Sunday, October 19, 2014


Recent posts by Adrian Hope Baille and Sina Motamedi have got me thinking again about the idea of the Federal Reserve (or any other central bank for that matter) adopting bitcoin technology. Here's an older post of mine on the idea, although this post will take a different tack.

The bitcoin ethos enshrines the idea of a world free from the totalitarian control of central banks. So in exploring the idea of Fed-run bitcoin-style ledger, I realize that I run the risk of being cast as Darth Vader (or even *yikes* the Emperor) by bitcoin true believers. So be it. While I do empathize with the bitcoin ideal—I support freedom in banking—I rank the importance of bitcoin-as-product above bitcoin-as-philosophy. And at the moment, bitcoin is not a great product. While bitcoin has many useful features, these are all overshadowed by the fact that its price is too damn volatile for it to be be taken seriously as an exchange medium. This volatility arises because bitcoin lacks a fundamental value, or anchor, a point that I've written about many times in the past. However, there is one way to fix the crypto volatility problem...

Enter Fedcoin

Setting up the apparatus would be very simple. The Fed would create a new blockchain called Fedcoin. Or it might create a Ripple style ledger by the same name. It doesn't matter which. There would be an important difference between Fedcoin and more traditional cryptoledgers. One user—the Fed—would get special authority to create and destroy ledger entries, or Fedcoin. (Sina Motamedi gives a more technical explanation for how this would work in the case of a blockchain-style ledger)

The Fed would use its special powers of creation and destruction to provide two-way physical convertibility between both of its existing liability types—paper money and electronic reserves—and Fedcoin at a rate of 1:1. The outcome of this rule would be that Fedcoin could only be created at the same time that an equivalent reserve or paper note was destroyed and, vice versa, Fedcoin could only be destroyed upon the creation of a new paper note or reserve entry.

So unlike bitcoin, the price of Fedcoin would be anchored. Should Fedcoin trade at a discount to dollar notes and reserves, people would convert Fedcoin into these alternatives until the arbitrage opportunity disappears, and vice versa if Fedcoin should trade at a premium.

As for the supply of Fedcoin, it would effectively be left free to vary endogenously, much like how the Fed currently let's the market determine the supply of Fed paper money. This flexibility stands in contrast to the fixed supply of bitcoin and other cryptocoins. The mechanism would work something like this. Should the public demand Fedcoin, they would have to bring paper dollars to the Fed to be converted into an equivalent number of new Fedcoin ledger entries, the notes officially removed from circulation and shredded. As for banks, if they wanted to accumulate an inventory of Fedcoin, they would exchange reserves for Fedcoin at a rate of 1:1, those reserves being deleted from Fed computers and the coins added to the Fedcoin ledger.

Symmetrically, unwanted Fedcoin would reflux to the central bank in return for either newly-created cash (in the case of the public) or reserves (in the case of banks), upon which the Fed would erase those coins from the ledger. The upshot is that the Fed would have no control over the quantity of Fedcoin—it would only passively create new coin according to the demands of the public.

Apart from that, Fedcoin would be similar in nature to most other cryptoledgers. All Fedcoin transactions would be announced to a distributed network of listening nodes for processing and verification. In other words, these nodes, and not the Fed, would be responsible for maintaining the integrity of the Fedcoin ledger.

Why implement Fedcoin?

The main reasons that the Fed would implement Fedcoin would be to provide the public with an innovative and cheap payments option, and to provide the taxpayer with tax savings.

The public would enjoy all the benefits of bitcoin including fast transaction speeds, cheap transaction costs, and the ability to transact almost anywhere and with almost anyone as long as all parties to a transaction had a smartphone and the right software. At the same time Fedcoin's stability would immediately differentiate it from bitcoin. No longer would users have to fear losing 50% of their purchasing power prior to making a transaction.

Fedcoin's distributed architecture would be both complementary and in many ways superior to Fedwire, a centralized system which currently provides for the transferal of Fed electronic reserves among banks. I won't bother getting into the specifics: see this old post.

By introducing Fedcoin, the Fed would also lower its costs. While I haven't done the calculations, I have little doubt that running a distributed cryptoledger is far cheaper than maintaining billions of paper notes in circulation. Paper currency involves all sorts of outlays including designing and printing notes, collecting, processing and storing them, as well as constantly defending the note issue against counterfeiters. A distributed ledger does all this at a fraction of the cost. As Fedcoin begins to displace cash, and I think that this would steadily happen over time due to its superiority over paper, the Fed's costs would fall and its profits rise to the benefit of the taxpayer.

Fedcoin would have no impact on monetary policy

Fed officials might balk at giving the idea a shot if they feared that adopting a Fed cryptoledger would impede the smooth functioning of Fed monetary policy. They needn't worry.

The Fed currently exercises control over the price level by varying the quantity of reserves and/or the interest paid on reserves. The existence of cash doesn't get in the way of this process, nor has it ever gotten in the way. Bringing in a third liability type, Fedcoin, the quantity of which is designed to fluctuate in the same way as cash, would likewise have no impact on monetary policy. The Fed would continue to lever the return on reserves in order to get a bite on prices while allowing the market to independently choose the quantity of Fedcoin and cash it wished to hold.

Well, almost none: Interest on Fedcoin and the zero lower bound

Ok, I sort of lied in the last paragraph. While it happens only rarely, there are times when cash does get in the way of monetary policy, and so would Fedcoin if it were implemented. If the Fed needs to reduce rates on reserves to negative levels in order to hit its price and employment targets, the existence of cash impedes the smooth slide below zero. With reserves yielding -2% and paper notes yielding 0%, reserves would quickly be converted en masse into cash until only the latter remains. At that point the Fed would have lost its ability to alter rates—cash doesn't pay interest nor can it be penalized—and would no longer be capable of exercising monetary policy. This is called the zero-lower bound, and it terrifies central bankers.

Fedcoin has the potential to alleviate the zero lower bound problem. Here's how.

As Fedcoin adoption grows among the public, cash would steadily be withdrawn. And while it might not shrink to nothing—the public might still choose to use some cash—at least the Fed would have a good case for entirely canceling larger denominations like the $100 and $50.

Consider also that it would be possible for interest to be paid on each Fedcoin  (unlike bitcoin and cash), the rate to be determined by the Fed. And just as Fedcoin could earn positive interest, the Fed could also impose a negative rate penalty on Fedcoin. This would effectively solve the Fed's zero lower bound problem. After all, if the Fed wished to reduce the rate on reserves to -2 or -3% in order to deal with a crisis, and reserve owners began to bolt into Fedcoin so as to avoid the penalty, the Fed would be able to forestall this run by simultaneously reducing the interest rate on Fedcoin to -2 or -3%. Nor could reserve owners race into cash, with only low denomination and expensive-to-store $5s and $10s available.

So by implementing something like Fedcoin, the Fed could safely implement a negative interest rate monetary policy.

(Lastly, monetary policy nerds will notice that the displacement of non-interest yielding cash with interest-yielding Fedcoin is a tidy way to arrive at Milton Friedman's optimum quantity of money, or the Friedman rule.)

The big losers: banks

Fedcoin has the potential to tear down the private banking system. Interest yielding Fedcoin would be able to do everything a bank deposit could do and more, and all this at a fraction of the cost. As the public shifted out of private bank deposits and into Fedcoin, banks would have to sell off their loan portfolios, the entire banking industry shrinking into irrelevance.

One way to prevent this from happening would be for the Fed to make an explicit announcement that any bank could be free to create its own competing copy of Fedcoin, say WellsFargoCoin. Like the Fed, Wells Fargo would promise to offer two-way convertibility between its deposits/cash/Fedcoin and WellsFargoCoin at a rate of 1:1 to ensure that the price of its new ledger entries were well-anchored. The bank could then implement features to compete with Fedcoin such as higher interest rates or complimentary financial services. Even as Wells Fargo's deposit base steadily shrunk due to technological obsolescence, its base of WellsFargoCoin liabilities would rise in a compensatory manner.

The resulting lattice network of competing private bank crypto ledgers built on top of the Fedcoin ledger would work in a similar fashion to the current banking system. Wells Fargo would make loans in WellsFargoCoin and take deposits of FedCoin as well as competing bankcoins, say CitiCoin or BankofAmericaCoin. Intra-bank cryptocoin payments would be cleared on the books of the Federal Reserve with reserves transfers over the Fedwire funds system, although Fedcoin might eventually take the place of Fedwire. A change in the value of Fedcoin or reserves due to a shift in monetary policy would be transmitted immediately into a change in the value of all private bankcoins by virtue of  the convertibility of the latter into the former.

Nor would it be necessary to start with Fedcoin and then introduce bankcoins. Why not begin with the latter and skip Fedcoin altogether? Why aren't private banks at this very moment switching out deposits and replacing them with cryptoledgers?

KYC: Know your customer

'Know your customer' regulations would make implementation difficult, but not impossible.

With bitcoin, the location of a coin (its address) is public but the identity of the owner is not. However, laws require banks to gather information on their customers to protect against money laundering. As these laws are unlikely to change with the advent of new technology, banks would probably require anyone wanting to use bank cryptoledgers to have an account with a regulated bank. This would not be too onerous given that most Americans already have bank accounts.  However, it compromises anonymity, one of the key ideals of bitcoin, since each coin would be traceable by the authorities to a real person.

Perhaps there is still a way to preserve some degree of anonymity. Historically the Fed has always been spared from KYC rules since it has never had to document who uses cash. By grandfathering KYC exemption to Fedcoin, any user who wanted to preserve their anonymity could use Fedcoin rather than any of the multiple bankcoin ledgers, just like today they prefer to use anonymous Fed cash rather than bank accounts to transact.

In summary

So that's a rough sketch of Fedcoin—a decentralized, flexible, and well-backed payments system that grants one user, the Fed, a set of special privileges and responsibilities. Feel free to modify the idea in the comments section.

And just so we are keeping tabs, these are the institutions that Fedcoin could eventually make obsolete: bank deposits, banks (unless the latter are allowed to innovate their own bankcoins), the credit card networks Visa and Mastercard, bank notes, Fedwire, and even bitcoin itself, which would be unable to compete with a stable-value copy of itself.

Bitcoin true believers may not like this post, but perhaps they can take something constructive from it. Fedcoin is one of the potential competitors in the distant horizon. Now is the time for the rebels to figure out how to create a stable-price version of bitcoin, before Darth Vader does it himself. Otherwise they may someday find themselves closing down their bitcoin startups in order to write code for the Empire.

Note: My apologies to readers for my having succumbed to the constant temptation to adorn all blog posts with Star Wars references.

Sunday, October 12, 2014

The market monetarist smell test

I gave myself a quick whiff this week to determine if I pass the market monetarist smell test. This is by no means definitive, nor is this an officially administered MM® test.

To be clear, my preferred policy end point is market choice in centralized banking. In other words, you, me, and my grandma should be able to start up a central bank. But that's a post for another day. First-best option aside, here's my reading of a few market monetarist ideas.

Target the forecast

**** 5 stars

Big fan. Targeting the forecast would take away the ad hoccery and mystique that surrounds central banks. We want central bankers to be passive managers of yawn-inducing utilities, not all-stars who make front covers of magazines.

First, have the central bank set a clear target x. This is the number that the central bank is mandated to hit in the course of manipulating its various levers, buttons, and pulleys. Modern central banks sorta set targets—they reserve the right to be flexible. Bu this isn't good enough. To target the forecast, you need a really clear signal, not something vague.

Next, have the central bank create a market that bets on x. Either that, or have it ride coattails on a market that already trades in x. If the market's forecast for x deviates from the central bank's target, the central bank needs to pull whatever levers and pulleys are necessary to drive the market forecast back to target.

The advantage of targeting the market forecast is that the tasks of information processing and decision making are outsourced to those better suited for the task: market participants. Gone would be whatever department at the central bank whose task is to fret over incoming data to determine if the bank is on an appropriate trajectory to hit x. Gone too would be the functionaries whose job it is to carefully wordsmith policy statements. The job of Fed-watching—the agonizing process of divining the truth of those policy statements—would disappear, just like lift operators and bowling alley pinsetters have all gone on to greener pastures. Things would be much simpler. If the market bets that the central bank is doing too little, its forecast will undershoot the target and the central bank will have to loosen. Vice versa if the market thinks the central bank is doing too much.

Targeting the forecast is the "market" in market monetarism. It's elegant, workable, and efficient—let's do it.

NGDP targeting

*** 3 stars

Meh, why not?

If we're going to target the forecast, we need a number for the market to bet on. Using the same target that central banks currently use is tricky. Most central banks are dirty inflation targeters. They try to keep the rate of change in consumer prices on target, but reserve the right to be flexible. Central banks have been willing to tolerate a little more inflation than their official target, especially if in doing so they believe that they can add some juice to a slowing in the real economy. Alternatively, they may choose to undershoot their inflation target for a while if they want to put a break on excessively strong output growth.

An NGDP target may be a good enough approximation of a flexible inflation target. NGDP is real GDP multiplied by the price level. If a target of, say, 4% NGDP growth is chosen, and the real economy is growing at 3%, then the central bank will only need to create 1% inflation. But if output is stagnating at 0.5%, then it will create 3.5% inflation.

So NGDP targeting affords the same sort of flexible tradeoff between the price level and real output that dirty inflation targeting affords, while serving as a precise number for markets to bet on.

The quantity of base money

* 1 star

Market monetarists have a fixation on the quantity of base money. This is where the monetarism in market monetarism comes from. Specifically, market monetarists seem to think that a central bank's policy instrument is, or should be, the quantity of base money. The policy instrument is the lever that the Carneys and Draghis and Yellens of the world manipulate to get the market to adjust the economy's price level.

But modern central banks almost all pay interest on central bank deposits. The quantity of money has effectively ceased to be a key policy instrument. (The Fed was late, making the switch in 2008). Shifting the interest rate channel (the gap between the interest rate that the central bank pays on deposits versus the rate that it extracts on loans) either higher or lower has become the main way to get prices to adjust.

This doesn't mean that the base isn't important. Rather, the return on the base is the central bank's policy instrument—it always has been. This is a big umbrella way of thinking about the policy instrument, since the return incorporates both the interest rate paid on deposits and the quantity of money as subcomponents. Reducing the return creates inflation, increasing it creates deflation.

Market monetarists seem to think that the interest rate channel ceases to be a good lever once interest rates are at 0%. But this isn't the case. It's very easy for central banks to reduce the return on deposits by imposing deposit rates to -0.5% or -1.0%. Going lower, say to -3%, poses some problems since everyone will try to immediately convert negative yielding central bank deposits into 0% cash. But if a central bank imposes a deposit fee on cash, a plan Miles Kimball describes more explicitly here, or withdraws high face value notes so that only ungainly low value notes remains, which I discuss here, there's no reason it can't drop rates much further than that.

If anything, it's the contribution of quantities to the base's total return that eventually goes mute. In manipulating the quantity of central bank deposits, central banks force investors to adjust the marginal value of the non-pecuniary component of the next deposit. Think of this non-pecuniary component as package of liquidity benefits that imbue a deposit with a narrow premium in and above its fundamental value. Increasing the quantity of central bank deposits results in a shrinking of this premium, thereby pushing their value lower and prices higher, while decreasing the quantity of deposits achieves the opposite. At the extreme, the quantity of deposits can be increased to the point at which the marginal liquidity value hits zero and the premium disappears, at which point further issuance of central bank deposits has no effect on prices. Deposits have hit rock bottom fundamental value.

So in sum: yes to targeting the forecast, and I suppose that an NGDP target seems like a good enough way to achieve the latter, and to hit it let's just keep using rates, not quantities. Does this make me a market monetarist?

Of course there's more to market monetarism than that, not all of which I claim to understand, but this post is already too long. Nor am I wedded to my views—feel free to convince me that I'm deranged in the comments.

Incidentally, if you haven't heard, Scott Sumner is trying to launch an NGDP prediction market.

Saturday, October 4, 2014

Stock as a medium of exchange

American Depository Receipt (ADR) for Sony Corp

You've heard the story before. It goes something like this. There's one unique good in this world that serves as a universal vehicle by which we conduct every one of our economic transactions. We call this good "money". Quarrels often start over what items get lumped together as money, but paper currency and deposits usually make the grade. If we want to convert the things that we've produced into desirable consumption goods (or long-term savings vehicles like stocks), we need to pass through this intervening "money" medium to get there.

This of course is fiction—there never has been an item that served as a universal medium of exchange. Rather, all valuable things serve to some degree or other as a medium of exchange; or, put differently, everything is money. What follows are several examples illustrating this idea. Rather than using currency/deposits as the intervening medium to get to their desired final resting point, the people in these examples are using a non-standard intervening media—specifically, listed equities—in order to move from an undesired currency to a preferred currency.

Zimbabwe and Old Mutual

In the midst of the Zimbabwe hyperinflation I began to toy with the idea of purchasing Zimbabwean stocks. The market value of the entire Zimbabwe Stock Exchange had collapsed to a fraction of its Zambian and Botswanan peers, and picking up a few bellwether names might provide some value, went my thinking. The difficult part was buying the Zimbabwean dollars necessary to build my position. Selling my Bank of Montreal deposits (I live in Canada) for deposits at a bank in Zimbabwe, say Barclay's Bank Zimbabwe, would not only take a long time to complete, but I'd end up having to pay the official rate for Zimbabwe dollars, which was far below the market rate. The losses on this forex conversion would destroy any opportunity for a profit on the shares.

There was an alternative route. I could sell my Royal Bank deposits for shares in a firm called Old Mutual, listed on the London Stock Exchange. The kicker is that Old Mutual had (and continues to have) a listing on the Zimbabwe Stock Exchange. Using a stockbroker in Zimbabwe I could have transferred my London-listed shares to the Zimbabwe Stock Exchange, sold the shares, leaving Zimbabwe dollars in my brokerage account. Since the ratio of Old Mutual in London and Zimbabwe was free to fluctuate (unlike the official exchange rate), I'd effectively be purchasing Zimbabwe dollars at the correct market rate, not the overvalued official rate.

Next I could have used my Zim dollars to buy the Zimbabwe-listed stocks that I wanted. When the time came to get out, I could have sold my shares for Zimbabwe dollars, repurchased Zimbabwe-listed Old Mutual shares, had my broker 'uplift' those shares over to the London stock exchange upon which I would once again sell Old Mutual for British pounds, eventually ending up with my Bank of Montreal deposits.

What an incredible chain of transactions! Which explains in part why I chickened out. Nevertheless, the example illustrates the necessity of having an appropriate and non-standard "medium of exchange", in this case Old Mutual, in order to shift from one brand of "money" deposits to another to another.

ADRs and the Argentinean Corralito

A similar example played out during the Argentinean corralito of late 2001 and early 2002. In early December 2001, in an effort to prevent massive capital outflows, Argentinean authorities established financial controls which, among other restrictions, imposed a ceiling of $1,000 a month on bank withdrawals. This became known as the corralito, the diminutive of corral, or animal pen. With a devaluation imminent, and even worse, pesofication—the forced conversion of bank deposits from USD into pesos—Argentineans could only sit helplessly as their frozen deposits awaited their doom.

Argentineans quickly found a way to evade the corralito. While they could only withdraw limited amounts of dollars from their bank accounts, they were allowed to buy any amount of stocks listed on the Buenos Aires stock exchange. Since stocks would be protected from the ensuing devaluation and pesofication, a mad rush into the markets ensued along with a terrific rise in share prices.

Snipped from Auguste et al, 2005.

What is interesting is that certain Buenos Aires-listed stocks were adopted as a convenient medium for escaping Argentina altogether. Here's how. An asset class called the American Depository Receipt, or ADR, trades on the New York Stock Exchange. ADRs are market-listed securities that represent an underlying batch of non-US shares. The way an ADR works is that a U.S. custodian bank will issue an ADR to an investor after the underlying shares having been deposited in a foreign depository bank where they will be held for safekeeping. An owner of ADRs enjoys all the economic rights (dividends, votes, capital appreciation) as the underlying shares held in deposit.

A number of Argentinean names traded on ADR form in New York, including a Banco Frances ADR and a Telecom Argentina ADR. During the corralito, an Argentinean could buy an Argentinean stock that traded on the Buenos Aires Stock Exchange, say Telecom Argentina, and immediately deposit these shares with a local depository. The shares having been deposited, a U.S. custodian bank would create an overlying ADR for the Argentinean investor. Since these ADRs were traded in New York, the Argentinean could turn around and sell the ADR for U.S. dollar deposits. Telecom Argentina shares and its linked ADR had become a medium of exchange of sorts, allowing Argentinean investors to convert from one brand of money, pesos, into another, US dollars.

Canada: Norbert's Gambit

Nor is the use of equity as a medium of exchange solely a phenomenon of crisis economies like Zimbabwe and Argentina. Enter Norbert's gambit. The name comes from Norbert Schlenker, an investment advisor in B.C. who popularized the technique. Canadian discount brokerages charge around 1.5% on forex conversions, which is a lot. Norbert's Gambit is a cheaper way to convert Canadian dollars to U.S. dollars and back.

The gambit works this way. Horizons US Dollar Currency ETF, which holds very short term US debt, trades on the Toronto Stock Exchange in US dollars under the ticker DLR.U as well as the ticker DLR, which is quoted in Canadian dollars. Investors can spend Canadian dollars in their brokerage account to buy DLR, convert those units to DLR.U, and then sell those DLR.U units for US dollar deposits. Voila, they've used an ETF as a medium to move from one "money" to another.

Interlisted stocks like Royal Bank or Potash Corp, which trade on both the Toronto and New York markets, can also be mobilized for Norbert's Gambit.


Norbert's Gambit, the Old Mutual switch, and the Argentinean ADR evasion are only a few examples of things that we normally don't consider to be "money" being mobilized as media of exchange. But these three are just the tip of the iceberg. Consider the fact that everyone who acts as a dealer in goods or securities is using these items as an exchange medium. Just as someone builds up a stock of cash for eventual future exchange, a t-shirt dealer purchases an inventory of t-shirts for future sale.

It's not just t-shirts. Every dealer from the gas utility to the car lot owner to a market maker in a small cap stocks uses the particular good in which they specialize—natural gas, cars, and penny stocks—as their medium of exchange. Some media are more general than others and will tend to appear in a larger proportion of transactions, but this doesn't make them qualitatively different from those that are less general. Put differently, there is no such thing as a valuable good that does not function as a medium of exchange: rather, there are only good media of exchange or bad ones.


There is a body of academic work on the Argentinean corralito, stock prices, and ADRs

1. Melvin, 2002., A Stock Market Boom During a Financial Crisis: ADRs and Capital Outflows in Argentina
2. Yeyati, Schmukler, & Van Horen, 2003. The price of inconvertible deposits, the stock market boom during the Argentine crisis.
3. Auguste et al, 2005. Cross-Border Trading as a Mechanism for Implicit Capital Flight: ADRs and the Argentine Crisis.
4. Brechner, 2005. Capital Restrictions as an Explanation of Stock Price Distortions During Argentine Financial Collapse: December 2001 – March 2002.
5. Lam, 2011. New Evidence on the Wealth Transfer during the Argentine Crisis.

No work has been done on Old Mutual and the Zimbabwean hyperinflation.

Sunday, September 28, 2014

The law of reflux

One of the coining press rooms in the Tower of London, c.1809 [link]

[This is a guest post by Mike Sproul.]

The law of reflux thus assures the impossibility of inflation produced by overexpansion of bank credit. (Blaug, 1978, p. 202.).

It is the reflux that is the great regulating principle of the internal currency; and it was by the preservation of the reflux, throughout all the perils and temptations of the period of the restriction, that the monetary system of these kingdoms was saved from the utter wreck and degradation which overwhelmed every paper-issuing state on the Continent… (Fullarton, 1845, p. 68.)

If you want to understand the law of reflux (and you should), then think of silver spoons. The silversmith shown in figure 1 can stamp 1 oz. of silver into a spoon. If the world needs more spoons, then silversmiths will find it profitable to stamp silver into spoons. If the world has too many spoons, then people will find it profitable to melt silver spoons. Unwanted spoons will “reflux” back to bullion. In this way, the law of reflux assures that the world always has the right amount of silver spoons. We could hardly ask for a simpler illustration of the Invisible Hand at work. But it costs something to stamp silver and to melt it, so the price of spoons will range within a certain band. It might happen, for example, that silversmiths only find it profitable to produce spoons once their price rises above 1.03 oz., while people only find it profitable to melt spoons once their price falls below 0.98 oz. If the costs of minting and melting were zero, then a spoon would always be worth 1 oz.

This is a point worth emphasizing: The value of a spoon is equal to its silver content. An increase in the demand for spoons would not raise the price of spoons much above 1 oz, since new spoons would be produced as soon as the price rose above 1 oz. A drop in the demand for spoons would not push the price much below 1 oz, since spoons would be melted when the price fell below 1 oz. Likewise, if the quantity of spoons supplied became too large or too small, market forces would restore the quantity of spoons to the right level, while keeping the price at or near 1 oz.

In figure 2, the silversmith starts being called a mint, and instead of stamping silver into spoons, the mint stamps silver into 1 oz. coins. The law of reflux works the same for coins as for spoons, always assuring that the world has the right amount of coins, and that the value of each coin always stays at 1 oz., or at least within a narrow band around 1 oz.

The usual thought experiments of monetary theory don't work in this situation. For example, economists often imagine that if the money supply were to increase by 10%, then the value of money would fall by about 10%. But the law of reflux won't allow this to happen. Mints would only issue 10% more coins if the public wanted coins badly enough to part with an equal amount of their silver bullion. And even if mints went against their nature and issued more coins than the public wanted, those coins would be melted or stored, and the value of a coin would not deviate very far from its silver content of 1 oz.

In figure 3, the mint re-invents itself again, this time as a bank. Rather than stamping customers' silver into coins, the bank stores the silver in a vault, and issues a paper receipt called a bank note. (Checkable deposits would also work.) This system has several advantages over coins. (1) It saves the cost of minting and melting. (2) It avoids wear of the coins. (3) Bank notes are harder to counterfeit, easier to carry, and easier to recognize than coins.

The law of reflux still works the same for bank notes as it did for coins. If the economy is booming and people need more bank notes, then people will deposit silver into their banks and the banks will issue new bank notes. If the economy slows and people need fewer bank notes, then people will return their unwanted notes to the banks and withdraw their silver.

Once again the thought experiment of imagining a 10% increase in the quantity of bank notes is pointless. Banks would only issue 10% more notes if the public wanted those notes badly enough to bring in 10% more silver. And even if we imagine that the banks took the initiative, printing 10% more notes and using those notes to buy 10% more silver, every bank note is still backed by 1 oz. and redeemable into 1 oz of silver at the bank, so every bank note remains worth 1 oz.

In figure 4, the bank makes one more important change. Rather than requiring customers to bring in 1 oz of actual silver to get a bank note, the bank also accepts an equal or greater value of bonds, bills, real estate deeds, or anything else that can fit in the vault. This system has several advantages: (1) Handling bonds, etc. is easier and safer than handling silver. (2) The silver formerly deposited can be put to productive use. (3) The quantity of bank notes is no longer constrained by the amount of silver available. (4) The bank earns interest on its bonds, bills, etc.

The law of reflux still operates as before, except that when people want more notes, they can bring in either silver or bonds, and when people have excess notes, the notes can be returned to the bank for either silver or bonds. As before, it makes no sense to ask questions like “What if the bank issues 10% more bank notes?” And as before, so long as every bank note is backed by, and convertible into, 1 oz. worth of assets, every bank note will be worth 1 oz. Just as reflux assures that the value of a spoon is equal to its silver content, reflux also assures that the value of a bank note is equal to the value of the assets backing it.

The Channels of Reflux

Here is a list of some of the many channels through which bank notes might reflux to the issuing bank:
1. The silver channel: Unwanted notes are returned to the bank for 1 oz. of silver. Alternatively, the bank sells its silver for its own notes, which are retired.
2. The bond channel: The bank sells its bonds in exchange for its notes, which are retired.
3. The loan channel: The bank's borrowers repay loans with the bank's own notes.
4. The real estate channel: The bank sells its real estate holdings for its own notes.
5. The rental channel: The bank owns rental properties, and tenants pay their rent in the bank's notes.
6. The furniture channel: The bank sells its used furniture for its own notes.

As long as enough reflux channels are open, it does not matter if a few channels are closed. Customers would not care if the furniture channel was closed, as long as major channels, like the bond channel, stayed open. The bank could take a more drastic step and close the silver channel, or could delay silver payments by 20 years, and as long as enough other channels stayed open, the law of reflux could operate as always, except that notes might be redeemed for 1 oz. worth of bonds, rather than 1 oz. of actual silver. The bank could even un-peg its notes from silver. Rather than redeeming a refluxing dollar note for 1 oz. worth of bonds, it could redeem dollar notes for 1 dollar's worth of bonds. As long as the bank's assets are worth so many oz., it doesn't matter if those assets are denominated in oz. or in dollars.

Once metallic convertibility is suspended, it would be an understandable mistake if people forgot all about the other channels of reflux, and started to think that bank notes were no longer backed by, or convertible into, anything at all. Unfortunately, this mistake has made it into the textbooks:
You cannot convert a Federal Reserve Note into gold, silver, or anything else. The truth is that a Federal Reserve Note has no inherent value other than its value as money, as a medium of exchange. (Tresch, 1994, p. 996.)
There you have it. The closing of just one channel of reflux (the metallic channel), has fooled economists into wrongly rejecting the idea that modern bank notes like the US paper dollar are backed and convertible. Once economists reject this simple and obvious explanation for why modern paper money has value, they are forced to resort to the more exotic explanations offered by textbook monetary theories, which are anything but simple and obvious.

Blaug, Mark, Economic Theory In Retrospect, 3/e. Cambridge: Cambridge University Press, 1978
Fullarton, John, Regulation of Currencies of the Bank of England (second edition), 1845. Reprinted by Augustus M. Kelley, New York: 1969.
Tresch, Richard, Principles of Economics, St. Paul, Minnesota: West, 1994

Wednesday, September 24, 2014

A brief history of the Guinea

1685 Guinea with the bust of James II (link)

The guinea makes a fascinating story because its evolution reveals so many different monetary phenomena. It began its life in 1663 in the Kingdom of England as a mere coin, one medium of exchange in a whole sea of competing exchange media that included crowns, bobs, halfpennies, farthings, not to mention all the foreign coins that circulated in England, Bank of England paper notes, as well as the full range of portable property—like jewelery and art—and property-not-so-portable, say houses and land and such. If things had stayed that way, the guinea's life would be a boring one and I wouldn't be writing about it.

But in the late 1600s the guinea crossed a line and became a very different thing. Rather than functioning as just one exchange medium among many, the guinea suddenly emerged as one of Britain's two media of account, the items used to define a nation's unit of account, in this case the £. Within a few decades it had wrested the medium of account function for itself, holding this pre-eminent spot until 1816, at which point the guinea was decommissioned.

Interestingly, while the guinea ceased to exist in 1816, its memory was sufficiently strong that it continued to function as a unit of account, albeit a relatively unimportant one, well into the 1900s. More on that later.

Just a regular coin

Whereas most of England's coinage at the time was silver,  the guinea was a gold coin. Introduced in 1663 during the reign of Charles II, it was initially rated at 20 shillings, or one pound (£), by the monetary authorities (the mint and the king). Pounds, shillings, and pence, or £sd, comprised the English unit of account—the set of signs that merchants affixed to their wares to indicate prices. The pound unit had been defined in terms of silver coins for centuries, but the the decision by the mint to give a 1 pound (or 20 shilling) rating to the guinea meant that the pound would now be dually defined in terms of both gold and silver coins.

However, according to Lord Liverpool, both the public and the authorities ignored this 20 shilling rating so that a market-determined price emerged for the guinea. In this way the guinea was no different from any other item of merchandise; its price floated independently according to the whims of buyers and sellers.

This stands in contrast to England's silver coinage. Silver pennies, halfpennies, and farthings had an extra function; they served as the nation's medium of account. The pound unit, the £, the symbol with which merchants set prices or denominated debts, was defined by the nation's silver coinage. Put differently, by setting a farm's price at £10, a seller was stipulating that the farm was worth the amount of silver residing in a collection of pennies and farthings.

When something serves as the medium of account, it's price doesn't float independently. Rather, the whole universe of other prices shifts to accommodate changes in the value of the medium of account. For example, if the value of silver were to have risen in the 1670s due to increased demand for silver jewelery, then the entire English price level would have had to fall. Alternatively, if the amount of silver in the nation's coinage was debauched, then the English price level would have risen. A change in the demand for gold in the 1670s, however, would have produced an entirely different result; the relative price of the guinea would have shifted, but little else. That's why a medium of account is so special. Unlike all other items, the price of everything pivots around it.

The fact that the guinea's initial 1663 rating had been ignored was very important. Imagine that the authorities had been stern about enforcing it. Returning to our farm example, in setting the farm's price at £10, our seller would have been stipulating that the farm was worth either the amount of sliver residing in a collection of pennies and farthings, or the amount of gold residing in the guinea. A very different monetary system would have emerged; bimetallism. But more on that later.

Liverpool tells us that the guinea fluctuated between 21 and 22 shillings in its first decades, but in 1695 its price rose rapidly to 30 shillings. This wasn't because of an increase in the demand for gold but a function of the quickening pace of clipping and sweating of pennies, which reduced the quantity of silver in the coinage. Guineas weren't the only commodity to rise in 1695; the entire array of English prices had to pivot around the diminishing value of the silver penny. Once the silver coinage was reformed (its silver content being restored) in the Great Recoinage of 1696, the price of guineas quickly returned to 22 shillings.

The switch to bimetallism

Things all changed in 1697 when the Exchequer, the department responsible for receiving taxes, announced that all guineas were to be accepted by the Exchequer's tellers at 22 shillings. Prior to then, the Exchequer had accepted guineas at the going market rate. As Sykes points out, after 36 years of floating this was tantamount to fixing the price of the guinea relative to silver. Guinea couldn't circulate for less than this stipulated amount, say 21 shillings, because an arbitrageur would mop up those guineas at 21 shillings and use them to pay 22 shillings worth of taxes, earning him or herself a 1 shilling gain. (The next year, the Exchequer would reduce this rate to 21 shillings 6 pence.)

Britain, which had been on a silver standard up to 1697, was now on a bimetallic standard, with the £ unit defined as the amount of silver residing in the English penny, and simultaneously the amount of gold residing in the guinea.

The guinea takes over

The problem with the new standard was that in setting the guinea at 21s 6p, the Exchequer had overvalued gold relative to the market price, more specifically the silver-to-gold ratio prevalent in the rest of the world. By how much? In 1702 Sir Isaac Newton, Master of the Mint since 1699, concluded that 'Gold is therefore at too high a rate in England by about 10 pence or 12 pence in the Guinea.' In other words, the Exchequer should have announced it would only accept guineas at around 20s 6p, or 4.6% less than it had.

What were the consequences of this over-valuation? All of the silver pennies began to leave Britain, gold coins filling the void. Given the choice between paying a debt or a tax in either an overvalued or undervalued instrument, people will always select to use the overvalued one. After all, buying 20 shillings 6 pence's worth of gold in France and using it to discharge a 21s 6p shilling tax liability in England resulted in a 4.6% profit (less transportation and minting costs). The undervalued instrument, in this case silver, is best used in other parts of the world where it is capable of purchasing a larger real amount of goods (or discharging a larger real quantity of taxes) than in the country in which it is artificially undervalued. This is, of course, Gresham's law; the bad drives out the good.

So our guinea, which had started its young life as a mere medium of exchange, had not only graduated to becoming one of only two English media of account, but was responsible for the mass flushing out of silver from England.

By 1717, the silver outflow was getting significantly bad that the authorities decided to do something about it. Newton, still Master of the Mint, noted that the market price for the guinea was around 20s 8d, given the exchange rate between silver and gold in other European markets, and suggested an initial rate reduction from 21s 6d to 21 shillings.

But even at this lower price the English authorities were still overvaluing the yellow metal. They had now fixed the silver to gold ratio at 15.069 to 1, but because the rate was 14.8 to 1 in Holland and France, a profit still remained on exporting silver and importing gold. This silver outflow would continue over the decades until most silver was gone. England had gone from a bimetallic standard to a monometallic standard. Though it was still de jure bimetallic, de facto it had become a gold standard. And the guinea, which was now the controlling element in English prices, was to blame (or at least the decision to misprice it was).(1)

The end of the guinea

For the next century, the English price level pivoted around the value of the gold guinea, until the Great Recoinage of 1816, at which point the guinea's life suddenly came to an end. Since the days of Isaac Newton, the guinea had been awkwardly rated at 21 shillings, or one pound one shilling. This must have made payments somewhat arduous since there was no coin that could satisfy an even 1 pound bill or debt, and people like round numbers. The decision was made to introduce a less awkward gold coin, the sovereign, with slightly less gold. The sovereign was conveniently rated at exactly 1 pound, or 20 shillings, the upshot being that the pound unit of account still contained just as much physical gold as before, but now a coin existed that corresponded with the exact pound unit. The guinea was dead.


Well, not entirely. Though is was no longer being minted, the guinea continued to be used as a way to price items. According to Willem Buiter (pdf), auction houses and "expensive and pretentious shops" continued to set prices in terms of guineas through the 1800s and 1900s. Bespoke tailoring and furniture, for instance, was quoted in the legacy gold coin. The unit used was g, or gn, with the plural being gs or gns, although payments were made in sovereign coins or Bank of England notes.

Gillette advertisement (link)

Doctor's and lawyer's fees, often known as "Guinea fees" we're advertised in terms of the legacy gold coin. Whereas common laborers were paid in pounds, payments in guineas was considered more gentlemanly. You can see it pop up in the literature of the time. In Arthur Conan Doyle's Sherlock Holmes tale the Adventure of the Engineer's Thumb a stranger offers Mr Hatherly, a hydraulic engineer who is down on his luck, a unique proposal. "How would fifty guineas for a night's work suit you?"

An ad from 1929 (link)

The standard rate paid by Charles Dickens for contributions to his weekly periodicals Household Words and All The Year Round was half a guinea a column or a guinea a page. In his novels, the guinea pops up often. In Oliver Twist (set in the 1840s), a 5 guinea reward for information on Oliver is posted by the kind Mr. Brownlow.

In more modern times, horses continue to be auctioned in terms of guineas.

Dancing Rain sold for 4 million guineas (link)

Now of course this is a bit of a come-down for the once almighty guinea. Serving as the unit at Tattersalls isn't the same as underpinning the entire price level. But at least its better than the sovereign, the coin that replaced the guinea, which has gone silent, or most other medieval coins for that matter, which neither circulate nor serve as legacy units.

(1) The 1717 reduction of the guinea to 21 shillings was accompanied by the requirement that those guineas be accepted as legal tender at that price. Prior to then, only silver had functioned as legal tender, meaning that a debtor could only discharge a debt with silver coins. After the change, a debtor could choose to use either guineas or silver coins to pay off their debt, a decision made easier given gold's overvaluation.

Some References:

Lord Liverpool, A Treatise on the Coin of the Realm, 1805.
Sargent & Velde, The Big Problem Of Small Change, 2001.
Selgin, Good Money, 2008.
Sykes, Banking and Currency, 1905. 
Macleod, Bimetallism, 1894.

Sunday, September 14, 2014

Getting naked: in praise of naked short selling

Photo by Spencer Tunick, Netherlands 8 (Dream Amsterdam Foundation) 2007 [link]

If short sellers are considered to be the Mussolinis of the financial market, then naked short sellers are its Hitlers.

In this post I'll show that naked short selling isn't solely a hedge fund or equity market phenomenon. In fact, the good old fashioned practice of deposit banking amounts to what is essentially naked short selling, thus making staid bankers, and not hedge funds, the world's largest naked short sellers. This means that anyone who vilifies the naked short selling of equities must also be against the common practice of banking—a crack pot position if there ever was one.

Short selling is when an investor borrows shares of, say, Microsoft, then sells those shares in the open market. At some point—either at the lender's behest or the investor's—the borrower will repurchase the shares in the open market and return them to the lender. A short seller hopes that the price of Microsoft has declined in the interim so that when the time comes to repurchase them, it will cost less money, thus resulting in a profit to the short seller.

Naked short selling is similar in every respect save for one: when our investor sells Microsoft shares short in the open market, they do so without borrowing those shares ahead of time. (To get more specific, read this SEC page)

Which sounds odd, right? How can someone sell something if they haven't either purchased it or borrowed it ahead of time? No wonder people wrinkle there noses at the practice of naked shorting—it seem like sleight of hand!

The best way to think about naked short selling is to turn to banking. Why? Because bankers engage in short selling Just as an equity short seller will borrow and then sell Microsoft with the intention of repurchasing it at a better price, bankers borrow and then sell dollars with the intention of repurchasing them at a better price. Apart from the respective instruments involved, dollars vs stock, there's no difference between what an equity short seller and banker are doing.

So if bankers engage in short selling, do they act as mere regular shorts sellers or do they get naked?

In the previous paragraph you may have noticed that I described banking as the borrowing of depositors' dollars in order to lend those dollars out. Because the dollars were borrowed prior to sale, this would qualify their activity as regular short selling, not naked short selling.

But hold on, this isn't at all how banks function. Bankers don't wait for physical Federal Reserve dollars to be deposited by the public before selling them away—they short dollars whenever they wish, creating electronic deposits out of nothing in order to buy things like bonds or personal IOUs. Banks are engaged in naked shorting pure and simple: they sell a financial instrument that they never actually had in their possession.

How do they do this? The key here is that banks don't actually sell Fed paper dollars short, rather, they sell dollar-linked IOUs (i.e. deposits) short. A deposit is a claim on the bank's capital that mimics Fed paper dollars by being indexed, or denominated, in terms of those paper dollars. It's similar to a Fed dollar, but it's an entirely different instrument.

Circling back to naked equity short sellers, the same thing is occurring when a naked short is initiated. The instrument that they are selling short isn't a Microsoft share, but a newly-created IOU that is denominated in Microsoft shares. It would be as if I gave you scrap of paper with the words "I owe you one Microsoft share" on it. Rather than buy a real share, you could just hold the IOU I gave you. The instrument would look like a share, walk like a share, and even circulate alongside shares, however it would be an entirely new financial instrument.

This ability to "print" new IOUs denominated in terms of Federal Reserve dollars (in the case of the banker) or in terms of Microsoft shares (in the case of the short seller) often results in a quantity of derivative units that far exceeds the underlying issue of base units. We get an inverted triangle of sorts where on top of a narrow base of Fed paper dollars is arrayed a much larger quantity of dollar-denominated deposits, often 10 or 20 times more. Likewise, the number of Microsoft-denominated IOUs that naked short sellers create may eclipse the number of actual Microsoft shares outstanding.

It is the naked short seller's possession of a so-called printing press that draws the wrath of CEOs. The accusation is that a hedge fund can make a good profit by manufacturing and selling massive quantities of Microsoft-denominated IOUS in order to drive Microsoft's stock price down to zero, thus benefiting its short position. Emblematic of this belief is the battle waged by Overstock CEO Patrick Byrne against short sellers who had been engaging in naked selling of his firm's stock, which had fallen on hard times. As early as 2005, Byrne accused short sellers of creating a fake supply of Overstock shares (at one point reputably six times more than actual shares issued) in order to drive its price lower. Byrne went so far as to launch several lawsuits against the perpetrators.

How legitimate is Byrne's concern? Let's return to our bank analogy. Is there anyone who would argue that because banks can create and short deposits willy nilly, they'll drive down the underlying Fed dollar's price towards zero (ie. create hyperinflation) and thus earn outsized profits? Of course not. Banks in the U.S. and Canada have been creating deposits for centuries without causing hyperinflation. It simply isn't a concern because the issuer of underlying dollars, the Federal Reserve, stands ready to support the value of the dollars it has issued. It can provide this sort of anchor because it holds a variety of assets that can be mobilized to repurchase and cancel paper dollars, thereby removing any excess supply that might emerge thanks to competing issues of dollars by banks.

Likewise, if naked short selling creates a glut of Overstock IOUs and begins to drive down the price of Overstock, then in the same way that the Fed can deploy its assets to remove the supply of Fed dollars to stabilize their value, Overstock's Patrick Byrne could have used his firm's assets to repurchase stock. If he chose not too do a buy back, one might wonder if his company had the assets on hand to begin with.

To sum up, in the same way that bank issuance of dollar-denominate IOUs cannot drive the purchasing power of underlying Fed dollars down as long as the Fed has sufficient assets and chooses to use them, neither can naked short sellers drive Overstock prices down if the company has sufficient assets and is willing to conduct the necessary repurchases.

So haters of naked short selling, are you consistent in calling for an outright bank on banking? You say that naked shorting drives down stock prices, which means you no doubt also believe that banks inevitably create hyperinflation, right?

JKH has a post on the topic here, the Full Monty on Naked Short Selling.

Thursday, September 11, 2014

Getting rid of the monetary triumvirate

The textbook definition of money is anything that functions simultaneously as a store of value, a medium of exchange, and a medium of account. This is the monetary triumvirate, and we need to get rid of it.

The first problem with this explanation is that all goods and assets function as stores of value, some better than others. Items that can't 'store' value would be be worthless because their lives would be too fleeting to provide any utility. Even an ice cream cone serves as a store of value, at least for a few minutes.

So if everything serves as a store of value, then money must be that peculiar good that functions as both a medium of exchange and a medium of account, right?

Wrong. All valuable things function as media of exchange, or, put differently, they all have a degree of exchangeability. A head of cabbage is a cabbage farmer's medium of exchange, since he uses it exchange with a food distributor, and it also functions as one of the distributor's many media of exchange, since he uses it to exchange with a grocer, and it also functions as one of the grocer's many media of exchange, since the grocer holds an inventory of cabbage in order it to exchange with the public. We can quibble over the general acceptability of any given medium of exchange; a dollar bill is more exchangeable than a cabbage, after all. But a dollar bill, like a cabbage, is not universally acceptable—try buying a house with it, or Microsoft stock.

So if everything serves as a store of value to some degree or other, and everything serves as a medium of exchange to some degree or other, then money must be that peculiar good that functions as a medium of account.

The upshot is that the only binary difference between the various goods and assets in this world is along the medium of account-or-not axis, both the store of value and medium of exchange functions being ranges or spectra, not binary categories. This means that a good is either a medium of account, or it isn't. There's no point in using an umbrella word like "money" anymore, since medium-of-account stands on its own as a useful definition.

A medium of account, if you don't remember, is the good that we use to quote prices. There are only a handful of media of account in the world, with the great majority of things not functioning as media of account. Dollar bills are certainly a medium of account. Credit cards (combined with network fees) also function as a medium of account. There are weird artificial media of account, like whatever is used to define Chile's Unidad de Fomento. Commodities like cloth, or macutes, have served as media of account in West Africa, as have silver pennies in Europe.

So let's retire that tired old triumvirate. The word money is redundant and meaningless; if we really want to divide the world into these and those, the medium-of-account bucket is about all we need. The other two functions, store of value and medium of exchange, are pervasive rather than exclusive (everything has at least a little bit of each), and therefore can't serve as the basis for drawing strict lines between goods.

Saturday, September 6, 2014

Draghi's fake zero-lower bound and those pesky €500 notes

Having reduced the ECB's overnight target rate to +0.05% and the deposit rate to -0.2%, Mario Draghi confidently told those assembled at Thursday's press conference that the ECB wants to “make sure that there are no more misunderstandings about whether we have reached the lower bound. Now we are at the lower bound.” So it's official, according to its leader the ECB has run out of powder and can't reduce interest rate anymore.

But that's simply not true. I figure that the ECB has at least a handful of interest rate reductions left in its arsenal before the true lower bound bites, especially given that it's now adjusting rates in smaller increments of 0.1% and not 0.25%. And if the ECB were to get rid of its pesky issue of €500 notes, it would have a whole extra round of reductions up its sleeve (more on that later). Shame on Draghi for claiming impotence when he actually has plenty of rate ammunition still left.

The lower bound starts to bind when interest rates are brought sufficiently low that all those banks who own ECB deposits suddenly start to convert them en masse into euro banknotes. Banknotes yield 0%, after all, so if the ECB were to reduce rates on deposits to, say, -10%, then the prospect of costlessly converting those penalized deposits into holdings of 0% yielding notes starts to get pretty tempting. Central bankers are petrified of hitting this cash tipping point, so they refuse to institute anything below a 0% rate on deposits. That's why they call it the zero lower bound.

But the true tipping point at which mass cash conversion kicks in doesn't happen at 0%, nor at -0.05%, and probably not even -0.5%. The reason for this is that cash comes with its own set of inconveniences. For banks, storing cash is costly: it requires a vault, guards, time and energy to count and sort the stuff, and finally it must be insured. The transfer of cash is also expensive: Brinks armoured cars must be hired and loading bays properly staffed. Compare this to an electronic deposit which can be costlessly stored, instantaneously transferred at no cost, and needn't be insured against robbery.

Banks, anxious to avoid these inconveniences, are more likely than not to accept significantly negative rates on central bank deposits before they switch to cash. Imagine, for instance, cheque payments being cleared with daily shipments of cash rather than a click-of-a-button transfer of central bank deposits. It would be hellish. Or consider the huge inconvenience of conducting interbank payments on behalf of clients by shuttling cases of paper notes across town. No, if next month Draghi were to announce a reduction in the interest rate on the main refinancing operations by 10 basis points to -0.05%, and another one the next month to -0.15%, and another one after that, there would be no mass desertion of deposits for cash. Rates would have to go significantly below those levels before the actual lower bound starts to bind. There is a lower bound, but its certainly not at zero.

How far below zero?

This is where the ECB's pesky €500 note comes into the picture. The ECB has differentiated itself from almost all other developed country central banks by issuing a mega-large note denomination, the €500 note. The chart below shows the largest denomination notes issued by G20 countries in US dollar terms, with the Eurozone easily leading the pack.

According to this WSJ blog post, the architects of the ECB decided to issue the €500 note because six of the founding members already had bills whose value exceeded exceeded €200: Holland, Belgium, Italy, Austria, Luxembourg and Germany, with the Bundesbank's 1,000 Deutsche Mark banknote tipping the scale at about €510. And since the ECB is explicitly modeled on the Bundesbank, that's how Europe got its €500 note.

Nor is the value of €500s in circulation minimal. The chart below shows the nominal value (not the quantity) of euro notes in circulation by each denomination, with the value of €500 notes being eclipsed by only that of the €50.

The €500 note creates a uniquely European problem because its large real value reduces the cost of storing cash and therefore raises the eurozone's lower bound. Think about it this way. To get $1 million in cash you need ten thousand $100 bills. With the €500 note, you need only 1,545 banknotes, or about one-eighth the volume of dollar notes required to get to $1 million. This means that owners of euros require less vault space for the same real quantity of funds, allowing them to reduce storage costs as well as shipping & handling expenses. In other words, the €500 note is far more convenient than the $100 note, the €100, the £100, the ¥10,000, or any other note out there (we'll ignore the Swiss). Thus if Draghi were to reduce rates to -0.25%, or even -0.35%, the existence of the not-so-inconvenient €500 very quickly begins to provide a very worthy alternative to negative yielding ECB deposits. The lower bound isn't so low anymore.

All the more reason to remove the €500 note in order to provide the ECB with further downward flexibility in interest rates. If the existence of the €500 note means that Draghi can't push rates below, say, -0.35% without mass cash conversion occurring (ie. another four easings of 0.1% each starting from today's +0.05% rate), but the removal of said note from circulation allows him to drop that rate to -0.65% before the cash tipping point, then he's bought himself an extra three rate reductions by removing the €500. (Hell, by removing the €200 note next, and then the €100 after that, and then... he'd be able to continue reducing rates until deflation had been reversed and 2% inflation re-instituted)

Who loses by the  €500's removal? Regular folks won't suffer much, but denizens of the underground economy probably will. The large-denomination euro is a convenient medium of exchange for criminals, corrupt government officials, and anyone seeking to avoid paying taxes. For instance, in 2010 the UK's Serious Organised Crime Agency required local banks to cease supplying British customers with €500 notes when it found that 9 out of 10 notes were used for illegal activities. Just look at the different demand patterns for the €50 and the €500 in the chart above for evidence. The €50 shows seasonal spikes at Christmas. That's because people withdraw notes at Christmas to make sure they are equipped for unexpected expenses while traveling. Demand for the €500 doesn't budge at Christmas. That's because crime isn't a seasonal enterprise, it's a year-around affair.

So to sum up, Draghi is confused if he thinks he's actually hit the lower bound. Sure, he's brought rates down to zero, but the actual lower bound is a handful of rate cuts below that. The man has got more ammo than he realizes. And second, Draghi can get his hands on even more ammo by getting rid of that silly €500 note. It's existence only greases the wheels of criminal commerce, and insofar as further rate reductions could very well be necessary to help keep Europe out of a painful deflation, its mere existence raises the lower bound and thereby prevents those reductions from happening, thus hurting the regular European. That's two good reasons to get rid of the dang thing!

Related posts on cash and the lower bound problem: 

The zero-lower bound as a modern version of Gresham's law
Does the zero lower bound exist thanks to the government's paper currency monopoly?
No need to ban cash to avoid the zero-lower bound problem

Saturday, August 30, 2014

A market for corporate votes

Berkshire Hathaway annual general meeting

When you purchase a share you're not only getting the opportunity to make some extra cash. You're also buying a vote. Put differently, a share offers two different features: a) a claim on earnings and b) the right to exercise partial control over the corporation.*

Why not separate the two features and put each of them up for sale? Let's have one market for corporate votes, and a separate one for corporate returns.

Here's how it would work. Imagine you want to buy some Microsoft shares but don't care to participate in the governance of Microsoft. The quoted price on the market, $44.93, is for a whole share of Microsoft, both its attached voting rights and its capitalized return. So you buy 500 whole shares for $27,465.

Next you turn to the parallel public voting market. Microsoft votes are trading for around 25 cents each, say. You 'detach' each of the 500 votes from the shares you've just bought and sell those votes for 25 cents each in the voting market for a combined $125. Not a bad day's work. In selling the votes that you never wanted anyways you've defrayed your initial purchase cost.

A few years later you decide to get out of Microsoft. One way is to find a set of buyers who, like yourself, don't care to vote, and sell the voteless shares directly to them. Alternatively you can repurchase the 500 votes in the voting market, reattach them to the shares, and sell them in the whole share market.

Here's another hypothetical: imagine that you have 500 shares of Microsoft but feel that it's your destiny to have a much more active role in Microsoft governance than your 500 votes would otherwise provide. Say you'd like ten times the votes, or 5,000 votes. To amass that quantity of votes it would normally cost you the price of 4,500 additional shares at $44.93 each, or about $207,000, but that's far out of your league. That's where the market for Microsoft votes comes in. For a mere $1125 you can pick up 4,500 detached votes, assuming they trade at 25 cents each. Without having stumped up too much capital, you've become a much more formidable shareholder activist.

So why have a market for corporate votes?

According to Broadridge, some 70% of retail shares go unvoted. Participation rates are better on the institutional front where some 90% of institutionally-owned shares are voted, but this is due to a legally-mandated fiduciary responsibility to vote. The responsibility for voting these shares is usually outsourced to a proxy advisory company like ISS which, according to one account, advised on over 50% of corporate votes cast in the world. ISS's success is due in part to the fact that institutional shareholders have scarce resources, most of which are ready allocated to searching for new investments and monitoring existing ones. They can't spare the cost of setting up expertise in corporate governance.

So to a large proportion of retail and institutional investors, votes represent little more than a nuisance. In order to play the stock market game, these investors hold their noses and pony up enough cash to buy a share and its combined vote; but they'd really be quite happy if they didn't have to buy the latter, especially if it meant reducing their overall costs.

If those who view votes as a nuisance comprise the sell side of the corporate vote market, then the buy side would be comprised of a cadre of institutional investors who specialize in corporate governance and shareholder activism. Activist investors, say someone like Bill Ackman, have developed expertise and a set of practices that allow them to efficiently put votes to work, instituting change in a company's structure or management in order to make it more profitable. They place a much higher marginal value on the votes attached to shares than the majority of their not-so-active colleagues.

A market in corporate shares would allow both the apathetic and the active to meet, with the final result being a more efficient allocation of returns and voting rights.

What I'm proposing may sound a bit sci fi, but what if I told you that such a thing already exists?

The fact is that we already have an informal market of sorts in corporate votes. In Canada, for instance, firms often issue both non-voting, voting shares, and multiple voting shares. In the U.S. the practice is less common, one example being Google which has issued 'A' shares with one vote apiece; 'B' shares with ten votes each; and 'C' shares with no votes. Or consider Warren Buffet's Berkshire Hathaway. An owner of $10,000 worth of Berkshire Class B shares has 0.15% of the votes that an owner of $10,000 worth of Class A shares has.

When companies have dual share structures, to buy votes, an investor need only short the non-voting shares in order to fund a long position in the voting class. And to sell votes, do the opposite. The cost one would incur on this transaction indicates the dollar value the market places on the right to vote.** Canadian readers may well remember that Mason Capital engaged in this strategy with Telus shares back in 2012 when it purchased Telus voting shares and shorted its non-voting shares.

But there's a more interesting way to get one's hands on extra votes. Start by borrowing whole shares just prior to a vote, much like a short seller borrows shares prior to selling them short. Rather than selling the borrowed shares, however, an activist holds them in order to exercise their voting rights, then returns the shares soon after the vote to the lender. The cost they'll pay on this round trip represents the price of a vote. From the perspective of the the owner who has lent the shares out, they require a high enough fee in order to compensate them for having foregone their franchise over the interim.

For instance, in 2002, Laxey Partners, a hedge fund, held about 1% of the shares of British Land, a major U.K. property company. However, on the day of British Land's shareholder meeting Laxey controlled 9% of the votes, note Hu and Black, all the better to support a proposal to dismember British Land. Just before the record date, Laxey had borrowed 8% of British Land's shares.

The term used for having more votes than shares is empty voting. Someone with 5,000 votes and only 500 shares is in possession of 4,500 empty votes, since those 4,500 votes have been 'emptied' of their economic interest. Empty voting is welfare-improving when an activist investor with a good plan acquires votes beyond his or her economic interest in order to ensure that their plan is adopted. However, at the extreme, empty voting can get downright spooky.  Consider a fund that has amassed short position in a stock (ie. it expects the shares to fall in value) while building a long position in votes. Perversely, this 'rogue' fund could very well use their franchise to implement changes that hurt the firm, not help it, and thereby bolster their short position.

Hu and Black, who refer to the decoupling of votes and economic interest as "the new vote buying", note that vote transactions are often hidden from the public and regulators. All the more reason to have a formal market for votes as described at the start of this post rather than the terribly confusing one that already exists. A transparent price for voting would help reveal rogue attempts to corral large empty voting positions. Those activists who truly want to create shareholder friendly changes would be able to accurately price out the cost of resisting the rogues.

And all those investors who are too unsophisticated to understand the murky world of stock lending, ie. retail investors, would be able to use widely-disseminated prices to better gauge the value of their vote and access an open market for the transferral of those votes.

* A share also offers a third feature, a liquidity return. I've pointed this out many times before. For the sake of this post, we'll ignore the liquidity portion.
** Strictly speaking, if the non-voting shares you short also happen to be less liquid than the voting shares you are long, then you are not only buying votes, you're also buying liquidity. But as I pointed out in the above bullet point, I'm ignoring liquidity returns for the sake of simplicity.
*** I have an ulterior motive for a market for corporate votes. I think the phenomenon of naked shorting doesn't deserve the vilification it receives in the press and on blogs. In fact, naked shorting is a necessary part of ensuring that liquidity premia on equities are kept at market clearing prices. The proper functioning of what I've referred to as the 'moneyness market' depends on naked shorting. The problem with a naked short is that the resulting synthetic security that the short seller creates doesn't have a vote. It is a non-standard instrument. With the existence of a corporate vote market, a naked short seller might re-standardize the instrument by purchasing a vote and attaching it to the IOU that they've created via their naked short. I do plan on writing about this next month, so if you didn't understand my point, just wait. 

Hu & Black, 2006. The New Vote Buying: Empty Voting and Hidden (Morphable) Ownership
Aggarwal, Saffi, & Sturgess, 2010. Does Proxy Voting Affect the Supply and/or Demand for Securities Lending
Financial Post, November 2012. Empty Voting Clouds Shareholder Rights Law
Black, 2012. Equity Decoupling and Empty Voting: The Telus Zero-Premium Share Swap
Brav & Mathews, 2011. Empty voting and the efficiency of corporate governance