Money
July 26, 2011
Monetary exchange
• Money: an object that circulates widely as a medium of exchange
• Evidently, it is frequently easier to acquire some goods indirectly
— if I want coffee, I first sell my labor for money, then use my money to
buy coffee
• But why must this be the case?
— not the way exchange is organized in small communities
— gift-giving is more prevalent (families, clubs, etc.)
A lack of double coincidence of wants
• LDCW: when A and B meet and A values what B has, but B does not
value what A has (⇒ no bilateral gains to trade; barter is impossible)
• It is possible to have multilateral gains to trade even when bilateral gains
to trade are absent
• Consider three people: (A)dam, (B)etty, and (C)harlie
• A wants to eat bread in morning, B wants to eat bread in afternoon, and
C wants to eat bread at night
• A produces bread at night, B produces bread in morning, and C produces
bread in afternoon
• Assume that each person values their own production “a little bit”
• Bread is nonstorable
• The socially efficient allocation is to have people produce bread when they
have the opportunity to do so and then pass it along as a gift to those
people who value it the most
— from each according to his ability; to each according to his need
• There are multilateral gains here, but no bilateral gains
Limited commitment
• Suppose A,B,C meet at the beginning of the day and promise to do the
socially optimal thing
— can people be expected to follow through on their promises?
— a question of fundamental importance for the operation of financial
markets (markets where promises are exchanged)
• Suppose that A issues a security representing a claim against future output
(night bread)—this is something that C would value
• But A also values his own output “a little bit”—what is to prevent him from
reneging on his promise to deliver his output elsewhere?
The role of reputation
• Reputation: Public awareness of a person’s trading history
• Ostracism: The practice of banishing people from society
• Reputation + (threat of) Ostracism = willingness to keep promises (even
among those who are not intrinsically trustworthy)
• To see this, imagine that A reneges on his promise...how will the others
feel about this?
• If A does not deliver on his promise, then in the future, C will refuse to
give output to B; and B will refuse to give output to A
— in this example, the economy reverts to “autarky” (all trade ceases)
— in more general settings, trade will continue among subset of people
who “behaved well”
— the person who reneged is ostracized
• So by reneging on C, A gets a short-term gain, but suffers a long-term pain
• If the future pain is sufficiently large (e.g., if A is patient), then A will not
renege
The limits to reputation
• A complete set of credit histories for all of humanity is probably not feasible
• People can fabricate histories, issue counterfeit reputations
• In short, keep an accurate, comprehensive, and secure set of records is
costly—especially in large societies
• But if some people (or agencies) are more reputable than others, then even
those without reputations (anonymous agents) may be able to engage in
non-barter trades
Money as a record-keeping device
• In our ABC economy, imagine that A is reputable and that B,C are not
— that is, A’s trading history is public knowledge; B and C are anonymous
• Then A can issue security representing a claim against night bread
— must be non-counterfeitable (otherwise, A’s reputation is counterfeitable)
• The security issued by A can be used as money by B and C
• Note that B accepts A-money (in return for her produce) only because
A-money can be used to purchase output from C (this is like my earlier
coffee example; i.e., money is not acquired for its own sake)
Liquid and illiquid assets
• Liquidity: an asset is said to be liquid if it is “easily” accepted as a form
of payment (or as a form of collateral for a loan)
• There is a sense in which A’s asset is liquid, while the assets belong to B
and C are not
— N.B., here I mean assets in the form of promises to deliver future output
• So here, illiquidity is associated with lack of commitment and anonymity
(evils), leading Kiyotaki and Moore to suggest that evil is the root of all
money (a play on Timothy)
The supply of and demand for liquidity (money or good collateral)
• If everyone could commit to their promises, or if we all had public reputations (with sufficient value), then all of our assets (including our human
capital) are likely to be very liquid
— N.B., I am assuming here that underlying asset values are publicly
known (if not, there is an added layer of complication)
• In such a world, there would never be a need to borrow money
— everyone’s assets are already liquid
• In this case, supply of liquid assets = all available assets; demand for liquid
assets = demand for assets in general
Limited commitment and asset shortages
• If only a subset of agents in society can commit (or have public reputations), then there may be a “shortage” of liquid assets
• Available liquid assets, if in short supply, will command a “liquidity premium;” i.e., they will be valued in excess of their “fundamental” value
liquidity premium = market value - fundamental value
• The liquidity premium reflects “exchange value;” the value that the asset
possesses in facilitating transactions
• May look like an “asset price bubble” to outside observers
Limited commitment and an elastic money supply
• If liquid assets are sufficiently scarce (command a high liquidity premium),
there exists incentive for liquidity creation
• Firms in the business of creating liquidity (money) are called banks
• Banks—like all financial intermediaries—are in the business of asset transformation
• E.g., insurance companies transform assets (deposits) into state-contingent
liabilities
• Banks transform assets (deposits) into liquid liabilities (e.g., demand deposit liabilities)
• E.g., you “deposit” your home as collateral for a money loan
— the “money” is created by the banking system (historically, in the form
of private banknotes, today, in the form of electronic credits in an
account)
• In the context of the ABC model, if A’s money is expensive (large liquidity
premium), a competing bank may try to “monetize” C’s asset
• This act of bank lending expands the supply of liquidity (and presumably
drives down the liquidity premia of competing assets)
The process of money creation and money destruction
• Consider ABC model, where bank monetizes A’s asset; Bank retains rights
to A’s asset as collateral, prints up some money, and lends it to A (money
creation)
• A uses money to buy B’s output; B uses money to buy C’s output; C uses
money to buy A’s output (money in circulation)
• A is willing to sell output for money (rather than reneging on bank loan)
if A values access to future credit
• When money loan is repaid, money is withdrawn from circulation (destroyed)
Narrow money vs. broad money
• Historically, private monies are typically made convertible into a base
money (historically, specie, these days, government cash)
— banknotes redeemable on demand for specie
— deposit liabilities redeemable on demand for cash (ATM)
• So banks typically hold base-money reserves; but only a fraction of total
money created (fractional reserve banking)
• Most of a bank’s liabilities are backed by its loan portfolio (the assets it
accepts as collateral for the money it creates)
Shadow banking (repo market)
• Bank-like activities occurring outside the sphere of regulated chartered
banks
• Repo is short for “sale and repurchase”
• Used by agencies to manage cash flow and to finance purchases of capital
• E.g., firm wants to park $500M overnight in safe investment vehicle
— a bank deposit of this size is not safe
— could purchase an asset (e.g., government bond) from a firm that has
a short-term demand for cash, and re-sell next day (repo)
— equivalent to a collateralized loan (cash loan using bond as collateral)
• Resembles banking because firm with short-term cash need is “monetizing”
its asset (bond) by using it as collateral for a short-term money loan (except
that money is not created here; it is just reallocated between saver and
borrower)
• Moreover, these overnight loans are frequently rolled-over, night after
night...cash is “withdrawn” on demand (when depositor no longer wishes
to roll over)
Banking vs. shadow banking
• Banking system creates money (demandable liabilities) out of relatively
illiquid assets (mortgages, personal and business loans, bonds, etc.)
• Shadow banking system does not create money per se; instead, it increases
the liquidity of illiquid assets by enhancing their desirability as collateral in
short-term lending arrangements
• So in both cases, the primary service is liquidity creation—issuing short-term
liabilities (liquid) backed by longer-term assets (illiquid)
• Last 10 years: banks finance mortgages; shadow banks created MBS used
as collateral in repo
Business cycles, financial booms and busts
• Private money supply expands and contracts naturally with business conditions
• As (rational or irrational) optimism grows over return to investment, asset
prices and liquidity premia grow
• Induces new share issue, new corporate debt issue, and new bank lending
to finance new investment
• Bank lending ⇒ monetizing more capital (possibly of lower quality? complacency? sowing the seeds for crisis?)
• Economic contractions in history are frequently associated with financial
crisis
• Financial crisis = plunging asset values, debt default, difficult to borrow,
hard to sell assets (illiquidity increases)
— illiquidity reflected in discount rates (e.g., 90, 80, 70, 60 cents on the
$) on assets that normally trade closer to par
— or market simply shuts down (bid-ask spread remains high)
• Not clear whether financial crisis causes economic contraction, or the other
way around
• Average discount on debt used as collateral in repo approached 50 cents
on the dollar (source: Gary Gorton)
U.S. National Banking Era (1863-1913)
• No central bank; banks with national charters allowed to issue currency,
state-chartered banks issued checking accounts
• Banknotes and checking accounts redeemable for specie (on demand)
• Several “bank panic” episodes during this era
• From EH.net: a banking panic may be defined as a class of financial shocks
whose origin can be found in any sudden and unanticipated revision of expectations of deposit loss where there is an attempt, usually unsuccessful,
to convert checking deposits into currency (my italics)
• These events usually occurred near a cyclical peak—then, “something happens” leading to growth slowdown and lower expectations
• In recession, some firms expected to fail, including some banks...but which
banks?
• People start converting banknotes and checking accounts into specie (mass
withdrawals from the banking system called bank runs); circulating banknotes discounted heavily
• Under fractional reserve banking, the banking system does not have enough
specie reserves to honor all redemptions on demand; banks can try to sell
their assets (at firesale prices, further depressing asset values), or suspend
redemptions (refuse to let people withdraw) ⇒ disruption in payments
system ⇒ further economic contraction
Private sector response...
• Bank coalitions, called clearinghouses, would form (usually led by a prominent banker, like J.P. Morgan)
• Clearinghouse would temporarily suspend redemptions of specie, instead
offer clearinghouse certificates (claims on the pooled assets of member
banks)
• Certificates were meant to substitute for the base money
• At the end of the day, losses on deposits turned out to be small (but much
disruption along the way...over-reaction?)
Government money
• Government involvement in the financial sector from the very beginning
• Historically, the rationale for intervention was to finance government spending
• At some point, governments began issuing their own paper money (frequently accompanied with legislated monopoly over small denomination
note issue)
• E.g., Dominion of Canada notes issued from 1870-1935 (coexisted with
private banknotes)
Dominion of Canada Note (Government)
Royal Bank of Canada Note (Private)
Central banks
• A big debate on free-banking vs. central banking in the late 19th century
• Big push for central banking in U.S. came after the great Panic of 1907
— led to the Federal Reserve Bank of the U.S. in 1913
— in Canada, the Bank of Canada established in 1935
• Nowadays (and for better or worse), central banking is universal
• Central banks often viewed with suspicion (End the Fed, by U.S. Congressman Ron Paul)
The Federal Reserve Bank of the United States
• Created by the U.S. Congress (Federal Reserve Act of 1913)
• 12 regional Feds (private) plus Board of Governors in Washington D.C.
(government)
• Original motivation was to provide a “lender of last resort” facility; an
“elastic” currency
• Again, this is related to the idea (or allegation) that the private sector is
not good at creating its own money, especially in times of financial crisis
• Re: in a financial panic, all sorts of private paper (good and bad) become
illiquid—they are discounted heavily
• Instead of relying on some J.P. Morgan, why not institutionalize the emergency lending facility?
— e.g., the Fed’s discount window
— purpose is to discount private paper (e.g., @ 95c/ instead of 75c/)
• Effectively a subsidy for those agencies that have access to discount window
or other emergency lending facilities
• Question: does this subsidy give rise to a “moral hazard” problem?
• Potential problem: less incentive for due diligence on investments by agencies that have access to discount window
• Another concern: does this subsidy give rise to excessive money creation
(and inflation)?
What is monetary policy?
• In principle, any intervention that directly impinges on the business of
money creation (asset transformation)
— includes legislation affecting regulatory regime for banks and related
financial intermediaries
• In postwar era, taken to mean (primarily) control over base money supply,
or short-term nominal interest rate, or medium-to-long term inflation
• Since the financial crisis in 2008, attention has turned back to lender-oflast-resort activities
How does monetary policy differ from fiscal policy?
• In my view, monetary policy deals primarily with liquidity provision via
asset transformation (collateralized lending, discounting assets, etc.)
— monetary policy is about banking (the central bank is a bank)
• Central banks are not (typically) allowed to spend money on goods and
services or to make transfers (no helicopter drops!)
— latter belongs to the realm of fiscal policy
• Normally, Fed is restricted to purchase U.S. treasuries (transform bonds
into cash); usually via “open market operations”
• Purchases of bonds “increase the (base) money supply” and increase bond
prices (reduce interest rates)
• Sales of bonds “decrease the (base) money supply” and decrease bond
prices (increase interest rates)
• Note: cash is (normally) zero-interest-bearing and bonds are (normally)
interest-bearing (i.e., discounted)
• So one way to think of monetary policy is that it determines the division
of the outstanding government debt between its interest-bearing and noninterest-bearing components
• The Treasury determines the total amount of debt
The purpose of conventional monetary policy
• Conventional view is that the Fed can use these sales/purchases to smooth
the business cycle (we’ve talked about this before)
• Evidently, Fed policy in recent decades appears to follow a “Taylor rule”
 = ∗ + ( −  ∗) + ( − ∗)
where   0 and   0
•  = federal funds rate,  −  ∗ is output gap,   −  ∗ is inflation gap
The effectiveness of conventional monetary policy
• Cash is like a zero-interest bond
• In a world where U.S. treasuries are becoming increasingly liquid (esp. via
their use as collateral in repo, store of value in emerging economies, etc.),
not entirely clear what money-bond swaps are supposed to accomplish
• This is especially true when interest rates are close to zero
⇒ “liquidity trap” phenomenon