Summary: I claim that financial innovation has coupled the real economy to asset valuations more tightly than in the past. This coupling results from an increase in the liquidity of many assets, which has led to genuine growth, and is mostly a good thing. But the downside is a much higher cost to errors and volatility in the valuation of assets, as asset write-downs feed directly into contractions of nominal GDP.
The argument is based on a thought-experiment substitute for traditional monetary aggregates, which I think yields useful insights (and is inspired by a conversation with HZ in the comments to a previous post).
If I were to make up Steve's estimate of the money supply, it would look something like this...
In other words, I claim that the effective money supply is related to the sum over all individuals and firms in an economy of all of assets — including real assets, financial assets, and potential labor or service provision — with each asset valuation being adjusted by fudge factors reflecting the liquidity of each asset and the propensity of the asset's holder to use claims against the asset as the basis for some form of sale or exchange.
What distinguishes Msteve from, say, M1, or M2, or M3 is that my measure of the money supply has nothing to do with the amount of currency in circulation or dollars in bank account. Msteve is also distinguished from more conventional measures of the money supply by its incapacity to be, well, measured. Msteve is just a thought experiment, a theoretical construct. But I claim that if Msteve could be estimated, it would be a better estimate of the money supply.
To be more precise, Msteve can be thought of as a replacement for the left-hand-side of the so-called equation of exchange:
MONEY x VELOCITY = PRICE_LEVEL x TRANSACTION_VOLUME
Msteve stands in not for "the quantity of money", but for the degree to which claims on assets are mobilized as the basis for exchange. It subsumes the so-called velocity of money, whose work is taken up by including the "liquidity propensity" of each asset of each particular entity.
Msteve = PRICE_LEVEL x TRANSACTION_VOLUME
Another nice aspect of Msteve is its applicability to a world of many currencies. Traditional measures of money supply depend on some measure of dollars or yen outstanding, which is hard to make sense of in a global economy. You can choose any currency you like as units for the Msteve-ified exchange equation, as long as your valuations are given in that currency.
Msteve is the product of some dude's intuition, it's nothing more than a thought experiment. As we'll see there are interdependencies between and ambiguities about the factors of Msteve. But I think it provides a helpful framework for understanding how changes to the global economy can be driven by financial innovation.
Financial innovation tends to increase both the liquidity and the valuation of assets. In a world without Wall Street, a house would be a very illiquid investment. If one had a house and needed dinner, the only way one could mobilize the value of that house towards purchasing dinner would be to sell the whole thing. Banks allow homeowners to borrow money against the value of their houses, making a house a much safer thing to own for people who like to eat and don't have much more money than their house is worth. But banks are limited in their ability to make houses liquid, because they are only permitted to lend so much, and their appetite for risk in any single sector is limited. Securitization of home loans further increases the liquidity of a home, by letting many sorts of investors underwrite the lending of homes, without the regulatory or risk constraints faced by banks. Deep markets for packaged and securitized home loans means that for a homeowner to gain liquidity in her home, the lender doesn't need to forgo liquidity. The lender can always turn his loan into cash by selling a security. So, thanks to financial innovation, all of the equity in a home — and many other assets — is quite close to cash.
Increasing the liquidity of an asset intrinsically increases its valuation, as purchasers who historically required a discount for illiquidity in order to purchase an asset are willing to pay full price, and the market for previously illiquid assets is expanded to include potential buyers who have use for the asset but cannot tolerate illiquidity.
Financial innovation increases asset valuations in other ways as well. Diminishing the transaction costs associated with buying or selling an asset also may increase its the value. Rights associated with ownership of an asset — such as the right to sell an asset a certain price and time — can be "unbundled" and separately securitized. The sum of the unbundled rights of ownership will sometimes much more than what the integrated asset would have been worth absent markets for the unbundled rights.
Going back to the Msteve-ified exchange equation, we can see that a simultaneous increase in valuations and liquidity would be expected to lead to higher prices and/or higher transaction volumes, something like increased nominal world GDP. If one views, as I gather monetarists traditionally do, the growth of transaction volumes to be capped at a low rate, one would expect most of the excess valuation and liquidity to flow through to prices. But if one thinks, as a theoretical matter, or because of temporary conditions like China's growth spurt, that transaction volumes can move upward, then perhaps financial innovation feeds forward to a genuine increase in goods and services produced and traded in the economy.
So far, this is all very virtuous. Financial innovation creates flexibility and liquidity for asset-holders, which is a good in and of itself. By increasing valuation and liquidity, it may lead to some inflation as long as innovation proceeds at a rapid clip, or it may stimulate real economic growth. In the real world, inflation has been at worst quite managable, and there does seem to have been a lot of real growth, particularly in developing Asia.
But there is a downside. Prior to recent advances in finance, the right-hand-side of the Msteve-ified exchange equation may have been much more impervious to changes in asset valuation. For many assets, the liquidity factor would have been very low, meaning that the full valuation of many assets could not be mobilized for use in exchange. A rise or fall in the value of these assets had little impact on PRICE_LEVEL x TRANSACTION_VOLUME, which we henceforth fudge as nominal GDP.
Financial innovation has increased nominal GDP by increasing the liquidity factor of many assets in a way that may be quite stable, so long as the new institutions endure. But in this new financial world, volatility in asset valuations feeds much more directly into volatility in nominal GDP. We've discussed some quite benign ways that financial innovation increases asset valuations. But financial innovation often means securitization, and historically, securities markets have been quite prone to bubbles and corrections. Further, innovations in finance have produced a variety of complicated new assets, whose valuation is complex and theoretical, and whose realizable value may prove to be very volatile. The valuation of exotic financial assets, so long as they are liquid, feeds directly into nominal GDP according to Msteve.
Financial innovation really has lived up to the hype of "unlocking the wealth" hidden away in our homes, our future capacity for labor, and many other secret places. In doing so, it may have helped to create real growth. But we may find that we've created a world in which the real economy is as volatile as securities markets are, and in which securities markets are more volatile than they once were.
Volatility is a function of security definition and market structure, among other things. Defining claims against the world's real assets that more amenable to accurate and stable valuations is the next great frontier in financial innovation. In the meantime, hold on tight.
- 11-Mar-2006, 12:00 p.m. EET: Fixed some typos and grammatical errors; included risk as well as regulation among constraints of banks.
|Steve Randy Waldman — Monday March 6, 2006 at 8:42am||permalink|