QE and the nature of money
Izabella Kaminska has a great post over at Alphaville on the difference between private and state money. I want to pick up a small point that she doesn’t touch on directly, though I think is implicit in what she says.
The first thing to note is that a narrow definition of what does and doesn’t constitute money is not going to get us very far. It is precisely this type of thinking that lead people to assume that QE would inevitably lead to runaway inflation – moar money, moar problems. Thankfully most of the doom-mongers have since toned down their more apocalyptic predictions.
What gives an asset money-like qualities, or “moneyness”, (at least in New Monetarist thinking) was helpfully defined by Steve Williamson on his blog last year:
“[A]ll assets are to some extent useful in exchange, or as collateral. "Moneyness" is a matter of degree, and it is silly to draw a line between some assets that we call money and others which are not-money. Second, the technology determines how different assets are used in exchange. Financial innovations made asset backed securities very useful as collateral, and in financial market exchange. Those innovations changed the relationships among what we measure as monetary aggregates, inflation, asset prices, and aggregate activity. Third, regulations matter for how assets are used in exchange. Paying interest on reserves matters; paying interest on transactions deposits at banks matters; reserve requirements matter; deposit insurance matters; moral hazard problems and how they are regulated matter.”
So if we look back at pre-crisis financial markets you can clearly see financial assets, including the now infamous mortgage-backed securities, moving around the system just as easily as if they were dollars or euros. As long as people believed that the market was deep enough and the assets effectively “risk-free” then there was no barrier to them being considered equal to state-backed currency.
Yet unlike state-backed paper, when the quality of these assets are called into question their moneyness can suddenly evaporate. As Kaminska says, this can lead to a stampede into state-backed assets, whether currency or debt, or commodity backed currency substitutes. Those holding the proverbial hot potato, the private assets, find themselves unable to trade them and are left to accept the inevitable write-downs.
In these circumstances the state has two options – either supply the market with enough state-backed assets as it demands to prop up the money supply or try to reinstate the moneyness of private assets. (Or, I suppose, some combination of both). It is fairly apparent how the state could accomplish the former, either through directly printing money or increasing government debt issuance. But how can it hope to restore private sector assets to parity with state-backed money?
One way would be to commit to buying a whole lot of them. If the crisis of confidence in these assets is predominantly a liquidity concern then a central bank can help unstick the system through secondary market purchases in exchange for (state-backed) bank reserves. If the commitment is deemed credible then the private sector can get back to trading these assets in the knowledge that they can always be passed to the state in a crisis – until eventually the don’t require the backstop anymore.
Liquidity provision, however, is only temporary insofar as the limitations of private money are not seen as too great and the clear preference for state assets entrenched. In such a scenario asset purchases can bestow moneyness on any asset but only for as long as the programme sustains. Once the QE tractor-beam is turned on, it therefore becomes exceedingly difficult to remove without causing another crisis in confidence.
It is then no surprise to see people casting around for money-like instruments such as crypto-currencies or retreating into metallist fallacies to divine new (or ancient) sources of private money. If Kaminska is right, however, their search will likely prove fruitless. As she says, “the free banking system [is probably] falling apart and the state [is] doing everything it can to restore it, ideally in a way that injects stability without the need for the state becoming a universal money issuer”.
The question for central banks is whether QE can restore trust in the moneyness of private assets or is limited to creating state-backed money by proxy. If the latter then the Fed`s flirtation with tapering may come to look woefully premature.Update
For those interested, see this discussion on the difference between value and moneyness:
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