Believe those who are seeking the truth. Doubt those who find it. Andre Gide


Tuesday, October 23, 2012

No more bubble talk (please!)

I am currently at the Institute of Advanced Studies in Vienna, which hosts one of the best little macro conference in Europe: The Vienna Macro Cafe. Excellent papers, lively discussions, wonderful camaraderie, and an unbeatable location. (Let me know if you'd like to be placed on our mailing list.) 
  
After this uplifting experience, I made the mistake of checking the econ blogosphere. Blah. 

I guess it all started with Paul Krugman (who else?), who goes off here in his usual assertive style: Bubble, Bubble, Conceptual Trouble. Steve Williamson takes issue with some of the claims that Krugman makes here: The State of the World. And then Noah Smith steps in to attack one part of Williamson's post here: Money Is Just Little Green Bits of Paper! Noah gets it all wrong, but that doesn't stop both Krugman and DeLong in congratulating him for an argument that even they apparently do not understand. And so it goes. 

Let me now explain why I think Noah gets the "bubble" issue wrong. Here is how Noah starts off. 
Have you ever heard people say that "money is just little green pieces of paper"? Well, that is exactly what Steve Williamson claims in this post.
Um, no...Steve never said that "money is just little green pieces of paper." So right away, we're off to a bad start.
To understand what Steve meant, we have to start with Krugman's own "definition" of a bubble:
Over and over again one hears that we can’t expect to return to 2007 levels of employment, because there was a bubble back then. But what is a bubble? It’s a situation in which some people are spending too much.
It's a situation in which some people are spending too much? Thanks for that, Paul. To which Steve replies:
What is a bubble? You certainly can't know it's a bubble by just looking at it. You need a model. (i) Write down a model that determines asset prices. (ii) Determine what the actual underlying payoffs are on each asset. (iii) Calculate each asset's "fundamental," which is the expected present value of these underlying payoffs, using the appropriate discount factors. (iv) The difference between the asset's actual price and the fundamental is the bubble. Money, for example, is a pure bubble, as its fundamental is zero. There is a bubble component to government debt, due to the fact that it is used in financial transactions (just as money is used in retail transactions) and as collateral. Thus bubbles can be a good thing. We would not compare an economy with money to one without money and argue that the people in the monetary economy are "spending too much," would we?
The only quibble I have with this reply is Steve's use of the word "bubble." Bubbles mean different things to different people. As Steve emphasizes, the definition should be made relative to a specific model. "Bubbles" are not something you can actually "see" in the data -- "bubble dynamics" are an interpretation of the data. 

In any case, what word might Steve have used instead of "bubble?" While less colorful, I think that the label "liquidity premium" is more accurate. It is the market price of an asset above it's "fundamental" value. The distinction here seems similar to the one that Marx made between "use value" and "exchange value;" see here.

Here is how I like to think about it. Imagine an economy with just one person, as in Robinson Crusoe. Crusoe likes to eat coconuts. So he values coconuts. And he values the trees that produce coconut dividends. One way to measure value here is to ask "how many coconuts would Crusoe be willing to give up to have one more coconut tree?" The answer to this question will provide a measure of the tree's "fundamental" value. Because there are no other people on the island (prior to Friday), there is no exchange value associated with tree ownership. There is no "bubble" in a Robinson Crusoe economy.

The situation can be quite different, however, in an economy consisting of more than one person wanting to trade intertemporally in credit markets. One friction that hampers intertemporal trade is what economists call a lack of commitment. Essentially, people cannot be relied upon to keep their promises. Monetary theorists have shown that in this type of world, various objects may be employed to enhance the volume of intertemporal trade. These objects are called exchange media.

Exchange media may take the form objects that are commonly viewed as "money"--objects that circulate widely from hand to hand, or from account to account. They may also take the form of collateral objects, like the senior tranches of MBS that (until recently) circulated widely in the repo market. Because U.S. treasuries are used widely to facilitate financial transactions, they too constitute an important medium of exchange.

Abstracting from risk, the market price of an exchange medium can be broken down into two components: fundamental value and market value. We can estimate the fundamental value of an asset by assessing its value under the assumption that it is illiquid (i.e., does not circulate as an exchange medium). The difference between market price and fundamental value is a measure of liquidity value. Because an asset may be priced above its fundamental value, there is a sense in which the asset price embeds a "bubble" component according to many popular definitions. But the word is more trouble that it's worth--our discussions might be clearer and more productive if we avoided the term entirely.

Aside: Steve's point is that in a world of financial frictions, exchange media and their associated "bubble" prices may be useful for increasing the level of spending closer to socially optimal levels. If so, then how does Krugman's definition of a bubble--a situation where people are spending too much--make any sense? There may be bubbles that have this property. But then there may be bubbles that do not. Williamson is telling Krugman that he needs to be more careful. The message, unfortunately, seems hopelessly lost. 
  
Alright then, back to Noah, whose whole column is based on Steve's throwaway comment: 
Money, for example, is a pure bubble, as its fundamental is zero.
To which Noah replies:
Can this be true? Is money fundamentally worth nothing more than the paper it's printed on (or the bytes that keep track of it in a hard drive)? It's an interesting and deep question. But my answer is: No. 
First, consider the following: If money is a pure bubble, than nearly every financial asset is a pure bubble. Why? Simple: because most financial assets entitle you only to a stream of money. A bond entitles you to coupons and/or a redemption value, both of which are paid in money. Equity entitles you to dividends (money), and a share of the (money) proceeds from a sale of the company's assets. If money has a fundamental value of zero, and a bond or a share of stock does nothing but spit out money, the fundamental value of every bond or stock in existence is precisely zero.
While it may not have been clear to the average reader, I happen to know that Steve was referring to a special kind of monetary object: a pure "fiat" currency. "Fiat" in the modern sense of the word means "intrinsically useless" or "zero use value."The USD issued by the Fed may not fit this description exactly because, as others have pointed out, government money does have the power to discharge a real tax obligation. On the other hand, pure fiat money does seem exist; see my post: Fiat Money in Theory and in Somalia. The point is that even fiat money can have exchange value, and if it does, then its value is entirely a liquidity premium or "bubble" and that, moreover, it is probably a "good" bubble to the extent that fiat money facilitates trade. 

What of Noah's claim that if money is a bubble, then nearly every financial asset is a bubble? This just seems plain wrong to me. Financial assets are typically backed by physical assets. For example, the banknotes issued by private banks in the U.S. free-banking era (1836-63) were not only redeemable in specie, but they constituted senior claims against the bank's physical assets in the event of bankruptcy. Mortgages are backed by real estate, etc.

Of course, there is the problem of dividing up the physical assets, but at some level, someone ends up with property rights in the physical asset--and it is this property right that gives most assets a "fundamental" value.

Note: I see that Steve Williamson has his own reply here: Money and Bubbles