Friday, March 30, 2012

Deleveraging and Financial Intermediation

One consequence of the financial crisis was that our economy had to experience a period of deleveraging.  This period, according to conventional wisdom, constrains the ability of an economy to grow.  I thought it would be interesting to examine the economics of  deleveraging and how the process harms the economy.

In this discussion of deleveraging, I focus on deleveraging that occurs in financial services industry, as that was the primary focus of the deleveraging concerns following the financial crisis.  Nevertheless, the same principles apply to any industry whose participants utilize nonequity capital (e.g. debt, deposits, etc.) to fund its operations.

Financial services companies help savings equal investment in the economy.  Individuals can make direct investments in stocks, bonds, or real estate.  Many, though, don't have the expertise or familiarity with risky investment opportunities to make informed decisions. Financial services companies, also known as financial intermediaries, allow investors to contribute to valuable, yet risky investments, without having to select the investments and, in many cases, accept the risk of the investment.  For example, a bank depositor may earn a small return on his or her deposit, which is guaranteed by the bank and the FDIC.  Meanwhile, the deposit can be used to make a mortgage or small business loan, investments with considerably more risk.  The financial intermediary has expertise in selecting quality investments from among those available, channeling individuals' savings into the most productive investments.  For this service, the intermediary keeps the difference in return between its investment (mortgage or small business loan) and the individual's investment (savings deposit).

The critical contribution that financial intermediaries make to our economy is they allow uninformed, risk adverse individuals to provide capital for risky investments.  Although their investments are risky, financial intermediaries (generally) possess the expertise to select only those investments where the expected return compensates for the risk borne.  When financial intermediaries take lower risk capital and use it in higher risk investments, they are creating financial leverage.  The use of financial leverage requires that the providers of low risk capital have confidence in the financial intermediary to select the appropriate investments and perform appropriate investment monitoring.  

When intermediaries have lost the confidence of those seeking lower risk investments, they can no longer rely on financial leverage.  Deleveraging is the process by which financial intermediaries have to decrease their use of low risk capital sources to make their investments, likely because of a loss of confidence from these low risk investors. Companies can lose investor confidence through a variety of means, including making poor investment selections, experiencing accounting irregularities, or through bad publicity.  During the financial crises, all of these examples were present in some capacity.

When financial leverage is unavailable, the intermediary may be able to raise equity capital to fund its investment opportunities.  As described above, however, many investors don't have the expertise or familiarity to make risky investments in equity.  These investors seek lower risk investments, and when traditional low risk investment alternatives become unacceptable, no investment occurs.  In essence, the individuals with capital to invest don't have the expertise to determine which investments are profitable; during the process of deleveraging they are also unwilling to provide the capital to institutions that do have such expertise.  Profitable investment opportunities are lost as a result, and economic growth suffers.

Thursday, March 15, 2012

Money's Impact on Economic Output and Growth - Part 2

In Part 1 of  Money's Impact on Economic Output and Growth, the implication of money's role as a a medium of exchange and a store of value was discussed.  The third role of money in our economy--a unit of account--follows here.

Unit of account

Because money trades against all goods and services, it is easy to compare value across goods and services in a monetary economy.  Austrian economists discuss how prices send signals to market participants, and these signals result in resource allocation and innovations.  Prices (and interest rates) are the unit of account that occurs in monetary economy.  Barter economies don't have a common unit of account until one of the goods trades against all other goods. If a good started trading against all other goods (think of gold for example), the common good being traded has essentially evolved into a form of money.

The benefits from the information content in prices and interest rates is vast.  Business managers and entrepreneurs make decisions based on current and expected prices for the goods and services.  Allowing the value of goods and services to easily be measured against one another makes decision making more effective.  As prices change in our economy, businesses are able to respond and new companies form to seize profitable opportunities.

The nominal value of money can also cause our economy problems, most notably when there are unexpected changes in the overall price level (inflation or deflation).  Contracts are generally written in nominal terms, unadjusted for price changes.  For example, the standard bond (a very common business contract) promises to pay the holder a set amount of money over time, regardless of what happens to prices in the future.  A large price increase makes the bond issuer better off, but the bond holder worse off,  because the payments under the bond contract now purchase fewer goods.  Possibly even more destructive to our economy is a deflation, where prices drop across the board.  Because nominal contracts do not fall with prices, companies are faced with larger debt balances relative to their operating profits.  Widespread bankruptcies can occur during deflations, leading to large levels of unemployment.  This is one of the common observations of what occurred during the great depression.

Both parties of any contracts based on nominal dollars are subject to risks from changing price levels.  This is a main reason why central banks, including the Federal Reserve, generally have a mandate to keep overall price levels stable.*  Because governments control the money supply and inflation rates to a large extent, the credibility of the government to enforcing price stability is paramount to participants willingness to contract.  As contracts, including debt contracts, play such a large role in our economy, a loss of government credibility in fighting both inflation and deflation can lead to a loss of total output and employment.

* A mandate to keep the overall price level stable does not mean central banks prevent relative price changes. Price changes occur as preferences change between goods, leaving some goods more expensive and others less expensive.  Overall the price level in such a scenario remains the same.

Thursday, March 1, 2012

Money's Impact on Economic Output and Growth - Part 1

We take our use of money in society as a given.  It seems ridiculous to think of an economy as sophisticated as ours trying to operate on a barter system.  The benefits of using money are large.  However, the use of money creates obstacles as well.  Here I'd like to explore the effects of a monetary economy on the total output (GDP), and also fluctuation in that output.

There are many definitions of money.  The Federal Reserve has tracked money in the form of M1, M2, and M3; each of these terms, respectively, is a broader definition of the concept of money.  For example, M1 includes currency in circulation, plus demand deposits ((i.e. checkable deposits).  M2 includes all of M1, plus savings deposits, time deposits less than $100,000, and money market deposits.  Other measurements of money, such as the monetary base and money of zero maturity (MZM) are also referred to and discussed in the media.

The role that money plays in an economy are generally categorized into the following three groups.
  1. Medium of exchange
  2. Store of  value
  3. Unit of account
I'd like to examine these roles for money, and how each impacts the economy output and growth.  In my opinion:
  • the medium of exchange role results in large benefits at no costs for an economy.  
  • the store of value role results in harmful effects for an economy.  
  • the unit of account aspect of money results in benefits as well as costs for an economy, although the benefits exceed the costs.  
Overall, money increases total output in an economy, and facilitate economic growth as well.  It is no certainly no panacea, however, and a study of its harmful effects is important to understanding how our economy functions.  In Part 1, I'll discuss the medium of exchange and store of value aspects of money.  In Part 2, I'll address benefits and costs that result from the unit of account role of money.

Medium of exchange

By having an asset that is readily accepted to settle all transactions, costs associated with exchange are significantly reduced.  The costs of a barter economy include search costs, negotiation costs, divisibility costs (how could you buy a truck from someone who wanted payment in cars, when the truck was worth between 1 and 2 cars?)  As a result, in monetary economies individuals and institutions can specialize in producing a narrow range of goods or services, assured that they can trade for other goods and services they need.  The alternative to a specialization and exchange society is one in which individuals produce all goods and services they consume. Such a proposition is tremendously costly, and reduces the total output available.

I believe the medium of exchange characteristic of money is the easiest of the three to understand and observe in daily life.  Its impact on economic output is exclusively positive, unlike the other two characteristics of money.

Store of value

Individuals can store wealth in money or in other assets.  In our fiat monetary system (fiat simply refers to money has value because the government says it does, and not because it can be redeemed for real assets), money demonstrates two unusual characteristics:
  1. Money, unlike other assets, is not affected by certain market forces.
  2. The marginal value of money to the real economy is zero.
Lets look at these characteristics separately.

When demand for all other assets increases, the price of that asset increases.  Not so with money, which always keeps its nominal value.*  In addition, fiat money is controlled by the government and the banking institutions.  With fractional reserve banking, banks can alter the supply of money to a point.  However, banks are subject to governmental regulation, so ultimately money supply is a function of the government control.  Whereas for most real assets (e.g. oil, trucks, housing), market forces cause supply to increase when demand increases, this does not necessarily hold true under a fiat monetary system.

Once an economy has a well accepted monetary exchange system in place, additional money does not increase the wealth in the economy.  This is because, as widely accepted among economists, prices adjust to  reflect changes in the money supply.  The relationship between money and prices is referred to as the quantity theory of money.  Paradoxically, we can conclude that, for the economy as a whole, money is the only asset where an increase in quantity does not result in an increase in wealth.  Consider any other asset in an economy (e.g. oil, trucks, housing)--as more of these assets are held, the economy becomes richer.  For money, such a fundamental, logical relationship does not hold, as an increase in money only makes prices of real assets move higher.

Why does all this matter?  Well, when demand for money increases in our society, i.e. when people seek to hold more money for its store of value attributes, we face economic problems. Any supply response (whether from banks or from the government) does not add any value to our economy.  Any additional money supplied in an economy can be considered artificial assets, as it ultimately results in higher prices, not any value creation.  In essence, when demand for money increases in our society, we switch our demand from wealth creating assets (i.e. real assets) to wealth neutral assets (i.e. artificial assets).  Total real output suffers as a result.  

Macroeconomists that follow the concepts first articulated by John Maynard Keynes, generally termed Keynesian macroeconomists, refer to an increase in demand for money as "a fall in aggregate demand."  I believe a more precise term such an effect should be "a fall in demand for real goods and services."  After all, money is generally considered an asset, and demand for goods (including assets) and services has not actually changed in aggregate.  Instead, demand has been shifted, in part, from real goods and services to artificial assets. Our GDP and employment levels depend on the amount of  real goods and services produced.  When demand reallocates from real to artificial assets, we face declining real output and employment.

* Unlike other assets, whose price is generally expressed as an amount, the price of holding money can be expressed as the prevailing interest rate.