Recently I wrote here about a paper Guillermo Calvo prepared for the IMF in 1991, on “The Perils of Sterilization.” I also asked Professor Calvo, now of Columbia University’s School of International and Public Affairs, for some further elucidation of that paper, and how his insights there may apply to the present situation in Europe, where the ECB has committed to “sterilize” its Outright Monetary Transactions.
Calvo replied that the situation in Europe is different from that of the emerging market nations he had in mind in 1991, where the central bank was part of the problem. In Europe, there is a chance that ECB bonds will be considered safe assets, in which case the program could be successful. For further discussion, he referred me to a very recent paper of his on the Price Theory of Money.
That paper is fascinating, in part because it pins a good deal of explanatory power and for that matter a lot of hope on the “stickiness” of wages and prices, something that is but a footnote in much of economics’ literature. Whether one accepts Calvo’s inferences or not, they may elucidate many of the quests for alpha in our time, a time when monetary policy and its decisions seem central to investment strategies through much of the world. Thus it is worth expounding here. The following is a brief paraphrase of Calvo’s theory, with a lot of direct quotations, and without further editorial comment from me.
Price Theory of Money
The phrase “price theory of money” has been used by others, and it’s such a natural complement/contrary to “quantity theory of money,” that one would be surprised if it hadn’t been.
The underlying idea behind Calvo’s use of the term is that people value fiat money, [which, as he says up front, “contains the seeds of its own destruction”] because and to the extent that wages and prices are sticky. This is an answer to the question why has fiat money not disappeared, why has dissatisfaction with ‘mere paper’ not already driven people into a barter economy or the use of the precious metals as de facto currency.
One common answer is that the government supports its own fiat money in various ways, notably through legal tender laws and the requirement that taxes be paid in such a way. But Calvo thinks that answer inadequate. Even if such “buttressing [were] completely absent,” he says, he would expect use of the fiat dollars to continue.
The reason he believes this is that suppliers of goods and services “broadcast, far and wide, their willingness to take fiat money in exchange for the wages and services they own. Moreover, they reaffirm their willingness to do so over extended stretches of time….” So regularly that it can become boring. Further, they often promise to hold prices constant, even during inflationary times. Thus, gold “may not succeed in debunking the US dollar … unless gold becomes a unit of account and, more to the point, a substantial share of prices and wages are quoted in terms of gold,” and this seems to Calvo unlikely.
For non-goldbugs, though: of what significance is this theory, the invocation of the stickiness of prices as a support of fiat money? It offers Calvo an “optic” for looking at such questions as whether the euro will survive. After all, if enough European firms and individual keep posting their prices, or contracting for wages, in euro terms, then the euro may survive whatever the political machinations.
Two Distinct Liquidity Traps
From this follow the following further observations: certain fixed-income assets, benefitting from both the perception of low counterparty risk and this stickiness of prices, can become quasi-moneys; that helps us understand the rise of the asset-backed securities a decade ago – the private sector had a great incentive to generate quasi-monies. Further (as more recent experience indicates) the value of these quasi-monies can suddenly disappear (“massively evaporate” as Calvo puts it) into a liquidity trap.
Now, none of this gets us back to the Keynesian “liquidity trap” familiar to those who studied mainstream economics even at the undergraduate level. Keynes said, putting it quite roughly, that the Depression of the ‘30s was a vicious cycle in which people hoarded cash in their pillow cases and mattresses because there weren’t any decent investment opportunities, and there continued to be no good investment opportunities because all the cash hidden in pillow cases made their development impossible.
Calvo’s liquidity trap is of a very different sort, a “supply side” analog. Thus, he gives it a different name “Prospero’s Liquidity Trap.” [Why this name? So far as I can tell, it is because Calvo sees the magic involved in his liquidity trap as in some sense more benevolent than that of Keynes’ liquidity trap, thus he sees here the contrast between Prospero and Sycorax in Shakespeare’s The Tempest. But working through the allusion would be more trouble than it’s worth for us.]
The PLT is a different vicious cycle. A “massive collapse in the nominal price of a significant number of means of payments” Calvo says, undermines the safety of loan collaterals, undermines credit flows, and thus undermines output and employment in a matter that “cannot be easily undone.” The engine of debt sputters out, and is inclined to stay out.
The Re-creation of Safe Assets
The engine almost certainly can’t be restarted, Calvo says, by fiscal policy. Keynesian fiscal stimulus after a PLT has been sprung will prove a feeble response.
Thus, government and central banks have an essential monetary task before them once a society has fallen into PLT. They have to create sufficient “safe assets” to allow the resumption of collaterals and credit flows.
Here we see the reason why Calvo believes the present situation in the U.S. and Europe quite distinct from that to those to which he alluded in his 1991 paper. He believes that prices in developed economies remain sticky, so fiat monies remain viable, and the central banks have an opportunity to re-create Safe Assets, re-starting the engine of debt.