ETFs as Analogy for Sovereign Currency

By Brian Andersen

By now, everyone has heard the expression “financial innovation” to refer to changes that have taken place in our financial markets. Like all innovation, the goal of financial innovation is to solve problems. To bring our intelligence to bear on the problems that we face. Sometimes those innovations fail completely. At other times they achieve a narrowly defined success while causing new problems to emerge in their wake.

One of the financial innovations that have worked out comparatively well are Exchange Traded Funds (ETFs). ETFs have a lot in common with ordinary stocks. They are listed on a stock exchange and you can buy and sell them just like any stock. Like stocks, ETFs represent fractional ownership in a corporation (the issuer). What distinguishes ETFs from ordinary stocks is the trading strategy of the issuer.

For most public firms, the issuer sells a fixed number of shares to the public in an initial public offering (IPO). After the IPO, the number of shares that trade on the stock exchange is fixed (with a few exceptions like corporate buybacks and secondary offerings). The firm obtains operating capital in the IPO.  After that it doesn’t sell any more shares or receive any more liquidity via the equity markets. Its next task is to put that capital to work by building a profitable business that adds value to the real economy. AAPL produces ipads. XOM produces oil and gas. Valuable products.

The way an ETF works is completely different. Its only business is to buy, hold and sell the shares of other firms. The ETF basket is the portfolio of stocks held by the ETF. The basket is a matter of public record, and is completely static with the exception of an occasional rebalance. The ETF doesn’t produce ipads, gas, or anything else that the real economy needs. Its value is purely as a tool for traders and investors. And that value derives from two properties of ETFs; price stability and liquidity.

ETFs achieve price stability when the ETF shares trade close to the value of the underlying basket of stocks that it holds. It does not mean that the market value of the ETF shares is stable. It means that the ETF can be exchanged for a fixed amount of the basket. ETFs achieve liquidity when traders and investors can trade them on demand and at low cost. Generally the cost of trading an ETF is far less than the cost of trading its underlying basket, even for brokers who don’t have to pay commissions. Because ETFs have been so successful at achieving both price stability and liquidity, they are loved by almost all market participants including retirement savers, broker/dealers, high-frequency traders and hedge funds. There are many things wrong with our financial markets, but the price stability and liquidity of ETFs are simply not among them.

It is worth nothing that ETFs do not always produce stable prices and they do not always remain liquid. This is most likely to be the case with more exotic ETF structures that are used to offer leverage, inverse exposure, or exposure to things other than stocks (like commodities). But for this discussion, I would like to focus only on the operations of simple ETFs with equity underliers. These have been the most successful ETF structures.

I mentioned earlier that for an ordinary stock, the quantity of tradable shares is fixed at the IPO. A consequence of this is that the market value of shares can fluctuate wildly depending on the imbalance of supply and demand from traders. The price of the shares can then become completely unhinged from the value of the assets held by the corporation. The result is that investors have to be careful not to overpay when purchasing these shares. This is the opposite of price stability. The lesson is that if the quantity is fixed, the price will float.

So what was the operational innovation behind ETFs that allowed them to achieve stable pricing and high liquidity? They let the total quantity of shares float. That is all there is to it. Unlike stock issuers which no longer participate in the market after their IPO, ETF issuers stick around to create new shares whenever traders prefer to hold the ETF shares over the underlying basket. Likewise, whenever they prefer to hold the basket over the ETF shares, the ETF buys back its own shares in exchange for stock, effectively destroying them. This is known as the create/redeem process. It ensures that the quantity of ETF shares that exist is always in line with the size of the total basket that the ETF holds. This means that if you hold an ETF, you know exactly how much of the underlying basket you could claim via the redemption process, and you know that that amount will never change in the future. The composition of the basket may change due to a rebalance. The result is that the market value of the ETF shares are tightly bound to the market value of the basket. The price of an ETF share is fixed!

If you already know about ETFs you might be wondering why I made you read this explanation of how they operate. After all I am not saying anything new. You might be also be wondering what this has to do with MMT. The answer is that I believe the same innovation behind the ETF create/redeem process can be applied to the operation of a sovereign currency. That is because the same features that have made ETFs popular with traders are also what we want from a currency. Those features are price stability and liquidity.

In the case of currency, price stability means that you can exchange it for equal valued assets over time. If you can buy an apple for a dollar today you should be able to do the same tomorrow, unless there has been a change in the availability of apples relative to other goods. Price stability makes the currency savable. You can hold it over time without losing or gaining purchasing power.

Liquidity means that you have the ability to buy and sell the currency on demand. Buying the currency is called earning. Selling the currency is called spending. So the currency has good liquidity if you can spend it on demand and you can earn it on demand.

Like ETF shares, currencies are intended to serve as a claim over a portion of a basket of underlying assets known as the real economy. Like ETF shares, we want our currency to be liquid; meaning it is earnable/buyable and spendable/sellable on demand. Finally, if the quantity of the assets claimed by a given unit of currency is successfully fixed, the currency will be stable in price and therefore savable. If our currency had all three of those features, the system would be fair to savers, earners, and spenders.

So let’s see if we can derive some guidelines for a currency issuer based on what we already know about successful ETF operations.

  • The issuer never creates/sells a share without taking delivery of the corresponding quantity of real assets, company stock in this case. To do otherwise would dilute the value of the shares.
  • The issuer never redeems/buys a share without returning the corresponding quantity of real assets to users. To do otherwise would inflate the value of the shares.
  • The issuer always stands ready to create and redeem shares upon demand from users. This ensures that the shares are both creatable and redeemable.
  • The issuer does not become an active buyer or seller of the shares because it would have to make price concessions in order to do so. This would cause inflation or dilution of the share values.

Now let’s convert these guidelines back into the language of sovereign currency issuance.

  • The currency issuer should only spend/create currency for those willing to earn it.
  • The currency issuer should only tax/redeem currency while earning it itself.
  • The currency issuer should remain responsive to users desire for more or less currency in circulation.
  • The currency issuer should not attempt to increase or decrease the supply of currency of its own volition.

The first two guidelines are what provide price stability. They ensure that the currency always trades for a consistent quantity of real assets and is therefore savable. The second two rules ensure liquidity. They make it possible for users to earn or spend the currency on demand.

I have attempted to show that these four rules are consistent with the rules that allow ETFs to serve as liquid and stable trading vehicles. I also believe that these rules are consistent with the existing policy recommendations of MMT. If that is the case, then the success of ETFs carries empirical evidence in support of MMT as a way to create currency offering both high liquidity and price stability. We could carry this same innovation into the monetary sphere in order to create currency that is equally savable, spendable, and earnable.

14 responses to “ETFs as Analogy for Sovereign Currency

  1. golfer1john

    Very interesting insight.

    The only problem is that even today, in the US, as the monetary sovereign is not creating enough currency to offset demand leakages, the value of the currency is still depreciating relative to real goods. There is simultaneously inflation along with very high unemployment. The ECB is more restrictive, holding inflation near zero on average, like an ETF, but at the cost of Great Depression-level unemployment in some countries.

    I think the problem is that inflation is not so completely under the control of the monetary sovereign, as it is under the control of the ETF issuer. There must be some other cause for the gradual depreciation of the dollar, and it is not oil, since oil has been quite stable for a long time as inflation continues, and inflation has persisted in the past even during long periods when oil prices have crashed.

    Only two other real resources have the same sort of pervasive influence on prices that energy has: labor and land. There is no production of additional land, only greater use of the fixed supply as population increases. The increased use can occur only in areas that are more remote or less productive than the currently used areas, and that means the price must go up.

    MMT lacks any solution for the harm and unfairness of continuous low-level inflation. MMT provides policy advice to prevent hyperinflation and wage inflation, but seems to be agreeable to something along the lines of the Fed’s current targets of 2-3% annual inflation of prices in general. ETFs would not be so successful and widely accepted if they adopted such a policy.

    • Regarding the long-term inflation, I believe it is caused by government making interest payments to bondholders. Keeping to the ETF analogy, this would be like the ETF issuer printing up new shares and giving them to ETF share holders for free. Obviously this would dilute value of the shares. Making free interest payments on currency must have the same effect. I have a follow up post tomorrow where I discuss this issue in more detail.

      • golfer1john

        Why is interest the cause of inflation, and not other government spending that is “for free”, not in exchange for goods and services? Or, for that matter, any government spending, even if it is to consume real resources?

        • My view is that any time you increase the supply of currency without also increasing the supply of real wealth there is a dilutionary effect on the currency. Interest payments are the primary example. Outright subsidies to businesses and individuals are another, but these are already widely seen as harmful. On the other hand, when government spends to hire teachers and firefighters and road workers, the increases to real wealth are immediate and generally worth far more than the monetary cost. For example, a firefighter that earns $40,000 can easily save millions worth of property in the course of a year.

          • golfer1john

            “Harmful”? When taxation is too high, outright subsidies to businesses and individuals who would spend them are helpful, not harmful, to the economy. The same medicine can save a life or take one, depending on the situation and the dose.

            “Primary example”?? Interest is only about half of welfare, and less than 1/4 of Social Security. It’s the smallest of the “outright subsidies” in the Federal budget.

            • But if the problem is over-taxation, the solution is not to continue over-taxing while trying to offset the macro-economic damage by giving handouts somewhere else. That is government taking money out of one person’s pocket and putting into someone else’s. I’m actually a fan of private property. Let’s have the right set of taxes, and the right set of spending programs to create a stable, liquid currency.

              I don’t think we have to do a line by line analysis of the budget here. All I’m saying is that when you create nominal wealth without real wealth to match, you get dilution. And that can be delayed for a long time due to demand leakages. But the lesson from the ETF market is that you need to keep the nominal and the real assets inline if you want price stability over the long term.

              • golfer1john

                Any deficit spending creates net financial wealth in the non-government sector, with no increase in real assets. Even if the government paid 0% interest, and even if all “handouts” were abolished. And that is a necessary condition, for a country with a trade deficit and positive domestic savings. The economy is not an ETF.

                But, still, with high unemployment – which is the evidence that government is not creating enough “free money” – we still have inflation. There is some other cause for that, not the deficit, not the handouts, and not the interest. The economy is not an ETF.

                Still, the ETF analogy is a good illustration of monetary sovereignty.

    • golfer1john

      What exactly do you see as the “harm and unfairness of continuous low-level inflation” ?

      • golfer1john

        Inflation transfers financial wealth from savers to borrowers. Government is a net borrower, the people are net savers. People work for 40 or so years, saving to accumulate the money they will need when they are no longer working, and inflation takes away the value of that money, so that in order to survive they have to work longer than if the currency were one that really “always trades for a consistent quantity of real assets and is therefore savable”.

        • It is a continual fascination for me that the majority of MMTers never ever usually include serious macroeconomic phrases like “beneficial to the global economy”. All I see is American economic policy, driven for reasons so openly laid out in the Kissinger Report(1974) for America’s sole and primary economic advantage and later fully instituted as policy by the secret rules of the Washington Consensus, continuously attempting to grossly fiddle and bend trade policy as well as corrupting both the free markets principles and dollar outcomes for America’s sole benefit. The ETF was indeed secretly invented as a market tool for this very purpose along with the Treasury’s illicit ESF(Exchange Stabilization Fund).

          It is also well known that the ETF gold supposedly held by the NY COMEX is now being sold and over-leveraged by a factor of about two hundred. This means, for instance, that every purchased bar of gold held by the COMEX — that same bar of gold — has been sold to 200 separate customers. The NY COMEX nearly suffered defaults twice in 2008/2009 when their customers cashed out and began demanding payment in gold as was their right. These COMEX customers were, instead, forced to accept US dollars.

          So I would say that golfer1john is mostly right — inflation is probably one of the main reasons that the average American has no money now. And let’s all give a big Hurrah!! for the argument that inflation helps to reduce debt. Absolutely. But, inarguably, inflation also devalues the dollar in your own pocket. And if you have no money in the first place and you are in debt up to your eyeballs with no hope of a job — how is this inflationary situation supposed to help the average US citizen and how does continual inflation by the Fed help the ever-ongoing lack of demand and liquidity on the ground? Can some clever and honest economist please explain how the governments obvious trickle-down-economics QE strategy(certainly a false strategy just to feed free cash to the megabanks instead) is supposed to help the average Joe on Mainstreet?

          If you use dollar inflation simply as an illicit tool to inflate away America’s foreign debt(rather than indulging in proper trade) then it stands to reason that developing nations will also eventually end up hating the US dollar — due to the inevitable continual erosion in their accumulated Treasury savings value — which has been the casefor decades. American economists call this inflationary approach a mechanism for “properly balancing the global economy”. Really? And for whose real beneifit? And who the hell do America’s economists think they are — is that economic approach the new democratic way or can this be more obviously and honestly viewed as economic dictatorship?

          Many nations, including China, Russia, India, other BRICs, ASEAN nations and other countries in the Middle East are now abandoning the dollar in droves and are moving to gold as a result of these crass US inflationary policies. Innumerable currency swaps — completely avoiding the trade dollar — have been arranged between major economies since the financial disaster of 2007-8. It is also a fact that India, Japan, the ME, the ASEAN nations, Europe and UK have also moved to using swaps and not the dollar for trade with China. It has become very obvious to me that the selfish dollar is too heavily being used and manipulated for self-advantage by the American govt and the Fed.

          In the above comment, golfer1john made the argument(which I would agree with) that Americans are having their savings inflated away. I’ve merely extended that argument to those developing countries who are forced to accumulate Treasuries from dollars earned through the honest trading of their manufactured goods with America. America then has free reign, via her dollar manipulations, to inflate away their savings(America’s foreign Debt). With continual abandonment of the dollar by the world economic community, I also shudder to think of what this effect will have on the ordinary American citizen. But this unfair punishment is well under way.

          Finally, I have to say that whenever I introduce such questions in these economic debates, particularly with MMTers, they never ever answer my many questions but generally evade by referring me to perhaps Randall Wray’s magnificent new book an macroeconimics or whatever. So these questions that I ask always remain unanswered by the MMTers. But I confess that I much prefer reading books like Michael Hudson’s wonderful book — Super Imperialism: The Economic Strategy of American Empire. Or William Blacks The Best Way to Rob a Bank is to Own One.

          If America’s doesn’t clean up its economic policies, I see little hope for America in the future. And so went Rome.

          The Goths are coming…

          • golfer1john

            “It is a continual fascination for me that the majority of MMTers never ever usually include serious macroeconomic phrases like “beneficial to the global economy”. ”

            One of my first thoughts about MMT was “What would happen if every country did it”? There would be no asymmetrical advantage to the US as would occur if only the US pursued full employment with a JG. If everyone did it, probably trade would be more balanced, certainly poverty and property crime would be greatly reduced throughout the world, and political and ethnic tensions and violence, often fueled by feelings of victimization, would be reduced.

            MMTers do often emphasize income equality, but that tends to be a politically charged, and thus divisive, phrase, and they usually restrict it to the context of a single country. I think an approach emphasizing the reduction of poverty and crime and violence worldwide would be more widely accepted. I’m surprised there isn’t more emphasis on that.

  2. @mikeriddell62

    Hi Brian
    Liquidity and stability aren’t the only things that I want from a currency.
    I want a currency that is earned into existence for contribution to the common good rather than a currency that is lent into existence for GDP purposes.
    It’s time we got away from the stunted conversation of ‘money/modern monetary theory’ and instead talked about the valuation system that underpins it.
    In addition to stability and liquidity, I want a valuation system that values community.

    • I want a currency that is earned into existence for contribution to the common good rather than a currency that is lent into existence for GDP purposes.

      I agree completely. But it is included under the price stability objective (but not explicitly stated as such). You have to EARN the currency into existence by making a positive contribution to the real wealth basket. Examples include being a teacher or a firefighter, soldier, working on roads and infrastructure. These are all valuable contributions to public purpose that make us collectively more wealthy. What we should not do is give free money to bondholders. It just dilutes the value of the currency.

      • Mike Riddell

        If you widened your list of examples to include other activities such as teaching, giving or learning, and provided licensed community groups with the software to create them and record how long participants were involved in them, then you’d have an alternative valuation system that is underpinned by the universally recognised unit of account that is time.
        And that in itself would be the beginning of a reputation currency that all the communities of the world could use to identify themselves as givers not takers.