OK. Let's simplify this whole Eurozone mess.
Central banks do two things:
1. They do normal, boring, monetary policy. They keep an eye on things like inflation and unemployment or whatever, and move the money supply or interest rates up and down to try to make Aggregate Demand and the economy go where they want it to go.
The European Central Bank can normally do normal monetary policy like any other central bank. Sure, there's the whole question of whether the Eurozone is an Optimal Currency Area ("one size fits all"), but that's just a difference of degree between the Eurozone and, say, Canada.
2. They act as lender of last resort. This is the exciting part of monetary policy. But because people know that central banks will usually act as lender of last resort if they ever need to, monetary policy rarely gets exciting. Which is a Good Thing.
Anybody with assets or a good credit rating can act as a lender of last resort. I sometimes act as lender of last resort to my kids. But only a central bank can act as an unlimited lender of last resort, because only a central bank can print unlimited quantities of irredeemable money.
If you only borrow money you know you can pay back when the loan comes due, you never need a lender of last resort. You have neither liquidity nor solvency problems. But if you borrow short, and invest long, so you will need to rollover your debt when it comes due, you may need a lender of last resort, even if you know you can eventually pay your debts. You have a liquidity problem, but no solvency problem. And then there are in-between cases, where you can't pay your debt when it comes due, but you will be able to pay some of it eventually, if you can roll it over. You have a mix of liquidity and solvency problems.
Commercial banks need a lender of last resort, because their very business is to borrow short and lend long. Governments usually need a lender of last resort, because some government debt is short term, and they may be running a fiscal deficit when that debt comes due, so they need to roll it over. Even if they are running a fiscal surplus when the debt comes due, the surplus may not be big enough to pay off all the debt that comes due today. It may be very difficult to increase taxes or cut spending quickly enough and big enough without rolling over the debt. And commercial businesses may also need a lender of last resort, if credit markets freeze up, and they have borrowed short and invested long.
Even lenders may need a lender of last resort. If I have invested in long bonds, and want to sell some now to spend, I will be unable to spend if I cannot sell my bonds because the credit market has frozen.
Central banks are ideally suited to handle a pure liquidity problem. If people suddenly decide they want more liquidity, and try to switch out of government bonds, commercial bonds, or even run on bank deposits, the central bank just takes the other side of the trade, and creates the liquidity they demand. It buys government or even commercial bonds, or lends to banks, by expanding the monetary base in line with the increased demand for the monetary base.
A mixed liquidity and solvency problem is a bit trickier. The central bank Governor may need a meeting with the Finance Minister to decide whether to do the bail out. (Because the Finance Minister gets the central bank's profits, and may need to cover its losses, or else accept future inflation if the central bank prints money in future to cover its own losses.) If the government is the one that needs bailing out, the outcome of that meeting is obvious. It's less obvious in some other cases, but at least the Governor and the Finance Minister presumably share a common objective — the economic well-being of the country.
At the macroeconomic level, liquidity and solvency are not separate. If there is a liquidity crisis that is not resolved, it may cause a recession and deflation which may create solvency problems.
At the macroeconomic level, normal monetary policy and the lender of last resort function are also not separate. Acting as lender of last resort may be the only way for a central bank to prevent recession and deflation, and thus meet the objectives of normal monetary policy.
Most central banks can act as lenders of last resort. Can the ECB act as lender of last resort? If it can't, can it even meet its normal monetary policy objectives?
Even if the ECB breaks any of its own rules against acting as lender of last resort, what would be the outcome of a meeting between the President of the ECB and 16 Eurozone Finance Ministers? Anybody want to guess? Markets can't guess either.
Worthwhile Canadian Initiative 
Also: “We’re dealing with options with … no expiration…”
No, you can’t short sell indefinitely. A lender who loans you shares, charges no interest on the loan and doesn’t specify a date by which you have to return the shares has basically given you the shares. This not what happens in practice.
Stock lending requires the borrower to pay interest and the loans have a maturity date.
Adam:
Since everyone agrees that you can force a profit on an underpriced share by going long and taking delivery of the firm, I’m surprised that you’d argue against the exact opposite strategy of going short and making delivery of the firm in order to force a profit from on an overpriced share. It’s something that most finance professors could confirm, but it’s pretty clear that you won’t take my word for it.
LOL
I was also planning on going long dollars, taking delivery of the central bank, and “unlocking the value” of the assets backing those dollars, earning a risk-free profit.
Alas, other arbitrageurs beat me to the punch, and the relative price of the dollar in relation to.. the dollar rose as a result, bringing the dollar back to its fair dollar value.
On the other hand, when the assets backing the dollar fell in value, then I knew I could short the dollar and make delivery of the central bank — it is like a closed ended fund, right? — and in the process, I would earn an arbitrage-free profit. Alas — even here, I was defeated by swifter arbitrageurs that myself. As soon as the dollar price of the dollar-paying bonds fell, the purchasing power of the dollar in terms of dollar paying bonds grew, undoing my short-selling attempts. It was a vicious battle, trying to determine the “fair value” dollar price of the dollar, as a function of its backing by dollar paying bonds.
But Nick assures me that a dollar can indeed be worth more than a dollar, because of the refuge value in excess of the “exchange value”, while Mike argues that taking delivery of the central bank can allow one to earn an arbitrage free profit by shorting the dollar when the dollar-paying bonds become cheaper in terms of dollars — or is it more expensive?
😛
Ok, Mike we’ll agree to disagree.
BTW, I have a bank account with 10,000 euros in it. Would you loan me 12,622 USD (EUR/USD is 1.2622 on bloomberg as I type) if I agree to pay back either the 12,622USD or the bank account. It’s my choice which one to pay back. If you accept I’m ready to actually do this deal (we’ll adjust to a particular eurusd fixing).
Please let me know.
PS: I’m happy to pay interest on the loan. That is, if I decide to deliver the US dollars I’ll pay them back with interest (as long is the rate is no greater than what I can earn from a USD denominated deposit account).
Similarly, if I decide to deliver the euros I’ll include any interest the account has earned.
Adam P:
You’re thinking of calls with a positive strike, which of course sell for a premium. I’ve been talking about calls with a zero strike, which have no premium. For example, a call that allowed its bearer to buy $1 for 0 euros will always sell for $1, and if it ever sold for $.99 or $1.01 there would be an arbitrage opportunity on either side.
Adam P
Now that I think about it, this business of options with zero strikes or positive strikes is probably not a good way to make my point. Just think of that firm with the $60,000 bank account. Say the stock is selling for $59/share, which is underpriced. The arbitrage strategy is to buy the stock for $59,000 and take delivery of the $60,000 bank account. You might ask “Who would be dumb enough to give me the choice between 59,000 of stock and a 60,000 bank account?” Easy answer: The guy who is, by assumption, dumb enough to be on the wrong side of an arbitrage. It works the same way if the stock is selling for $61,000. Short the stock and deliver the bank account. Who would be dumb enough to go along? Answer: the same kind of guy as before.
It’s one thing for you to be arguing about options and whether they have premiums. That’s fine. But I wonder: Do you actually think that it’s possible to arbitrage when securities are underpriced, but impossible when they are overpriced?
Mike, you’re clearly not thinking at all.
In the case where the I buy the entire company for $59,000 I can take the contents of the bank account because I’m now the sole owner of the company. This sort of arbitrage does happen in real life, private equity firms make their living doing it.
In the case where the market value of the company is $61,000 I have to borrow the shares from their owner and sell them short. I now owe the owner of the company his shares. You suggest I “will deliver either the shares or the contents of the bank account” but what I actually owe is the shares. Furthermore, I can’t literally deliver the bank account since I don’t own the company.
Now, what you apparently mean is that I deliver to the owner of the shares $60,000 of the proceeds from the stock sale instead of his shares, I don’t literally deliver the bank account that the company owns (this is an important distinction if you wish to make an analogy to company with other assets besides bank accounts, things like franchise value etc.).
The question then is, if the market value of the comany is $61,000 why does the guy who loaned me the stock accept only $60,000? Why doesn’t he insist that I actually return the shares I borrowed, which are worth $61,000?
And Mike, the answer to this question: “Do you actually think that it’s possible to arbitrage when securities are underpriced, but impossible when they are overpriced?”, is that it depends on the security and the arbitrage strategy. The reason arbitrage pricing pins down the price of, say, a call option is exactly that the REPLICATING STRATEGTY doesn’t require any one agent to do something stupid.
Your arbitrage requires somebody who owns a stock worth $61 per share to accept $60 per share for his holding. Why then is it limited only to stocks that have a bank account as the sole asset. Why does the owner even need to know what the assets are? Why not go to the owner of a share of GE, currently trading at $18.21, and offer to borrow the shares with the specification that you will return either the shares or $17.21 per share, where you get to choose which one to return? How is that different?
“Do you actually think that it’s possible to arbitrage when securities are underpriced, but impossible when they are overpriced?”
To say that you are performing an arbitrage operation between an asset and currency is to say (in a convoluted way) that the asset is over-priced or under-priced. Your arbitrage operation will only succeed if you manage to predict the future price movements accurately.
The unit of measurement is currency. The unit of measurement of future value — say value 10 years from now — is the 10 year risk-free bond. The present value of future cash-flows is therefore the price of the 10 year bond in terms of currency.
It is non-sensical to talk about “arbitrage” between the 10 year bond and currency, anymore than it is sensible to talk about “arbitrage” between the inch and the foot.
Central banks operate by creating currency, and using that to buy risk-free bonds. They can also sell some of their risk-free bonds for currency (and then destroy the currency). In this way, they can adjust the relative quantities of different risk-free assets held by the private sector.
The asset side of the CB balance sheet is the residual — it measures the running total of currency created and destroyed in the past. It is like the markings on the wall your parents made as you were growing up. Looking at the the asset side gives you information about the quantity of currency in circulation, but it does not set this quantity, anymore than the wall-markings of your childhood set your height. Getting the causality right is important.
Neither does the asset side of the CB balance sheet set the general price level or long term interest rates. You need to make a lot of assumptions about supply and demand for goods, the ability of the private sector to create credit (e.g. velocity), propensities to consume, expectations, government fiscal policy and tax policy, etc. The asset side of CB balance sheets doesn’t shed a lot of insight about these things — it sheds no insight that is not already embedded in these other factors.
This is how the Japanese took care of their poorly performing loans: http://reversewealtheffect.blogspot.com/
Saturday, December 27, 2008
Quote:
Bubble is caused by peoples’ expectation that the price of certain asset(real estate) will rise in future, with pouring high-powered money to the asset side of economic entities’ balance-sheet. So, to solve this problem, such asset bubble on economic entities’ balance-sheet must be gotten rid of, by the new system as below.
Adam P:
You agree that if the stock is underpriced, then the owner will sell it to you for $59,000 even though he is giving you the choice to either sell the stock for $59,000 or take the $60,000 bank account. Yet if the stock is selling for $61,000, you won’t admit that the owner will let you borrow it in return for your promise to return the stock or the bank account. Obviously the owner is making a mistake in both cases, but you’ll allow the one mistake and not the other.
It’s a nice clean process: profit from an underpriced security by going long in the security and taking delivery of the underlying assets. Profit from an overpriced security by going short in the security and making delivery of the underlying assets.
RSJ:
So people never arbitrage against central banks? It’s especially easy to see for a convertible currency. Some central bank stands ready to pay $1 for 1 peso. But the Bank has only $99 worth of assets backing 100 pesos. So customers arbitrage by bringing all 100 pesos back to the bank for $1 each, until the last peso-holder is left with nothing. If that same bank suspended (physical) convertibility, then either the peso must trade for $.99, or rival banks will issue their own pesos to get that $.01 free lunch, or people will return their overvalued pesos to the Bank. If the Bank doesn’t use its assets to buy those pesos back, then the pesos will lose value.
Mike, you’ve completely missed the point.