The General Pattern: Risk-Free Nominal Assets

By Brian Andersen

It only makes sense to compare ETF issuers to currency issuers if issuing currency is like issuing ETFs. In my other posts I assumed that to be the case. But perhaps that isn’t obvious. So the question becomes, what do ETFs and currency have in common that make one an appropriate model for the other?

The answer is that ETFs and currency are both examples of risk-free nominal assets. The language stems from philosophy where there are thought to be things and names, and the names are used to retrieve the things. So nominal assets are the names and real assets are the things that they retrieve. Just as it is unhelpful to have multiple names referring to the same thing, it is unhelpful to have too many nominal assets trying to make claim on a given pool of real assets. While interesting from an etymological point of view, it is not entirely accurate to think of nominal assets as names referring to specific things.

That is because in the real world, nominal assets normally claim a fraction of an entire pool of assets, rather than one specific asset out of the pool. One share of AAPL stock is a nominal asset, but it doesn’t claim a specific iphone sitting in inventory. Instead it is thought to claim a tiny sliver of EACH individual line item on the company balance sheet. So stocks are nominal assets that claim a fraction of the entire balance sheet of a firm like AAPL. But there is a fixed size pool of shares, and the value of the balance sheet fluctuates according to the p&l of the firm. This makes company stock a RISKY nominal asset. The risk comes from the fact that the quantity of shares is not tied to the value of the underlying balance sheet. The share quantity is fixed while the value of the balance sheet is allowed to float. This risk is not necessarily a bad thing. It is what allows for the possibility of price appreciation as the real assets on the balance sheet expand while the nominal assets remain fixed in supply. Without that, there would be no reason to invest.

Let’s compare this to an ETF. In this case the ETF shares are nominal assets, and balance sheet of the ETF are what those shares claim, just as AAPL shares are claims on the balance sheet of Apple Computer the firm. The ETF balance sheet contains company stock, which are risky nominal assets as discussed above. But as I explained in previous posts, the pool of ETF shares is allowed to expand and contract to keep it perfectly in line with the underlying balance sheet. The result is that the ETF itself is a risk-free nominal asset, meaning that the ETF shares always claim a specific quantity of the underlying basket. Please do not read me as saying there is no financial risk to ETF shareholders. It means that the ETF itself does not pose ADDITIONAL risk to the shareholder, beyond the risk that already exists in the underlying shares. The risk of the underlying shares is huge. This means you will not get a premium or discount on the underlying shares when you trade the ETF. This stands in contrast to trading company stock where you may have to pay too little or too much for the underlying value of the balance sheet.

Now let’s talk about currency. Like stocks and ETFs, currency are nominal assets. Their value is based on the fact that they can be used to claim a fraction of a pool of underlying assets known as the real economy or real wealth basket. It is simply incorrect to say that fiat currency is not backed by anything. It is backed by EVERYTHING for sale in that currency! The bigger the basket, the better the currency. And as the basket gets bigger and the currency gets better, people want more of it, and the issuer has to create more. That is why fiat currency issuers run deficits. It isn’t because they are irresponsible, it is because people love the currency and once they get it they don’t want to let go of it. But as I discussed previously, economists are generally in favor of restricting the growth of the currency supply. They do this is by allowing the labor market liquidity to fail. But while the growth of the currency supply is restricted, the real wealth basket keeps growing and growing. If more earnings were available, it could grow even more. The result is that the currency does not trade like an ETF for a fixed share of the basket. It trades like a risky stock! Whenever you buy or sell currency, you are likely to experience a premium or a discount to fair value for whatever you are trying to sell or buy. And if you are not able to wait for a fair price, you are probably going to end up selling at a discount and buying at a premium. This is because economists want to restrict the supply of currency where it should be allowed to float freely. The currency supply should expand or contract to exactly match the size of the real wealth basket.

So there is a general pattern here. Nominal assets are assets whose value depends on the ability of a holder to claim a portion of some other basket of assets. Nominal assets are risky if the quantity is fixed even while the underlying basket expands or contracts. And they are risk-free if the quantity of nominal assets floats to track the size of the underlying basket.

So stocks, ETFs, currency, mortgage loans, bitcoins, futures contracts, and gift cards are all examples of nominal assets. Rice, oil, cars, homes and office space are not. Out of the list of nominal assets, only ETFs, futures contracts and gift cards fit the definition of risk-free nominal assets. But futures contracts do not have a single issuer; anyone can be a seller of futures contracts and therefore an issuer. This makes it hard to talk about the appropriate strategy for a monopoly issuer. Gift cards don’t have a secondary market so it isn’t very interesting to discuss liquidity or stable pricing in that context. This makes ETFs a uniquely valuable analogy. Like currency, ETFs have a monopolist as the issuer and a stable, liquid secondary market.

But our currency, under the control of economists, is not truly a risk-free nominal asset because its quantity doesn’t reliably adjust to track the size of its underlying basket. On one hand, the currency is trying to appreciate as the basket grows faster than the supply of currency. But on the other hand, the lack of sufficient liquidity is keeping a lid on that expansion. When things get really bad, people take to the streets and we get a little net spending in response, but never enough to allow for sustained growth. Meanwhile, currency issuers continue to print free money (mostly for the wealthy who enjoy political influence) in the form of tax credits, subsidies, and interest payments which dilute the value of the currency over time. With this many crosscurrents in effect, the result is a pool of nominal assets that track the real wealth basket very poorly, and a currency that trades like volatile stock, not like an ETF with stable pricing and great liquidity.

The economy is not an ETF. But it is a pool of valuable assets undergoing expansion and possible contraction, like an ETF. The currency are not shares of an ETF, but they are a pool of nominal assets that act as claims on the real wealth basket. Therefore, if a stable valued and liquid currency is the goal, the quantity of currency must be allowed to float up when the basket expands and down when it contracts. And the strategy followed by ETF issuers is an appropriate model for making this happen.

18 responses to “The General Pattern: Risk-Free Nominal Assets

  1. golfer1john

    I guess another problem is how you define “currency”. Most of the money in our economy is issued by banks, and the economy tracks the quantity of bank credit fairly well. There’s no measure of government money that tracks anything, even before QE began. How do you hope to establish a connection for control purposes, and to what measure of money?

    • “Most of the money in our economy is issued by banks”

      Under licence from the state on a 1-1 conversion ratio. Therefore it is the same as state currency.

      The banks are limited in what they can do though because they only lend, not spend. And lending requires credit worthy borrowers.

      Having your expansion rely *solely* upon people borrowing at exactly the right moment for exactly the right purpose is not a sensible strategy for ensuring that there is the right amount of currency circulating at any point in time.

      • golfer1john

        Bank money (“currency” has a different definition) trades at par with government money, because it is guaranteed by the government. Bank money is even more ETF than ETFs, in that a dollar of bank money always exchanges for a dollar of government money, and there is no management fee or transaction cost.

        But the quantity of bank money is not under any central control, it fluctuates with the market for loans. It is created and destroyed without any reference to real assets, only the borrower’s promise. There is much more bank money than government money, so it is bank money that drives the economy, mostly, and if price stability depends on the amount of bank money, then it is not under control of the monetary sovereign.

        And it is pro-cyclical. It cannot be used to manage the economy.

        • You are saying bank money but I think you mean bank credit. The money to pay principle and interest on that credit has to come from somewhere else. That money comes in the form of currency issued by the government in exchange for public service work.

          • golfer1john

            No, I mean bank money: deposits. What you can spend because you have a balance in your bank account.

            It is created when banks make loans. The money to pay the interest on the loans can come from two sources: government deficits, or non-government dissaving.

    • I think anything that tracks the dollar (risk-free nominal assets) is currency.
      So vault cash, bank reserves, deposits, repos, treasuries and even bonds.
      That is roughly in order of increasing riskiness.
      The sum of all previous spending minus the sum of all previous tax is the amount of currency.
      What THEY call debt.

      • golfer1john

        “The sum of all previous spending minus the sum of all previous tax is the amount of currency.”

        Now you’re mixing lots of unlike things together.

        Usually “currency” means bills and coins, when you talk about the amount of it. “A currency”, meaning, for instance, the US Dollar or the Euro, is a homonym. To manage the currency like an ETF means to manage “the dollar”, not the number of dollar bills.

        The net of federal government spending and taxing (= “the debt”, except for a few relatively small exceptions) is not the amount of currency or the amount of money, it is non-government net financial assets.

        Deposits and (non-Treasury) bonds are each much larger than “the debt”. Bank reserves don’t circulate, and don’t have much influence on anything except the clearing process.

        “Repos” (and swaps, and other derivatives of the dollar) have a notional value hundreds or thousands of times the size of “the debt”. I don’t know of anyone else who considers them to be money or currency.

        Casino chips are money, too, and could be considered currency, but if they have to be managed by government in order to control inflation, I’m afraid it’s an impossible task.

        • To manage the currency like an ETF means to manage “the dollar”, not the number of dollar bills.

          Managing an ETF means managing the number of ETF shares to keep it inline with the ETF basket. So if we were to manage to dollar the same way, managing the dollar would mean managing the number of net assets that track the dollar to keep it tied to the size of the real wealth basket.

          Currency is issued the same way. Reserves are treasury liabilities and assets of commercial banks. Repos and swaps are interbank liabilities/assets. Deposits are liabilities of commercial banks and assets of depositors. Bonds are central bank liabilities and assets of bondholders. These are all examples of nominal assets that are free of pricing risk, but not necessarily credit risk. They are all credit constructs, meaning the assets are tied to liabilities 1 for 1. The only thing that increases the NET financial assets of the private sector (what I would like to call currency) are bank reserves which are liabilities of the treasury, the issuer of the currency. Just as ETFs are liabilities of the ETF issuer.

          The casino chip example is helpful. Casino chips are liabilities of the casino and assets of the casino customers. The casino can issue all the chips it wants but if gives away chips without taking some other form of currency in exchange, it is losing money. Casino’s don’t like losing money so there is no reason to worry that they will go wild issuing free chips leading to runaway inflation. Those chips are claims on the remaining assets of the casino. The chips themselves meet the definition of currency but that doesn’t mean the casino can create/issue NET currency. Issuing chips subtracts from the value of the casino balance sheet.

          Only the treasury can create new NET assets that track the dollar. But those assets can take many forms via the private sector credit network which includes banks, households, firms and even casinos.

  2. Winslow R.

    Okay I get the idea bitcoin failed to incorporate any of the social, politcal or moral supports that a real currency needs to survive.

    “Therefore, if a stable valued and liquid currency is the goal, the quantity of currency must be allowed to float up when the basket expands and down when it contracts.”

    Quantity of currency or demands of currency?

    The demands of currency needs to expand and contract in response to growth or contraction of real resources basket. Which still leaves out the social, political and moral institutions that allow currency creation/destruction to happen in a sustainable manner

    • This is true. I was hoping to explain why we need to increase the supply of currency without resort to any moral or political assumptions.

      • Winslow R.

        Yes you explain why (except it is the demands of currency that need to expand/contract, not necessarily the quantity of currency itself).

        The ability to expand or contract currency isn’t enough ( as QE’s failure shows) as it doesn’t necessarily affect currency demands.

        The ability to expand currency’s demand while creating currency should work ( fiscal deficit spending).

        The ability to expand demand while not creating currency might work as well ( fiscal deficit spending while taxing rich taxpayers currency savings) which is at least a possibility of what Picketty is suggesting.

        There probably are more choices available, like MR’s business loan/deposit expansion with business financial assets given special status as bank capital.

        Most Mmters prefer the ELR.

        I’m not sure if your suggesting some sort of ETF that would be purchased/sold by the Fed, Treasury, or banks that would qualify as bank capital?

        If this ETF had some social, political or moral institution built into to it, you might be on to something.

  3. “Quantity of currency”

    It’s quantity of circulation that matters.

    The ETF analogy is a very good analogy but it breaks down a bit when you get to people holding savings in currency form.

    • Why? Aren’t ETFs also held for the purpose of long-term savings/investment? That is on top of their use as trading and hedging vehicles. It seems to me that they are subject to the same kind of demand leakages as currency.

  4. –because people love the currency —

    They do not love currency only for the sake of currency rather because of the means it gives to purchase goods and services.

  5. Many people use their net worth as a way of measuring their progress in life. It’s all about the number for them. My grandpa was that way. Same with many people on Wall St. Then there are investment institutions whose sole mandate is to use currency to get more of it, not to purchase goods and services. They are measured by their ability to create positive returns. Corporation are measured by their earnings but their shareholders aren’t looking to spend that money. Dividends tend to be reinvested in an attempt to get even more money.

    Of course people wouldn’t use currency this way if it wasn’t spendable. But the fact that people use the currency as a sort of measuring stick rather than an actual claim on goods and services means that the issuer needs to create more. Once created, it is very hard for the issuer to get the currency back. That’s what I mean by “love”.

    • Money as a nominal asset needs to be balanced to the total real assets of society, not just those real assets created by government, such as infrastructure. It also needs to be decoupled from the score keeping of the elites.

      Yes, net worth is being used to keep score. The wealthy, in their constant effort to run up their “score” do everything in their power to suck money out of the real economy so it can be added to their net worth, which is a constant drain on the supply of money that the non-wealthy can use to claim real assets. At the same time, the money in possession of the wealthy still represents a theoretical claim on those real assets, and because the goal is to maximize returns for score-keeping reasons, the wealthy and the managers of their corporations are unwilling to sell those real assets for money prices that will fail to “earn” them additional money at the rate of return they expect. The result is we have price rises on necessities like food, clothing, energy, medical care and education, no income increase for the non-wealthy and resultant misery for the working poor and destitute.

      What needs to be done is to discourage the use of money for this score keeping purpose. This was done after WW II through very high marginal tax rates. It became futile to use money for score keeping. The true value of high marginal tax rates is not the collection of additional revenue from the elites. The true value is the disincentive to use money for score keeping. High tax rates are not the only way to manage this. Another idea being floated is to cap CEO pay at a multiple of the median pay of the workforce, whether employed directly or indirectly through contractors. This gives CEOs an incentive to reward the productivity gains of their work force. The two concepts could be combined by tying the CEO’s tax bracket to multiples of employee pay.

  6. If this is a new way to create demand through an ETF you are not being clear.

    It is possible an ETF could be used to match consumer and investment demand to the supply of real resources.

    The ‘market orientation’ of an ETF could appeal to at least half of the political spectrum.

    The other half of the political spectrum that worries about morality and various social issues, would like to see how this ‘market mechanism’ would regulate the amount of demand.

    Would the ETF have citizen ownership?
    Would it have dividends distributed on a per share basis in times of low demand?
    Would share pay interest that could only be withdrawn after retirement or disability?

    The article seems to have some confusion regarding what creates demand for real resources. Currency (or whatever you want to call it) isn’t it.

    • I’m not arguing for a completely new currency regime based on ETFs. I’m arguing that the currency is already enough like an ETF that we can use the same logic that makes ETFs work to make our currency work better. And we can go the other way and think about currency problems (example inflation) by considering what would happen to ETFs if they operated like currencies.

      Public purpose is very important. But not as a fundamental principle in a theory of money. The problem with taking things as fundamental is that you lose the ability to prove them. So we want the smallest base of assumptions that we can work with. In order to have a sound case for public purpose, we need to show how it arises naturally out of the more fundamental ideas and goals that we can all agree on. Price stability and liquidity are ideas that the right has been bludgeoning the population with for decades. That needs to stop. Their policies do not create price stability or liquidity. So I will take price stability and liquidity as my assumptions about the goals of currency issuance, and work from there to develop a case for public purpose.

      The article seems to have some confusion regarding what creates demand for real resources. Currency (or whatever you want to call it) isn’t it.

      I don’t try to explain why there is demand for real assets. In calling something an asset I assume that it has value to multiple agents. If that is the case there will be natural demand (order flow) for the asset. It is nominal assets (ETFs and currency are both examples) whose value requires an explanation. The answer is that they can be spent/sold (possible via multiple layers of indirection) in exchange for a real asset.