Tuesday, August 19, 2014

Liquidity Preference on the F Line

Sitting on the subway today, I was struck by the fact that the three ads immediately opposite me were all for what you might call liquidity services. On the left was an ad for "personal asset loans" from something called Borro: "With this necklace ... I funded my first business," says a satisfied customer. Next to it was an MTA ad trumpeting the fact that you can pay your fare with a credit card. And then one from AptDeco.com, which I guess is a clearinghouse for used furniture sales, with the tagline "NYC is now your furniture store."

the Borro ad was the next one to the left
This was interesting to me because I've just been thinking about the neutrality of money, and what an incoherent and contradictory idea it is.

The orthodox view is that the level of "real" economic activity is determined by "real" factors -- endowments, tastes, technology -- and people simply hold money balances proportionate to this level of activity. In this view, a change in the money supply can't make anyone better or worse off, at least in the long run, or change anything about the economy except the price level.

Just looking at these ads shows us why that can't be true. First of all, the question of what constitutes money. All three of these ads are, in effect, inviting you to use something as money that you couldn't previously. Without the specialized intermediary services being hawked here, you couldn't pay the startup costs of a business with a necklace (what's this thing made of, plutonium?), or pay for a subway ride with a promise to pay later, or pay for much of anything with a used couch. And this new liquidity has real benefits -- otherwise, no one would be buying it, and it wouldn't be worth the cost of producing (or advertising) it. The idea -- stated explicitly in the Borro ad -- is that the liquidity they provide allows transactions to take place that otherwise wouldn't. The ability to turn a piece of jewelry or a car into cash allows people to use productive capacities that otherwise would go to waste.

And of course this makes sense. The orthodox view is that money is useful -- there must be a reason that we don't live in a barter world, and more than that, that all this huge industry of liquidity provision exists. But money, for some reason, is not subject to the same kind of smoothly diminishing returns that other useful things are. There is a fixed amount you need, you can't get by with less, and there's no benefit at all in having more. The problem is worse than that, since the standard view is that money demand is strictly proportionate to the volume of transactions. But, which transactions? Presumably, the amount of economic activity depends on the availability of money -- that's what it means to say that money is useful. And furthermore, as these ads implicitly make clear, some transactions are more liquidity-intensive than others. No one is offering specialized intermediary services to help you buy a hamburger. So both the level and composition of economic activity must depend on money holdings. But in that case, you can't say that money holdings depend only on the volume of activity -- that would be circular. In a world where money is used at all, it can't be neutral. An increase in the money supply (or better, in liquidity) may raise prices, but it won't do so proportionately, since it also enables people to benefit from increasing their money holdings (or: shifting toward more liquid balance sheet positions) and to carry out liquidity-intensive transactions that were formerly unable to.

This is a very old issue in economics. The idea that money should be neutral is as old as the discipline, and so is this line of criticism of it. You can find both already in Hume. In "Of Money," he lays out the argument that money must be neutral in the long run, since it is just an intrinsically meaningless unit of measure; real wealth depends on real resources, not on the units we count them in. Unlike most later writers, he follows this argument to its logical conclusion, that any resources devoted to liquidity provision are wasted:
This has made me entertain a doubt concerning the benefit of banks and paper-credit, which are so generally esteemed advantageous to every nation. That provisions and labour should become dear by the encrease of trade and money, is, in many respects, an inconvenience; but an inconvenience that is unavoidable, and the effect of that public wealth and prosperity which are the end of all our wishes. ... But there appears no reason for encreasing that inconvenience by a counterfeit money, which foreigners will not accept of in any payment, and which any great disorder in the state will reduce to nothing. There are, it is true, many people in every rich state, who having large sums of money, would prefer paper with good security; as being of more easy transport and more safe custody. ... And therefore it is better, it may be thought, that a public company should enjoy the benefit of that paper-credit, which always will have place in every opulent kingdom. But to endeavour artificially to encrease such a credit, can never be the interest of any trading nation; but must lay them under disadvantages, by encreasing money beyond its natural proportion to labour and commodities, and thereby heightening their price to the merchant and manufacturer. And in this view, it must be allowed, that no bank could be more advantageous, than such a one as locked up all the money it received, and never augmented the circulating coin, as is usual, by returning part of its treasure into commerce.
You can find similar language in "On the Balance of Trade":
I scarcely know any method of sinking money below its level [i.e. producing inflation], but those institutions of banks, funds, and paper-credit, which are so much practised in this kingdom. These render paper equivalent to money, circulate it throughout the whole state, make it supply the place of gold and silver, raise proportionably the price of labour and commodities, and by that means either banish a great part of those precious metals, or prevent their farther encrease. What can be more shortsighted than our reasonings on this head? We fancy, because an individual would be much richer, were his stock of money doubled, that the same good effect would follow were the money of every one encreased; not considering, that this would raise as much the price of every commodity, and reduce every man, in time, to the same condition as before. ...
It is indeed evident, that money is nothing but the representation of labour and commodities, and serves only as a method of rating or estimating them. Where coin is in greater plenty; as a greater quantity of it is required to represent the same quantity of goods; it can have no effect, either good or bad, taking a nation within itself; any more than it would make an alteration on a merchant’s books, if, instead of the Arabian method of notation, which requires few characters, he should make use of the Roman, which requires a great many. 
From this view -- which is, again, just taking the neutrality of money to its logical conclusion -- services like the ones being advertised on the F train are the exact opposite of what we want. By making more goods usable as money, they are only contributing to inflation. Rather than making it easier for people to use necklaces, furniture, etc. as means of payment, we should rather be discouraging people form using even currency as means of payment, by reducing banks to safe-deposit boxes.

That was where Hume left the matter when he first wrote the essays around 1750. But when he republished "On the Balance of Trade" in 1764, he was no longer so confident. [1] The new edition added a discussion of the development of banking in Scotland with a strikingly different tone:
It must, however, be confessed, that, as all these questions of trade and money are extremely complicated, there are certain lights, in which this subject may be placed, so as to represent the advantages of paper-credit and banks to be superior to their disadvantages. ... The encrease of industry and of credit ... may be promoted by the right use of paper-money. It is well known of what advantage it is to a merchant to be able to discount his bills upon occasion; and every thing that facilitates this species of traffic is favourable to the general commerce of a state. But private bankers are enabled to give such credit by the credit they receive from the depositing of money in their shops; and the bank of England in the same manner, from the liberty it has to issue its notes in all payments. There was an invention of this kind, which was fallen upon some years ago by the banks of Edinburgh; and which, as it is one of the most ingenious ideas that has been executed in commerce, has also been thought advantageous to Scotland. It is there called a Bank-Credit; and is of this nature. A man goes to the bank and finds surety to the amount, we shall suppose, of a 1000 pounds. This money, or any part of it, he has the liberty of drawing out whenever he pleases, and he pays only the ordinary interest for it, while it is in his hands. ... The advantages, resulting from this contrivance, are manifold. As a man may find surety nearly to the amount of his substance, and his bank-credit is equivalent to ready money, a merchant does hereby in a manner coin his houses, his household furniture, the goods in his warehouse, the foreign debts due to him, his ships at sea; and can, upon occasion, employ them in all payments, as if they were the current money of the country.
Hume is describing something like a secured line of credit, not so different from the services being advertised on the F line, which also offer ways to coin your houses and household furniture. The puzzle is why he thinks this is a good thing. The trade credit provided by banks, which is now "favourable to the general commerce of the state," is precisely what he was trying to prevent when he wrote that the best bank was one that "locked up all the money it received."Why does he now think that increasing liquidity will stimulate industry, instead of just producing a rise in prices that will "reduce every man, in time, to the same condition as before"?

You can't really hold it against Hume that he never resolved this contradiction. But what's striking is how little the debate has advanced in the 250 years since. Indeed, in some ways it's regressed. Hume at least drew the logical conclusion that in a world of neutral money, liquidity services like the ones advertised on the F train would not exist.

[1] I hadn't realized this section was a later addition until reading Arie Arnon's discussion of the essay in Monetary Theory and Policy from Hume and Smith to Wicksell. I hope to be posting more about this superb book in the near future.


  1. Thanks for this. The Hume passage is fascinating!

  2. Nice post. Do you read the Moneyness blog (jpkoning.blogspot.com)? It's full of nuggets along these lines.

    1. I don't, but I'll take a look. Thanks!

    2. Hm. I like where he's coming from. Not sure about where he's going. But definitely worth reading.

  3. My random thoughts on the subject (which have no doubt been better articulated and thought-out these past 250 years*):

    The Central Bank can create money and inflation. It has the government and taxpayers behind it, as well its history of keeping the currency sound. Or more specifically, today central banks create money and provide liquidity to member banks to target a certain level of inflation like 2 percent which politicians deems as most conducive to commerce.

    Banks can create money and inflation by providing credit, but there are limits (just as there are with central banks). The bank needs to make profitable loans on balance to remain in business. It has reserves at the central bank and borrows from the central bank and other banks. How much and at what rates depends on the central bank's policy at the moment. Then there's the competition among banks for providing liquidity services.

    So all well and good. So liquidity services work well enough and help the economy (and boost inflation) as long as the credit channels are working fine. But if the credit channels get messed up through bad loans and fraud, etc., obviously this is bad for commerce.

    Perhaps Hume had witnessed credit crunches and financial panics around the time of the earlier excerpts and the final excerpts were written in a time of growth and prosperity where financing helped with business creation, job growth and overall well-being.

    Seems like an obvious point. Credit and liquidity services work fine and help commerce as long as they are composed of good loans that will be paid back. And a bank will be fine as long as the good loans outnumber and outweigh the bad ones.

    In the distant future I don't see any reason why the central bank couldn't determine a certain level of credit creation and liquidity services in the financial sector and create a certain amount of inflation in that manner while also simultaneously creating money and inflation by directly depositing new money in citizens' accounts. Or take money out if inflation was getting to high. There would be less danger of the credit channels collapsing.

    *IMO the the history of economic thought should be a required course.

    1. And then there's government regulation of banks and the credit channels. You want a sweet spot-Goldilocks level of regulation which neither overly burdensome or too weak.

  4. Thanks for writing this entry point on the subject of "neutrality of money".

    It seems to me that the concept of "neutrality of money" would be correct if we at each point in our discussion considered only how much money was available at the moment of measurement. This measurement would be a static evaluation of money with all components static.

    The second way of looking at the "neutrality of money" is to consider how the supply of money might increase. An increase of the supply of money between measurement periods is definitely not neutral in effect. It is the act of money supply increase that is not neutral.

    To see this point more clearly, consider the case of a perfect counterfeiter. A perfect counterfeiter would be able to produce money that would be indistinguishable from legitimate money. Each time the perfect counterfeiter produced money, the result would be an increase in the money supply. The act of increasing the money supply would occur when the perfect counterfeiter purchased something. The demand for that "something" would increase and the perfect counterfeiter would have the pleasure of consumption in exchange for the simple act of creating a perfect duplication of money.

    Echos from the production of perfect counterfeit money would not stop with the first purchase by new counterfeit money. The initial seller would have an increased money supply allowing him to make a purchase not possible unless the initial perfect counterfeit purchase was first made. This second purchase does not increase the money supply; only the initial purchase by the perfect counterfeiter increased the money supply.

    Now we can see that money does have both a "neutrality of money" and a clear "non-neutrality of money" dependent upon the source of "new money".

  5. The problem with money neutrality is that it only make sense in the context of comparative statics. It is not unreasonable to say that for a given equilibrium, if the quantity of money is higher, then all prices and nominal quantities need to be equally higher. However, in a real economy, a change in the money supply must have immediate real effects and there's no reason to suppose that those real effects will simply go away, given enough time.

    1. Exactly.

      The (usually unstated) assumption of money neutrality is that the economy is normally close to the absolute physical limit of what can be produced, and there are no opportunities for productive activity going to waste. But the problem with this is (1) logically, it corresponds to a world where money is absolutely abundant, not a world where there is the "right" finite quantity of money, and (2) it's utterly wrong as a description of the world around us -- again, as these ads illustrate. There are endless opportunities for productive cooperation between people beyond what is being carried out now.

    2. "It is not unreasonable to say that for a given equilibrium, if the quantity of money is higher, then all prices and nominal quantities need to be equally higher."

      Isn't it unreasonable, though, that one has to assume that the prices adjust BEFORE participants in the market have acted in ways that will cause the prices to adjust? In other words, the prices "adjust themselves" in anticipation of the actions that people will subsequently take. Or maybe the invisible hand did it.

  6. Snadwichman - Yes!

    I want to write more on this. But it really seems to me that this is a basic contradiction in the idea of money neutrality.

    The orthodox view is that (1) long-term income does not depend on money, and (2) that rational agents make expenditure choices based on long-term income. But in that case, how is a change in the money stock supposed to bring about a change in the price level? If nobody changes their expenditure decisions based on the availability of money, then there will be no change in prices. But if people do change their expenditures, then either (1) or (2) must be false. Either the supply of money does have long-term effects, or people are irrationally basing their consumption decisions on their money holdings rather than their real income. I've never seen someone explain how spending can be both independent of money (so that "real" outcomes ultimately depend only on "real" parameters) and also dependent on money (so that spending changes to bring about the required price adjustments). Have you?

    1. So yes -- the only way the mainstream theory is coherent is if the price adjustments somehow happen without any change in production or spending. But how is that supposed to work?

    2. I haven't seen a convincing alibi for the discrepancy, no.

      I've started to think of the problem as a version of the Liar's Paradox -- or possibly Zeno's paradox of the arrow. The static analysis has logical consequences whose seriousness has rarely been acknowledged (Marshall [somewhat], J.M. Clark, Georgescu-Roegen explicitly) and is routinely ignored and denied.

      The narrative form denial takes is what interests me. I'll get back to you in a few days on this. Off to an island to do some kayaking first...

    3. and it goes without saying, Marx and Veblen... but that goes without saying. (Keynes, sotto voce).

    4. What's Georgescu-Roegen's take?

    5. see his critique of "arithmomorphism" in chapter two of The Entropy Law and the Economic Process...

  7. Assuming that there is an optimum level of transactions in an economy (for example one that keeps the economy close to full employment) then one can imagine that sometimes increased liquidity services will be a good thing (increasing the number of transactions towards optimum) and sometimes will be inflationary.

    An active monetary policy aimed at stabilizing AD would respond to an increase in liquidity services by tightening money. This is consistent with the view that money can only be seen as neutral if all other things remain equal - which typically they are not thru the business cycles.

    Final thought: When bank lending thru normal channels is tight it seems reasonable to assume that demand for liquidity via other means (such as those in the ads seen on the metro) will increase.

    1. When bank lending thru normal channels is tight it seems reasonable to assume that demand for liquidity via other means (such as those in the ads seen on the metro) will increase.

      That's an interesting point, I hadn't thought of that. But is it true? Tight credit will increase demand for these services, but loose credit will increase the supply og them. Not clear which effect will dominate.

  8. Assuming that there is an optimum level of transactions in an economy

    Yes, that's the problem.

    The next step in the argument here is to get rid of the idea of potential output, and take endogenous growth, (anti-)hysteresis, and Verdoorn's Law seriously.

  9. Some points not necessariously related one to the other:

    1) It seems to me that all three advertisements are really directed to people who can't make week's end and need fast money just to stay alive. Are those advertisements so common in the USA (in Italy they became much more common since the crisis)? I think we are doomed.

    2) The first Hume citation that you use as an example of the "neutrality of money" camp, ends by actually advocating deflation. This is a bit weird because, if money really was neutral, inflation wouldn't be a problem (as stated in the second Hume citation). People who fear inflation, implicitly don't believe in the neutrality of money argument, or (more likely) fear the redistribuition that might come with inflation, not inflation in itself.

    3) I think that the concept of "non-neutrality of money" is too ambiguous, in particular when opposed to the concept of "real" values.
    I'm a big fan of the labour theory of value, and as such I think that the "real" value of, say, a factory, could be determined as its cost of production in terms of hours of simple labour (that is, it is independent of money). On the other hand, some stuff, like bonds, have a nominal value. At any given moment we could calculate how many "labour hours" a bond is worth, given the labour value of one money unit. If the value of money falls, the "real" value of the factory stays the same (but in nominal terms it increases, while the "real" value of the bond falls (but in nominal terms stays the same). But this doesn't mean that the "real" value of the bond is actually "real", it doesn't correspond to any "real" thing (whereas the factory is actually made of bricks). So we actually have three different levels:
    - At a level 0, we have real stuff, made of bricks, that have a real value due to real (i.e. material, tecnological) reasons;
    - at a level 1, we have this real stuff plus some other financial stuff, like credit, that doesn't necessariously have a real counterpart, but can be exchanged for real stuff and thus also has a "real" value. Note that the amount of financial stuff isn't really determined by "real constraints": for example, suppose that the amount of "real" stuff in the USA amounts to 3 times the yearly GDP, we can certainly think of two different scenarios where in the first, the amount of financial goods is +1times the GDP, and in the second, the amount of financial goods is +5times the GDP, but this has nothing to do with inflation (a fall in value of the unit of money);
    - at a level 2, we have inflation proper, that is a change in the value of the unit of account. This also isn't neutral, since some stuff has a price that is nominally fixed, while other stuff doesnt and presumably will bounce to keep its "real value", so that inflation (expecially unexpected inflation) is likely to have distributional effects. While this might change the amount of financial goods in the economy, it isn't the same thing.

    1. [continues]

      4) I think that while many people speak of inflation as it was one thing, each "school" is thinking of a different economic effect and call it "inflation".
      For example, I implicitly used above a definition of inflation based on the LTV, but under this definition, to have 0 inflation means that 1h of work on average produces always, say, 1$. However, if there is productivity growth, 1h of work will produce more stuff, so my definition of 0 inflation corresponds to actual deflation in the normal use of the term. I think that goldbugs, unconsciously, use a definition of inflation similar to mine, so when the say "no inflation" they actually mean "deflation proportional to growth". This is, I think, the reason so many people think that inflation is underestimated, because they use a different definition of inflation that is based on an implicit LTV (but don't tell them or they'll have an heart attack!). I actually think this definition of inflation is more coherent, as it is purely based on the nominal value of money VS a fixed parameter (hours of work). On the other hand if one speak of inflation in the usual sense, one has to take in account both the amount of money and the productivity growth, that isn't a monetary phenomenon in itself. For example, if we reach peak oil and the cost of everithing rises because we run out of oil, in the normal sense this would be considered "cost push inflation", but in reality this isn't inflation (a fall in value of the money unit) but an adverse tecnological shock.

      5) Unrelated to the above and partially contradicting it: usually, an increase of the quantity of money is supposed to be caused by credit, and this might rise the price of stuff. But when we speak of the price of capital assets, it is very likely IMHO that the opposite happens: if we assume that the market price of a capital asset is the cost of a certain cashflow at the expected profit rate (for example, if the expected profit rate is 5% and a certain capital assets gives a cashflow of 100$, its market price will be 2000$ = 100$/5%), if the expected profit rate falls, for example because the economy approaches potential and so marginal capital assets become unprofitable, the value of all capital assets will rise inversely. Thus the amount of "value" present in the economy will increase, and, since people can use those capital assets as collateral, also the endogenous quantity of money will increase (that is, it is the capital asset price that influences the quantity of money and not the opposite). This would not cause an inflation in the usual keynesian sense of an increase of the price of consumption goods, but from the point of wealtholders/capitalists, they have to invest more to have the same profits, so it really looks like inflation to them. Since I think this actually happened, this added to the different definition in (4) explains the inflationphobia and the fact that it is tipically a right leaning phenomenon.