Money. Doing it Right this Time.

I recently read an article about money, central banking and the current crisis. Here's a part I found interesting (beware bad translation, my bolding):

Central banks can't create infinite amounts of money. Too much new money will likely erode the value, purchasing power will decrease and so inflation becomes a fact. Because of this, Central Banks watches price trends closely.

But perhaps they made a crucial mistake, according to Matt King [interviewed Credit Analysis responsible at Citibank].

-They've only focused on prices of goods and services but not prices of shares and real estate. If they'd done that the credit expansion would not have happened as quick.

So why not taking prices of shares and housing into account when estimating inflation/money supply? Isn't that by the way the two most common markets creating bubbles? Seems such bubbles could be mitigated or even prevented if the heads of Central Banks issued warnings and/or raised rates whenever those markets got hotter.
 
Leoreth: good question and I will try to get to it this weekend. Busy busy week.
Great, I'll look forward to it. Take your time though :)

[...]

Real business investments have uncertainty plus typically long time horizons for payoff. And the more uncertain the economy as a whole is, the more uncertain the investments in it are. And so money looks for a use elsewhere. They look for a sector of the economy that's really booming. Or they look internationally for a booming location. Or they look for something new that they can get in on the ground floor of.

Or they look for something that's safe as houses.

And when enough money finds one of these places, that's where you get a bubble.

Now bubbles draw money away from real productive business investment. Investors misjudge the safety of the investments. And so the high returns look really attractive. And it is sometimes difficult to tell where legitimate asset growth leaves off and a speculative bubble starts. The borders can be blurry, and even the "experts" can disagree. A number of people called housing a bubble in the US in 2005-6. But a number of others didn't see it for a critical couple of more years.

That money could have gone to productive business investment. But stagnating consumer purchasing power made that look like a less attractive bet. While housing looked, for many reasons, including vast amounts of outright fraud, to be both a higher return and a safer bet.
Thanks for the long answer, which I cut down a bit only to avoid my post becoming too large. What I'm wondering at this point is whether the ratio of "real business" investments to other forms of investments is really proportional to the amount of available money. Isn't business investment limited to the amount of business actually conducted, plus maybe an also limited amount of expansion or technological innovation waiting to be implemented with enough money available? Other "creative" forms of investment don't seem to be that easily limited in the same way.

From there, I want to see what Integral has to say. I suspect that he's much more comfortable with the monetary explanation than I am. Now it is money. But that doesn't tell you all that you need to know. And I'm uncomfortable saying that it is all about the money. You can shut off the spigot of money, but that doesn't go straight to shutting off the bubble. It shuts off the whole economy, and probably the bubble last of all. And that's why I'm leery of a monetary response to bubbles. It can't be targeted in that way.
That's a good point. Although, with the tightening of money, wouldn't investors be more inclined in investments grounded in actual businesses because there's not so much speculation involved that's bound to collapse as soon as there's less money involved in the equation. But that's where the (ir)rationality of the actors comes into play I suppose.

I suspect that a lot of the answer to why bubbles are flying so fast and furious these days is primarily 2 things: 1) Money is much more concentrated now than it has been in the modern era. That means that there's far more investable capital, but there is a smaller proportion of consumer purchasing power. And that means that the opportunities for productive business investment are artificially narrowed. And so there's just more money chasing fewer real investment opportunities. And 2) the speed with which money can flow from one investment to another, both with in a country and worldwide, has simply gotten so fast that money rushes around faster than people really think and analyze what they are doing. In the money markets now it is all about moving faster than everyone else in order to get that little more rate of return than they get. And all that rushing around means that there is just less thought and planning involved.
Point (1) is also very interesting. Who does benefit in the most direct way from expansive monetary policies? It appears that it's those already involved in the business of investing otherwise unused money, because they are much less averse to taking that kind of risk than the average person, who only benefits indirectly and only if the money is put to sound use by these people.

Additional note: I don't want to criticize expansive monetary policy here; I rather try to reiterate some points of its critics that intuitively didn't seem wrong to me to see how they fit into the big picture of professional economics.
 
I recently read an article about money, central banking and the current crisis. Here's a part I found interesting (beware bad translation, my bolding):



So why not taking prices of shares and housing into account when estimating inflation/money supply? Isn't that by the way the two most common markets creating bubbles? Seems such bubbles could be mitigated or even prevented if the heads of Central Banks issued warnings and/or raised rates whenever those markets got hotter.


As far as I know, that is an approach being debated in monetary economics circles. Which Integral is in, and I'm on the outside of. So hopefully he can give you a better response than I can.

The problem remains, as I see it, that you still risk choking off the real economy before having much of any effect on the bubble.
 
Thanks for the long answer, which I cut down a bit only to avoid my post becoming too large. What I'm wondering at this point is whether the ratio of "real business" investments to other forms of investments is really proportional to the amount of available money. Isn't business investment limited to the amount of business actually conducted, plus maybe an also limited amount of expansion or technological innovation waiting to be implemented with enough money available? Other "creative" forms of investment don't seem to be that easily limited in the same way.


Well that's really the point I'm trying to make. But I don't quite have the theory or statistics to pull it off. :) Over the past 30 years income and wealth have become more concentrated in the US. What that accomplishes is that consumers have less wealth to spend. And that results in less business opportunities for those people and firms that want to relieve consumers of their money.

Less opportunity for profitable business investment.

Yet that money does not want to sit idle. What does it go to when it can't find those sound business investments?



That's a good point. Although, with the tightening of money, wouldn't investors be more inclined in investments grounded in actual businesses because there's not so much speculation involved that's bound to collapse as soon as there's less money involved in the equation. But that's where the (ir)rationality of the actors comes into play I suppose.


If investors invested rationally and with good information, you would have a point. Can you say that they do?


Point (1) is also very interesting. Who does benefit in the most direct way from expansive monetary policies? It appears that it's those already involved in the business of investing otherwise unused money, because they are much less averse to taking that kind of risk than the average person, who only benefits indirectly and only if the money is put to sound use by these people.

Additional note: I don't want to criticize expansive monetary policy here; I rather try to reiterate some points of its critics that intuitively didn't seem wrong to me to see how they fit into the big picture of professional economics.


I'll try to make a post on the basics of central banking soon. I know some of the foundation theory. Integral is into the modern and detailed theory.
 
If investors invested rationally and with good information, you would have a point. Can you say that they do?
Not to mention that a lot of what is considered "irrational investment" is actually quite rational.
For example investing in a bubble can be rational. It usually represents a high risk, high reward proposition. Just think of all the groups that dumped their motgage backed securities and/or real estate in early 2008. Even Ponzi schemes can be good to invest in because, if you are able to get out before it breaks you can have a big payday.
 
Not to mention that a lot of what is considered "irrational investment" is actually quite rational.
For example investing in a bubble can be rational. It usually represents a high risk, high reward proposition. Just think of all the groups that dumped their motgage backed securities and/or real estate in early 2008. Even Ponzi schemes can be good to invest in because, if you are able to get out before it breaks you can have a big payday.


That's an important point. You can make a lot of money on a bubble, even knowing that it is a bubble, particularly knowing that it is a bubble, if you get out before the bubble burst.

The reason Goldman Sachs still exists is that they were the first major firm to get the hell out of Dodge when it looked like housing was going to go belly up. The reason Freddie Mac and Fannie Mae caught all the bad debt and are still catching the bad debt is because they were the last ones to get into the housing bubble.
 
That may be true for individual actors (and frankly I hate how European politicians try to shift the complete blame for the current debt crisis to the "irrational markets"), but bubbles are still not beneficial for the economy as a whole. So a good economic policy would seek to prevent them.
 
There are plenty of other things that can be hoarded. In older times, hoarding land was an issue. You keep the people off it that need it to grow food and reserve it for only the use of the owner. Gold, silver, gems, any of the things that can be bought with money.

What money gives you is a greater ease of having it and letting others use it. In practical terms, there really isn't hoarding, as it is commonly thought of, in the present times. That money is available for the use of other, only at a price. Where hoarding in the old fashion way just took it out of the economy and set it to the side under guard.

I said money is EASIER to hoard and amass, not that it is the only thing that can be hoarded. Moreso nowadays with literally virtual currency. You don't even need the small room you once needed to hoard it.
 
I said money is EASIER to hoard and amass, not that it is the only thing that can be hoarded. Moreso nowadays with literally virtual currency. You don't even need the small room you once needed to hoard it.

Amass, yes. But "hoard" has a very different meaning. And in the modern sense, hoarding simply does not take place.

The term hoarding assumes that the money is accumulated and held separate from the rest of the economy. And that isn't true. Money is accumulated, that's true. But then it is made available to investors and borrowers. Just at a cost. If it was hoarded, then it would not be available to investors or borrowers.



That may be true for individual actors (and frankly I hate how European politicians try to shift the complete blame for the current debt crisis to the "irrational markets"), but bubbles are still not beneficial for the economy as a whole. So a good economic policy would seek to prevent them.


Sure. But easier said than done. As I mentioned, there's often no agreement that something is a bubble until it's fairly far advanced. And even once it is generally recognized to be a bubble, policy choices really are not very good.
 
Yeah, I was referring to creating an environment that makes bubbles less likely or less damaging, not combatting individual bubbles. Which is, of course, even more difficult.
 
I don't think that's a simple issue to deal with. Certainly some of those people into monetary theory are more focused on getting money right in order to deny bubbles fuel. I personally don't have a lot of confidence that that approach alone would be sufficient. Which of course leaves other choices that, for one reason or another, are considered bad or at least less than optimal by others.
 
:bump:

This is not a post. This is a note. :)

Question queue
Narz: political economy of money
uppi: monetary policy in the long run with commodity currency
Loereth: easy money and bubbles (maybe venture in to Austrian stuff?)
Cutlass: the monetary base in an open economy (why can't the Bank of China do open-market operations on US currency?)
Hakim: why target P? What about asset prices?

Jump in the hoarding discussion?

Did I miss anyone?
 
Loereth: easy money and bubbles (maybe venture in to Austrian stuff?)
Don't know if that question was directed at me or yourself, but if you consider it relevant it would definitely be interesting. I don't mind sidestepping for someone else's question if you want to answer it first, by the way.
 
Cutlass: the monetary base in an open economy (why can't the Bank of China do open-market operations on US currency?)

Not even a foreign central bank. Just hoards of the private market. The Asian financial crisis of a few years ago was a huge influx of foreign capital, a bubble, and a withdrawing of foreign capital. The US housing bubble had a lot of foreign money buying up the mortgage backed securities as part of the fuel. That sort of thing.
 
There are plenty of other things that can be hoarded. In older times, hoarding land was an issue. You keep the people off it that need it to grow food and reserve it for only the use of the owner. Gold, silver, gems, any of the things that can be bought with money.

What money gives you is a greater ease of having it and letting others use it. In practical terms, there really isn't hoarding, as it is commonly thought of, in the present times. That money is available for the use of other, only at a price. Where hoarding in the old fashion way just took it out of the economy and set it to the side under guard.
Thats naive. No one kindly lets other people use their money. They take advantage of those less fortunate by lending at high interest.

Thus non-contributors like bankers make a killing off of those who actually put that money to work. The result is what we see now. This is why usury has been denounced for over two thousand years.
 
Thats naive. No one kindly lets other people use their money. They take advantage of those less fortunate by lending at high interest.

Thus non-contributors like bankers make a killing off of those who actually put that money to work. The result is what we see now. This is why usury has been denounced for over two thousand years.


If you ban the lending of any money at interest, then people will just find a different, more complicated and expensive, way to do the same thing.

You cannot stop the loaning of money without putting a stop to the economy as a whole. The economy is absolutely dependent on credit.

Usury is not all lending at interest. It is a description of excessive interest. And the only excessive interest many people pay is on credit cards. The interest on most business, home, student, and car, loans is pretty low, and has been for a long time.
 
What makes financial markets different from normal markets?

Brad DeLong said:
In a standard economic transaction, it is no mystery where the value to both sides comes from. When I buy a double espresso from Café Nefeli for $2.25, the coffee is more valuabe to me then $2.25 is...The sources of the gains from trade are obvious.

But in finance neither side is getting useful commodities. Instead, both sides are trading away claims to a pile of money and getting claims to a different pile of money in return. So how is it that me selling this pile of cash I have to you for that pile of cash that you currently own can be a good idea for both of us? Doesn't one of the piles have to be bigger? And isn't the person who trades the bigger for the smaller pile losing?

Think about that for a second. If I offer to sell you a share of stock for $10, why would you buy it? Well, you might buy it because you want to diversify or otherwise adjust your investment portfolio (to give you, say, more risk or longer maturity). But - let's be frank - chances are you'd buy it because you think that sometime in the future it'll be worth more than $10. Right? So now ask yourself: If I (the seller) also thought it would be worth more than $10 in the future, why the heck would I sell it to you for $10???

The answer is: I wouldn't. If someone offers to sell you a stock for $10 and tells you it's going to go up, in general don't buy it. Because if the guy selling you the stock really believed his own prediction, he'd keep the stock for himself. The only time you should buy the stock is when you have good reason to believe that you are smarter or better-informed than the guy who's selling - in other words, if you think he's a sucker. Of course, he's only selling to you because he thinks you're a sucker.

So what we see is that while normal markets consist of people making trades because they have different preferences, financial markets mainly consist of a bunch of people with the same preferences all trying to sucker each other. This fact is called the "No-Trade Theorem," and economists have known about it for a long time.

So in 1978, J. Michael Harrison and David M. Kreps decided to write down a model of a financial market in which everyone was trying to sucker everyone else. As far as I know, this was the first model of its kind. Even though few people believe that the model describes exactly how the real world works, it has become enormously influential, because it gives an idea of what the world would have to be like in order for us to observe the enormous volumes of financial trading that we actually see happening.

From Noahpinion
 
What if the seller simply wanted the money now more than the expected profit later?
 
Sure, people have different time rates of preference. And people look to diversify their portfolios, so that explains some of the trading that goes on.

But there's no way those effects add up to more than a few percent of the volume you see.
 
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