In one important sense, there is a "bubble" in US government bonds, and we should be worried about it.
There is always something normative in saying that the price of something is above the fundamental value, so that people are paying "too high" a price, more than they "should", more than its "real value". I want to make that normative element explicit.
If the US and world economy were operating as it should be, with expected and actual inflation higher than it is, expected and actual real growth higher than it is, and the expected and actual return to investment in real assets higher and safer than it is, the price of government bonds would be lower than it is. And the price of real assets (like houses) would be higher than it is.
I approach the question of "fundamental value" as a macroeconomist, not a microeconomist — from a general equilibrium, not partial equilibrium perspective. If we define the "fundamental" value of an asset as the price that asset would have if all markets, not just the market for that asset, were in long-run equilibrium (and with inflation at target), then bond prices are above their fundamental values. And if we define "bubble" as a price above that fundamental value, then bond prices are a bubble.
A bubble in house prices is a bad thing. It will cause over-investment in building new houses, under-investment in other things, and under-consumption. A bubble in bond prices is a much worse thing. It will cause under-investment in everything, and under-consumption in everything, because it causes under-employment of everything. That's because bonds and money are close substitutes. A bubble in bonds causes a bubble in money. And a bubble in money can cause a bubble in bonds. Or perhaps they are just different aspects of the same bubble, in both money and bonds.
It's not the bubble in bonds per se that is the big problem. If there were only a bubble in bonds, and no bubble in money, it would be no worse than a bubble in houses. It might lead to the wrong mix of real investment and consumption (presumably too little real investment and too much consumption, due to a wealth effect). It's when a bubble in bonds spills over into a bubble in money, the medium of exchange, that we get a big problem. An excess demand for the medium of exchange is what causes, and is the only thing that can cause, a general glut of all goods. And that causes employment and output to fall, and both consumption and investment to fall.
That's why we should be worried about the bond bubble.
If the US and world economy returned immediately to long-run equilibrium, and expected and actual inflation increased to target, the price of US government bonds would immediately fall. And people who held bonds would suffer a large loss when the bubble burst. But perhaps it won't return to long-run equilibrium for a long time. That is what holders of bonds must be forecasting, because if they are right in this forecast, their decisions to hold bonds at current prices are rational.
And maybe they are right. Who am I to know better? But, like all bubbles, the beliefs that sustain the bond bubble are, at least partly, self-fulfilling. The bond bubble, and the associated money bubble, create the general glut, and prevent the economy returning to long-run equilibrium. And the belief that the economy will not return soon to long-run equilibrium is what sustains the bond bubble.
We need to burst the bond bubble. Bursting the bond bubble will help the economy recover more quickly.
Worthwhile Canadian Initiative 
Too Much Fed: I deleted 5 of your comments. Sorry, but you should really read an Intro Economics book if you are wanting answers to general economic questions. There are limits.
Note to other commenters: don’t worry about this. Nobody else is coming anywhere close to those limits.
Is this equivalent to saying that recessions are bond (or money) bubbles?
Jim: I can’t make up my mind on that. I don’t think that’s true in general. For example, if there’s an exogenous cut in the money supply, that will cause a recession, but I don’t think you could say it’s a money bubble. But I think this one is a money and bond bubble.
“If we define the “fundamental” value of an asset as the price that asset would have if all markets, not just the market for that asset, were in long-run equilibrium (and with inflation at target), then bond prices are above their fundamental values.”
The inflation caveat is interesting. It sounds like you expect different equilibria, depending on inflation. Do you think that each inflation level has its own (one and only) equilibrium? (And you are talking about a world equilibrium, right?)
“And if we define “bubble” as a price above that fundamental value, then bond prices are a bubble.”
Thanks for defining your terms. 🙂
“That’s because bonds and money are close substitutes. A bubble in bonds causes a bubble in money. And a bubble in money can cause a bubble in bonds. Or perhaps they are just different aspects of the same bubble, in both money and bonds.”
I am not at all sure that the people who are talking about a bubble in US bonds are contemplating a bond bubble that is just one aspect of a money bubble. Not that I really know what they mean, but my impression is that it has to do with a world flight to safety in US bonds. That buoys the USDollar while depressing other currencies, so we cannot simply talk about its effect on money, right?
Is a strong dollar bad for the US economy? For the world economy?
“A bubble in bond prices is a much worse thing. It will cause under-investment in everything, and under-consumption in everything, because it causes under-employment of everything.”
That’s contingent on how the government responds though, right? What if the government responds to the change in bond prices in the same way that businesses normally respond to low interest rates on their debt: by financing more marginal projects. Couldn’t that maintain employment and investment, while possibly (if it is a bubble) leading to over-investment in, say, infrastructure?
So you’re adopting the hot new definition of a bubble, relative prices for an asset that are higher than in my preferred state of the world.
The rest of us, however, are continuing to soldier along with the old-fashioned definition of a bubble: a market in which demand for an asset is driven primarily by expectations of capital gains.
Maybe you could explain why the new definition is superior? Or alternatively, why the old-fashioned Keynesian idea of liquidity preference — which is all that excess bond demand amounts to — is usefully re-labeled as a bubble?
On the other hand, that bonds and money are close substitutes is important. For sure they are; but they weren’t always. So, since the zero lower bound? since central banks started paying interest on reserves? or since when?
Min: “The inflation caveat is interesting. It sounds like you expect different equilibria, depending on inflation.”
The economy will have different long run equilibria, depending on the central bank’s inflation target. Even if we assume super-neutrality, so that real variables aren’t affected by the target rate of inflation, bonds are a nominal asset, so the equilibrium price of a bond will be lower today the higher the expected rate of inflation. So I needed to make that caveat.
I should be thinking about a world equilibrium, yes.
“That buoys the USDollar while depressing other currencies, so we cannot simply talk about its effect on money, right?”
It buoys the US$ against other currencies, but also against US real assets and real goods. That’s the problem.
“Is a strong dollar bad for the US economy? For the world economy?”
If it’s stronger than the fundamental value, then yes and maybe.
Liked your liquidity definition of bubbles better–oh maybe you didn’t draw the threads closed quite like that, but you should have.
This then ties up with the line of reasoning that there is a storage of low-risk assets. Its ‘disliquidity’ of everything else.
It all becomes the same thing, and best of all, it means bubbles are rational. Its just then that aggregate preferences are unstable.
So you can have wild prices swings much as happens when people suddenly reject peanut butter or eggs because its just been the subject of a salmonella scare, and then learn the contamination is limited.
I like it.
Nick,
Consider a standard OLG model with capital, where the competitive equilibrium interest rate is below the population growth rate (there is a dynamic inefficiency). Capital is overaccumulated in this economy (if capital was fixed, it price would exceed its “fundamental” value — a “bubble”).
Now inject another “bubble” into this economy, say, in the form of fiat money (in fixed supply). The resulting “bond bubble” actually improves economic efficiency (even if does contract the capital stock). (The effect I just described is not an artifact of the OLG structure; it holds more generally, e.g., in most NM models).
In light of this theoretical result (which I know you know), do you have any way of distinguishing if an apparent bubble is good or bad? Are all bubbles necessarily bad (the way your post suggests)? Could it be that bubbles are an imperfect market mechanism to cope with some deeper problem (an “asset shortage,” for example), and that by “popping” the bubble, we might things worse, not better?
There is another possibility. Perhaps you have the direction of causality reversed. The “excess” demand for bonds is not the byproduct of some self-fulfilling prophesy; rather, it reflects a rational “flight to relative safety” in the face of some fundamentally depressing news concerning the likely future return to capital investment.
Rob: I’m not sure. Suppose you were a business and there were a bubble in your bonds. And you knew the bubble would last for 5 years then pop. Then it would make a lot of sense to invest in 5 year projects. They pay off just when the bubble pops. But if you invested for longer than 5 years, and needed to rollover your bonds, you could be in trouble. Would that be the same for government?
JW: “The rest of us, however, are continuing to soldier along with the old-fashioned definition of a bubble: a market in which demand for an asset is driven primarily by expectations of capital gains.”
That’s not a good definition of a bubble. Some assets pay no dividends. Like Treasury Bills, for example, which just pay a fixed $100 one year from now. The only reason buy them is for capital gains, but that doesn’t mean their fundamental value is zero.
Or take houses, as a less extreme case. If interest rates are 4%, and rents are rising at 2%, then the fundamental value of a house will be rising at 2%, and half the current fundamental value of a house will be made up of expected capital gains.
“Or alternatively, why the old-fashioned Keynesian idea of liquidity preference — which is all that excess bond demand amounts to — is usefully re-labeled as a bubble?”
Precisely because the people who are now saying that bonds are not a bubble, might be lead to rethink their position, and think that in some important sense, the demand for bonds and money is too high, and that the thing we ought to be doing is worrying about this, and bursting that bubble, not propping it up. Rhetorical? Sure.
Jon: I’m actually starting to forget what I’ve written in previous posts. Did I give a liquidity definition of a bubble? Was it good?
The sort of swings in aggregate preferences I had in mind (though, maybe it’s beliefs rather than preferences, strictly speaking), is where everyone else is scared, so that scares me too, because I think of the scary things they will do when they are scared. Like trying to sell everything, buy nothing, and accumulate money. So I do the same.
David: I vacillate. I did a post once arguing we need a bubble: http://worthwhile.typepad.com/worthwhile_canadian_initi/2010/03/do-we-need-a-bubble.html
Suppose the economy is dynamically inefficient, and needs a bubble. The bubble asset could be the one we happen to use to live in (houses), or it could be the one we happen to use as a medium of exchange (money). Suppose the bubble switches from houses to money. That’s a frightening possibility. Not because the price of houses falls, but because the price of money wants to rise but can’t (I’m a sticky price guy, of course). The price of money can’t rise, because money’s the medium of account, and prices in terms of money are sticky. That means M/P can’t rise (or can’t rise quickly enough). And we are talking outside money/ money as net wealth/ base money/ so M/P would need to rise by a massive percentage amount to get any serious net wealth effect, and play the role needed to in an economy which needs a bubble.
If money weren’t the medium of exchange also, this wouldn’t be a big problem. It wouldn’t create a recession. But because money is medium of exchange, and we can’t trade without someone letting go of money, which is in excess demand, trade collapses.
Maybe we need a bubble. But if we do, there will be competition between assets to play the role of bubble asset. So we will switch from one asset to another. And we hope to God it never switches so that money becomes the bubble asset, because that is much worse (given sticky prices and a monetary exchange economy) than any other asset playing that role. But that, maybe is what just happened.
David: I found my second old bubble post, which argues that we can both need a bubble and that bubbles are inherently unstable: http://worthwhile.typepad.com/worthwhile_canadian_initi/2010/03/the-supply-and-demand-for-bubbles.html
Basically the same argument I make in my comment above.
@Nick: you object to the definition of a bubble as one where investors are counting primarily on capital gains, saying “That’s not a good definition of a bubble. Some assets pay no dividends. Like Treasury Bills, for example, which just pay a fixed $100 one year from now. The only reason buy them is for capital gains, but that doesn’t mean their fundamental value is zero.
Or take houses, as a less extreme case. If interest rates are 4%, and rents are rising at 2%, then the fundamental value of a house will be rising at 2%, and half the current fundamental value of a house will be made up of expected capital gains.”
While I think the rule as stated by JW is overly parsimonious (it should really be ‘capital gains unsupported by realistic assumptions about cashflow’, which can be restated as the Greater Fool Theory), your answer is wrong (I think). If rents are rising at 2% (let’s say long-term inflation or long-term inflation plus population growth), there is NO requirement whatsoever to say that the fundamental value is ‘made up of expected capital gains;’ it’s a realistic estimate of long-term cashflow. There’s no need to sell at all to realise the fundamental value – which IS required for the capital gains expectation.
The trick, of course, is what’s ‘realistic’ in long-term (for uncertain cashflows).
I don’t understand your objection on T-bills at all; valuation is based on a straightforward estimate (realistic at that) of cashflows. No capital gains required at all.
And this is the crux of the argument about bonds: since the cashflows are pretty certain, it is arguable about whether you can have a bubble, unless the expectation is that all purchasers of bonds expect to sell before redemption (another way of saying that the entire market is betting long). (Similar to maturity transformation, except that most maturity transformation businesses – i.e. banking – as opposed to short/long bets is based on assuming the short-term funding is stable and will roll over.)
I understand you’re making a rhetorical point (looking at liquidity preference from the ‘bubble’ point of view), but the contrary point is – it’s most emphatically NOT a bubble if purchasers of bonds believe the deflation/long-term underperformance is realistic.
The causality as you’ve stated is reversed: there’s no bubble until what’s causing the underperformance is fixed. (Of course, there is interaction – if everyone changes liquidity preference, it will result in spending/investment, but the ‘bubble’ is not the cause).
Forgot to say, thanks for the post. It is always interesting to read the question ‘reversed’ (and it usually can be), even if I disagree.
Most pleased to see this wasn’t the usual argument in favour of a bond bubble.
Nick, in my bond bubble post three days ago I have argued that Bernanke should burst the bond bubble, and there are three different senses in which we have the bond bubble at this moment:
1. As a matter of public policy, there should be more monetary stimulus and lower bond prices
2. Markets (and Krugman) are underestimating the chances (1) will actually happen
3. Bond prices are too high because of dumb trend-following traders
On Friday Bernanke threatened more QE and bond prices fell. I hope this reflects the bursting of bond bubble in the sense of (1) and (2), but not (3).
Why would the threat of QE make bond prices fall? Shouldn’t the threat of QE make bond prices rise?
According to most people, the market sold off on the news that there wasn’t going to be the near term QE that was being expected.
http://www.reuters.com/article/idUSN2727368020100827
I don’t understand the statement “If the US and world economy were operating as it should be…”. How do you (e.g.) know that real growth and returns “should be” higher?
There is much nuance to bond yields right now. I wonder how it affects your view of the “bubble”?
What stands out about declining yields is how real yields have behaved. The 5yr TIPS yield has recently fallen below zero before bouncing slightly. Implied TIPS inflation has also fallen, but is still above 1%. What does this mix imply? I don’t have TIPS-type data from Japan, but I would think the collapse in yields there was accompanied by expectations of outright deflation, such that the long term real yield was significantly positive. Here, there is no expectation of outright deflation, and investors are happy to park their money in Treasuries for zero long term real return.
To further confuse the picture, the “flight to safety” or “safe haven” explanations for zero 5yr real yields simply do not fit with other asset prices. Investment grade corporate bond spreads, for instance, are at very tight levels — indicative of little credit fear. High yield bonds are also enjoying a boom. So the bond market is sending mixed signals: corporate default risk is very low, but required real returns on a risk-less asset are zero. Further, record-high gold prices are indicative of some level of long term inflationary fear, and while TIPS inflation has declined, it is still positive. How could these prices all be reconciled?
I think the prices are indicative of expectations of Fed intervention post-crisis: 1) the market expects the Fed to engage in QE for some time to come, which creates the prospect of price appreciation in Treasuries and eliminates the need for a real return from the yield (this fits with your “bubble” definition); 2) the market fears that the Fed’s response to a deflationary episode (combined with permanently high deficits) might create much higher inflation in the future, so that the 1.2% 5-yr TIPS inflation rate is the mean of a distribution with ever-fatter tails; and 3) investors seek to hedge against both the deflation and inflation tails by buying yet more Treasuries, and also by buying gold.
The “safe haven” explanation for what is going on should be consistent across asset classes. It has too many exceptions to be valid. The “fat tails” explanation does not suffer from that problem. What it implies is that, as the tails get fatter, we should not be surprised if investment remains chronically below trend. After all, how much faith can actors have in long term real returns from projects when the possibility of deflation and high inflation co-exist? Further, if the above explanation is correct, we would expect to see downgrades to gdp forecasts continue to result in a rise in both bond and gold prices.
“It’s when a bubble in bonds spills over into a bubble in money, the medium of exchange, that we get a big problem. An excess demand for the medium of exchange is what causes, and is the only thing that can cause, a general glut of all goods… It’s when a bubble in bonds spills over into a bubble in money, the medium of exchange, that we get a big problem.”
To the degree that bonds are a substitute for money, a bond bubble relieves some of the demand that would otherwise be directed toward money. That’s a good thing in that it “dilutes” some of the demand for money that might otherwise cause/exacerbate a general glut. So the extent of the potential money bubble has already been tempered by the demand for bonds, rather than the bond bubble being a threat to spill over into a money bubble.
@Nick: Many thanks for your helpful and informative reply. 🙂
Nick,
From your old post, which you directed me to: When a bubble is big enough to satisfy people’s desire to save, the economy works well. But when it bursts, people often resort to saving in the bubble asset par excellence, money. But money is the medium of exchange. And because the medium of exchange is typically the unit of account as well, and prices are sticky, the real value of the money bubble cannot rise quickly enough to fill the space left by the bursting of the other bubble. So there’s an excess demand for the medium of exchange. And that causes a recession. Until the next bubble comes along. And that happens as soon as the growth rate picks up enough to exceed the rate of interest.
You know, this combination of ideas hangs together very nicely. (I would like to say that it is brilliant — at least, I have never seen anyone else expressing things quite this way). Let me think about it.
In the meantime, would you care to address my second point? Imagine that a recession is not caused by a bursting bubble. Instead, imagine that it is caused by the arrival of “bad news;” i.e., information relating to the future prospects over the return to capital. There is a stock market crash and investment spending contracts. Moreover, there is a “flight to quality,” as people substitute into government money and bonds (bidding up their values). An outside observer may lament the decline in economic activity and blame the emerging “bond bubble” as the culprit. But popping the bubble would, in this case, make things worse, not better. (That is, popping the bubble would stimulate capital spending, but this is precisely what you do not want to do when the expected return on such an activity is so low). The developments in the money/bond market are symptomatic of deeper causes, not immediately evident to the naked eye.
PS. A simple model that formalizes this idea can be found here (under the subtitle “Flight to Quality”): http://andolfatto.blogspot.com/2010_07_01_archive.html
Nick, I strongly agree with your view that very high (risk free) bond prices are indicative of something being out of whack, but can’t quite see how this fits in with the term ‘bubble.’ Bubble is already an extremely hard term to define, but it seems to me that the most sensible definitions referred to situations where prices that had risen more than predicted by the EMH. Now you are calling bonds a bubble even if the EMH holds for the bond market. Obviously you are free to define the term that way, but when bubbles sometimes mean violation of EMH, and sometimes do not, then things get kind of confusing.
By your definition the price of German equities in 1923 was a bubble, because their nominal price was higher than it would have been if German inflation had been running 2%, instead of 2 billion percent. If so, then even Fama could agree that German stocks were a bubble (by that definition.) But in that case the term bubble becomes so diffuse that it is almost meaningless.
How would you propose popping that bubble in ways that don’t worsen other conditions? What should we be investing in and why aren’t we?
Professor,
I do have a problem with economists claiming that the most liquid and followed market in the world is in “bubble” territory. This implies that:
1) the market for U.S. treasuries is crazy and irrational (why should we have faith in any other market price signal is then a complete and total mystery);
2) economists that are clever enough to detect the bubble before the market does could make a killing by shorting the hell out of US or Canadian treasuries (why they don’t is then a complete and total mystery)
3) the Japanese bond market has been in a bubble for at least the last 15 years (why it did not burst so far is a complete and total mystery)
Alan Greenspan went on TV last April to say that the 10-year US Treasury approaching 4% reflected the market’s concerns about the Federal debt and deficit. Of course, this is complete nonsense. Yields on US Treasuries strictly reflect expectations regarding the evolution of short term rates in the future. The very steep yield curve at the time therefore reflected investors consensus that rock-bottom short term interest rate was only a very temporary phenomenon. I wholeheartedly disagreed with this assessment and therefore invested in long dated treasuries because they appeared to me totally undervalued last April. As market consensus shifted from “low short term interest rate is only a temporary phenomenon” to “low short term interest rate will be with us for a much longer that we thought”, of course traders started bidding up the long end of the curve, thereby flattening the yield curve in the last few months.
On paper, I did make great return from my investment so far. And I am not selling. I plan to add more to my holding particularly if the long bond flirts back with 4%. As long as the Government does not declare “total war” on unemployment, the inflation outlook will remain extremely tame and so does the outlook for future level of short term interest rates. This complete “indifference for the unemployed” from the government and economists is, very unfortunately I shall say, super bullish for Treasuries and bidding up treasuries is then a perfectly rationale market reaction.
By bidding up US Treasuries, the market is begging right now on its knees for more fiscal stimulus and for the government to tackle the unemployment problem. All the while, economists are busy talking about a “bond bubble” at their garden party.
Scott,
It would be helpful if you would define what you mean by EMH. I take it to mean that financial markets are “informationally efficient,” in the sense that they rapidly capitalize all relevant information into asset prices. This does not necessarily mean that assets are priced at their “fundamental” value; in particular, certain asset classes may exhibit “liquidity premia” (for fiat money, the liquidity premium constitutes 100% of its value). So I see no inconsistency in saying that EMH holds for an asset that is priced above fundamental value.
DA
Nick, Scott has absolutely nailed it right here:
“By your definition the price of German equities in 1923 was a bubble, because their nominal price was higher than it would have been if German inflation had been running 2%, instead of 2 billion percent. If so, then even Fama could agree that German stocks were a bubble (by that definition.) But in that case the term bubble becomes so diffuse that it is almost meaningless.”
You don’t define fundamental value by discounting at the long-run steady state value of the real rate, you define it by discounting at today’s market clearing real rate.
TMDB: (from your blog): “5. Many economists think that bubbles are harmful and that the Fed should actively lean against the bubbles. Well, the bond bubble is also very harmful, as bonds are pricing in extended unemployment and below-trend inflation. Bernanke should print more money ASAP in order to burst the bond bubble.”
I should have read that, but didn’t. (Too pre-occupied with which pedal on the Fed bus is brake and gas). We are on the same page there.
GA: “If rents are rising at 2% (let’s say long-term inflation or long-term inflation plus population growth), there is NO requirement whatsoever to say that the fundamental value is ‘made up of expected capital gains;’ it’s a realistic estimate of long-term cashflow. There’s no need to sell at all to realise the fundamental value – which IS required for the capital gains expectation.”
If the current fundamental value of the house is V, current rents are R, growing at rate g, and the interest rate is r, (both g and r real, for simplicity), then the Gordon equation(?) says V=R/(r-g), and in my example, with r=4% and g=2%, V will be twice as big as if g were 0%. And V will be growing at rate g. You would rationally pay V for a house, because rents are growing, which is equivalent to V growing, whether or not you ever planned to realise those capital gains. You could realise them if you wanted to, if there’s no bubble, so P=V.
“I don’t understand your objection on T-bills at all; valuation is based on a straightforward estimate (realistic at that) of cashflows. No capital gains required at all.”
Suppose it’s a 1-year Tbill, but you only plan to hold it for 6 months. At 4% interest, it’s worth $96 today, and $98 6 months from today (approx), if there’s no bubble.
Rob: “Why would the threat of QE make bond prices fall? Shouldn’t the threat of QE make bond prices rise?”
In theory, the effect could go either way. If you buy something, that causes its price to rise. But monetary easing would raise expected inflation, and also raise expected growth rates of GDP, and those tend to lower long bond prices. This is a question Scott and I have been wondering about.
Peter: “I don’t understand the statement “If the US and world economy were operating as it should be…”. How do you (e.g.) know that real growth and returns “should be” higher?”
Well, we would return to “full employment”, and investment would be more profitable, because firms would expect to be able to sell the extra output that could be produced by the extra capital. Nothing magic or very controversial in my opinions there.
David: I don’t have much to add about your more “nuanced” picture. Yes, I’m working at a very crude level in seeing the bond market. Gold is a puzzle (as always). The other bubble asset? Willem Buiter says gold is always a bubble. I think he’s got a point.
JKH: “To the degree that bonds are a substitute for money, a bond bubble relieves some of the demand that would otherwise be directed toward money. That’s a good thing in that it “dilutes” some of the demand for money that might otherwise cause/exacerbate a general glut.”
I think you might be right, and if so, it’s an important point. I’m annoyed my head is not working properly this afternoon. I ought to be able to say it’s right (or wrong). But for some reason I’m blanking.
David: many thanks! I would love to see someone like you try to model it more formally, to check the story really hangs together logically. One thing missing from my “model” there is bonds. It’s implicitly a money-only model. Back to JKH’s point above.
On your second point. I can’t really think of a plausible news shock that would make what we have observed something vaguely like the response that even an imperfect central planner would have chosen. Arnold Kling’s “recalculation” story comes closest, but not close enough to my taste. But all I’m basically saying here is that I don’t agree with RBC theory. Nothing new or insightful. Bond prices in your model rise, but it’s not really a bubble, because the fundamental value of bonds rises by the same amount (I think).
Scott and Adam: I confess that my use of the word “bubble” here is partly a rhetorical device. But there’s also a sense in which we ought to extend the word bubble in this direction. Given the general equilibrium insight, if one market is out of whack, all other markets will be affected. We can’t really define partial equilibrium values. Graham and Dodds, for example, the bible of fundamental analysis of stock prices, and they do good analysis of individual stocks, but zero analysis of stocks as a whole. They just assume a “normal” equilibrium P/E ratio.
David A.,
“for fiat money, the liquidity premium constitutes 100% of its value”
That seems like a bold assertion on the face of it. I can’t think off-hand how one would disprove it – except by demonstrating that fiat money has some value content that is similar to what lies outside of the defined liquidity premium value zone for non-money.
Is there a way to demonstrate this assertion logically, or is it self-evident to all except those who’ve chosen not to have a career in monetary theory? 🙂
P.S. In general, I find the exercise of rigorously defining the meaning of “bubble” to be at least slightly frivolous, but in my defense, I don’t have a career in monetary theory.
Scott and Adam again. OK, I see your point now. Yep, maybe I should be defining a bubble as when the real price is above the real fundamental price? My head’s not working.
Sorry everyone, I need to take a break from blogging for a bit, to clear my head and body. It’s been too exciting a couple of days.
Time to go for a walk, or work on my car.
David: “for fiat money, the liquidity premium constitutes 100% of its value”
No, it has a certain intrinsic value because the government always stands ready to accept it as payment of taxes.
“A prince, who should enact that a certain proportion of his taxes be paid in a paper money of a certain kind, might thereby give a certain value to this paper money.” That’s it, really. (Adam Smith, Wealth of Nations, Vol. I, Book II, Chapter II).
One of the best papers you’ll ever read: http://faculty.chicagobooth.edu/john.cochrane/research/Papers/Cochrane_money_as_stock_JME.pdf
JKH: I was defining “fiat” the way it is used in contemporary monetary theory. An object that has zero intrinsic value. By definition then, if fiat does have value, it trades above its fundamental value (zero), and its value is entirely a “liquidity premium.”
Adam P: Do you believe that US government money would stop circulating if the government suddenly announced that it would not discharge tax obligations by accepting USD as payment? The answer is no, not likely. But more to the point, even if govt money is in some sense backed by taxes, it is only partially backed–the rest of money’s value is in the form of a liquidity premium. The same holds true of all assets. The key issue in monetary theory is largely the question of what determines liquidity premia across different assets.
I already know and love that paper by Cochrane. Here is a paper that I’m sure you’ll like very much too: Famous Myths of Fiat Money
Click to access 0108_0800_0805.pdf
David, of course not. After all the Argintenian government never accepted US dollars for tax payments (I assume). But when did I ever say the liquidity premium was 0% if the value?
Fiat money and bank money are exchangeable for each other, 1:1.
Bank money certainly does not have zero intrinsic value.
Is it consistent then for fiat money to have zero intrinsic value?
Adam P: got it.
JKH: An interesting question. Here’s my take.
Bank money is a debt instrument that embeds within it an American put option (you can redeem it, on demand, and…normally…at par). Historically, private banks did the same thing – they issued paper notes, redeemable on demand for specie. But moreover, these historical banknotes constituted senior claims against the bank’s capital in the event of bankruptcy. Modern day bank liabilities appear to be senior as well.
So, bankmoney is backed by more than the underlying object of redemption (specie or fiat). So bankmoney is not fiat, even though it can legally be redeemed for fiat. In normal times, the two objects usually trade at par (in crisis, this fixed exchange rate regime can break down). All of this is not inconsistent with fiat money having zero intrinsic value.
The next sentence in that idea then is that deposit insurance is the guarantee that bank money will be redeemed in to government fiat money for most people, during those exceptional times when they don’t trade at par.
David,
Makes sense, thx.
My first thought was that an option to convert something into something else with intrinsic value might give the converted entity at least some intrinsic value, but I guess the convertibility characteristic and the intrinsic value characteristic are quite separate.
“No, it has a certain intrinsic value because the government always stands ready to accept it as payment of taxes.”
“A prince, who should enact that a certain proportion of his taxes be paid in a paper money of a certain kind, might thereby give a certain value to this paper money.”
You’re switching Adam Smith’s “certain value” with your own “certain intrinsic value”. In that particular passage Smith was referring to the fact that a prince could add a premium to the exchange value of his money by making acceptable for taxes. If you read before and after that quote, you’ll see Smith locates money’s intrinsic value in its possible final redemption for gold, and gold’s intrinsic value in its labour/cost of production.
JKH: “Bank money certainly does not have zero intrinsic value.”
Why not?
Bank money is a claim on the bank’s net assets. Virtually all a bank’s assets are claims payable in a fixed value of fiat money. If fiat money has no intrinsic value, then neither does bank money. We can argue about whether fiat money has intrinsic value in its own right, but its makes no sense to start from the premise that bank money has intrinsic value.
JP, I got the quote from Cochrane’s website so if it’s taken out of context I’ll pass the blame off on him.
The quote from Smith is anyway irrelevant to the point, I don’t care if Adam Smith was really making the same point or not.
Regarding “intrinsic value”… Since we’re post-marginal revolution, why are we even talking about the intrinsic value of something? Value is supposed to be subjective.
By saying that something has intrinsic value, maybe you’re all saying it has utility? But surely both bank and fiat money have utility since we all hold both for daily use in trade, and the conversation ends there.
And now that revealed preference has superseded utility, as long is individuals show they prefer money (fiat or bank) to something else, than it has value. The intrinsic nature of something has no place in a revealed preference framework.
What do you guys mean by intrinsic? Why should anyone care about this old fashioned idea of money’s intrinsic value?
Actually though, JP I think you can argue that the original citation’s meaning is being respected.
Gernerally you’d think you can write the value of an asset as intrinsic value + liquidity value. David was saying the intrinsic value was zero, I was disagreeing.
Now, Smith may have located money’s value in its gold redeemablility but if the value of gold is entirely a liquidity value then we could say the same of the that part of the money’s value. So in that cased there’s no conflict. Or it could be that Smith meant that the intrinsic value is increased above that it derives from gold, again no conflict since current dollars also derive an amount of value based on their gold backing (the amount is zero). Again, no conflict with the original.
But as I said, it doesn’t matter. I was only disputing whether money’s value is 100% from the liquidity service.
And of course they’re not independent things, knowing that people can use money to pay taxes makes it easier to believe (if I’m ever in doubt) that they’ll trade goods for my dollars and the same applies to them reasoning as to whether or not to trade for my dollars. So having some intrinsic value enhances the liquidity value.
Andy,
I do not understand what you are saying. Bank money is a claim on a bank’s “net” assets? How do you define “net” here?
My understanding of bank money is that it represents the most senior claim against all of the assets on the LHS of the bank’s balance sheet. Some of these assets are in the form of “cash reserves” (historically specie, today fiat). A good chunk of these assets are “hard” assets, like mortgages (ultimately backed by property, in the event of default). If this is true (and I believe it is), I think JHK was perfectly correct in stating that bank money certainly does not have zero intrinsic value.
DA
This money stuff is just way too obscurantist. It’s at least arithmetically possible that we (in the US) have a full employment economy, with GDP 8% larger, employment 8% greater, household spending 7% greater, fixed investment and government spending on goods and services unchanged from now, more savings by either households or via a lower government deficit, of about 3% of GDP, and the trade deficit fairly close to nil. Also, spending by households that are now fully employed need not change, except perhaps to decrease, if that’s where the increased savings comes from. So, why don’t we? And what does a bond bubble have to do with it?
“the rest of money’s value is in the form of a liquidity premium”
Seems to me that money get’s a big part of its value from the fact that the people I want to trade with will accept it. So is ‘liquidity premium another way of saying that I can use money to store consumption utility for later use/trade? Is money a sort of option on future consumption utility?
David, I think I am assuming that values of assets equal their fundamental value. A $1 federal reserve note (or dollar bill) has a fundamental value of $1 doesn’t it? Perhaps I’m not defining fundamental value in the right way, but here’s how I think about money. In the US, the total liquidity value provided by all cash is about $900 billion in present value terms. There are real services provided by cash, which is a convenient way of making transactions. So a currency unit equal to 1/900,000,000 of the total stock of cash in the US should be worth around $1, and low and behold it is worth exactly $1. The EMH works. Does that make sense, or am I misinterpreting what you mean by “fundamental?”
“A bubble in house prices … will cause … under-consumption.”
Nick, you should really visit Vancouver some time, I think it would clear up some misunderstandings you have about bubbles. Of course, the experience in the U.S. should really have been enough pause for thought on this one. Do you really think a housing bubble causes less consumption??
I guess you’re thinking people spend more on housing, so less on everything else, but the way it works is that people spend more on houses, this prompts more borrowing, the borrowing creates new money and this money is used for consumption. The housing bubble does lead to under-investment in other things, but under-consumption, I don’t really think so.
Adam, forget about Smith. I only commented because you seemed to be describing a state-theory of money at 2:59, using Adam Smith as the relevant quote, which was surely not what Smith was describing in the Wealth of Nations, nor in the quote your provided. But intrinsic value was important to him, as it seems to be to you.
“Gernerally you’d think you can write the value of an asset as intrinsic value + liquidity value. David was saying the intrinsic value was zero, I was disagreeing.”
As per my comment at 7:44, the meaning of the words “intrinsic value” is not immediately apparent to me. If you define the word, than perhaps I can pin you down better on why you think fiat has intrinsic value.
Declan: I think the problem with your depiction, and what Nick does not acknowledge, is that the housing bubble was a symptom of a different bubble all together – a credit bubble.