Wednesday, September 10, 2014

A fly in the ointment

You know the economy is screwed up. That's why you're here. It's what you do on the Internet, think about the economy. Me, too.

You know we need to fix it. But everything has an economic component, a money component. So the conversation can go anywhere. Makes it hard to focus. Makes it hard to know what's relevant. That's unfortunate.

You know our world is full of well-written explanations and well-accepted memes, not all of which are correct. Not all of which can be correct. So it goes.

Maybe you are reading Frances Coppola's Ultra-Liquidity at Pieria. Well-written, certainly seems right.


All assets can be regarded as “money” to a greater or lesser extent: the extent to which assets have “moneyness” is really a matter of liquidity.

Sure. The concept of "near money" isn't new. But I guess Coppola's point is that liquidity is different now. Liquidity is "ultra".

She gives some excellent examples, beginning with her stay at Lindau. Using a VISA debit card she could "pay for a meal in Euros directly from my sterling account":

Because of technological changes, what was formerly an illiquid asset in Germany (sterling) has become transparently liquid.

Coppola says we could easily do the same thing with "a smartcard or a smartphone app". This helps me understand a little of what Steve Roth has been writing about.

Me? I don't use smartcards or smartphone apps or a VISA debit card.

It was interesting, I thought, that Coppola said this:

... suppose that instead of a sterling bank account, a smartcard or a smartphone app enabled me to pay a bill in Euros directly from my holdings of UK gilts? This is not as unlikely as it sounds. It would actually be two transactions...

Yeah: It's two transactions. One of them pays for dinner. The other pays for the currency swap: a financial transaction. Coppola's significant fact is that "This pair of transactions in today's liquid markets could be done instantaneously."

My significant fact is that financial transactions increase costs.

Coppola makes a good point:

ANYTHING that can be used to settle transactions really should be regarded as money: and as technology increases liquidity in all asset classes, so they become easier to use for transaction settlement and therefore more money-like.

Okay. This is a significant change: We now have technological liquidity. Like gunpowder and the bomb, it probably won't be going away.

But it doesn't come free, either. And the more financial transactions we participate in, the more is the cost of finance. This is true, for any given rate of interest. It is true, even if the transactions occur "instantaneously".

I see financial cost as a problem. My solution is the same, always: reduce the size of finance. Rely more on government-issue money and less on bank-issue.

The cost of finance doesn't seem to cross Frances Coppola's mind.

The article is about the increase in the liquidity of non-monetary financial assets, a change that has turned them into money. But as Coppola points out, ultra-liquidity is not always reliable:

CDOs were highly liquid near-money assets prior to the financial crisis. Now, they are about as liquid as flies in amber, and worth considerably less.

Again, Coppola:

No wonder yield-hunters go for intrinsically illiquid assets such as property, or assets that carry significant credit risk such as junk bonds. They can't get any sort of return on safer and/or more liquid assets. And the more technology improves market liquidity – and the more regulators push for improvements to market liquidity – the lower returns will be across all classes of financial asset.

And the more regulators push for improvements to market liquidity, she says.

It is policy to "push for improvements" in liquidity. By "improvements" Coppola means "increases" in liquidity. Policy increases liquidity, Coppola says, even though it drives investors into junk.

In the conclusion Coppola writes:

Above all, though, we need to rethink how we do monetary policy... Liquidity is becoming to all intents and purposes free. The question for policy makers now is how to influence the returns earned on illiquid investments such as property.

In other words, she accepts this brave new world and wants to find a way to deal with it. I think that's the wrong approach. I think Coppola, like the regulators, is heading for the wrong goal. We want to minimize finance, not maximize it.

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