"If money isn't loosened up, this sucker could go down" - George W. Bush warned in September 2008

Saturday, October 2, 2010

Brad DeLong and flight to safety

Brad DeLong ponders the issue of the root cause of the crisis. Is it that the full-employment planned demand for safe assets is greater than the supply, or is it that the full-employment planned demand for medium of exchange is greater than the supply? In other words, is it the flight to safety, or is it the flight to liquidity? Brad DeLong argues that we have the flight to safety:

"Thus we would expect a downturn caused by a shortage of liquid cash money to be accompanied by very high interest rates on, say, government bonds--which share the safety characteristics of money and serve also as savings vehicles to carry purchasing power forward into the future, but which are not liquid cash media of exchange."

The problem is that government bonds serve both as savings vehicles and as medium of exchange. As Gary Gorton said, "it seems that U.S. Treasuries are extensively rehypothecated and should be viewed as money". You purchase groceries with cash, and you purchase other financial assets with U.S. Treasuries, but in both cases we are dealing with media of exchange.

It is very hard to disentangle these two facets of U.S Treasuries, but we have a great natural experiment. After the collapse of Lehman, TIPS were a perfectly safe savings vehicle, but they were much less liquid than cash or other Treasuries. Lehman has mainly used TIPS as repo collateral, and after liquidation the pattern has shifted, the marginal holder of TIPS was more likely to use it as savings vehicle rather than for transactional purposes. The result was what FT Alphaville has called "The largest arbitrage ever documented", as the price of TIPS fell by as much as 20 cents on the dollar as compared to much more liquid Treasuries. This gives us a clear indication that post-Lehman panic was a flight to liquidity, and not a flight to safety. This means the best policy response was the expansion of the quantity of liquid, rather than safe assets. After March 2009 QE announcement, the Fed has greatly enhanced liquidity properties of TIPS.

While the root cause of the crisis might have changed since the Lehman panic, the low prices of Treasury securities give us no indication what it is. We might have the lack of safe assets, or we might have the lack of liquid assets. Policy responses that expand both are to be preferred at this point. One good option is credit easing - expansion of central bank lending collateralized by a diversified mix of medium quality private sector assets. Replacing 3-month T-Bills with reserves achieves nothing, as 3-month T-Bills have greater utility as medium of exchange than reserves, we know this because 3-month bills often yield less than the effective fund rate.

When the Minsky moment arrived in September 2008, we had a flight to liquidity that was not fully accommodated by the Fed. Investors who thought that we had a flight to safety underperformed after Lehman as they purchased safe but less liquid assets such as TIPS, off-the-run Treasuries and gold mining stocks.


  1. Nominal bonds were also a depression hedge, so in a marginal portfolio addition sense, it's not clear that TIPS were as safe.

    Though, I have to say, I was surprised, looking at the Fed's data just now, to learn that TIPS yields rose about 50 basis points more between August and November of 2008 than did yields on Baa bonds (which surely weren't a good depression hedge, judging by their performance during the early 1930's). So I guess you're right. Unless there was a huge decline in inflation expectations at the same time.

  2. 123 - themoneydemand.blogspot.comOctober 2, 2010 at 6:55 PM

    even if you take changing inflation expectations into account, the TIPS puzzle remains.

  3. This is the sort of post I've been trying to write, but can't.

    Were Tbills *really* media of exchange, in the full sense of the word?

    If we define "money" as all media of exchange, did the money supply fall?

    Was Milton Friedman right after all? Was this recession too caused by a fall in the money supply? Just like the bank runs in the 1930's. And we just didn't see it, because we didn't see this stuff as truly being part of the money supply? So we thought it was a rise in money demand?

  4. Nick,

    If anything, I would think including T-bills in the money supply would mean that the supply of outside money was rising faster than reported. The Fed's balance sheet shows very few T-bills at any point after August 2008, so it was not merely exchanging one form of money for another (and prior to that point, it was actually selling T-bills while buying other assets, so in that sense it was increasing the money supply). And of course the Treasury was continuing to borrow all along, so I presume it was net issuing T-bills. There was a shift in its maturity policy at one point, but I don't think that came until 2009.

    But maybe you mean that commercial paper and other inside assets are also media of exchange? And perhaps some that had been considered acceptable media of exchange became unacceptable, so the money supply fell in a way that is not reflected in any statistics? That's an interesting idea.

    You might be interested in a post I did a few months ago, where I argue that, with money and T-bills essentially perfect substitutes on the margin, the Treasury's financing policy is really monetary policy.

  5. Nick,

    T-bills are a media of exchange only to extent they are used in repo transactions. M3 aggregate that includes repo has been discontinued, but I'll check perhaps Gary Gorton has got something.

    M3 reconstruction by Shadowstats shows sharp decline in growth rate of M3 starting from early 2008, but I don't know if this is reliablie.

  6. Andy: "But maybe you mean that commercial paper and other inside assets are also media of exchange? And perhaps some that had been considered acceptable media of exchange became unacceptable, so the money supply fell in a way that is not reflected in any statistics?"

    That's sort of what I had in mind.

    123: was there something that prevented Tbills being used in repo transactions as much as they had previously been used, or did people choose to use them less in repo than they previously had?

    You see, Milton Friedman said that as long as you kept the money supply growing at k%, where k is a small constant, nothing much could go wrong with AD. I had always thought he was wrong, and that this recession was an example. That in practice fluctuations in money demand were just as big as fluctuations in money supply, and that this recession had a big increase in money demand. But when I try to get my head around this Gary Gorton stuff, I realise it's not that obvious at all.

    There's a lot of dark matter being used as media of exchange we're not measuring. If the desired reserve ratio increased in the shadow banking sector, and if shadow banks collapsed, then the money supply could have fallen without me seeing it.

    I want/plan to write a short post on this, just raising the question. But I haven't a chance of answering it myself. It would only work if some guys like you come in and give some sort of answers.

  7. Nick, here is Gary Gorton on repo ( http://online.wsj.com/public/resources/documents/crisisqa0210.pdf - BTW this document is an excellent summary of Gorton's views) :
    " Repo is money.  It was counted in M3 by the Federal Reserve System, until M3 was discontinued in 2006.  But, like other privately created bank money, it is vulnerable to a shock, which may cause depositors to rationally withdraw en masse, an event which the banking system – in this case the shadow banking system cannot withstand alone.  Forced by the withdrawals to sell assets, bond prices plummeted and firms failed or were bailed out with government money.

    "We don’t know how much was withdrawn because we don’t know the actual size of the repo market. 
    But, to get a sense of the magnitudes, suppose the repo market was $12 trillion and that repo haircuts rose from zero to an average of 20 percent. 
     Then the banking system would need to come up with $2 trillion, an impossible task.

    The rough estimate of $2 trillion means there was a huge instability in money supply, and this instability of money supply was an important causal factor in this recession.

    Now there is this whole social construction of reality stuff. ECB has never abandoned the analysis of broad monetary aggregates, and even though perhaps some parts of shadow money stock where not counted, growth rate of M3 clearly shows the instability of money supply:

    In the US M3 was discontinued, and all we got are the interest rates in shadow banking system. Only the conspiracy theorists are reconstructing M3:




    You asked:
    "was there something that prevented Tbills being used in repo transactions as much as they had previously been used, or did people choose to use them less in repo than they previously had?"
    The main reduction in repo money was caused by the decline in value of private sector securitized bonds. There was also a natural experiment whereby after bankruptcy Lehman's repo TIPS portfolio was dumped on buyers who were not using repo.

    Please tell if you have any further questions.

  8. Thanks! I did my post. http://worthwhile.typepad.com/worthwhile_canadian_initi/2010/10/was-milton-friedman-right-after-all.html
    Now it needs someone like you, obviously more competent than me, to respond to it!

  9. Good post Money Demand.

    I know something about what you are describing. As a gold investor in the chaos of Sep-Oct 2008, I was bemused to see my portfolio lose money.

    Riddle me this. If the Lehman reaction was a rush to liquidity, and if the U.S. dollar is the most liquid medium of exchange, then why did the value of the yen increase dramatically against the U.S. dollar in fall 2008? Why a movement towards illiquidity? There must be more to the story than just liquidity.

    Re: defining the money supply.

    When we look back at things 500 years from now, our efforts to define the stock of "money" and count it will look as silly as the our attempts to define the aether and measure it.

  10. JP Koning,
    good question.

    Yen rallied, because carry trade collapsed. I guess it was more related to developments in relative liquidity of Yen vs. USD, than to relative developments in relative safety of these two currencies. I have to think about this more. Another possibility is that collapsing carry trade was an additional cause of lower dollar liquidity.

  11. Have we reached a pass where the flight to liquidity is the same as the flight to safety?

  12. Anonymous, this is a 64 billion dollar question.

    If at this point flight to liquidity is the same as the flight to safety, then QE2 purchases of government bonds will work only by signalling that there will be plenty of liquidity in the future when demand for safety subsides.

  13. What happens when a nation's national debt outstrips that nation's M3? Historically, has it ever happened before either in this country or elsewhere?

  14. Anonymous, it makes more sense to ask if M3 is too large/small, is national debt too high/low separately.

  15. There must be trend lines with upper and lower boundaries which, when violated by more than a certain percent and by more than a certain length of time, ring bells and raise flags.. I realize that economists have only been dealing with these astronomical numbers for a couple of decades, but aren't we in an economic terra incognita now?

  16. Anonymous,
    Yes, there might be boundaries. For debt, see Rogoff:

    For optimal quantity of money, see Scott Sumner:

  17. Thank you very much.


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