Wednesday, February 4, 2015

Nick Rowe gets lost taking a shortcut

Nick Rowe is like the anti Tyler Cowen- lots of content, no links, tons of interaction with his commentors which explains why he will never be (wildly) popular. Marginal Revolution is the something for everyone (well everyone who likes econ) blog while Rowe's posts at Worthwhile Canadian Initiative are for everyone that wants to spend half an hour thinking about his simplest post- and trying to write a 2 line intro to a piece has totally distracted me and now I am looking up econ blog rankings.... why am I so easily dis . . .  hey look a ball!

So Nick Rowe has a post - if you want to get the specifics you should read his blog. I mean honestly if you aren't related to me and simply trying to monitor my mental health state surreptitiously (I am on to you!) you shouldn't be reading this blog unless are already reading his.  So let me skip beyond a summary and get to a point already.
But that's not all there is to it. Because the demand for my autographs will also depend on whether people expect they will appreciate or depreciate in value.
Suppose the current total market value of my autographs is $100 (10 autographs at $10 each). If I want to shrink it to $50, all I need do is threaten to produce autographs in unlimited amounts if the total market value ever rises above $50. And I must be prepared to carry out my threat, to make it credible. By printing autographs at a faster rate I make them depreciate in value at a faster rate, which reduces the demand for my autographs, which reduces the total market value of my autographs.
And then later
Bits of paper with my signature are just like bits of paper plastic or silicon with the signatures of Stephen Poloz and Carolyn Wilkins (Governor and Deputy Governor of the Bank of Canada). Except we measure prices of everything else in the latter and not in the former, so a fall in the price of my autographs is equivalent to a rise in the price of everything else in terms of their autographs. And we use the latter but not the former as a medium of exchange (which is why the latter have a demand curve where quantity and price are inversely proportional).
As it happens I was recently talking to someone who was concerned with high inflation in the future, and his reaction to this worry is to increase his demand for money right now.  Crazy, right?  No, because he is on the verge of retiring and in his view dying with a million dollars in the bank is a far better outcome than living for 5 years broke, struggling and feeling like a burden on his family.  In financial terms he has asymmetrical risk.

Much of our modern economy is exposed to asymmetrical risk, banks in particular are heavily exposed to the risk of future inflation.  Lets say as CEO of a bank you are hosting a huge party to celebrate $100 billion dollars in loans, when a top financial analyst run into the room and whispers in your ear that he has crunched the numbers and, gasp, inflation is going to be 2 percentage points per year higher than you thought over the next 10 years. What, besides snide remarks about run on sentences, is your plan for future loans?  Obviously making more loans at the current rate is out of the question since you are just increasing your exposure, and you will need a healthy cushion so you can maintain your reserve ratio, and finally you want a large cash hoard to loan out after inflation has hit (and interest rates have gone up) to rebuild the portfolio and cover the losses on loans made recently.

What does this look like from a CBs point of view?   Demand for money seems to have risen, so now the CB prints (or promises to) more money, which should push our bank to expect even more inflation, so it hoards more.

What happens in the economy?  Mortgages are harder to come by, either they have higher interest rates or they are simply unavailable.  Either way home prices decline and people who are selling homes either have to pay for two places to live or take a lower price, so their consumption is likely to be cut back to compensate (people buying at "lower" prices but higher interest rates aren't gaining much, if any, purchasing power, and those that want to buy but can't- its difficult to say).  Now we have a liquidity crisis because the bank is hoarding and we have lower measured inflation due to lower consumption (and possibly just through lower housing prices depending on how housing is included), so what is a CB to do?  Why, print more!   Promise more inflation!  Scare the bank more!  Make the bank hoard more!

I put an unstated assumption in here to make it work- that inflation can happen with a lag.  Nick Rowe puts the opposite assumption- that inflation is close to immediate (we both simplified a lot as well).   The point here isn't to aruge that my scenario is correct and his isn't, it is to identify that Nick's is dependent on simplification, that there isn't a lag in inflation, that there aren't third parties exposed to moves in the prices of his autographs and a whole bunch of other (likely) things.


  1. Thanks!

    Hang on though. If you expect higher inflation, would you really want to be holding extra *currency*, which will now be depreciating in value at a faster rate? Wouldn't you want to hold a different asset instead, whose value might keep up with inflation?

  2. Hopefully a multipart reply coming, though I am sleep deprived right now with a 1 week old in the house (ok, you got me, she isn't the problem, the 2 year old is the problem).

    In the example of the soon to retire- he would love to have an asset that would match his exposure, but his fear of inflation isn't about new computers or gas prices. As a 70 year old his concern is about rising medical costs, something like TIPS won't protect him fully, and in the more damaging scenarios (the ones he is most concerned about) they will barely protect him at all. If he doesn't have (or even just doesn't know about) an option that fully protects him his course of action will be some combiation of continue working (producing) longer and consuming less. His concerns/expectations about future inflation as a market participnt dont fully make it into the prices that CBs use as signals about inflation and inflation concerns.

    1. When we switch over to banks we can see an analogy. What the bank wants is an asset that will match their losses as closely as possible. They aren't concerned with inflation, but with the impact inflation will have on interest rates. TIPS are a more realistic option, though the total market for TIPS is to small if the concerns about future inflation are broad (an individual bank could protect themselves with TIPS but the market as a whole cannot). TIPS also cause issues if your forcast of inflation is incorrect (especially with near ZIRP policies in place).

      The asset that best tracks a bank's current mortgage portfolio will be future mortgages. So the assets you want to hold are highly liquid and short term, while they won't hold the upside of TIPS they also wont hold the downside. It is easy to describe an institution that heavily prefers this kind of security over potential profits (and that description closely resembles the current banking system in the US).