Money and Bubbles

Money. Bubble. Liquidity. Fire sale. Those words are used a lot, particularly with reference to the recent financial crisis. Sometimes the words are used as if we all agree on what they mean, but if you engage anyone in a discussion about any of them, you'll find a distinct lack of agreement. I've seen several shouting matches in seminar rooms over what "bubble" means. Thus, it's not surprising that Noah Smith, Paul Krugman, and I don't think about bubbles in the same way.

From my previous post, here's my bubble definition, with examples:

What is a bubble? You certainly can't know it's a bubble by just looking at it. You need a model. (i) Write down a model that determines asset prices. (ii) Determine what the actual underlying payoffs are on each asset. (iii) Calculate each asset's "fundamental," which is the expected present value of these underlying payoffs, using the appropriate discount factors. (iv) The difference between the asset's actual price and the fundamental is the bubble. Money, for example, is a pure bubble, as its fundamental is zero. There is a bubble component to government debt, due to the fact that it is used in financial transactions (just as money is used in retail transactions) and as collateral. Thus bubbles can be a good thing. We would not compare an economy with money to one without money and argue that the people in the monetary economy are "spending too much," would we?

Noah Smith and I once had a conversation along these lines, and I thought we were making progress, but apparently not. Noah says the above paragraph is nonsense, since most payoffs on assets in monetary economies (like the one we live in) are denominated in terms of money. Thus, Noah reasons, if money is a bubble, then all assets are bubbles. How dumb could I be?

The payoffs on my stocks and bonds, and the sale of my house, may be denominated in dollars, but that does not mean that the value of those assets is somehow derived from the value of money. It's useful to ask what would happen if the monetary bubble "bursts." Think about an identical economy where money is not valued (that's always an equilibrium) and ask what happens. Everything changes of course, as now it's more difficult to carry out transactions - but not impossible. People will find other means to get the job done. Private financial intermediaries will issue substitutes for government money; people might engage in barter; people might use commodity monies. There is no reason why stocks and bonds and houses can't exist and be traded, with payoffs denominated in terms of something other than government-issued liabilities. Indeed, because private assets are substituting for government liabilities in exchange, some of those assets will have larger bubble components than in the monetary economy.

To give a practical example, think about monetary arrangements in the United States during the free banking era before the civil war. There was no fiat money or central bank. Transactions were executed primarily using the paper notes issued by private, state-chartered, banks, and using commodity money. Think of the role that gold played in that era. The price of gold had a bubble component as the stuff was used in exchange. It's not used in exchange today, so the bubble has gone away.

Here's Krugman's bubble definition:

I’d start by asking, what do we mean when we talk about bubbles? Basically, I’d argue, we mean that people are basing their decisions on beliefs about the future that are based on recent experience but can’t be fulfilled. E.g., people buy houses because they expect home prices to keep rising at a pace that would eventually leave nobody able to buy a first home...This sounds a lot like what happens in a Ponzi scheme...

It's different, right? My definition was based on rationality, and bubbles can be sustained forever. The crucial elements of a Krugman bubble are irrationality, and lack of sustainability. That's pretty much where the discussion ends. Krugman finds his notion of a bubble useful. I find mine useful. Krugman is in the Shiller bubble camp. I'm in the monetary theorist bubble camp.

Here's something interesting, though. Toward the end of his post, Krugman discusses fiat money, and Samuelson's overlapping generations (OG) model, which is one framework for thinking about money and what it does. No one took this model seriously as a model of money for a long time, perhaps because the tone of Samuelson's article is half-serious. However, Lucas used it in his 1972 paper, and this inspired Neil Wallace and his Minnesota students in the early 1980s to develop it further. The OG model captures Jevons's absence-of-double-coincidence problem in a nice way, it's easy to work with, and it admits complications like credit arrangements in a simple manner. Indeed, this book by Champ/Freeman/Haslag is essentially OG models for undergraduates.

One interesting feature of an equilibrium with valued money in the OG model, is that it looks like a Ponzi scheme - i.e. it has a feature Krugman associates with his bubble. And it's sustained forever. In each period, the young transfer goods to the old in the belief that they will receive goods when old from the next generation. Indeed, that arrangement looks just like social security, which is also a Ponzi scheme, though Krugman doesn't want to admit it. There's nothing wrong with it of course. Under the right conditions, social security can be an efficient and sustainable Ponzi scheme.