Sunday, March 16, 2014

Endogenous money demand - major constraint to both fiscal and monetary policy.

A recent paper by BoE on money creation has squarely put the Bank of England on the side of endogenous money supply, which hopefully will dispel widely held misconceptions about how money is created and the role of central banks.  However, this is only the first step in understanding the true nature of money.

The second step is to recognize that money demand is also endogenous, and more importantly, it is inversely related to money supply.  Endogenous money demand has profound impact on the macro-economy.  For starters, the inverse relationship between money supply and demand is the primary driver of the business cycle.  Second, money demand is the one macro-economic variable that governments have little control of, and as such it places a constraint on both fiscal and monetary policy as evidenced by current experience at the lower zero bound or prior periods when the global economy was faced with asset bubbles or inflation. 

The next logical step is to endorse the hybrid approach to government intervention, which calls for equipping central banks with fiscal policy tools in the form of consumption and investment credits.  Such tools will give policy makers a great degree of control over money demand and for the first time in history will put central banks in a position to manage the economic cycle without introducing distortions such as asset bubbles and inflation.

Let's first talk about endogenous money supply.  Money is created within and as part of processes taking place in the real economy.  All modern money is created as a result of borrowing.  While all money is debt, not all debt is money.  The moneyness of debt (or its capacity to be used as money) is determined by two factors - zero duration and zero credit risk.  Zero duration means that the nominal value of the debt does not change with changes in interest rates - paper money being the perfect example since its nominal value is constant.  Zero credit risk is the more onerous requirement since there is no such thing as debt without risk of default with one notable exception.  Domestic currency reserves are deposits held at the central bank.  Since central banks have authority to print domestic currency, they have unlimited capacity to meet their deposit liabilities.  You can take this a step further and ask what monetizes paper currency.  We accept paper bills as money because the state is required by fiat to accept paper bills as payment of taxes.  In effect, paper money is monetized by our tax liability as citizens, which is the ultimate backstop representing the productive capacity of the entire economy.

It should be pretty clear by now that the money supply is determined by the demand for borrowing and by the capacity of the financial system to monetize the resulting liabilities.  A central bank has only indirect control over money creation through its ability to manipulate the financial system via capital and reserve requirements as well its willingness to supply reserves (substitute its liabilities for those of the banks).  Central banks achieve their interest rate targets by supplying the financial system with the level of reserves demanded at such rates.  Contrary to popular myth, central banks do not create money since the bank liabilities they monetize have to exist in the first place.  Using a similar line of reasoning, money supply cannot be represented with a vertical line in economic textbooks.

However, there is another piece to the money puzzle, namely that the demand for money is also endogenous and furthermore, it is inversely related to the supply of money.  Money demand has two motives - an exchange motive and an asset motive.  Transaction money (Mt), which represents the exchange motive, is determined by the level of GDP.  Asset money (Ma), on the other hand, represents the amount of money people hoard in mattresses or bank accounts.  Now that we know that money is debt, why would people want to invest their savings in debt which pays 0%?  To re-phrase the question, would you lend $1,000 to someone who has perfect credit but refuses to pay interest or guarantee the purchasing power of the money upon repayment? 

Before answering this question, let's try to quantify the two money motives and see how they have changed over time.  The two motives can be segregated using the quantity of money equation:
M2 = Mt + Ma
Q P = Mt Vt

Based on data provided by the St. Lous Fed, the average velocity of money since 1959 is about 1.85.  By plugging that number in the above identities, changes in money demand can be easily derived as illustrated in Chart 1.

Chart 1 (data source: St. Louis Fed; Updated as of Q3-2013)

By definition, changes in Mt are directly correlated to GDP.  Ma on the other hand exhibits very different behavior.  Up to the late 1980's changes in asset money demand affected inflation.  After the Fed defeated inflation under the chairmanship of Paul Volker, asset money demand began to undergo significant fluctuations, which as I show in the post on asset bubbles, are directly correlated to the boom and bust cycles of the last 25 years.  Chart 2 below is a stark demonstration of the these effects.

Chart 2

Clearly, demand for asset money has changed over time with huge potential impacts on the economy.  If inflation expectations are high, changes in asset money demand will be plowed directly into the real economy driving up inflation pressures as was the case in the 1960's and 70's.  If inflation expectations are low, excess money supplies begin to churn in stock and real-estate markets giving rise to asset bubbles.  Finally, a dramatic rise in asset money demand will render "money printing" efforts by central banks akin to pushing on string with little impact on the real economy and inflation.  Liquidity trap is another label for this conditions, which is where we find ourselves 5 years into the Great Recession.  The fact of the matter is that asset money demand is endogenous because it is driven by a fundamental economic force - time preference.  As such asset money demand places a constraint on both fiscal and monetary policy.

Time preference measures the difference between the marginal utility of current and future spending.  If you expect your future wealth to double (positive expected returns and positive time preference), spending $100 now will bring you a lot more marginal utility compared to spending $100 in that blissful future when all of your needs will be satisfied.  Accordingly, a saver will demand interest to compensate for the loss of utility associated with delayed consumption.  For the very same reason a borrower is willing to pay interest.  By spending the borrowed money today, a borrower gains utility compared to the future utility he or she forgoes upon paying back the debt.  However, if you expect to be poorer in the future (negative expected returns and negative time preference), saving for a rainy day at 0% doesn't seem like such a bad idea.  That is exactly what people are doing when they choose to hold money as an asset (either in bank accounts or as cash) - they are arbitraging their negative expectations of future returns.  A positive time preference drives the demand for loans and consequently the money supply.  A negative time preference drives the demand for asset money, hence the negative relationship between the supply and demand for money. Transaction money demand is positively related to time preference but not to a degree sufficient to offset inverse change in asset money as evidenced in chart 3 below.

 Chart 3

Time preferences and interest rates are two measures of the same thing, namely expectations of future returns.  Interest rates measure such expectations as expressed in financial markets in terms of the supply and demand for money.  Time preferences measure those same expectations but in the real economy as expressed in terms of actual spending and investment decisions.  In a perfect world time preferences and interest rates would be identical.  However, the intermediation of banking and the exogenous reserves supplied by central banks divorce the two measures.  Basically, banks do not need savers to extend credit, nor do they need borrowers to meet savings demand.  As a result, the supply of money does not have to equal the demand for money.  Perfect illustration is the current level of excess reserves.  Loan demand is insufficient to generate enough money supplies to meet demand.  Accordingly, the Federal Reserve has injected reserves in order to avoid a money shortage.

In order to fully understand money, you need an endogenous ISLM model that illustrates how the mismatch between supply and demand for money drives the business cycle, inflation and asset booms and busts.  If money supply exceeds demand, people attempt to divest of the excess either by increasing spending and investment, which gives a further boost to the economy, or by buying assets, which leads to an increase in asset prices.  Either way, this initiates a virtuous cycle of self-fulfilling positive expectations driving the economy into a boom.  At some point the economy reaches full capacity, which initiates inflationary pressures and diminishing returns setting the stage for the downturn.  As negative expectations take over, money demand increases rapidly just as loan demand and money supply collapse.  Money becomes scarce prompting spending cuts and asset liquidations.  This initiates a vicious cycle of self-fulfilling negative expectations driving the economy into a downward deflationary spiral.
Governments rely on active monetary and fiscal policy to counter the pro-cyclical influence of money.  However, as we saw above, fluctuations in asset money demand or the lack thereof can render both policy approaches ineffective.  The fact of the matter is that neither fiscal nor monetary policy can affect asset money demand.  Simply governments cannot compel people to stop holding cash and instead, spend and invest in the real economy.  The reverse is also true.  Governments cannot compel their citizens to hold newly-minted money created to fund government deficits (unless of course, they were to raise taxes in which case there would not be deficits to fund).  Instead, both fiscal and monetary policies are confined to manipulating the money supply.  Active fiscal policy expands or shrinks the money supply directly through fiscal deficits or surpluses.  Active monetary policy aims to do the same but indirectly through the level of reserves the central bank is willing to extend to the financial system.  Without capacity to control money demand, government intervention introduces distortions such as asset bubbles and inflation.  If left unchecked, such distortions could render counter-cyclical policies a self-defeating exercise.

Currently, we find ourselves at the lower zero bound where we can experience first hand the limitations imposed by asset money demand on monetary policy.  This is an example of conditions where the cumulative time preference in the entire economy is negative.  The Federal Reserve can prevent a deflationary downward spiral by providing sufficient reserves to meet excess demand for asset money; however, it cannot induce inflation because it cannot compel people to invest and spend.  Instead, people arbitrage negative expectations of future returns by hoarding newly-printed money at 0% with no impact on the real economy.  This condition is described as stagnation - a persistent economic malaise characterized by low inflation, excess of savings, lackluster loan demand and high unemployment. 

Policy makers have two options.  Central banks can continue to aggressively monetize liabilities and inject reserves into the system in the hope that money supply will exceed demand causing an increase in asset prices.  The plan is that the associated wealth effect will lift time preferences back into positive territory.  This is the tried-and-true central bank toolkit, which ultimately leads to asset bubbles.  The second option calls for increase in government spending and large fiscal deficits to make up for the shortage in borrowing.  The hope is that such direct intervention can bring the economy back to full employment.  MMT economists have even proposed that governments should take on the role of employer-of-last resort and engage in massive money creation schemes to pay for job and income-guarantee programs.  The problem is that fiscal deficits whether funded with borrowing or newly printed reserves at the stroke of a key, do not come without distortions of their own.  Preferential distribution, inflated financial claims and depressed productive capacity will sow the seeds of future instability as soon as the demand for those newly-printed dollars begins to decline.

In either case, the fundamental problem remains unresolved. The cause for the economic malaise is the negative time preference in the economy.  Basically, people fear the future and stock up money for a rainy day. As a result of such fears, the marginal utility of future spending is higher than the utility of current spending.  Neither fiscal nor monetary policy offers a solution to this core issue.  That's why I advocate for a hybrid approach to government intervention which calls for equipping central banks with fiscal tools in the form of consumption and investment credits.  By funding consumption credits, governments have unlimited capacity to increase the utility of current spending thus lifting time preferences back into positive territory.  In simple terms, a 5% sales tax credit has equivalent impact on consumption as 5% inflation.  The plan can work both in the US with the introduction of sales tax credits, as wells as in the Eurozone in the form of VAT Credits.

Such tools will provide policy makers with immediate capacity to change time preferences in the real economy and by extension control both the demand and supply of money.  This will introduce a complete shift in paradigm - central banks will no longer have to rely on outsized moves in interest rates that could later fuel asset bubbles, nor target 2% inflation out of fear from the zero lower bound.  Neither would fiscal deficits distort economic activity and raise the risk of inflation.  The hybrid approach targets precisely the market malfunction that causes the business cycle, namely the mismatch between time preferences in the real economy and interest rates in financial markets.  Positive government policies that can correct market imperfections without creating distortions of their own is one of the fundamental principles of market positivism.

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