What makes a central bank special?

Nick Rowe over at WCI has an interesting post asking what makes a central bank special; see Currency, Interest, and Redeemability.

According to Nick, what makes a central bank special is not that it can borrow and lend, create money, and set interest rates. All of us can do these things in principle; and in practice, many large private financial institutions do do these things. The difference, as Nick explains, is what he calls "asymmetric redeemability." The Bank of Montreal, for example, issues money redeemable in BoC liabilities; but the reverse is not true.

I think that's right; but let me expand with a few related thoughts of my own.

If one looks at history, a recurring property of monetary economies is the emergence of a "base money" that serves as the redemption object for "broad money" objects. Frequently, the broad money is made redeemable, on demand, and at par, with the base money. (We might even call base money "central" money, as it serves as the focal point for all other monies.)

In modern economies, the demandable liabilities created by chartered banks (M1, say) constitute broad money made redeemable, on demand, and at par, with government cash (small denomination paper). In the antebellum US, private banknotes were made redeemable on demand at par for specie (gold and silver coin). And so on throughout much of recent monetary history.

Now, there are a lot of interesting questions that arise here that are not the main focus of my post here. For example, why do banks embed their liabilities with what amounts to be an American put option (liabilities made redeemable on demand at a fixed strike price)? Is it the byproduct of a legal restriction, or is it an equilibrium phenomenon?

Either way, it seems obvious that the agency in control of the supply of base money (the object of redemption) is going to be in a position to implement "monetary policy." Whether this is a good or bad thing is the subject of much debate of course (let's not get into that here). And so, I have to agree with Nick's conclusion:

There is something very seriously wrong with any approach to monetary theory which says we can assume central banks set interest rates and ignore currency. It is precisely those irredeemable monetary liabilities of the central bank (whether they take the physical form of paper, coin, electrons, does not matter) that give central banks their special power.

(He is, however, not quite right about private agencies not being able to issue irredeemable objects and get them to be used them as money; see Bitcoin).

Scott Sumner, who runs a very nice blog himself, has an interesting take on Nick's post; see: The Bank of Canada is Important Precisely Because it is not a Bank.  Here is Scott:

Now let’s consider a different monetary system.  Imagine a gold standard and a monopoly producer of gold.  The gold mine company would reduce short term interest rates by increasing the supply of gold.  Like currency, gold is irredeemable.  But no one would call this gold mining company a “bank” because it possesses no bank-like qualities.  Banks don’t create irredeemable assets, gold mines do.

Scott is trying to tell us that a central bank is not a bank; it is the monopoly supplier of base money. He also says that "banking has nothing to do with monetary policy."

I find it difficult to evaluate this view because he does not define "bank" or "monetary policy" here (although I'm sure he does elsewhere). Permit me once again to give my 2 cents worth.

A financial intermediary is an asset transformer. An insurance company, for example, takes "deposits" (premiums), purchases assets, and creates a set of state-contingent liabilities backed by these assets. A pension fund, as another example, takes "deposits" (contributions), purchases assets, and creates a set of time-contingent liabilities backed by these assets. A bank, finally, takes "deposits", purchases (or finances) assets, and creates a set of demandable liabilities backed by these assets.

So a bank is a special kind of intermediary. It is special because the demandable liabilities created by banks are used widely as payment instruments; i.e., money (and the demandable property of these liabilities probably goes a long way to enhancing their acceptability as money, but that's another story).

When a bank accepts your land as collateral for a money loan, it performs an asset swap. It is transforming your illiquid land into a liquid asset (the liability created by the bank). Banks are in the business of transforming illiquid assets into liquid assets. This leads us to ask what the Fed is doing when it purchases (say) MBS or UST assets? In my view it is transforming (relatively) illiquid assets into a very liquid asset (Fed cash). QE is banking; and it falls under the category of monetary policy, in my books at least.

So in some sense, all banks (private and public) are engaged in a form of  "monetary policy." But it still remains true that a central bank with legislated monopoly control over the economy's base money object is "special" precisely for this reason. And any theoretical framework that is to have any hope of ever understanding the role of money and banking in society is going to have to model these objects explicitly; the way this guy does, for example. 

Burtless: It's *not* regulatory and tax uncertainty

Gary Burtless, an economist at the Brookings Institution, seems pretty sure that the relatively depressed levels of U.S. business investment and employment have nothing to do with the alleged uncertainty over future tax and regulatory regimes. Mark Thoma reports the story here.

The main thrust of the argument is contained in the following paragraph:

Then why was uncertainty about taxes and the future burden of the Affordable Care Act holding back business investment right now? If managers thought taxes or regulatory costs might go up in the future, wouldn't it make sense to take advantage of today's low taxes and lower burdens to invest and hire today? According to the "uncertainty" argument, businesses are fearful they might face high taxes and extra health cost in 2016 and 2018. Shouldn't they expand hiring right now and scale back employment when they actually face higher costs (if they ever do)?

Burtless raises some good questions here, but I don't think they are the nail-in-the-coffin he makes them out to be. Why not more investment now, if taxes might go up in 2016 or 2018?

First of all, I'm not sure that those are the only dates businesses have to consider (governments can raise taxes anytime). Second, many large capital projects take a lot more than just a few years to complete. Think about the act of committing a large amount of capital (belonging to you, your friends, your creditors, your shareholders) destined to payoff (if at all) sometime in the distant future. Once committed, this capital is almost completely irreversible and--significantly--it is easily appropriated, since capital cannot run away once it is built). Is it completely crazy to imagine that those contemplating such investments in the current economic climate might want to worry (among other things) the possibility of future changes in tax regime?

Well, maybe my argument does not work so well for employment. As Burtless suggests, why not hire people now and then lay them off if and when taxes rise? One response to this is: How does he know for sure that the future regulatory climate will allow firms to lay off people in this easy manner? If the U.S. is moving to a more European-style economic model (and I'm not saying here whether this is good or bad), then firms may at some point in the future face large penalties for letting workers go.

So what is the problem, according to Mr. Burtless. Predictably, it is this:

The odd thing is, when businesses are asked why they're not expanding, "high taxes" and "heavy regulatory burdens" and "tax uncertainty" don't feature as prominent answers. They mostly say they don't see good prospects for extra sales. But right-wing economists have their talking point, even if they make little sense, and they're sticking to them.

Ah yes, those evil right-wing economists (one can see the halo hovering over his head as he says this).

I've tackled the issue of how firms reply to these business surveys here: Deficient Demand: The Deflated Balloon Hypothesis. Basically the idea is as follows. Consider any shock that leads to a contraction in one sector of the economy. Imagine that sectors are characterized by an interlinking network of demands for intermediate goods and services. A collapse in residential construction can now be expected to reverberate throughout the economy. A decline in the demand for housing also leads to a decline in the demand for all the products that go into making houses. It would not be surprising for someone in the business of producing (say roof shingles) to report that his or her main problem appears to be a "lack of demand" for their product.  But that by itself does not constitute evidence that the macroeconomic problem is a "lack of aggregate demand."

Burtless may very well end up being correct in his assessment. I'm just not sure how he knows for sure that what he says is true.

Updates: September 06, 2011

Regime Uncertainty: The Real (Option) Deal, Craig Pirrong
This is a direct rebuttal to Burtless (h/t Prof J)

Other related links:
Regime Uncertainty: Why the Great Depression Lasted So Long and Why Prosperity Resumed After the War, Robert Higgs
The Great Recession and Government Failure, Gary Becker (h/t Alex Karaivanov)

Fiat money in theory and in Somalia

A classic question in the theory of money is how an intrinsically useless object like fiat money can possess exchange value. The modern theory of money has essentially settled on the answer first provided by Ostroy (1973). In a nutshell, circumstances may dictate that some objects are relative good for record-keeping purposes, quite apart from any other use they may have in consumption, production, or storage; see also, Kocherlakota (1998).

The basic idea is as follows. We know that monetary exchange is not necessary, even in economies where mutually beneficial bilateral barter exchanges do not exist (what economists clumsily call a lack of double coincidence of wants). This is not simply a theoretical statement; we know of (and indeed most of us belong to) small economies (networks of families and friends) that operate according to "gift giving" principles. We are willing to make individual sacrifices without monetary compensation, hoping that they will be noticed, remembered, and most importantly, reciprocated at some point in the future.

Gift-giving societies seem to work well enough in small groups. This is probably because it is relatively easy to keep track of (remember) individual contributions and rewards in small groups. This "societal memory" seems to break down in large groups. Evidently, there are limitations to how much information can be recorded securely in the collective minds of people who make up society. When this is the case, some substitute form of memory could be useful. This is where money comes in.

Imagine that there is an object that is durable, divisible, portable, hard to counterfeit, and in limited supply. A lot of commodities fit this description, including gold, silver, and salt (think of what "salary" means). Historically, privately-issued paper in the form of asset-backed securities (like the banknotes of antebellum America) have also fit this description. In larger economies, objects like these begin to circulate as a means of payment. They become money.

Let me explain the basic idea. In the past, I may have made a contribution to society for "free." Well, not exactly for free; but because I knew that my contribution would be noticed and reciprocated. But as my community grows, it becomes increasingly difficult for people to keep track of each other's contributions. Well, if that's the case, then it might make sense to record my gift in some other manner. Accepting a monetary object is one way to do this. The money in my possession constitutes information about my past contributions to society. In the language of Narayana Kocherlakota (currently president of the Minneapolis Fed), money is memory.

Because commodities (including the physical capital that may back paper money) have uses in consumption and production, an implication of this is that society must bear a cost if such goods are tied up in facilitating exchanges. Their value in exchange generally means that they are priced above their "fundamental" value; that is, they possess a "liquidity premium." (This is related to what Caballero calls an asset shortage.)

Now, here is where fiat money potentially plays a role. According to the theory described above, the role of money is to encode a particular type of information (relating to individual trading histories). But information like a credit history is intrinsically useless (one cannot eat someone's credit history, for example). So rather than tying up intrinsically useful commodities to record intrinsically useless information, why not delegate the job to an intrinsically useless asset instead? Like the U.S. paper dollar, for example. (Electronic book-entry objects can work as well.)

According to this view, the market value of fiat money consists exclusively of a liquidity premium. The asset has no intrinsic value, and yet it has a positive price. Fiat money is a "bubble" asset -- but this is a bubble that plays a useful social role (it economizes on commodities that have uses other than record-keeping).

Prior to Ostroy's work, the answer to the question of how fiat money can possess exchange value was that its value is somehow supported by government decree (the original meaning of the word "fiat"). In particular, the government could introduce paper and insist that taxes be paid in government paper.

A recent paper by William Luther and Lawrence White (Positively Valued Fiat Money after the Sovereign Disappears: The Case of Somalia) casts some doubt on the strength of the mechanism highlighted by this older view.

Evidently, it is the case that the Somali shilling continues to circulate in that country long after the government that issued that paper collapsed in 1991. Here is a quote from the paper:

One of the most astounding phenomena of the domestic market is the continued circulation of the old Somali bank notes. The Somali currency has had no central bank to back it up since the bank was destroyed and looted in 1991. Nonetheless,the currency has maintained value, and has floated against other foreign currencies that are traded freely in local markets.

One reason the shilling continues to maintain its value is no doubt related to the fact that it's supply can be trusted to remain relatively constant over time. In fact, it's supply may be contracting over time as notes wear out (I have heard stories of where old notes are laminated to make them more durable, but am unable to confirm this.) On the other hand, there is some evidence of counterfeiting; e.g.,

Perhaps the most convincing evidence that the Somali shilling held a positive value in the absence of sovereign support, however, is that individuals found it profitable to counterfeit these notes. Mohammed Farah Aideed ordered roughly 165 billion Somali shillings in 1996 from the British American Banknote Company based in Ottawa, Canada. Another 60 billion Somali shillings were imported by Mogadishu businessmen in 2001. In total, an estimated 481 billion in unofficial Somali shilling notes have been printed since 1991.

This counterfeiting phenomenon, however, does not appear to be excessive; and, indeed, it probably plays some positive role in keeping the supply of shillings relatively stable.

A Bad Rap for the Bond Raters?

Who's going to listen to a company whose name translates to "average and below average"? Jon Stewart.

In my previous post (Wonderland), I asked what sort of evidence justifies making public sport out of the major bond rating agencies and their role in the recent financial crisis. The type of sentiment I question was repeated the other day by Paul Krugman here; I quote:

And S&P, along with its sister rating agencies, played a major role in causing that crisis, by giving AAA ratings to mortgage-backed assets that have since turned into toxic waste.

The first thing we have to ask, of course, is what does a AAA rating actually mean? The only thing most people know is that AAA is the highest rating that agencies attach to bonds. But that's an ordinal statement; it does not necessarily imply "absolutely free of risk." Apart from death and taxes, there are no perfect guarantees in life.

The second thing we have to ask is what sort of risk are the ratings trying to measure. In a nutshell, they measure the risk that the terms of a contract are not fulfilled. They do not measure the liquidity risk associated possession of the asset (the major problem during the financial crisis). Note: by liquidity risk, I mean the ease with with one can dispose of an asset (or use it as collateral in a loan) over a short period of time, without the asset being ridiculously discounted in the market.

Now, there seems to be no question that in the depths of the crisis, a lot of MBS was treated as if it were toxic (it was heavily discounted). But as I said above, bond ratings do not (I do not think) measure liquidity risk. They measure things like, well, did the MBS actually deliver on the interest and principal that was expected?

It surprising how difficult it is to find out just how much of the outstanding MBS actually did end up as toxic waste. Paul Krugman seems to think it was a lot. So do a lot of other people. But where is the data?

I decided to ask Gary Gorton, who knows more than most about these matters. Here is how he replied to me:

Of the notional principal amount of AAA/Aaa subprime bonds issued in the years 2006, 2007 and 2008 (which is almost $2 trillion), the realized principal loss as of Feb 2011 is 17 basis points – almost nothing, but much higher than AAA/Aaa other stuff.  Yes, I think the agencies are being treated unfairly by uninformed people.  There are many other facts that are similar that are also inconsistent with the popular narrative of the crisis. 

If this is true, it is indeed remarkable. The actual losses on these "toxic" products has been tiny. That is the type of risk that was being evaluated. (I might add that the losses on bank deposits during the great financial panics of the U.S. National Banking Era (1863-1913) were reportedly in the order of 50 basis points.)

Evidently, Gary has a PhD student working on this. I look forward to reading her findings (and reporting them here). Of course, if anyone out there has evidence relating to this question, I'd greatly appreciate hearing from you.

Update: August 10, 2011

Thanks to Jesse for this link to Bond Girl, who makes a lot of the same points (and more).

I also received this note from Don Brown (thanks, Don--I will investigate):

I cannot verify current loss=17bp figure, but it doesn't sound surprising to me.  HOWEVER, that misses the point.  There are significant losses to be taken on 05-07 vintage subprime, due to massive delinquencies.  It will be on the order of 12-15% of the original amount of AAA subprime securities that FNMA/FHLMC bought.  I encourage you to do your own original research to verify this, but as a quick back-of-the-envelope:


I know that agency portfolios were buying wide-window AAAs off subprime, mostly 06-07 vintage.  They bought a lot ($250B if I remember correctly).  Note: portfolios were the hedge funds that FN/FH were running, outside of their traditional business as mortgage guarantor.


Average original subordination was 26-30%.  So actual losses on subprime would have to be around this level to start showing losses.  Currently, actual losses aren't at this level, but it's easy to see that they will increase (barring a miracle).

To date, most subprime deals have taken losses in the 15-20% range (percentage of original balance).  They have serious delinquencies 40-60% of current balance (serious dlq defined as 90+ days dlq, FCL, or REO).

15% current losses leave you with 11-15% subordination (on average).  Currently, subprime loss severity is around 80% (upon liquidation of the house).  For a 50% dlq deal => 50%x80% = 40% additional losses from here (distributed over time).  That would imply actual losses of 25-29% on the current face of the class.  Average factor for these classes are 0.55.  Very roughly, this translates to 12-16% loss on the original investment.


For examples, take a look at OOMLT 07-5 1A1(cusip 68403HAA0) and CWL 06-26 1A (cusip 12668HAA8).  One of the agencies owns these classes (almost all subprime deals have a Group1 / Group2 structure.  Group1 was conforming balance subprime loans that went to the agencies).  You can find the remittance reports at BoNY web site or CTS.  They are publically available.

Update: August 14, 2011

Rebel Economist (see comments below) directs me to this interesting link: Is Blaming AAA Investors Wallstreet Serving PR? 

Ron Paul on Bernanke's Press Conference

CNBC interview with Congressman Ron Paul yesterday (April 28, 2011); click here.

The interviewer begins by quoting a statement Paul made after Bernanke's news conference:

Bernanke continues to ignore his culpability for the inflation all Americans suffer due to the Fed's relentless monetary expansion.

Let's take a look at U.S. inflation since 2008. Here it is.

The average annualized rate of inflation over this time period is a dizzying 1.6%. Note the significant deflation experienced during the economic crisis. Ah, good times. The rate of return on your money was really high back then! I can recall clearly how savers were rejoicing...praising the Fed for the deflation.

PCE inflation measures the nominal price of a basket of consumer goods. You know, the stuff people buy to maintain their material living standards. This price index was actually falling in 2010. For better or worse, the Fed interprets "price stability" as 2% inflation. This explains QE2.

PCE inflation has recently jumped up to near 5%. This jump is attributable primarily to food and energy prices. Despite what some people like to believe, the Fed does not control food and energy prices (at least, not separately from other prices). Most economists attribute these relative price changes to geopolitical events and other temporary global shocks affecting the world supply and demand for food and energy.

It seems that what Congressman Paul means by inflation (judging by this interview) is "commodity price inflation." I think he must have in mind the price of commodities like gold. Why is the price of gold rising? Because people are dumping the USD and flocking to a "currency" they can trust.

Well, alright. There is probably something to this notion of currency substitution. If the Fed grows the money supply, its value must fall. The price of gold must rise. In the interview above, the Congressman claims that even grade schoolers can understand this (suggesting that Bernanke cannot).

Recent money supply and gold price dynamics seem to support Congressman Paul's hypothesis, which he states as some sort of obvious universal truth. But if this is so, then what explains the following data?

The graph above plots the price of gold and the (base) money supply over the 20 year period September 1980 to March 2001. As you can see, the Fed created a lot of money "out of thin air" over this 20 year period. The base money supply increased by over 300%.

Imagine that you are 50 years old in September 1980. Imagine that a trusted friend of yours--oh, let's say your doctor--convinces you to put all your savings into gold. The reason he offers is that the Fed is pursuing a policy of "relentless money expansion." He warns you that the money supply is set to grow by 300% over the next 20 years. So you listen to him.

You buy gold at $673 per ounce. And then you wait. You wait until you turn 70. And then you go to withdraw your savings. You discover that the gold price in March 2001 is $263 per ounce. That's a whopping rate of return of...wait for it... -60% over 20 years. That's a minus sixty percent.

All you kids understand now? Viva la gold standard! Class dismissed.

Meet the FOMC

From CNBC News, a nice little snapshot of the people who currently make up the Federal Open Market Committee.

When people think of "the Fed," they might picture a monolithic building in Washington, D.C., or the serenely smiling, bearded face of its chairman, Ben Bernanke.

But the reality is, the group making decisions about raising or cutting rates or pumping money into the economy through so-called quantitative easing is made up of several highly educated, opinionated individuals with sometimes-conflicting ideologies, personalities and policy specialties.

Meet the Federal Open Market Committee.

Read more: Infighting at the Fed? 

Time to replace the Core Inflation measure?

As almost everyone knows, inflation appears to be ticking upward. PCE inflation has recently approached an annual rate of around 5%. However, core inflation--the inflation rate that strips out the food and energy components of the consumption basket--remains relatively subdued (almost 2%, though it too has been rising as of late).

The Fed is widely understood to have an implicit inflation target of 2%. And the Fed has been known in the past for preferring the core PCE inflation measure over actual (headline) inflation numbers. With food and energy prices rising rapidly as of late, the reference to core inflation makes the Fed look out of touch with the prices consumers actually pay for their daily basket (food and energy make up about 25% of the average consumption basket).

What, if anything, justifies looking at price indices that strip out components of the index? A cynical view is that the Fed may prefer core to headline because it evidently makes the Fed's performance look better (in terms of keeping inflation low). This cynical view conveniently ignores the fact that headline inflation is frequently below core.

If you want to educate yourself about the issues surrounding the use of core, I recommend that you read this piece by Jim Bullard: Headline vs. Core Inflation: A Look at Some Issues. He starts as follows...

Monetary policymakers are responsible for maintaining overall price stability, which is usually interpreted as low and stable inflation. In order to decide on appropriate policy actions given their objective, policymakers need to know the current rate of inflation and where it is headed. What makes for a reliable predictor of future inflation has been debated throughout the years and continues to be the subject of economic analyses today.  

and concludes with...

In the end, the policymakers' goal is to use the inflation measure that helps them achieve low and stable headline inflation in the long run. 

In short, the Fed is not wedded to any particular policy-relevant measure of inflation. Many different measures should likely be used as input into any policy decisions.

In terms of the use of core inflation, my own personal view leans toward dispensing with any inflation measure that strips out components of the consumption basket. If the main object of doing so is to get at some measure of "trend" inflation, then why not just compute a trend directly? For example, here is what one would get by using a simple exponential trend:

My crude measure of trend is not that much different from core. I doubt that there would have been any substantive difference in the way policy was actually conducted if reference had been made to this (or some other) measure of trend over the core measure. And an explicit reference to trend rather than core may have deflected the silly charge made by some that the Fed does not care about food and energy prices.