NGDP Futures Convertibility - Unworkable?

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Scott Sumner has been championing "nominal GDP futures" ("NGDP futures") as a means of creating "market-based monetary policy." This has provoked all kinds of debate, such as whether the Efficient Markets Hypothesis holds. In my view, this is a distraction from the main point - the market would not function. Sumner has proposed a few models; this article discusses what he said is his current preference - futures convertibility.

Michael Sankowski has written a long article about the difficulties with GDP futures implementation. I have not spent much time looking at nominal GDP futures, but I have looked at CPI futures. Those futures failed for reasons very similar to what Sankowski describes. Please note that I see a great many issues with Sumner's idea; this article is only touching on one issue. I am more interested in his comments on the linkage to the monetary base, which is a subject that fits in with my upcoming book - Abolish Money (From Economics)!

In the paper, "A Market-Driven Nominal GDP Targeting Regime", Sumner writes:

William Woolsey proposed another method of using market expectations to guide monetary policy, which uses a principle similar to the classical gold standard. The basic idea is to make money (currency and bank reserves) convertible into NGDP futures contracts at a fixed price (such as $1.0365) [emphasis mine - BR], in much the same way that currency notes were once convertible into gold bullion at a fixed price. However, unlike the NGDP futures targeting plan discussed earlier, there is no automatic connection between the purchase and sale of NGDP futures and open-market operations by the central bank.

The problem with this idea is that it makes no sense if "NGDP futures" resemble other traded futures.

When you enter into a futures contract, the usual convention is that you pay no money - whether you are long or short. (You do have to post collateral, which is based upon the price volatility of the contract.)

Let's assume a NGDP future has a notional of $1,000,000, and the price (based on annualised GDP) is $1.06 (corresponding to 6% annualised GDP growth). For numeric simplicity, I assume that the central bank is offering convertibility at $1.05 (5% growth).

If you think GDP growth is going to be 7%, you want to enter into a long position. You have two options:

  1. Put down $0, and enter into a long position at $1.06 (which has a notional value of $1.05 million).
  2. Pay the Fed $1.05 million for the privilege for entering into a long futures position (the Fed would have to be short to balance the open interest) at a price of $1.05. This means that you paid $1.05 million for the privilege of getting a mark-to-market gain of $10,000 on a futures contract.

The central bank's conversion option is only of value if annualised growth is greater than 105% (or less than -95%). Since it would never be exercised outside of a hyperinflation, it is entirely irrelevant, and the idea is reduced to having a futures on nominal GDP (which would fail in the same way that CPI futures did).

The only way that this can sort-of work is that what Sumner/Woolsey are really talking about is nominal GDP "bonds", where you have to put 100% down to buy them. In this case, the convertibility option is just a one-way price peg (or a two-way price peg, if you can convert the bond to cash) at the central bank's conversion price (he uses $1.0365 for some reason).

The problem with an instrument that you put 100% down is that it is indeed a bond, and then boring bond analysts start asking awkward questions. Who is the borrower? What is the money used for? How will they pay me back? The inability to answer those questions cleanly is one very important reason why futures operate on the "no money down" principle.

For those readers who are unfamiliar with the justifiable paranoia of fixed income analysts, let us imagine that crude oil futures operated with 100% money down. Assume that we bought $100 million in crude oil futures. There are two sensible places where the $100 million would go - either the seller(s) of the crude oil futures, or the futures exchange.

  1. If it goes to the seller, what is to stop fly-by-night operators from pocketing the $100 million, and jetting off to a country without an extradition treaty with my country? Since we cannot research our counterparties in a futures trading environment, this is completely unacceptable. (Investors are obligated to investigate the creditworthiness of each of their over-the-counter (OTC) derivatives counterparties; and smart investors generally do not structure trades to advance large amounts of money through derivatives structures.)
  2. If it goes to the futures exchange, what is it going to do with the money? If the futures exchange is sitting on hundreds of billions in liquid securities, what is to stop it from jetting off with a slice of the stash? (Yes, investors post collateral, but it is a fraction of the notional amounts.)

Even if we imagined that NGDP futures operated with 100% collateral requirements, it still costs us $0 to buy the contract; we just need to find collateral. That collateral, as the name implies, is still our property. It still makes no sense to "convert" money into the futures contract.