Monday, March 16, 2015

What's Wrong With "Helicopter Money"?

Quite a lot.

Adair Turner has written a somewhat provocative article for Project Syndicate: "Japan’s Accounting Problem". As a scientist I'm indebted to Turner in many ways. For instance, his "Stockholm Speech" provided me with a very clear overview of the "big picture" around our global debt overhang and helped me forward with my theoretical work.

When it comes to this new article, and "overt money financing" (OMF -- Turner's name for "helicopter money") in general, I strongly disagree with him. As "money" itself is just an IOU, government debt cannot be monetized in the way Turner seems to suggest.

Quantitative Easing replaces government bonds (IOUs) in the hands of the public with reserves/deposits (IOUs). The total nominal value of government IOUs in the hands of the public remains more or less intact. Whereas the repayment of bonds held by the public (Case 1) leads to deposit transfers from taxpayers to bondholders, the repayment of bonds held by central bank (Case 2) -- as those bonds fall due -- leads to deposit transfers from taxpayers to the government/central bank.

In Case 1 (see above), the consequence of this government debt repayment is reduced aggregate nominal value of all government bonds held by the public, while the aggregate nominal value, or amount, of deposits held by the public remains intact.

In Case 2, the consequence of repayment is reduced aggregate nominal value, or amount, of deposits in the hands of the public. This reduction is equal to the reduction of aggregate nominal value of all bonds held by the public in Case 1.

Thus, what is important is not the type of IOUs in the hands of public, but the overall budget deficits and their eventual effect on agents' inflation expectations -- which are affected by agents' trust in the government's "promises to pay" (IOUs) -- promises to pay via taxation. Whether these deficits lead to an increasing amount of bonds in the hands of the public, or to an increasing amount of deposits in the hands of the public, is close to irrelevant. This is especially true now that government bond yields are close to zero -- as has been the case in Japan more or less since 1998 when 10-year JGB yield fell below 2 %.

OMF offers, unfortunately, no easy solution to our global (government) debt problems.

I have criticized "helicopter money" advocates for their implicit assumption that inflation can be micromanaged (by "micro-" I mean something like "within 5 percentage points") in a previous post: 

For more information on deposits being IOUs, see, for instance, these two posts (I elaborate my "postulates" in the comment sections of the posts):

Saturday, March 14, 2015

Making Credit(s)

Instead of money, it is credit, in the form of an IOU, which functions as a medium of exchange and a store of value. Only credit takes a concrete form through debt contracts, while money remains an abstract measure -- a unit of account -- of the assumed value of these contracts (for my definition of "money", see an earlier post).

As I have stated earlier (see this post), a seller does not receive a payment when he receives an IOU. To claim otherwise would be illogical. "IOU" is an abbrevation for "I owe you"; it is synonymous with a "promise to pay (back) (later)".

I understand very well how this might cause confusion. And, as my statement is strictly unconventional, and for many even counterintuitive, it would be only natural if the ones I manage to confuse assumed that I, the writer, must ultimately be the one who is confused. The source of the confusion must be me, because the "facts" seem to be clear: money must exist and it is silly to suggest that money cannot pay for anything.

Perhaps I could be dismissed as a confused philosopher -- a logician who doesn't understand economics and the real world. But that would be wrong. Everything I say here is either derived from real world observations, or, tested against real world evidence.

This is science. This is economics.

Once we accept that where we used to see money is only IOUs, then many things start to make more sense. There's no more mysterious money that can be created "out of nothing". Paul Krugman's "debt is money we owe ourselves" loses all the meaning it might have previously had. The money which sloshes around the world is drained -- for good. (Was money yet another "flood myth"?) No more headlines like "ECB unleashes a wall of money" in The Financial Times. Note that here I'm only referring to respected sources, not to any fringe theory advocates who think that real money must assume material form.

Tuesday, March 10, 2015

On Negative Bond & Bund Yields

Frances Coppola has written an insightful article titled "The ECB’s policy mix is poison for banks" (

Here's one sentence which caught my attention:

If the expectation is first that inflation will continue to fall and second that central banks will continue to intervene in markets to try to prevent inflation falling, then yields will continue to fall without limit.

Well, "without limit" might be too bold a statement, but it is hard to tell where any limit eventually lies. For me, the important point to draw from this is that, as things stand, "short-selling" government bonds with a negative yield could be a "widowmaker" on a par with selling short Japanese government bonds (JGB) in the past two decades. But here I mainly talk about German bunds and some other AAA/AA bonds. Due to political instability and fragility in the construction of the euro system, we cannot extend this to any and all eurozone bonds. Prudence, not hope, should guide our decisions.

Here's Ms Coppola again:
Even in a deflationary environment, retail customers — who provide the majority of banks’ stable funding — are generally unwilling to accept negative rates on deposits, especially as physical cash is an alternative. This, of course, is the reason for the ECB’s minus 0.2 per cent limit. It cannot lower the interest rate on excess reserves much without hitting the “slightly negative lower bound” at which banks would exchange reserves for vaulted cash.

I must admit I had mostly overlooked the possibility that banks could exchange reserves for vault cash. Would be interesting to hear about any practical limits to this. For instance, would the authorities print 100-800 billion worth of new euro banknotes (large denominations) just like that? I doubt it.

Overall, Ms Coppola seems to possess an independent and searching mind. In my opinion, we need people like her if we are to make sense out of all what is going on in the world economy today. As is typical and even natural for this kind of mind, her article includes some "clumsy statements" and no doubt errors too, but those are more than balanced by the new insights she offers and thoughts she provokes. It seems to me that she is not too wedded to any economic theory, so she is more free to describe what she actually sees; what really is happening in the real world -- quite literally so, as her focus on real interest rates shows.

But here I think Ms Coppola goes wrong (assuming I don't misinterpret her):

First, the investment function of government bonds is changing. Traditionally, they have been used as hedges in a diversified portfolio. But once yields are deeply negative and falling, they can no longer be regarded as hedges: since holding them incurs an inevitable loss, they must be regarded as risky, not risk-free, and therefore actively traded for a capital return. Their replacement would, of course, be physical cash and other zero-yielding assets, possibly including zero-coupon issues from blue-chip companies.

 First, to equate "risk-free" with "hedge" is hasty, to say the least. I'm sure she knows how risk-free was never really free of all risk. It's more like a heuristic, or at worst, conventional wisdom. For instance, holding these "hedges" has given investors very good returns since the early 1980s as bonds have appreciated. These returns, depending on the timeframe we choose, are often competing head-to-head with stock returns. In a high inflation environment, we would have seen these "hedges" bring considerable losses to investors.

Second, holding these bonds doesn't incur an inevitable loss. Buying them at more than face value and holding them to maturity does incur a nominal loss. Well, this is probably what she actually meant.

Here is my third, and most important, objection to Ms Coppola's statement: Why would these bonds be less risk-free than they used to be if the investor who buys them today is guaranteed a nominal loss if he holds them to maturity? I don't see much risk in a guaranteed nominal loss, the size of which is known ex ante. This statement is also in contrast with her showing earlier in the article how she understands how it is real, not nominal, outcomes which ultimately matter. We need to assess real risk, not nominal risk. Government bonds have always carried real risks. And we cannot assume that blue-chip companies would be a safer bet, even if their bonds yield more. Neither is physical cash safer for anyone with hundreds of millions, if not billions, to look after.

Next I delve into something Ms Coppola seems to omit in her article -- as I believe most of the other commentators have done too.

CORRECTION (MAR-10-2015 -- 20:50 GMT): Frances Coppola kindly advised me that she has discussed the "hot potato" effect (which I discuss below) already in another article (see here) which her FT post linked to. It seems I have a lot of relevant stuff to read tonight. My apologies & thanks for the feedback, Frances!

Commercial Banks and Hot Potatoes

As a consequence of QE, the commercial banking system as a whole ends up holding excess reserves. (For how this works, see this paper from New York Fed -- a paper I referred to in my first post in which I present a sketch on bank reserves and other "monies".) These excess reserves, which usually yield less than any alternatives (I'll get to these soon), become a "hot potato" which any individual bank would like to get rid of, but which banks in aggregate cannot get rid of. One could think that this "hot-potatonizement" is especially strong when the deposit rate "paid" on these reserves is negative -- as it is now at ECB --, but does it need to be so? What probably matters more is the "spread" between the yield on reserves and the yields on any alternative assets banks might want to hold.

If we assume that European banks are operating in a "risk-off mode" (they build buffers while they adapt to a stricter regulatory environment), we can conclude that these banks would prefer to hold, instead of excess reserves, any "near reserves" as long as those yield more than reserves. These "near reserves" can be German Bunds and other AAA/AA bonds which banks can, any day, exchange for reserves should they need them. By buying these bonds from investors with accounts in other banks (so that the bank ends up transferring reserves to the other bank), a bank can switch excess reserves to bonds with (slightly) higher yields -- until the yields on these converge with the yield on reserves.

Even if it won't make much sense for the bank to buy more of these "near reserves" when the yields on them have already converged with yields on reserves, it might make sense for a bank to hold on to these bonds as they are an asset that keeps on appreciating -- regardless of the reason it does so.

There is, of course, the "hot potato" problem: these reserves might eventually return to the bank if other banks try to pass them on in a similar fashion, although it might be mainly a problem of the largest banks where most of the deposit accounts reside. In any case, the U.S. commercial banks have increased their holdings of "near reserves" (Treasuries, and Agency Securities like MBS) significantly during QE1, QE2 and QE3:

As Bloomberg reports:

Investing in government bonds is proving to be a profitable move for banks. They’re making over a full percentage point more by purchasing five-year Treasuries instead of leaving the idle cash parked at the Fed, where they earn only 0.25 percent.

Now, I don't claim that this is the only, or even the most important dynamic behind the very low and in some cases even negative bond yields we are witnessing. No doubt German Bund yields are driven down also because those are one of the few euro-denominated "safe haven" securities -- especially if one factors in the risk of certain countries leaving the euro in the foreseeable future. The current yield on a German 2-year Bund speaks for these other yield-compressing factors, as it stands already at minus 0.24 percent. And like always, there is a lot of "front-running" by other investors involved in this. All this makes it very hard if not impossible to rigorously test any "causal hypothesis" against the market data.

Monday, March 9, 2015

What Is Money?

Money is an abstract unit of account.

This is all there is to money. If something else is called "money", it is a matter of convention.

In economics, the term "unit of account" is synonymous with "(monetary) unit of measure". "Measure of value" carries very much the same meaning, too. There are various units of account in use around the world and worldwide, for instance "US Dollar", "Euro" and "Malaysian ringgit" (all abstract).

Here is a formal expression which might further illustrate my point:

P = r  x  [P]

where P is a monetary value ("price"), r is any real number and [P] is money (e.g, US Dollar).

The monetary value of various objects and contracts is expressed as P (price), which in turn is denominated in [P] (money). It logically follows that money can never be touched, nor can it be lent or owed. In other words, [P], money, cannot take the form of any object. In this sense it is no different from a "metre", a unit of length. Let's say we have an iron bar which is 1-metre long. The iron bar can have many functions, for instance "building material" or "a weapon". But no scientist would posit that the iron bar, in addition to its other uses, functions as a "unit of length".

Why should we define money in this narrow way?

First, I haven't seen any other definition of money that would be both logical and meaningful. Just like that, the enigma called "money" disappears; money is not what money does, but an abstract unit of account. Second, this definition allows us to build an economic theory which is both simpler (more elegant) and better in explaining various economic phenomena than any of our prevailing theories. Unlike the prevailing, often competing and contested, theories, this new theory helps us answer a wide range of pressing economic questions of our times -- questions related to the amount of global debt and its sustainability; and also to the widening income and wealth inequality in our societies.

Do you find any reasons why we shouldn't define money in this way?


J.M. Keynes used the term "money-of-account" when talking about our narrowly-defined money in his A Treatise on Money (1930):

“Money-of-Account, namely that in which Debts and Prices and General Purchasing Power are expressed, is the primary concept of a Theory of Money.... Money itself, namely that by delivery of which debt-contracts and price-contracts are discharged, and in the shape of which a source of General Purchasing Power is held, derives its character from its relationship to the Money-of-Account, since the debts and prices must first have been expressed in terms of the latter”

It seems he wasn't able to let go of the conventional concept of "money", so he only separated it in two: "money-of-account" and "money itself". It was a good start, but it was clearly not enough to bring clarity into the matter.

Tuesday, March 3, 2015

The Global Savings Glut Explained

The savings we talk about when we talk about a "global savings glut"  (see, for instance, this article) are all in the form of IOUs, mainly as deposits and bonds. Any other type of savings could not be "searching for safe assets". And these safe assets, of which AAA/AA-rated bonds constitute the absolute majority, are just another type of IOU. There is, actually, one pure barter market in the world and that is the financial market where one type of IOU gets exchanged to another type of IOU only if there exists a "double coincidence of (credit, or IOU) wants". (Remember: deposits are IOUs.)

So, with our massive, global debt overhang, we must have a "savings glut". It is a matter of logic. These savings are just the flipside of the debt we have amassed. These savings are not a cause for lower interest rates and increased total debt -- they are the effect of lower interest rates and increased total debt. Naturally, we have reflexivity at play here, so that any "excess deposits" -- which came to being through increased bank lending -- are searching for willing borrowers. It's important to notice that these must be bond-issuing borrowers (government bonds, MBS, ABS, investment grade, high-yield, etc), as commercial banks do not lend existing deposits to their loan customers (as explained by Bank of England).

When the bond is issued by a commercial bank/financial institution (as in the case of MBSs/ABSs), then the transaction does not add to the total amount of IOUs in the economy: a deposit is just switched to a bond, i.e. the deposit disappears (see my second post for further details). But when the bond issuer is a non-financial business, the transaction adds to the total amount of IOUs in the economy. A new bond is created and the deposit changes its holder/owner, but does not disappear.

The important point to realize is that the excess deposits arise from increased commercial bank lending -- increasingly to households since the 1980s -- and this can be seen as the ultimate cause for our "savings glut".

If these excess deposits, created in the course of commercial bank lending, are taken as "money-as-a-commodity" -- and not correctly as "money-as-an-IOU" --, then we get fooled and start thinking that there is a lot of savings out there. And we view these IOUs as current ("real") wealth, incorrectly ("incorrectly" from a macroeconomic perspective, and this is the perspective we need to adopt here). As a consequence of this misunderstanding, everyone feels richer, for a while. This is what has happened during all credit bubbles we know of (see my sketch of credit boom dynamics).

Tell me where I go wrong? I really hope I do.

Sunday, March 1, 2015

Inflation Cannot Be Micromanaged, or "Greenback Whirlybird Down!"

Contrary to conventional wisdom, central bankers don't have have the tools required to maintain price stability. Neither do governments. This is not to say that their actions don't affect inflation. When we combine the tools the central bank has (mainly the target rate) with the tools government has (mainly its control over the budget deficit/surplus), we are able to create inflation or deflation, depending on which one we want.

The ability to create inflation doesn't translate to ability to maintain price stability. The problem is that even though we can create inflation at will, we have no idea how much of it we will get -- and even more importantly, what will be the rate of change in inflation (for geeks: this is the second derivative of the hypothetical, general price level) at any point in time. Two years after the start of a government intervention, inflation could be three percent or it could be 10 percent, and it could be accelerating or decelerating. The most technically-minded among us might try to convince you otherwise, but they ignore the importance of inflation expectations and the role psychology plays in forming these.

The appearance -- or even a threat thereof -- of large fiscal deficits would affect inflation expectations among the public (investors included) in a very unpredictable way. As a consequence, inflation itself would be unpredictable (to be clear, time-lags, too, would make inflation management very difficult). This is because inflation expectations -- which depend heavily on human psychology and the relative attractiveness of competing stories -- are what really drives current and future inflation. All this is related to reflexivity.*

The "natural" (this is, absent a large-scale government intervention) outcome of our current debt overhang would be debt deflation. As far as I know, this is what William White is alluding to when he says "They have created so much debt that they may have turned a good deflation into a bad deflation after all.".

As I suggest above, and as Milton Friedman among others has suggested before me, a deflationary spiral could be countered through very large fiscal deficits (~10-20 %, without pretence to accuracy). This deficit could be "sterilized" (I stretch this concept) through a) new issuance of government bonds (by Treasury), or b) sale of existing ones (by central bank), or it could be un-sterilized as in "helicopter money" (see, for instance, Simon Wren-Lewis here) or overt money financing (OMF). (Related to this, I'd like to hear from Wren-Lewis, or any other expert, what is the difference between financing the deficit, on one hand, through bond issuance, and via OMF on the other, in a world where 2-5-year bond yields are negative while cash yields zero?)

So, my mental framework (or, theory) suggests that through large fiscal deficits an impending, severe debt deflation can be turned into volatile and unpredictable inflation. This inflation, or expectations thereof, would initially bring us increased spending, increased output and employment. It would increase the real GDP. This is exactly what the most short-sighted of us are after when they call for substantial government spending financed by a large fiscal deficit (this is why the "austerity vs. stimulus" debate doesn't make much sense to me). But this boost to the economy would be, to a large extent, due to increased speculation. At the extreme, we would see a Black Friday-esque spending frenzy as perfectly rational agents rush to buy real assets with existing and newly-created IOUs (formerly known as "money"), as they expect the value of currency to greatly diminish in the future. All this should be clear to any attentive student of inflation. Almost as clear to me is that we have already seen this kind of speculation in 2009-2014, albeit on a very small scale relative to potential.

Eventually, after a period of accelerating inflation, we would need to do what Paul Volcker and the Fed did -- thanks to sufficient public, and thus political, backing -- in the early 1980s. We would need to bring inflation down through an instant, deep recession and mass unemployment. Of course, there's always another option: to let the inflation run its course. I think we widely agree that it's better to take the recession than go down this path. Still, we cannot fully count on this to remain the case if push comes to shove.

There's always a possibility that the fiscal deficit would not be large enough -- let's say, due to political resistance -- to get the inflation even at the target level. In my world, this deflation or "low-flation" would ultimately have its cause in authorities' inability to convince agents that they should spend before inflation arrives and starts eroding the purchasing power of the currency. Something like this has been going on in Japan for something like two decades. But as my critique is aimed mostly at the same people who insist that Japan has not yet tried hard enough, and that all would be better there had they just tried harder, I won't analyze this possibility in detail here. All I want to say is that if we try hard enough, at one point we will get the volatile inflation and the (new) problems that come with it.

I state my critique once more: Inflation is not micromanageable in the way Modern Monetary Theorists (MMTers) or the living advocates of The Chicago Plan (CPs) seem to suggest. And I'm willing to bet that many of our best investors agree with me. We should never underestimate the effect of speculation on economic outcomes. Neither should we underestimate the difficulties we face if we try to differentiate between speculative and non-speculative transactions.

The biggest reason why we ended up with this massive, global debt problem is our inability to understand how all "money" is just a promise to pay (an IOU), and, as it logically follows, that it is not possible to pay for anything with this "money" (see my post from yesterday). Once we accept this, we must accept that the Quantity Theory of Money (QTM) should be dismissed in its entirety. But this we haven't done. Even people who understand quite well how "money" is just an IOU (for instance, MMTers and CPs) still view inflation more like a technical issue, something that is micromanageable -- wait for it -- through well-calibrated injections and withdrawals of "money" by the government. Are they all monetarists now?

I'm puzzled. Sometimes I wonder if nearly all our economists are suffering from doublethink.

* I'm greatly indebted to George Soros who, with his book "The Alchemy of Finance" (1987), has shed much light on reflexivity both in financial markets and the economy in general. Robert Shiller has helped me better understand the role stories have in affecting outcomes (see, for instance, his article at Project Syndicate). I present Soros as the prime evidence for my claim that to understand the economy one needs to be a philosopher, while Shiller's work speaks for the importance of understanding psychology. The society consists of individuals who contemplate and participate (i.e. act); they both compete and co-operate. That's probably all there is to an economy.

Mumblings post scriptum

There are many ways out of our current mess. Some are much better than others. None of them is an easy one. We have only bad options left. On the normative side, once we get there, I have a lot of suggestions on how to ease the pain, how to take care of the society and build a better future for all of us. (I'm dismal only as a scientist, not as a human being.) But first, we need to agree on what is ailing us -- only then we can try to apply the right treatment.

What got us here is our mistaken belief in the existence, both on a microeconomic and a macroeconomic level, of "money". The truth is that our financial system consists only of debts and credits -- all kinds of liabilities and a mountain of IOUs. The current amount of these liabilities and the corresponding IOUs is just too big. This is what is ailing us. We need to get it back to a substantially lower level, and it seems to me that it will take a global recession ("It" will happen again) to achieve this. This is my diagnosis (it's based on a considerable amount of work I've done since 2008). As we analyze the treatment options and weigh them against each other, we should keep in mind the following goal: to get the world through this turmoil with the least possible damage.

This is only my 11th blog post. It won't take long to read all of them, in case you would like to get a better understanding of where I come from. If someone is interested, I could add a short bibliography. I find myself unable to add any specific references in my text, as I usually have no clue about the person who planted a certain thought in my head. My list of suspects is very long. A random sample ("name-dropping"): Adam Smith, Léon Walras, Charles Mackay, Silvio Gesell, Walter Bagehot, Knut Wicksell, Alexander del Mar, Eugen Böhm-Bawerk, Ludwig Mises, Alfred Mitchell-Innes, Joseph Schumpeter, Friedrich Hayek, John Maynard Keynes, Irving Fisher, Henry Simons, Karl PolanyiJames Tobin, Adam Fergusson, Charles Kindleberger, Milton Friedman, John Kenneth Galbraith, Hyman Minsky, Paul Volcker, William White, Adair Turner, Claudio Borio, Philip Coggan, Nassim Taleb, George Soros, Robert Shiller, Daniel Kahneman, Amos Tversky, Bill Gross, Howard Marks, Stanley Druckenmiller, Warren Buffett, Charlie Munger, George Cooper, Michael Lewis, Matt Taibbi, David Graeber, Steve Keen, Izabella Kaminska, Steve Roth, Noah Smith, Martin Wolf, Matt Stone, Trey Parker, Paul Krugman and "Tyler Durden".