Base money is just as special as it ever was

Here’s Frances Coppola:

Technology changes and post-crisis monetary policy are making financial assets and money indistinguishable. Central banks now need to work in partnership with fiscal authorities.

Several economists at the Lindau meeting were severely critical of central banks’ conduct of monetary policy in the light of continuing depression in the US, Japan and much of Europe, and called for greater use of fiscal policy to bring about recovery. Among the most critical was Christopher Sims, who gave a trenchant presentation on “Inflation, Fear of Inflation and Public Debt”.

He started by announcing the death of the quantity theory of money, MV=PY. Due to interest on reserves and near-zero interest rates, “money” can no longer be clearly distinguished from other financial assets. This is a fundamental point which requires some explanation.

These days, nearly all forms of money bear interest, which makes them indistinguishable from interest-bearing assets. For Sims, the paying of interest on bank reserves, coupled with the decline of physical currency, all but eliminates the distinction between interest-bearing safe assets such as Treasury bills and what we traditionally call “money”. All assets can be regarded as “money” to a greater or lesser extent: the extent to which assets have “moneyness” is really a matter of liquidity.

Sometimes words can get in the way of meaning.  There is no point in arguing about what the term “money” really means, it obviously means different things to different people.  But the term “base money” still has a pretty clear meaning; currency in circulation and bank deposits at the Fed.  The Fed happens to have a complete monopoly on the (US$) monetary base.  Prior to 2008 it could determine the supply of base money through OMOs and discount loans, and it could influence the demand for base money through changes in reserve requirements.  After 2008, a 4th tool was added—interest on reserves, which also impacts the demand for base money.  With these four tools the Fed can push the value of the dollar (in terms of euros) to anywhere between zero and infinity.  That’s a lot of power.  Nothing fundamental has changed, at least nothing relating to the validity of the quantity theory of money.

A few other points:

1.  The quantity theory of money has NOTHING to do with the equation of exchange.  That equation is best viewed as a definition of velocity, nothing more.  Definitions are not theories.

2.  Currency is not “declining.” The currency stock is growing faster than GDP.  It is also becoming a steadily larger share of the monetary aggregates.

HT:  Marcus Nunes


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28 Responses to “Base money is just as special as it ever was”

  1. Gravatar of Major.Freedom Major.Freedom
    8. September 2014 at 17:44

    “Technology changes and post-crisis monetary policy are making financial assets and money indistinguishable.”

    No technology can ever make “financial assets” and “money” indistinguishable.

    A central bank paying interest on reserves does not turn such money into a “financial asset”, any more than me lending my neighbor $100 today in exchange for $105 at the end of the week does not make $100 a “financial asset.”

    Financial assets and money are categorically separate economic objects of action. Money is instant purchasing power that can extinguish debts. A financial asset is delayed purchasing power that cannot extinguish a current debt.

    I’ve seen this argument before. Money is allegedly a range of financial assets each having a degree of “liquidity”. A 100 year bond is just a really, really illiquid money, whereas a $100 bill is a really, really liquid money. This argument is untenable, because money is a medium of exchange, and the only commodity that satisfies this is that which is not only not regarded in terms of “liquidity”, but is that which the concept of “liquidity” is based. The more liquid a financial asset, the more easily it can be exchanged for…money. The less liquid a financial asset, the less easily it can be exchanged for…money.

  2. Gravatar of CMA (@CMAMonetary) CMA (@CMAMonetary)
    8. September 2014 at 19:29

    Base money would be even more special if anyone could hold it directly and transact in it directly. As a result the payments and deposits system would become risk free and the fed could directly conduct policy with people.

  3. Gravatar of Johannes Fritz Johannes Fritz
    8. September 2014 at 21:28

    At a talk in Zürich yesterday, ECB GC member Ewald Nowotny motivated the cut from -.1 to -.2 exactly this way. He was content that “markets finally got the message” and the euro depreciated since.

  4. Gravatar of benjamin cole benjamin cole
    8. September 2014 at 23:58

    Excellent blogging. OT, btw, Martin Wolf calls for permanent QE in his latest book. This is worth a post…

  5. Gravatar of J.V. Dubois J.V. Dubois
    9. September 2014 at 01:18

    Very well put. Just a minor note – the name spells Frances.

  6. Gravatar of ssumner ssumner
    9. September 2014 at 05:58

    CMA, Anyone can hold base money.

    Thanks JV, I fixed it.

  7. Gravatar of TallDave TallDave
    9. September 2014 at 08:23

    “Technology changes and post-crisis monetary policy are making financial assets and money indistinguishable.”

    Indistinguishable, eh? Oh good, I can start paying all my bills with IOUs 🙂

    Seriously though, it’s very strange to argue we need government to spend more money due to more things bearing interest. The non-base “indistinguishable” forms of “money” can no more escape the consequences of monetary authority action on the base than I can pay my bills with IOUs. MOE, nut just MOA.

  8. Gravatar of Mike Sproul Mike Sproul
    9. September 2014 at 09:28

    Scott:
    “the Fed can push the value of the dollar (in terms of euros) to anywhere between zero and infinity. That’s a lot of power.”

    The fed can push the dollar down, but not up. If the fed has 100 oz worth of assets backing $100, then as soon as it tries to push the dollar up to 1.1 oz, we’d get a Thailand-style run on the fed, the fed would lose all its assets, and the dollar would fall to zero. Rival moneys (euros, pesos, deposits at private banks) would step in to fill the void.

  9. Gravatar of Jason Smith Jason Smith
    9. September 2014 at 10:12

    Bennett McCallum said the QTM was MV = PY plus long run neutrality (which is mathematically enforced by homogeneity of degree zero in the supply and demand functions). I like this formulation because it reminds me of how particle physics is done — define the particles/fields (M, V, P, Y) and a symmetry principle (homogeneity of degree zero).

  10. Gravatar of TallDave TallDave
    9. September 2014 at 13:50

    100 oz worth of assets backing $100

    Hmmm, not sure how much a stack of Treasuries weighs.

  11. Gravatar of BC BC
    9. September 2014 at 17:52

    I had a similar question to Mike Sproul, prompted by a discussion in Marginal Revolution about monetary systems for a hypothetical (for now) new Scottish state. To shrink the base money supply, doesn’t the Fed need assets to sell? If so, then isn’t the Fed limited in how high it can push the dollar’s value by the value of its own assets?

    Related question: suppose the Fed tries to push the dollar’s value to infinity by setting very high IOR to increase money demand. How does it obtain the money to pay the interest: (1) creating new reserves or (2) selling assets? If (1), then at some point doesn’t the increase in money supply offset the increase in demand? If (2), then that requires having assets to sell.

    Then, does this mean that fiat money ultimately derives its value from the central bank’s assets? That would be the case for a private bank’s notes, right? What is different about a central bank’s notes other than they have a nominal value of 1?

  12. Gravatar of BC BC
    9. September 2014 at 17:57

    Btw, here is a link to the discussion on hypothetical new Scot monetary policy: http://marginalrevolution.com/marginalrevolution/2014/09/does-sterlingsation-make-sense-for-scotland-or-would-a-separate-currency-be-better.html#comments

  13. Gravatar of ssumner ssumner
    9. September 2014 at 18:52

    Mike, They can simply do a deflationary monetary policy, by sharply cutting the money supply. This will cause deflation, increasing the value of each remaining dollar in circulation. Consumers need about 2% of GDP in currency to make purchases. So if the monetary base falls to $1, that dollar will be worth about $340 billion. Of course prices would be rather confusing, expressed in tiny fractions.

    Jason. The QTM is long run neutrality. That equation is something that may or may not be useful in explaining the QTM, but it is not the QTM. The equation is exactly true even if the QTM is totally wrong. It would be like saying C + I + G = GDP is the Keynesian model. No, it’s an equation used to illustrate the model. Is M*V = C + I + G the Keynesian or monetarist model?

    BC, There are cases where the value of a currency depends on its backing. Mainly where backing has an important impact on the expected future path of the money supply, or where it impacts the likelihood it will be redeemed when it stops being money (think about the former Eurozone currencies.) In general, changes in backing don’t have much (if any) impact on the value of the US dollar, as people don’t worry about that issue. They assume the Treasury would bail out the Fed if there were a problem. I think that assumption is correct.

  14. Gravatar of ssumner ssumner
    9. September 2014 at 18:54

    Mike, Here’s another way of thinking about it. Think about what the Fed did to cause the Great Inflation. Now do the reverse. OMPs instead of OMOs.

  15. Gravatar of Mike Sproul Mike Sproul
    9. September 2014 at 19:09

    Scott and BC:

    Starting with 100 oz worth of assets backing $100 of federal reserve notes, the fed starts doing open market sales of its assets (That’s what you meant, not OMP, right Scott?). After a lot of OMS’s, the fed is left with 1 oz worth of assets backing $1 of FRN’s, and $1 is still worth 1 oz. Then the fed sells the last 1 oz for $1, and all the FRN’s are gone, presumably replaced by foreign currencies or other rival moneys. But there’s no deflation.

    Also, when you say the Treasury would bail out the fed, you’re implicitly saying that FRN’s are ultimately backed by the government’s assets (mainly ‘taxes receivable’). You’re demonstrating that FRN’s ARE backed, not that they aren’t backed.

  16. Gravatar of TallDave TallDave
    10. September 2014 at 05:33

    Mike — what if the Fed said “we’re going to target inflation at -10%” and then raised interest rates?

    You can’t go to the Fed and demand they give you any number of ounces of anything for your dollar. If you’re referring to the Thai issues in early 2014, that was due to political instability and questions about a massive rice subsidy.

  17. Gravatar of TallDave TallDave
    10. September 2014 at 05:41

    ultimately backed by the government’s assets (mainly ‘taxes receivable’)

    Which in turn is back by the state monopoly on force. That’s why backing typically only matters in situations where the sovereignty of the monetary sovereign is in question.

    So in essence, fiat currency is backed by lots of big guns.

  18. Gravatar of Mike Sproul Mike Sproul
    10. September 2014 at 09:20

    Tall Dave:

    1)”target inflation at -10%” and then raised interest rates?”

    If the fed was a competitive bank, then nobody would borrow from the fed and nothing would happen to the value of the dollar. If the fed had significant monopoly power, then higher interest rates could either make the fed richer or poorer, and would affect the value of the dollar accordingly, though nothing like the “zero to infinity” range that Scott suggested.

    2)”You can’t go to the Fed and demand they give you any number of ounces of anything for your dollar.”

    You can demand bonds, or repay a loan from the fed, or pay your taxes. The fact that one form of convertibility (‘ounces’) has been suspended is irrelevant as long as other forms of convertibility remain.

    3) “fiat currency is backed by lots of big guns”

    The same is true of the deed to my house. It’s all backing just the same.

  19. Gravatar of Mike Sax Mike Sax
    10. September 2014 at 10:03

    Definitions may not be theories but I notice that different theories tend to prefer different definitions

  20. Gravatar of TallDave TallDave
    10. September 2014 at 10:38

    then higher interest rates could either make the fed richer or poorer, and would affect the value of the dollar accordingly

    But we already agreed the Fed’s most important asset is the guns of the federal government, which are unaffected by interest rates.

    You can demand bonds, or repay a loan from the fed, or pay your taxes.

    The first two are dollar-denominated assets, even assuming I could demand the Fed honor them, which I can’t. The latter doesn’t do me any good unless I owe as much or more taxes than I want to exchange, even assuming I could pay my taxes to the Fed, which I can’t.

    The same is true of the deed to my house. It’s all backing just the same.

    Yes, but the federal government will have guns irrespective of whether the Fed has assets. So your definition of backing doesn’t support what you say would happen.

  21. Gravatar of Mike Sproul Mike Sproul
    10. September 2014 at 14:17

    TallDave:

    About the fed’s dollar-denominated assets:

    First, the fed issues $100 of FRN’s and gets 100 oz of silver. So $1=1 oz. Next, the fed prints $200 FRN’s and uses them to buy $200 worth of dollar-denominated bonds. The public is now holding $300 of FRN’s, but if the public suddenly decided to hold $200 less, then people could return the extra $200 to the fed in exchange for the $200 of bonds. Note that the extra $200 was issued for $-denominated bonds in the first place, so it’s no big deal to retire those $200 of FRN’s in exchange for $-bonds later on. Not every FRN must be redeemable for actual silver. It’s also irrelevant whether the retirement happens at customers’ initiative or at the fed’s initiative. The FRN’s are retired just the same.

  22. Gravatar of BC BC
    10. September 2014 at 17:36

    Mike Sproul: “After a lot of OMS’s,…all the FRN’s are gone, presumably replaced by foreign currencies or other rival moneys. But there’s no deflation.”

    I don’t think this is correct. When the Fed sells 1 oz of assets for $1, the amount of assets that then must be held in equilibrium by the public increases by 1 oz and the amount of base money that must be held decreases. Thus, the price of assets (and goods) should go down and the value of base money should go up, i.e., deflation. That’s why OMSs are contractionary and OMPs are expansionary.

    I agree, though, that the Fed is limited in how many OMSs it can do by the value of its assets. Thus, OMSs are asymmetric with OMPs. The caveat to that is that, as you pointed out, the treasury’s assumed willingness to “bail out” the Fed is a type of intangible Fed asset. So, one explanation for Scott’s point that “backing” doesn’t seem to impact the US dollar is that this intangible asset (of treasury guarantee) is much more valuable than the Fed’s tangible assets of MBSs, bonds, etc. The fluctuation in value of the Fed’s tangible assets is small relative to the value of the intangible asset.

    Then, I guess the government’s taxing power is responsible for fiat money’s value, but not for the oft repeated explanation that people need money to pay taxes. Instead, the government can use its taxing power to obtain/confiscate assets that it can then give to the central bank to sell to decrease money supply, thus preserving money’s value.

  23. Gravatar of ssumner ssumner
    10. September 2014 at 17:55

    Mike, Yes, there was a typo on the OMSale. Otherwise it seems like you are shifting the goal posts. I said the Fed could create almost infinite inflation or deflation. You said no because of the backing problem. Now you say maybe they could, but only if there is implied backing from the Treasury. Let’s say you are right. I could still argue that my original statement was correct, as I believe there is, in fact, implied backing from the Treasury. So instead of saying I was wrong, you should have said I was only correct if the Treasury was willing to backstop the Fed if there was a run on the dollar and not enough assets on the balance sheet.

    I’d guess where we disagree is on the price level when we are far from a situation where the Fed is likely to run out of assets. Say they start with assets equal to 150% of the base. Then they have a wide range over which they can conduct policy where they adjust the base, and the price level, and where the exact backing percentage plays little or no role. Instead ordinary money supply and demand factors determine the price level. I presume you disagree with that?

    I concede there are “danger zones” where (if there is no implied Treasury backing) a low level of assets may lead to a loss of confidence about the future value of the dollar, and hence backing may play a role.

  24. Gravatar of TallDave TallDave
    10. September 2014 at 18:02

    Mike — That’s pretty weak “backing,” though. If I can’t demand that the Fed honor its notes in silver (or anything, except more dollars), what do I as a Fed noteholder care whether the Fed has silver? In any case, the large majority of Fed assets are government securities, which is to say they are merely future promises to deliver the same dollars I can’t exchange for anything else.

    But I think we can see backing theory dies at its own hand as soon as it admits the Fed is backed by federal force. The Fed’s total holdings are something less than $5T. The NPV of the next 25 years of expected tax receipts at the historical 20% of GDP is (to be really conservative, let’s assume 1% growth and discount at 10%) is ~$30T. That explains why no one much cares that the Fed owns few assets other than future promises to deliver the same dollars that aren’t backed by anything other the promise of more dollars.

    (BTW, here’s another nail in the coffin of backing theory — it doesn’t matter what effect interest rates have on the value of Treasuries, because by law the Fed passes that interest back to the federal government. By your argument either every such transfer event should be inflationary, or the value of Treasuries as Fed assets should already have the interest payments removed so interest rate changes can’t affect the value of Fed assets.)

  25. Gravatar of Mike Sproul Mike Sproul
    11. September 2014 at 06:45

    BC:
    BC:
    We agree that the possible government bailout of the fed is an intangible asset to the fed. (We’d probably also agree that in Weimar Germany, the possible government looting of the central bank was an intangible liability of the central bank.)

    But this is a problem:

    “When the Fed sells 1 oz of assets for $1, the amount of assets that then must be held in equilibrium by the public increases by 1 oz and the amount of base money that must be held decreases. Thus, the price of assets (and goods) should go down and the value of base money should go up, i.e., deflation.”

    The statement runs afoul of the law of reflux. Basically you have to ask why the the fed sold assets for FRN’s in the first place. Presumably it was because the public’s desire for FRN’s just rose, and its desire for bonds just fell. That argument, by itself, is not very strong, I know. It leaves us chasing our tails. But keep in mind that if we start with 100 oz backing $100, then $1=1 oz. If we then move to a new equilibrium where 99 oz is backing $99, then we still have $1=1 oz, just like the backing theory says.

  26. Gravatar of Mike Sproul Mike Sproul
    11. September 2014 at 19:41

    Scott:

    Once again, it feels like you and I are talking at cross purposes, so let me just try to boil things down, and see if we can resolve some simple principles.

    You’ve said many times that you reject the backing theory (and its alter-ego, the real bills doctrine). To me that means you think that the value of the dollar is determined by the intersection of the Ms and Md curves, and not by the fed’s assets. But you also seem to think that the fed’s assets do matter, since if the fed has to buy back frn’s, it needs assets with which to buy them. A die-hard quantity theorist would say that the fed’s assets don’t matter at all, and could be dumped in the ocean, so you’re apparently not in that extreme camp. Furthermore, you think (and I agree) that the government’s potential bailout of the fed is an implicit asset to the fed.

    So let me ask you: If the fed has issued $100 of frn’s, and if all of the fed’s assets, including potential bailouts, were only worth 90 oz, do you think the fed could maintain $1=1 oz just by conducting appropriate OMO’s? What if the fed’s assets were only worth 20 oz?

    By the way, if the fed’s assets were worth 150 oz, then I’d say that the fed could maintain the value of $1 at 1 oz OR LOWER, but as soon as it tried to maintain $1=1.01 oz, it would present an arbitrage opportunity to speculators, and soon go broke.

  27. Gravatar of Mike Sproul Mike Sproul
    11. September 2014 at 19:50

    Tall Dave:

    1. The backing theory is not refuted by the observation that the potential backing for FRN’s is large. It is easy for the fed to maintain the value of the dollar below what its assets could support.

    2. Transfers from the fed to the treasury have no effect on the combined wealth of the fed and the treasury. If you think of FRN’s being backed by both the fed and the treasury (as we should), then transfers are irrelevant.

  28. Gravatar of Mike Sproul Mike Sproul
    11. September 2014 at 19:52

    Typo:
    Should have said:

    “$1 at 1.5 oz OR LOWER, but as soon as it tried to maintain $1=1.51 oz,”

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