Thursday, August 1, 2013

Google as monetary superpower — a parable

In trying to understand how modern monetary policy works, I find it useful to create parables, or alternate monetary worlds, and put them through the wringer. Hopefully I can learn a bit about our own world via these bizarro universes.

Let's say that in an alternate universe, people have decided to use Google stock (in bearer and digital form) as way to conduct most transactions. To top it off, all prices are set in fractions of a Google share. Shares get issued into the economy when Google pays employees with stock, makes corporate acquisitions, or purchases things from suppliers. Shares are removed when Google does buybacks.

Here are some questions we can ask of our Google priced world. What can Google do to cause the price level to rise? to fall? What do open market operations do, and what happens when Google "prints"?  Does Google QE have a large effect on the price level, or is it irrelevant? Once we've answered some of these questions, we can take what we've discovered over to our own universe in which Federal Reserves notes and deposits are monetary dominant and ask the same questions: what did QE1, QE2, and QE3 accomplish? What happens when the Fed "prints"? How does the Fed determine the price level? Let's explore our Google universe a bit and see what it has to teach us. [1]

In our alternate universe, people hold Google shares in bearer format in their wallets, or they own shares as electronic entries in a centralized database. Should you walk into a store to buy cigarettes, the sticker price might be 0.3 Googles. You can either hand over 3 Google bearer shares, each equal to 1/10th of a full share, or you might electronically debit your Google share account for the full amount.

Like any other share, a Google share is also a claim on the cash flows of the underlying business. Say that a week has passed and Google's shares have exploded in value due to higher margins announced at their quarterly earnings call. Now when you go to the store to buy cigarettes, they cost only 0.1 Googles. Alternatively, Google's prospects take a turn for the worse when it is sued for massive copyright infringement. Now when you go to buy cigarettes, a pack costs you 0.8 Googles. You get the point. A Google price level would be highly volatile, with all the thorny macroeconomic implications that such instability brings with it.

Google has come to recognize the public service that Google shares provide as both a medium of exchange and a unit in which other people post prices. It decides to take steps to ensure that Google shares neither rise too fast nor fall too much, or, put differently, that the general price level should be stable.

The manipulation of Google's returns shapes the price level 

One way Google can go about managing the price level is by varying the returns that shareholders enjoy. If the general price level is falling too fast, or, put differently, if Google shares are in a bull trend, CEO Larry Page may choose to suddenly announce that going forward, less earnings will flow to shareholders. By increasing the interest coupon on all Google-issued bonds, a larger share of profits will be diverted from the equity class to bondholders. In reaction to this announcement, Google's share price fall and, conversely, the price level begins to rise. This only makes sense. After all, in one fell swoop the present value of future Google shareholder income, often called fundamental value, has been reduced.

On the other hand, if inflation is the problem (i.e.if Google shares are collapsing), Larry Page might announce that henceforth bond coupons are to be cut, thus diverting more of the firm's profits back to shareholders. The share price will pull out of its bear trend -- after all, shareholders can expect a greater discounted flow of income than before -- and conversely, the price level will cease bounding upwards.

Larry Page has thus emerged as the economy's price-level setter. By either diverting profits away from or sluicing profits towards shareholders, Page holds the general price-level steady.

What do Google open market purchases do?

You'll note that I haven't mentioned money supply changes (ie. Google share supply changes) as the driver of the price level. Changes in the quality of Google shares -- their fundamental value -- and not the quantity of shares have been driving the price level up till now.

In fact, the classical example of an increase in the quantity of money -- broad open market purchases of assets -- needn't make much of a difference to our Google-determined price level. As long as Google consistently buys liquid and quality earning assets with newly printed shares and/or invests in decent projects that are neither over- nor underpriced, then all shareholders will retain the same claim on earnings that they did prior to the open market operations being conducted. Fundamental value remaining constant upon the completion of open market purchases, Google's share price will remain unchanged, as will the economy-wide price level.

This isn't to say that open market purchases are always neutral. One way for Google to use open market operations to affect the price level would be to issue new shares in such a way that upon completion, Google's per share earnings will have declined. We can call these sorts of transactions dilutive acquisitions. The best way to make a dilutive acquisition is to overpay for assets or buy worthless assets. Put in a bid for a collection of awful paintings, offer to pay a 50% premium to take out a company that already trades at fair value, or purchase a rail car full of carrots set to go bad the next day. Each of these transactions will permanently impair Google's per-share earnings base and destroy fundamental value. Google's share price will plummet to a new and lower floor as a result, the mirror image of which is a jump in the economy's price level.

On the flip side, Google can fight inflation by making a series of stock-financed accretive acquisitions. Buy up companies trading at undervalued prices and/or invest in projects with superior risk-adjusted yields. As a result of an accretive open market purchase, Google shareholders will enjoy an increase in per-share earnings. Should Google shares be in the midst of a bear trend (ie. inflation), a series of these accretive acquisitions will halt the bear and stabilize the price level.

This is an odd observation. We are accustomed to thinking of open market purchases, or money printing, as increasing the "money supply" and therefore causing inflation. This mental short cut is a result of a naive version of the quantity theory of money, a theory which posits a positive relationship between the money supply and the price level. But in the previous paragraph I've demonstrated how Google open market purchases increase the "money" supply yet cause deflation, not inflation. [2]

There is a lack of symmetry between overpaying to stop a deflation in the Google price level and underpaying to stop an inflation. One is easier to do than the other. To overpay for something, just go to any store and offer twice the sticker price for an item. No store owner will try to dissuade you. Google could offer to buy a few million shares of Microsoft at 20% above market value. They'd have no shortage of investors willing to take them up on that offer. On the other hand, try walking into the same store and offering to pay half the indicated sticker price, or watch Google try to wade into the market for Microsoft shares only to bid 20% under the current price. You're not going to be able to buy anything at the store, nor will Google get any offers for Microsoft.

The upshot of this asymmetry is that it's far easier for Google to stop a deflation with open market purchases  than to stop an inflation with open market purchases.

Google QE is irrelevant...

If Google announced its own version of QE or QE2, say $500 billion in upcoming treasury bond purchases, neither the announcement nor the actual purchases would be likely to affect the price level much. This is because the markets in which Google is buying assets are very deep and the announced purchases are being conducted at market prices. Google's risk-adjusted per share earnings, or fundamental value, will be the same both before and after QE.

In order to get the price level to rise or, equivalently, the value of Google shares to fall, rather than announcing QE of $x billion, Google should announce purchases of $x billion at a y% premium to the last market price. The losses incurred upon acquiring these assets at non-market prices would immediately drive the value of Google shares down, and the price level up. So the way to give QE bite is to be irresponsible and conduct purchases at silly prices.

...well, not entirely irrelevant: manipulating Google's liquidity premium 

Having just said that Google open market purchases are irrelevant if they target assets trading at market values, I'm going to backtrack a bit. This isn't entirely correct, because we need to include the idea of a Google liquidity premium.

Before Google shares ever became popular as exchange media, they were valued as mere equity claims. Rational traders would have ensured that the price of shares did not fluctuate far from their fundamental value, or the risk-adjusted net present value of cash flows thrown off by Google's underlying business. In this respect, Google stock was like any other stock, whether it be Apple, Cisco, or Exxon.

As Google shares became more widely used as exchange media, their price would have risen above fundamental value by a thin sliver called a liquidity premium. In essence, where before a Google share threw off a single pecuniary stream of cash flows, that same share now throws off not only the pecuniary stream but also a stream of non-pecuniary services related to its liquidity. All things staying the same, the addition of this extra non-pecuniary stream of services would have put a Google shareholder at an advantage relative to shareholders in other companies. After all, the quality of being moneylike, or having what I like to call "moneyness", is a desirable property in an asset. These excess returns would not have lasted long. The market would quickly bid up the price of Google stock until it offered a return commensurate with all other assets. The amount by which Google's price would have been bid up is what we call the liquidity premium.

The general price level thus contains within it two components. The first and original component is explained by Google's fundamental value. The rest of the price level is related to Google's liquidity, or a liquidity premium.

As already noted, QE, or open market operations at market prices, can't affect the first component. Both before and after QE, Google's per-share cashflow stay the same. But QE can affect the latter component, the liquidity premium. The increase in the supply of shares brought about by QE means that the marginal owner of Google exchange media finds their demand for liquidity satiated. What follows is the hot potato effect that market monetarists so dearly cherish. Those with an excess supply of Google exchange media will sell whatever shares (ie. cash) they no longer need, putting downward pressure on the price of shares and upward pressure on the price level. This is the classical quantity theory of money, in which an increase in the supply of media of exchange pushes the price level higher.

But the hot potato effect will not cause shares to fall by more than the value of their liquidity premium. If they fall by more, then share's will effectively be worth less than their fundamental value, a situation that won't last long as rational investors bid share prices back up. There is a floor below which more QE simply has no effect.

The depths to which Google's price falls because of QE depends on the size of the liquidity premium relative to fundamental value. The larger the liquidity premium, the more there is for QE to shrink, and the greater the price-level effect. I doubt that Google's liquidity premia will be very large, especially in open and competitive markets, so I don't think QE will push the shares down much or bring prices up too high. To get a massive rise in the price level, better for Google to announce QE at non-market prices. The effect would be a double whammy: not only would Google's liquidity premium shrink via the classical hot potato effect, but its fundamental value would deteriorate too.

Having explored our Google monetary universe, let's transfer what we've learnt to our own universe in which central banks such as the Federal Reserve are monetary dominant.

Making the analogy to the Fed: manipulating deposit rates to shape the price level  

Just as Google varies the price level by fiddling with the return on Google stock, the Fed can vary the price level by toying with the return that investors expect to enjoy on Fed-issued financial instruments. One obvious difference is that Google issues stock whereas the Fed issues deposits. But this is a difference of degree, not of kind. Both a deposit and a stock are instruments that provide a claim on their issuer. A deposit provides a safer fixed claim whereas a stock provides a riskier floating claim, but at the end of the day both instruments derive their value from their ability to act as titles to underlying businesses. The better the underlying business, the more valuable each respective claim will be.

If inflation is moving up too fast, the Fed can divert extra income towards depositors by increasing the interest rate it offers on deposits. This notching up of the interest rate enhances the life-time value of cash flows thrown off to owners of central bank deposits relative to other assets. This excess return will be quickly arbitraged away as investors compete to buy deposits, pushing their price up until they offer the same return as all other assets. This brings the general price level down, nipping inflation in the bud.

Vice versa, if the price level is deflating too fast (ie. if deposits are rising in value), the Fed can reduce the interest rate on deposits. This lowers the return on deposits relative to all other assets in the economy. Investors sell deposits until their price has fallen to a low enough level that they once again offer a competitive return. Thus the Fed terminates an incipient deflation.

Open market purchases by the Fed

Large open market purchases at market prices bring in a sufficient amount of earning assets to ensure that depositors will always receive the same risk-adjusted return that they enjoyed prior to the open market operations. There is thus no reason for the market to bid the price of deposits down when the Fed announces open market operations. Deposits are just as fundamentally sound as they were before.

On the other hand, if the Fed creates new deposits to purchase a collection of awful paintings, or offers to pay a 50% premium to take out a company already trading at fair value, or buys a rail car full of almost rotten carrots, the value of deposits will fall and the price level rise. This is because the Fed now owns less income-generating assets than before, thereby rendering it more difficult to make future interest payments to depositors. The risk-adjusted return on deposits -- their fundamental value -- has deteriorated. Investors will quickly bid down the price of Fed deposits until they once again offer a sufficient return to compete with other assets. A series of these dilutive purchases, much like Google's dilutive purchases, will put a halt to any deflation.

Manipulating the liquidity premium on Fed deposits

As in Google's case, open market purchases at market prices can't hurt the underlying fundamental value of Fed-issued deposits. But purchases will still have a bite on the price level by reducing the liquidity premium on Fed deposits.

I'll hazard a guess that the liquidity premium on Fed deposits is normally much higher than what Google would enjoy in our Google monetary universe. This is because unlike Google, the Fed can force banks to use deposits as an interbank settlement medium. By limiting the amount of deposits it issues and inhibiting the ability of competitors to provide alternatives, the Fed ensures that its deposits command a higher liquidity premium than they would in a free market. Thus, open market purchases and sales, even at market rates, will typically have significant effects on prices since a proportionally larger part of the price level is explained by deposit liquidity premia. In other words, the monetarist hot potato effect is large.

This has all changed since 2008. The Federal Reserve operates with a massive amount of excess deposits, or reserves. The supply of deposits is no longer special, artificially limited, or difficult to acquire. This means that the liquidity premium on deposits is probably much lower than before. So while open market purchases at market rates may have some effect on reducing prices, they can only narrow what was already a very thin liquidity premium. In other words, today's hot potato effect set off by QE is a feeble version of what it was before 2008.

To sum up...

The Google price level is determined by two elements: the underlying earnings power of Google's business as well as a liquidity premium arising from the superior ease of transacting with Google shares. Google monetary operations can change the price level by working on either of these two elements. I've hypothesized that the same rules apply to the Fed.

If we can take one lesson from our Google monetary universe, it's that mass open market purchasing schemes like QE probably have little bite because they don't change the fundamental value of Google or the Fed. QE has been conducted at close-to-market prices, and therefore brings an appropriate amount of assets onto the Fed's balance sheet to support the deposits created.

Nor do mass open market operations affect the liquidity premium much, since the current glut of Fed-issued deposits means that their liquidity premium is probably very small. In order for QE to significantly push down the return provided by deposits, and drive up prices, the Fed needs to do more than announce large asset purchases -- it also needs to announce that it will buy at wrong prices.

[1] This blog post is pretty much a mashup of everything I've read over the last few years  from Nick Rowe, champion of the hot-potato effect, Mike Sproul, defender of the fundamental/backing theory of money,  Stephen Williamson, who likes to talk about liquidity premia, and Miles Kimball, who introduced the blogosphere to Wallace Neutrality.

[2] Everything I've said about Google open market purchases is just as applicable to open market sales. The classical quantity theory of money story is that open market sales reduce the supply of money, therefore causing deflation, or a fall in the price level. But if asset sales are conducted at the going market rate, then in Google's case, expected per-share earnings stays exactly the same as before and there is no reason to expect Google's share price to improve.

Google can use open market sales to affect the price level only if it sells assets at non-market prices. For instance, Google might conduct share buy backs when it perceives that its shares are underpriced. If Google execs have evaluated the situation correctly, then each open market sale will improve Google's financial situation and cause the share price to jump. On the other hand, Google can purposefully sell assets held in its portfolio at below-market prices in order to hurt fundamental value and cause inflation. 

03.08.2013 - added the reference to Miles Kimball in note 1
03.08.2013 - Changed "advantage relative to other shareholders" to "would have put a Google shareholder at an advantage relative to shareholders in other companies"
03.08.2013 - Added "moneyness" link.
21.08.2013 - exploded [added "in value"]
21.08.2013  - "open market purchases at market prices can't hurt the underlying financial viability" ... financial viability changed to fundamental value.


  1. "In order for QE to significantly push down the return provided by deposits, and drive up prices, the Fed needs to do more than announce large asset purchases -- it also needs to announce that it will buy at wrong prices."

    Buying at wrong prices is just a fiscal transfer, with the loss adding to the national debt. So that doesn't work either.

    It's easy to raise the price level: simply announce a higher price index target. It's no more difficult than changing the price of gold under a gold-standard system. Controversial, but not hard.

    1. Max, you're making the simplifying assumption that the government will always support the central bank, and do so in a timely manner which, as this post points out, is by no means a guarantee.

      An institution can't simply announce a higher price target and expect to hit it if it's not willing to somehow degrade it's existing financial base, or if its issued liabilities don't already have a large liquidity premium. If neither of these conditions are met, then it's just barking without a bite.

    2. The financial base is a constraint in one direction only. It constrains the ability of the central bank to deflate. In the case of a formal, explicit policy statement, I don't see why an inflation policy wouldn't be credible, even without any showy actions.

    3. On the directional constraint, that was my point on asymmetry.

      I don't see how a monetary policy announcement can't be executed without a functioning lever... some mechanism to make good on a statement. QE as it has been carried out over the last few years has been a weak lever because it has been executed at market prices. The same goes for an expansionary Google monetary policy. If Google's lever was to buy huge amounts of stock in companies exactly like Google at market prices, then the market would soon call Google's bluff and discount the policy.

      QE would have been a great lever to execute an inflationary policy prior to 2008. Reserves were scarce, so QE could get a bite by attacking the liquidity premium on Fed deposits.

    4. Who in their right mind would want to bet against the central bank in the case where the CB, as you agreed, is unconstrained?

      It doesn't make sense unless you think the CB is lying - that it intends to reverse the policy.

    5. Rational investors will take the trade.

      Say that the market clearing price for Google shares is a multiple of 10x earnings. Google announces massive non-reversible QE **at market prices**, which means per share earnings don't change over the course of QE. If for some reason Google's price falls even a little bit upon the announcement, say that it trades at a multiple of 9x earnings, smart investors can now buy Google at a sub-market price. As long as they're offered this gift, they'll buy Google shares until they've pushed the price back up to 10x earnings. Thus QE (at mkt prices) won't cause inflation.

      (I'm assuming that the liquidity premium is negligible)

    6. Google shares are an equity claim. A dollar is only worth what the Fed says it's worth.

      Suppose that the Fed devalues (i.e. raises its price index target) by 30%, but for some reason nobody believes it. Then the Fed could buy whatever it wanted at a 30% discount and record a massive profit. That's not likely to happen. All the flexible prices in the economy will instantly jump on the announcement.

    7. "A dollar is only worth what the Fed says it's worth."

      In my example, a Google share is only worth what Google says it's worth.

      "Suppose that the Fed devalues..."

      Sure. Say that Google announces it intends to raise inflation, overpays for a bunch of assets, but no one pays attention. At some point smart investors will realize that Google is vastly overpriced relative to earnings, short the shares, buy a risk free bond, and earn an excess return. They'll push shares down until the excess disappears, thereby creating the very inflation Google initially announced.

      The fact remains that if Google decides to raise inflation, pays *market prices* for a bunch of assets and no one pays attention, then there is no mechanism for smart investors to push the Google share price down.

      Here's an older post on the subject. Funny enough, you make an appearance in it.

    8. "In my example, a Google share is only worth what Google says it's worth."

      That's confusing, but okay. If google is targeting a price level, then what you call bonds are the real equity, and the shares are a debt. Exactly the same as a central bank.

      "The fact remains that if Google decides to raise inflation, pays *market prices* for a bunch of assets and no one pays attention, then there is no mechanism for smart investors to push the Google share price down."

      The mechanism is the same. The balance sheet is just a commitment device, potentially. For example, suppose that a central bank marks up the value of its assets and pays out a dividend to the government. Depending on how well capitalized it was to begin with, that might irreversibly commit the bank to a higher price level (if we ignore the possibility of the government later bailing out the bank).

    9. "suppose that a central bank marks up the value of its assets"

      You'll have to explain that a little clearer, your wording is vague and could imply several different actions.

    10. The bank knows that its assets (its non-monetary assets, not bonds/loans) are temporarily undervalued if the market is ignoring its promise to inflate, so it uses an estimate of fair value rather than market value. It now has more capital, so it can pay out a dividend while maintaining the same leverage.

      Anyway, the point again is that it's all about commitment. People have to believe that the bank won't renege on its promise. Or at least, that such a policy flip flop won't occur with certainty. Balance sheet operations can make a promise more credible, but they aren't essential.

    11. "The bank knows that its assets (its non-monetary assets, not bonds/loans) are temporarily undervalued if the market is ignoring its promise to inflate..."

      Ok, but if an undervaluation develops then you're assuming the exact point I've been pushing against this entire post -- that Google QE at market prices is suitable ammunition to back a commitment to inflate. I say it's a hollow threat. The undervaluation you describe won't develop, and so there's no free lunch for anyone to capitalize on.

      On commitment: Who cares about a promise to inflate if the mechanism used to pursue that goal -- buying assets at market rates -- is powerless? It's like the Fed announcing a higher inflation target to be achieved by Bernanke doing cartwheels on the Fed's front lawn until that target is met. Or Larry Page promising to sing O Susanna until Google's price falls. There's no way to get from A to B.

    12. Money can't rationally be worth more than the central bank says. It would be a bubble. If everyone, not just some people but everyone, is determined to be irrational, then you may have a problem, but this is fantastically unlikely.

      To bring this back to the real world a little, the Fed is not actually trying to raise the price level with QE. At least, they are not saying it's what they want. So it's not surprising it isn't happening.

      I think the market takes QE as a vague expression of dovishness, and not as a firm commitment of any kind. So it's stimulus of a sort, but not very potent.

  2. I don't think changing the net worth of the central bank impacts the price level. That is because the money isn't an equity claim but rather debt instrument. For the most part, the value of the assets purchased impacts the gain to the government from monopolizing the issue of money.

    If the interest rate paid on money is equal to the interest rate on the assets the central bank purchases, it does seem to me that open market operations don't impact the price level. The standard assumption is that the interest rate paid on base money is zero and that the assets the central bank purchases have positive interest rate. The zero nominal bound is when the assets the central bank usually buys have a zero yield.

    However, if the central bank pays interest, and it acts like any other intermediary, it will pay less interest on its liabilities than it earns on its assets. That is how it covers costs and makes a profit.

    In that situation, changes in the quantity of money (given the demand for money,) will result in changes in spending and the prices of output in the usual way.

    Even if the central bank operates as a mutual fund, as long as it charges for its services, so that the yield on the mutual fund shares is less than the yield on the assets purchased, then open market operations will impact the value of the shares. Only if you assume, perhaps implicitly, that it varies its charges so that the demand to hold the shares varies with the quantity are the open market operations ineffective.

    I don't believe that google can issue new shares of stock to buy up the entire world. I think that such a plan will result in a reduction in the value of its share prices. I sure don't think they can issue debt instruments with a constant coupon rate and buy up the world without the bonds going to a very high discount.

    1. Bill, the market price of a debt instrument will always be impacted by the underlying financial health of the issuer. If Exxon has a massive oil spill, both its equity and its bonds will fall, although its equity will of course incur the larger percentage loss. So even if some medium of exchange is a debt instrument and not equity, a deterioration in the underlying issuer's net worth will still cause inflation, though not as much if that medium of exchange were equity.

      A central bank always faces the risk of incurring large enough losses that it must not only cease paying a dividend to the government but will also face credibility problems vis a vis its ability to continuing paying interest on deposits. People have problems with this idea because they don't pay enough attention to central banks in developing countries.

      Lastly, I think that as long as Google is smart and pays the right prices so as to maintain per share earnings, it can easily buy up the entire world without reducing the value of either its shares or its debt instruments. But it would never actually want to do this since the task of a business is to increase per share earnings, and to do so a business must be very selective.

  3. Great post, JP!

    How big do you think that liquidity premium on the US dollar might be? 5%? 10%? You'd agree that it would be much smaller for Mexican peso's or NZ dollars, right?

    I can see how gold and silver could have had big liquidity premia 500 years ago, but once people stop actually using gold and silver as money, and switch to trading paper and deposits, that premium would disappear.

    But it's different to claim that the paper dollar can have a liquidity premium. There are just too many rival moneys out there, and too much profit to be earned by issuing rival moneys.

    1. Mike, I'm not sure what the liquidity premia on dollars is nor if the premium would be larger for pesos or any other currency.

      There are two sorts of dollars issued by the Fed, paper dollars and deposits. Deposits are ultimately used to clear & settle interbank payments. For banks, there are no rivals to these clearing balances. Only one "brand" will do here -- Federal Reserve balances. No rivals exist. So I'd hazard a guess that the liquidity premium on Fed deposits is pretty high compared to the premium on other assets.

    2. Two other suitable media for interbank payments are (1) Deposits held by a private bank, (2) bank notes.

      I expect T-bills would also do in a pinch.

      Personally, I'd put the liquidity premium for bank notes at under 3%, just big enough that potential arbitrage profits would be eaten up by transaction costs.

    3. Yes, I suppose there are alternative media. What I meant was that rival clearinghouses are prevented from competing with central banks. Banks are required to maintain accounts with CBs. And often a reserve requirement forces banks to hold more in their account than they otherwise would prefer. All of which would inflate the premium on central bank deposits.

  4. Doesn't empirical evidence suggest though that QE actually is effecting prices of at least equities? Or is it a coincidence that equities rise with QE or expectations thereof and fall without it?

    1. Yes, there have been a few papers that find an effect in financial markets. This one for instance:

      But the results are not necessarily conclusive. See for instance:

  5. Sorry for the late comment. I stumbled on to this one from a comment on Scott Sumner's blog. I think the MOA will play a role here. Any dividends that google returns to its shareholders are in the form of bonus google shares. If the MOA in the market is percentage of google ownership, then any dividends are effectively useless as their percentage of google ownership does not change. If the MOA in the market is google shares itself, only then will google be able to perform any of these monetary operations.