Archive for August, 2010

Economising on Liquidity is Deflation’s Antidote

August 17, 2010

What is liquidity and what is it for? The most liquid asset, money, we use to make purchases. Since what we ultimately use it to buy -consumable value- is constrained by available goods and services it may be tempting to construe liquidity as being similarly limited by real economic factors. This is incorrect.

In order to examine what liquidity is, it is necessary first to introduce the concept of purchasing power. This refers to the value a saver believes should be obtainable from or in exchange for an asset. Purchasing power differs from value in one critical way: whereas value is a measure of currently consumable surpluses, purchasing power does not specify the time of consumption. While it is its offspring, purchasing power is not yet constrained by saving; it allows for some projection of future, yet-to-be-produced value too.

So, what value is to consumers, purchasing power is to savers. Consumers demand goods and services on the basis of what value they offer now in relation to their price: value is assessed at purchase before being consumed as utility, both experienced subjectively. It should not matter to one consumer what the experience of another is. Savers, meanwhile, seek instruments on the basis of how much value these ought to return in the future, which is also a subjective determination.

However, actually discovering an asset’s purchasing power typically involves the intermediary step of monetisation, either at maturity (for redeemable assets) or upon sale. Both routes hinge on savers transacting with third parties. A maturing instrument will only pay off if its issuer honours its obligations. In a sale scenario, the views of prospective buyers constrain what price is fetched. In the latter, it is the proximity of one saver’s estimate of purchasing power with those of others that tells us anything about the instrument’s liquidity. This is not something capable of being conveyed in the instrument’s spot price, but only over time as price volatility (and only then to a limited extent). While an instrument’s liquidity may be signalled by the time that elapses between offering it for sale and completing the transaction, this is a function of the degree to which the seller’s (initial) price expectations may exceed those of prospective buyers. [Note 1: For a low-order good, a consumer may come to believe that he overpaid for it, but this will not be because he miscalculated other people’s assessments: value is always a subjective matter. In matters of pricing, liquidity is relevant only to purchasing power, since (unlike value) this determination is market-mediated.]

So while goods and services must be produced or performed in order to be consumed and offer real value, financial instruments are neither produced nor consumed; they are virtual and their purchasing power largely depends on sentiment. Durable “saving” goods fall somewhere between these two poles: a house, for instance, will be bought on the basis both of its current and residual utility; any bid reflects not only its usefulness as a dwelling to the bidder (its value), but also the bidder’s expectation of what others may be prepared to bid for it in the future (its purchasing power). A house appeals to an instinct to save inasmuch as it quenches the desire to consume: as with all high-order goods, a home is not consumed at once but over time through a process of gradual depreciation. [2: The phenomenon of rising house prices told us little about the value of the homes, which was depreciating. However, it did reflect the rising price of the land beneath, which accounts for a large part of any purchase price. Since land is in perpetually short supply, it commands rent, the level of which responds positively to both output and population. The rate at which the price of homes (including those in terminal decline) was rising indicates just how much general sentiment towards future economic activity was improving. Nevertheless, where prices have been slow to fall, this is probably not because of continued favourable sentiment, but may simply signal a lack of property transactions: with borrowing costs so low, many homeowners have been able to put off selling in the hope that their homes will fetch more acceptable prices in the future.]

Whereas policy should seek to ease economic constraints on value and financial capacity, the fact that sentiment is not subject to economic constraints has been exploited by policymakers. Neither purchasing power nor liquidity is subject to any fixed gravitational pull. The former should be left well alone by politicians; the latter, meanwhile, should be economised, as I argue below (following on from previous posts). This involves swimming against the tide, since it is easy to purport abundant liquidity as being an unambiguous good. Indeed the practice of modern banking is predicated on allowing all savers to be liquid: much of savers’ assets has been homogenised, eliminating purchasing power dispersion in the process. [3: Increasingly, payments are settled not in physical money (cash) but by transfers of savings held in the form of bank liabilities (deposits). In a given currency bloc, all bank deposits are considered identical in kind, and trade at par with the central bank’s own monetary liabilities. This identity (which ultimately hinges on an implicit or explicit public guarantee) is the basis of the liquidity enjoyed by money: there is nothing to distinguish among any holdings of money except their respective nominal amount.]

If we have demonstrated that liquidity need not be scarce, we are still to identify the problem of insulating savers (prepared to forgo higher returns offered elsewhere) from market risk. The short explanation is that this transfers price volatility from savers into the market for real goods, which affects a broader group and risks introducing into production a systemic, or cyclical, character. If changes in discretionary consumption can be made with impunity, shifts in demand for the products of labour will be registered as fluctuation in the price of goods and services. Not only would consumers be punished indiscriminately by rising prices, the opposite would only tend to reduce production.

Without any offsetting positive effect on interest rates as a result of rising consumption, investment could not be expected to fall in the event prices and production grew. Yet one might well hope that some counter-cyclical weight should bring to bear directly on consumption growth. A rise in the price of goods and services cannot in itself be relied on to reduce consumption demand; indeed, the reverse would happen if acquisitions were brought forward in anticipation of even higher prices to come, a self-fulfilling prophecy capable of entrenching inflationary expectations. The flip side of this coin -a fall in consumption and prices- could lead to a postponement of purchases, dampening production, income and subsequent demand, and prodding society nearer a veritable abyss: deflation. With prices stagnant in much of the West, deflation is currently high on the agenda of economists, who look to Japan’s experience with justifiable dread.

Yet the medicine prescribed so far has been the provision to savers of even more liquidity, administered via quantitative easing (QE) programmes (explored further below). An alternative that I have proposed in previous posts is to do the reverse: to tax, and thus to economise on, liquidity. In this way, only those wishing to transact would wish to hold money, with any excess actively marketed in exchange for non-monetary (and so non-taxed) instruments. For their part, savers not holding money would have to liquidate assets in order to increase discretionary consumption above what is ‘scheduled’ by the term structure of their savings. By doing so, they face possible trading losses, especially at times of high consumption demand when the call on liquidity would rise, and with it, the rate of interest. Conversely, should demand fall, the price of various saving instruments would rise, enticing savers to liquidate their holdings and increase consumption.

Note that changes in the price of redeemable instruments, by virtue of bearing a ‘face value’, would be less prone to positive feedback and path-dependency than in the market for goods and services lacking any nominal value. And even if speculative forces were to emerge -were savers to hold on to assets in the hope of even higher prices; or were holders of money to hold out for lower prices for saving instruments- they would be held in check by the taxation of money and the related urge to economise on liquidity. Taxing money increases its velocity, which, incidentally, is the intended outcome of QE – an outcome being thwarted by the Keynesian ‘liquidity trap’.

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A desirable consequence of my proposal would be that changes in demand for goods and services would first be signalled within the financial markets: the price of financial instruments would rise and fall inversely with demand for liquidity (required in anticipation of spending). A rise in the price of instruments would signal a fall in the price of money -a decline in the rate of interest- whenever consumer spending peters off; the prospect of profit-taking would prompt some savers to consider consuming instead; also, with rates low, investors could avail themselves of cheaper financing. These responses would stimulate greater demand for goods and services, causing an increase in the rate of interest. Remaining savers would now face steeper discounts on their assets, while prospective investors would find financing more expensive to come by. Here, rising interest rates would temper demand.

In this way, shifts in interest rates would act to flatten spending cycles, cushioning the real economy from swings in saver sentiment and stripping out considerable price volatility from the markets for goods, services, labour, land and capital. In this way, cyclical (systemic) disruption to employment and income would be reduced, largely freeing the allocation of factors of production from monetary influence. As we will see further down, the price of goods and services could still fluctuate, but this would be in response to actual changes in demand consistent with myriad choices as between consumption or saving, not to speculation about the course of future prices.

Thus far I have recommended a transition from an economy addicted to the most liquid savings (money) to one that can allow much more of its productive surpluses to be represented in less liquid forms. Of course our society has already invented various vehicles that savers can hold besides money, such as bonds, pensions, insurance and equity. Whatever methods are adopted, savers’ interests always remain rooted in production: only by investing in capital can saving (not involving outright hoarding) take place.

More will be required than simply to contrast against money some ideal saving instrument: the connection between the proposed method of saving and the processes of investment must also be revealed for this alternative arrangement to be considered credible. After all, in the current banking system the functional co-dependence of saving and investment finds some expression, however warped. Banks satisfy savers’ ‘liquidity preference’ at the same time as providing long term financing to investors, silently performing the task of ‘maturity transformation’ – or better, concealing the state’s ultimate responsibility for this. Yet by supposedly shielding both camps -savers and investors- from liquidity (or market) risk, banks have extracted huge public concessions and lodged themselves firmly into the financial sector – but only by making themselves extremely fragile.

So successfully has its ‘services’ been sold to the public that most savers and investors consider banking indispensable. Not only does the public act as guarantor to savers; not only does the related moral hazard distort the rationing of financing; more than these, banks’ promotion of liquidity provokes widespread and unnecessary misery by transforming the natural ebb and flow of economic life into often violent swings in prices and production, virtually institutionalising cycles of boom and bust. Banking has ensnared savers into a liquidity trap, and ultimately foisted massive fiscal stimulus on society in a perilous bid to stave off deflation.

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In the proposed model, current banking would be disestablished, with saving funds losing all privileges. Money would face continual taxation and redistribution to all (leaving its global quantity unchanged). Raising the tax rate would increase monetary velocity, and vice versa; this tool would be the principal level of monetary policy (as explored further below). Rent would be entirely confiscated in taxation and then redistributed to all, vesting in each citizen the right to receive an equal stream of rent over one’s lifetime – a natural asset base. [4: The due-dates of taxed rental payments (though not taxes levied on money) would be staggered across the population to smooth the demand for money that would arise for this purpose. The treasury would instantly remit these collections; expediency suggests that remittances should not be uniform, but rather staged such that each individual would have a periodic (say annual) payment.]

These high quality rental assets (secured under social contract and thus free from counterparty risk) could be auctioned by those seeking liquidity (for consumption or investment purposes) to anyone wishing to save. [5: It would be worth exploring whether and how to assure a notional payout on saving instruments. For instance, per capita rental dividends could be floored as an (admittedly arbitrary) percentage of what has been distributed at any time in the past. Equally, as an alternative to private life insurance, this same percentage could be further guaranteed in respect of anyone who dies above the age of 21 until such time that they would otherwise have reached say 60. Therefore any beneficiary of their future rental allowance would be able to rule out mortality risk. With these twin safeguards, a homogeneous class of saving instrument could be constructed to account just for the guaranteed rental dividend, allowing pricing for this to be based exclusively on the opportunity cost of liquidity for various tenors (i.e. the yield curve).]

All financial transactions involving these rental receivables would have to clear through a public exchange to allow for re-registration. Additionally, this would ensure that in spite of being taxed, scarce money would have to be acquired prior to consumption (including as part of investment). [6: In other words, payments could not be settled in non-monetary instruments such as these rental receivables (whose title would be evidenced exclusively in the public registry). Admittedly, at least in theory, some payments could be effected by offering real assets; however, as now such barter operations would impose punitive transaction costs.]

In sizing how much money to accumulate, prospective consumers would take their cue from the prevailing price of capital, goods and services. Investors would supplement this with the prevailing wages and rent charged in order to hire labour and land, and could accommodate scheduled costs by compiling a portfolio of instruments with a range of tenors. As liquidity over time is being economised at each point in time, the price of money -more generally, the rates of interest across various tenors- would regulate demand into the future, ensuring it responds to changes in the supply of goods and services (by which it is always constrained). This helps to prevent sudden swings in prices, with all the associated costs on production and employment.

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As hinted previously, economising on liquidity does not mean that prices in general are unable to rise, although this would require an increase in the velocity of money. If there was involuntary unemployment, then the cost of production could be contained even as consumer prices rise, implying growth in the return to capital (producer profits), which is a condition for greater investment. The increase in productivity associated with more capital should temper price rises (and profits) after the initial surge; savers are not compelled to assume their purchasing power has eroded.
If, instead, the supply of labour were inelastic, implying that any unemployment was voluntary (leisure), then rising prices would tend to push up wages, constraining producer profits and investment. By definition, a uniform rise in general prices is, in static terms, consistent with maintained output. It is true that savers will have passively yielded purchasing power to investors, although this transfer is only known ex post; only if this leads to an expectation of further increases in price will current savers tend to liquidate assets and the propensity to save fall. The resultant increase in interest rates will depress investment. Unless this moderates inflation expectations sufficiently and interest rates ease back down, the lower levels of investment will harm future economic growth.

What can we conclude from all this? If there is involuntary unemployment, then an increase in demand and prices can stimulate expansion, and higher overall welfare. The appropriate policy response to involuntary unemployment would therefore be to increase taxes on liquidity, increasing monetary velocity, stimulating prices, profits and production. (It should be noted that with the proposed reforms, there would arguably be next to no involuntary unemployment.) At full capacity, however, rising demand raises all prices, but leaves profits and investment unchanged. With no increase in production, should the price increase create a general expectation of inflation, and therefore higher rates, the policy response should be to lower taxes on money in order to temper price gains and therefore encourage lower consumption.

At present, this monetary policy instrument has not been used. Rather, in the wake of the banking crisis, and with central bank interest rates hovering above zero, authorities have instead directly expanded the quantity of money in QE operations. In his Prices and Production, Hayek analysed what would happen if demand was ‘artificially’ increased by an injection of new money (to consumers). In his analytical framework, which countenances neither the possibility of involuntary unemployment nor its counterpart, excess liquidity, Hayek reasons that by increasing consumer prices, such ‘forced saving’ will eventually lead to productive power shifting from high-order capital projects to low-order goods, as producers seek to profit from nascent price differentiation.

In due course, as the ratio of the supply of consumer to producer goods increases, this pricing differential is eliminated, removing the initial impetus to so-called ‘less capitalistic’ methods of production (caused in effect by higher interest rates according to Hayek) provoked by monetary expansion. Consequently, as the rate of interest falls to its ‘natural’ rate, the organisation of production also reverts to what actually corresponds to real demand. For Hayek, only relative prices are meaningful, and these cannot be tampered with in the long run by changing the quantity of money – that is, unless it is repeated on an ever-increasing scale. Since this comes with its own inflationary problems, Hayek concluded that monetary policy is rendered ineffective at averting recession (in his case the Great Depression), and if authorities intensify their efforts (as many are currently predicting) this may even worsen any downturn.

What can we make of Hayek’s analysis? In his model, money is neutral and lacks any lasting ability to alter economic equilibria. Yet by ignoring the tendency for savers to hoard money, he dismisses too the evidential phenomena of involuntary unemployment. Scarcity does not guarantee economisation, and may even do the reverse: when in fixed supply, savers can profit simply by hoarding money, adding downwards pressure on prices, and thus increasing their own purchasing power. Monetarism departs from the Austrian tradition (of which Hayek was a proponent) by recognising that money can be a real economic factor. In the early 1970s, monetarist-inspired lawmakers removed the outer limits that gold’s official price had placed around the quantity of money. Banks were given the power to alter the money supply at their commercial discretion, and became hugely more influential over economic life as a result.

With banks now in utter disarray, economists from the Keynesian tradition and those of a monetarist persuasion have entered into a temporary truce, uniting under the banner of QE. Each camp seems undeterred by Japan’s experience of combating deflation in the same way. Even if abundant liquidity is an effective inflationary palliative, in order to support this measure one must either be unaware of the volatility that it unleashes or else view it as an acceptable long term cost. Whether mainstream economists are unfamiliar with the option to tax liquidity, consider it politically unpalatable, or believe it would pose greater economic costs, a debate of its pros and cons is conspicuous only by its absence. The ideal of neutral money, as illuminated by classical economists centuries back, remains a valid goal. What is less well appreciated is that allowing money to act as medium of exchange and unit of account does not require it to serve also as a store of value; it requires holders of liquidity to be charged a premium.

Neoclassical economists contend that the opportunity cost of forgoing non-monetary alternatives will ensure that liquidity comes at a premium, as measured by the excess (risk-adjusted) yield offered over money. According to this, and provided it is high enough, a premium will entice savers to release money, averting a liquidity trap. In practice, when savers’ fears mount, especially at a time of panic, their breakeven premium hikes to such exorbitant levels as to rule out economisation of liquidity. With Knightian uncertainty savers flock back into liquidity (unless unopposed). [7: As opposed to risk, Knightian uncertainty eludes parameterisation i.e. where a lack of data or methods makes it difficult to estimate probability.]

It does not help matters that the mere fear of this outcome makes the likelihood and severity of downturn all the greater. Stockpiling liquidity raises term interest rates, accelerating the journey to economic contraction; QE is an attempt to avoid rates rising on the brink of a recession. However at this juncture more is required than avoiding interest rate rises, because to maintain spending it is necessary for the liquidity premium to increase, not fall. The only way to increase the liquidity premium without also raising interest rates is to tax money. [8: This may arouse opposition on the basis that for it to circulate, money must be in demand. This is correct – though despite what may be believed, this does not mean money should be a store of value (with which taxation would of course be in conflict). Compulsory demand for money is created by general taxation; moreover, as already outlined, under my proposal mandatory use of money would be extended to include any transaction related to rent i.e. not just for payment of taxes, but also for subscription of future rent.]

Assuming it was taxed judiciously, such innovation would neutralise money. When neutral, money provides an absolute, linear scale for value, and is no more subject to artificial interference than weight is for mass. Any linear scale is divided into an arbitrary number of units; the choice of unit makes no difference to the scale, much as different numbers of ounces and grams express the same weight. (It is similarly quaint of mankind to retain duplicate currencies to denote the same amount of money). It should be self-evident that the number of units into which a linear scale is divided makes no difference to the use of that scale. Increasing the quantity of neutral money would simply reduce the coverage of each unit of currency along the value scale in indirect proportion, and vice versa. Since taxing liquidity is a precondition for neutral money, altering this tax rate is preferable to QE as a monetary policy tool, which would allow the quantity of money to be stabilised, and the breach in the link between prices and production to be healed.