Interest rates and slumps: competing views

As Paul Krugman notes here, the nominal interest rates on U.S. Treasuries are at historic lows. He seems to take this as vindication for his view that more government "stimulus" was/is needed. (I take "stimulus" here to mean deficit-financed government purchases of goods and services.) Well, let's think about it.

First of all, I think that Krugman (along with many others) deserve credit for recognizing that money-bond swaps (Fed policy) are largely irrelevant in very depressed environments. He (again many others too) also deserve credit for understanding the special "safe haven" role that U.S. Treasury debt plays in today's world economy. But does understanding all this necessarily lead to the conclusion that what the economy needs is more (it never seems to be enough) government "stimulus?"

Some of our economic theories suggest that the answer is yes, while some suggest no. What Krugman is suggesting is that the latter group of theories should be discarded because their predictions on nominal interest rates have been completely wrong. He is getting a little ahead of himself here.

Unfortunately for Krugman, there are theories out there that generate predictions broadly consistent with the data but which do not lead to the same policy conclusion.  One such theory is the "new monetarist" model I published for the Bank of Japan (during my visit there in 2002): Monetary Implications of the Hayashi-Prescott Hypothesis for Japan. (See also here.)

The basic story is this. First, it is conceivable that "real" factors are contributing to a "growth slowdown." Here, one is free to pick your favorite bogeyman. Maybe it's becoming more difficult to expand the technological frontier (see, for example, Tyler Cowen). Maybe it's the fear that people (via their political representatives) will become more interested in appropriating wealth, rather than creating it (see, for example, The Grabbing Hand).  Whatever the case may be, the upshot is that people--investors, in particular--are rationally pessimistic (over the future after-tax return to their investment activities today).

In the model I used in my BoJ paper (an overlapping generations model), rational pessimism generates a "flight to quality"--people begin to substitute government money/debt for private assets. The effect is deflationary (driven by the increase in real money demand). The economy looks like it is suffering from "deficient demand" (it is not). There is downward pressure on the real interest rate (as the demand for investment contracts). These are not crazy predictions.

In my model economy, the central bank has control over the real interest rate, and cuts in the interest rate stimulate investment and (future) GDP. When the nominal interest rate hits zero, the central bank can no longer influence the real interest rate via money-bond swaps (i.e., there is a "liquidity trap"). Real activity may be stimulated, however, by increasing the inflation target (the operation must be undertaken by the fiscal authority in my model; the monetary authority is powerless in a liquidity trap). It might also be possible for increases in G to expand GDP (as is the case in many neoclassical models). All of this is true. And yet, it does not follow that any of these "stimulus" programs are necessarily desirable (among other things, it depends on what social welfare function one adopts).

Now, I'm not absolutely sure about the empirical relevance of my little model. This is because I can think of another theory that generate predictions that are observationally equivalent to my model, and yet delivers very different policy prescriptions.

The model is the one evidently used by Krugman, DeLong, and others (Nick Rowe?). In a nutshell, recessions are caused by an increase in money (treasury) demand. That's just like in my model. But there is a big difference. In their view (as far as I can tell), the pessimism that drives up the demand for money is attributable to "irrational" fear. And if the private sector is afraid of spending, maybe the government sector should step in and take its place.

But perhaps this is not entirely fair. There is, in fact, a literature that explains how expectations can become self-fulfilling prophesies. I could, for example, modify my model to incorporate a form of increasing returns to scale in the economy's production technology. This could generate what economists call "multiple equilibria." Each equilibrium is determined by expectations. If  people are optimistic, good things occur. If people are pessimistic, bad things occur. The pessimistic expectations are "rational" at the individual level, but not at the social level. There is potentially a role for policy here.

Krugman, DeLong and Rowe do not frame things in quite this way, so I'm not sure if this is what they are talking about. But Roger Farmer has been working in this area for a long time and I think his ideas are finally starting to gain some traction; see The Fear Factor.

Anyway, my basic point here is, as always, that we need to be more circumspect in our claims about what we know for sure. Beware of economists that make claims like this. 

Fractional reserve banking

Fractional reserve banking is sometimes portrayed as a sort of scam; a method by which rich bankers  underhandedly sap the wealth of society. This short video here, How Fractional Reserve Banking Increases Inflation and Steals our Wealth, is fairly representative of a view I hear expressed quite often.

As you might have guessed, I think that this view is somewhat distorted and misleading. Let me explain why I feel this way.

The video starts off with an hypothetical depositor who starts off with $1000 and asks what happens when it is deposited. Right away we are off to a poor start.

Does he mean starting off with $1000 of cash? Or does he mean $1000 of money (say, in the form of a paycheck)? It makes a difference. When was the last time you made a cash deposit? If you are like me, you cannot remember when. Of course, money gets "deposited" all the time in your account. At work, for example, you might be paid by check or by direct deposit. But this is not what the guy means by "making a deposit"--these "deposits" are simply debit and credit operations in a linked system of accounts (your paycheck is credited to your account, and is debited from your company's account). What the guy means by a "deposit" is a cash deposit. The main source of cash deposits in all likelihood originates from the cash registers of retail businesses.

Alright then, evidently there is cash in circulation. These days, cash primarily takes the form of small denomination paper notes issued by a central bank, like the Fed (in the past, cash frequently took the form of specie--gold and silver coin). There is a demand for cash. Cash is useful for purchasing some types of goods and services when no other means of payment is available. (Cash is also used when transactors wish to keep their exchanges anonymous). And so people occasionally visit ATMs to make cash withdrawals. This cash ultimately finds its way in the cash registers of businesses (however, it is estimated that a lot circulates in the underground economy and, in the case of the U.S., outside of the country).

O.K., so where does banking fit in all this? Maybe your ideal view of a bank is simply as a place to keep your cash safe, kind of like your piggy bank. You deposit your cash with the bank, and the bank issues you a receipt, which constitutes a record of your cash deposit and represents a claim for cash (deliverable by the bank). Or the bank may simply record your deposit as a book entry item. Either way, your cash deposit constitutes a liability for the bank. These liabilities are sometimes called "bank-money" because, well, because they can be used as money. Receipts (especially if they are made payable to the bearer) can potentially circulate as money. Similarly, checks can be written ordering the transfer of cash sitting at the bank from one account to another. If the value of liabilities issued by the bank do not exceed the amount of cash it holds as assets, then we call this 100% reserve banking. (The liabilities issued by the bank are backed 100% by cash.)

Of course, banks do not just keep your cash safe and perform debit/credit transactions for you. They also make money loans. And here is where the confusion generally begins. It starts with the idea that the bank might have the temerity to lend YOUR cash out to someone else--at interest, to boot!

Well, that's not quite what happens. Let try me explain (well, to the best of my understanding, of course).

Suppose you want to start a restaurant business. You own the property and building, but nothing else (apart from your human capital). The building needs to be made into a restaurant. You need ovens, utensils, rooms to be made and finished, furniture, staff, advertising, accountants, lawyers, etc. How do you pay for all this stuff? You clearly have wealth (physical and human capital). You just don't have any cash.

But what do you need cash for anyway? Why not pay for all this stuff using your wealth? One way to do this, in principle at least, is to issue receipts representing shares in your wealth. These shares are liabilities against your wealth. Each share represents an IOU against the future income stream generated by your capital. (The IOUs could take a variety of forms. They could, for example, be made into coupons redeemable for food from your restaurant--something very similar to Canadian Tire Money).

Um, one problem. If you're like me, not very many people know who you are. A randomly selected member of society is unlikely to recognize us, or have any idea what we really own, or have any idea how well we might live up to the promises (IOUs) we issue. Basically, most of us are anonymous (except for within a relatively small network of friends and business relations--and even then, we keep a lot of information private). Anonymity renders our capital illiquid (it is not easily or widely accepted as a means of payment).

O.K., so scratch the idea of creating your own money. This is where a bank now comes in. Let's imagine that the bank reviews your business proposal and concludes that it is likely to be profitable. The bank also thinks that your capital is of high quality and that your ownership title is clear (btw, you are now no longer anonymous to the bank). Now, you might think that the bank is then going to lend you the cash you need to finance your operations. Well, you would be wrong (sort of). That is, you do not need cash--what you want is bank-money. And that's what you typically get from the bank: a money loan in the form of bank liabilities (not cash).

Now, the commentator in that video claims that this bank-money is created out of thin air. That is both correct and completely irrelevant; see my earlier post here. The bank-money (whether in the form of paper notes or book-entry objects) are backed by the assets you put up as collateral for your loan. As long as the loans officer makes good decisions about which business ventures to lend money to, the bank-money created by the bank is fully backed (and consequently, not inflationary; i.e., the new money issue is not dilutive). What the bank has in effect done here is transform your illiquid capital into a liquid liability. This is hardly an activity that one might reasonably label as being inherently "evil."

But this is not quite the end of the story. I have just made the claim that banks issue fully-backed liabilities that serve as money instruments. If this is true, then what do people mean by fractional reserve banking? Let me explain.

In practice, banks issue a very peculiar type of liability, called a demand-deposit liability. In the lingo of financial wonks, these are liabilities that have embedded within them a contractual stipulation known as an American put option. This option gives the debt holder (the depositor) the right to exercise a redemption option on demand at a fixed price. The redemption option in this case consists of the right to redeem bank-money for cash on demand (and usually at par, but frequently subject to a service charge). This is what happens every time you make a withdrawal of cash from your bank or an ATM.

Why do banks do this? Isn't is a recipe for potential trouble?

I don't know why banks do this. In many jurisdictions, it may constitute a legal restriction (as part of the bank charter). I'm not sure if the restriction is binding, however. That is, it is my understanding that banks used to do this even when they were not legally required to do so. Evidently, the redemption option is valued by those who make use of bank-money.

I am aware of only two (not necessarily mutually exclusive) explanations for this contractual stipulation. One is that consumers value insurance against "liquidity shocks" (events were only cash is accepted). The other is that the redemption option serves as sort of a discipline device for bank managers (see Calomaris and Kahn, AER 1991). That is, the put option makes the bank's liability a very short-term debt instrument, so that depositors can potentially pull out very quickly if they sense any hanky-panky. The threat of mass redemptions (and the bankruptcy it would entail) is presumably enough to dissuade self-interested bankers from absconding with depositor wealth.

Sounds wonderful except that, of course, only a very small fraction of a bank's assets are typically in the form of cash. Most of the bank's assets are tied up in "long-term illiquid" assets, like your house, or your human capital. Consequently, while the bank's liabilities may be fully backed, only a small part of this backing is in the form of cash. This is the true nature of fractional reserve banking.

The potential trouble, of course, comes to play when a bank (or worse, the banking system as a whole) is subject to a wave of mass redemptions. There is simply not enough cash in the banking system to honor all of its short-term debt obligations simultaneously. (This is not fraud or deceit; it is something that everyone is--or should be--plainly aware of.) In this event, banks are compelled to sell off their assets to raise the cash they need. This is not something that all banks can all accomplish simultaneously; at least, not without depressing asset values and creating a deflation (the fall in the price-level reflects an increase in the demand for, hence value of, cash relative to goods and services).

There are basically two (possibly more, as readers have suggested below) ways to eliminate retail-level banking panics (waves of mass redemptions). Neither are without cost. One way is to adopt some sort of national deposit insurance system. This is the system that presently exists in the United States (FDIC plus the Fed discount window). People criticize this system because it allegedly promotes moral hazard (banks are induced to take on excessively risky investments). On the other hand, the U.S. has not experienced a retail-level bank run since the Great Depression.

The other way to eliminate retail-level banking panics is to pass legislation requiring all banks to hold 100% cash reserves. This would, of course, kill the business that transforms your illiquid assets into a liquid payment instruments. But it would not necessarily kill the prospect of bank-run-like phenomena. This is because bank-run-like phenomena can emerge even without fractional reserve banking. The phenomenon is possible whenever short-term debt is used to financed long-term (illiquid) asset purchases, as is the case in the wholesale-level banking sector (the so-called "shadow banking" sector).

The use of short-term debt to finance long-term asset purchases (think of the overnight repo market) is, again, a very peculiar financing structure. Like the demand deposit liability, the structure is likely explained by the need to align incentives. While this structure may enhance efficiency along some dimension, it comes at a cost. The analog to a bank run here is a "roll over freeze." This is an event where creditors (depositors) refuse to rollover their short-term funding en masse. In this event, debtors must now scramble to raise funds or dispose of their assets (at "firesale" prices).

If this sounds familiar, it should: it is exactly what happened in our most recent financial crisis. It is also what policymakers currently fear might happen to European banks (who have borrowed USD short-term, to finance longer-term asset purchases; see here). 

What Scott Sumner Knows for Certain

Love TheMoneyIllusion. But does Scott go a little too far with this proclamation?

Here’s what we know for certain about the US business cycle:

1.  If nominal wages are highly sticky, then NGDP slowdowns will raise unemployment.

2.  Nominal wages are highly sticky for at least some workers.

3.  The period after mid-2008 saw the largest NGDP growth collapse since the Great Depression.

4.  The period after mid-2008 saw a huge rise in unemployment.

Points 3 and 4 are empirical statements (and they are true).

Point two sounds like an empirical statement too, but it is not really. The reason is that there are many different theoretical (and empirical) notions of what exactly constitutes a "sticky" nominal wage. Most people have in mind the idea that nominal wage rates do not appear to adjust quickly to changing economic circumstances. But ideally, the concept should be defined more precisely than this (preferably within the context of an explicit economic model). At the very least, we could then be absolutely certain that we were talking about the same thing!

(The other thing I should like to point out here is that people often ignore the huge monthly gross flows of workers into and out of employment. The wages of these workers likely display much more flexibility than those workers employed for some time at a given establishment. I discuss turnover issues here.)

The first point is clearly a theoretical proposition: if X, then Y. As a theoretical proposition, it is likely to remain valid only under a set of specific conditions. Unfortunately, Scott does not provide us with the model he has in mind. And to make matters worse, he seems to want to make us believe that, whatever this model is, it "for certain" applies to the U.S. economy. (Most of what I am complaining about is probably the by-product of loose blogger language, but I think it's important for some things to be more precise.)

Now, I can certainly think of a model that might deliver something resembling the proposition in question. Think of a neoclassical labor market model, where money is somehow necessary, and were nominal price adjustment (or formulating contingent contracts) is costly. Then think of an exogenous decline in the price level (who knows what might have been responsible for that). The implication is that the real wage rises and that this reduces the demand for labor (though why this translates into an increase in unemployment, and not an increase in non-participation, is not usually discussed).

As I have argued elsewhere (The Sticky Price Hypothesis: A Critique), Marshall's scissors (static supply and demand curves) are probably not the best tool we have available to interpret the labor market. The labor market is a a market in relationships, much like the marriage market. The spot wage is irrelevant in enduring relationships; what matters is the time-path of wages and the division of the joint surplus. There are many different wage paths that cost the firm the same in net present value terms. A "sticky" wage (whether real or nominal) need not have any allocative consequences.

I therefore confess that I, for one, do not know "for certain" that if nominal wages are sticky, then NGDP slowdowns will raise unemployment.

It ain't what you don't know that gets you into trouble. It's what you know for sure that just ain't so. Mark Twain

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?