Wednesday, July 4, 2012

Muddled Monetary Policy and Negative Money Multipliers

A deviation from the textbook to a complex world of shadow banking and collateral chains

An effective monetary regime requires a functioning concrete mechanism. For as much as Nick Rowe discusses nonlinear chains of causality or the chuck Norris expectations model of monetary policy, the concerns of those of the concrete steppes cannot be totally ignored. A recent Voxeu paper by Manmohan Singh and Peter Stella provides a cautionary tale for those who want to leap off the concrete steppes without a closer look. What's the problem? A potential monetary policy negative money multiplier.

In the traditional Econ 101 explanation of monetary policy, the federal reserve expands the money supply by buying treasuries, thereby expanding the monetary base. Banks use that cash by lending it to businesses that subsequently invest the money. This spending makes its way back to the banks via deposits, thereby adding to the stock of demand deposits and the money supply. A fraction of the deposits, as determined by the reserve ratio, is held in reserve by the banks; the rest is lent out again. This is one of the marvels of fractional reserve banking:The "money" that the fed creates in its open market purchases multiplies itself throughout the money supply through this lending/re-lending process.

Singh and Stella emphasize a different channel of money multiplication: collateral chains. Their fundamental argument is that, in a world of shadow banking, repos, and financial derivatives, a lot of credit creation takes place by pledging the same collateral over and over again, a process otherwise known as rehypothecation. High quality collateral, "safe assets", serves the role deposits serve in the textbook explanation of monetary policy. Safe assets, instead of being deposited like cash, are used over and over again by different firms to obtain financing, thereby expanding the "shadow money supply". Banks who were burned in the past want to limit their loans and try to deleverage. But in this process, banks shorten the collateral chains, make credit less available, and contract the shadow money supply. Central banks can compound the problem by reducing the supply of safe collateral by purchasing the assets in open market operations. As a result, traditional purchases of US treasuries become contractionary. While they may increase the base, they prevent collateral chains from forming and facilitating more credit creation. The cash that financial institutions get from open market operations can't be rehypothecated, and therefore fails to expand credit supplies. Instead, collateral chains contract and this "shadowy" money supply grows more limited. So yes, the Fed can raise prices to any level by printing money. But no, rehypothecation and collateral chains prevent quantitative easing from being fully effective.

Collateralization also brings up the possibility that the Fed could ease not by Quantitative Easing, but rather by Qualitative Easing. Instead of buying up collateral and replacing it with uncollateralizable cash, the Fed could buy up risker assets (mortgage backed securities again?) and replace them with safer treasuries. While it may not expand the size of the Fed's balance sheet, it would help with the collateral chains and expand credit. Fiscal policy then gains new traction, as increases in government debt can 

1) Increase available collateral, thereby directly expanding credit
2) Limit the contractionary effect of the Fed's buying of collateral

An interesting corollary of this is that if fiscal policy becomes more effective, the Federal Reserves interest rate forward guidance becomes more powerful. As I've written before, the interest rate guidance would lose its indeterminancy, and change from Delphian to Odyssean. Low interest rates no longer represent low expectations for NGDP, rather they represent a committment to a temporary period of faster than trend NGDP growth. Interest rates aren't low because of low NGDP, but rather in spite of it.

Meanwhile, David Beckworth's NGDP targeting - safe assets story becomes murkier. David argues that, in a world of stable NGDP growth, private sector safe asset creation goes up significantly. So if the Fed commits to a stable NGDP growth path, the collateral chain problem goes away as there's enough private sector safe assets for rehypothecation. But if the NGDP growth path is uncertain, Quantitative Easing won't help. While the initial treasury purchases may marginally increase lending, the credit contraction from collateral chains may cause the policy to be net contractionary. However, the story is still not that simple. Much like currency depreciation in a small economy, there exists a sufficiently large change that would boost growth. Quantitative Easing would only have an effect once it has collapsed collateral chains to their minimum. After that point "printing money and buying assets" would undoubtedly raise NGDP. This leads to a peculiar result when we take Nick Rowe's concepts of nonlinear causality and expectations into account. If the scale of the initial asset purchases is perceived as credible enough to shape future NGDP expectations, even though initial purchases would shorten collateral chains, the supply of collateral would expand as the private sector created more safe assets. 

A major problem with this scenario is that the market response function becomes highly nonlinear. With no policy action the market contracts. With some policy action the market contracts further. Only with outsize policy action are private agents convinced of a stable future NGDP target, and do collateral chains continue to expand. In this situation, it would be hard for a central banker to tell how many asset purchases "would be enough". Consequently, a credible NGDP target becomes even more important. First, it facilitates private safe asset creation. Second, it assures the market that the Fed won't end up in the middle where collateral chains contract and monetary expansion fails to raise output or prices. This is a critical argument in favor of NGDP targeting in an increasingly complex world. In spite of all of the complications in modern finance and banking, stable nominal expectations can help smooth those problems over and maintain the processes of safe asset creation.

Another lesson we can learn from the debt rehypothecation/shadow money supply story is that nominal GDP targeting has a critical role to play in limiting the negative growth effects of financial regulation. If debt chains serve a function to expand the shadow money supply, then banning debt in a move to a more Black Swan free society can have severe monetary effects, significantly hampering growth. But if the central bank targets nominal GDP (ideally through a mechanism not as bank or debt-centric as treasury purchases), this would help ease in the structural adjustments to build macroeconomic resilience.

Monetary policy is muddled, adjustments are painful, but stable expectations can help. While Singh and Stella's story may not be perfectly applicable now, it is an interesting example of the peculiar nexus of modern finance and modern monetary policy. These uncertainties will only get worse in the future, so it's even more important to find a credible, robust, stable regime now.


  1. Yichuan:

    I was really keen to read Singh and Stella's post when I read the title. But I was badly disappointed. First, because it is poorly written. I read it three times, and still didn't really understand what they were trying to say. Second, because they don't explain what they mean by "money", and how whatever is created is in fact money, rather than simply credit. For all its faults, the traditional textbook story does tell you what "money" means, and that the balances in your chequing account are money, so that when the money multiplier story comes to an end with a higher stock of balances in people's chequing accounts, that money continues to circulate and is used to buy and sell things. Singh and Stella don't do this.

    "Central banks can compound the problem by reducing the supply of safe collateral by purchasing the assets in open market operations."

    But when they engage in open market operations, central banks buy one safe asset and sell another safe asset.


    "The cash that financial institutions get from open market operations can't be rehypothecated,..."

    Why can't "cash" be rehypothecated?

  2. Yichuan emailed me, and asked me to post this comment by him (firewall problems):

    After reading their post (and attendant ftalphaville links) a few more times, I think there's a more precise formulation stated in terms of assets, medium of exchange, and interest on reserves.

    We can start the story by simplifying money to its medium of exchange property. Then if money is defined this way, there is a continuum of monies, ranging from currency (most liquid) to things that we might normally just call assets (treasury bonds). In most situations, banks can use treasuries as their collateral in repos for day to day liquidity needs. Non-banking institutions, who held the cash or more liquid assets, would be on the other side of this repo agrement. These non-banking institutions (shadow banks) would depend on these repo agreements to stay afloat and fund themselves. Additionally, these repo agreements would take place over and over again over the maturity of the treasury to get the maximum return (see their IMF paper:

    [To be continued. The above was written by Yichuan Wang. NR]

  3. [continued, from Yichuan, NR]:

    When the crisis struck, the demand for treasuries shot up, making the yield on repo agreements very low. Banks wouldn't be willing to give their treasuries at such high repo rates because the treasuries filled a gap for safe assets for collateral needs. This sent shadow banks scrambling, and, as a result, they had to cut back on their liquidity operations and, importantly, shortened the collateral chains. This is the "money supply" that we may typically think about. The liquidity provided by the shadow banks/money market funds/collateral chains is a medium of exchange that can be exchanged between financial entities for various purposes. It isn't credit anymore. Even if the repo agreement is a form of credit, the money market funds use it to provide money-like medium of exchange functions. To use a housing analogy, loans are forms of credit, but once the loans are securitized and sold they become a highly liquid asset that can be used as a medium of exchange. In the VoxEU article, Singh and Stella discuss an OTC derivative exchange, but I think there's plenty of transactions that would qualify. The "shadow money" multiplier story comes down with shadow banks with higher deposit liabilities, much like regular banks have at the end of a money multiplication process.

    n the Vox article, Singh and Stella very explicitly state their perspective on the money/credit issue:

    "We start from two principles: credit creation is money creation, and short-term credit is generally extended by private agents against collateral. Money creation and collateral are thus joined at the hip, so to speak. In the traditional money creation process, collateral consists of central bank reserves; in the modern private money creation process, collateral is in the eye of the beholder. Here is an example."

    For OMO's, at least the textbook version I know is that the bank takes private treasuries out of the system and replaces them with cash. If you're counting cash as the safe asset, then your two questions turn into the same thing: why is cash special?

    The way I read the articles, cash is special for the banks because the banks can store the excess reserves at the Fed and collect IOR. In effect, IOR sterilizes the asset purchases from ever reaching the shadow banking sector. Remember that the shadow banks need cheaper (higher yield) treasuries so that the treasuries are "less of money" (but just as safe) and can yield a higher repo rate to facilitate continued rehypothecation. A slightly higher repo rate would spur banks to rehypothecate the treasuries to get the ball rolling. So when the Fed buys up treasuries and gives banks the cash, the cash doesn't serve the usual liquidity functions as it's just deposited at the Fed. It's a risk-free return, so there's little incentive for the banks to do anything else with the money. Now we're left in a world with neither treasuries nor cash are working as a medium of exchange. These effects cascade through the system, ergo negative money multiplier.

    At least that's how I'm reading the articles. I'm not very familiar with all the tri-party repo/derivative/shadow banking mechanics, but the story I outlined above seems to make sense in my head.


    [The above was written by Yichuan Wang. NR]

  4. When I read these articles, it seemed to me that there is an implicit assumption that it is important to maintain, or really, to rebuild, the shadow banking sector. Obviously, those firms and individuals who build up expertise in this sector are worse off because shadow banking collapsed. And they would perhaps do much better if it recovered. So?

    Why is it better for firms to hold repurchase agreements rather than money in a checking account? Why is it better for firms to borrow by selling short term debt rather than using a line of credit at a commercial bank?

    Well, the commercial banks have hefty capital requirements and so pay less on ordinary checking accounts and charge more for loans. I see the private benefit of avoiding those regulations, but what is the public benefit?

    The banks are just keeping reserve balances (and mostly funding the general government and government guaranteed mortgage debt.) Well, quit paying interest on reserves.

    Anway, the entire approach assumes that monetary policy works by allowing people to borrow more and spend. Not an unusual notion. But how about getting people to sell off their current holdings of securities or reducing their money balances and purchasing consumer and capital goods? That involves not more borrowing and more spending, but less lending and more spending. What is the problem? Well, if I was in the finance industry, maybe it is a problem.

    I did spend some time trying to understand rehypthecation, and I never really did understand the benefit of borrowing short with T-bills posted as collateral rather than just selling the T-bills. And then, the firm that buys the commercial paper (secured by the T-bills,) why would they borrow against that T-bill secured commerical paper rather than sell it, or... how about not buying it in the first place and spending that money that was used to buy the commercial paper?

    It seems to me that what is really happening is all the corporate treasuers would be trying to make slight gains on interest rate differentials. My guess is this is almost entirely a zero sum game by money market traders.

    Supporting all of this is socially beneficial?

    Let them hold checkable deposits and earn the interest rate on that, and those that really need to borrow, let them borrow from commercial banks. How boring.

  5. Thanks Yichuan. Buit i still don't get it. And I'm very strongly beginning to suspect a snow-job by Sigh and Stella.

    For example, they say: "We start from two principles: credit creation is money creation,...."

    No way. Suppose I lend Bill $20. I give Bill a $20 note, and Bill gives me an IOU for $20. Bill and I have just created credit. Bill's IOU is a credit that didn't exist before. But Bill's IOU is not money. It is not *generally* acceptable as a medium of exchange, or in payment for goods and services.

    If I go to the pawnbroker and pawn my $30 watch for a $20 loan, I and the pawnbroker have not created money. It's a loan.

    I'm with Bill.

  6. @Bill

    I think I agree with your comments on the shadow banking center. Your point on chasing yields is well taken and I think mostly true. I've written before on this issue of financial monoculture, and I do think it's a serious issue. Having a network of financial entities that are so prone to bank runs probably is not a good thing. But even with that normative judgment, I don't see how it affects the positive economic story of collateral chains and rehypothecation as a form of "shadow money supply".

    Your point on more spending and less lending is true, but is there anything stopping lending from going up after expansionary monetary policy? I think not, which means the lending story still has some traction.


    I don't know if it's a snow job, but it at least seems like an interesting notion to entertain. Why isn't the IOU money? If it can be rehypothecated, why doesn't it function as a medium of exchange? If it's liquid enough, I don't see why it can't be accepted as payment. A mortgage is a loan, not money. But when it's securitized and becomes a highly liquid asset, why can't it serve the same role on the market?