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Cash and T-bills are not close substitutes

DATE POSTED:October 17, 2020
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Tyler Cowen Alex Tabarrok recently linked to an interview of Eugene Fama. His discussion of the EMH is brilliant, as you’d expect. He’s right about “bubbles”. But Alex chooses to quote from his discussion of monetary policy, which is almost completely inaccurate:

It’s not just the Fed, around the globe central banks are flooding the system with liquidity like never before. Is this a reason for concern?

Frankly, I think this is just posturing. Actually, the central banks don’t do anything real. They are issuing one form of debt to buy another form of debt. If you are an old Modigliani–Miller person the way I am, you think that’s a neutral activity: You’re issuing short-term debt to buy long-term debt or vice-versa. That’s not something that should have any real effects.

Then again, the financial markets sure seem to love it. At least it looks like that the S&P 500 is moving upwards in tandem with the expansion of the Fed’s balance sheet.

Every day we hear a story about the movement of stock prices. But the story is different each day. So basically, these stories are made up after the fact. But when we look at it systematically, we don’t see a big effect of Fed actions on real activity or on stock prices or on anything else. That’s why I use to say that the business of central banks is like pornography: In essence, it’s just entertainment and it doesn’t have any real effects.

Let’s consider the applicability of Modigliani–Miller to monetary policy. Is it true that the Fed was just swapping one liability for another similar government liability, which should not have much impact on relative prices?

Conventional economists might try to disprove Fama by pointing to the fact that the Fed can use OMOs to control interest rates. But here I’d agree with Fama; their control of rates is greatly exaggerated. Unfortunately, he’s still wrong about OMOs not having much effect.

Fama’s been making this argument for a long time, well before the zero bound situation arose. So let’s go back to 2007, when the monetary base was 98% composed of currency. At the time, one-month T-bills yielded 5% and currency yielded 0%. How can yields have been so different on two assets that are supposedly close substitutes?

[Update: In the comment section, John Cochrane says Fama is speaking to the post-2008 period, so the preceding paragraph may be in error. The sentence beginning “Actually” kind of sounded like he was making a general proposition about central banks in various times and places. The central banks of India? Turkey?]

And how many times in your life have you stood in a checkout line at a store behind someone trying to pay for purchases with T-bills? Zero? Same here.

So both common sense experience and market prices confirm that currency and T-bills are not at all close substitutes. Don’t like 2007? In 1981, T-bills yielded 15% while cash yielded 0%. In Switzerland, cash yields more that government bonds. How does M-M explain that fact?

Currency is more like “paper gold”, an asset with idiosyncratic uses that are almost unrelated to our financial system. Most currency is used for small transactions and tax evasion, areas in which T-bills are useless.

So Fama’s basic approach is wrong. Now it’s true that modern interest bearing bank reserves are much closer substitutes for T-bills than is currency. And it’s useful to think about how to model this. But you need a general model that applies to both bank reserves and currency. The M-M theorem is not a useful starting point, even in the world of 2020.

Fama’s also wrong about market responses to Fed announcements. Fed announcements often have a powerful effect on financial markets within seconds of the announcement. The odds of this being random are far less than 1 divided by the number of atoms in the universe. Perhaps Fama hasn’t studied this area.

To be sure, there are plenty of problems with empirical work on the impact of monetary policy, especially its longer run impact on the macroeconomy. Economists have done a poor job of addressing the identification problem, and this may partly explain Fama’s skepticism. But there’s no doubt that the Fed has a huge impact on asset prices; anyone that follows the markets closely knows this.

In one respect it is like pornography; I know it when I see it. Here’s the impact on the Dow of the unexpectedly contractionary Fed announcement of December 11, 2007, which occurred at 2:15pm:

That’s more disgusting than any picture of a naked lady.

There are dozens of similar examples. Modigliani–Miller has no implications for monetary economics.

Here’s why my dispute with Fama is so ironic. Who convinced me to look at monetary policy this way? Fama did! Once I understood the EMH, I realized that other macroeconomists were doing things all wrong. The way to do macro is to look at the immediate impact of policy surprises on asset prices. I quickly saw that economists were grossly underestimating the impact of policy shocks like December 11, 2007, which triggered the Great Recession.

So I’ve used Fama’s EMH model for monetary economics, and ended up as far away from Fama as it is possible to be.

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