms that reduce the incentive for banks to convert central bank deposits into cash. I've written about them here.

Secondly, the SNB and the BoJ, along with the Danes, have set up an array of interest rate tiers. While the marginal deposit earns a negative rate, the majority of the tiers are only lightly penalized or not penalized at all. This tiering represents a central bank subsidy to commercial banks; in turn, banks have passed this subsidy on to their retail depositor base in the form of higher-than-otherwise interest rates, the upshot being that very few banks have set negative deposit rates on retail customers. This has helped stifle any potential run on deposits.

Tiering and cash escape inhibitors have helped dissuade cash withdrawals by two members of the public, retail depositors and banks, but not the third; large non-bank institutions. That these latter institutions haven't bolted into cash shows that the natural costs of storing wads of paper are quite high, and that the effective lower bound quite deep.

Monday, May 16, 2016

Aggressive vs defensive debasement

COINING IN PARIS c. 1500 (From a French print c. 1755)

Not all debasements, or reductions of the precious metals content of coins, are equal. Among scholars of medieval coinage, there is an interesting distinction between aggressive, or bad debasement, and defensive, or good debasement.

Let's take defensive debasements first.

In medieval times, the minting of coins was usually the prerogative of the monarch. Any member of the public could bring their silver bullion or plate to the mint where the monarch's agents would strike a fixed amount of coins from that silver, returning the appropriate number of coins to the owner but taking a small commission for their pains.

A decline in the quality of coin was a fairly natural feature of medieval societies. As silver pennies passed from hand to hand, oil and sweat would remove small flecks of metal.  Compounding this deterioration were less honest methods of removing small bits from each coin, like clipping. Nicholas Mayhew, a numismatist, estimated that each year 0.2% of the coinage's silver content was lost; more colourfully, 'seven tons of silver vanished into thin air' during every decade in the fourteenth century. Less conservative estimates go as high as 1% per year.*

Using Mayhew's 0.2% rate of decline, if the king or queen's mints manufactured pennies that contained 2 grams of silver in 1400, these 1400-vintage pennies might contain just 1.81 grams by 1450, fifty years later.

This created a huge problem. Long before 1450 people would have lost their incentive to bring raw silver to the mint to be made into new coins. Let's say a merchant in 1450 owed 10 pence to his supplier. One option was for the merchant to bring enough silver to the mint to get ten new pennies and then pay off his debt. With the king maintaining his fifty year-old policy of turning two grams of silver into a new penny, that meant the merchant had to bring 20 grams to be minted.

But the merchant had a better alternative; buy ten pennies of the 1400-vintage that together contained just 18.1 grams of silver (1.81 x 21) and then pay off the supplier. The key here is that all pennies, whether they be 1400-vintage or 1450-vintage pennies, passed at face value as legal tender. Thus the merchant's creditor had to accept any penny to settle the debt, bad or good. The merchant's decision was therefore a simple one. Far cheaper to pay off the debt with ten 1400-vintage pennies, the equivalent of 18.1 grams of silver, than ten new pennies, which contained 20 grams.

Because the king's mint was effectively providing too few new pennies for a given quantity of silver, no one would ever bring silver to the mint. (If you work it out, you'll see this is in instance of Gresham's law.) And with no new coins, coin shortages emerged. The legacy coinage had to circulate ever faster to meet society's demand for a medium of exchange, and this would have only increased its rate of depreciation. And a faster decline in the quality of the coinage made them more susceptible to counterfeiters, which only reduced their legitimacy. An inflationary spiral emerged.

The way to simultaneously halt inflation and encourage the creation of new pennies was to introduce a defensive debasement. If, in 1451, the royal family announced a debasement of the coinage so that its mint now struck pennies that contained, say, 1.75 grams of silver rather than 2.0 grams, then people would start bringing silver to the mint again. After all, our merchant could take ten worn-out 1400-vintage pennies that contained 1.81 grams to the mint, have them recoined into ten new pennies with 1.75 grams of silver, pay his debt, and still have some silver left over. The entire generation of old worn out coins would be brought to the mint to be replaced with a new generation of harder-to-counterfeit and clip pennies.

In sum, to ensure a steady supply of new coins the king or queen had to debase the coinage ever few decades. Meir Kohn calls this a ratification of the natural deterioration in the silver content of coins; "defensive debasements did not cause the gradual inflation that took place so much as ratify it." This was sound monetary policy.

Aggressive debasements, one the other hand, were unsound monetary policy.

You may have noticed that by debasing the penny from 2.0 to 1.75 grams, the monarch would be drawing large amounts of silver and old pennies into his or her mint to be turned into new pennies. After all, why would anyone pay debts with pennies that contain 1.81 grams when they can bring them to the mint to be recoined into pennies that contain just 1.75 grams? Another way to think about it is this: if a horse is selling for a pound (where a pound was defined as 240 pennies), why pay for it with 240 pennies minted in 1400 containing a total of 434 grams when they can be first reminted into 240 new pennies that contain just 420 grams, these new pennies being just as acceptable in trade as the old ones? In other words, better to buy a horse for 420 grams of silver than 434.

Debasements were profitable for the monarch. As I mentioned earlier, the royal family levied a fee on all silver brought to his mint. This fee is referred to as seigniorage. In more modern terms, think of a mint as a pipeline where the owner takes a cut on throughput. So by debasing the coinage, the monarch would dramatically increase mint throughput and therefore boost seigniorage revenues.

When a monarch debased the coinage at a much faster rate than the natural rate of wear and tear, he or she wasn't just playing catch up, this was aggressive debasement. One of the most aggressive debasements of all, that of Henry VIII, involved ten debasements between 1542 and 1551, each in the region of 30-40%. These diminutions were so successful in driving silver to the royal mints that Henry had to erect six new mints just to meet demand, according to Kohn.

The motive for aggressive debasements was almost always the funding of wars. As John Munro points out, securing "additional incomes from taxes, aides, loans, or grants from town assemblies, ‘estates’, or other legislative assemblies was difficult and usually involved unwelcome concessions, and this was not necessarily forthcoming." The mints, however, were firmly under the control of the royal family and were therefore a trustworthy form of revenue.

In Henry VIII's case, his debasement revenues were used to fund wars in the 1540s against Scotland and France. But his debasements were bad monetary policy as they caused rampant inflation, specifically a 123% rise in the English consumer price index from 1541 to 1556.


By the way, it was in response to these aggressive debasements that one of the earliest economic tracts, Nicolas Oresme's de Moneta, was written. Oresme's essay, which dates to 1360, was a response to the aggressive monetary policies of Philip VI and John II. According to Robert Mundell, John II debased the coinage 86 times. Wrote Oresme:
I am of opinion that the main and final cause why the prince pretends to the power of altering the coinage is the profit or gain which he can get from it; it would otherwise be vain to make so many and so great changes.
All monetary policy debates since then, including the explosion of words on the econ blogosphere beginning after the 2008 crisis, are versions of the one that Oresme engaged in: what constitutes good debasement and what constitutes bad? While the content of the debate has changed, the structure is pretty much the same.

* I get this from John Munro.
Note: I have an old post from 2013 on defensive debasement. This post is different because it works out the aggressive side of the debasement equation.

Friday, May 6, 2016

What makes medieval money different from modern money?

What's the main difference between our modern monetary system and the system they had in the medieval ages? Most of you will probably answer something along the lines of: we used to be on a commodity standard—silver or gold—but we went off it long ago and are now on a fiat standard.

That's a safe answer. But the fiat/commodity distinction is not the biggest difference between then and now.

The biggest difference is that in the medieval age, base money did not have numbers on it. Specifically, if you look at an old coin you might see a number in the monarch's name (say Henry the VIII) or the date which it was minted, but there are no digits on either the coin's face or obverse side indicating how many pounds or shillings that coin is worth. Without denominations, members of a certain coin type could only be identified by their unique size, metal content, and design, with each type being known in common speech by its nickname, like testoon, penny, crown, guinea, or groat. Odd, right?

By contrast, today we put numbers directly on base money. Take the Harriett Tubman note, for example, which has "$20" printed on it or the Canadian loonie which has "1 dollar" etched on one side.

This seemingly small difference has huge consequences for the monetary system. I'll illustrate this further on in my post by having a modern central bank adopt medieval-style numberless money. The interesting thing is that, contrary to our prejudices about commodity-based money, the medieval system had the potential to be a highly flexible monetary system, far more capable of coping with shocks than our current one, and by implementing medieval money, a modern central banker would get a powerful tool to help in his or her efforts to keep inflation on target.

But first, here are a few more important details about the medieval monetary system. Back then, sticker prices and debts were not expressed in terms of coins (say groats or testoons) but were always advertised in the abstract unit of account, pounds (£), where a pound was divisible into 20 shillings (s) and each shilling into 12 pence (d).  Say that Joe wants to settle a debt with Æthelred for £2 10s (or 2.5 pounds). In our modern monetary system, it would be simple to do this deal. Hand over two coins with "1 pound" inscribed on it and ten coins with "one shilling" on them. Without numbers on coins, however, how would Joe and Æthelred have known how many coins would do the trick?

To solve this problem, Joe and Æthelred would have simply referred to royal proclamation that sets how many coins of each type comprised a pound and a shilling. Say Joe has a handful of groats and testoons. If the king or queen has proclaimed that the official rate is thirty testoons to the pound and eighty groats in a pound, then Joe can settle the £2 10s debt with 60 testoons and 40 groats or any another combination, say 75 testoons. If the monarch were to issue a new proclamation that changes this rating, say a pound now contains forty testoons, then Joe's debt to Æthelred must be settled with 100 testoons, not 75.

To sum up, in the medieval ages the method of determining the content of the unit of account was divorced from the physical objects that were in circulation. Rather than appearing on the coin, the proper ratings were printed up on a royal decree. By contrast, in our modern era monetary authorities have stopped the practice of remotely defining the unit of account in favor of striking it directly onto physical and digital objects.


Let's try to get a better feel for what it would be like as consumers if we didn't have numbers on our modern money. Let's convert today's standard into a medieval standard using U.S. currency as our example. Start by removing the words "one cent" from all one cent coins. Americans take to calling them Lincolns, since Abraham Lincoln is on the obverse side. Next, let's strip all mentions of "one dollar" and "$1" off the dollar bill, which now goes by the moniker "a Washington." Finally, blank out any incident of "100" and "one hundred" from the one hundred dollar bill. Say that people now call it the Franklin. (For simplicity, assume the $10s, $20s etc don't exist.)

Say we go shopping for groceries and get a bill for $302.15. Without numbers on our bills and coins, how are we to know how many Lincolns, Washingtons, and Franklins we should pay?

We would start off by launching our Federal Reserve app to check how many Lincolns, Washingtons, and Franklins the Fed has decided to put in the dollar unit of account that day. Now it could be that the Fed is rating the dollar as 100 Lincolns, 1 Washington, and 0.01 Franklins, which would correspond to the ratios we are so familiar with. In which case, the grocery bill can be discharged with three Franklins, two Washingtons, and fifteen Lincolns. Easy.

But there is no reason that the Fed couldn't be setting a different definition of the dollar unit of account that day. Say that the Fed has re-rated the dollar so that it is now worth 140 Lincolns, 1.4 Washingtons, and 0.014 Franklins. It would be as if an old dollar bill now had $0.714 printed on it instead of $1 (where 1/$1.4=$0.714). In effect, this increases the value of the dollar unit of account in terms of physical cash or, put differently, reduces the purchasing power of the Washington/Lincoln/Franklin. The $302.15 grocery bill must now be discharged with four Franklins and twenty-three Washingtons, where the Franklins cover the first $285.71 and the Washingtons cover the remaining $16.43.

So that's pretty interesting, no? In a modern version of the medieval monetary system, not only do we need to keep track of the coins and notes in our wallet, we also need to follow the Fed's ratings, say with an app. It's cumbersome system but it seems to have worked.


As for the central banker's perspective, let me repeat my earlier point: if the Fed (or any other central bank) were to adopt a medieval system, it would have far more flexibility in hitting its inflation targets than it currently does. Right now, an inflation targeting central bank like the Fed can only target the CPI by modifying the nature or supply of the physical and electronic tokens in circulation, say by altering the quantity of these tokens, changing their interest rate, or shifting their peg (to gold or some other currency). With denominations effectively etched onto coins and printed onto notes, the ability to directly manipulate the unit of account by adjusting the number of bills and coins per dollar has been taken away from it.

By blanking out the numbers and defining the coin/bill content of the dollar remotely, the Fed gets an extra degree of freedom. If it wants to create inflation, it simply posts an alert on its app that the dollar will now contain fewer Lincolns, Washingtons, and Franklins than before. In response, stores will quickly increase their sticker prices so that they receive the same real quantity of payment media as before. Voila, the CPI rises. To create deflation, the Fed does the opposite and puts more notes and coins into each dollar. Just as it currently schedules periodic interest rate announcements, the central bank might issue these edicts every few weeks or so.

In some sense, central banks already engage in alterations of the bill/coin content of the dollar when they redenominate currency. But redenominations are rare, usually occurring during hyperinflations when a central bank cancels all existing currency and issues new bills and coins with a few zeros lopped off. They aren't a regular tool of monetary policy because a continuous series of small redenominations would involve constant recoinages and printing of new notes, an expensive way of doing monetary policy.

By removing numbers from bills/coins so that only blanks circulate and then defining the value of those blanks remotely, redenominations become a cheap tool of monetary policy, much as they were in the medieval days. The Fed wouldn't have to call in all bills and coins and print/mint new ones, it would simply announce a re-rating on its app.


In any case, I hope you can see now that the medieval monetary system was far more complex than we commonly assume it to be. Because we are so used to having number on our bills and coins, we'd be quite lost if we were transported back to the 1500s. As for the monetary authorities, they had an extra set of powers that today's central bankers don't have, the ability to directly define the unit of account. Hypothetically, these powers could have been used to target stable prices or nominal income. In reality, monarchs had different motives, including the funding of wars, so they used the tool for that purpose. But that's another story.

[1] The Spufford Currency Exchange
[2] Meir Kohn: Medieval and Early Modern Coinage and its Problems
[3] John Munro: The Technology and Economics of Coinage Debasements in Medieval and Early Modern Europe

Tuesday, April 26, 2016

Why hasn't Canadian Tire Money displaced the Canadian dollar?

Canadians will all know what Canadian Tire Money is, but American and overseas readers might not. Canadian Tire, one of Canada's largest retailers, defies easy categorization, selling everything from tents to lawn furniture to hockey sticks to car tires. Since 1958, it has been issuing something called Canadian Tire Money (see picture above). These paper notes are printed in denominations of up to $2 and are redeemable at face value in kind at any Canadian Tire store.

Because there's a store in almost every sizable Canadian town, and the average Canadian make a couple visits each year, Canadian Tire money has become ubiquitous—everyone has some stashed in their cupboard somewhere. Many Canadians are quite fond of the stuff—there's even a collectors club devoted to it. I confess I'm not a big fan: Canadian Tire money is form of monetary pollution, say like bitcoin dust or the one-cent coin. I just throw it away.

It's the monetary oddities that teach us the most about monetary phenomena, which is why I find Canadian Tire money interesting. Here's an observation: despite the fact that it is ubiquitous, looks like money, trades at par, and is backed by a reputable issuer, Canadian Tire money doesn't circulate much. Stephen Williamson, a Canadian econ blogger, had an entertaining blog post a few years back recounting unsuccessful efforts to offload the coupons on Canadians. Sure, from time to time we might encounter the odd bar or charity that accepts it, or maybe a corner-store in Wawa. But apart from Canadian Tire stores, acceptability of Canadian Tire money is the exception, not the rule.

Why hasn't Canadian Tire money become a generally-accepted medium of exchange? One explanation is that Canadian law prevents it. Were the government to remove the strict rules that limit the ability of the private sector to issue paper money, bits of Canadian Tire paper would soon be circulating all across the nation, maybe even displacing the Bank of Canada's paper money.

A second hypothesis is that even if the law were to be loosened, Canadian Tire would remain an unpopular exchange medium. Some deficiency with Canadian Tire money, and not strict laws, drives their lack of liquidity. Nick Rowe, another Canadian econ blogger (notice a theme here?), once speculated that this had to do with network effects. Canadians have long since adopted the convention of using regular Bank of Canada-issued notes, and overturning that convention by accepting Canadian Tire money would be too costly. David Andolfatto (not another Canadian econ blogger!), would probably point to limited commitment as the deficiency. IOUs issued by Canadian Tire simply can't be trusted as much as government money, and so they inevitably fail as a medium of exchange.

In support of the first view, which is known in the economics literature as the legal restrictions hypothesis, Neil Wallace and Martin Eichenbaum (yep, another Canadian) recount an interesting anecdote. Back in 1983, competitor Ro-Na (since renamed RONA), a major hardware chain, started to accept Canadian Tire coupons at face value. I've found an old advertisement of the offer below:

RONA advertisement in La Presse, 1983 (source)

Eichenbaum and Wallace say that this is evidence that Canadian Tire money isn't just a mere coupon but readily serves as a competitive medium of exchange among Canadians. After all, if a major store like RONA accepted the coupons, then their acceptance wasn't just particular—it was general.

The story doesn't end there. Here is an interesting 1983 article from the Montreal Gazette:

The article mentions how in retaliation Canadian Tire sought an injunction against RONA to prevent it from accepting Canadian Tire money. We know this tactic must have been somewhat successful since RONA does not currently accept said coupons. Eichenbaum & Wallace slot this into their legal restrictions theory, noting that the injunction was probably motivated by Canadian Tire's desire to comply with legal prohibitions on the private issuance of currency, a damaging law suit helping to inhibit general use of their coupons. Remove these legal restrictions, however, and Canadian Tire would probably not have sued RONA, and usage of Canadian Tire coupons as a medium of exchange would have expanded. Presumably if Tim Horton's took up the baton from RONA and accepted Canadian Tire money, and then Couche-Tard joined in, you'd end up with a new national currency.

So we have two competing theories to explain Canadian Tire money's lack of acceptability. Which one is right? Let's introduce one more story arc. Zoom forward to 2009 when Canadian Tire lawyers sent a notice to a NAPA car parts dealer asking him to stop accepting Canadian Tire money. The reason cited by Canadian Tire: trademark infringement. As the article points out, Canadian Tire Money constitutes intellectual property, and if companies do not sufficiently police their trademarks against general usage, they may lose control of them. For instance, over the years Johnson & Johnson has had to vigorously defend its exclusive rights to the name "Band-Aid." If it hadn't, it might have lost claim to the name in the same way that Otis Elevator lost its trademark on the word "escalator" because the word fell into general use. That the 1983 RONA challenge probably had less to do with currency laws than trademark infringement damages Eichenbaum &Wallace's argument.

The last interesting Canadian factoid is the observation that a number of community currencies circulate in Canada. Salt Spring dollars, a currency issued by the Salt Spring Island Monetary Foundation, located off the coast of British Columbia, is one of these. Other examples include Calgary Dollars and Toronto Dollars. According to Johanna McBurnie, Salt Spring dollars are legal because they are classified as gift certificates. If so, I don't see why the use of Canadian Tire money as a medium of exchange wouldn't fall under the same rubric. This puts the final nail in Wallace & Eichenbaum's argument that restrictions on circulation of competing paper money have prevented broad usage of Canadian Tire paper. Rather, if laws are to blame for the minimal role of Canadian Tire Money's as currency, then it is the company's desire to protect its trademark that is at fault.

That local IOUs like Salt Spring dollars can legally circulate but lack wide acceptance (even in the locality in which they are issued) means we need something like the Nick Rowe's network effects or David Andolfatto's limited commitment to  explain why incumbent paper money tends to exclude competing paper money from circulation. Which isn't to say that Canadian Tire money would never circulate. As Larry White and George Selgin have pointed out, private paper money has circulated along with government paper money in places like Canada. But the bar for Canadian Tire money is probably a high one.

Wednesday, April 20, 2016

A 21st century gold standard

Imagine waking up in the morning and checking the hockey scores, news, the weather, and how much the central bank has adjusted the gold content of the dollar overnight. This is what a 21st century gold standard would look like.

Central banks that have operated old fashioned gold standards don't modify the gold price. Rather, they maintain a gold window through which they redeem a constant amount of central bank notes and deposits with gold, say $1200 per ounce of gold, or equivalently $1 with 0.36 grains. And that price stays fixed forever.

Because gold is a volatile commodity, linking a nation's unit of account to it can be hazardous. When a mine unexpectedly shuts down in some remote part of the world, the necessary price adjustments to accommodate the sudden shortage must be born by all those economies that use a gold-based unit of account in the form of deflation. Alternatively, if a new technology for mining gold is discovered, the reduction in the real price of gold is felt by gold-based economies via inflation.

Here's a modern fix that still includes gold. Rather than redeeming dollar bills and deposits with a permanently fixed quantity of gold, a central bank redeems dollars with whatever amount of gold approximates a fixed basket of consumer goods. This means that your dollar might be exchangeable for 0.34 grains one day at the gold window, or 0.41 the next. Regardless, it will always purchase the same consumer basket.

Under a variable gold dollar scheme the shuttering of a large gold mine won't have any effect on the general price level. As the price of gold begins to skyrocket, consumer prices--the reciprocal of a gold-linked dollar--will start to plummet. The central bank offsets this shock by simply redefining the dollar to contain less gold grains than before. With each grain in the dollar more valuable but the dollar containing fewer grains of the yellow metal, the dollar's intrinsic value remains constant. This shelters the general price level from deflation.

This was Irving Fisher's 1911 compensated dollar plan  (see chapter 13 of the Purchasing Power of Money), the idea being to 'compensate' for changes in gold's purchasing power by modifying the gold content of the dollar. A 1% increase in consumer prices was to be counterbalanced by a ~1% increase in the number of gold grains the dollar, and vice versa. Fisher referred to this fluctuating definition as the 'virtual dollar':

From A Compensated Dollar, 1913

Fisher acknowledged that 'embarrassing' speculation was one of the faults of the system. Say the government's consumer price report is to be published tomorrow and everyone knows ahead of time that the number will show that prices are rising too slow. And therefore, the public expects that the central bank will have to increase its gold buying price tomorrow, or, put differently, devalue the virtual dollar so it is worth fewer ounces of gold. As such, everyone will rush to exchange dollars for gold at the gold window ahead of the announcement and sell back the gold tomorrow at the higher price. The central bank becomes a patsy.

Fisher's suggested fix  was to introduce transaction costs, namely by setting a wide difference between the price at which the central bank bought and sold gold. This would make it too expensive buy gold one day and sell it the next. This wasn't a perfect fix because if the price of gold had to be adjusted by a large margin the next day in order to keep prices even, say because a financial crisis had hit, then even with transaction costs it would still be profitable to game the system.

A more modern fix would be to adjust the gold content of the virtual dollar in real-time in order to remove the window of opportunity for profitable speculation. Given that consumer prices are not reported in real-time, how can the central bank arrive at the proper real-time gold price? David Glasner once suggested targeting the expectation. Rather than aiming at an inflation target, the central bank targets a real-time market-based indicator of inflation expectations, say the TIPS spread. So if inflation expectations rise above a target of 2% for a few moments, a central bank algorithm rapidly reduces its gold buying price until expectations fall back to target. Conversely, if expectations suddenly dip below target, over the next few seconds the algorithm will quickly ratchet down the content of gold in the dollar to whatever quantity is sufficient to restore the target (i.e. it increases the price of gold).

Gold purists will complain that this is a gold standard in name only. And they wouldn't be entirely wrong. Instead of defining the dollar in terms of gold, a compensated dollar scheme could just as well define it as a varying quantity of S&P 500 ETF units, euros, 10-year Treasury bonds, or any other asset. No matter what instrument is being used, the principles of the system would be the same.

A compensated dollar scheme isn't just a historical curiosity; it may have some relevance in our current low-interest rate environment. Lars Christensen and Nick Rowe have pointed out that one advantage of Fisher's plan is that it isn't plagued by the zero lower bound problem. Our current system depends on an interest rate as its main tool for controlling prices. But once the interest rate that a central bank pays on deposits has fallen below 0%, the public begins to convert all negative-yielding deposits into 0% yielding cash. At this point, any further attempt to fight a deflation with rate cuts is not possible. The central banker's ability to regulate the purchasing power of money has broken down.*

Under a Fisher scheme the tool that is used to control purchasing power is the price of gold, or the gold content of the virtual dollar, not an interest rate. And since the price of gold can rise or fall forever (or alternatively, a dollars gold content can always grow or fall), the scheme never loses its potency.

Ok, that is not entirely correct. In the same way that our modern system can be crippled under a certain set of circumstances (negative rates and a run into cash), a Fisherian compensated dollar plan had its own Achilles heel. If gold coins circulate along with paper money and deposits, then every time the central bank reduces the gold content of the virtual dollar in order to offset deflation it will have to simultaneously call in and remint every coin in circulation in order to keep the gold content of the coinage in line with notes and deposits. This series of recoinages would be a hugely inconvenient and expensive.

If the central bank puts off the necessary recoinage, a compensated dollar scheme can get downright dangerous. Say that consumer prices are falling too fast (i.e. the dollar is getting too valuable) such that the central banker has to compensate by reducing the gold content of the virtual dollar from 0.36 grains to 0.18 grains (I only choose such a large drop because it is convenient to do the math). Put differently, it needs to double the gold price to $2800/oz from $1400. Since the central bank chooses to avoid a recoinage, circulating gold coins still contain 0.36 grains.

The public will start to engage in an arbitrage trade at the expense of the central bank that goes like this: melt down a coin with 0.36 grains and bring the gold bullion to the central bank to have it minted into two coins, each with 0.36 grains (remember, the central bank promises to turn 0.18 grains into a dollar, whether that be a dollar bill, a dollar deposit, or a dollar coin, and vice versa). Next, melt down those two coins and take the resulting 0.72 grains to the mint to be turned into four coins. An individual now owns 1.44 grains, each coin with 0.36 grains. Wash and repeat. To combat this gaming of the system the government will declare the melting-down of  coin illegal, but preventing people from running garage-based smelters would be pretty much impossible. The inevitable conclusion is that the public increases their stash of gold exponentially until the central bank goes bankrupt.

This means that a central bank on a compensated dollar that issues gold coins along with notes/deposits will never be able to fight off a deflation. After all, if it follows its rule and reduces the gold content of the virtual dollar below the coin lower bound, or the number of grains of gold in coin, the central bank implodes. This is the same sort of deflationary impotence that a modern rate-setting central bank faces in the context of the zero lower bound to interest rates.

In our modern system, one way to get rid of the zero lower bound is to ban cash, or at least stop printing it. Likewise, in Fisher's system, getting rid of gold coins (or at least closing the mint and letting existing coin stay in circulation) would remove the coin lower bound and restore the potency of a central bank. Fisher himself was amenable to the idea of removing coins altogether. In today's world, the drawbacks of a compensated dollar plan are less salient as gold coins have by-and-large given way to notes and small base metal tokens.

In addition to evading the lower bound problem, a compensated dollar plan would also be better than a string of perpetually useless quantitative easing programs. The problem with quantitative easing is that commitments to purchase, while substantial in size, are not made at any particular price, and therefore private investors can easily trade against the purchases and nullify their effect. The result is that the market price of assets purchased will be pretty much the same whether QE is implemented or not. Engaging in QE is sort of like trying to change the direction of the wind by waving a flag, or, as Miles Kimball once said, moving the economy with a giant fan. A compensated dollar plan directly modifies the price of gold, or, alternatively, the gold content of the dollar, and therefore has an immediate and unambiguous effect on purchasing power. If central bankers adopted Fisher's plan, no one would ever accuse them of powerlessness again.

*Technically, interest rates need never lose their potency if Miles Kimball's crawling peg plan is adopted. See here.

Saturday, April 9, 2016

ETFs as money?

Blair Ferguson. Source: Bank of Canada

Passive investing is eating Wall Street. According to 2015 Morningstar data, while actively managed mutual funds charge clients 1.08% of each dollar invested per year, passively managed funds levy just a third of that, 0.37%. As the public continues to rebalance out of mutual funds and into index ETFs, Wall Street firms simply won't be able to generate sufficient revenues to support the same number of analysts, salespeople, lawyers, journalists, and other assorted hangers-on. It could be a bloodbath.

Here is the very readable Eric Balchunas on the topic:

Any firm that faces declining profits due to narrowing margins can restore a degree of profitability by driving more business through its platform. In the case of Wall Street, that means arm-twisting investors into holding even more investment products. If Gordon Gecko can get Joe to hold $3000 worth of low margin ETFs then he'll be able to make just as much off Joe as he did when Joe held just $1000 in high margin mutual funds.

How to get Joe to hold more investments? One way would be to increase demand for ETFs by making them more money-like. Imagine it was possible to pay for a $2.00 coffee with $2.00 worth of SPDR S&P 500 ETF units. Say that this payment could occur instantaneously, just like a credit card transaction, and at very low cost. The coffee shop could either keep the ETF units as an investment, pass the units off as small change to the next customer, use them to buy coffee beans from a supplier, or exchange them for a less risky asset.

In this scenario, ETF units would look similar to shares of a money market mutual fund (MMMF). An MMMF invests client money in corporate and government debt instruments and provides clients with debit and cheque payments services. When someone pays using an MMMF cheque or debit card, actual MMMF shares are not being exchanged. Rather, the shares are first liquidated and then the payment is routed through the regular payments system.

Rather than copying MMMFs and integrating ETFs into the existing payment system, one idea would be to embed an ETF in a blockchain, a distributed digital ledger. Each ETF unit would be divisible into thousandths and capable of being transferred to anyone with the appropriate wallet in just a few moments. One interesting model is BitShares, provider of the world's first distributed fully-backed tracking funds (bitUSD tracks the U.S. dollar, bitGold tracks gold, BitCNY the yuan, and more). I wrote about bitUSD here. Efforts to put conventional securities on permissioned blockchains for the purpose of clearing and settlement are also a step in this direction.

Were ETFs were to become a decent medium of exchange, people like Joe would be willing to skimp on competing liquid instruments like cash and bank deposits and hold more ETFs. If so, investment managers would be invading the turf of bankers who have, until now, succeeded in monopolizing the business of converting illiquid assets into money (apart from money market mutual fund managers, who have tried but are flagging).

Taken to the extreme, the complete displacement of deposits as money by ETFs would get us to something called narrow banking. Right now, bankers lend new deposits into existence. Should ETFs become the only means of payment, there would be no demand for deposits and bankers would have to raise money in the form of ETFs prior to making a loan. Bank runs would no longer exist. Unlike deposits, which provide fixed convertibility, ETF prices float, thus accommodating sudden drops in demand. In other words, an ETF manager will always have just enough assets to back each ETF unit.

Two problems might emerge. Money is very much like an insurance policy—we want to know that it will be there when we run into problems. While stocks and bonds are attractive relative to cash and deposits because they provide superior returns over the long term, in the short term they are volatile and thus do not make for trustworthy money. If we need to patch a leaky roof, and the market just crashed, we may not have ETF units enough on hand. Cash, however, is usually an economy's most stable asset. So while liquid ETFs might reduce the demand for deposits, its hard to imagine them displacing traditional banking products entirely.

A fungibility problem would also arise. Bank deposits are homogeneous. Because all banks accept each others deposits at par and these deposits are all backed by government deposit insurance, we can be sure that one deposit is as good as another. And that homogeneity, or fungibility, means that deposits are a great way to do business. ETFs, on the other hand, are heterogeneous. They trade at different prices and follow different indexes. Shopkeepers will have to pause and evaluate each ETF unit that customers offer them. And that slows down monetary exchange—not a good thing.

Somewhat mitigating ETF's fungibility problem is the fact that the biggest ETFs track the same indexes. On the equity side, three of the six largest ETFs track the S&P 500 while on the bond side, the two largest ETFs track the Barclays Capital U.S. Aggregate Bond Index. Rather than just any ETF becoming generally accepted media of exchange, the market might select those that track the two or three most popular indexes.

In writing this post, I risk being accused of blockchain magical thinking—distributed ledgers haven't yet proven themselves in the real world. All sorts of traditions and laws would have to be upended to bring the world of securities onto a distributed ledger. Nevertheless, it'll be interesting to see how the fund management industry manages to squirm out of what will only become an increasingly tighter spot. Making ETFs more liquid is an option, though surely not the only one.

PS. Here is the blogosphere's own Tyler Cowen (along with Randall Kroszner) on "mutual fund banking" in 1990:
In contrast to traditional banks, depository institutions organized upon the mutual fund principle cannot fail if the value of their assets declines. Since the liabilities of the mutual fund bank are precisely claims to the underlying assets, changes in value are represented immediately in a change in the price of the deposit shares. The run-inducing incentive to withdraw funds at par before the bank renders its liabilities illiquid by closing vanishes with the possibility of non-par clearing. In effect, there would be a continuous (or, say, daily) “marking to market” of the assets and liabilities. Such a system obviates the need for much of the regulation long associated with a debt-based, fractional reserve system, as the equity-nature of the liabilities eliminates the sources of instability associated with traditional banking institutions.
With the rise of ETFs and blockchain technology, the modern version of mutual fund banking would be something like distributed ETF banking described in the above post,

Wednesday, March 30, 2016

Finance's Battle of the Somme

When I think of senseless waste, I think of the Battle of the Somme. Whole generations lost in
order to move a trench line forward by a metre or two. Zoom forward in time to the modern finance industry which, for many decades, has been marshaling starry-eyed recruits in search of excess returns. I worry that all their effort has been wasted because, like the Somme's trenches, the integrity of prices can't be advanced any further once large amounts of effort are already being expended in beating the market.

Fund managers who want to beat the market must find unique information in order to get a leg up on their competitors. But the supply of such information is limited so that at some point, prices include pretty much everything there is to know about a company. Any additional effort to hunt down information is wasteful from a society-wide perspective.

The recent-ish phenomena of indexing gives us a feel for how far beyond the 'waste point' we've gone. Rather than trying to beat the market, indexers randomly throw darts at stocks in order to harvest the average market return. Throwing darts is far cheaper than hiring Harvard grads to hunt down information. An indexer is betting that information has already had most of its value wrung out of it, so any effort to search for more doesn't justify the cost.

Say that the finance industry had only progressed a step beyond the waste point. If so, then as investors begin to adopt indexing, the bits of information they stop analyzing become unique again. The marginal return to hunting for information will rise above zero and those engaged in the activity should perform better. The popularity of indexing would quickly stall as money moves back into the beat-the-market game, pushing the value of information back to down to nil. We'd expect the size of the information hunting and indexing ecosystems to stay steady over time as shifts in the marginal value of information are quickly ironed out by movement from one group to the other.

The numbers show the opposite. Index investing has been growing for three decades and shows no sign of slowing. Managed funds have been shrinking since the mid-2000s. And rather than benefiting from the unparsed information that these indexers have left on the table, fund managers continue to lag the average market return. This suggests that we went FAR beyond the 'waste point.' After all, if the brain power that indexing is releasing from the information hunting process has not made information hunting more profitable, then there was way too many people engaged in the activity to begin with.

If markets are supposed to efficiently allocate resources, why did we go so far past the waste point? I suppose we can chalk it up to a combination of greed, hubris, cynicism, and naivete. Whatever the reason, the long trek beyond the waste point has been the financial equivalent of the Somme. For decades, all those investors who thought they could beat the market would have been better off allocating their resources elsewhere. And generations of young Wall Street whizzes could have been making useful things for the rest of us rather than engaging in the equivalent of converting a scorched desert into a scorched desert.

The good news is that the rise of indexed investing is steadily undoing this misallocation. Fund managers, traders, analysts, and advisers are currently being let go so that they can move into different sectors of finance or entirely different industries, a trend that could continue given the fact that non-indexers continue to underperform the market. And this will proceed down the line to financial journalists, financial economists, and all other workers who provide support to the information hunters. These people are alert, ambitious, mobile, and intelligent so the real world should become a more productive place.

As I was writing this, I thought of this post from David Glasner.

Thursday, March 24, 2016

Slow money

Would it make sense for firms to try to slow down their equity structure?

Equity markets are made of two classes of participants. The minority consists of long-term investors who, like Ulysses, have 'tied themselves to the mast' and would rather fix things when a company runs into problems than sell out. The majority is made of up rootless speculators and nihilistic indexers who cut and run the moment the necessity arises.

Because their holding period is forever, the long-term investor class does all the hard work of monitoring a company and agitating for change. Keeping management honest is the only recourse they have to protecting their wealth. Speculators and indexers are free loaders, enjoying the same upside as investors without having to contribute to any of the costs of stewardship.

How might long-term investors be compensated for the extra expenses they incur in tending the garden?

One method would be for a firm's management to institute a slow/fast share structure. The equity world is currently dominated by the fast stuff, shares that can be bought and sold in a few milliseconds. A slow share is a regular share that, after having been acquired, must be "deposited" for, say, two years. During the lock down period the shareholder enjoys the same cash dividends as a fast share but they cannot sell. Only when the term is up can the slow share be converted back into a fast share and be got rid of. The illiquidity of slow shares is counterbalanced by a carrot; management makes a promise that anyone who converts into slow shares gets to enjoy the benefit of an extra share down the road i.e. a stock dividend. So a shareholder with 100 fast shares who pledges to lock them in for two years will end up with 101 fast shares once the lock-up period is over.

The investor class, which until now has received no compensation for their hard work, will quickly choose to slow down all their shares and enjoy the biennial stock dividend. Feckless speculators and indexers, unwilling to stay tied down for two years, will keep their fast shares and forgo the dividend. After all, the S&P's constituents could change at any moment, so an ETF/index fund needs to be able to cut and run. And a speculator's trend of choice could reverse at any moment.

By the way, ETFs and index funds aren't the only asset type that I include in the fast money category. Also qualifying are the huge population of funds that claim to be "active" but are actually "closet" indexers, as well as all those funds that say they are engaging in 'investing' but are really just speculators. Given the possibility of sudden redemption requests, they need the flexibility that liquid fast shares provide.

As the slow/fast share structure goes mainstream, the benchmark to which market participants are compared, the S&P 500 Index, will evolve into two flavours, the Fast S&P 500 and the Slow S&P 500, the former including the fast shares of the 500 index members while the latter includes only the slow. The Slow S&P will, by definition, show better returns than the Fast S&P, since slow shares enjoy stock dividends at the expense of fast shares. Nihilistic indexers and rootless speculators will choose to benchmark themselves to the lagging Fast S&P. Active investors with a genuine long-term bias, most of whom will choose to own slow shares, will compare themselves to the better-performing Slow S&P.

Mass adoption of fast/slow share structure could change the complexion of the very combative active vs passive investing debate. Passive investors have typically outperformed active investors after fees, largely because they have been able to freeload off of the stewardship of long-term investors. With a new structure in place, buyers of passive indexed products would—by definition—begin to underperform the average long-term active investor. This is because the dual share structure obliges the passive class to compensate long-term investors for their efforts.

I suspect that the adoption of a fast/slow share structure would increase the size of the investor class. After all, with a long-term investing mentality now being rewarded, those on the margin between the investing class and the mass of speculators/indexers will elect to slow down their shares. Once they have lost the ability to cut & run, the only way to protect their wealth will be through constant surveillance of management and a more activist stance. This is a good thing since long-term shareholders are better stewards of capital than short-term ones. In general, share prices should rise.

On the other hand, as more shares are locked down, market liquidity will suffer. Will the increase in stock prices due to improved stewardship outweigh the drop in prices due to a much narrower liquidity premium? If I had to guess, I'd say yes. Which means that even feckless indexers and speculators should support the subsidization of long-term investors.

Addendum: This isn't a new idea. Read all about loyalty-driven securities here.
Disclaimer: I consider myself to be 50% speculator, 25% indexer, 25% investor. But I'm trying my best to boost the last category.

Monday, March 14, 2016

Shadow banks want in from the cold

Remember when shadow banks regularly outcompeted stodgy banks because they could evade onerous regulatory requirements? Not any more. In negative rate land, regulatory requirements are a blessing for banks. Shadow banks want in, not out.

In the old days, central banks imposed a tax on banks by requiring them to maintain reserves that paid zero percent interest. This tax was particularly burdensome during the inflationary 1970s when short term rates rose into the teens. The result was that banks had troubles passing on higher rates to savers, helping to drive the growth of the nascent U.S. money market mutual fund industry. Unlike banks, MMMFs didn't face reserve requirements and could therefore offer higher deposit rates to their customers.

To help level the playing field between regulated banks and so-called shadow banks, a number of central banks (including the Bank of Canada) removed the tax by no longer setting a reserve requirement. While the Federal Reserve didn't go as far as removing these requirements, it did reduce them and allowed workarounds like "sweeps." But the shadow banking system never stopped growing.

In negative rate land, everything is flipped around. Central bank reserve requirements no longer act as a tax on banks, they can be a subsidy. The Danmarks Nationalbank, Swiss National Bank and Bank of Japan have resorted to a strategy of tiering, where only a small portion of bank reserves are charged a negative rates (say -0.5%) while the rest (the inframarginal amount) can be deposited at the central bank where it earns 0%. Setting a 0.5% penalty on the marginal amount has been enough to drive interest rates on short term government bills and overnight lending rates to -0.5%. Banks that can invest some portion of their funds at 0% rather than the going market rate of -0.5% are getting a nice gift. They can in turn pass this windfall on to their customers by protecting them from negative rates. Shadow banks, which don't have  access to these subsidies because they don't have accounts at the central bank, are at a competitive disadvantage; they must invest all their funds at the going market rate of -0.5% and will therefore have to share the pain with their customers by reducing deposit rates into negative territory. This growing deposit rate gap should lead to retail and corporate flight from shadow bank deposits into protected regulated bank deposits.

We've certainly seen this in Japan. Around ten MMMFs quickly closed their doors to new funds after the Bank of Japan reduced rates to -0.1%. And now money reserve funds (MRFs) are clamouring for protection from negative rates. So while it used to be a disadvantage to be a subjugated bank and good to be a shadow bank, in negative rate land it's the exact opposite. Better to be shackled than to be free.

By the way, I'm wondering if this is why the ECB decided not to introduce tiered deposit rates last week, pointing to the "complexity of the system." Europe has a relatively large MMMF industry compared to Japan; perhaps it wanted to avoid any financial turbulence that might be set off by subsidies that benefit one set of bankers but not the other.