In my previous post, I discussed the tradeoff between liquidity and rates of return. But here’s the thing: investors are constantly in search of a better deal. So long as an investment is available whose expected costs are exceeded by the expected returns, funds will flow into the market until the difference between the two is reduced to zero. This dynamic drives the development of financial markets, where intermediaries attempt to reduce the cost of transferring savings to investors.
Modern markets have especially reduced the price paid for liquidity – the ability to quickly convert assets to money without loss – by savers. In doing so, financial markets have alleviated stresses that would otherwise arise when money becomes dear. Observing the rise in liquidity, Leland Yeager noted in 1978 that “distinctions between banks and other financial institutions and between the medium of exchange and near moneys” appear to be blurring. The truth of his observation has only increased in the nearly four decades since.
Carl Menger’s evolutionary theory of money posits that a commodity will arise as money if its adoption sufficiently reduces the cost of barter. Money not only allows for efficient exchange, but also provides an efficient means of saving. Thus it should be no surprise that once money evolved, so too did credit and, along with that, means for saving wealth that do not require the direct possession of the commodity itself. The functions of that arose with commodity money need not require the commodity. Even the role of medium of exchange can be transferred to financial instruments. Further, we find that money’s role as store of value can be separated from its role of medium of exchange. The now retired measure of the money stock, M3, includes repurchase agreements and Eurodollar deposits. Generally, we include as money those investments that can quickly be exchanged for money if desired by the owner.
Whether the money considered is commodity money or a form of credit, the quantity of the money made available by the market is regulated by the market in light of changes in the relative price of that money. For credit instruments, this price is the interest rate. David Glasner argues that financial markets perform many of the functions that we would expect of a free banking system. He points to the Eurodollar market as a source of liquidity and returns in the marketplace in an era of legally constrained interest rates.
The search for returns for savers at traditional deposit banks was challenging due to regulation-Q, which limited the level of interest paid on deposit accounts. This could be avoided if accounts were held outside of the country. The low cost of transferring these funds made the regulation ineffective. Milton Friedman observed that “the Fed’s insistence on keeping Regulation Q ceilings at levels below market rates has simply imposed enormous structural adjustments and shifts of funds on the commercial banking system for no social gain whatsoever.” The solution was for U.S. banks with foreign branches to invest dollar deposits in those branches and borrow the same amount from that branch in order to fulfill reserve requirements. This allowed banks to pay a higher interest rate on dollar deposits than regulation-Q allowed, thus attracting savings and allowing for money creation that otherwise would not have taken place due to regulation-Q.
The increase in liquidity provided by the market enables investor to decrease their demand for base money, although many of these instruments are not included as part of many aggregate monetary measures. In terms of macroeconomic theory, this expansion of credit should diminish the lowering of the velocity of base money that would otherwise occur if these instruments didn’t exist. These dynamics appear starkly in the lead up to an economic crisis.
Investors evidenced their anticipation of a crisis in the market place by increasing their demand for liquid assets. This tends to increase the price of these liquid assets. In the years preceding the 2008 crisis, the price of 4-week Treasury bills greatly increased preceding the crisis, as evidenced by the falling interest rate.
Commodities futures contracts saw a similar increase in prices. They also saw a long term increase in demand, as evidenced by the increase in aggregate value of a basket of open interest contracts. (Aggregate OI Value data is the sum of the value of the following open interest futures contracts: BO, CO, CP, C, GF, HE, KW, LB, LE, MW, O, RR, RS, SM, S, W.) There was brief sell-off in this market as investors exploited this liquidity during the 2008 crisis. However, the total value represented by the market soon recovered and has remained close to these levels since that time. Perhaps it is ironic that monetary evolution began with commodity money, and now has returned to commodities in the form of claims to their delivery in the future.
In addition to its stabilizing effect on market volatility, the development of new sources of liquidity has tended to weaken the government’s ability to collect seigniorage through increase of the base money stock. This should come as no surprise since one function of money is to minimize the costs incurred during exchange. Early in monetary evolution, this meant lowering the costs of finding a trading partner. With the development of modern financial instruments, this has meant lowering the costs of intermediation and intertemporal exchange and, therefore, the costs of moving wealth between currency and assets value in terms of that currency. The prices of these liquid assets also adjust quickly to changes in the expected inflation rate. Stated generally, financial innovation has helped to offset costs arising due to uncertainty from government intervention in the monetary system.