The Money Illusion

[scepticus]

#1 The Money Illusion

This thread is about possibly the greatest collective delusions ever suffered by mankind. There may be bigger ones, but I can't think of any right now. The money illusion holds that only base money is money and no other money exists to affect inflation

I'm going to begin with a suggestion, that I have made before, that government debt in the form of bonds in a fiat money economy, is money. That is, it is 99% equivalent to cash – paper and bank reserves. I aim to reasonably prove that assertion, plus a few others that relate to it, and show where HPI really comes from. If government debt is money, and if that government bond-money has velocity (which it does) then I suggest that this (public debt issuance) is where most of the inflation in our recent fiat monetary economy comes from.

Since this will be a long post, here is the executive summary for now

* Government bonds are cash equivalents. They became so when they became default free as a result of the move to fiat money and when their trading volumes rose to match and then exceed that of tenners after the financial big bang. In economics terms they became nominal liquid bonds.

* A liquid security will always command a higher price than an illiquid one, that is simple economics. Given that both gilts and tenners are liquid securities, the market over the last 40 years has been moving to equalise their prices (remove arbitrage), which is manifested in bond price increases and yields falling.

* When the financial big bang occurred in the 80s, existing government debt was effectively instantly monetised since it was both risk free and also it suddenly became highly liquid thanks to new exchanges and markets. The drivers behind this are fiat money and electronic communications. Because the secondary market for gilts at the time was not perfect (and still is not quite perfect) it has taken some time for the arbitrage to be removed. When all arbitrage is removed the yield curve will be perfectly flat except for small excursions due to changes in long run inflation expectations

* At the same time, the liquidity (daily volume in all stocks) of the equity and corporate bond market have sky rocketed thanks to electronic trading, ETFs and so on. Therefore the highly traded big-cap liquid equities have become more money like and so their yields have fallen by the same logic that gilt yields have fallen. Most of the stock market gains of the last 30 years have been due to increasing liquidity premium.

* If money is defined as any security which can be sold today, tomorrow, next year, next decade for fair value (e.g. a deep market exists) then that security is money-like. Therefore we can now characterise the UK money supply as M0 plus public debt plus the total value of all daily liquid equity and bond securities trading on UK exchanges. These non government liquid securities can be viewed as a family of competing currencies brought into existence through the action of markets and market makers. The velocity of gilts and money is measured by the number of times they change hands via the banking system or any other system that buys and sells them. The velocity of stocks is the same - the number of times they change hands. Fractional reserve is not the issue here, just velocity - how many times each security is used to pay for something. Likewise one may save by holding any of these securities.

* Given that illiquid securities and assets must by market logic command a significantly higher return over liquid ones, this would explain why the return to land, small cap shares and so on has been market beating over the last 40 years. While your blue chip portfolio may have soared in nominal terms, illiquid assets and securities returned more. So your stocks went up, yay, but so did everyone else's, and their houses. Hence the hunt for yield, and the feeling of a constant global casino.

[edit: data points to follow]

Edited August 2, 2010 by scepticus

[bendy]

money is the root of all evil is the best line ever.

unfortunately many people like it and find ways to blame others for their own money woes.

[Injin]

#1 The Money Illusion

This thread is about possibly the greatest collective delusions ever suffered by mankind. There may be bigger ones, but I can't think of any right now. The money illusion holds that only base money is money and no other money exists to affect inflation

I'm going to begin with a suggestion, that I have made before, that government debt in the form of bonds in a fiat money economy, is money. That is, it is 99% equivalent to cash – paper and bank reserves.

It isn't.

Do the experiment.

[scepticus]

#2 government bonds are money

Lets begin with a tenner. A tenner has liquidity because you expect to be able to trade it at fair value today, tomorrow, the day after tomorrow, next year, next decade. That doesn't mean it'll always buy the same amount of stuff. Rather, you expect that the market will value your tenner in exchange for a tin of beans according to the demand for beans and the supply of tenners. But you can rely on there being a market to redeem that tenner. You can also rely on the fact that a tenner is always worth ten quid. It is risk free. The tenner has high value, because it is so liquid. It has a liquidity premium. In fact it has such a high value compared to other things it pays no interest and has no yield.

Now consider a corporate bond from a small cap company. A junk bond. The market is limited - it may not even be there at all - and it is hard to value. In fact you may have to hold it to maturity with no trade ever being offered. Consequently its price is low compared to tenners, since it has little liquidity and as a result it earns a darn fine rate of interest. It may also be risky, but its low price reflects both risk and lack of liquidity. They are not quite the same thing but they are related.

(A second opinion on liquidity: http://wallstreetpit.com/16194-what-is-liquidity-iv )

Now, what about a UK Gilt? Lets see: can you trade it every day? Yes you can. Is it free of principal or default risk, like the tenner? Well yes it is, assuming we all believe that the UK would rather print than default.

So what really, is the difference between a gilt and an equivalent amount of tenners?

Absolutely nothing of consequence.

Ah, but gilts earn interest. So do tenners if you give them to a bank. A paper tenner is cash with a put option on inflation. A gilt is the same. If expectations of inflation go up you lose money.

Gilts can't buy sandwiches. True, but people moving seriously large amounts of money around don't want to buy sandwiches with their gilts. They want to buy a competitor company, or perhaps some mortgage backed securities. In fact for these players, gilts have a liquidity premium that is higher than tenners because their carrying cost is lower. The shadow banking system (and the real banking system) uses gilts and US treasuries etc as their medium of exchange. So do multinational corporates and sovereign wealth funds.

Ah but gilts are not levered up 9:1 by the fractional reserve banking system. Well actually, gilts appear over the last 15 years to have had a velocity between 7 and 8. That is, each gilt changes hands seven or 8 times a year. That is not very far removed from the money multiplier conferred on base money by the fractional reserve banking system.

The UK M4 money supply is about 1.2Tn in 2010. Take 820 Bn of public debt, multiply by 7.5 and you get 6150 Bn, thus adding about 50% to the money supply right away.

Here are the figures on supply and velocity of gilts:

http://www.dmo.gov.uk/reportView.aspx?rptCode=D5L&rptName=63927080&reportpage=Gilts/Turnover

(I just checked this link and it seems their database is down right now – spooky)

So, why do gilts pay any interest at all? The answer is, they shouldn't, apart from a small premium to compensate holders for taking a position on long run inflation, which is a riskier proposition than taking a position on short run inflation by holding tenners. In fact the coupons paid on gilts are an abhorrent arbitrage, and markets being markets, are moving to eliminate that arbitrage. This is why long rates on the yield curve have been moving down since the closure of the gold window, and why the curve is now trying to flatten itself. This is where japan finds itself now, at the end of this logical free market process.

[Edit, actually gilts should pay whatever interest rate is the UK base rate, plus that very small premium for taking a position on long run inflation. Right now, you can buy a 25 year, hold it for a year to get some coupon payments, and then sell it. So you get paid a 25 year rate for holding for one year. That is the arbitrage the market is removing]

So what then of our national debt? What then are the implications of monetising it? In truth, the markets themselves have been 'monetising' our national debt since the day fiat money was born, in order to remove the arbitrage inherent in a risk free long duration debt relative to other debt securities which are not risk free. It has not all been monetised by the markets overnight after the big bang because it has taken time for the market liquidity to develop sufficient gilt velocity for it to act 100% as base money does. But my suggestion is that the markets have already monetised the vast majority of the public debt by now, and this is the main source of HPI the last 40 years. The coming great inflation many of you fear has already happened.

Here it is:

QE just moves the same amount of real world money round the books and gives it a new name.

Soon as this penny is going to drop with the general market conciousness (maybe bill gross will be the first to admit it...) and when it does so the narrative of the global economy is going to change focus from sovereign default to focus on deficits, because when this cat is out of the bag everyone will know that:

government borrowing == printing money.

Next up – some more data and a little more economics to place behind the points made above (BTW, anyone else with confirming or contrary data to share, please post it here). After that, more about liquidity in general including equity market liquidity and its very own effect on inflation.

Edited August 2, 2010 by scepticus

[scepticus]

For anyone reading who finds these ideas even partly persuasive, may I invite you to study these two working papers from the US Federal Reserve, which make the same case I am doing.

http://www.mpls.frb.org/research/sr/SR275.pdf

In many societies, individuals trade both money and nominal bonds. Often, as with

Treasury bills, the bonds are essentially risk-free in nominal terms, and so they provide little

benefit over money itself in terms of risk-sharing. Why then does a society find it beneficial

to have both money and nominally risk-free bonds? To put the question in the jargon of

monetary economics, What kinds of economic frictions lead to bonds and money both being

essential?

In this paper, I provide an answer to this question. I show that in the equilibria of

monetary economies, individuals may have different marginal rates of substitution between

current and future consumption. Hence, individuals would like to engage in additional intertemporal

trades of money. To make these intertemporal trades work, though, there must

be a credible record of who received money in the past and who gave up money in the past.

I argue that the role of nominal bonds is to provide this credible record. More precisely,

I show that if nominal bonds exist, some households can give up bonds for money, while

others receive money for bonds. Later, the holders of the nominal bonds can exchange them

for monetary interest rate payments. In this way, nominal bonds serve as a record-keeping

device in the context of intertemporal monetary exchanges.

In making this argument, I find that it is important to distinguish between illiquid

and liquid bonds. By illiquid, I mean bonds that cannot, because of physical or informational

reasons, be exchanged for goods. I show that illiquid bonds can be used as a record-keeping

device for intertemporal exchanges of money, but liquid bonds cannot be. In this sense, I

endogenize the illiquidity of bonds by showing that it is efficient for bonds to be illiquid

rather than liquid.

I formalize these arguments in a cash-in-advance model and a random-matching model

in which agents experience unobservable shocks to their marginal utilities of consumption.

I look at the consequences of adding three types of durable tokens–money, liquid bonds,

and illiquid bonds–to these economies. I prove three results.

The first is that, given the presence of money, liquid bonds are inessential: they can be eliminated with no loss in welfare.

Intuitively, liquid bonds are equivalent to money, and there is never any reason to have both types of assets

And more recently: http://www.rcfea.org/RePEc/pdf/wp13_09.pdf

[scepticus]

More data: money multipliers (velocity)

Note that US M2 historically has velocity=8. Gilts have about the same. Above US M2 sits another tower of lending facilitated by circulation of M2/M1/M0, and I think you'll find another tower of lending (what is left of that portion of the shadow banking system run out of the UK) sits atop the circulation of gilts.

[CokeSnortingTory]

Edit, actually gilts should pay whatever interest rate is the UK base rate, plus that very small premium for taking a position on long run inflation. Right now, you can buy a 25 year, hold it for a year to get some coupon payments, and then sell it. So you get paid a 25 year rate for holding for one year. That is the arbitrage the market is removing

I think the interesting point for me is the relationship between gilts and the base rate, which seems to be subtler than generally acknowledged, in that the relationship is two-way. If gilts are being arbitraged to zero, then the UK Government is not going to be able to raise base rates even if it wants to.

Which kind of removes Government's one lever for controlling the economy.

[scepticus]

I think the interesting point for me is the relationship between gilts and the base rate, which seems to be subtler than generally acknowledged, in that the relationship is two-way. If gilts are being arbitraged to zero, then the UK Government is not going to be able to raise base rates even if it wants to.

Which kind of removes Government's one lever for controlling the economy.

it can raise base rates, just by paying interest on bank reserves. In fact thats how it does it right now, and for quite a while now.

in which case it would have to pay more on gilts too, but the point is the 25 year won't be much higher than the 1 year.

A gilt is basically cash with an interest rate swap. A proper bond is one where you buy it, hold it till maturity then get your principal back.

Therefore give it a few years, and all the very flat yield curve (when compared to that of today) will tell us is whether people think long run inflation is up or down.

To construct a real yield curve that is actually useful you probably need to measure the yield on a basket of mid/long term securities and fixed assets inlcuding gilts, corporate bonds, land, and energy futures of some kind.

[CokeSnortingTory]

it can raise base rates, just by paying interest on bank reserves. In fact thats how it does it right now, and for quite a while now.

in which case it would have to pay more on gilts too, but the point is the 25 year won't be much higher than the 1 year.

A gilt is basically cash with an interest rate swap. A proper bond is one where you buy it, hold it till maturity then get your principal back.

Therefore give it a few years, and all the very flat yield curve (when compared to that of today) will tell us is whether people think long run inflation is up or down.

To construct a real yield curve that is actually useful you probably need to measure the yield on a basket of mid/long term securities and fixed assets inlcuding gilts, corporate bonds, land, and energy futures of some kind.

Yeah, I was thinking more about the general idea of deficits being used to control the overnight rate, as outlined here: http://pragcap.com/the-message-is-getting-out-uncle-sam-isnt-going-broke/comment-page-1#comment-22155

Which I believe is part of MMT. Therefore I'm just trying to think of a future situation in which inflation may be caused by non-monetary issues such as resource shortages, and gilt issues having to be severely restricted in order to raise attractive enough yields for them to find buyers. The potential problem with Government borrowing contributing to the liquid money supply is that that money supply may at times be needed to be restricted when the Government itself needs to maintain or extend its borrowing.

[Little Professor]

[Injin]

Sceppy, your initial premise is incorrect.

Do the experiment.

[aa3]

If any of you have traded on the stock exchange.. you will notice usually extraordinarily heavily traded stocks have a higher market cap than you would expect based on the company's profits.

I've thought this was because of the liquidity and stability of an extremely deep market. Look at Cisco, Yahoo, Microsoft the Nasdaq stocks. How huge the daily volume is and how they tend to be more moderate in their moves compared to stocks with less volume.

Of course the NYSE has made changes to make its trading similiar to NASDAQ and the volume keeps rising on the NYSE. Scepticus is noting it might be creating a moneyness to the stocks which adds to their value.

[scepticus]

Yeah, I was thinking more about the general idea of deficits being used to control the overnight rate, as outlined here: http://pragcap.com/the-message-is-getting-out-uncle-sam-isnt-going-broke/comment-page-1#comment-22155

OK so you are suggesting that to raise rates they must sell bonds and people may not buy them?

No that is not required. They can just pay interest, raised from taxpayers, on bank reserves to slow their circulation. Any bonds that won't be bought go to bank reserves via QE and then get interest paid on them at the short rate. The point of my post is that this is mostly neutral given the fact that the inflation due to monetisation of all this debt has mostly already happened.

Which I believe is part of MMT. Therefore I'm just trying to think of a future situation in which inflation may be caused by non-monetary issues such as resource shortages, and gilt issues having to be severely restricted in order to raise attractive enough yields for them to find buyers.

There certainly is an issue here - taxpayers can't stump up for ever increasing interest payments whether on base money or on bonds. Certainly the interest they'd have to pay on base money is a lot less, but when inflationary pressures do arrive, which at some point they may well do, the rate that must be paid on reserves would go up. So nothing I have posted here is intended to imply the government can simply deficit spend without fear of inflation. In fact I am saying that deficit spending by issuing bonds is immediately and directly inflationary as if most of the face value of the bond had just been issued as base money.

The other problem with what has been going on (market monetisation of gov bonds), is that it means there is no real world risk free long term asset to act as a bench mark. I have a feeling that much of the long term investments that go on (and mortgage lending) need such a benchmark.

Consider another way to restrain inflation - they could just impose transaction fees on longer duration bonds, such that if you don't hold them for a decent amount of time you forfeit the coupons. This would have the effect of de-monetising existing and new debt by lowering its liquidity and would certainly restrain inflation and clip the wings of the unofficial banking system. But under these circumstances I don't think they'd get away with much if any new issuance.

So the message is that we in the UK should not be worried about paying off the existing national debt, but we should be aiming to reduce the deficit to balanced budget state, or at least totally eliminate the structural portion of it.

[Injin]

Your initial contention is wrong.

This is a fairly easily testable thing - so run the experiment and let empiricisim correct you.

[scepticus]

Your initial contention is wrong.

This is a fairly easily testable thing - so run the experiment and let empiricisim correct you.

no, my initial contention is validated by predicting falling interest rates, which is what have had and what we shall continue to have until the yield curve is flat.

[Injin]

no, my initial contention is validated by predicting falling interest rates, which is what have had and what we shall continue to have until the yield curve is flat.

Interest rates are set by a small commitee of men, they aren't a law of physics.

Your initial contention that government debt is equal to tenners (and oher recordings of debt are as well) is incorrect.

The experiment is simple to carry out. People in the general population do not use tenners as debt, they trade them as a commodity.

[scepticus]

The experiment is simple to carry out. People in the general population do not use tenners as debt, they trade them as a commodity.

What I am saying is the reverse, people use government debt as tenners.

[Injin]

What I am saying is the reverse, people use government debt as tenners.

no they use tenners and don't know about any debt.

That the tenners aren't tenners is an unknown to most.

And a conversion is hyperinflation.

[scepticus]

no they use tenners and don't know about any debt.

That the tenners aren't tenners is an unknown to most.

And a conversion is hyperinflation.

no you missed my point. Large scale investors including corporates, sov wealth funds and so on use government debt like it was a tenner (or ten-millioner if you like).

Its all spending power whether its a many buying a sarnie for a tenner or a hedge fund buying MBS for a ten-millioner.

[Injin]

no you missed my point. Large scale investors including corporates, sov wealth funds and so on use government debt like it was a tenner (or ten-millioner if you like).

Which is nice and all but they don't count for much.

Its all spending power whether its a many buying a sarnie for a tenner or a hedge fund buying MBS for a ten-millioner.

Except sarnies are real and hedge funds and MBS are simply dividing up resources the tenner traders created.

[scepticus]

Except sarnies are real and hedge funds and MBS are simply dividing up resources the tenner traders created.

not when the hedgies are using bonds to buy oil or commodities.

also, the interest rate arbitrage that can be earned on government bonds comes straight out of taxpayer pockets. See my recently posted 'antal fekete says the fed is an engine of deflation' post for an austrian economist who agrees with me.

[Injin]

not when the hedgies are using bonds to buy oil or commodities.

also, the interest rate arbitrage that can be earned on government bonds comes straight out of taxpayer pockets. See my recently posted 'antal fekete says the fed is an engine of deflation' post for an austrian economist who agrees with me.

Look, just do the experiment.

Have a commodity of some sort and then isssue a load of debt based on it.

Then turn the debt real by creating more of the commodity.

See what happens to the price of said commodity.

It's called derivative for a reason.

[Panda]

Sceppy, nice name Injin............................

What is in store for the UK, i am asking whqt you think.

If you had say £100k in sterling right now, sitting in your current account, would you;

Buy Gold

Buy a cash bond paying interest

Buy Gilts

Buy a house

Invest in Stocks

.....................................What would you do, to preserve your £100k? Do you see wage inflation up and above cost inflation, i don't do you?

[scepticus]

what I see, according to all the above for us, is japan.

as I have pointed out the public debt level as it currently stands is largely immaterial. we may not do quite as well because we have less industry, OTOH our demographics are not so very bad and we are more self sufficient in both oil and food than they are.

So what I suggest is that you look at japan.

[Injin]

what I see, according to all the above for us, is japan.

Where are they going to export the hyperinflation to?

as I have pointed out the public debt level as it currently stands is largely immaterial. we may not do quite as well because we have less industry, OTOH our demographics are not so very bad and we are more self sufficient in both oil and food than they are.

So what I suggest is that you look at japan.

Where does the carry go?