## Monday, October 22, 2012

### Money and Bubbles

Money. Bubble. Liquidity. Fire sale. Those words are used a lot, particularly with reference to the recent financial crisis. Sometimes the words are used as if we all agree on what they mean, but if you engage anyone in a discussion about any of them, you'll find a distinct lack of agreement. I've seen several shouting matches in seminar rooms over what "bubble" means. Thus, it's not surprising that Noah Smith, Paul Krugman, and I don't think about bubbles in the same way.

From my previous post, here's my bubble definition, with examples:
What is a bubble? You certainly can't know it's a bubble by just looking at it. You need a model. (i) Write down a model that determines asset prices. (ii) Determine what the actual underlying payoffs are on each asset. (iii) Calculate each asset's "fundamental," which is the expected present value of these underlying payoffs, using the appropriate discount factors. (iv) The difference between the asset's actual price and the fundamental is the bubble. Money, for example, is a pure bubble, as its fundamental is zero. There is a bubble component to government debt, due to the fact that it is used in financial transactions (just as money is used in retail transactions) and as collateral. Thus bubbles can be a good thing. We would not compare an economy with money to one without money and argue that the people in the monetary economy are "spending too much," would we?

Noah Smith and I once had a conversation along these lines, and I thought we were making progress, but apparently not. Noah says the above paragraph is nonsense, since most payoffs on assets in monetary economies (like the one we live in) are denominated in terms of money. Thus, Noah reasons, if money is a bubble, then all assets are bubbles. How dumb could I be?

The payoffs on my stocks and bonds, and the sale of my house, may be denominated in dollars, but that does not mean that the value of those assets is somehow derived from the value of money. It's useful to ask what would happen if the monetary bubble "bursts." Think about an identical economy where money is not valued (that's always an equilibrium) and ask what happens. Everything changes of course, as now it's more difficult to carry out transactions - but not impossible. People will find other means to get the job done. Private financial intermediaries will issue substitutes for government money; people might engage in barter; people might use commodity monies. There is no reason why stocks and bonds and houses can't exist and be traded, with payoffs denominated in terms of something other than government-issued liabilities. Indeed, because private assets are substituting for government liabilities in exchange, some of those assets will have larger bubble components than in the monetary economy.

To give a practical example, think about monetary arrangements in the United States during the free banking era before the civil war. There was no fiat money or central bank. Transactions were executed primarily using the paper notes issued by private, state-chartered, banks, and using commodity money. Think of the role that gold played in that era. The price of gold had a bubble component as the stuff was used in exchange. It's not used in exchange today, so the bubble has gone away.

Here's Krugman's bubble definition:
I’d start by asking, what do we mean when we talk about bubbles? Basically, I’d argue, we mean that people are basing their decisions on beliefs about the future that are based on recent experience but can’t be fulfilled. E.g., people buy houses because they expect home prices to keep rising at a pace that would eventually leave nobody able to buy a first home...This sounds a lot like what happens in a Ponzi scheme...
It's different, right? My definition was based on rationality, and bubbles can be sustained forever. The crucial elements of a Krugman bubble are irrationality, and lack of sustainability. That's pretty much where the discussion ends. Krugman finds his notion of a bubble useful. I find mine useful. Krugman is in the Shiller bubble camp. I'm in the monetary theorist bubble camp.

Here's something interesting, though. Toward the end of his post, Krugman discusses fiat money, and Samuelson's overlapping generations (OG) model, which is one framework for thinking about money and what it does. No one took this model seriously as a model of money for a long time, perhaps because the tone of Samuelson's article is half-serious. However, Lucas used it in his 1972 paper, and this inspired Neil Wallace and his Minnesota students in the early 1980s to develop it further. The OG model captures Jevons's absence-of-double-coincidence problem in a nice way, it's easy to work with, and it admits complications like credit arrangements in a simple manner. Indeed, this book by Champ/Freeman/Haslag is essentially OG models for undergraduates.

One interesting feature of an equilibrium with valued money in the OG model, is that it looks like a Ponzi scheme - i.e. it has a feature Krugman associates with his bubble. And it's sustained forever. In each period, the young transfer goods to the old in the belief that they will receive goods when old from the next generation. Indeed, that arrangement looks just like social security, which is also a Ponzi scheme, though Krugman doesn't want to admit it. There's nothing wrong with it of course. Under the right conditions, social security can be an efficient and sustainable Ponzi scheme.

1. " Calculate each asset's "fundamental," which is the expected present value of these underlying payoffs, using the appropriate discount factors."

The notion "underlying payoffs" can be vague. As in Duffy et al emca paper, one can argue money, and probably T-Bill for collateral, has liquidity service. So they counts as underlying payoffs and there is no bubble.

When the bubble never bursts then we can't say/ distinguish it is really bubble. I think one has to start with a model of multiple equilibria in order to have a meaningful notion of bubble. Lagos and Wright can be one

1. It's certainly true that, if you price assets, say in a Lagos-Wright model, the "payoffs" will enter in a more-or-less standard way - you weight the payoff by someone's marginal utility of consumption, discount, take the expectation, etc. Some of those payoffs can come by way of exchange, in that I hold the asset not because I like it or because I'm going to consume a dividend the asset pays, but because I like the stuff I can receive in exchange for it - it has a medium-of-exchange property. You can calculate a "liquidity premium" on the asset, and I think it's useful to call that a bubble. It's not just semantics, as I think this identifies something important about what the asset is and what it is good for.

If we want to explore your idea that multiple equilibria are what is important in terms of how you want to think about something empirical you think is a bubble, that's fine. That can be interesting. Monetary models - Lagos-Wright and OG included - are loaded with equilibria, and in some of those you can get fluctuations in asset prices that involve sudden crashes, I think.

2. The whole discussion in Noah blog becomes a mess. Look at how Andofatto got trapped in mud. Better to stay here

Anyway, the notion of bubble must be model-specific. It has to be an accounting exercise to sort out different components of price, like Y = C + I +G. It is meaningless (yes I am talking about Noah) to argue bubble exist or not, just as denying particular component in national income accounting.

The thing is, why the accounting bubble vs fundamental in this way is useful? How it useful to understand and identify the fluctuation of asset prices?

3. It helps you think about the problem of explaining asset prices, which we do a poor job of. Basic asset pricing models determine asset prices as the present value of intrinsic payoffs. But those models fail to explain how asset prices behave - particularly the volatility. We might be successful if we model the role of assets in exchange and as collateral.

2. Don't you think that having a model and having a bubble contradict each other? A bubble bursts when apparently no model can any longer justify the valuation of the given asset. It is not about *A* model. It is about *all* models out there. And obviously noone can confidently know all models that exist out there.

3. This is a good post. Better to use the term liquidity premium, not bubble. David Andolfatto says the same on his blog.

"It's different, right? My definition was based on rationality, and bubbles can be sustained forever. The crucial elements of a Krugman bubble are irrationality, and lack of sustainability."

Liquidity premiums can both be sustainable and unsustainable. The liquidity premium on gold has existed for millenia, although it has probably shrunk. British pounds carry a centuries' old premium. But the liquidity premium on NASDAQ tech stocks suddenly exploded in 1999 before collapsing in 2000-2001. In understanding liquidity premiums you need to be aware of both phenomenon.

1. "Better to use the term liquidity premium, not bubble. David Andolfatto says the same on his blog."

I like calling it a bubble, as I think it's possible that you can explain some of the phenomena that people call bubbles as what Andolfatto wants to call a liquidity premium. Besides, if Andolfatto tells me to do something, I like doing the opposite.

4. The payoffs on my stocks and bonds, and the sale of my house, may be denominated in dollars, but that does not mean that the value of those assets is somehow derived from the value of money.

False

The house is more valuable because of the efficiencies arising from the use of money

2. Delong, explaining Money to Williamson:

It is simply not the case that we can cheaply and easily buy things with money because it is valuable. It is, instead, the case that money is valuable because we can cheaply and easily buy things with it.

One way into the tangle of understanding why it is wrong is to ask each of us why we are happy accepting money in exchange when we sell useful commodities. Hint: it's not because we are looking forward to going down to the bank, exchanging our bank notes for the little disks of gold usually decorated with pictures of bearded men on one side and allegorical female figures on the other with lettering saying things like "Fecund Augustae" or "Concordia Militum" or "Fides Exercituum" on them, taking our little disks home, and feeling happy looking at them.

That's not why we accept money.

We accept money because if we don't have any money we have to buy commodities with other commodities, and when we do so we are unlikely to receive the cost of production for what we sell. Have you ever tried to buy a latte at Peets with a copy of Ludwig von Mises's Money and Credit? It does not go well.

The fact is that your wealth is only worth its cost of production if you are liquid--if you can wait to sell until somebody willing to pay full cost of production comes along, which is not every minute. The use-value of money is that it allows you to time your other transactions so that you can realize the full exchange value of what you sell, rather than having to sell it at a discount.

Thus there is no paradox: no sense in which the existence of fiat money creates a situation in which society must necessarily think that it is richer than it is, with claims to total wealth valued at more than the value of total wealth itself. You think--correctly--that your fiat money has value, and that value is just equal to the discount from its cost of production that your other wealth incurs because it is illiquid. But what if the government prints more fiat money than the illiquidity gap in your other wealth? Well, then people will say: "I don't need to hold all this extra money. I would be liquid enough with less." Everybody will try to run down their money balances, and so the price level will rise until the real money stock is just what people think covers the illiquidity gap between their other wealth and its cost of production."

3. De Long's misses the part, however, where people fed up with the government printing fiat money at excessive rates decide to give it up and conduct their transactions using other money. This happens you know, in which case your old fiat money has no use whatsoever, except perhaps in facilitating transactions with the government.

Fiat money is the only asset I can think of that if all people tried to apply its use at the same time, exchange it for goods and services that is, the asset would seize to be useful. This is not to say that it is not a useful contraption.

4. Somehow I don't feel instructed.

5. my 2 cents is that you are blinded because you are inside the economics silo.

Law students (and lawyers) are poor generally at economics but that quickly understand that money is Coasean and the primary limiter of their livelihood. Without money, contracts (promises) for future performance would still be made but the paper (and legal work) would be immense.

To the point, sophisticated lawyers laugh at economist who worry about "money." If you think that the gov't may print too much, hire a good lawyer and broker and write contracts that hedge all your positions.

You will find that these services cost 5 to 7% of the contract price, but insurance can be obtained.

Viewed in this light, the true nature of complaints about fiat money, etc., are exposed. The complainers are lazy and greedy, wanting someone to do their own work. CA is a prime example. He is just a welfare queen in different garb. If he has cash in a Mason jar in the back yard he could forward hedge, at a cost. He just wants a gov't subsidy.

Do not take these remarks as carte blanch permission for the gov't to print money.

Life is a confidence game and, generally, on of its rules is that excessive printing works against confidence.

6. "...sophisticated lawyers..."

Isn't that an oxymoron?

7. Oh, come on now Stephen, have you ever tried to keep up with an ambulance?

5. If I understand correctly, some object to the use of the work "bubble" because the premium reflects a useful property, liquidity. My problem is that, by taking this logic to the extreme, nothing can ever be called a bubble. There was no derivatives bubble, the high price of mortgage-backed securities simply reflected their uefulness as a medium of exchange. There was no housing bubble, their price increase reflected their use as an "input" in the "production" of mortgage-backed securities. And so on...

Interestingly, many of the same people have criticized economists for not identifying the housing bubble. Is it my impression, or are people trying to have it both ways?

1. No. I addressed that in the last post. Here's the relevant passage, so you don't have to look it up:

But the bubble component of housing prices after, say, 2000, does not appear to have been entirely a good thing, as it was built on false pretenses. Various kinds of deception resulted in housing prices - and prices of mortgage-related assets - that, by anyone's measure, exceeded what was socially optimal. As a result, I think we can make the case that pre-2008 real GDP in the US was higher than it would have been otherwise. Further, the housing-market and mortgage-market boom could have masked underlying changes taking place in US labor markets - for example David Autor's "hollowing out" phenomenon. One could argue that there was a cumulative effect in terms of the labor market adjustments needed, and that these adjustments took place during the recent recession, and are still taking place. See for example this paper by Jaimovich and Siu. That's why all the long-term unemployed. So that's not some confusion. People are talking about alternative ideas that have some legs, and may have quantitative significance. Why dismiss them?

2. Got it, thanks! Of course, it is hard enough to detect in real time deviations of prices from fundamentals, I can't imagine having, on top of that, to decompose these deviations to liquidity premiums or overvaluations dues to deceitful practices.

3. "My problem is that, by taking this logic to the extreme, nothing can ever be called a bubble. There was no derivatives bubble, the high price of mortgage-backed securities simply reflected their usefulness as a medium of exchange."

That's a good thing. Take a dotcom stock. The stock's liquidity premium reflects its usefulness as a medium of exchange. But what drives the perception of the stock's liquidity premium isn't just how it performed as a medium in the past, but how it is expected to perform in the future. If people expect that even more people in the future will be willing to buy the stock, then the dotcom's liquidity premium rises. Its market price rises.

Persistent increases in these expectations will create spikes in the dotcom's price... which are really just spikes in its liquidity premium. Of course, these spikes can't continue indefinitely since there are a finite number of people who can enter the market. Until then, it's rational to buy as long as you assume that you haven't approached the end of the chain. But it can end in tears too.

4. false pretenses . . .

Munger invented a wonderful word describing this problem, febezzlement, building on John Kenneth Galbraith who had come up with the term "bezzle" to describe the outright frauds

The process is vicious---as with embezzlement, you think you are richer but you are actually poorer.

The question is why, more than 5 years into the crisis, no one seems to have seriously attempted to quantify this most fundamental of issues.

How are we supposed to know what effort will be required to repair the economy without first knowing or having good estimates of how badly it was damaged?

1. Who is Karl Smith?

2. http://www.sog.unc.edu/user/148

6. "Money, for example, is a pure bubble, as its fundamental is zero."

Well, the Fed does have assets, and federal reserve notes are a first claim against those assets. The fed currently has enough assets to buy back every dollar it has outstanding. So what if they don't buy them back right now? Maybe they will do it in 200 years. So the value of the dollar now is the present value of the expected price the fed will pay for its notes in 200 years. Sounds pretty fundamental to me.

1. Except there is no backing -- the Fed does not have to permit you to swap those notes for anything except different notes. The assets are not relevant.

2. Hi Mike,

I thought you might show up to complicate things. Federal reserve liabilities are indeed not literally fiat money. Leaving out the unusual assets the Fed has recently purchased, their portfolio consists primarily of government debt, so we could think of the value of money as being linked to fiscal policy and the power to tax. That shows up in some macro theory - for example Sargent and Wallace's "Unpleasant Monetarist Arithmetic," and the fiscal theory of the price level.

The Fed is a financial intermediary, which is important. Here's a question. What would happen if the Fed attempted to sell its entire asset portfolio and retire the stock of currency and reserves? Is that even feasible?

3. But Steve, you also said this:

"Money, for example, is a pure bubble, as its fundamental is zero."

So money, at least Federal Reserve liabilities, are not fundamentally worth zero. In hindsight, if you had put this front and centre in your first post you wouldn't have Noah saying silly things like all financial assets which pay out USD are pure bubbles.

4. JP,

There is nothing that can stop Noah from saying silly things. When I said "money," I had a theoretical concept in my head - fiat money. Actual central banking is another thing altogether, though of course thinking about pure fiat money helps you understand what the central bank is up to. Note how I started this post. Words like "money" and "bubble" are loaded with baggage.

5. Ok. All understood.

This is an interesting topic though. You differentiate between fiat and central bank money. Can you think of any examples of fiat money, either current or historical?

7. Your problem is that you are wedded to the obsolete and repeatedly discredited idea of value. There is no such thing as value. There are only prices. Once you get rid of value, you don't have these silly arguments about "intrinsic value" or "effective value" or "expected value".

1. Your problem is that you're not terribly bright. I'd rather have Steve's "problem".

8. The fed, like all central banks, has assets. Those assets back its money, just as private bank assets back the money issued by private banks. The dollar is currently inconvertible into gold. But 'inconvertible' does not equal 'unbacked'. The fed might not buy back its dollars with its gold, but it will buy back its dollars with its bonds, and it is possible that at some future date, the fed will even sell off its gold in exchange for federal reserve notes. (comment by Mike Sproul. The comment software is acting up.)

2. Stephen:Of course it's feasible for the fed to sell off its assets and buy back its money. It just wouldn't be comfortable. Here's an interesting example of what happened when the American colonies did it.
--Mike Sproul

“The retirement of a large proportion of the circulating medium through annual taxation, regularly produced a stringency from which the legislature sought relief through postponement of the retirements. If the bills were not called in according to the terms of the acts of issue, public faith in them would lessen; if called in there would be a disturbance of the currency. On these points there was a permanent disagreement between the governor and the representatives, discussions concerning which reveal themselves in 1715 and traces of which are frequently found after that date.” (Davis, 1910.)

9. "The payoffs on my stocks and bonds, and the sale of my house, may be denominated in dollars, but that does not mean that the value of those assets is somehow derived from the value of money"

The numeraire (\$ in the case of the USA) is EXACTLY how we "derive" the value of an asset. Yes we can figure how to value it in Euros or Pounds or Yen too but its "valuation" is a derivation of the money system in place. With no money system in place the value would not be universal in any way. Your pigs might be worth 100 hours of my labor or 40 of my watermelons but my neighbor might give you none of his labor and two apples for the pig. Try and set up a society like we have with those operating principles at the microlevel.

1. Sure, it's important to coordinate on a unit of account. I didn't say it wasn't.

2. Yes, but that "coordinate on a unit of account" IS how asset values are derived. There can be no other way.

If asset values arent derived from value of the money, what else are they derived from?

10. So here is a story I had in mind. Assume that we perfect teletransportation (as in Star Trek) so cars become useless and their production and repair seizes. Assume also that, following a retro movie, cars become a fad, and people start collecting them. They go from having a price of zero to having a positive, potentially high price. Gradually, even people who don't share the fad become willing to accept them in exchange for money or other goods, because they hold their value well and their market is deep. Is this a bubble? If no, why not? If yes, how is it different than fiat money?

11. That's more like a commodity money. There is someone out there that actually gets utility from having the thing.

1. In the case of fiat money someone equivalent to the few collectors would be the government (who likes to get paid in its own currency). But in both cases there is a liquidity premium over that value. Does the government's preference turn fiat money into commodity money?