Money and bond bubbles: a parable

I'm using this fable to try to clarify my thoughts.

Suppose, just suppose, that Nortel shares had sticky prices. Rather than adjusting almost instantly to ensure market-clearing equilibrium, the price of Nortel shares adjusted slowly over time in response to excess demand or supply of Nortel shares.

That would mean that uninformed traders, who knew only the past history of Nortel share prices, could forecast the price of Nortel shares. Not perfectly, but it wouldn't be an unforecastable random walk. If the price of Nortel shares increased today, it would probably increase tomorrow too. If the price of Nortel shares decreased today, it would probably decrease tomorrow too. The sort of naive extrapolative expectations that create bubbles would then become rational.

But it would be difficult to profit from that ability to forecast the price of Nortel shares. If you saw the price rising, you would expect it to keep on rising, and you would want to buy Nortel shares. But who would take the other side of the trade? Only if you were lucky, and were at the front of the queue of buyers, and found someone willing to sell for idiosyncratic reasons (his car just broke down, so he needed to sell his Nortel shares to buy a new car) would you be able to profit.

Now suppose, just suppose, that in addition to having sticky prices, Nortel shares were used as the medium of exchange. So everyone was always buying and selling Nortel shares for all sorts of idiosyncratic reasons. Everyone is a noise trader too. When you sell your old car, you buy Nortel shares in return. When you buy a new car the next day, you sell Nortel shares in return.

So if you saw the price of Nortel shares had been rising, and you knew it would probably keep on rising, you would want to hold more Nortel shares. And everyone else would want to do the same. You might get lucky, and be at the front of the queue of people wanting to buy more Nortel shares, and find someone to take the other side of the trade. But if Nortel shares were the medium of exchange, there's a sure-fire way for any individual to hold more Nortel shares: simply sell fewer Nortel shares by buying fewer other goods.

As the price of Nortel shares rose, trading volume would fall, because people would want to sell fewer Nortel shares, even as they wanted to buy more, so fewer Nortel shares would actually be bought and sold. And people would notice the declining volume of trade, and the excess demand for Nortel shares, and the excess supplies of other goods, and call it a recession.

Now suppose, just suppose, that in addition to having sticky prices, and being used as a medium of exchange, Nortel shares had very safe earnings that were recession-proof, while earnings on other assets tended to fall in recessions. So if you saw the price of Nortel shares rising, you would expect a recession, and you would expect the earnings on other assets to fall, which would increase the fundamental value of Nortel shares as a safe haven. Any bubble in Nortel shares would increase the fundamental value of Nortel shares.

Now let's go back to the real world.

Government bonds are substitutes for government money. As the price of bonds rises, and the rate of interest on bonds falls towards 0%, they become closer and closer substitutes for money. So a big enough increase in the demand for bonds becomes an increased demand for money+bonds. And the price of money+bonds, in terms of other goods, is sticky, because it's just the reciprocal of the general price level, which is sticky. And money is the medium of exchange. And money+bonds is a safe haven in a recession, when the return on other assets falls.

A bond bubble, leading to a money+bonds bubble, is much more rational, and much more damaging to the economy, than a bubble in real-world Nortel shares.

Money is different from other assets: money doesn't have a price of its own; everyone is a noise trader in money. Update: and when money's trading volume falls, everything's trading volume falls too.

Comments

[RPLong]

Okay, I'm with you.

I read your post twice. The first time, I read it exactly as written. The second time, I substituted the phrase "housing and real estate" everywhere you used the phrase "Nortel shares." I didn't come across anything that weakened the analogy the second time, but maybe I don't know a whole lot about this stuff.

Now suppose, just suppose, Paul Krugman suggested suggested some 10 years ago that the way to help get the economy out of a recession was to create a real estate bubble...

[Nick Rowe]

RPLong: funnily enough, I was originally thinking of using "land" rather than Nortel shares. But land (and house) prices do seem to be a little bit sticky in fact. I switched to Nortel shares because we normally assume share prices are perfectly flexible, so I could make a clear distinction between my hypothetical and the real world.

Some economies do in fact need a bubble. But a bubble in money can be the most damaging.

[Daniel]

It's probably time to stop using Nortel shares as an example of a typical Canadian stock. Soon the youngsters won't have any idea what you're talking about.

[Nick Rowe]

Daniel: yep. But IIRC, when Nortel shares were at their height, they were something like 40% of the total TSX index?? Which means market cap/GDP for Nortel shares was about the same order of magnitude as the federal debt/GDP ratio. Yet a much bigger bubble in Nortel shares did much less economic damage than a bond+money bubble.

[Frank Restly]

"Money is different from other assets: money doesn't have a price of its own; everyone is a noise trader in money."

Government money has a cost all its own (nominal interest rate). The real interest rate is only determined after the money is borrowed into existance and cycles through the economy.

Government money has a value all its own when used to settle legal agreements (pay taxes).

"Government bonds are substitutes for government money. As the price of bonds rises, and the rate of interest on bonds falls towards 0%, they become closer and closer substitutes for money."

In a single currency system, there are no leveraged buyers of money (borrowing money to buy money). There are leveraged buyers of government bonds - borrowing money short term to buy longer term government bonds. As you move out the term structure window of government bonds, they become less and less like money irrespective of interest rate ( a one year note that pays 3% is more like money than a 20 year bond that pays 3% ).

"Now suppose, just suppose, that in addition to having sticky prices, and being used as a medium of exchange, Nortel shares had very safe earnings that were recession-proof, while earnings on other assets tended to fall in recessions. So if you saw the price of Nortel shares rising, you would expect a recession, and you would expect the earnings on other assets to fall, which would increase the fundamental value of Nortel shares as a safe haven. Any bubble in Nortel shares would increase the fundamental value of Nortel shares."

You are missing the supply part. If you saw the price of Nortel shares rising you might also conclude that the supply of Nortel shares available to buy is shrinking. You would then need to determine whether the owners of Nortel shares are risk averse OR are restricted from purchasing other assets.

[Nick Rowe]

Some monies pay interest. That interest rate is not the price of money. It is the dividend yield on Nortel shares, not the price of Nortel shares.

[Josh]

Great post Nick.

[Frank Restly]

Nick

"Some monies pay interest. That interest rate is not the price of money. It is the dividend yield on Nortel shares, not the price of Nortel shares."

If the interest payments on existing borrowed money are funded by borrowing new money then the interest rate is not the cost of money, it is the growth rate of the money supply (Ponzi finance style). If the interest payments are funded by the circulation of existing money then the interest rate is the cost of money.

[Yancey Ward]

Just curious- how much money did you lose on Nortel?

[Steve Roth]

Add: you can create more Nortel shares by simply laying down your credit card and signing the receipt.

I think (?) Frank Restly may be right: "You are missing the supply part."

[Nick Rowe]

Josh: thanks!

Yancey: none, I actually made a little, but as much by sheer luck as anything else. I sold at around $40, because my broker thought it was getting a little bit overpriced, and watched it climb and climb, with regret. I was tempted to buy back in when it went back down to a couple of dollars, but again my broker thought it might be a bit risky.

Steve: unfortunately, an IOU signed by me can be used to postpone payment, but it doesn't circulate as a medium of exchange to let me postpone payment forever. Yes, I left out the supply side, which can affect the fundamental value. That's where monetary policy comes in. Because I wanted to focus on the demand side.

[Phil Koop]

Very nicely argued post.

[Steve Roth]

@Nick: "an IOU signed by me can be used to postpone payment, but it doesn't circulate as a medium of exchange"

But the new Nortel shares that were created (which I've simultaneously given to Target in exchange for new fuzzy slippers) are deposited in Target's account, and circulate. Right?

[Alex Godofsky]

Nick:

Now suppose, just suppose, that in addition to having sticky prices, Nortel shares were used as the medium of exchange. So everyone was always buying and selling Nortel shares for all sorts of idiosyncratic reasons. Everyone is a noise trader too. When you sell your old car, you buy Nortel shares in return. When you buy a new car the next day, you sell Nortel shares in return.

I think you go awry here. As soon as Nortel shares are the medium of exchange, they no longer have one prices - they have many prices, one for each good or asset you can buy with them (I learned this from you). So you have to talk about which prices are sticky, and how much. The price of Microsoft shares in terms of Nortel shares would probably not be sticky, for instance.

[Nick Rowe]

Alex: you are right. The parable gets stretched at that point.

Steve: commercial banks can create money. But commercial bank money is redeemable on demand into Bank of Canada money, at a fixed exchange rate, and it is those commercial banks' responsibility to keep that exchange rate fixed, which is what gives the Bank of Canada ultimate control over monetary policy. Just as when the Bank of Canada decides to fix the exchange rate of the Canadian dollar against the US Dollar, Canadian monetary policy becomes under the control of the US Fed.

Phil: Thanks! (That was my second attempt to get the structure of the argument right; I didn't publish the first draft.)

[JP Koning]

This made me think of the gold speculation theory of the Great Depression. Beginning in 1928 the Bank of France and many private institutions decided to hoard gold, pushing its price up. Gold was the medium of account for most currencies, and prices were inflexible, so a massive downturn ensued. Same if Nortel were the medium of account and/or medium of exchange.

[Nick Rowe]

JP: once nominal interest rates on bonds approach zero, then the relation between bonds and money today becomes the same as the relation between gold and money under the gold standard. I think.

[Ryan V]

Maybe it just feels this way because I've already read all your other posts about it, but I think this is your clearest and best explanation yet of why the medium of exchange is Special.

I think your last post (about Japan needing a crisis) would have been better received if you had talked about "bursting the bubble" instead of a "crisis". It's the same basic process, but with fewer negative connotations.

[Steve Roth]

@Nick: "it is those commercial banks' responsibility to keep that exchange rate fixed, which is what gives the Bank of Canada ultimate control over monetary policy"

By "responsibility" I think you're saying "banks must stay solvent" or it breaks the buck. Right?

But the CB is also responsible for maintaining that exchange rate, no? If they don't issue sufficient reserves in response to new bank lending, transactions won't clear. Which breaks the buck. Ditto if they don't bail out insolvent banks (which is [sort of?] the same thing as issuing new reserves...)

The fed can adjust engine power and propeller pitch, but it can't do anything about atmospheric density. That "controls," limits, what the Fed can do without crashing or shooting off into space, hence what it will do. People who understand those physics (and the Fed's understanding of those physics) can predict the Fed's moves, which is why bond yields tend to lead the Fed funds rate.

But that is all sort of a tangent from my original implicit point:

Money --financial assets in general -- are not scarce, at least not in the same way that real assets are. (Though they appear so to individuals competing for the existing inventory.) They require no inputs to production. Production capacity is infinite and effortless -- just plunk down a credit card -- though willingness of creditors and debtors is otherwise. I haven't figure out how to model this in S/D diagrams, but my intuition is that (cf. Hicks' disclaiming) IS/LM isn't doing it.

[marris]

This is a great post Nick. I think it illustrates a money theory of recessions very well.

I have one question: Suppose I lived in your example. Wouldn't it make sense for me to keep some money in a safe-deposit box in case of recession? I could withdraw the money and use it to buy non-money goods very cheaply. Why is this not done? [Why aren't there more "firesale fund" allocations in people's portfolios?]

I think some companies do this. For example, Microsoft and Apple are very cash-rich.

I think the answer may also have to do with the relative size of credit to base money (the credit collapse dwarfs the volume of all safe-deposit boxes in existence, etc :-)

[Nick Rowe]

Ryan: thanks. Yes, looking back, it has been a long process, both to get my own thoughts clear, and to express them clearly. This time I came up with the "noise trader" analogy. I'm still thinking that one through. When I Googled "noise trader", to find a link explaining the concept, I found a number of slightly different definitions/explanations. The one I linked to (I think it's Mike Moffatt's) seemed best for my purposes. Very simple models of asset prices assume everyone is the same. But then you can't explain why assets are traded. More sophisticated models assume three types of people: informed; uninformed (who know they are uninformed); and noise traders. Because without noise traders the uninformed would just buy and hold, because anyone who offered to sell or buy must know something you don't, so you wouldn't want to make the trade. When it comes to modelling money, I think we have to assume that everyone is also acting partly like a noise trader. If I sell money to buy a car, it isn't (usually) because I have superior information about money; it's because I need a car.

Yep. You are probably right about "bursting the bubble" vs "creating a crisis". Hard to tell them apart though.

[John Salvatier]

This might be good place to mention that, I haven't been able to find a simple mathematical model of monetary disequilibrium. That inspired me to put one together, based off the backrub economy example Nick gave. You can find it here (http://goodmorningeconomics.wordpress.com/2012/04/07/the-backrub-economy-a-simple-mathematical-model-of-monetary-disequilibrium/).

Is this sort of thing publishable? I'd guess not, but seems worth asking.

[Too Much Fed]

"And money is the medium of exchange."

By "money" (a term I'd rather not use), do you mean monetary base?

"And money+bonds is a safe haven in a recession ..."

If the bonds are defaultable, will they be a safe haven? What about FDIC insured accounts?

[JoeMac]

Nick,

When you say "an excess demand for the medium of exchange," you mean money in terms of flow, not stock, right?

[steve]

So QE makes sense in a bond-money bubble?

Steve

[Sina Motamedi]

I liked this -- helped get a feel for how money works.

[Simon van Norden]

Nick: Nortel stock did not have a fixed maturity date. Govt. bonds do. Money doesn't.

That matters for the kind of bubbles that you're talking about (rational ones with representative agents.) Getting bubbles into assets with finite lives is tricky. (Allen and Gorton did a nice job of it by dumping representative agents.) It also implies that the bubble has finite life, doesn't it?

[Simon van Norden]

Is your bond-bubble is a very fragile thing?

Once bond prices are expected to fall, it unwinds rapidly doesn't it?

[Greg Ransom]

Nick,

Now go in the other direction.

And think about the relation of this investment in alternative production processes, and the whole structure of relative prices, and the whole production plans, savings plans, and consumption plans.

[Frances Coppola]

Steve,

Unless I've completely misunderstood what Nick is saying (which is not unusual) QE makes no sense at all in a bond-money bubble. At very low yields there is no preference between holding gov bonds and holding money. Investors will arbitrage any difference between interest rates on money and bond yields, so ALL interest rates are forced down. Money and bonds become indistinguishable. And once money and bonds become indistinguishable, swapping one for the other - which is all QE does - becomes pointless.

However, if I have this right, then Nick's analysis also implies that QE might actually be counter-productive when you have a bond-money bubble developing, since it would reinforce investors' expectation that bond prices will rise in a downturn.

[andrew lainton]

Nick, try also substituting in the model an asset we know has a slow turnover / is sticky housing , and replacing 'means of exchange' with 'store of value, and demands for bonds with demand for credit in anticipation of rising house prices. You have recreated Homer Hoyts House Price cycle model.

[Tomashirstmoney]

Nick,

Is there an underlying assumption here of low inflation expectations?

If the expected real return on government debt becomes negative and secondary trading is limited then would it not be difficult to justify demand as reflecting expectations of nominal price increases? Moreover, unlike the equity example the appeal of government debt would surely fall as yields move downwards and the potential upside to the value is reduced.

[Nick Rowe]

Simon: "Nortel stock did not have a fixed maturity date. Govt. bonds do. Money doesn't."

Good point. I had to think about that one. I think it means it would be hard to get a bond bubble, unless it was a money+bond bubble. Because bonds mature and pay money, you would need a bubble in both.

"Is your bond-bubble is a very fragile thing?

Once bond prices are expected to fall, it unwinds rapidly doesn't it?"

Yes, I think so. But by "prices" here we mean prices in terms of real goods.

[Nick Rowe]

Steve and Frances C: it's not QE by itself. It's what the central bank communicates about its future target for monetary policy that matters.

Andrew: Yes, housing seems to me to be an asset with sticky prices. Perhaps because each house is different. But houses aren't used as a medium of exchange, of course.

JoeMac: a stock excess demand for money creates a flow excess demand for money, because people try to increase their flows in.

marris: thanks! I think some people do keep some money (or safe liquid assets like bonds) as an insurance against recession/losing their job/income.

[Simon van Norden]

Nick: I have no problem with a money bubble, nor (when bonds yield zero) a bond+money bubble.

I worry more about the fragility issue, because I think you'd like to describe something that is persistent (i.e. hangs around for many quarters or a few years.) The goods-price of money might be sticky, but the money-price of bonds is not. I think the key element in your story is that you need agents' expected return (in money terms) on bonds to be very persistent in order for these periods of excess bond demand/supply to be very persistent.

[Nick Rowe]

Simon: I *think* I agree. With a standard Bank of Canada inflation-targeting monetary policy, for example, it shouldn't work. Suppose there were an increased demand for money and/or bonds, the BoC would just reduce the overnight rate of interest to let bond prices adjust and/or increase the money supply to satisfy that demand, to prevent a fall in expected inflation even getting started. My parable only gets going when the BoC either doesn't or can't (because of the ZLB) do something like that.

[Simon van Norden]

Nick; right.

I like parables. I was wondering whether you intend this one be be helpful only in thinking about the North American case (ZLB holds) or also some of the very depressed European economies (I'm thinking of Italy and Spain) where govt. bond yields are quite a bit higher. In the latter case, some critics of fiscal austerity have argued that a major part of the problem is excessive savings/insufficient consumption. Your bubble model features just such a mechanism. More interestingly, the two European countries I picked are Euro-members and so do not control their money supply.

[Nick Rowe]

Simon: I was thinking US and Japan. But I think you are right to include Eurozone.

[Dan Thorn]

What about Fisher?
Isn't the difference between a bubble like the tech bubble financed with equity and a financial crisis like 2008 where the bubble was financed with debt significant? I am not sure I see how Fisher's debt deflation theory is captured in your parable.
The question would be, are people actually hording money as you suggest or are they paying down debt?

[Twofish]

One problem here is that in the real world you have a central bank that intervenes to buy and sell government bonds.....

Quote: Money and bonds become indistinguishable. And once money and bonds become indistinguishable, swapping one for the other - which is all QE does - becomes pointless.

Just because things have the same value doesn't mean that they are indistinguishable. If you have a contract that requires settlement in dollars, you can't offer payment in bonds. If you have a shortage of dollars, then you are less likely to write contracts that are settled in cash which causes economic activity to grind to a halt.

Also there is default risk. Now the government won't default (well....), but if you have liabilities in cash, but you are holding bonds, you are assuming that when you need to pay your contracts, that you can go to your friendly neighborhood investment banker you can convert your bonds into cash, and we know that you can do that since investment banks never shut down..... Ohhhh....

OK. You now are worried that in an emergency you can't pay your contracts since you have reason to believe that you can't convert bonds to cash. What do you do? You hoard cash, and you refuse to spend money on anything. What will convince you to actually stop hoarding cash.....???? Well maybe if the government tells you that if you need cash, they'll convert your stuff to cash.....

There is a standard economic assumption that if the value of X=Y then X is interchangeable for Y. That works under "normal" conditions when you have a huge financial infrastructure in operation. But one of the reasons that the rules changed in 2007 was that it's obvious to everyone that in a crisis convertibility between X and Y will be in question, and once of the major challenges of the "new world" is to describe a situation in which convertibility between economic assets is not guaranteed because of credit risk.

Quote: However, if I have this right, then Nick's analysis also implies that QE might actually be counter-productive when you have a bond-money bubble developing, since it would reinforce investors' expectation that bond prices will rise in a downturn.

The thing that people are worried about in a downturn is credit risk in addition to interest rates, and not just the credit risk of the bond issuer but also the credit risk of all of the intermediaries.

Also, by and large bond trading is not driven by expectations of future prices. People at the short end of the bond yield curve aren't affected by bond price changes. People at the long end of the bond yield curve are often banks, pension funds, and insurance companies that use "hold to maturity" accounting to value their bond prices and they don't want to get rid of that status by trading bonds at which point they end up with "mark to market" accounting. Bond traders make money from short term flow and they don't care if the prices go up or down.

[Twofish]

Simon: I was wondering whether you intend this one be be helpful only in thinking about the North American case (ZLB holds) or also some of the very depressed European economies (I'm thinking of Italy and Spain) where govt. bond yields are quite a bit higher.

The role of the central bank is very important. In the case of US Treasuries, the Fed showed that it was willing to step in and in an emergency convert US Treasuries (and everything else) into cash. Even though the ECB has bought national government debt, there is much less confidence that in a crisis the ECB will step in. The fact that the Fed was willing and able to buy massive non-treasury assets like mortgage backed securities got the US out of the ZLB since even at zero treasuries interest rates, the Fed was still able to pump cash into the economy.

Come to think of it, I think that you might argue that this model really wouldn't work in the US where the Fed has shown that it is both willing and able to intervene to prevent a bond bubble, but it might be more accurate in the Eurozone or in Japan where the Central Bank has fewer resources and willingness to intervene to get people out of the trap. After some kicking and screaming, the ECB was willing to buy some government debt, but it doesn't have the ability to do the massive interventions that the Fed did.

The other reason why this might be a more accurate model of Europe and Japan is that US bond purchases are driven by the huge trade deficit with China and the oil states which adds all sort of complications.