Saturday, March 28, 2015

The bond-stock conundrum

Here's a conundrum. Many commentators have been trying to puzzle out why stocks have been continually hitting new highs at the same time that bond yields have been hitting new lows. See here, here, here, and here. On the surface, equity markets and bond markets seem to be saying two different things about the future. Stronger equities indicate a bright future while rising bond prices (and falling yields) portend a bleak one. Since these two predictions can't both be right, either the bond market or the stock market is terribly wrong. It's the I'm with stupid theory of the bond and equity bull markets.

I hope to show in this post that investor stupidity isn't the only way to explain today's concurrent bull market pattern. Improvements in financial market liquidity and declining expectations surrounding the pace of consumer price inflation can both account for why stocks and equities are moving higher together. More on these two factors later.

1. I'm with stupid

The I'm with stupid view goes something like this...

If investors expect strong real growth for the next few decades, a new bond issue has to provide a competitive coupon in order to attract capital. Soon after the bond is issued, economic growth stagnates and the economy's expected real rate of return falls. The bond's coupon, originally rated for a much healthier economy, has become too good for the new slow-growth environment. The price of the bond has to rise relative to its face value (thus counterbalancing the juicy coupon with a guaranteed capital loss) so that its overall rate of return falls to a level commensurate with the economy's lower real rate of return. That's why rising bond prices are often a sign of a bleaker future.

As for equities, that same decline in the real rate of return will result in a fall in prices. A stock is a claim on whatever profits remain after interest, and lower real growth means a smaller remainder. No wonder then that a number of investment commentators believe that the modern rise of stock and bond prices requires one set of investors to be acting irrationally; after all, things can't be simultaneously better and worse off in the future. Either that or arbitrage between the two markets is simply impossible, say because large actors like the Fed are rigging the market. Whatever the case, concurrent bull markets implies a giant market inefficiency, as Diego Espinosa has described it.

Massive inefficiency isn't a very satisfying theory for the twin rises in bond and stock markets. Thankfully, we don't need to resort to changes in real growth rates to explain securities price changes. Let's explore two other factors that could be driving the concurrent bull market pattern:

2. Falling inflationary expectations and concurrent bull markets

Assume that the real growth rate is constant over time but inflation expectations decline. The real value of all flows of coupon payments from existing bonds are suddenly more valuable, causing a one-time jump in bond prices. If inflation expectations consistently fall over time, then a bull trend in bond prices will emerge. This is standard stuff.

And stocks? What many people don't realize is that those same declining inflation expectations will set off a bull market in equities as well. The general view is that a firm's bottom line waxes or wanes at the same pace as inflation, the result being that real stock returns are invariant to inflation. Corporate shares are supposed to be hedges against inflation.

This is (almost always) wrong, a point I've made before (here and here). Let me take another stab at it. In short, thanks to the interaction between historical cost accounting and the way taxes are collected, rising inflation expectations will boost a firm's real future tax burden, reducing real cash flows and therefore stock prices. Falling expectations about inflation act like a tax cut, increasing real cash flows and stock prices.

For folks who want to work through the logic, what follows is a numerical example. Take a very simple firm which incorporates itself, buys inventory and a machine with the cash raised, operates for four years, and dissolves itself. At the end of each year it pays out all the cash it has earned to its shareholders. At the outset, the company buys 40 unfinished widgets for $60 each. Over the course of its life, it expects to process 10 widgets a year and sell the finished product at a real price of $100. In order to process the unfinished widgets, it buys a widget upgrader for $500. The upgrader is used up, or depreciated, at a rate of $125 year so that it will be useless after year four. Since the company will have also depleted its inventory of unfinished widgets by that time, it has nothing left over after the fourth year.

The first table shows the anticipated cash flows that will be paid to shareholders after taxes have been rendered to the tax authority, assuming 0% inflation over the course of four years. The cash amounts to an even $876.25 a year.

Let's boost the expected inflation rate to 1% (see table below). The real value of cash flows starts out at $876.25 in year one but steadily declines, hitting $866.66 by year four. Shareholder get less real cash flows than they did in a stable inflation environment.

On the other hand, if we ratchet down expected inflation to -1%, the real value of cash flows starts out at $876.50 in the first year but climbs to $886.24 by the end of year four. Shareholders enjoy a larger real flow cash payments than they did in either the stable or the rising expected inflation environments. If cash dividends are immediately spent on consumption, this means that shareholders enjoy the greatest flow of consumption when inflation expectations are falling.

A reduction in expected inflation will cause a one-time jump in our company's share price. If these reductions in expected inflation occur consistently over time, we get a series of jumps in the company's share price, or a bull market.

The core intuition behind this result is that under historical cost accounting, a company's cost of goods sold and its depreciation expenses are both fixed in time. Cost of goods sold is valued on a first-in-first out basis, which means the price of the oldest good is used to value unit costs (in our case, $60), while depreciation is calculated as a fixed percentage of a machine's original purchase price. When inflation is stable, this is unimportant. But once expected inflation rises, the firm's costs grow stale and can no longer keep up with its anticipated revenues, the result being artificially higher pre-tax accounting profits and a larger tax bill. These bloated future tax bills drain cash from the firm, resulting in lower expected cash payouts to shareholders over the life of the firm.

When expected inflation falls, the firm's anticipated revenues shrink relative to its costs, the result being lower future pre-tax profits and a lighter tax bill. Less cash filters out of the firm, leaving more cash in the kitty for shareholders to enjoy at the end of each year.

The table below shows how our firm's real tax bill varies across each of these scenarios:

So a reduction in expected inflation is (almost always) good for equity prices as it amounts to a tax cut. Why have I inserted a caveat? When a company is indebted, lower-than-expected inflation will increase the real burden of that debt. If its debt load is heavy, the debt effect may outweigh the combined effects of cost of goods sold and depreciation. One reason why falling inflation expectations in Japan during the 1990s and 2000s didn't result in an equity boom is that Japanese companies tend to be far more indebted than companies in the rest of the world. (This may also explain why Japanese stocks outperformed U.S. stocks during the inflationary 1970s.) For most of the world's markets a reduction in expectations surrounding the rate of inflation is an ideal situation for equities.*

What do we know about the actual shape of inflation expectations? In general people have been marking their expectations downwards since the early 1980s, a trend that has been amplified since the credit crisis as central banks around the developed world have consistently undershot their inflation targets. We thus have the underpinnings for a concurrent bull market in stocks and bonds, driven by falling inflation expectations.

3. Liquidity and the concurrent bull market pattern

Let's move on to our second factor. Assuming that the real growth rate and expected inflation both stay constant, we can also generate concurrent bull markets in stocks and bonds by simultaneously improving their liquidity. Innovations in market infrastructure over the years have made it easier to buy and sell financial assets. Investors can increasingly use financial assets as media of exchange, swapping them directly for other financial assets rather than having to go through deposits as an intervening medium. Think buzz words like re-hypothecation and collateral chains.

As financial assets become more liquid, a larger portion of their overall return comes in the form of a non-pecuniary liquidity yield. All things staying the same, investors must cough up a larger premium in order to enjoy this liquidity-augmented return, resulting in a one time jump in asset prices. Consistent improvements to liquidity will result in a step-wise asset bull market.

I've written here about the ongoing liquidity enhancements in equity markets, and speculated here that thirty-year bull market is bonds is (partly) a function of improved bond liquidity. In the same vein, Frances Coppola once penned an article noting that when everything becomes highly liquid, the yield curve is flat, reducing returns across all classes of financial assets (a flattening of the yield curve implies a jump in the price of long term bonds).

While I think that liquidity-improving innovations in market technology and declining inflation expectations can explain a good chunk of the stock bull market, I don't think they can't quite explain as much of the secular rise in bond prices. After all, market interest rates haven't just plunged. In many cases both nominal and real bond interest rates have gone negative.

We can salvage this problem by resorting to another liquidity-based explanation for why bond investors are willing to accept negative returns. Government bonds provide a unique range of liquidity services in their role as a financial media of exchange, a role that cannot be replicated by central bank reserves or any other medium of exchange. Reserves, after all, can only be held by banks, and corporate bonds aren't safe enough to serve as universally-accepted collateral. However, governments have gone into austerity mode, reducing the flow rate of bonds coming onto the market. At the same time, central banks are buying up and removing government bonds from circulation. As a result, the supply of unique liquidity services provided by bonds is growing increasingly scarce, forcing investors to bid up the price of these services. Liquidity premia are high. So a negative real return on bonds may be a reflection of the the hidden fee that bond investors are willing to pay to own a government bond's flow of liquidity returns. I've written about this here.

In sum, the I'm with stupid theory, with its implication of massive inefficiencies, shouldn't be our only theory for concurrent bull markets. Asset prices move for many reasons, not just changes in expected real growth. Bond and equity investors may be reacting non-stupidly to shifting liquidity patterns and declining inflation expectations, the result being a steady bidding up of the prices of both assets.

*If you are interested in the difference between Japan and the rest of the world, here are some papers worth investigating: 

The Taxation of Income from Capital in Japan, Kikutani and Tachibanaki (pdf)
The Cost of Capital in the U.S. and Japan: A Comparison, Ando and Auerbach (pdf)
Are Japanes Stock Prices to High. French and Poterba (pdf)

Wednesday, March 18, 2015

Hawk, Doves, and Canaries

Central bankers are usually classified as either hawks or doves. This post is devoted to a third and rare breed; today's monetary policy canaries. Having taken their respective deposit rates to -0.75%, deeper into negative territory than any other bank in history (save the Swedes), the Swiss National Bank and Denmark's Nationalbank are the canaries of the central banking world, plumbing depths that everyone assumes to be dangerous. Other central bankers, in particular the ECB's Mario Draghi, will no doubt be watching the Swiss and Danes quite closely. The information these two nations generate as they go deep into the bowels of negative rate territory will give a good indication of the level to which the others can safely reduce their own rates before hitting their respective effective lower bounds.

That there is an effective lower bound to rates stems from the fact that at some negative nominal interest rate, everyone will choose to convert deposits into cash, preferring to pay storage and handling costs on the underlying paper instrument than enduring a negative interest penalty on the electronic equivalent. Once this process starts, a central bank will be unwilling to push rates much lower given the possibility that the economy's entire deposit base gets converted into paper.

Last week Danish central banker Lars Rohde told the WSJ that while there is some lower bound for negative interest rates, "we haven't found it yet." What Rohde was basically saying is that the marginal storage costs of Danish cash are higher than -0.75%, Denmark's current monetary policy rate. If costs were lower, than Denmark's largest and most efficient cash hoarders, Danish banks, would have already rushed to convert their deposits held at the Nationalbank into banknotes—and Rohde would have found his as-yet inactive lower bound. Given his confident tone, Rohde must not be seeing much demand for banknotes. He would know. As his nation's central banker, he's privy to real time information on the quantity of cash that the central bank is being called upon to print up and provide to commercial banks.

We can get a rough feel for the data that Rohde is seeing. The chart below shows the year-over-year percent increase in end-of-month Danish cash and coin outstanding. The data is current to the end of February, eighteen days ago. Given that Denmark's deposit rate was initially reduced to -0.5% on January 29 and then to -0.75% on February 5, the data affords us an insight into the first thirty or so days of Danish cash demand at ultra low interest rates.

The chart shows that the yearly rate of growth in cash outstanding has accelerated slightly but is well within its normal range. What does this tell us about paper storage costs? Let's crunch some numbers. Danish banks currently have around 350 billion krone in funds on deposit at the Danish Nationalbanken in the form of certificates of deposit. This amounts to about US$50 billion. The central bank's -0.75% interest rate imposes yearly charges of around 2.5 billion krone, or US$375 million, on those deposits. In choosing to hold funds at the central bank, Danish banks are revealing that the cost of handling and storing paper cash must be somewhere above $375 million a year, else they'd have already started to convert into the cheaper alternative.

Keep in mind that this illustrates just thirty days with deep negative rates. With cash use in Denmark having been stagnant for a number of years (see chart here), vault space may have been re-purposed for other uses—maybe employees have been parking their commuter bikes in unused vaults or storing old bank documents in them. It could take time for vaults to be cleaned up. If so, a dash into cash could simply be delayed by a few weeks.

When Denmark hits its effective lower bound, what will the above chart look like? The 350 billion krone in deposits that banks currently keep at the central bank would quickly be converted into cash. Since Denmark currently has just 65 billion krone in notes and coin in circulation, we'd see a quintupling in cash outstanding. For comparison's sake, this would dwarf previous episodes of strong krone cash demand, like Y2K.

And what of our other canary, the SNB? The Swiss, so timely on matters of transport, don't think that up-to-date central banking data is important. The SNB's most recent data on cash outstanding is too stale to give a good idea how the Swiss have reacted so far to -0.75% rates. All we've got is anecdotes. This article reports that a Swiss pension fund attempted to withdraw a portion of its investments from its bank and hold it in a vault, thus saving 25,000 francs per 10 million francs after storage & handling costs, the implication being that these costs run around 0.5% a year. We'll have to wait for more data to come out of Switzerland before we can gauge whether it is at its effective lower bound.

What we do know is that Switzerland's bound will be much tighter than Denmark's. That's because while Denmark's largest denomination note is the 1000 krone note (worth about US$141), Switzerland's largest note is the 1000 franc note (worth about US$993.) That makes a US$1 million bundle of Danish notes seven times more bulky than that same bundle of Swiss notes, resulting in higher storage costs. This has important implications, since Mario Draghi's ECB, which issues a 500 euro note (worth US$530), likely has an effective lower bound that lies somewhere in between these two.

All of these data points may seem quite being arcane, but they have a very real policy significance. They're the difference between a central bank running out of interest rate ammunition, or buying itself an extra ten 10 basis point rate cuts.

Thursday, March 12, 2015

The final chapter in the Zimbabwe dollar saga?

Here's an interesting fact. Remember all those worthless Zimbabwe paper banknotes? The Reserve Bank of Zimbabwe (RBZ), Zimbabwe's central bank, is officially buying them back for cancellation. According to its recent monetary policy statement, the RBZ will be demonetizing old banknotes at the "United Nations rate," that is, at a rate of Z$35 quadrillion to US$1. Stranded Zimbabwe dollar-denominated bank deposits will also be repurchased.

As a reminder, Zimbabwe endured a hyperinflation that met its demise in late 2008 when Zimbabweans spontaneously stopped using the Zimbabwe dollar as either a unit of account or medium of exchange, U.S. dollars and South African rand being substituted in their place. Along the way, the RBZ was used by corrupt authorities to subsidize all sorts of crazy schemes, including farm mechanization programs and tourism development facilities.

Upon hearing about the RBZ's buyback, entrepreneurial readers may be thinking about an arbitrage. Buy up Zimbabwe bank notes and fly them back to Zimbabwe for redemption at the RBZ's new official rate, making a quick buck in the process. But don't get too excited. The highest denomination note ever printed by the RBZ is the $100 trillion note. At the RBZ's demonetization rate, one $100 trillion will get you... US$0.003. With these notes selling for US$10 to $20 as collectors items on eBay, forget it—there's no money to be made on this trade. If you've already got a few $100 trillion Zimbabwean notes sitting in your cupboard, you're way better off hoarding them than submitting them to the RBZ's buyback campaign.

But this does give us some interesting data points about the nature of money. Last year I wrote two posts on the topic of whether money constituted an IOU or not. With the gold standard days long gone, central banks no longer offer immediate redemption into some underlying asset. But do they offer ultimate redemption into an asset? A number of central banks—including the Bank of Canada and the Federal Reserve—make an explicit promise that notes constitute a first claim or paramount lien on the assets of the central bank. This language implies that banknotes are like any other security, say a bond or equity, since each provides their owner with eventual access to firm assets upon liquidation or windup of the firm.

George Selgin is skeptical of the banknotes-as-security theory, replying that a note's guarantee of a first claim on assets is a mere relic of the gold standard. However, the Bank of Canada was formed after Canada had ceased gold convertibility. Furthermore, modern legislation governing central banks like the 2004 Central Bank of Iraq (CBI) Law declares that banknotes "shall be a first charge on the assets of the CBI." [See pdf]. So these promises certainly aren't relics of a bygone age. The Zimbabwean example provides even more evidence that a banknote constitutes a terminal IOU of sorts. After all, Zimbabwean authorities could have left legacy Zimbabwe dollar banknotes to flap in the wind. But for some reason, they've decided to provide an offer to buy them back, even if it is just a stink bid.

Given that banknotes are a type of security or IOU, how far can we take this idea? For instance, analysts often value a non-dividend paying stock by calculating how much a firm's assets will be worth upon break up. Likewise, we might say that the value of Zimbabwean banknotes, or any other banknote, is valued relative to the central bank's liquidation value, or the quantity of central bank assets upon which those notes are claim when they are finally canceled. If so, then the precise quantity of assets that back a currency are very important, since any impairment of assets will cause inflation. This is a pure form of the backing theory of money.

I'm not quite willing to take this idea that far. While banknotes do appear to constitute a first claim on a central bank's assets, the central bank documents that I'm familiar with give no indication of the nominal quantity of central bank assets to which a banknote is entitled come liquidation. So while it is realistic to say that the Reserve Bank of Zimbabwe always had a terminal offer to buy back Zimbabwe dollars, even during the awful hyper-inflationary period of 2007 and 2008, the lack of a set nominal offer price meant that the value of that promise would have been very difficult to calculate. More explicitly, on September 30, 2007, no Zimbabwean could have possibly know that, when all was said and done, their $100 trillion Zimbabwe note would be redeemable for only US$0.003. The difficulty of calculating this terminal value is an idea I outlined here, via an earlier Mike Friemuth blog post.

While the final chapter of the Zimbabwe dollar saga is over, the first chapter of Zimbabwe's U.S. dollar standard has just begun. Gone are the days of 79,600,000,000% hyperinflation. Instead, Zimbabweans are experiencing something entirely new, deflation. Consumer prices have fallen by 1.3% year-over-year, one of the deepest deflation rates in the world and the most in Africa. With prices being set in terms of the U.S. dollar unit of account, Zimbabwean monetary policy is effectively held hostage to the U.S. Federal Reserve's 12 member Federal Open Market Committee. Most analysts expect the Fed to start hiking rates this year, so I have troubles seeing how Zimbabwean prices will pull out of their deflationary trend. Few people have experienced as many monetary outliers as the citizens of Zimbabwe over such a short period of time. I wish them the best.

Saturday, March 7, 2015

Paul Krugman contemplates the lower bound

Paul Krugman has two posts discussing the effective lower bound to interest rates. The first I agree with, albeit with a caveat, and the other I don't.

In his first post Krugman takes Evan Soltas to task for including not only storage costs in his calculation of the effective lower bound, but also the extra convenience yield provided by deposits. Krugman's point is that once people are "saturated" with liquidity, as they seem to be now, then forgoing the liquidity of a short term marketable debt instrument (like a deposit) costs them nothing. If so, then the lower bound to nominal interest rates is solely a function of storage costs.

I agree with Krugman on this count. Take the 2 1/8% Nestle bond maturing May 29, which may be one of the first corporate bonds in history to trade at negative rates:

If it costs 0.50%/year to store and handle Swiss paper currency, then the rate on a Nestle bond can't fall below -0.50%. If it trades at -0.55%, an arbitrageur will contract to borrow the bond until it matures on May 29, sell it now, and convert the proceeds into 0% yielding SFr 1000 banknotes (these notes eventually being used to repay the bond lender). Our arbitrageur will incur 0.50%/year in storage costs while getting 0.55%/year from the bond lender, earning a risk-free return of 0.05%. Competition among arbitrageurs to harvest these gains will prevent Nestle's bond yield from falling much below storage costs.

However, here's the caveat. Krugman is assuming that liquidity is a homogeneous good. It could very well be that "different goods are differently liquid," as Steve Roth once eloquently said. The idea here is that the sort of conveniences provided by central bank reserves are different from the those provided by other liquid fixed income products like deposits, notes, and Nestle bonds. If so, then investors can be saturated with the sort of liquidity services provided by reserves (as they are now), but not saturated by the particular liquidity services provided by Nestle bonds and other fixed income products.

Assuming that  Nestle bonds are differently liquid than central bank francs, say because they play a special roll as collateral , then Soltas isn't out of line. Once investors have reached the saturation point in terms of central bank deposits, the effective lower bound to the Nestle bond isn't just a function of the cost of storing Swiss paper money, but also its unique conveniences.

This changes the arbitrage calculus. Our arbitrageur will now have to pay a fee to the lender of the Nestle bonds in order to compensate them for services forgone. Let's say the cost of borrowing the bond is 0.25%/year. Shorting the bond once it hits -0.55%, paying the borrowing cost of 0.25%, and storing the proceeds at a cost of 0.50% a year results in a loss of 0.20%. With the arbitrage being unprofitable, the Nestle bond can theoretically fall further than in our previous example before it hits the effective lower bound (specifically, its lower bound is now -0.75%).

How realistic is it that different goods are differently liquid? Since everybody seems to turn to Michael Woodford as the ultimate moderator of all questions monetary, here he is in his famous Jackson Hole paper [pdf] talking about the potential for different assets to have different types of convenience yields: might suppose that Treasuries supply a convenience yield of a different sort than is provided by bank reserves, so that the fact that the liquidity premium for bank reserves has fallen to zero would not necessarily imply that there could not still be a positive safety premium for Treasuries.
Unfortunately, it's almost impossible to know for sure whether the liquidity services of a Nestle bond, or any other bond for that matter, are valued on the margin when people are already saturated in reserves. This is because there is no market for liquidity. If there was, then we could back out the specific price that investors are currently placing on a given bond's liquidity services, say by asking them to put a value on how much they need to be compensated if they are to forgo those services for a period of time. I've mentioned liquidity markets in many different posts. But I digress.

Krugman ends his first post saying that "I am pinching myself at the realization that this seemingly whimsical and arcane discussion is turning out to have real policy significance." But in his second post he backtracks, saying that a "minus x lower bound" isn't all that special in term of policy, implying that x (i.e. storage cost) is low and likely to diminish thanks to financial innovation. Here I disagree. Once a central bank has reduced rates to the point at which it is facing a run into paper storage, it can turn to a new tool to buy itself even more room to the downside for rate cuts: the manipulation of x, or the storage costs of cash.

To conclude, we've all found out by now that there isn't a zero lower bound. Instead it's a minus x lower bound. The next step is to realize that x isn't set in stone, it can itself be made into a tool of monetary policy.

Wednesday, March 4, 2015

Why so down?

If you've been reading Bill Gross's last few letters, you'll know that he's been a bit grumpy of late. It's that dang new trend that has hit bond markets, negative interest rates. Gross has been using words like incredible, surreal, and inconceivable to describe their arrival.Negative nominal bond rates certainly seem odd. Just look at the chart below, which illustrates what could very well be the two lowest-yielding bonds in the world, maybe all of history: the 3.75% Swiss government maturing in July 10, 2015 and the 4% Danish government bond maturing November 15, 2015. But is the idea of a negative rates really so strange?

Gross blames negative rates on central bankers who "continue to go too far in their misguided efforts to support future economic growth," in doing so "distorting" capitalism's rules. He's not alone; plenty of people claim that without autocratic price fixers like the SNB's Tommy Jordan and the Danmarks Nationalbank's Lars Rohde, rates would rapidly to rise to a more natural level like 1% or 2%.

Not necessarily. Even an economy without meddling central banks could be characterized by negative nominal rates from time to time, or, stealing from Tony Yates; "a negative rate doesn't distort capitalism, it IS capitalism."

Let's exorcise central bankers entirely from the economy. Imagine that we live in a world where things are priced in grams of gold. People walk around with pockets full of gold dust and a set of scales to measure the appropriate pinch necessary to pay for stuff. In this world, we all have a choice between two states: 1) we can hold gold dust in our pockets or 2) we can lend the dust to someone else for a period of time in return for an IOU. (Let's assume that the borrower is risk free.)

Each state has its own advantages and disadvantages. If we hold the gold dust in our pockets, we'll have instant access to a highly-liquid medium of exchange. Unlike illiquid media of exchange, liquid media provide us with the means to rapidly re-orient ourselves come unexpected events. With gold dust on hand we can purchase the necessities that allow us to cope with sudden problems or to take advantage of lucky breaks. At the end of the day, we may never actually use our gold to purchase things, preferring to keep it horded under our mattress. Even so, it hasn't sat their idly, but has provided us with a stream of consumption over time. The discounted stream of comfort that liquidity provides represents the total expected return on gold dust-held.

If we choose the second state and lend out our gold dust, we lose access to this liquidity and thus forfeit the expected stream of comfort that gold dust provides. Because we need to be compensated for this loss, a borrower will typically pay the lender a fee, or interest. But gold dust is burdensome. It is heavy and must be arduously weighed out and stored overnight in expensive vaults. IOUs, on the other hand, are a breeze to store. By offering to take our gold dust off our hands for a year or two, a borrower agrees to unburden us of storage expenses while providing us with a feather-light IOU in return.

So on the margin, when choosing between gold dust and an IOU, we are comparing the low storage costs of the illiquid IOU against the extra liquidity of cumbersome gold dust.

What might make rates turn negative in our central bankless gold dust world? Here are two ways:

1. Rising storage costs

Say that the costs of storing and handling gold dust grow substantially. At some much higher carrying cost, rather than requiring a fee from a borrower (i.e. positive interest) a lender will willingly pay the borrower a fee (i.e. will accept a negative interest rate) for the benefit of being temporarily unburdened of their gold dust. The loss of liquidity that the loan of gold dust imposes on the lender is entirely overwhelmed by the benefits of being freed from onerous storage costs. We get a sub-zero interest rate.

2. A narrowing liquidity gap

The second way to arrive at sub-zero interest rates is to narrow the vast gap between the respective liquidity returns on gold dust and IOUs. There are a few ways to go about this. Imagine that retailers who had previously only accepted gold dust as payment begin accepting IOUs too. Simultaneously, borrowers innovate by printing their paper IOUs in round numbers, making them far easier to count than grams of dust. All of this narrows the liquidity gap by improving the liquidity of IOUs. If the liquidity of IOUs improves so much that it exceeds the liquidity of the gold dust, an IOU effectively provides a greater stream of relief-providing services than gold. When this happens, lenders will clamour to pay a fee in order to lend their gold dust, since the superior optionality that an IOU provides is valuable to them. This fee represents a sub-zero interest rate.

Another way to narrow the vast liquidity gap between gold dust and IOUs is to create so much liquidity that, on the margin, liquidity becomes like air; it has no value. Neither gold dust nor IOUs can offer a superior liquidity return if society no longer puts any price on liquidity. In this situation, the interest rate on IOUs is purely a function of storage costs. Since an IOU will typically be less costly to store than the dust, the borrower of gold will typically receive a fee from the lender, a negative interest rate, in order to cover storage costs. Paul Krugman takes this tack here to explain negative rates.

So in the end, we can get negative nominal interest rates without central bankers. How far below zero can interest rates fall in a gold dust world? At least as low as the cost of storing gold dust and the degree to which the marginal value of an IOUs liquidity exceeds that of gold dust. Obviously we don't actually use gold dust in the real world, but the same principles apply to a cash-using economy. The theory behind negative rates isn't so surreal after all, Mr. Gross.

Some links to read:

Beyond bond bubbles: Liquidity-adjusted bond valuation by JP Koning [link]
What's the Actual Lower Bound? by Evan Soltas [link]
How Negative Can Rates Go? by Paul Krugman [link]
It turns out that the US was never at the zero bound by Scott Sumner [link]
What gold's negative lease rate teaches us about the zero-lower bound by JP Koning [link]

Thursday, February 26, 2015

Sweden and peak cash

The Swedes really don't like cash. First, consider that Sweden is the only country in the world that I'm aware of where reliance on paper money is in decline. Second, no country's central bank has produced a nominal deposit rate as negative as Sweden's, for as long. Yet even at -0.85% per year, Swedish banks who own those deposits haven't fled into 0% cash, providing some indication of the degree to which they hold banknotes in disdain.

ABBA won't accept paper

As the chart below shows, cash outstanding continues to grow in almost every country except Sweden. Japan and Denmark are the only countries that come close to pacing the Swedes, although both nations continue to show incremental growth in demand for banknotes. Even Kenya, where m-pesa has taken hold, shows strong cash demand.

Sweden reached "peak-cash" somewhere between 2007 and 2008. The reason for this change of heart is public preferences, not government diktat. The monetary authorities can only indirectly influence the demand for cash, say by introducing/removing various banknote denominations, or altering the quality of its note issue (say by making notes harder to counterfeit). By virtue of deposits being convertible into cash whenever the depositor desires (and vice versa), the allocation between cash and deposits is primarily up to the public, not the monetary authorities.

One theory is that Sweden become more law-abiding in 2008, thus reducing their demand for paper kronor. Cash is typically demanded by criminals and tax evaders to avoid creating a paper trail. That Sweden's underground element suddenly decided to go legit doesn't seem very plausible to me. Demographics is a more likely contributor to peak cash. As a nation's population growth slows, the demand for cash peters off with it. This can't be the entire explanation, however, since other countries that also suffer from poor population growth profiles (like Canada) show rising cash demand. This leaves technology as the most likely culprit. As electronic payment options improve, it makes little sense to endure the hassle of withdrawing and holding a small horde of dirty paper in one's wallet.

According to a MasterCard study, 89% of transactions in Sweden are cashless, compared to 80% in the U.S. Situation Stockholm, the street paper sold by homeless vendors in Sweden's capital, can be purchased with a card rather than cash, and while London's buses went cash-free earlier this year, bus fares disappeared several years ago in Stockholm. Unlike the U.S. and other laggards, Sweden has a near real-time person-to-person payments system called Bankgirot which has been active since 2011. Bank customers can download an app called Swish, which allows them to make immediate mobile payments over the Bankgirot network. In southern Sweden, Vicar Johan Tyrberg has installed a card reader to make it easier for worshipers to make offerings. And finally, despite having a hit song entitled Money, Money, Money, ABBA refuses refuses to accept cash at the ABBA Museum. Apparently ABBA member Bjorn Ulvaeus is leading a crusade against banknotes after his son's apartment was burgled twice.

No zero lower bound, at least not yet

As a second illustration of Swedish cash abhorrence, consider that no other central bank has maintained a negative deposit rate as low as Sweden's central bank, the Riksbank, for as long. The Riksbank reduced its deposit rate to -0.85% this month after having maintained it at -0.75% since October 2014. A few nations come close. The Swiss, for instance, reduced rates to -0.75% in January, as have the Danes—but both are behind the pace set by the Swedes.

The key point here is that with Riksbank deposits being penalized 0.85% per year, one would assume that that they'd be quickly converted into Swedish banknotes. Cash, after all, pays 0% a year, superior to -0.85%. But that hasn't happened. As the chart below shows, cash left on deposit at the Riksbank stands at around 150 million kr, roughly the same level it has been at for the last twelve months (and far above 2008-2012 levels).

Who keeps funds on deposit at the Riksbank? As the business day progresses and Swedes make payments among each other, banks who maintain settlement accounts at the Riksbank will find themselves in a surplus or deficit position. While those in surplus can elect to park their excess at the Riksbank's overnight deposit facility, they'll usually try to lend these positions to deficit banks in the interbank lending market or participate in Riksbank fine-tuning operations at the end of the day, both of which provide superior returns to the deposit rate. For whatever reason, Swedish banks typically leave a small portion of their surplus in the deposit facility, bearing the awful return on deposits for the sake of enjoying whatever conveniences the deposit facility offers.

That this 150 million kr in -0.85% yielding deposits hasn't been converted into cash is an indication of just how low Swedish opinion on cash has sunk. Consider the myriad number of costs a bank that wants to cash out its balance will have to incur. A Brinks truck must be hired in order to transport the cash to the bank's vaults. The cash must be counted, requiring a diversion of tellers' resources from other important activities. With the majority of Swedish bank branches having gone cashless, they may need to reinvest in handling infrastructure before they can take delivery of a truck full of banknotes. Next, that cash needs to be vaulted, which means displacing other valuables from being safeguarded (like a client's jewels), forcing the bank to forfeit a vaulting fee. Finally, the cash needs to be insured from theft. No wonder Swedish banks continue to use the Riksbank's deposit facility, even at a -0.85% rate; like the public, banks don't consider cash to be a convenient option.

Could Swedes one day re-embrace cash?

Swedes are proud of their move towards digital payments, but this trend could very rapidly come to an end. In an effort to hit its inflation target, the Riksbank may have to push interest rates even deeper into negative territory. At much lower levels, even the most cash-hating Swedes will have to re-consider their aversion to paper. The consequences could be significant. While only a small quantity of deposits are kept in the Riksbank's deposit facility, much larger amountsaround 30 billion kroneare invested at the Riksbank via overnight fine-tuning repos, which currently pay -0.2%. If the Riksbank reduced the fine-tuning rate much lower (say to around -1.5%), these repos would be rapidly converted into cash by banks. The public holds many hundreds of billions more worth of deposits at Swedish commercial banks. Should Riksbank rate reductions force banks to respond by ratcheting down their own deposit rates to -1 or -2%, how long before Swedes empty out their bank accounts, turning Sweden into a cash-only economy?

To avoid reverting to a cash-only economy at extreme negative rates, the Riksbank would do well to hitch itself to the cashless trend. One way to go about this without calling in all banknotes would be to reign in the number of paper products the central bank currently offers consumers, in particular high denominations of notes. Just stop allowing conversions into the 1000 krona note, and maybe the 500 krona note too, or consider canceling these large denominations outright. Not only would this reduce the central bank's printing costs, but it would provide more room for further rate cuts into negative territorywithout the threat of a mad dash into Swedish cash.

As for the rest of us...

As in Sweden, I'm pretty sure that cash demand in places like Canada and the US will eventually peak as continued advances in payments technology and a more rapid adoption of those technologies lead consumers to demand less of the stuff. Central banks might consider adapting to this trend ahead of time by reducing the number of paper products they offer to the public. Do the Swiss really need a 1000 SFr note? Do Europeans need a €500 note, and Canadians $100 notes? Alternatively, why not do what Bill Woolsey advocates? Let's gradually privatize the issuance of paper currency. If anyone can make cash relevant again, it's innovators in the private sector. And if they can't, then maybe the banknote deserves to die a slow death.

Secondly, Sweden shows that the so-called zero-lower bound isn't actually at zero, but some distance below that. Cash is awfully burdensome, as evidenced by Swedish banks who are willing to hold deposits at -0.85% despite the option to earn 0%. Central bankers at the Federal Reserve, ECB, and elsewhere would do well to heed this Swedish data point. If they need to loosen monetary policy in order to hit their targets, they can go well below -0.5% before having to fear mass conversion into cash. The world's central bankers have much more interest rate ammunition than they let on.

Tuesday, February 17, 2015

A lazy central banker's guide to escaping liquidity traps

For lazy central bankers, this post describes three lite strategies for getting interest rates below the zero lower bound. Rather than requiring drastic action, these methods can be quickly deployed without having to spend too much energyleaving plenty of time for the afternoon squash game.

1) Let's start at the beginning. What is the zero lower bound? If a central bank reduces interest rates below 0% then banks will rapidly convert all their central bank deposits into cash. No point accepting a -2% return if you can get 0%, right?

2) The zero lower bound is a problem. From time to time, a central bank may need to venture into negative territory to hit its monetary policy targets. Cash impedes the smooth descent into negative territory.

3) We already have a few go-to plays for dealing with our inability to get below zero: quantitative easing, forward guidance, and fiscal policy, each with its own set of warts. While quantitative easing has become a popular tool over the last few years, theory tells us that purchases are irrelevant at the zero lower bound. Promising to keep rates at 0% for longer than is prudent has also been used by a few central banks, notably the Bank of Canada. Unfortunately the market finds forward guidance confusing and may see little credibility in it, given the fact that the central banker who initiates the promise may not be in office to carry it out. This problem is called time inconsistency. And lastly, while fiscal policy may be a good way to evade the zero lower bound problem, it hinges on flaky political processes and arduous negotiations.

4) A more direct way to get around the zero lower bound problem may be necessary. Our lazy central banker might have to make alterations to the very nature of cash itself.

5) A sure-fire way to remove the lower bound is an outright abolition of cash. It gets around the time inconsistency problem and the flakiness of politics. But abolishing cash is a drastic step. Banknotes serves a role in protecting privacy and are popular with the unbanked. Abolish cash and you hurt both. Given the degree of preparation and effort needed to remove cash, and the political wrangling this option would require, a lazy central banker may want to take a pass.

6) Rather than removing cash, just harm it. Silvio Gesell's stamp tax, for instance, attacks cash's pecuniary return. In this spirit, Miles Kimball's crawling peg between electronic currency and paper currency burdens those who own cash with a capital loss. The crawling peg banishes the zero lower boundwithout requiring the drastic step of immediately removing all banknotes. It's an elegant solution, you can read the details here (pdf).

7) There are a few drawbacks to a crawling peg. Driving a wedge between paper and electronic currency creates two different sets of prices at the till, one for deposits and the other for cash. A chocolate bar, for instance, might have a sticker price of $1.00 in electronic money, but require a cash payment of $1.05. This will be confusing and inconvenient for shoppers, necessitating an expensive and costly education campaign by our central banker. According to Kimball, instituting a crawling peg requires that a nation enact a unit of account switch. Prices must be set in terms of electronic currency, not paper currency, otherwise the central bank will lose control over the price level. While a switch in standards is by no means impossible, it does require time and effort.

8) Which finally gets us to our lite strategies for lazy central bankers. These options don't suffer from time inconsistency or flaky politics. They get us below zero without requiring the abolition of cash, nor do we get two different sets of prices at the till, nor do we need a nation to switch to a new unit of account. In short, if enacted, they'd keep our system pretty close to the current system.

9) Laziness isn't without a cost. Unlike the abolition of cash and Miles Kimball's crawling peg, the lite methods don't free us entirely of the lower bound. They only soften it up a bit, re-situating the bound a few percentage points lower. This buys room for central banks to cut rates,  but not infinite amounts. If extremely negative rates are necessary, say -6%, then there is no lazy option: best get off the couch and go with a full-out crawling peg.

10) There are a number carrying costs on cash holdings, including storage fees, insurance, handling, and transportation costs. This means that a central bank can safely reduce interest rates a few dozen basis points below zero before flight into cash begins. The lower bound isn't a zero bound, but a -0.5% bound (or thereabouts).

11) The various lite strategies all exploit the fact that differences in carrying costs among the various note denominations mean that banknotes are not naturally fungible. Put differently, bills aren't perfect substitutes for each other. Large denomination notes, say $100 bills, incur lower storage and handling fees than small denomination notes like $10s. After all, a hundred-thousand $10 bills (worth $1,000,000) take up ten times more storage space than a ten-thousand $100s (also worth $1,000,000). However, a central bank renders the two types of notes equivalent by offering to convert pesky low denomination $10s into sleek large denomination $100s at no cost to the owner. This means that the public can avoid the nuisances of small denomination note storage, for free. So at any point in time the note-owning public is bearing the carrying cost of the highest denomination note, not the lowest ones.

12) To get a bite, the following three lazy techniques all boost the carrying cost of cash.

13) They do so by interfering with the traditional smooth switch out of small denomination notes and deposits into large denomination notes afforded by a central bank. The effect is to put an end to banknote fungibility. The public, previously sheltered from the hassles of holding pesky low denomination notes, must now bear those costs, while being barred from racing into sleek high denomination notes.

14) By implementing any one of these lite techniques, the additional carrying costs now imposed on cash remove any incentive to convert increasingly negative yielding deposits into banknotes. A central bank that had previously reduced its deposit rate to, say, -0.5% before finding itself snug against the lower bound, will now be able to reduce its deposit rate to a much lower level, say -2.5%, without fear of mass flight into cash.

15) The first method a lazy central banker should consider is the abolition of large denomination notes. A central bank issues a proclamation giving people one month to bring in all $100s for conversion into ten $10 bills. Any large denomination notes remaining in circulation after one month will be disavowed. Once all high-value denomination are demonetized, the market clearing carrying cost on cash holdings will no longer be the superior rate on $100s, but the much heftier one on $10s. The expected return on cash holdings having been diminished, a central banker who had previously found him or herself stuck against the lower bound now has room to go lower without fear of mass flight into cash.

16) Even with the $100 having been abolished, the remaining low denomination notes in circulation can continue to serve a role in protecting privacy and serving the unbanked.

17) The second method involves closing the high denomination "conversion window." Specifically, a central bank ceases converting both low denomination notes and deposits into high denomination notes. The only window the central bank will keep open is between deposits and low denomination notes. This means that anyone who converts deposits into cash can now only get pesky small notes, forcing them to bear the higher carrying costs of $10s rather than the minimal inconveniences of sleek $100s. A central bank can now cut its deposit rate much deeper into negative territory than before since depositors are far less likely to flee into bulky cash.

18) If we close the conversion window, won't those who hold negative-yielding deposits and low denomination notes simply trade them for zero-yielding high denomination notes on the secondary market? Sure, but the opportunity will be a fleeting one. The closing of the conversion window effectively freezes the quantity of high denomination notes in circulation. The price of $100s will immediately rise to a premium over bulky low denomination $10s and negative-yielding deposits. After all, $100s impose much lower carrying costs than the other two instruments. This premium removes any incentive to flee deposits and low denomination notes.

19) Won't the public suffer the inconveniences of having two different sets of prices? Not really. Rather than having an electronic currency price and a cash price (as in point 7), the closing of the high denomination conversion window will create a combined electronic/low denomination price and a high denomination price. The public, which almost never transacts in high denomination $100s anyways, can conveniently ignore the high denomination price level.

20) Nor does our lazy central banker need to worry about switching standards. Given that consumers only rarely pay with high denomination notes, it's highly unlikely that retailers currently set prices in terms of $100s. In fact, even now retailers often refuse to accept large value notes. It's likely that we probably already live in a world with a low denomination/electronic currency standard.

21) Which brings us to our third method: vary the conversion rate between low denomination notes/electronic currency and large denomination notes. Central banks currently allow free conversion between deposits, low value notes, and high value denominations. The idea here is to keep the conversion window open, but levy a fee, say three cents on the dollar, on anyone who wants to convert either deposits or low denomination notes into high denomination notes. Conversion between low value notes and deposits remains free of charge.

22) A central banker can now safely guide rates to a much more negative rate than before, say to -2.5% rather than just -0.5%. Prior to instituting a conversion charge, the public would have fled from deposits to cash at such low rates. Now, while people can still convert deposits at no cost into low denomination notes, this offers them no real advantages given the high carrying costs on such notes. And flight into high value notes is forestalled by the conversion fee.

23) As with the second lite method, the third creates two different sets of prices: one for low denomination notes/deposits and one for high denomination notes. But this doesn't matter, see point 19. Nor do we have to switch standards, see point 20.

24) The main difference between the second method and the third one is that the exchange rate between high denomination notes and low denomination notes/deposits is allowed to float in the former versus being fixed under the latter.

25) The third lite method is akin to Miles Kimball's crawling peg, except that the conversion penalty is set on high denomination notes only, not cash in general. But if we steadily widen the peg so that it includes mid-value denominations, and then add small denominations, then the third lite technique isn't so lite anymore. It has basically become Kimball's peg. At some point along that transition, we start to inherit the inconveniences of the crawling peg (see point 7). For instance, the dual price level becomes much more inconvenient, especially once $10s (and lower) are included. However, the advantage is that we can now push rates much deeper into negative territory.

26) Which means its possible to incrementally transition from a lite program to an all-out option like a crawling peg or total abolishment of cash. Lazy central bankers may prefer to stick their toes in the water before jumping all the way in.

27) By the way, I've mentioned the first lite technique here, here, here, and here. I mentioned the second lite technique here. I haven't mentioned the third before.

28) If I was a lazy central banker, of the three lite programs I'd be partial to the second one; the closing of the high denomination conversion window. Removing high denomination notes from circulation would probably have messy political implications and draw the public's wrath. Levying a fee is an assertive, some might say aggressive stance necessitating the creation of new processes and administration expenses. Simply closing the $100 window seems like it would take the least amount of effort. It doesn't require that any new infrastructure or the decommissioning of existing machinery. As for the pricing of high denomination notes, this gets outsourced to the market.

Thursday, February 12, 2015

Slow greenbacks, fast loonies

Canada trails the U.S. is a common refrain, but not when it comes to payments. Courtesy of the Interac e-transfer service, Canadians have been able to make person-to-person (P2P) payments in real-time as early as 2002. By person-to-person, think email or mobile phone payments to friends, family, or your landlord, and by real-time, the receiver of a payment can immediately turn around and use those funds to buy something. By contrast, most Americans are still stuck in the nebula of three day delays when it comes to P2P. 

Why this incredible lag? I think it's for the same reason why the U.S. banking system is so much more unstable than the Canadian banking system. Whereas Canada has a small number of strong national banks, the U.S. has a large population of weak undiversified regional. This lack of size and strength renders U.S. banks prone to failure while simultaneously making it difficult for them to coordinate together in order to create shared-use systems. 

Part of the problem in providing a real time P2P solution to consumers is that U.S. banks can't use the Federal Reserve's existing small payment network, ACH, to do the job. ACH is a forty year old system that transfers funds with delays sometimes lasting as long as 3-4 days. That being said, the Canadian equivalent small payment system, the ACSS (run by the Canadian Payments Association) isn't much better, with settlement occurring the next business day. Yet somehow we Canadians enjoy real time P2P. 

Over a decade ago, Canadian banks decided to avoid ACSS altogether and set up their own proprietary network to provide real time P2P capability. Run by Interac, a bank-governed non-profit, the network processes P2P payments, nets them out across all banks, and provides instant communications among participants. At the end of the day, the banks settle balances owing and owed by trading Bank of Canada clearing deposits via the CPA's Large Value Transfer System (LVTS). Even before the banks settle among each other, Canadians will have instant access to funds they have received either via email or their smart phone (or, if they have been debited, lose access to these funds). Heck, Royal Bank even has real-time payments via Facebook. [1]

As anyone who has read the free banking literature knows, the U.S. has an awful history of bank regulation. Until recently, law makers forbade banks from setting up national branch systems, with unit banking being the norm. (Here is George Selgin on the topic). As a result, the U.S. is characterized by a patchwork quilt of banks, 6,891 in fact, with the top five banks accounting for only 56% of all deposits. Canadian law, on the other hand, never discouraged national branch banking. As a result, Canada has five dominant banks with broad exposure to all provinces and maybe two dozen smaller banks, the "big 5" accounting for at least 80% of Canadian deposits. 

You can understand now why it would be difficult for U.S banks to set up their own real-time payments system. In Canada, only a handful of bankers needed to be convinced that the time and effort to build a mutually beneficial system was worthwhile before the remaining minority followed. A much larger expense must be incurred in herding U.S. banks towards that same equilibrium. It's sort of like fax machine adoption. A single fax machine is useless, but the value of every fax machine increases as the installed base of fax machines grows, since the total number of people with whom each user can send/receive faxes rises. Ideally, everyone just agrees ahead of time to get a fax, or in the case of P2P, all bank decide to jointly build a shared network. Tough to do when you're a thousand squabbling voices. Enlightened cooperation among a few large banks, the Canadian solution, gets you there quicker.

The result is that in the U.S. most of the P2P solutions haven't been developed by banks, but by technology companies. Finance tech giants Fiserv and Fidelity National Information Services have developed their own networks; Popmoney and People Pay. Upstart Dwolla is trying to convince financial institutions to adopt its FiSync real-time service. This plethora of competing networks reminds me of what I've read about the early days of electrical utilities in the U.S., with multiple competing wire systems running down the streets. To avoid this sort of redundancy, some might say that the best option is to have a regulated monopoly like the Fed take the baton, say by upgrading ACH to real time. And with so many different competing systems, I can't help but wonder how they 'talk' to each other. If there were three or four brands of fax machines, and each brand could only receive its own faxes, how much less useful is the fax network?

So we Canadians have ubiquitous real time P2P and the Americans don't. However, the dark side to the Canadian system is that cooperation among the few needn't always be so enlightened. Just as the chiefs of the big 5 banks can get together in a back room and cobble together a mutually beneficial shared network, it's just as easy for them to set up a mutually beneficial pricing schemeat the expense of consumers. It costs $1.50 to do an Interac e-transfer. Sounds suspiciously high to me. 

[1] My source for information on the Interac e-payments system is the CD Howe's Mati Dubrovinsky, who briefly describes how the system works here.  

Sunday, February 1, 2015

The zero problem

The price of bitcoin is a capricious thing. Imagine that you've saved enough bitcoin to take your significant other out to a fancy restaurant. When the bill comes you discover to your horror that the price of bitcoin has crashed sometime between main course and desert. For the next few hours you're both stuck doing the restaurant's dishes. Far less embarrassing to choose dollars as your payment media at the outset given the unlikelihood of a dollar crash. This has always been one of bitcoin's main problems. The burden that a consumer must endure in absorbing bitcoin's incredible volatility until the time of payment outweighs any reduction in transaction fees that they might enjoy.

Or maybe not. Marc Andreessen recently posted a number of thoughts on twitter. The most interesting ones are #9 to 17, namely that bitcoin's fabled volatility needn't deter regular folks from using it as a cheap and fast payments mechanism.

In effect, it's possible to enjoy all of bitcoin's benefits without having to hold an inventory of the schizophrenic stuff. Consider that when merchants currently receive bitcoin in exchange for their product, their payments processor (say Bitpay or Coinbase) will instantaneously convert those coins into US dollars, thus sparing the merchant the risk of holding volatile bitcoin. As for shoppers, a service that allows them to purchase bitcoin in the instant prior to paying for a good would preclude them from having to bear the risk of a bitcoin crash. (1)

It's the "never-hold" approach to bitcoin. As long as just-in-time bitcoin purchases and sales are possible, shoppers and merchants can avoid bitcoin's worst feature, its volatility, while enjoying all of its best features, low fees and speed. These just-in-time services aren't free. Bitpay and Coinbase extract a fee for providing merchants with protection from bitcoin hyper-volatility, and a provider of shopper volatility protection would also expect to be compensated. Now I'm not sure how large these two fees would come out to. However, as long as the total cost is less than the fees levied by competing mechanisms like credit card networks, then bitcoin provides a net benefit to society. (2)

Touché, Andreessen. En Garde!

I've been talking about the potential for bitcoin to be displaced by stable-value cryptocoins as media of exchange for a while now. But if Andreessen is right (and I'm inclined to think he is) then who really cares if bitcoin suffers from +/-50% daily price changes? Whether it's worth $100 or $100,000, either way it serves regular folks as a superior last-second value transfer mechanism (subject to the above cost condition). We may not need stable-value cryptocoins after all.

But Andreessen is missing one of the larger points of the volatility criticism, which I'll call the zero value problem. Granted, we needn't care whether bitcoin is worth $100 or $100,000, but we do care if it is worth $0. While no categorical difference exists between any two given positive bitcoin prices, a categorical difference *does* exist between a positive price and a price of zero. Bitcoin works smoothly at any positive price, but it breaks down as value-transfer mechanism when it's worth nothing.

A key pillar of the volatility critique is that bitcoin's price earthquakes arise because the only players in the market are speculators. A more fancy way to say this is that bitcoin has no non-monetary demand. By non-monetary demand, I'm referring to that portion of an asset's total demand that would remain if prospective owners were notified that they could never sell that asset after purchasing it. Given this imposition, I sincerely doubt anyone would be willing to buy bitcoin. By and large, people only want the stuff because it can be got rid of in the future.

By way of comparison, gold has both monetary and non-monetary demand. There are consumers who will purchase the yellow metal knowing that they can never sell it again, say as jewelry or ornamentation. Same with an IOU like a stock or banknote. Because an IOU offers dividends (or a promise of cancellation at an attractive price), investors will be content to hold that IOU knowing that they can never resell it. This is the Warren Buffett approach to holding an asset, whereby one's favorite holding period is forever.

With the only folks holding bitcoin being future sellers, i.e. speculators, enter the zero value problem. An object whose value is purely speculative has no equilibrium price. In economics-speak, its price level is indeterminate. A $10,000 price is as good as a $10 price, or a $0 price. And that last price will inevitably arrivemaybe in 2015, maybe in 2020, maybe not till 2025when for some reason or other speculators all begin to get antsy at the same time. It could be something as innocuous as the belief that everyone else is about to sell (because they expect everyone else to sell, because they expect everyone to sell, etc). When a reflexive process like this begins, the only way for the bitcoin market to accommodate everyone's desire for an exit is for the price of bitcoin to hit zero.

For illustrative purposes, gold isn't subject to the zero value problem because if a speculative panic begins, consumption demand kicks in to anchor gold's price at some lower level. The same goes for central bank money.

At $1, bitcoin still works. But at zero, bitcoin breaks down as a payment mechanism. Since bitcoin no longer has a positive purchasing power, regular shoppers can no longer make just-in-time bitcoin purchases in order to consummate a transaction. Merchants will quickly pull bitcoin price quotes from their websites, unwilling to trade something (their wares) for nothing (bitcoin). Since the financial reward to mining will have disappeared, the process for verifying the blockchain may become tenuous. All the hard work put into building a payments mechanism will be gone in a few moments of speculative fervour. And what happens to all of the other "use cases" that Andreessen describes, like bitcoin apps and sidechains, when bitcoin hits zero?

Even if bitcoin hits $0 for an hour or two, won't the inevitable dead cat bounce fix the problem? Not necessarily. The best theory for how bitcoin rose above zero back in 2009 is the 'bootstrapping theory.' A small clique of insiders conspired to trade what was then an intrinsically-useless token among each other, generating a long enough history of positive prices so that bitcoin began to be accepted by naive outsiders at a non-zero price. From nothing, otherwise worthless tokens had pulled themselves up by their own bootstraps. Andreessen admit as much in his eleventh tweet.

The point I'm trying to make here is that if bitcoin were to fall to zero, a dead cat bounce isn't the natural next step. Rather, as in 2009, an outlay of time and resources would be required to fabricate a positive price. In essence, bitcoin would need to be re-boostrapped. But how to go about this process? Who would be willing to join the front line and risk their capital trying to trick the market into valuing bitcoin at a positive price again? Surely not all the former bitcoin millionaires. Keep in mind that it might take multiple efforts to jump start the system. And with bitcoin being so much more widely known than before, the re-bootstrapping process might take significantly more resources than it did in 2009. Finally, even if the system is successfully kickstarted after a few days, what about the damage that is incurred in the interim thanks to a period of inactivity? Could it do irreparable damage to bitcoin's reputation as a payments mechanism, in the same way that Visa would suffer if it went down for a few days?

How to overcome the zero problem

Luckily, there's a pretty easy fix to the zero problem. Set bitcoin's minimum price at US$1 so that it never has to go through a re-bootstrapping process.

To set a minimum price, bitcoin believers like Andreessen should consider donating US$21 million to a bitcoin stabilization fund. The fund will have a standing bid to purchase all bitcoin at $1. Since there will never be more than 21 million bitcoin in existence, the fund will have the financial resources to credibly support this price. In an extreme scenario in which all speculators run to the exits, the stabilization fund will be left holding 21 million bitcoin and no dollars. The good thing is that no harm will be done to bitcoin as a just-in-time value transfer system. The fund will make a market in bitcoin at $1, providing shoppers with an avenue to acquire the requisite bitcoin from the fund (say at $1.01) just prior to consummating a purchase, and providing merchants with a right to sell bitcoin at $1 in the moment after a sale.

The core idea here is that if speculators are for the moment unwilling to set a positive value for bitcoin, then someone else needs to. At some point after hitting the fund's $1 floor, speculators will likely gain enough confidence to once again take up the baton and drive bitcoin's price above $1. The roller coaster ride begins anew. If so, the stabilization fund's job is done, for the time being at least. It can start selling its hoard of bitcoin into the rally, replenishing its dollar reserves so that it can once again enforce the $1 floor should that necessity arise.

Think of the provisioning of a bitcoin stability fund as a public service. If bitcoin's promise is as enormous as folks like Andreessen believe, then the fund's $21 million price tag is a small cost to ensure that said promise isn't destroyed in a zero-value bitcoin scenario.

(1) I was going to point out that I don't think anyone is offering this service, but now I see that one is: Cryptosigma.
(2) If the combined cost of merchant protection and shopper protection +  bitcoin transfer fees are higher than the costs that banks and the card networks earn on transactions, then bitcoin may not be the panacea that everyone makes it out to be.