Money, valuation, and financial innovation

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…

 
 

2 Responses to “Money, valuation, and financial innovation”

  1. HZ writes:

    Nice work, Steve. It will take a while for me to come up with some semi-intelligent comments, but I will put down some immature thoughts for now.

    First the goal of the central bank: price stability. I think the ultimate goal is really to have market function efficiently. Obviously for market to have any use at all, price must fluctuate to give signals to producers/consumers. A static price would be useless. Normally rational participation of the speculators increases liquidity and help establish expectations of demand/supply. A commodity futures market allows commodity producers to plan and hedge. But speculation gets out of hand sometimes: for a normal market to work when price of something goes up, consumers need to slow down and seek alternatives while producers need to step up production; however if an expectation of price appreciation is established, speculators will pile in on the buy side as price goes up or sell as price goes down, sending wrong signals to consumers/producers and producing micro or macro boom/bust cycles and causing mis-allocations of capital. So I view the function of price stability as really to ensure that speculation does not get out of hand. As a former Fed Chairman said: “to take the punch bowl away while the party gets going”. That is also why inflation expectation is the most important gauge in central bankers’ calculations.

    Now coming back to our topic of the fundamentals of money. We agreed that there are various forms of money, really claims, from the most general and liquid claims (reserve bank notes) to less liquid and general claims that are securitized (bank CDs, MBS/ABS/CDO, bonds, stocks) to least liquid and most specific claims (I think ownership of physical things can be put in this category, so now we can now conveniently just deal with claims and bartering is implicitly taken care of). These are all traded with different speeds and have their own markets. Central bank only sets the price for one of them through the interest rate (really the opportunity cost of holding reserve bank notes). By affecting the cost of one claim it hopes to ensure all other claims trade in markets that are orderly and rational. AG seems to view this as an impossible task, considering his passivity in face of the Y2K bubble. As you said the trading of the claims do spill over into the real economy, by affecting the consumer’s propensity to spend and, I may add, also by signalling producers about capital allocation decisitons. Just looking at the CPI-type inflation index or GDP deflators is woefully inadequate, the proverbial driving but looking at the rear-view mirror. We really need some kind of rationality index to tell us how rational market participants are :-)

    Then there is the issue of claims owned by foreigners, one that Dr. Setser is fond of, as long as there are still national boundaries and huge differences in development levels among the nations. There is the issue of distribution of ownership of claims, which obviously affect spending patterns. There is also the issue of money as value store. As always the utility of money or general claims is to bridge the mismatch in needs among market participants. In this case, for people saving for retirement (or other future spending needs) it is awfully hard to save physical things instead of collecting more general claims. So there is also obligation to maintain the value of money.

    As I said these are mostly immature thoughts that need to be sorted out. I am sure it will take a long while, if ever!

  2. jkbjhzsen writes:

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