A while back, Nick Rowe had a post about the option value of cash. Rowe asserts that cash gives a real option to do anything. At first, I didn’t see a problem with this, but as part of my ongoing debate with Silas Barta, I’ve thought a bit more about this. I think Rowe’s point is technically correct, but misleading because he neglects to mention that all reasonably liquid stores of value give this option value. Reasonably liquid stores of value, primarily financial assets, can give you the option to purchase whatever you like later on. Now cash is more liquid than any other asset, so on the time scale of hours or days only cash gives you the option value you want, but on reasonable time scales (enough time for your brokerage firm to wire you the money) many financial assets will do.
It can also be misleading for another reason; it can be tempting to think that it’s cash itself that creates that option value, that this option free in the sense that it is available regardless of the state of the world. However, money is just a kind of asset. If the option of saving in terms of money sends false signals about the profitability of actual short run saving (in the form of trading promises or of doing actual real investment), this can cause problems. In the usual case, where cash pays 0% interest and market rates for short run saving is positive, say 2%, this leads people to inefficiently avoid holding money. In the case where cash pays 0% interest and market rates for short run savings are negative, say -2%, this causes the opposite problem people try to hold too much cash.
If the option of waiting a short period of time is very valuable, so everyone wants to do it, this may cause short run rates to be very negative and the 0% cash option to be very distortionary.
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October 14, 2010 at 5:15 am
Nick Rowe
Your first paragraph seems to me to be a fair critique. But you maybe lost me on the second paragraph. Are you saying that what’s individually optimal isn’t socially optimal? If so agreed. In a recession, individuals hold more cash than is socially optimal. But outside a recession, in normal times, I think it’s the opposite. Milton Friedman’s Optimal Quantity of Money argument says that people hold less money than is socially optimal.
October 14, 2010 at 7:47 am
Silas Barta
John: Refer back to my energy example in the post you linked to: in such a case like that (which I try to refer to with the term “discoordination”), it *is* socially optimal for people to *all* cut back spending and investment — because of real uncertainty about the relative value of resources. Such resources would bear a risk cost, and printing money hides (but does not eliminate) this risk, leading to waste.
(And I had remarked that Nick_Rowe’s post was better way of making the same general point.)
Incidentally, this insight (about recessions being recalculations that amplify the relative value of definitely-useful resources over resources that, say, require a certain ecosystem around them to be useful) can account for why normal people are seeing inflation now, even as “the numbers” claim we’re not: stuff people actually want, that they don’t cut back on (in their regular shopping bill), increase in value, while more complex, special-purpose things fall in value.
That can lead to inflation that is officially 0% or less yet feel painful: money trades at a premium, but food trades at almost the same premium! So expressed in dollars, food might not increasing in nominal price, yet still be more expensive more real terms.
October 14, 2010 at 7:59 am
jsalvati
I’m not really disagreeing with that here, though I might disagree somewhat elsewhere.
I am pointing out that it’s important to remember that all assets give this role, and that for institutional reasons (cash pays 0% interest), cash can send misleading signals about the opportunity for saving resources, implying that you can save resources on better terms than you can in actuality. That’s bad.
October 14, 2010 at 8:40 am
Silas Barta
I’m not sure how it is you can say you agree, but then say your second paragraph. If people curtail spending/investment because they’re hoarding cash, which because they’re uncertain about what the short-term future of energy will look like, that represents a *real* savings of resources, because it avoids (in the aggregate) depletion of resources that will turn out to have significantly more value in one of the two scenarios (purported energy source fake vs. non-fake).
On what basis do you think they’ve acted on a misleading signal by doing so?
October 14, 2010 at 8:41 am
Silas Barta
sorry, that should be “…because they’re hoarding cash, which is because they’re uncertain …”
October 14, 2010 at 9:07 am
jsalvati
It’s not that holding more cash *must* be misleading (though I think this should be met with an increased supply of cash), but having people hold cash of misleading reasons should be avoided.
In your example, its easy to change your example so that drop in investment is inefficient. If in your example the primary input to investment is labor (or some other difficult to store resource) such a drop off caused by people hoarding cash will be inefficient, resources not spent in the current period are simply lost. People should get an appropriate signal about the terms on which they can save, if the marginal saving activity has a return of say -2%, people shouldn’t be lead to believe they can save at 0%. If literally *no* other methods of funding saving activities involving simply storing resources are not available monetary expansions would be distortionary, but futures markets exist for many kinds of storable resources and banks and other investors can and do provide loans/equity for such activities. If asset markets are reasonably efficient monetary expansion to offset increased desire to hold cash during a time of high option value will encourage resource saving in the correct way.
I think perhaps this deserves its own post, so I might do that/incorporate it in to the intro I am working on.
October 14, 2010 at 9:55 am
Silas Barta
That example doesn’t support your view, though. Remember, my contention is that there is very rarely “pure labor” — labor involves matching up with appropriate, heterogenous capital, which fits into a production structure and economic “ecosystem”.
It would indeed be wasteful to literally “store” labor, which immediately “spoils”. But it is *also* wasteful to narrowly direct heterogenous capital toward uses which will (per the example) quickly become obsolete (in the aggregate, even if a few guesses are right).
If you actually had a case where the primary input is labor, and all capital has become questionable in light of uncertainty, then the appropriate response is … in-household production, using no capital except multi-purpose tools, plus (self-)barter — which fits in with my general point here:
uncertainty –> incentive to hoard –> increased return to household production and barter –> appropriate handling of uncertainty
(You can replace “uncertainty” with “certainty that all production processes are crap” and the same point holds.)
October 14, 2010 at 7:48 am
jsalvati
I am saying that the central bank can send misleading signals about the opportunities for saving via the the interest rate on money. During recessions it will imply that you have the option of saving at 0% even though this might not be the case. If the CB is paying 0% on money and buying bonds that pay -2%, that’s a problem.
Also, if the central bank is not doing a good job of maintaining monetary equilibrium and the difference between how attractive saving via money looks and saving via other instruments shrinks for reasons not related to an actual change in costs for the bank (for example the rate on money is fixed at 0%) this can make monetary disequilibrium worse since people will demand more money than they did before.
December 8, 2011 at 11:30 pm
Dean Morel
Hi,
Can you please list some of the other financial assets that provide the same option value as cash? During systemic crises most financial assets become illiquid or devalue exactly when the option value of cash has its largest payoff. Under normal circumstances I agree, but we’re not living in normal times 🙂