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

Friday, August 6, 2010

Asset Shortages and Price Bubbles: A New Monetarist Perspective

I confess that I'm a big fan of Ricardo Caballero's 2006 paper: On the Macroeconomics of Asset Shortages.  (Some easy-to-read presentation slides available here.)

In a nutshell, the Asset-Shortage Hypothesis asserts that "good" assets are scarce; in particular, the type of assets that people would feel comfortable accepting as collateral for a loan, or as a store of value. It is remarkable how much might follow from this one property: asset price bubbles, low real interest rates, deflationary pressures, global imbalances, etc. In his presentation slides, Caballero concludes by saying that this simple ingredient can explain the main global macroeconomic phenomena of recent years. I want to argue that organizing one's thoughts around this general principle is probably a good way to think about macroeconomics in general.
In many ways, I think that the so-called New Monetarist (NM) brand of macroeconomic theory does precisely this. One of the fundamental frictions common to this class of models is the assumption of limited commitment (or limited enforcement--I'm not quite sure of the distinction). This friction can lead naturally to the asset-shortages emphasized by Caballero. A sticky price friction does not. (In the immortal words of Pierre-Simon Laplace: Je n'avais pas besoin de cette hypothèse-là. My own thoughts on the sticky price hypothesis can be located here).

Limited commitment/enforcement

The financial market is essentially a market in promises. In particular, debt constitutes a promise to repay. Of course, the flip side of debt is an extension of credit. And credit, in turn, requires a belief that promises will be kept (credere in Italian = to believe). The financial market would be a pretty boring place if people could simply be trusted to make good on their obligations (equivalently, if promises made could be enforced at zero cost). Unfortunately, things are not so boring.

It seems unlikely that people are intrinsically trustworthy. The supply of promises seems infinite. It is easy to ask for some favor now in exchange for a reward promised far into the future. Repaying a debt, on the other hand, appears rather more difficult. If they could do so with impunity, debtors are likely to renege on their promises. The result would be a suspension of credit. This is how a lack of commitment/enforcement leads to an asset shortage.

Institutional responses

Societies go to some length in adopting institutions that facilitate intertemporal trade. Perhaps the most basic of these institutions is reputation. The gain/loss of "reputation capital," leading to enhanced/diminished trading opportunities, will in many cases be sufficient to sustain debt. In many societies, the punishment for noncompliance (dishonor) frequently takes the form of social ostracism. (See what happens if you do not buy your fair share of beer for your drinking buddies, for example). Of course, more painful punishments are possible (knee-capping, whippings, debtors' prisons, etc.); but these enforcement mechanisms consume resources.

Unfortunately, reputational concerns are not always enough to promote good behavior (hello, Bernie Madoff). What other (relatively low-cost) ways might debt be sustained? It is worthwhile to note that a jilted creditor cannot eat an abandoned reputation; a transferable asset would surely taste better. It is for this reason, I think, that debt collateralized by some form of physical capital--an asset backed security--is one way to expand the supply of credit.

What makes good collateral?

Heck, I don't know. I think it may depend on both the physical and legal characteristics of the object in question. Physical capital is frequently used as collateral, whereas human capital is not. Why is that? Well, for one thing, physical capital is not likely to run away and hide from a claimant. But perhaps more importantly, indentured servitude is now legally prohibited in most jurisdictions. 

Not all physical capital is created equally, of course. Capital that is fixed in place, like real estate, has some obvious advantages. Mobile capital (automobiles, consumer durables, inventory) seems less desirable to the extent that possessors can hide it from claimants. On the other hand, these latter goods are easily transferable; whereas transfers of titles to real estate may incur significant legal cost. But then again, none of this may really matter if legal stipulations prevent certain classes of capital goods from being used as collateral in the first place (bankruptcy laws frequently prevent creditors from seizing certain types of assets, like electric wheelchairs, pets, and even land in some jurisdictions).

In short, the system of property rights is likely to impinge on asset supply. To the extent that different jurisdictions possess different institutions, asset supply is likely to vary across countries. Agents or agencies belonging to countries whose institutions inhibit asset supply may wish to import (acquire) assets from other countries in exchange for goods and services. Is this a source of what some people refer to as  global imbalances? Caballero seems to think so.
The use of capital in the payments system

If the use of unsecured credit is impossible, you must pay for an object you desire now in one of two ways (apart from barter). First, you may pay by relinquishing an asset. Alternatively, you may pay by issuing an IOU backed by an asset. Either way, you face an "asset-in-advance constraint."

For the moment, I want to think of the asset in question here as a form of physical capital, or non-counterfeitable, durable, and perfectly divisible titles to physical capital.
On the surface, these two methods of payment look rather different. The first entails immediate settlement, while the second entails delayed settlement. To the extent that the asset in question circulates widely as a device used for immediate settlement, it is called money (in this case, backed money). To the extent it is used in support of debt, it is called collateral. But while the monetary and credit transactions just described look different on the surface, they are equivalent in the sense that capital is used to facilitate transactions that might not otherwise have taken place.

If what I just said makes sense, then the theory of "money" (objects that circulate as exchange media in immediate settlement transactions) essentially boils down to a theory of optimal payment methods. The answer may depend on (among other things) security concerns and the available record-keeping technology. Small denomination paper is frequently used in small-value spot transactions. The use of more secure centralized record-keeping agencies are typically preferred for large-value transactions.

To put things another way, perhaps a theory of "money" may be of secondary importance. What is important from an economic perspective is that the gains to trade are realized whenever possible. The question is why objects belonging to certain asset classes are needed to facilitate trade. From this perspective, the line between "store of value" and "medium of exchange" appears somewhat blurred (at least to my sad eyes). In fact, I am becoming more convinced over time that it is the "store of value" properties of assets that render them more or less desirable as exchange media (broadly defined to include collateral). I expect that some of you may want to set me straight on this.

Private money systems

In a NM model with capital, titles to capital (or the capital itself, if it is divisible and transportable) can be as exchange media (unsecured credit markets are unavailable because people are assumed to lack commitment). For example, in Lagos and Rocheteau 2008, capital is used as money; in Ferraris and Watanabe 2007, capital is used as collateral. The properties of this class of models are in fact similar to those that arise in a standard overlapping generations (OLG) model with capital accumulation (this is one reason why I like to use OLG models to communicate the basic properties of these more elaborate setups).

Note: the papers just cited assume an "elastic" supply of capital (the stock of capital is adjustable). One might alternatively assume an "inelastic" supply of capital (as in a dividend producing Lucas tree). In the former case, the price of capital is fixed and quantity adjusts. In the latter case, the quantity of capital is fixed and price adjusts. Intermediate cases are possible, of course.

Anyway, it turns out that a private-money system can work pretty well in a NM model. Supporters of free-banking, or of laissez-faire in general, will no doubt be pleased with this result.

On the other hand (you knew this was coming), whether or not a private-money system can be expected to exhaust all feasible gains from trade depends on parameters that describe certain properties of the economic environment. One key parameter is the productivity of capital. This technology parameter essentially determines the ability of economy to overcome the asset-shortage problem (the root cause of which, I remind you, is the limited commitment/enforcement friction). So apart from institutional frictions, it appears that technology might be important as well (or perhaps we might interpret productivity broadly to encompass aspects of an economy's institutions).

In any case, let me describe the potential problem. Limited commitment implies that capital has an additional role to play. That is, apart from its usual role in production and storage, it possesses an additional service value through its ability to facilitate payments (as explained above). Hence, the demand for capital (more precisely, the subset of capital goods that constitute good collateral) will be higher than it would otherwise be in a frictionless economy.

Now, if the productivity of inelastic capital is not-so-good, or if the ability to create new capital is limited, then the economy will face an asset-shortage. If capital is inelastic, it price will rise. Indeed, its price may rise above its "fundamental" value (the present value of its net income flow). Market price above fundamental value is sometimes interpreted as a bubble; although, liquidity premium might be a better label; see Ricardo Lagos 2010. If capital is elastic, its supply will increase. The analog to the bubble in this case is an overaccumulation of capital (as in a standard OLG model). Either way, the effect of this "saving glut" is to put downward pressure on the real rate of interest. If the real rate falls below its "natural" rate, there is a dynamic inefficiency (the competitive equilibrium is inefficient).

A dynamic inefficiency may emerge even if the return to capital is expected to be high on average, as long as its expected short-run return drops sufficiently low on occasion (as in a severe recession). This is a line of enquiry that I am currently pursuing with my coauthor Fernando Martin. Interestly, the effect appears to have little, if anything, to do with risk-appetite (the result continues to hold for risk-neutral agents). A good property of collateral used in the payments system is what we call "value preservation," which reflects a desire for truncated downside risk. Let me try to explain this by example.

Imagine that you have in your possession a mortgage-backed security (MBS) that you like to use as collateral for your short-term lending needs. Moreover, imagine that you have no trouble borrowing all you need with this asset. Now, if the value of this asset appreciates, you are happy of course, but this in no way affects your borrowing. The story may be very different, of course, if the market price of your MBS suddenly plummets. Now you may be temporarily debt-constrained. Of course, tightening debt constraints are the hallmark of a credit crisis, or credit crunch (or un mancamento della credenza, as it was referred to in the Florentine banking crisis of 1341-1346; see Jesus Huerta De Soto). To the extent that credit contraction inhibits investment, we also have a familiar financial accelerator at work.

Let me summarize (before I get too carried away). Limited commitment generates a demand for assets with "good" properties, where "good" is defined in terms of an asset's ability to facilitate exchange. The value of the capital backing these assets varies over time. In normal-to-good times, this value variation does not really matter (debt constraints are slack). But in very bad times, it does (debt constraints bind). Despite the private sector's best efforts at generating AAA asset classes, it may not have the capacity to generate enough assets with the desired limited downside risk property. Shit happens.

A role for government debt

Of course, it's been known for a long time that dynamic inefficiency provides a rationale for the existence of government debt; see Peter Diamond 1965. If record-keeping is too costly (think small-value transactions), so that immediate-settlement is optimal, then perhaps it should take the form of small-denomination zero-interest paper. If record-keeping is economical (think large-value transactions), so that delayed settlement is optimal, then perhaps it should take the form of interest-bearing book-entry objects, like U.S. treasuries today). In any case, the question of what form this government debt should take is peripheral to the points stressed in this essay.

One of the benefits of government debt is that it may substitute for capital in the payments system. Think of U.S. treasuries substituting for mortgage-backed securities in the repo market, for example, or government paper notes (fiat money) substituting for capital-backed private banknotes. The effect of this substitution is to lower the "excess" demand on capital (contracting the level of elastic capital and lowering the price of fixed capital), thereby increasing the real rate of interest (closer to its natural rate).

In this manner, the introduction of government debt may lower the liquidity premia (bubbles) on private asset classes that serve as good collateral. It is interesting to note, however, that asset price bubbles do not disappear--rather, they are "exported" to government securities. The market price for fiat currency (the inverse of the price-level), for example, consists entirely of a liquidity premium (the fundamental value of fiat money is zero, so its value can only be supported by a bubble). To the extent that treasury debt is not fully backed by future taxes, a part of its value too may consist of a bubble that reflects its desirable properties as a collateral instrument (note: the use of U.S. treasuries in repo and credit derivatives markets has exploded over the last 30 years). In short, asset bubbles can be welfare-improving in a world of asset shortages (they may also come with their own set of problems, of course).

Information insensitivity

A concluding thought (sorry--I've already expressed too many for one post). Perhaps one reason why senior grades of debt are valued as exchange media relates not to their risk characteristics, but rather to debt's(relative) insensitivity to certain types of information. This is a theme that Gary Gorton likes to stress. One good property of a monetary instrument is that due diligence need not be performed on the object in each and every transaction. The institution of debt may be explained, in part, by the need to create instruments whose value is not subject to the speculation of informed insiders; see Gorton and Pennacchi 1990. Needless to say, government debt may be particularly attractive for this reason.

But even if information is not asymmetric, I point out here that not all information has social value. What this means is that if the efficient-markets-hypothesis holds (asset prices rapidly incorporate all information, whether such information has social value or not), asset prices may exhibit a form of "excess volatility." Private money instruments may not be able to avoid this excess volatility (in particular, the downside risk I talked about earlier). Now, one usually thinks of the unbacked nature of fiat money as a drawback. But on the other hand, representing a claim against nothing in particular may have its advantages. In particular, the return to fiat money is not directly linked to any information that relates to the underlying fundamentals of a private asset. What this means is that fiat money may possess social value to the extent that its return is insensitive to information of no social value. Some food for thought, at least. But enough for now.


  1. You say:

    The market price for fiat currency ... consists entirely of a liquidity premium (the fundamental value of fiat money is zero...). To the extent that treasury debt is not fully backed by future taxes, [part of its fundamental value is also zero.]

    Is this internally consistent? It seems like if treasury debt has value derived from tax-backing, then the thing you need to settle tax liabilities (i.e. fiat currency or the equivalent) must also have value.

    It seems to me that both are ultimately backed by human capital. People accept cash in part because they know that, even if private parties stop accepting it, they or someone will still need it to give to the IRS under threat of imprisonment.

    Putting aside the legal niceties, if a sufficiently entrenched loan shark issued (an appropriately modest amount of) scrip that he would accept in lieu of vig at par, it would seem that that is effectively backed by kneecaps and could circulate as a dollar-substitute even among non-borrowers. Is fiat currency different?

    I feel like I must be wrong somewhere, and would be delighted to be set straight.

    [Please note that my metaphors are not intended to express any equivalence between the IRS and loan sharks; I'm merely trying to highlight the "backed by human capital"-ness I think is present in both cases.]

  2. 2 small points. I don't think either affects what you've said.

    1) I might buy the argument for Treasuries, but I don't see why you choose Government as the optimal issuer of currency.

    2) Even if record keeping is cheap, there is always some demand for privacy - cash provides this.

  3. A wonderful read. I come for the post, I stay for the comments. I appreciate the simple model examples in the comments forwarded by many regulars around here, as it helps rationalize and ground the "econospeak" of the post. (Nothing against its format implied.)

  4. David,

    I will respond to your post in another comment, but I first wanted to make some comments about Caballero's paper.

    First, it seems that a big part of Caballero's story is some sort of global savings glut. This is a common story, but it never actually existed during the period he's talking about. According to the IMF, global savings/GDP ratio has been right around 20% from 1980 through 2005. The composition, by country, has shifted as emerging markets savings have picked up while savings in high-income countries has gone down. Maybe this composition differential is what he's talking about, but that wouldn't imply a general shortage.

    Second, his definition of "bubbles" leaves a lot to be desired. He seems to want to say that any financial asset priced on capital gains instead of dividends is a bubble. Unless you take a very broad view of dividends, this is simply wrong, and ignores how corporations (and mutual funds, etc.) disperse earnings to their shareholders: buybacks. Stock buybacks are generally much more desirable than dividends for returning earnings to shareholders, for various institutional reasons (esp. taxes).

    Third, any time I hear "shortage" I think frictions. Either price ceilings, or artificial restrictions on supply or artificial demand creation. This seems to come up in Caballero's discussion of global imbalances when he talks about the lack of appropriate institutions in various countries that make it so people do not want financial assets supplied by the country in question. This is fine, but then the policy conclusions should really be: establish property rights and stop expropriating wealth (I'm looking at you, Chavez!)

    Now, maybe the problem is that I need to read Caballero's other papers, so if I'm off in my commentary, please set me straight.

  5. Franco:

    I did not express myself as well as I could have. Let me try to resolve the apparent inconsistency.

    I was, in my mind, considering two hypothetical worlds. In one, there was zero enforcement (hence, zero taxation). Government debt can (theoretically at least) exist in this world in the form of zero-interest-bearing fiat (a pure bubble). In the second world, the government has limited ability to tax, so government debt may have some backing (I was not thinking of debt here representing claims to fiat, more like claims to goods, acquired by tax). Even in this world, however, government debt may trade above its "fundamental" value -- it will have a "partial" bubble.

    I am aware of an older literature that stresses the lawful tender (slightly distinct from legal tender) aspect of government money as supporting its value. (And it sounds like you might enjoy this paper by Dror Goldberg: The Myths of Fiat Money). For a while, this was the way I thought of things too.

    But then I realized that monetary theory was not about explaining the existence of fiat money instruments. Instead, it is all about understanding why some asset classes have a "fiatness" about them. With fiat money, the fiatness is 100%. With my own personal IOUs, the fiatness is 0%. The fiatness of large cap stocks is higher than that of low cap stocks. In short, its all about understanding "liquidity premia," or maybe even asset price "bubbles."

  6. Pedro:

    Well, if you buy the argument for treasuries, you'll have to buy it for currency too because, as I said in the post, I don't think that the composition of government debt matters a whole lot (for the points I am making).

    Anyway, I don't think I ever said that the government should be the "optimal" issuer of currency. In the model I had in my mind, government debt is allowed to compete with private debt. Would you be against the government issuing currency that competed with private currency?

    Your second point is a very good one. In fact, here is a paper that makes precisely your point:

    Charles M. Kahn & James McAndrews & William Roberds, 2005. "Money Is Privacy," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 46(2), pages 377-399, 05

  7. Prof J:

    In response to your observations on Caballero's piece:

    [1] I'm not sure how one is supposed to measure a "saving glut" in the data. I think of it more as a theoretical construct that might help interpret the data. But I will ponder the evidence you cite.

    [2] I suppose there is no single well-defined notion of bubbles. I like what you have to say here.

    [3] Yes, you are absolutely right. Except for one small caveat. In my "inalienable rights" paper, I provide a polito-economic rationale for imposing such restrictions.

  8. What makes good collateral? How about the belief that others will accept it as collateral?

    During the crisis, bonds issued by the Canadian Housing and Mortgage Corporation, which (unlike Fannie Mae and Freddie Mac in the US) carried explicit guarantees by the Federal government for full and timely payment, demanded a 100bp premium over Government of Canada bonds of the same maturity. It was hard to understand why "blue" bonds should require a higher rate of return than "red" bonds--their risk characteristics seemed identical. It looked like an obvious and glaring failure of arbitrage and probably was (the Dept of Finance offered to buy up the CMHC bonds from banks in its IMPP program, paying for it by issuing GoC bonds, and made a nice little profit for a while).
    I was told by someone who worked in the financial industry, however, that there was an important difference between the two obligations: GoC bonds were accepted as collateral but CMHC bonds weren't. Of course that raised the obvious question...

  9. Angelo,

    Sure, there's something to said about that. You could have replaced "collateral" with "money" in that statement.

    On the other hand, the set of objects that end up circulating or serving as collateral do not appear to be chosen arbitrarily by self-confirming belief. Money/collateral is almost always in the form of debt, for example.

    Also, I'd like to know the answer to why GoC bonds were accepted as collateral, but CMHC were not. Sounds like an interesting case study.

  10. I've read your post a couple of times now. You're right - it is dense. I'm thinking this should be made into a chapter in your next textbook.

    I have one more thought on Caballero. I've been thinking of his paper since you posted it. I think papers that irritate me are better than papers I like because the irritating ones get me thinking. Anyway, put together Caballero's asset shortage with your discussion about "good" collateral and I think I've got something to hang on to here. What we're really talking about is an asset shortage relative to the supply of loanable funds. Phrased alternatively, there is too little savings to support current debt. Or again the ratio of indebtedness to savings is abnormally high.

    This gets into what constitutes "good" savings, and here one can talk about various forms of government currency, stocks, bonds, etc. And, importantly (as you point out) physical capital. I would like to add a dimension to this discussion. I think it is implicit in what you are talking about, but it is important enough (I think) to give it some careful explicit though: asset specificity.

    Consider a firm that makes robotic arms for automobile assembly lines. These arms are actually fairly portable so not as illiquid as, say, the assembly line itself. And, they are somewhat fungible (GM can sell its arms to Ford if needed). But, they are not totally fungible - there are adjustment costs required to retool and get the arms set up again. This specificity reduces the value of the capital as collateral, and in a way that I don't think can be fully assigned to liquidity. But, I think this specificity idea is implicit in your discussion of liquidity.

  11. Prof J,

    I certainly did not mean to imply any necessary link between the "specificity" of a capital good and its "liquidity" properties.

    So, for example, as I mentioned above, I believe that a legal restriction that prohibits the use of a capital good as collateral will render it illiquid (e.g., a law against indentured servitude makes human capital illiquid -- i.e., a poor collateral object). Not sure how this relates to the specificity of a particular asset.

    Ultimately, liquidity boils down to information and enforcement. Specificity will turn out to be important (for liquidity) only to the extent that it impinges on information and enforcement. At least, that's what I think right now.

  12. It's hard to wrap my head around this asset shortage hypothesis. Are there no diminishing returns as more paper is traded for goods, at least from the Chinese perspective? How can one characterize how much paper is enough?

  13. Pani Pani...I guess it's enough when it's value starts depreciating. As of this writing, yields on U.S. treasuries are still close to zero. There is a still a huge demand out there for this type of paper.

  14. put this in your spring reading list, dave