Monday, February 9, 2009

A Con Game Too Successful for Its Own Good

As long as you’re willing to assume that the world will end some day and that the end will be known in advance, it’s a simple matter to prove by induction that money is worthless.

Consider the last minute of the world. If you were living in that last minute, would you accept money as payment for anything? Of course not. You wouldn’t have time to spend it, so what good would it be to you? In the world’s last minute nobody will accept money as payment and therefore it will have no value to anyone: it will be worthless.

Now consider some minute in time where it is known that money will be worthless a minute later. If you were living in that minute, would you accept money as payment for anything? Of course not. You wouldn’t have time to spend it before it becomes worthless, so what good would it be to you? A minute before money is to become worthless, it will already be worthless.

Therefore, according to the principle of mathematical induction, money is always worthless. It will be worthless at the world’s last minute; it will therefore be worthless a minute before that; it will therefore be worthless a minute before that; and so on. Go back as many minutes as you need to go back, and you can get to any point in time and show that money is worthless at that point in time.

Thus, fundamentally, money is worthless right now. But even people like me, who are well aware of this proof, are willing to accept money as payment despite its fundamental worthlessness. Money is valuable to us because we expect it to be valuable to someone else. And since we are reasonably confident in the monetary authorities’ ability to recruit new generations of victims in this endless Ponzi scheme, we willingly allow ourselves to become victims. All of which is very convenient because it allows us to use money as a medium of exchange, a unit of account, and sometimes even a store of value. And it allows authorities to manage the supply of money so as to minimize the frequency and severity of economic downturns.

It’s a nice con game, one where we may rightly cheer the operators, given that the success of their game normally results in benefits for everyone involved. Sometimes, usually in small countries where monetary authorities have limited credibility, we see the con game fail, and generally we lament that failure.

But the other danger is that the game can be too successful. If people become too confident in the value of money relative to other assets, the result is hoarding of money and eventually deflation. And since money is neither productive (like a factory) nor useful (like food), the hoarding of something unproductive and useless supplants the creation of productive and useful things. Accordingly, the operators of the game always suffer from a very rational fear of success. And today, it would appear, their fear is coming true.

But this is crazy. There must be a way to stop rational people from hoarding endless amounts of an asset they know is fundamentally worthless. There must be a way to blow the whistle on this con game.

The solution, it seems to me, is to have the operators come clean – not come clean entirely, not admit that money is completely worthless, but declare in no uncertain terms their intention to cheat us out of quite a lot if we persist in having so much confidence in their scheme. Of course even that approach may not work – it’s possible that our collective gullibility has no limits – but it certainly seems worth a try.

What I’m suggesting is something that has already been suggested – in rather less shocking terms, perhaps – by various other economists (as for example in these posts by Greg Mankiw and Nick Rowe): the Fed should announce a price level target for some point in the future. And it should make that target high enough to scare people (and institutions) out of hoarding money.

It’s still a game of chance. Nobody can be sure that the Fed will be able to hit its price level target, or even get anywhere near it. As I said, in terms of the Ponzi scheme, there may be no limit to our collective gullibility. But let’s shift metaphors here: when you’re playing five card stud and you see that one of the other players has four hearts showing, even if you know the odds are against that player’s having a full flush, you’ve got to have a fair amount of guts to make a big bet on your three aces. And guts are in short supply these days. Nobody will know whether the Fed is bluffing; even the Fed itself won’t know whether it’s bluffing; but if the price level target is high enough, if the player with the four hearts throws enough blue chips into the pot, a lot of today’s ultra-risk-averse investors are going to fold.

And if enough of them fold – OK, here I have to shift the metaphor a little bit again, or maybe you have to think about hundreds of poker games being played at once, with some kind of arrangement where the house is allowed to pass cards from one game to another when the players in the first game fold – if enough investors fold, the game is over. If enough investors give up thinking that their three aces, (or zero-yield T-bills), are a safe asset, if enough investors start instead buying assets that are productive or useful, then the slack in the economy will diminish and eventually give the Fed a chance to push up prices by creating excess demand. And then the Fed can hit its price target and win the pot.

DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management.


Nick Rowe said...

Yes! Or, shifting metaphors again, it's like a game of cards where the Fed wants to lose, and wants people to bet against the Fed's hand. And the way to do this is to start playing stupidly (Paul Krugman's metaphor of making a commitment to be irresponsible in future money creation), or maybe to start throwing away some of it's good cards (buying toxic assets to destroy the net worth of the Fed's balance sheet, so it will have to print money to pay its debts).

Let's go the whole hog with that last metaphor: remember your previous post on zero interest bonds = money (why does it matter)? The Fed + Treasury needs to credibly damage the balance sheet of the Fed + Treasury. Let's borrow great wads of cash. Will we be able to pay it back without inflating? Dunno. You sure you want to hold that much money+bonds? Or maybe buy some real goods instead?

David Pearson said...

I think the suggestion has more merit than most. However, the question is how to control velocity once it is unleashed.

One way is to target a price level that coincides with a more manageable ratio of total credit to GDP. The ratio is now 350%, and it could stand to drop to 200% in order to eliminate the threat that nationalization of private debt poses to sovereign default risk. So, inflate the denominator, and slam on the breaks when nearing 200%.

The problem, of course, is that a visible target would be gamed by the market. The nearer to the target, the more velocity would again plummet in expectation of monetary contraction. So, keep the target a secret? That's one solution, but then, without any visibility on future stabilization of reserve growth, velocity could turn into the cancer of capital flight.

The above seem to present insurmountable obstacles to your suggestion. Perhaps you would argue, like some have, that the Fed can engineer an exit out of deflation directly into some benign level of inflation -- say, 2-4%. That would be sort of like jumping off a cliff and landing on a tightrope.

Anonymous said...

Hoarding of cash in mattresses causes the system to break down, but depositing cash in the bank (within reason) keeps the system running smoothly. Banks loan the cash to budding entrepreneurs so they can build productive factories. Zero inflation is consistent with a productive society as long as citizens have confidence that banks will return their cash with real interest. No one stuffs cash in a mattress if they can earn real interest safely.

The problem during the Great Depression was that citizens lost confidence that banks would return their cash. The FDIC solved that, and things gradually returned to normal. However, the high inflation period made citizens lose confidence that banks would return their purchasing power. Banks gradually lost depositors, as citizens switched to inflation hedges (McMansions and such).

The problem is that negative real after tax interest rates prevent citizens from buying capital goods with their savings just as surely as bank defaults did during the GD. Citizens will not build factories with their savings unless they get their purchasing power back with interest.

The proximate cause of the current crises is negative real after tax interest rates. Inflation hedges are no substitute for productive factories. Positive real after tax interest rates must be consistently maintained by banks for citizens to deposit in them. Without these deposits, factories will not be built.

Foreign capital cannot permanently substitute for domestic circular flow. Citizens must have confidence that banks will return their real purchasing power with interest for the system to be stable.

Anonymous said...

Here is what John Maynard Keynes wrote on the subject. Notice that John thought it absolutely essential that citizens buy capital goods with their savings:

"But capital-goods will not be produced on a larger scale unless the producers of such goods are making a profit. So we come to our second question—upon what do the profits of the producers of capital-goods depend? They depend on whether the public prefer to keep their savings liquid in the shape of money or its equivalent or to use them to buy capital-goods or the equivalent. If the public are reluctant to buy the latter, then the producers of capital-goods will make a loss; consequently less capital-goods will be produced; with the result that, for the reasons given above, producers of consumption-goods will also make a loss. In other words, all classes of producers will tend to make a loss; and general unemployment will ensue."

From "The Great Slump of 1930".

Citizens must buy capital goods with their savings, or the system will spiral downward. Inflation hedges are no substitute. Citizens must save money in the bank, so banks can lend to business. Citizens will not do this if the banks will not give them their purchasing power back.

Stevie b. said...

"If people become too confident in the value of money relative to other assets, the result is hoarding of money and eventually deflation"

People are NOT "too" confident in the value of money - they just have even less confidence in anything else - except perhaps gold which leads on to:

"since money is neither productive (like a factory) nor useful (like food), the hoarding of something unproductive and useless supplants the creation of productive and useful things"

Gold is neither productive or useful, but it can still be used as a medium for the creation of productive and useful things, if for no other reason than that gold is not fiat. Which leads to:

The Fed should announce it is buying gold.......and the so-called problems of deflation would be solved - without perhaps the serious, long-term inflation that would undoubtedly eventually result from a continuation of current policies.

Andy Harless said...


Usually the Fed doesn’t have much trouble managing changes in velocity. For most of the past 20 years it has maintained a fairly stable rate of inflation. The reason it’s having a problem now is that it has hit a liquidity trap, where the economy will accept unlimited quantities of money without using it for anything. But as soon as we get out of the trap, the Fed has its usual instruments at its disposal, and if it appears to be overshooting a price target, it just needs to tighten again. (I’m assuming there would be a series of price targets that eventually – but possibly over a fairly long time period – glides into a reasonable rate of inflation.) As long as the targets are high enough to begin with, it’s unlikely that we would get back into a liquidity trap. There might be some overshoots, and there might need to be some “intentional recessions” (like 1982, though probably much milder), but all in all I don’t think it would be that hard making a gradual transition to normal inflation. The road will be bumpy road at first, but it should smooth out over time.

David Pearson said...


The time period of 1983-2000 is hardly indicative. Those were, arguably, normal inventory cycles which the Fed was able to smooth.

The Fed's experience in tapping on the breaks in 2001-2008 experience is indicative. The commodity, housing and other markets went haywire. A little bit of tightening was too much, and rates ended up right where they started: 1% or below. Surely this casts some doubt on the ability for the Fed to remove stimulus without landing back in deflation.

There's also the 1937 experience, where the Fed's stimulus removal caused the "mini Depression" of 1937-1938, which arguably was a return to deflation, and which prolonged the Depression-era unemployment. Again, we left deflation in 1933, re-entered in 1937.

Then there's the example of countless emerging markets IMF-induced austerity measures, all based on the idea that countries reluctant to remove stimulus would have to bite the bullet and accept the ensuing deflation.

I urge you to come up with an example of a "smooth exit" from monetary stimulus following an economy-wide debt crisis. Before you say "Japan", please note that its faces deflation and a return to quantitative easing, just as in the examples I lay out above.

Andy Harless said...


I think we've learned from the examples of the late 30's and Japan. The lesson is not to remove the stimulus too quickly. Actually, Japan should have known better, and I said so at the time (as, I imagine, did many other economists). My argument can't be held responsible for the Bank of Japan's refusal to heed my advice ;)

The US eventually did have a fairly smooth exit from the problems of the 1930's, when the demand produced by World War II provided a sustained stimulus. There was a brief period of inflation thereafter, but that's exactly what I'm advocating: inflation to reverse the earlier deflation. The Fed brought that inflation under control fairly quickly. Once the exit actually happened, it was smooth.

I think that if you set price targets high enough and far enough into the future, then by the time it becomes necessary to slow down the economy, the effects of the original debt crisis will have dissipated.

Also, I don't think you can compare large economies like the US and Japan to small economies that have had to deal with the IMF. The US and Japan are not too far from being self-sufficient. A dollar crisis would not be disastrous for the US the way currency crises are for smaller nations that depend more heavily on trade.

David Pearson said...


Its possible that what defined the IMF-rescue countries was not "smallness" but propensity for default. It is that propensity which drives investors to prefer not to hold local currency. At its core, that preference comes from a fear that the Central Bank will simply produce too much of that currency in an effort to monetize deficits and so avoid default.

Of course there is some correlation between "smallness" and default risk. Correlation, however, is not causation. In the final analysis, it is the self-feeding nature of structural fiscal deficits (where rising interest costs drive them ever higher) that truly drives the causation. Is the U.S. at risk of incurring structural, expanding deficits? It depends on how much of the 310% of non-federal credit/gdp the government "nationalizes", either outright, through guarantees, or through direct Fed monetization. By the way, a recent Rogoff and Reinheart paper shows that the increase in government debt/gdp following debt crises has ranged between 80% and 250%.

The verdict on that default risk will be rendered by dollar velocity in the months ahead.

Andy Harless said...

My point was that a precipitous drop in the dollar would not do tremendous harm to the US, where imports are only 15% of GDP. And also, no matter what course of action the US took, other sovereigns would have individual incentives to help contain the crisis, because the precipitous drop in demand for non-US products would have potentially disastrous effects on their economies. Therefore, in the event of a crisis, the US would not need a rescue.

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