Thursday, December 16, 2010

Sumner and DeLong on Index Futures Convertibility

Scott Sumner provided a good explanation of the benefits of money expenditure targeting on National Review Online. He even gave a brief plug for index futures convertibility
In an ideal world, we’d remove all discretion from central bankers. The Fed would simply define the dollar as a given fraction of 12- or 24-month forward nominal GDP, and make dollars convertible into futures contracts at the target price. If the public expected NGDP to veer off target, purchases and sales of these contracts would automatically adjust the money supply and interest rates in such a way as to move expected NGDP back on target. It would be something like the classical gold standard, but with the dollar defined in terms of a specific NGDP futures contract, instead of a given weight of gold. The public, not policymakers in Washington, would determine the level of the money supply and interest rates most consistent with a stable economy.
I am very comfortable with describing the gold standard in terms of defining the dollar as a weight of gold. This is equivalent to fixing the dollar price of gold. Similarly, the BFH payments system defines the dollar in terms of a broad bundle of goods and services. This is equivalent to fixing the dollar price of the bundle, which is the sum of the dollar prices of the items in the bundle. Such a system is, in effect, a rule for stabilizing some measure of the price level.

Yet, somehow, defining the dollar as a fraction of 12 or 24 month forward nominal GDP leaves me puzzled. I do favor a rule keeping money expenditures (which can be measured by nominal GDP) on a stable growth path. I am persuaded that stabilizing its expected future value is both desirable and the best that can be done in an imperfect world. Sumner is trying to make the system appealing to those sympathetic to a gold standard. But to me, Sumner is proposing to define the dollar as a unit of fiat currency combined with a rule for stabilizing expected nominal GDP. Translating that back into a definition of the dollar in terms of a fraction of forward nominal GDP doesn't help me understand. (The privatized versions of the system I favor amount to the dollar being a debt claim that is settled according to a rule that keeps expected money expenditures on a target growth path. So, maybe I need to think harder about definitions of the dollar as a fraction of future money expenditures.)

More troubling is Sumner's claim that with dollars convertible into futures contracts, purchases and sales of the contracts automatically cause changes in the quantity of money and interest rates that move the expected value of NGDP to target. The problem with his brief explanation is that it creates the impression that money is created or destroyed when the Fed buys or sells futures contracts. While it might be possible to create a new type of security with a nominal interest rate that varies with deviations of NGDP from target, it would not be a futures contract. Index futures convertibility requires that the central bank use more conventional tools of monetary policy depending on its trades of the index futures contract. (Sumner understands all of this. We have been going back and forth on these issues for nearly twenty years.)

Brad DeLong
commented on Sumner's article and explained how he thinks the system would operate.
As I understand Scott's proposal, it is this: Nominal GDP in the fourth quarter of 2007 was $14.291 trillion. A 5% growth rate from that base would give us a value of $17.455 trillion for the fourth quarter of 2011.

So far, DeLong's interpretation isn't bad. I think Sumner would be satisfied with using the quarter before the recession began as a base, and creating targets based upon a 5 percent growth rate from there. My approach has been to find the trend for the Great Moderation and then extend it into the future. The target I propose for fourth quarter 2011 is $17.896 trillion for Final Sales of Domestic Product. Not too different from DeLong. (I think the reason for the difference is that NGDP growth had been slow for the year before the recession began.)

DeLong continues:

Add on another 3% for the average short-term nominal interest rate we would like to see, and we have $18.153 trillion. Therefore the Federal Reserve would, today, announce that it stands ready to buy and sell dollar deposits to qualified customers at a price of $1 = 1/18,155,000,000,000 of 2011Q4 GDP.
Here DeLong begins to go wrong. He adds in 3 percent because he believes that is a proper target for the long run average nominal interest rate. His figure assumes a 3 percent average nominal interest rate between 2007 and 2011. Whether or not that would be desirable, it plays no role in determining what the Fed should be doing during either the 4th quarter of 2011 or the 4th quarter of 2010. He has effectively put NGDP on an 8 percent growth path. Neither $18.155 trillion nor its reciprocal should play any role in the system.

Why does DeLong make this error? It is because he understands the proposal as automatically changing the quantity of money when futures are purchased and sold. In DeLong's view, when the Fed buys these contracts, it is providing money now, in the fourth quarter of 2010 and will receives the money back in the fourth quarter of 2011. The Fed is making a type of loan when it buys contracts. It makes sense that the Fed would charge interest on these loans. If the Fed charges 3 percent interest on the loans per year, then it provides dollar deposits (makes a loan of a dollar now) in return for (1+.03) times 1/$17.455 trillion of 4th quarter NGDP to be paid in one year. That is 1/(17.455 trillion/ 1.03) or 1/16.947 trillion of 4th quarter 2011 NGDP. When the Fed sells the contracts, it is borrowing (accepting a deposit) of a dollar in exchange for paying 1/16.947 trillion of 4th quarter 2011 NGDP in one year. It pays 3 percent interest on these deposits, again, adjusted for any deviation of NGDP from target.

DeLong's error was to calculate the interest payment for 4 years compounded, and then multiplying when he should have divided. If the contract was defined based on the borrowers paying the Fed a dollar when the loan comes due, like a T-bill, then multiplication would have been appropriate. The appropriate adjustment, however, is 1.03 times $17.455 trillion, which is $17.979 trillion, not $18,155 trillion. More importantly, because the adjustment for the deviation of NGDP from target would not be known up front, this would be inappropriate. Division is really the only sensible approach.

DeLong continues, explaining how the system operates:
If investors thought that nominal GDP in the fourth quarter of 2011 was likely to be lower than $18.15 trillion, they would take the Fed up on its offer: demand the cash
now, pay off the contract in a year by then paying 1/18,155,000,000,000 of
2011Q4 GDP, and (hopefully, if they were right) make money--thus the money stock
would increase.
While the proper number is 1/16.947 trillion, everything is correct except that what is really happening is that the Fed is lending money at an interest rate of 3 percent adjusted by the deviation of NGDP from target. If NGDP was expected to be 1 percent below target, the amount repaid would be 99 percent of 1.03, which is a nominal interest rate of about 2 percent.

While I agree that more will be borrowed from the Fed at a lower interest rate than at a higher interest rate, unless that natural interest rate was 1 percent, (the 3 percent target for the nominal interest rate DeLong built into his system less the 2 percent trend inflation implied by a 5 percent growth path) this is not necessarily expansionary.
If investors thought that nominal GDP in the fourth quarter of 2011 was likely to be greater than $18.155 trillion, they would take the Fed up on its offer: give cash to the
Fed now, collect the contract in a year by receiving 1/18,155,000,000,000 of
2011Q4 GDP, and (hopefully, if they were right) make money--thus the money stock
would fall.
Here people are making a sort of term deposit at the Fed. The Fed pays 3 percent on these deposits Again, leaving aside that the numbers are just a bit off, if NGDP comes in above target, then it pays more than 3 percent. Higher interest rates will attract more of these deposits, and so the amount of reserves and currency available now will be lower than otherwise. Of course, if the natural interest rate is above one percent, this approach will not keep NGDP on target.

The actual characteristics of such a system would be for the expected deviation of NGDP from target to generate an effective interest rate charged on loans or paid on deposits that cause an expected interest rate to equal to the natural interest rate. The scheme automatically limits the size of any deviations of NGDP from target. If the natural interest rate is 1 percent, then it should keep NGDP on target.

DeLong continues:
If nominal GDP were expected to fall, the Federal Reserve would be shoveling money out the door at negative expected nominal interest rates. If his scheme were applied today it would be quantitative easing on a pan-galactic scale, as everybody would run to the Fed with bonds to use as collateral for their promises to pay the expected futures contract in a year in exchange for the cash now.

The Federal Reserve would then become truly the lender of not just last but first resort. Why would anybody borrow on the private market even at 0% per year when they could borrow from the Fed at -3%/year? Savers would simply hold cash rather than try to match the terms that the Fed was offering borrowers. Borrowing firms
would borrow from the Fed exclusively. The Fed would thus create a wedge between
the minimum nominal interest rate that savers would accept (zero, determined by
the alternative of stuffing cash in your mattress) and the nominal interest rate
open to borrowers.
If NGDP was expected to be below target by more than 3 percent, then the Fed would lend at negative nominal interest rates. DeLong's error here was embedding the 3 percent interest rate target into the NGDP target and then to forget what he had done. If negative nominal interest rates at the Fed are necessary to stop a downward deviation of NGDP from target, then the scenario of all lenders holding currency, and all borrowers borrowing from the Fed seems plausible--at least for credit transactions with a duration of one year or less. I think the most problematic part of the negative nominal interest rate scenario is that people could borrow from the Fed and just hold currency and make a profit.

DeLong continues:
I see how this would solve a monetarist downturn--a shortage of liquid cash money projected to lead to nominal GDP below its target. Once arbitrage had kicked in there would be no shortage of cash money.

I see how this would solve a Keynesian downturn--a shortage of savings vehicles that means that balancing savings and investment at full employment requires a nominal interest rate of -3%, which the zero-bound keeps you from getting to. The Fed would lend to all comers at a nominal interest rate of -3%.

I cannot quite see how this would solve a Minskyite downturn--a flight to quality because of a collapse in the market's risk tolerance and a shortage of safe assets.
The only problem created by a Minskyite downturn (with the DeLong rule,) involves the collateral that the Fed requires for loans from the Fed. Generally, the borrowers that the now risk adverse lenders reject can go to the Fed. DeLong's scenario where the Fed crowds out all private sector credit would imply this. The only thing different from the Keynesian scenario is that if the Fed is liberal regarding the collateral it accepts, nominal interest rates don't need to be negative.

Anyway, index futures convertibility does not involve the Fed making loans or accepting deposits at a 3 percent interest rate adjusted for deviations of NGDP from target.

In the fourth quarter of 2010, The Fed buys and sells a one dollar index future on fourth quarter 2011 NGDP (or Final Sales of Domestic Product) for one dollar. When the figures for fourth quarter 2011 NGDP come in, the contracts are settled. For every percentage point that NGDP exceeds its target, sellers pay buyers a penny per contract. For every percentage point that NGDP falls short of its target, buyers pay sellers a penny per contract. (Make the contracts $100, then the payoff is a dollar per percentage point, and cents for fractions of a percent. Index futures contracts of $10,000 or $100,000 are more common.)

These payoffs create incentives to buy or sell the contacts during the fourth quarter of 2010. Those expecting NGDP to be above target in the fourth quarter of 2011 have an incentive to buy the contracts. Those expecting NGDP to be below target in the fourth quarter of 2011, have an incentive to sell the contracts. Because the Fed buys and sells them for $1, then the price remains at $1, at least during the fourth quarter of 2010.

Suppose Tayor, thinking that Fed policy is too inflationary, believes that NGDP will be above target in the fourth quarter of 2011. Taylor is a "bull." He goes long on the contract. He buys the contract.

Krugman, on the other hand, thinks that monetary policy is ineffective or, maybe just too tight, and expects that NGDP will be below target in the fourth quarter of 2011. He sells the contracts. Krugman is a "bear," and goes short.

If Taylor and Krugman trade the exact same amount, then the Fed is fully hedged. The Fed's net position on the contract is zero, Taylor is long, and Krugman is short. If Taylor is correct, and the Fed's policy created massive inflation, with NGDP for the fourth quarter 2011 coming in at 5 percent above target, then he will earn 5 cents on each contract he bought. Where does that money come from? From Krugman, who must pay 5 cents on every contract he sold.

But suppose Krugman was right. If the liquidity trap keeps NGDP below target no matter what the Fed's does, and it comes in 10 percent too low, then Krugman will make 10 cents on each contract he sold. Where does the money come from? The money comes from Taylor, who must pay 10 cents on each contract he bought.

Finally, if NGDP comes in exactly on target, then the contracts expire without any payments being made. Tayor and Krugman neither collect nor pay anything.

Now, suppose that the bulls, like Taylor, purchase more contracts than the bears, like Krugman, sell. At the current price, the desired long position by the market exceeds the desired short position. The market expectation is that NGDP will be above target. In an ordinary index futures market, the price of the contract would rise until the bears balance the bulls. The price rises until the desired long and short positions match.

However, with the Fed buying or selling at a price of $1, no such price change would occur, even for a second. Instead, the Fed would sell to the bulls, taking a short position to balance the long position of the market. If Taylor, and the other bulls are correct, and NGDP comes in above target, then the Fed, like Krugman and the other bears, must pay. On the other hand, if NGDP comes in below target, then the Fed collects from Taylor and the other bulls, along with Krugman and the other bears.

The opposite scenario is possible too. Suppose the market expects NGDP to be below target. This means that bears, like Krugman, sell more than bulls, like Taylor, buy. Rather than the price of the contract falling to reflect the market expectation of below target NGDP in the fourth quarter of 2011, balancing the desired short and long positions, the Fed buys contracts from the bears at a price of one dollar, taking a long position to match their short position. If Krugman and the other bears are correct, then they will make money on the contracts. The Fed, like Taylor and the other bulls, must pay. On the other hand, if Taylor and the other bulls are correct, then they and the Fed make money at the expense of Krugman and the other bears.

Again, if the NGDP is on target, then the contracts expire without any payments being made. Regardless of whether the Fed had to take a short position or a long position to keep the price of the contracts at $1, it pays or receives nothing.

Superficially, the Fed creates or destroys money when the contracts are settled to the degree it makes or loses money. When does this happen? When the contracts are settled.

If NGDP is on target, no one makes or loses money, including the Fed. If the Fed is hedged, and the market expectation is that NGDP will be on target, then money may be transferred between longs and shorts if NGDP actually deviates from target, but the Fed neither makes nor loses money.

Only if the Fed is compelled to take a position on the contract and that position loses money, does the Fed pay out and so, create money. And, similarly, if the Fed must take a position on the contract and it makes money, the Fed collects the funds and destroys money. However, any such changes in the quantity of money are undesirable, and the Fed should sterilize such changes. If the Fed makes money, it should buy ordinary securities--maybe T-bills--with its profits. Similarly, if it loses money, it should sell off ordinary securities, such as T-bills to fund its payoffs.

What about during the fourth quarter of 2010, when the contracts are being traded? Isn't money being created and destroyed? No. When Krugman and other bears sell the contracts, they receive no money now. What they have done is received a promise to receive money in a year if NGDP comes in below target in exchange for a promise to pay money in a year if NGDP comes in above target. Similarly, when Taylor and the other bulls buy contracts, they don't pay anything for the contracts now. They are being promised money in one year if NGDP comes in above target in exchange for a promise to pay money in one year if NGDP comes in below target.

What about margin requirements? Don't index futures contracts require margin accounts?

Yes, they do. Margin requirements are performance bonds. The purpose is to make sure that those losing money on the futures contracts make the promised payments. While it is true that those buying futures must put up a margin payment, and so, superficially are making a kind of down payment, they are really posting a performance bond. They are promising to pay the difference between the future price they contracted and the spot price when the contract expires.

Of course, those selling futures also must meet margin requirements. Clearly, the sellers are not receiving money now for some kind of future delivery. And they aren't selling at a negative price. Just like they buyers, they are posting a bond to cover any loss from the difference between the agreed price and spot price when the contract expires.

With index futures convertibility, both bulls, like Taylor, and bears, like Krugman, must keep "funds" in a margin account. The amount per contract depends on the size of the likely deviations of NGDP from target. Perhaps 10 cents per contract would be appropriate.

It would be possible to require "cash" margin requirements. Those trading the contracts would write checks (or wire funds) to the Fed, and then the Fed would decrease the reserve balances of the traders' banks. While the traditional monetary base would shrink by the volume of futures trading, there would be a new type of Fed liability, which would be a margin deposit at the Fed. Other things being equal, any trading of the security would be contractionary. (Sumner sometimes assumes this institutional framework and insists that the Fed pay interest on these margin accounts at a bonus rate. This would be even more contractionary.)

Ignoring what kind of margin requirements might apply to the Fed itself, consider a situtation where NGDP is expected to be below target and bears sell contracts. The bears must all post margin requirements equal to, say, 10 percent of their short positions, and so base money contracts by that amount. The Fed, and whatever bulls are in the market, take the matching long positions. The bulls also post margin equal to 10% of their positions, further adding to contractionary pressure. The effect of the margin requirements is perverse.

If, instead, the market expects NGDP to be above target, then the bulls buy contracts. They must post margin requirements equal to some fraction of their positions, which reduces base money. The contractionary consequence is desirable. The Fed must take the offseting short position, but if there are any bears who also take a short position on the contract, their margin payments reinforce the contractionary impact of those of the bulls!

Existing commodity exchanges use continuous settlement. As the price of a future contract changes, funds are transfered between the margin accounts of the shorts and the longs. For example, if the price of a contract rises by a $1, a dollar is moved from the margin account for each short contract to the margin account of each long contract. If the price of a contract falls by a dollar, the change is reversed. Funds are moved from the longs to the shorts. When the contract expires, there is no need to make significant shifts in funds for settlement because the funds were already shifted as the market price of the futures contract changed.

With index futures convertibility, during the fourth quarter of 2010, when the Fed is buying and selling futures contracts for fourth quarter of 2011 at a price of a dollar, the price of the contract does not change, and no funds are shifted between the margin accounts of longs and shorts.

Once the Fed stops trading that particular futures contract, then it would certainly be possible for those with short or long position to continue to trade at whatever market price they find agreeable. Following the conventions of existing commodity exchanges, funds could be transfered between margin accounts based upon changes in the market price of the futures contract.

To the degree that the Fed was hedged, having no short or long position on the contract, these changes would shift funds between longs and shorts in the private sector and have no contractionary or expansionary impact. However, if the Fed was left with a position on the contract, then continuous settlement would involve the creation or destruction of money depending on if the Fed suffered losses or made profits.

For example, if the market expected NGDP to be below target, and the Fed took a long position on the contract, when the Fed ceased targeting the price, and the price began to fall, then the Fed, like any other long, would begin to lose money. While the transfers between the shorts and any private sector longs would simply transfer funds, any payment by the Fed to cover its own losses would be an increase in the quantity of this special type of base money. If, as is customary, those making money can remove excess funds from margin accounts, then this would be expansionary. The Fed would, presumably, wire funds to their banks, and credit their banks' reserve balances.

Further, if the bears were wrong, and further information shows that NGDP will turn out to be above target, then the price of the contract would rise. As the Fed made money, it would decrease the margin accounts of those bears. If they had to make margin calls (replenish their margin accounts,) then there would be a further contractionary impact. On the other hand, if they refuse to make the margin calls, their positions could be closed out by selling to any private sector bulls, which simply transfers funds. If the Fed were permitted to close out its position by selling at a price greater than one, it would be taking profits. While the margin accounts of shorts would be somewhat depleted, when there accounts are closed and any remainer is returned to the shorts, the effect would be expansionary.

Worse, consider the situation where the market expects NGDP to be above target and buys, with the Fed being forced to take the matching short position. Once the Fed stops trading the contract at a price of $1, continued trading on the market could cause the price to rise. Using continuous settlement, the margin accounts of the bulls are increased. The bulls begin to make money at the expense of the Fed. If they are permitted to take profts from those margin accounts, then the Fed would wire funds to their banks, crediting the banks' reserve balances. The Fed would be creating a perverse expansion in the quantity of money. Similarly, if the market turned out to be wrong and the market price of the contract fell below $1, then continuous settlement would have the Fed decreasing the margin accounts of the longs, creating an additional contractionary effect.

The most sensible approach is for the Fed to sterilize the impact of the creation of any special margin accounts by offsetting open market purchases. Similarly, any changes in such margin accounts due to continuous settlement should be offset by additional open market operations as needed.

In my view, a better approach is to require those trading the futures to meet margin requirements with securities, such as T-bills. While changes in the demand for securities to meet margin requirements might have some kind of contractionary or expansionary effect on the economy, it is likely to be minimal and does not play any significant role in the process that tends to keep expected money expenditures on target.

As explained above, index futures convertibility requires that the Fed use some conventional tool of monetary policy to impact future money expenditures and bring the expected value of money expenditures back to target. The Fed could change reserve requirements, change the level of the interest rate it pays on reserves balances, change the primary credit rate it charges banks for loans at the discount window, undertake open market operations with T-bills, with longer term to maturity government bonds, or even with some other kind of security.

In my view, the Fed's goal should be to remain fully hedged. The market expection should be that NGDP remain on target. The long positions of the bulls should be exactly offset by the short positions of the bears.

If the market expectation is that NGDP will be above target, then the purchases of the bulls will be greater than the sales of the bears. The Fed will be left with a short position on the contract. To avoid the risk of loss, the Fed needs to undertake a contractionary policy--raise reserve requirements, raise interest rates paid on reserve balances, raise the primary credit rate to charge more for loans at the discount window, or make open market sales of T-bills, longer term government bonds, or whatever other assets it owns. Those bulls who expected only a slight increase in NGDP will start to find the risk of loss too great, and sell. Those who already thought that Fed policy was too contractionary sell more. Some who held no position on the contract perhaps will notice the Fed's contractionary policy and sell. When the Fed is hedged, and its position is zero, then the policy is right.

If the market expectation is that NGDP will be below target, then the sales of the bears will be greater than the purchases of the bulls. The Fed will be left with a long position on the contract. To avoid the risk of loss, the Fed needs to undertake an expansionary policy--lower reserve requirements, lower interest rates paid on reserve balances (perhaps to something less than zero,) lower the primary credit rate and charge less for loans at the discount window, or make open market purchases of T-bills, longer term government bonds, or some other type of security. This expansionary policy will result in those bears who were expecting that NGDP will be only slightly below target to close out their short positions by purchasing futures contracts. Those bulls who already expected NGDP to be above target will perhaps purchase more. And others, who weren't in the market, may buy as well. Once the market expectation of NGDP in the fourth quarter on 2011 is on target, then the Fed is fully hedged. The Fed's policy is right.

The Fed policy is right, or rather, the market expectation is that NGDP will be on target in the fourth quarter of 2011. Some of Sumner's versions of the system leave the Fed much less discretion and could be implemented by computer. For example, the Fed could be required to make parallel open market operations with the trades in the futures contract. If Taylor expects NGDP to be above target and buys a future contract at a price of $1, then the Fed not only sells the future, it also sells T-bills worth a dollar. Base money contracts by dollar for every futures contract purchased by bulls. If Krugman expects NGDP to be below target and sells a futures contract, then the Fed buys the futures contract and at the same time buys a dollar's worth of T-bills. Base money increases by a dollar.

If the market expectation is that NGDP will be on target, then the purchases of bulls like Taylor and sales by bears like Krugman offset, and while the Fed might purchase and sell equal amounts of T-bills, leaving the monetary base unchanged, the simplest approach is for the Fed to net out the required T-bill transactions, trade no T-bills, and leave base money unchanged.

The Fed then would change base money through conventional open market operations according to the size of its net position on the futures contract. Sumner argues that the equilibrium quantity of base money will keep the market expectation of NGDP on target.

It is a type of arbitrage argument. Suppose the current value of base money is expected to result in NGDP being above target in the fourth quarter of 2011. Base money is "too high." The market expects to profit by purchasing futures contracts from the Fed. The Fed sells the contracts at a price of $1, and it also sells a dollar's worth of T-bills, shrinking base money. If this new, lower level of base money is still too high so that NGDP is expected to be above target, then there must be expectations of profits from buying index futures from the Fed. The Fed sells still more futures contracts and more sells T-bills, with base money again decreasing by the value of the T-bills sold. In equilibrium, there can be no more expected profits from buying the futures, and so NGDP must be on target, and so, base money must have decreased enough for NGDP to be on target.

Notice that the Fed is left exposed with a short position. To the degree transactions cost, risk aversion, or anthing else leaves NGDP above target, the Fed will take a loss on this short position. Those trading with the Fed will earn enough profit to cover any costs. Unfortunately, if some unancipated shock causes NGDP to rise above target, then the Fed could be subject to heavy losses. In fact, it is the chance of just such an event that motivates those buying the futures to maintain the long position.

Of course, this scenario requires that base money was initially too high. How did it get so high? Consider the opposite scenario, where base money is too low. NGDP is expected to be below target. With a 5 percent target growth path for NGDP, all hand-to-hand currency being base money, and banks being required to keep base money reserves, the quantity of base money should generally be increasing.

Suppose base money is "too low," so NGDP is expected to be below target. There are profits to be made by selling the index futures contract, and the Fed must buy at at price of $1. The Fed makes open market purchases of T-bills in parallel with its purchases of the futures contract. This causes base money to rise. But if base money is still "too low" so that NGDP is still expected to remain below target, there are still profits from selling futures contracts--shorting NGDP, or at least the index futures contract on NGDP. In equilibrium, there can be no profits from selling the index futures contract, so NGDP must be expected to be on target. That means that the level of base money must be at the correct level.

Notice that this leaves the Fed exposed to a long position on the futures contract. If transactions costs or risk aversion leaves the expected NGDP below target, then the Fed will take a loss. This will compensate those short positions resulting in the increase in base money for any costs. Of course, if some unexpected shock causes NGDP to fall substantially below target, the Fed would be subject to heavy losses.

If the institution of parallel open market operations were taken literally, then the entire quantity of base money would need to be matched by purchases of futures by the Fed. The private sector would have to take a short position on the futures contract of hundreds of billions of dollars each and every quarter, growing by the year. To avoid that consequence, the obvious solution is for the rule to apply solely to changes in base money, and so, the Fed's security portfolio and the quantity of base money would initially be the level from the previous quarter (or whatever period,) and then change according to the Fed's net position on the futures contract for the current quarter. A rather simple modification would allow the Fed to use conventional open market operations to increase base money according to trend (say, 5 percent) at the beginng of each period, and then make changes from that level based upon changes in its net position on the futures contract.

Sumner has gone so far as to suggest that the Fed set base money however it thinks best at the beginning of each period, and then make adjustments to its target according the net position on the futures contract. In effect, the Fed sets base money and then allows the market to fine tune. As explained above, those who believe that the quantity of base money determined by the Fed is too high (Taylor) would buy contracts and those thinking the quantity of base money is too low (Krugman) would sell contracts. If "the market" agrees with the Fed, purchases and sales match, and the Fed leaves base money unchanged at what it thought was the appropriate level.

If instead, the bulls purchase more than the bears sell, "the market" expects NGDP to be above target, and the Fed sells futures contracts and T-bills, decreasing base money relative to its tentative target. While a requirement that the Fed always trade T-bills in parallel to its trades of the futures contract would suggest that if the decrease in base money results in bulls selling futures to close out their long positions, or bears selling even more, the matching purchases of futures contracts by the Fed, which hedges and closes out its short position, should be matched by purchases of T-bills which would again raise base money. A more sensible approach would be for the Fed to do nothing as its short position shrinks. Only if the selling goes so far that the Fed has a net long position should the Fed begin buying T-bills and raise base money.

Suppose "the market" finds the Fed's tentative level of base money too low. The bears sell more than the bulls buy, and the Fed purchases futures contracts and T-bills, increases base money relative to its tentative target. As the Fed purchases T-bills and expands base money, some bears may purchase futures to close their short positions, and bulls may expand their long positions. As the Fed sells futures, it hedges and closes its long position. The Fed should not sell T-bills and contract base money as sales shrink its long position. Only if the purchases by "the market" go so far as to cause the Fed's long position to disappear and turn into a short position, should be the Fed begin to sell securities and shrink base money.

Such a rule may be workable--the Fed must buy T-bills in parallel with its purchases of futures contracts if it is hedged or already has a long position, while selling T-bills in parallel with its sales of futures contracts if it is hedged or already has a short position. However, I still think the better approach is to allow the Fed discretion to adjust monetary policy as it chooses subject to the constraint--always stay hedged. While the Fed would have some discretion, this rule would require that "the market" expects money expenditures to remain on target.

P.S. And the proper target is an adjusted 3 percent growth path for Final Sales of Domestic Product starting at the end of the Great Moderation.

27 comments:

  1. Good post, Bill.

    The scheme where the Fed's trading in the NGDP futures market automatically cause OMOs is unstable. Arbitrage makes it work most of the time, but the scheme is vulnerable to the changes in the cost of arbitrage. Let's say the required return on participating in NGDP futures market increases from 5% to 6%. As traders liquidate positions, this creates huge changes in the money supply. If the changed money supply increases required return on arbitrage, we could sometimes get a positive feedback loop. So I agree that the always-hedged approach is much better.

    You said:
    "In my view, a better approach is to require those trading the futures to meet margin requirements with securities, such as T-bills."
    The design of margin requirements is very important for the operation of NGDP futures peg. One way such peg could break down is in the case where NGDP expectations are sensitive to margin requirements. Today we get different inflation expectations if we look at markets with different margin requirements - TIPS do not agree with inflation swaps. Significant macroeconomic disturbances could result if NGDP expectations in the market where the Fed sets margin requirements diverge significantly from NGDP expectations in other markets where margin requirements are less stringent.

    ReplyDelete
  2. I tried posting the following comment to your previous post (on Arnold Kling), but I got the error message: "The requested URL /2010/12/scarcity-and-unemployment.html... is too large to process." So I'm attaching the comment to this post (on Scott Sumner).
    ---------------------------
    You write that "if the demand for new homes falls 50 percent and new homes make up 10 percent of the economy, then the demand for other products in the economy should grow more than otherwise." I think you mean that the demand for new homes falls in such a way that the response from builders is to produce new homes at half the rate they had been doing. This sudden change in consumer desires will throw the economy into (greater) disequilibrium. Many of those employed in new homes construction will lose their jobs (especially if the change in consumer desires is expected to be permanent), and will have to take jobs in which they are less productive than they had been; therefore GNP will tend to decline, and so "the real volume of demand for the other products of the economy should grow" at *less than* "approximately 5 percent." A shock to the economy, requiring greater-than-normal "recalculation," should be expected to reduce the normal growth rate.

    In your gold-standard scenario I believe you are assuming that the rate of gold production does not increase, in spite of the increased demand for gold. And in the statement, "Everyone who holds money earns a real capital gain," you might tell us how you are using the term 'real'. (Likewise for your references to "[t]he real volume of expenditures on various goods" and "the real quantity of money.") You evidently have in mind some numeraire *other than ounces of gold* (in spite of the fact that in this scenario gold *is* money), but what is it?

    I still seem to detect some stock/flow confusion in your discussion. You write: "if the former home buyers [I think this should be: "those who formerly would have bought a new home or homes"] still have no [increased] desire to buy anything [else], they just have higher real money balances." This should read: "they just continue to *increase* their money balances": instead of accumulating a new home or new homes, they accumulate (rather than just "hold") more money. The topic is their flow of spending (or the lack thereof) rather than the stock of their holdings.

    In the subsequent helicopter-drop scenario, are we supposed to have abandoned the gold regime and moved to fiat money?

    I found the discussion of "inside money" confusing. I thought we were discussing various scenarios brought on by a shock to the system in the form of a sudden decrease in consumers' willingness to buy new homes and a corresponding increase in their desire to *accumulate currency*. But in the "inside money" discussion, it seems the topic has shifted: the consumers now want to hold more "money" in some broader sense, and in fact what they want to hold more of are *bank deposits*, which are really *loans to banks*. It's not more currency that people suddenly want (along with fewer new houses): it's more *savings* (of a super-safe, short-term variety). The banks then relend the funds deposited with them--but they have trouble finding borrowers, since people in general have become more determined to *save*. So interest rates have to fall, etc. But the original scenarios, involving *currency*, had nothing to do with interest rates.

    Thanks in advance for you clarifications or comments.

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  3. I tried posting the following comment to your previous post (on Arnold Kling), but I got the error message: "The requested URL /2010/12/scarcity-and-unemployment.html... is too large to process." So I'm attaching the comment to this post (on Scott Sumner).
    ---------------------------
    You write that "if the demand for new homes falls 50 percent and new homes make up 10 percent of the economy, then the demand for other products in the economy should grow more than otherwise." I think you mean that the demand for new homes falls in such a way that the response from builders is to produce new homes at half the rate they had been doing. This sudden change in consumer desires will throw the economy into (greater) disequilibrium. Many of those employed in new homes construction will lose their jobs (especially if the change in consumer desires is expected to be permanent), and will have to take jobs in which they are less productive than they had been; therefore GNP will tend to decline, and so "the real volume of demand for the other products of the economy should grow" at *less than* "approximately 5 percent." A shock to the economy, requiring greater-than-normal "recalculation," should be expected to reduce the normal growth rate.

    In your gold-standard scenario I believe you are assuming that the rate of gold production does not increase, in spite of the increased demand for gold. And in the statement, "Everyone who holds money earns a real capital gain," you might tell us how you are using the term 'real'. (Likewise for your references to "[t]he real volume of expenditures on various goods" and "the real quantity of money.") You evidently have in mind some numeraire *other than ounces of gold* (in spite of the fact that in this scenario gold *is* money), but what is it?

    I still seem to detect some stock/flow confusion in your discussion. You write: "if the former home buyers [I think this should be: "those who formerly would have bought a new home or homes"] still have no [increased] desire to buy anything [else], they just have higher real money balances." This should read: "they just continue to *increase* their money balances": instead of accumulating a new home or new homes, they accumulate (rather than just "hold") more money. The topic is their flow of spending (or the lack thereof) rather than the stock of their holdings.

    In the subsequent helicopter-drop scenario, are we supposed to have abandoned the gold regime and moved to fiat money?

    I found the discussion of "inside money" confusing. I thought we were discussing various scenarios brought on by a shock to the system in the form of a sudden decrease in consumers' willingness to buy new homes and a corresponding increase in their desire to *accumulate currency*. But in the "inside money" discussion, it seems the topic has shifted: the consumers now want to hold more "money" in some broader sense, and in fact what they want to hold more of are *bank deposits*, which are really *loans to banks*. It's not more currency that people suddenly want (along with fewer new houses): it's more *savings* (of a super-safe, short-term variety). The banks then relend the funds deposited with them--but they have trouble finding borrowers, since people in general have become more determined to *save*. So interest rates have to fall, etc. But the original scenarios, involving *currency*, had nothing to do with interest rates.

    Thanks in advance for you clarifications or comments.

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  4. Annonymous:

    The real capital gain, real expenditures and the like certainly not measured in ounces of gold. With a gold standard, those would be nominal capital gains, nominal expenditures and so one. Real values are calculated like usual, by dividing by the price level in terms of dollars. The dollar is defined in terms of ounces of gold.

    Second, I agree that there is a stock flow problem. If the demand for houses continues to be low and the demand for nothing else rises, then people are accumulating progressively higher money balances.

    The helicopter drops and tax cuts are fiat currency, of course.

    Currency can be inside money. It is just issued by banks. In previous posts I have discussed my view that it is sometimes best to see Federal Reserve notes as inside money. This is especially true if the Fed were actually constrained by a target for a growth path of money expenditures growth. But I actually favor a system where all money is issued by private banks, so it is all inside money--currency or deposits.

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  5. P.S.

    I agree that a redeployment of resources will involve lower production for a time. I don't agree that shifting resources from housing to other uses implies that the resources are less productive in those other uses. After the change in demand, they are more value productive in the other uses.

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  6. The first part does a masterful job of dissecting the complex of DeLong’s errors. I’m not sure how many people would make it through your explanation, but the diversity of the analytical missteps described there is a bit startling.

    The second part with the correct explanation is very impressive in its description of the operational perspective, with helpful symmetry in its descriptions of longs and shorts in action.

    The Taylor/Krugman face off is a nice touch, too.

    The discussion of margin account scenarios is particularly instructive.

    And Sumner’s arbitrage mechanism is well explained, with an interesting modification to the rule in your final paragraphs.

    All in all, quite brilliant – thanks.

    P.S.

    One point:

    “(Sumner sometimes assumes this institutional framework and insists that the Fed pay interest on these margin accounts at a bonus rate. This would be even more contractionary.)”

    I’m probably not thinking clearly on this one, because everything else seems perfect to me, but isn’t the interest payment alone either neutral (if it remains in the margin account) or expansionary (if it’s withdrawn from the margin account)? The payment is a debit to Fed equity and a credit to margin or the base respectively.

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  7. I'm skeptical of the Fed's ability to remain fully hedged (or even close) most of the time. However, I don't think we should imagine the Fed holding its unhedged positions after it stops trading a contract. The prudent policy would be to liquidate all positions in a contract when it stops trading that contract. Otherwise, the Fed (and the public, as beneficial owners of the Fed) would be exposed to subsequent surprises over which it would have little control (or at least, little control that it should be encouraged to exercise, given that the objective of maximizing the value of its outstanding positions would conflict with that of minimizing the size of its subsequent net positions).

    Moreover (assuming, for example, that the settlement dates are at quarterly intervals), it doesn't make sense for the Fed to dump a whole quarter's-worth of contracts all at once. To avoid this situation, it should actually be trading two contracts at once, targeting a weighted average of the prices, and shifting gradually, one day at a time, from one contract to the next. If I'm not mistaken, that procedure would leave the Fed with very little net exposure at any given time, even if it were far from fully hedged. For example, if the bears outnumbered the bulls, the Fed would constantly find itself selling the old contract a slightly depressed price but purchasing the new contract also at a slightly depressed price.

    There would still be a danger that the Fed could accumulate small losses over time and that this would add up to a big loss. I can imagine that happening, for example, if Krugman's position is both right and held by the majority. That is, if monetary policy (whatever that means) is so ineffective that the Fed is utterly incapable of hitting its target. In that case the Fed would be consistently long and, if I'm not mistaken, would consistently lose on the roll. It would lose very little on any given day, but it would lose every single day. Presumably in that case the losses should be unsterilized, and they would represent a way for the Fed to "drop money from a helicopter" (i.e. to increase the private sector's net assets rather than just changing the composition of those assets).

    There is no opposite extreme, however (except perhaps for the possibility of the Fed's going bankrupt). There is no question of the Fed's ability to "pull on the string" as opposed to pushing, and if it were facing ongoing potential losses on its futures positions, it would have an incentive to pull with all necessary force.

    I wonder about the possibility of the Fed's going bankrupt. It can keep raising the interest rate on reserves, but at some level that process would be recognized as a Ponzi scheme and would collapse. It has considerable power of taxation by means of reserve requirements, but at some level that process faces a Laffer curve peak, and banks would simply cease to operate, with the remaining reserves drained off as cash. If the Fed does not have sufficient assets left to absorb enough of that cash to stop making losses on its futures, it would need an infusion of public assets in order to avoid bankruptcy. I suppose, if we trusted the government not to let the Fed go bankrupt, we could expect a "helicopter vacuuming" that is the counterpart of the helicopter drop.

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  8. I think it's rather strange to think of futures contract in terms of loan and deposit. Normally, you think of it in terms of trade and reversing trade, which results in the arbitrage profit from the difference between settlement price and theoretical price. Plus, you take the interest on operating money into the consideration. In that case, multiplying makes sense, and division doesn't.

    To be more specific, in normal futures contract settings, you borrow the money and buy the futures if you think settlement price will be higher than theoretical price. So, the arbitrage profit, which is the difference between settlement price and theoretical price, must be larger than the borrowing cost for you to remain profitable. In Delong's NGDP futures case, settlement price is NGDP a year later, theoretical price is $17.455 trillion, borrowing cost is 3%. So the threshold value is 1.03 times $17.455 trillion, which is $17.979 trillion.

    On the other hand, if you think settlement price will be lower than theoretical price, you sell the futures and invest the proceeds. So, the total profit remains positive as long as the difference between theoretical and settlement price doesn't offset revenue from the investment. If the rate of return on the investment is 3%, the threshold value is 1.03 times $17.455 trillion, which is $17.979 trillion (same as the buy threshold).

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  9. I think the Fed’s objective should be to aim for a (cumulative) hedged position on the current contract.

    The Fed essentially makes a two way market at book value of the current contract (e.g. Q4) until it reaches the date for starting the next contract (e.g. Q1). It then ceases to make a market on the Q4 contract.

    As soon as the Fed starts making a market in the new Q1 contract, it should start marking to market any residual net exposure short or long on the Q4 contract.

    This requires a marking methodology. It could be observation of a secondary market in Q4 contracts, if that market develops. Or it could be some other fair value methodology (Level III, anyone?).

    But the important point is that the Q4 residual risk position gets marked on the Fed’s books as soon as book value market making ceases. The exposure to the Fed’s P&L (“profit and loss”) is immediate at that point.

    So the manner of disposition of the risk position should not be driven by P&L accounting concerns, but by risk management.

    Like any financial institution, the Fed might have risk limits for this purpose.

    E.g. one way of handling it would be for the Fed to exercise discretion in disposing of a net risk position by taking advantage of sympathetic market sentiment – e.g. if the Fed has accumulated a residual net long Q4 position, auction that position off to dealers if/when there is a (temporary) NGDP futures rally in early Q1. (That may well be subsequent to further easing by the Fed in response to additional Q1 net futures accumulations.) That said, there may well be an argument for automatic auctioning, although removing all discretion seems too constraining.

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  10. Andy and JKH,

    Sumner often says (and I agree) that we need more people thinking about the technical details of index futures convertibility.

    Thanks for your comments

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  11. himaginary:

    If you sell an ordinary futures contract, you must put up money into a margin account. Perhaps you borrow it and you have to pay interest on the money. It all depends on the relationship between the commodities broker and the investor, but those with seats on the exchange post securities for margin, and they earn interest on those.

    Anyway, those selling futures contracts don't get any money now to invest.

    And those buying futures dont pay the contracted amount now. Just like the sellers, they put up funds in a margin account. They might borrow that money.

    And I don't know what imaginary price means. There is the spot price at settlement and the price of the contract now, which generally changes over time until expiration at which time it equals the spot price.

    Perhaps you are confounding speculation with a hedging transaction. You borrow money and buy oil, and you sell a future contract on oil. When it expires, you sell they oil for the spot price and settle the future contract. You use the money you make to pay off the loan. Most of the money comes from the oil you were storing.

    If you have a tank of oil, you sell some of it and invest the proceeds, and you buy a futures contract. When the contract matures, you buy the oil and settle the futures contract. Most of the money to pay for the oil (which you needed for some reason, which is why it was in the tank to begin with) comes from selling off the funds you invested.

    These hedging operations lock in profits. They also keep the prices of storable commodities (which includes securities) and close to the futures price. The difference involves the interest rate.

    The purchase or sale of the oil has nothing to do with the futures contract really. You borrow money and buy oil. You sell oil you are storing, and invest the proceeds. That is where the borrowing and lending comes in.

    There is no way to buy or sell current NGDPs and hedge in this way.

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  12. As a geek but not an econ geek, I'm confused about the incentives and feedback here. It seems that you want the Fed to say "we will define an NGDP growth path, and if you bet against us expecting us to fail then we will use that as a guide to get back on track and thus make sure that you don't make any money." This strikes me as an inadequate incentive...do they make money somehow in your scheme even if the NGDP ends up back on target? It seems to me that if the bulls/bears bet, then they provide the feedback by which they don't make money; if they don't bet, there will be no feedback and the system fails. Bulls and bears alike are being asked to make self-negating prophecies.
    In the unlikely event that I'm interpreting this correctly, it seems that it would be easy enough to fix this by using a secondary (prediction) market in which we define the stimuli which the Fed will use to actually achieve its target NGDP, and then let bears and bulls buy contracts on how much stimulus will have been applied. But I don't see how to do it without a secondary market of some kind. Please explain!
    (My confusions are expressed at greater length here and back here, and even here. But probably I'm missing something really basic.)

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  13. As a geek but not an econ geek, I'm confused about the incentives and feedback here. It seems that you want the Fed to say "we will define the NGDP growth path, and if you bet against us expecting us to fail then we will use that as a guide to get back on track and thus make sure that you don't make any money." This strikes me as an inadequate incentive. I hope and expect that I'm missing something here; it sounds like the bulls/bears can only make money if the feedback they provide is insufficient to pull NGDP back on track. Bulls and bears alike are being asked to make self-negating prophecies.
    In the unlikely event that I'm interpreting this correctly, it seems that it would be easy enough to fix this by using a secondary (prediction) market in which we define the stimuli which the Fed will use to actually achieve its target NGDP, and then let bears and bulls buy contracts on how much stimulus will have been applied. But I don't see how to do it without a secondary market of some kind.
    (My confusions are expressed at greater length here and back here, and even here. But probably I'm missing something really basic.)

    ((btw, I tried several times to post or even preview versions of this comment before finding that I had to allow 3rd-party cookies; I'm hoping this works.))

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  14. This comment has been removed by the author.

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  15. Tom,

    Check out Scott Sumner's second FAQ at the end of this post. It at least attempts to answer your question, though I'm not sure it's really satisfactory, because he assumes that the stimuli (the monetary base, in his example) are observable, when in fact they are only partly observable: you can only observe what the Fed has already done, not what it is about to do. I would note a couple of things, though:

    1. Assuming that the market is highly liquid, individual speculators will have little impact on the Fed's actions, The impact comes from having a large number of people who bet on the same opinion. So an individual is not really betting against himself by trading the futures; he's just betting against the Fed's model of the economy. His own action won't change the outcome enough to dissuade him from doing it, unless a whole bunch of other people follow him.

    2. Many of the participants in the futures market will presumably be hedgers, who are willing to take positions that they don't expect to make money on, in order to insure against bad outcomes. Thus, for example, if you have a business that is very sensitive to the business cycle, even if you expect the Fed to hit its target, you might be willing to sell futures contracts to reduce your risk in case the Fed doesn't hit its target. Or conversely, if you have a long-term bond portfolio and are worried about rising interest rates, you might be willing to buy futures contracts to protect against the possibility that the Fed will exceed its target and have to raise interest rates.

    Most people writing about this have not really said much about the hedging aspect, but I think it's quite important. The Fed would essentially be offering an insurance contract on predictable terms, and this alone could help to stabilize the economy. Even if the Fed misses its target, at least you can protect yourself, so you have less uncertainty and are thus more likely to invest.

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  16. The speculators profit by doing better than the other speculators, not by doing better than the Fed.

    If you treat the market as "Mr. Market" and you imagine that he is playing a game with the Fed, then he has no incentive to play.

    But the Fed is not playing the game. Market participants are playing the game with one another. I buy knowing that base money will be where the market expecation is that NGDP will be on target, because I expect that the market expectation will be too low.

    I sell because I expect that base money will be such that the market expectation of NGDP will be on target, but I sell because I expect it to be too high.

    I very much favor the approach that lets the Fed implement the monetary policy it thinks best, subject to the contraint it is hedged.

    If no one trades, then the Fed is hedged. There is no contraint.

    If a speculator buys, and the Fed contracts a bit, that contraction should attract a seller. Apparently, everyone else thought the Fed's policy was just fine before.

    If a speculator sells, and the Fed expands, that should attract a buyer. Apparently everyone else thought the Fed's policy was just fine before.

    No one will make any money on the contracts if NGDP stays on target all the time. But just because the market expectation is that it will be on target doesn't mean that it will be on target.

    The benefit of trading is that if you are better than the market at figuring out if the current value of base money is consistent with NGDP remaining on target.

    Why buy any future? Surely, the market price of the future is the best estimate of the future price of the product. How can you possibly make money? Well, you do so because you think you know better than the market.

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  17. Posted the following at DeLong’s - hope its right. There’s a small qualification I'm not entirely sure of regarding the $ 17.979 trillion number - if there's an error in that regard or otherwise, please feel free to correct here/there/both:

    ---

    There were two parts to Woolsey’s post. The second part describes the concept of Sumner’s NGDP futures market proposal. The first part describes the concept of DeLong’s interpretation, the latter which in fact does not reflect Sumner’s proposal at all. Instead, it is in effect a separate “NGDP cash market” proposal. Woolsey describes the math that should apply to such a cash market proposal, notwithstanding once more that it has very little to do with Sumner’s proposed futures market structure.

    My own interpretation of some of the math that might apply to DeLong’s “NGDP cash market” idea:

    Let T
    = NGDP target for Q4 2011
    = $ 17.455 trillion.

    Let R = NGDP result for Q4 2011

    Define Q = R/T = result/target

    NGDP bulls expect Q >1.
    NGDP bears expect Q < 1.

    NGDP bulls go long (lend to the Fed)
    NGDP bears go short (borrow from the Fed)

    Assume the unadjusted interest rate is 3 per cent.

    If $ 1 is invested (borrowed), the amount returned (repaid) at maturity is:

    $ (.03 + Q)

    The “moneyness” or net risk payoff from the $ 1 NGDP bet is $ (Q – 1)

    And the adjusted interest rate including net risk payoff is (.03 + (Q – 1)) per cent

    (This applies to an interest bearing instrument. There really is no meaningful discount instrument equivalent, because full maturity value is not known until the time of maturity in either case.)

    It’s not clear to me how the $ 17.979 trillion number enters into required calculations.

    P.S.

    Woolsey captures the distinction between Sumner’s futures market proposal and DeLong’s cash market idea in the following paragraph, which separates the first part of his post (DeLong) from the second (Sumner):

    “Anyway, index futures convertibility does not involve the Fed making loans or accepting deposits at a 3 percent interest rate adjusted for deviations of NGDP from target.”

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  18. JKH the interest payment is assumed to be contractionary because it would attract people to place their money into a fed account simply to earn interest from the fed.

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  19. Bill Woolsey replies to my puzzlement, saying that
    "I sell because I expect that base money will be such that the market expectation of NGDP will be on target, but I sell because I expect it to be too high. ... If a speculator buys, and the Fed contracts a bit, that contraction should attract a seller. ... The benefit of trading is that if you are better than the market at figuring out if the current value of base money is consistent with NGDP remaining on target."

    "Why buy any future? Surely, the market price of the future is the best estimate of the future price of the product. How can you possibly make money? Well, you do so because you think you know better than the market."

    Obviously I didn't explain my puzzlement very well; I'll try again.

    Suppose you're a Super-Smart Investor, and you start in the stock market, where buying stock entitles you to a share in a company's future earnings. Your super-smartness enables you to see that which is not yet clear to the others. You outguess the market's implicit ratings of a few companies' earnings, and after a while when the evidence that you were right comes clear, the stock prices move towards where you knew all along they should be, so you sell at a profit and you're rich. Now as a successful Super-Smart Investor, you look at the Sumner/Woolsey dollar/NGDP markets. You foresee this scenario:
    (1) You analyze the current monetary policy stance, and let's say you work out that it will produce a 1.010101% annual growth in NGDP; the Fed is on course to undershoot its target.
    (2) You therefore line up with the bears, and buy some bets from a bull; the Fed is hedged.
    (3) Six months later, the evidence that you were right all along starts to come clear, and some bulls start to sell their bets.
    (4) The Fed "expands a bit", as you say, and attracts a buyer; (and again, and again...)
    (5) oops. The monetary policy stance that you analyzed in the beginning is gone. The problems that you foresaw have changed. The Fed may well end up with NGDP somewhere below target, as you originally thought, but it may be at or above target; it certainly won't be 1.010101%. As a Super-Smart Investor, you were indeed much "better than the market at figuring out if the current value of base money is consistent with NGDP remaining on target" but that doesn't help because it's the final value of base money (and other monetary-policy factors, right?) that counts, and that final value is determined after almost all the bets are on the table.

    Do you see why this doesn't look like the stock market to me? The Fed uses the cumulative bear investment to adjust its policy in a bullish direction, and uses the cumulative bull investment to adjust its policy bearwards. The fact that you, the Super-Smart Investor, can see that which is not yet clear to the rest, in this market only makes you Cassandra: you can be right as long as you're not believed.
    So, I'm still puzzled.

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  20. Dear Bill,

    thanks for this very interesting post. I guess I have to read it several times to understand it in full.

    But let me ask one question right away: if the Fed will always act to be hedged, isn't this exactly the circularity problem that Scott is trying to avoid by connecting a trade of a futures contract to an increase in the money supply?

    Ok, I should read your post once more...

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  21. "There is no way to buy or sell current NGDPs and hedge in this way."

    I suppose corporations will trade those futures for hedge purpose, based on the correlation between NGDP and their income. I doubt that any futures market based on speculation only and serves no hedge use would survive.

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  22. Kantoos:

    Yes.

    Tom Myers:

    Your puzzlement is the same as the circularity argument, more or less.

    Himaginary:

    The market will "survive" because the Fed makes a market. Perhaps no one will trade.

    Hedging by firms (against losses on inventory, perhaps, should be explored. I think this would be a straightforward development out of Sumner's first paper which depended on local information. It came from Lucas's misperception paper.

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  23. "Anyway, those selling futures contracts don't get any money now to invest. And those buying futures dont pay the contracted amount now."

    Perhaps it might be better to change this rule as for NGDP futures, and let trades directly affect *current* money supply. Affect on current money supply by way of margin requirement seems somewhat roundabout.

    FYI, futures trading for individual stock in Japan works this way. That is, it is the combination of actual trading and actual reversing trade. Why so? Because GHQ prohibited pure futures trading in the Japanese stock market after WWII.

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  24. himaginary:

    A forward contract is when you pay money now for future delivery of some good. The other side of the deal is to receive money now in exchange for delivering something in the future.

    Traditionally, forward contracts played an important role in foreign exchange markets.

    How I have described it, however, it would be the creation of a new type of bond with an interest rate that depends on the deviation of NGDP from target. Rather than picking a fixed interest rate like 3%, I would suggest having it vary with the T-bill rate...perhaps it is more like a repo.

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  25. I get the impression the Fed is relegated to being a day trader taking the "other side" of the trade.

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    1. Certainly there will be some fiscal policy and affect on the money supply as the government runs a deficit or surplus. Under such a system of private money creation, the government seems to be forced to borrow from the private money supply much like Europe. This means the government /could/ be insolvent issuing it's own currency with vigilantes affecting yields.

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  26. This obviously got huge effect and makes everyone worry but we need to be really careful on how we work out everything, I am happy to work with OctaFX broker since with them I have got safe side due to the massive 50% bonus on deposit, it is also use able and that is what makes it big for me and allows me to feel entirely comfortable with everything, It also reduces the risk for me big time and allows me to be working fairly smoothly.

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