(I'm not 100% happy with this post. Too much emphasis on interest rates, for one thing. I sat on it for a few days, but have decided to post it anyway. Because I like my question better than I like my answer. So let's see your answers.)
David Glasner has a very good post: Does Macroeconomics need Financial Foundations? And Scott Sumner too on: Is finance an important part of macro? Now let's ask the reverse question.
Decades ago I read Graham and Dodd. I thought it was a great book. But one thing bugged me more and more as I read it. They talked a lot about Price/Earnings ratios. And about how some firms had P/E ratios that were overvalued compared to other firms. And about how some times might have P/E ratios that were overvalued compared to other times. But they said nothing at all about what determined P/E ratios on average, across firms and across times. They just assumed there was some 'normal' P/E ratio, but said nothing about what determined it. The book was partial equilibrium analysis. It lacked a macrofoundation. Ultimately, it lacked a theory of interest rates, because a P/E ratio is like (though not exactly like) the reciprocal of a rate of interest.
Given what Graham and Dodd were trying to do in that book (help Warren Buffett get rich by choosing the right stocks) it was perhaps unreasonable for a young macroeconomist to expect anything more. But I do expect more. How can you do finance without a theory of interest rates? And I don't just mean interest rate differentials.
Here's a very simple (and totally inadequate) theory of the rate of interest: it is set by the Bank of Canada. Add or subtract adjustments for risk, duration, liquidity, and earnings growth, and you get the equilibrium earnings yield on stocks. Take the reciprocal, and you get the P/E ratio. Done.
Why is that theory totally inadequate? Because the Bank of Canada does not set interest rates in a vacuum. It sets the rate of interest it thinks it needs to set to keep inflation at the 2% target. And that interest rate in turn depends on things like the demand for goods, and the Phillips Curve, and on the inflation target. And the demand for goods in turn depends on things like desired saving and investment, both in Canada and around the world. And those in turn depend on time-preference, and expectations of future income, and on the marginal rates of transformation of present goods into future goods, and whether there will be a demand for those future goods or a recession.
And the Bank of Canada is only able to set interest rates at all because its liabilities are used as money. And the liabilities of commercial banks that are also used as money are valued at par with Bank of Canada liabilities because those commercial banks peg their exchange rates with Bank of Canada liabilities. And Bank of Canada liabilities are used as the medium of account, as well as a medium of exchange, so if there is an excess supply of Bank of Canada liabilities the value of those liabilities will fall, which means the prices of other goods will rise. And if people expect prices to rise you need to distinguish between real and nominal interest rates, and ask how monetary policy affects both.
And those monetary liabilities are used as media of exchange, and that what makes media of exchange special is that they have no markets of their own, but are traded in all other markets, and so talking about "the money market" is nonsense, because all markets are money markets. The bond market is a money market; the stock market is a money market; the labour market is a money market; the supermarket is a money market. The foreign exchange market is a monies market.
And if the Bank of Canada tightens monetary policy, does that mean lower or higher interest rates? Well, it depends, on things like the slope of the IS curve, and how it affects people's expectations of future inflation and future real growth.
And are Ponzi schemes really unsustainable, and destined to burst like the bubbles they are? Well, not necessarily; if the rate of interest on Mr Ponzi's liabilities is less than the growth rate of the economy, it might be sustainable. Look in your pocket, and you will see an example of just such a financial asset. It's paper currency. There may be more.
If the first principle of finance is the "time value of money", aka the rate of interest, how can you even begin to understand finance without having a solid money/macrofoundation?
It is even possible for the "time value of money" to be negative, as Silvio Gesell showed.
Can you do finance while knowing nothing about any of that stuff? Well, I expect you can. But is it a good idea?
Worthwhile Canadian Initiative 
A quibble: this isn’t really true. Really anyone with sufficient wealth could set interest rates. Imagine I owned all the oil in the world. By trading oil for bonds (using money as an intermediary) I could in principle control interest rates through the same OMOs the central bank uses.
It is just a lot easier for the central bank to do this because they can just print the money they need.
Alex: If it came to a fight between me and the Bank of Canada, both trying to set interest rates on Canadian dollars, I think I would lose, no matter how much wealth I owned. Because I promise to redeem my liabilities for BoC liabilities (not vice versa), and the BoC can make the make its liabilities go from $0 to plus $infinity (as long as it has paper and ink).
Unfortunately, the fundamental principle of finance is not time value of money but the fundamental theorem of asset pricing (the no-arbitrage principle, in essence) – given expectations of the future.
And you can do a lot without assuming any making any equilibrium assumptions at all (except for that of information-equilibrium).
Also, it remains a good idea to do finance even without understanding where the equilibrium rate comes from. There are plenty of variables which have orthogonal components to interest rates – hazard rates, volatility etc. Finance is about determining the fair value of claims and uncertainty associated with that fair value. Macroeconomics provides just the expected time-evolution of one of the variables it deals with (albeit an extremely important variable).
Akshay: In a world with zero transactions costs, the price of one apple + the price of one banana = the price of a bundle with one apple and one banana. Etc. Or there would be arbitrage opportunities, for people to bundle or unbundle apples and bananas. But that doesn’t seem to get you very far, in explaining the prices of apples and bananas.
Nick: That’s precisely the wrong variety of no-arbitrage example I am talking about.
No arbitrage talks about the relationship between risk and expected return. The financial crisis was entirely about being unable to find a single market price of risk to price assets off – which reduced liquidity drastically – the causative factors may have been macroeconomic – but not the mechanism.
By the way, (the price of one apple + the price of one banana = the price of a bundle with one apple and one banana) is the kind of “theorem” FTAP warns you against. You are citing a very simple triangulation-arbitration example. FTAP does far more than that.
A bundle of banana+apple may have different risk characteristics as opposed to a banana and an apple held in isolation (diversification effects). They will be priced differently by different agents depending on their risk preferences.
Finance built on the foundations of FTAP gives you the fundamental insight that the relationship that holds between the bundle and the independent fruits in a risk-neutral world will continue to hold in some form or the other in a risk-averse or risk-loving world – and that relationship is the market-price of risk [1]. And it’s when market participants are unable to agree upon a unique such price, that nominal shocks occur in the general economy.
It’s not finance, at this point, which needs to learn from economics, I think – it’s the other way round.
[1] – http://en.wikipedia.org/wiki/Fundamental_theorem_of_asset_pricing
Akshay: “A bundle of banana+apple may have different risk characteristics as opposed to a banana and an apple held in isolation (diversification effects). They will be priced differently by different agents depending on their risk preferences.”
Suppose people like to eat apples and bananas together; they are complementary goods, and give you a balanced diet when eaten together. It is still true that Pa+Pb=P(a+b).
Even if some people like apples more than bananas, and others like bananas more than apples, it will still be true that they all face the same equilibrium price for apples, and price for bananas. All people who consume both goods will have the same ratio of Marginal Utility of apples/Marginal Utility for bananas.
What really matters is the covariance of the returns on an asset with the Marginal Utility of consumption. Done properly, CAPM is a macromodel, that has an underlying theory of business cycles.
I would say that considering how finance people are getting involved more and more in the monetary policy I would say that getting some information about macro/money would be very beneficial. I would say that in many instance even basic micro course would not be wasted either. At least we would not have discussions where words with a very specific meaning like “demand”, “inflation”, “interest rates”, “aggregate supply” etc. when they are thrown without notion what they actually mean in econ language whey they are ordinarily used. Just an example, there was a moment in a very good discussion with Cullen Roche where he said: “The whole point is that there really is no “supply of loans”. There is a bank’s willingness to make loans to creditworthy borrowers”. Which is actually a pretty good and concise definition of supply of loans.
To me these discussions are a lot about what David Glasner said on comment section of his post:
“I am trying to understand why that might be the case. There should be some way of expressing the financial view in the language of macroeconomics, but I don’t think that I have yet figured out how to translate one language into the other.”
And so far these translations were pretty poor. The fact that some people who seem to know a lot about both worlds like JP Koning do not seem to find finance view as particularly useful explanation of what is actually going on make me incline that maybe there may be no golden nugget hidden here. But I keep my mind open.
Take an example: suppose there are two types of apples trees. Hot trees give higher yields in hot summers, and cold trees give higher yields in cold summers. Which tree is worth more? If the marginal utility of an extra apple is greater in a hot summer than in a cold summer (either because people like eating apples when it is hot, or because there are fewer apples in total when it’s hot, or because the banana crop fails when it’s cold, or because the money supply shrinks in hot weather so you get a recession, or whatever) then hot trees are worth more. You need a macromodel to tell you which of the two assets is worth more.
JV: what you say there sounds right to me. But on the other hand, a lot of Finance people do seem to me to be really smart (like ones that comment here, for example), and a lot of stuff that happens in financial markets does sound really complicated, and I know I don’t understand a lot of it, and I get a really uneasy feeling that I’m missing something there that they understand that would be important to me for macro if I understood it better.
I wish I understood shadow banking better.
I have a sense that a lot of it is really simple deep down, or could be simplified. It just needs a better way of thinking about it.
Must check in on David’s post, to see if any of the finance guys answered my 3 simple questions about QE and safe assets.
Nick: “It is still true that Pa+Pb=P(a+b)”
That’s what I’m trying to refute. The “P”‘s on the left side of the equation are not the same as the P on the right side of the equation.
The market will quote two different prices for the bundle and the independent assets (in isolation). And, in general,
P_a * q_a + P_b * q_b = P_bundle * q_bundle does NOT hold
(where P_a = price of apple, P_b = price of banana etc q’s are quantities and q_bundle = q_a + q_b).
This is the reason an index future like one on the S&P500 does not trade at the same level as the weighted sum of prices of individual component-stock futures. The index-future enjoys a liquidity premium (or even a risk discount) as it is easier to hedge the index-future than a basket of individual stocks.
Also, CAPM is a very well-founded micro-model emanating directly from Arrow-Debreu general equilibrium and Black’s theory for pricing contingent claims – it’s a mathematical result of FTAP (under the assumption of VNM utilities for agents) – it’s not a macro-model.
Nick Rowe: “Suppose people like to eat apples and bananas together; they are complementary goods, and give you a balanced diet when eaten together. It is still true that Pa+Pb=P(a+b).”
But it will not be true in general that P(na) + P(mb) = P(na + mb).
I know that there are a lot of smart finance people. But then I know a lot of smart people who believe some weird stuff especially if it is not something they are trained to deal with.
Look, the way I see it is that Krugman’s babysitting co-op did not need complex shadowbanking dealing with derivatives and market plumbing to explain the gist of what is going on during recession according to modern macro. There are videos on youtube explaining the basic idea behind AD/AS model in less than 15 minutes. And I know that there were even some finance people who were quite impressed with explanatory power of your “simple” banking story.
So the fact that I did not see something similar in comming out of finance angle to macro makes me suspicious. And I have some history of studying heterodox ideas. I for instance have some experience with Austrian models of business cycles – at least as they are laid out by one Roger W. Garrison. I do not agree, but I do understand. I cannot say so about this finance stuff. But yeah, like I said I am still open minded.
Ashkay: If there are transactions costs (if some goods are illiquid) then I agree that Pa+Pb =/= Pa+b.
But, absent transactions costs, risk alone won’t prevent Pa+Pb=Pa+b. Because people will just do the bundling or unbundling themselves, whichever is cheaper.
Yep, we normally say Arrow-Debreu is micro rather than macro, despite it’s being general equilibrium. But macroeconomics, as a field, largely came into being because economists recognised that Arrow-Debreu and earlier Walrasian general equilibrium theory didn’t seem to be able to explain the macroeconomic facts very well (some real business cycle theorists might disagree). Arrow-Debreu is an economy without money. It has one market, that opens at the beginning of time, where all goods are traded at the same time against all other goods. Then that market closes, and never reopens. If Arrow Debreu were true, there would never have been a financial crisis.
And all goods are perfectly liquid in that great Arrow-Debreu market that opens and closes again at the beginning of time.
I should actually point out (before people jump on me) that the piece that we do use in financial economics is the concept of an Arrow-Debreu security (also used quite generously in the Arrow-Debreu GE model – which is generally known as a macro model). Black further enhanced it with his theory of replicating portfolios under uncertainty – and it was refined still further by a lot of quantitative finance experts to become what is now known as the fundamental theorem of asset pricing (with Fama et al providing fundamental empirical evidence to support arbitrage-pricing theory – where it works and where it doesn’t).
Nick,
“And the Bank of Canada is only able to set interest rates at all because its liabilities are used as money.”
In the United States, the federal reserve was established in the 1913 Federal Reserve Act that gave federal reserve notes legal tender status. The ability of the federal open market committee to set bond market prices (the inverse of interest rates) didn’t come until the banking act of 1933. And so interest rate setting and legal tender status are not joined at the hip.
A central bank can issue medium of exchange liabilities without setting interest rates and it could conceivably set bond market prices (inverse of interest rates) without having its liabilities used as a medium of exchange. For instance a central bank (or any bank) could offer equity in the bank for bonds sold by the government – in essence bartering one non-monetary liability for another.
On a more philosophical note, the fundamental dichotomy I see between finance and economics arises from their treatment of risk. Econ models use rational expectations with mixed Nash equilibria etc or NK models with stochasticity thrown here and there (eg in DSGE models).
In finance, risk is a first-class citizen and the modelling and calibration of the parameters of the stochastic processes driving it forms the paycheck of many a quant on Wall Street. Risk is what drives prices of all financial assets and is fundamentally orthogonal to what the natural/equilibrium “risk-free” rate of interest in the economy is.
OT: A complaint about a recent change in the site.
When I load a page, it seems to take 30 sec. to 1 min. to load (depending on network traffic, I guess). During that time I cannot do anything but wait. Clicking on the comments link, for instance, does nothing. Apparently what is happening after the first few seconds is that little images are loading for the buttons for Twitter, Google, Facebook, etc. As there are several of them per page, it takes a lot of time.
JV: I’m really pleased they liked my little banking story. There is really very little (nothing?) new there, though I am proud of making it simple.
The one thing I really wish I understood better about Finance is liquidity. I do tend to slip into a mode of thought in which “money” is perfectly liquid and all other goods are equally illiquid. And JP Koning keeps insisting that’s not right, and he’s right to do that. Though I still think there’s something special about the most liquid good (“money”), and that it’s a winner-take-all race, so that the winner of that liquidity race has a difference in kind and not just in degree.
I’m rambling.
I see David Glasner addressed my points on his post. The finance guys didn’t.
Nick:
“Arrow-Debreu is an economy without money. It has one market, that opens at the beginning of time, where all goods are traded at the same time against all other goods. Then that market closes, and never reopens. ”
That’s not true. Areow-Debreu models handle multi-period economies. It also has money (the risk-free numeraire and forms part of the allocation bundle).
“But, absent transactions costs, risk alone won’t prevent Pa+Pb=Pa+b. Because people will just do the bundling or unbundling themselves, whichever is cheaper.”
Again – not true. You are attributing the bifurcation of these prices to “transaction costs” whereas the bifurcation actually happens because of risk preferences of the agents in the economy – ie the uncertainty related to the future payout of an asset/bundle.
Ashkay: “Risk is what drives prices of all financial assets and is fundamentally orthogonal to what the natural/equilibrium “risk-free” rate of interest in the economy is.”
Hmmm. I thought that one of the basic insights of CAPM is that the only risk that matters, in equilibrium, is undiversifiable risk. There is risk that is undiversifiable because of problems of asymmetric information (moral hazard/adverse selection). Aside from that, the only undiversifiable risk is macroeconomic risk. Booms and recessions. And that risk is not orthogonal to the natural rate, or to the rate of interest set by the Bank of Canada. It is no accident that real and nominal interest rates are very low in this recent recession.
Actually I must qualify that statement. The canonical Arrow-Debreu model is a two-period economy with an inadequate treatment of money. Radner et al later formulated derivative models which do handle such deficiencies.
Frank: yep. I don’t really believe that central banks really (let alone always must) set interest rates. But most people do believe that, so it seemed a good place to start. They certainly affect interest rates though.
Min: sorry to hear that. I’m having no problems getting WCI to load. Is anyone else?
Nick: “I thought that one of the basic insights of CAPM is that the only risk that matters, in equilibrium, is undiversifiable risk. There is risk that is undiversifiable because of problems of asymmetric information (moral hazard/adverse selection)”
True. I would rather phrase it as “unreplicable” risk (via other assets) – which is where the orthogonality comes from. So, the return over the risk-free rate is proportional to the magnitude of unreplicable risk you’re willing to take on (and the constant of proportionality is the market price of risk).
Most of implied macro-risk in advanced economies is completely diversifiable with financial derivatives. It’s the realized risk that leads to realized above-normal returns (positive or negative). Financial assets are priced off implied-risk- not realized risk (although it feeds into the calibration of implied risk in some models).
Ashkay:
Arrow-Debreu has multiple periods, as many as you like, but the market only opens once, before time even begins.
“It also has money (the risk-free numeraire and forms part of the allocation bundle).”
That is absolutely not money. Money is the medium of exchange and medium of account. The Arrow-Debreu has no role for either. A “numeraire” is the good the modeller uses to measure prices. The medium of account is the good that people use to measure prices. And money is certainly not risk-free. Zimbabwe.
Ashkay: “You are attributing the bifurcation of these prices to “transaction costs” whereas the bifurcation actually happens because of risk preferences of the agents in the economy – ie the uncertainty related to the future payout of an asset/bundle.”
I disagree. Can you give me a simple example, with zero transactions costs, so I can understand what you are saying.
“And money is certainly not risk-free. Zimbabwe.”
Money is totally risk-free (capital protected) in nominal terms. I hold a 100-dollar bill in my pocket. I will get a 100-dollar bill for it tomorrow from my friend regardless of what inflation/interest-rates are.
Bonds, on the other hand, are not risk-free – even in nominal terms.
Ashkay: Money is 100% risk-free, in terms of money. Copper is also 100% risk-free, in terms of copper. So is any durable good, in terms of itself.
Example of why a bundle’s market price differs from an equivalent combination of assets purchased in isolation:
E(r_bundle) = E(r_f) + m * risk_bundle
E(r_a) = E(r_f) + m * risk_apple
E(r_b) = E(r_f) + m * risk_banana
risk_bundle = sqrt(risk_banana^2 + risk_apple^2 + 2*cov(r_a, r_b))
m = market price of risk, r_x = stochastic return of asset X, risk = std-dev of returns of that asset, r_f = risk-free rate, E=expectation operator
Expected return on a bundle is different from the sum of expected returns on the individual assets. Why would the market pay the same price?
The only place it all adds up to be beautifully equal is where the market-price of risk is zero – ie a risk-neutral world. But the world is not risk-neutral.
Nick: “Money is 100% risk-free, in terms of money. Copper is also 100% risk-free, in terms of copper.”
Exactly. Why is a bond, which is just the discounted cashflows of “money” not risk free in terms of money? Do you now see what a risk-free asset is in terms of the numeraire?
Ashkay: cars would be worth less, if there was no gas. Gas would be worth less, if there were no cars. But that doesn’t mean that a car with a full tank of gas sells for a higher price than a car with any empty tank plus the price of a tank of gas.
Akshay: sure. But the modeller can make any good he chooses the numeraire. The Arrow-Debreu model only determines relative prices. With n goods, there are only n-1 relative prices. The modeller can choose any good he likes, and set its price equal to 1.
Take the equilibrium. Now divide all prices by the price of copper. Copper is now the numeraire, and the price of copper = 1. But it makes no difference to the equilibrium. It doesn’t make copper a “risk-free” good.
Agreed – the numeraire need not be risk free (except in its own terms). In the Arrow-Debreu model, it is – and I totally agrre it’s not a representation of reality.
However, financial asset risk can generally be broken down into two components – one due to the uncertainty in its “utility” in real terms and the uncertainty due to the choice of the numeraire.
I was doing an MA last year and took several mathematical finance classes — and this is exactly the kinda stuff I would think about. I can’t remember exactly what I did, but as a starter I tried to adjust many of the models used there to have some sort of relation between inflation and interest rates, and the fact that the BoC is targetting 2%. I didn’t have much success, unfortunately.
BUT, I definitely think it is important for macroeconomists to know financial mathematics, and vice versa. I can’t explain why exactly, but it certainly helps with the intuition in understanding things. (Financial mathematicians, for example, don’t understand monetary policy at all — and it is very important that they do.)
Nick: “cars would be worth less, if there was no gas. Gas would be worth less, if there were no cars. But that doesn’t mean that a car with a full tank of gas sells for a higher price than a car with any empty tank plus the price of a tank of gas.”
That’s because you’re risk neutral. Let’s make you a bit risk-averse.
Say you’re stuck in a desert with your car on an empty fuel-tank with the nearest gas station “half-a-tank” away – but the gas station may or may not be open. Your home is a “full-tank” away.
An angel comes down and offers you two choices: (money for half a tank of gas + half a tank of gas) OR (a full tank of gas).
Which one would you choose? If the angel turned out to be a mean businessperson, wouldn’t s/he quote a higher price for the second portfolio (considering you’re risk-averse)?
PS: You’re spelling my name wrong 🙂
Nick, I think you are using “finance” in a couple of different and incompatible ways.
As usually understood, finance is entirely about relative prices, partial equilibria, a glorified system of interpolation. I don’t see how it could possibly inform macroeconomic theory.
What about the other way around? Sure, in principle a general equilibrium model could tell you the proper price of each individual asset. But to be arbitrage-free, such a model would have to be quantitatively very, very accurate. As a practical matter, that is an absurd proposition: the state of the art can’t even produce a model with reasonable qualitative properties, in total.
The question of what is the “fundamental” value of an asset is not within the purview of finance. If macroeconomists could answer this question, then of course that would be of interest to investors. But if investors knew the fundamental value of all assets, they would have implicitly solved your G.E. model, would they not?
Here is a thought experiment that may be pertinent. Suppose at time, T0, the price of an apple and a banana are each $1, and that people always consume them together, one apple and one banana. Suppose also that their prices are perfectly negatively correlated, so that at any time, T, the price of one apple plus the price of one banana = $2. (No inflation, but we could add it in.)
Consider two scenarios.
Scenario 1) At time, T0, each person has n apples and n bananas. They are otherwise employed keeping the economy humming along optimally. At time, T1, each person eats one apple and one banana.
Scenario 2) At time, T0, half the population has 2n apples and half has 2n bananas. They are otherwise employed keeping the economy humming along optimally. At time, T1, each person wishes to eat one apple and one banana. But now, because of the weather, each apple costs $1.50 and each banana costs $0.50. Say that the people with bananas now do extra work to pay $1 to each of the people with apples. By assumption, this extra work by half the population is suboptimal. There may also be an argument that the transfer of money is suboptimal. (See Bernoulli’s Moral Value of Money.) There may also be an argument that, because of risk aversion on the part of the population, the loss in the price of bananas is worse than the gain in the price of apples.
Hmmm. I think that we can tighten the risk aversion argument in scenario 2) by positing time, T2, when each apple costs $0.50 and each banana costs $1.50. (The shoe is on the other foot.) Even granting that we cannot compare subjective gain and loss across persons, each person will have gained less when the price of his or her fruit went up to $1.50 than he or she lost when the price went down to $0.50. The net result of the swings is a loss for each person.
I agree finance is all about relative prices and accepting interest rates as given, but when it looks at history, like Graham, there is an implicit assumption of a mean and reversion to it even without a restoring force or an indication of when or how it will. In this very long view, growth is constant, the real risk free rate is zero, the real risk adjusted bond rate is the growth rate, and that our best guess is the future will be similar to the past, since the industrial revolution, not any further back. I get a vague sense of a belief in Friedman’s plucking model behind it.
Akshay: “Most of implied macro-risk in advanced economies is completely diversifiable with financial derivatives.”
Are you thinking just interest rates, CDS, … but, what about operational risk (declining auto sales)? Companies do use interest rate swaps, FX forwards, but when I go through company financial reports, they are never material. Most companies “hedge” macro risk by maintaining liquidity and minimizing large fixed costs and long-dated liabilities.
Your answer may elucidate, why doesn’t finance departments of the real economy do more macro hedging, if it was important?
jt: I should have qualified that sentence with “financial risk arising directly out of the uncertainty in macro variables”. You’re right – operational risks are a separate and largely unhedgable with financial instruments.
The overall economic uncertainty can be broken down into uncertainty in the “operational”/”real” economy and the “nominal” economy. Transactions happen at nominal levels, investment and financing take place at nominal levels.
Operational decisions on the other hand are taken (or should be taken) based on the state of the real economy. But quite often they aren’t – nominal variables serve as a proxy for the economy’s performance. Now, ideally we’d want nominal variables to paint an accurate picture of the real economy – but sometimes, they don’t.
Can we affect the real economy by adjusting risk and return levels in the nominal economy (via price/wage rigidities or some other channel – like term risk reduction/boosting money velocity by inflating collateral prices etc)?
That is the topic of the decade. So far, the effects of nominal policy-making have been undeniable – whether it be through QE or forward guidance or plain old short rate-cuts.
Nick, I am an investment guy who came to money/macro for almost the precise reasons described in your post. My take is that the trenches of dealer and treasury desks create a brain fogging myopia that enlarges beyond reason the importance of things like liquidity constraints and collateral haircuts in informing a practical macro model of the world. I understand, for example, a lot of what Izabella Kaminska likes to dive into (and I think she does a very nice job of it), but I almost never think it leads her to say any useful (or entirely coherent) about the supposed macro implications. I also think a lot of smart Macro-centric guys like Tyler Cowen are a little too respectful of the putative import of these kinds of trading desk jargon filled reality checks. And although I don’t share your “difference in kind not difference in degree” approach to thinking about the special liquidity characteristics of the medium of exchange (I think the only difference in degree that matters enough to be called a difference in kind is the MOA function), I still don’t think a deep dive into the intricacies of tri-party repos, shadow banking, and relative liquidity would likely be useful to you. You won’t ever wake up a New Monetarist. Even for very smart people, learning too much about finance is basically a prescription to intermittently forget about joint determination and underestimate the importance of expectational games.
But some of the most insightful stuff I’ve read works hard to combine a finance and macro view of the world. Like Cochrane’s Money as Stock paper. The vast majority of letters from great, brilliant hedge fund managers commit major and basic macro malpractice. It would be great to see you write a bunch of posts on the macro foundations of finance. Brad Delong sometimes writes good stuff like this too.
A rant (since I’m liking this post so much):
A few years years ago, when I was in college learning financial economics, the professor mentioned in class:
“One half of finance is about interest rates. The other half doesn’t quite matter.”
Some years of quantitative modelling of various asset classes in both the buy and sell side of finance in the backdrop of the biggest financial crisis my generation has seen has made me realize how true that statement was.
But the statement is not profound for what it says explicitly, but what it means implicitly.
The overt meaning might give economists much joy as validating their science as providing the fundamental input for all of finance (which is all about relative prices anyway, no?)
The implied meaning is much more powerful. It’s the nominally risk-free yield curve (we call it the zero-curve – there are two other popular varieties – forward and par-swap – and a super-duper important one now – the OIS) and the interplay of the various risk-premia that play out on top of that is what drives the plumbing of the monetary system – both via signalling of macro behavior and by providing the incentives to set the wheels in motion – at least in a nominal economy.
No, you don’t need to know how multi-curve discounting involving cost-of-tenor and cost-of-funding surfaces takes place in the modern world to price collateralized interest-rate swaps.
What you do need to know, however, are the fundamentals of financial economics. Why risk matters for the nominal world, how it affects the plumbing in the financial system etc.
I’d be accused of being a dweller of the concrete steppes for making such a statement – but any policy based on theory disregarding the institutional perspective (and hence nominal risks) of the macroeconomy and relying purely on equilibria assumptions – should come with a big “caveat emptor” sign pasted on it.
Good comment by dlr. As an “investment guy”, I agree with a lot of what he says.
And a good discussion by Nick. I like to think that both sides can inform each other. Hopefully I can give a better comment when I have the time.
But for the time being, here’s an interesting tidbit. Many people don’t know that Ben Graham was also a macroeconomist/monetary economist. He was not formally trained, but he was good enough to get an article in the AER. Read Perry Mehrling:
Click to access monetary_economics_benjamin_graham_revised.pdf
Which speaks to the general point that perhaps there are ways to combine the finance and macro views.
Nick,
You are calling “money” a “liability”, and in this post, a liability of the Bank of Canada. I certainly do not think of money as a liability of anyone. I do consider money to be “Evidence of Debt”.
I only have green U.S. Dollars in my wallet but there is nothing on that bill to indicate it is a liability to anyone. It does say on it “THIS NOTE IS LEGAL TENDER FOR ALL DEBTS, PUBLIC AND PRIVATE” for what ever good that does.
Now I do know that when I take a loan or make a loan, I exchange these notes for a promise to repay. Banks do the same thing. Governments do the same thing. All the evidence is that these notes that we call “money” are nothing more than “Evidence of Debt”.
I accept this “Evidence of Debt” because it is like receiving a gift certificate. In fact I rather like receiving money because I can buy just about anything with it, I just need enough.
Once in a while, I have more than enough money. I can lend a little. Nice! I will ask some interest rate, maybe negotiate a little, and trade my gift certificates for a promise to repay.
When I borrow, it is to accomplish with a large block of money, something that can not be accomplished with a small block. Yes, I am not doubt impatient and maybe anticipated inflation has something to do with my motivation. As an older gent, I have seen borrowers get badly burned, so inflation is not much of a impetus; it is much more important to be a able to cash flow a loan and maintain a fall-back position, all while cutting the bank into the deal with an interest carve-out that reduces loan attractiveness.
Do low interest rates help? Of course, but loan payback is the really important criteria.
test
If I can get Nick to take me seriously, I’ll attempt an explanation.
“And the Bank of Canada is only able to set interest rates at all because its liabilities are used as money. And the liabilities of commercial banks that are also used as money are valued at par with Bank of Canada liabilities because those commercial banks peg their exchange rates with Bank of Canada liabilities. And Bank of Canada liabilities are used as the medium of account, as well as a medium of exchange, so if there is an excess supply of Bank of Canada liabilities the value of those liabilities will fall, which means the prices of other goods will rise.”
I’m going to say that differently. It seems to me the central bank wants to keep demand deposits (DD’s) and currency 1 to 1 convertible so currency is always available to be withdrawn from the commercial banks while still being able to set the overnight rate (fed funds rate in the USA). I call this 1 to 1 fixed convertibility (relative pricing). If demand deposits double, then currency should also be able to double.
With a fixed 1 to 1 convertibility, what is the MOA and MOE here? Currency = $800 billion, central bank reserves = $200 billion, & DD’s = $6.2 trillion.
Let’s also try this.
The capital requirement is 10% for computer loans and 100% for computers. The reserve requirement is 0%. Computers depreciate at 1% per month. Ignore interest. Start here:
A: $2 in treasuries and $20 in computer loans
L: $20 in DD
E: $2
$1 of the DD’s are saved (now not circulating in the real economy). The bank sells $1 more of bank stock (equity).
A: $2 in treasuries and $20 in computer loans
L: $19 in DD
E: $3
The bank now creates $10 in new (emphasis) DD’s to buy a new (emphasis) $10 computer loan. The $9 increase in DD’s is needed.
A: $2 in treasuries and $30 in computer loans
L: $29 in DD
E: $3
Pay down $10 in computer loans for whatever reason.
A: $2 in treasuries and $20 in computer loans
L: $19 in DD
E: $3
Now there is a shortage of MOA/MOE (the demand deposits). Have the bank buy computers. It can only buy $1 (100% capital requirement).
A: $2 in treasuries, $20 in computer loans, and $1 in computers
L: $20 in DD
E: $3
There is still a shortage.
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