Wednesday, August 18, 2010

What's the Difference Between Money and Debt?

(An idea I've been playing with lately, just wanted to get something on virtual paper.)

Currency, dollar bills, are liabilities of the Federal Reserve. Federal debt is a liability of the US Treasury. Leaving aside some deliberate obscurity around the precise legal status of the Fed, both are liabilities of the US government. Of course there are various formal differences, but economically, wouldn't it be simplest to regard them the same?

In other words, while we are taught that there are no close substitutes for money but that government and private debt are substitutes for each other, wouldn't it be better to say that money and government debt are substitutes for each other and both are complements for private debt? More concretely, given lenders' need for liquidity, an increase in their holding of government debt may make them more willing to hold private debt, i.e. under some circumstances, an increase in government debt could put downward rather than upward pressure on interest rates further out the yield curve.

The canonical case is the recent financial crisis. As I've discussed before, there's an argument (which gets at least some support from non-crazies like Perry Mehrling and Brad DeLong) that insufficient federal debt contributed to the crisis, by creating demand for equivalently liquid but higher-return substitutes, thus fueling the financial innovation of the 1990s and 2000s. Of course this dynamic would have increased the availability of credit for private borrowers whose liabilities were (a) seen as implicitly enjoying a federal guarantee and (b) easily securitizable. But for borrowers that didn't meet those criteria, the lack of enough new federal debt may have made banks less willing to lend to them, in exactly the same way a lack of reserves would have in the old days. And even if the restriction of credit to non-securitizable borrowers was not that big in the boom, the lack of federal debt certainly exacerbated the crash.

So far this is just thinking aloud. But a bunch of smart people seem to be heading in this direction. Take for instance Roger Farmer's call for more quantitative easing (via DeLong). Says Farmer, "Even if the Bank of England were to buy the entire UK national debt, this policy would not be inflationary." This is just a dramatic way of making the point that as government debt and money have become closer substitutes, the economic consequences of shifts between them have become smaller. As Farmer says, money no longer occupies a discrete, unique role. Instead, there is a continuum of assets: "At the safe end of the spectrum there is cash. At the risky end there is equity and low grade bonds." And in a rich country like the US or UK, government debt is very close to the money end. Where Farmer is less convincing is his idea that the interchangeability of money and public debt came about all at once, when central banks began paying interest on reserves. Seems to me it was a longer process of institutional evolution.

One implication of this, again, is that a smoothly functioning financial system requires more public debt, indefinitely. (Another reason to agree with Davidson, Galbraith and Skidelsky that austerity tomorrow is no more desirable than austerity today.) But there's a second implication: If money as a discrete category is obsolete, then so is monetary policy as we know it. If Treasuries are as liquid as so-called high-powered money, then monetary policy -- which comes down to injecting and removing liquidity -- must work on the former and not just the latter; but of course the volume of federal debt is orders of magnitude greater than the volume of reserves. Which suggests that quantitative easing may be the only kind of easing there is, from here on out, that is, no more distinction between monetary and fiscal policy.


EDIT: What's the affinity between cranks and money? Everyone knows that discussions of monetary theory bring all the cranks to the yard. But am I the only one who finds that writing about this stuff, makes me feel like a crank?

4 comments:

  1. hi josh.

    me questioning aloud in response to your thinking aloud:

    1. for whom are money and private debt substitutes; and complements with private debt? (just want to make sure i'm understanding you correctly).

    2. how does the latter complementarity fit with the spectrum view of Farmer?

    3. would "sufficient" federal debt prevent a demand for similarly liquid higher-return substitutes as well? (i suppose i should look into this argument more.)

    4. to some extent your second implication about money as (not) a discrete category and monetary policy is similar (not identical of course) to the older problem associated with targeting the money supply in the absence of a singular measure. right?

    5. "Currency, dollar bills, are liabilities of the Federal Reserve. Federal debt is a liability of the US Treasury...but economically, wouldn't it be simplest to regard them the same?" Are they really liabilities in the same sense though?


    I need to think to myself a bit before commenting more...

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  2. Hey Joe. Thanks for the questions -- I'm still trying to clarify this in my own mind.

    The idea is that in the old days financial actors, in order to have an acceptable cushion of liquidity, sought to keep a certain portion of their assets in the form of money. (This was formalized for some assets, for some actors, for some period as reserve requirements but it's a general feature of asset markets even without them.) More money, more willingness to hold (i.e. demand for) illiquid assets, so the price of non-money assets should move in line with the supply of money, and the return inversely.

    Money was largely supplied by banks (including near-banks of various kinds) to the rest of the private sector, but banks' own liquidity needs being met by reserves. This two-stage process was what allowed the quantitatively small open-market operations to affect aggregate activity.Open-market operations operated on banks' Treasuries-reserves margin, so their effectiveness depended on the latter being more liquid than the former.

    So as federal debt becomes money-like, two things happen. First, for wealth owners in general, an increase in federal debt represents more liquid assets to offset their holdings of of illiquid ones (rather than, as in the past, more illiquid assets to be offset by increased money holdings) and so tends to push interest rates down rather than up. Second, for banks, the mix of reserves and federal debt in their portfolios no longer matters, so open market operations, which trade one for the other, no longer matter. Thus the need for QE.

    Krugman would say this convergence between debt and money is a phenomenon of the zero lower bound. Farmer would say it's a consequence of paying interest on reserves. Personally I think there are longer-term institutional changes at work too, altho I'm not exactly sure what they are.

    1. Money and debt are substitutes, and complements for private debt, (a) in bank portfolios, (b) as international reserves (I didn't talk about that in the post, but it's a big part of what's motivating my thinking about this), and (c) as liquidity for wealth owners in general.

    2. He's not really talking about that piece of the story, but they fit together as above.

    3. Yes, exactly. The idea is that if federal deficits had been high enough in the 1990s and 2000s, there would not have been pressure to securitize mortgages. (Of course this needs some working out -- in particular it seems to depend on the idea that wealth owners are not just seeking higher risk-adjusted return in general, but have some minimum target threshold.)

    4. The issues are similar in terms of the reserves->money link for banks. They're different in terms of the money->asset demand link for wealthowners in general.

    5. Why wouldn't they be?

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