Wednesday, April 30, 2014

The US Government need never default on its debt

I recommend this post by Andy Harless. It's a little technical, but not as bad as the title suggests. Andy is essentially discussing the "natural real rate of interest" and the limitations to that concept. To wit:
Most economists think that the natural real interest rate is normally positive. I have my doubts, but never mind, because I'm ditching the whole concept. Once we start correcting for expected normal growth rather than expected inflation, we are clearly not dealing with a natural rate concept that can be presumed to be normally positive.  If we are talking about a risk-free interest rate, then the need for physical capital returns to compensate for risk would make it very hard to achieve a long-run growth rate [an equilibrium with the interest rate] as high as the [growth] interest rate, let alone higher. To come up with a number that's usually positive, I suggest that we reverse the sign. Instead of talking about a "natural growth-adjusted interest rate," let's talk about a "natural discounted growth rate."
Good move by Harless. Reframing "expected inflation" to "discounted growth rate" better captures time preference of spending decisions which is really the underlying intuition that all these models try to capture. He goes on to pin down some key insights around "risk", or more specifically, the "risk free rate":
The thorny issue here is risk, and some will argue that the relevant interest rate for dynamic inefficiency is not the risk-free rate.  But I disagree.  The US government can produce assets that are considered virtually risk free, and a stable Ponzi scheme operated by the US government could presumably produce such assets yielding any amount up to the growth rate.  At today’s Treasury interest rates, which are clearly less than expected growth rates, marginal investors are (we can presume, since the assets are freely traded) indifferent between these low-yielding Treasury securities and investments that represent newly created capital.  So, given the risk preferences of the marginal investor, the government could, by operating a stable Ponzi scheme, be producing assets that have a higher risk-adjusted return than newly created capital.  Given the risk preferences of the marginal investor, it’s inefficient for the government not to be producing such assets.
I disagree with Harless' characterization as US Govt debt being a "Ponzi scheme", not because of the pejorative angle associated with that term--although I note that too and don't agree--but because in the fiat monetary system, a Government which runs a deficit is not technically, in Ponzi, because the Government does not need to borrow to make a payment.

For the US Govt to make a payment it simply marks up an account in a spreadsheet. To argue otherwise is to argue that the Federal Reserve is completely independent of the US Govt and will let the US Economy and monetary system collapse, which is unlikely to say the least.

In the comments, Rowe makes a point which would be true under a gold standard regime, but not in our fiat one:
Frances: I think the risk might be the risk of the amount of taxes paid by future generations. If we start with Samuelson 58 (whch is where Andy is coming from), and then introduce uncertainty in (say) population size for future cohorts, the government might need to vary future taxes/transfers to make government debt a perfectly safe asset.  
Monetarists like to laugh at Cochrane who says that fiscal stimulus does not work because spending is reduced in anticipation of increased future taxation, but Nick's point above is using the same logic, he's just not taking it to its final conclusion.

We need to re-think exactly what we mean by "risk-free" and to develop a realistic sense of exactly what safety and sovereign can and cannot provide. $100 will always be worth $100, which doesn't help if you're planning on buying a loaf of bread (what will that cost in the future?!) but it is extremely useful when you are planning on paying down or servicing nominal debt. The ability for this nominal wealth to manage nominal debt is critical to anticipating and modeling household and firm financial decisions and is discrete from household and firm decisions around real goods and services. The two are related, but not the same, and this conflation may make modeling simpler, but it leads you to error.

Friday, April 18, 2014

What is a central bank?

Nick has a post on "alpha" and "beta" banks where he alights on one idea for what distinguishes a central bank from a non-central bank:
Here's the answer. Commercial banks promise to redeem their monetary liabilities for the monetary liabilities of the central bank at a fixed (or at least pre-determined) rate. Central banks do not promise to redeem their monetary liabilities for the monetary liabilities of the commercial banks. This asymmetry of redeemability is what gives central banks their power over commercial banks. But a bank with that power is nevertheless not a true central bank unless it acts like one, and uses that power.
I think this is an interesting question to ponder, but I don't come to the same conclusions that Nick does. When looking at existing central bank institutions, such as the US Federal Reserve for example, you don't see an "asymmetric redeem-ability" function like Nick postulates, and I'm sure Nick would agree that the Fed is a central bank.

So, given that central banks can and do exist without asymmetric redeem-ability, what is it precisely that they have which make them central?

Here's my take:

First and foremost, they need to act as a hub to handle payment settlements, and thus need to be able to operate at negative liquidity and capitalization levels which would put a regular bank out of business. To operate in this way they need an essentially different regulation scheme than commercial banks and are, by merit of this regulation scheme, an "extension" of the Government. There may be a better term than "extension" but I think it works for now.

In the real world this interbank interconnection is handled via reserve accounts, which are Fed liabilities and bank assets. Money circulating between banks as coordinated through the Fed so that checks do not bounce simply because of liquidity or solvency problems at a particular bank.

Another perspective is that the reserves circulating between banks via the Fed are the "inside money" counterpart to the deposits and loans circulating between the non-bank sector via the banks. The right hand and left hand sections of the balance sheets have to balance.

Note that this function is only necessary when there are multiple banks which need to have payments and transactions settle across them. If there was a single bank, in addition to the central bank, you would not need reserves to manage this process as everything would clear within the bank itself and you would not need a central clearing house capability.

Regardless, even in this scenario, you would still need/want a central bank to set interest rates. In the absence of a reserve system, it could introduce one and use requirements around that as an interest rate setting mechanism, but I think as a practical matter it would create a separate mechanism for this instead such as a modified discount window. I view the use of reserves, with their associated requirements, as a mechanism for setting interest rates as an artifact of the organic evolution of banking and not a sound, engineered solution for this function. And this then would be a second central bank characteristic, the ability and responsibility of setting rates through whatever mechanism is at hand. (And on that, note how the US Fed instigated IOR when needed--not a well engineered solution but expedient given what was on hand).

So, I do not find the story about asymmetric redeemability a compelling one given that nothing of the sort is observed in real life, and misses the key central bank function of supporting payment settlement. Instead, I would classify asymmetric redeemability as a theoretical model of something that could substitute for OMO today, but there are many such candidates and I don't think Nick was advocating this one as being particularly good.

I would also see this approach as a logical conclusion of lumping in reserves with deposits, thus conflating the liability side of the central bank along with the liability side of the commercial banking sector, and seeing those two as being fundamentally interchangeable. I think this is a source of all the errors and confusion that come from Monetarism as reserves and deposits are fundamentally different, they serve different functions, and they are not interchangeable the same way two fluids in a heat exchanger are not interchangeable nor do they intermingle. Reserves are best thought of an abstraction layer that lets independent commercial banks coordinate payments and settlements amongst depositors by having a separate reserve system act as the other part of the balance sheet at a higher level. This core function was then co-opted (again, not a great word choice) for setting interest rates.

Friday, April 04, 2014

HFT is not an act of nature

The FT reviews Michael Lewis' new book, "Flash Boys" and ends on this note:
Indeed, as Lewis explains, much of their behaviour was perfectly in line with regulations – the Securities and Exchange Commission deliberately tried to weaken the monopoly power of large exchanges to create more competition. It may not have appreciated the scale of what it would unleash – 13 public stock exchanges and more than 40 private “dark pools”.

And financial trading is not the only ecosystem that is highly complex and aggressive. “I would ask the question, ‘On the savannah, are the hyenas and the vultures the bad guys?’ ” says one of Katsuyama’s more dispassionate colleagues. “We have a boom in carcasses on the savannah. So what? It’s not their fault. The opportunity is there.”
The analogy with the jungle is telling because it presupposes that HFT, or the environment that created HFT, is simply an "act of nature" and thus being "natural" beyond this type of moral scrutiny. But markets are not "natural" -- they are constructs put together for public purpose (to use Mosler's term) and our equity markets are no different.

HFT seems so plainly on its face to be an exploit of the system, and it makes it difficult to defend it publicly, and it is this reason why I think the "only natural" argument seems to weak. The FT itself points out this contradiction because, one paragraph before declaring it "natural" it says that this came about because of changes in SEC regulation a little earlier.

The stronger arguments about liquidity and tighter spreads are more compelling, but I think Lewis makes a good case by distinguishing between liquidity and activity. Liquidity comes from players willing to take the opposite sides of trades when things are going south, not withdrawing from the market altogether, and there are few institutions capable and willing to do that at all times. I don't think HFT algorithms can be counted amongst that number either. Ultimately, I think only the government can reliable act in a truly counter-cyclical manner.