NGDP Futures Still Don’t Work

I’d seen this a few months back but Scott Sumner is still flogging the dead horse of NGDP futures. He published a longer paper on NGDP futures with the Mercatus center back in July of this year. 

NGDP futures will not work. They have an incoherent structure as proposed by Scott Sumner. Every single possible structure for NGDP futures as proposed by Scott Sumner has a fatal flaw.

If NGDP futures could work, then they have cool properties which might help central bankers. Scott spends much of his time in the paper demonstrating how great the world would be if we had NGDP futures. The problem is he neglected to do the homework on how markets and futures work well enough to determine if the idea was workable in the real world.

It would be cool if we had free, infinite energy too. We might fly to mars, or have awesome houses, or maybe floating cities in the sky with all this free, limitless energy. But energy is never free, and there are limits to the amount of energy we can control. Speculating what we might do with a large amount of free energy is fun, but it’s science fiction, not science. This is essentially what this paper is – a speculation on a cool technology which cannot exist in the real world.

Honestly, the dismissal/rebuttal to the core problems I identified with NGDP futures is really a bit lame. Waving your hands and saying “Well someone will figure this out!” misses something very, very important. I am the guy who figures this stuff out for futures markets. I am that someone, and my warning light is flashing for NGDP futures.

There are two different market structures proposed by Scott, and both structures have extremely serious practical problems.

The first basic structure has a non-varying price set by the fed. Traders can buy and sell in infinite quantities at this price. The market consensus is then based on the total open interest. Problem: This structure is very prone to manipulation, because speculators cannot lose money if they exit the market before settlement. If the market is designed to have a price which does not vary, then traders will manipulate the market and take multi-billion dollar windfall profits.

The second structure is to allow the price of NGDP futures to vary. Determining the market consensus is based on the price level of NGDP futures. Problem: NGDP does not correlate well (or at all) with any monetary business risks. If the market prices are allowed to vary, nobody will trade the market except for speculators. In this case, speculators mean “people trying to manipulate the market”. So the largest economy in human history will have it’s monetary policy set by a small handful of politically driven market manipulators.

There are not other options, and there are not solutions to these problems for this market.

Scott attempts to address the market manipulation critique with a few short paragraphs.

“Another concern is that special-interest groups might try to manipulate the market for financial gain. Thus, a firm that would benefit from faster NGDP growth might sell a large number of NGDP futures contracts short, pushing the Fed to adopt a more expansionary monetary policy. Evidence from field experiments by Robin Hanson and by Hanson, Ryan Oprea, and David Porter suggests that it is difficult to effectively manipulate a prediction market. Any attempt at market manipulation opens up profit opportunities to other traders, who would take advantage of a gap between the current market price of NGDP futures and the expected future price of NGDP futures.

Nonetheless, given the importance of monetary policy, the central bank might want to take extra precautions against market manipulation. One idea would be to limit the net long or short position for any single trader. It would be preferable to allow unlimited trades but then have the Fed take an opposing position for any “suspect” trades. Over time, this system would provide information about whether the Fed’s suspicions of market manipulation were correct. If the Fed tended to lose money on these trades, it would suggest that market manipulation was not the moti- vation for private traders taking large long or short positions in NGDP futures.”

Yes, this is the entire pushback on manipulation. A few studies that manipulation might be theoretically hard to do.

Here in the real world, manipulation is the norm until regulated and enforced away. The two largest markets in the world – LIBOR and FX – are currently under investigation for massive market manipulation. These two markets are essentially as good as markets get – huge, liquid, many participants, world wide, and most importantly, nearly completely unregulated compared to other financial markets.

I want to stress these markets are as close to perfect as humans have yet to create, and they are now under investigation for manipulation.

The evidence for widespread manipulation is huge. You should at least read the articles in this post by Washington. It turns out nearly every major market in the world is rigged to some degree.

Every market gets manipulated even when regulators are looking. The SEC and CFTC charge people all the time with manipulating markets. The reason the acts of 1933 and 1934 were passed with such crazy broad language is because markets get manipulated, and it is so lucrative.

It’s hard to create markets where the market isn’t juicy for some manipulation. You’ll find this out if you try to setup a new market with the CFTC.

And can prediction markets get manipulated? Well, the market for presidential prediction apparently was manipulated!  Someone lost $4m trying to manipulate the market for Romney. My guess – it was David Koch operating through some lackey who was doing the trades for him. And how about 2008 with McCain? That market was manipulated too.

The pushback from Scott and others is simply not credible. Manipulation can and does happen in nearly every market in the world. Manipulation would be attempted in the NGDP futures market.

Remember, manipulation in the NGDP futures market would happen under either possible structure.

In the case of no price movement, traders and speculators can’t lose if they get out early enough. There is no market discipline forcing losses on traders attempting manipulation in the “no price movement” market structure.

In the case of price movement, there is nothing to force NGDP futures back into line but other speculators. Data is scarce for NGDP. Someone like the Koch brothers are willing to spend hundreds of millions on elections already. Why wouldn’t they impact monetary policy through buying NGDP futures and forcing the fed to step on the brakes during a democratic administration?

There isn’t a way around the basic observation NGDP futures don’t exist today. The reason NGDP futures don’t exist is NGDP is a poor hedge for financial risks facing businesses. There isn’t someone or anyone who would be easily able to make money on an NGDP forecast which is .75% too high.

Again, the response is weak:

What if no one trades?

The United States does not currently have the sort of NGDP futures market that could be used to guide monetary policy. Later, I will show that this fact actually supports the case for NGDP futures targeting. But suppose there is not enough interest in NGDP futures to create a highly liquid market. What if very few people trade the contracts?

There are two ways of addressing this concern. One response is that if no trades are being made then presumably the market thinks that either the Fed will not miss its NGDP target or it will not miss its target by an economically significant amount. So a lack of trading does not necessarily mean that NGDP targeting would not work.

Nothing like what happened in late 2008 could occur under NGDP futures targeting, even if no one chose to trade NGDP futures. If the public expected NGDP to be far below target (as in late 2008), then anyone selling NGDP futures could easily earn large excess returns. But this profit opportunity violates the efficient markets hypothesis. If this argument seems too good to be true, it is because NGDP target- ing does not have to succeed in a way that a finance theorist would define “success” in order to be highly effective in a macroeconomic sense. Thus, if the market was only efficient enough to prevent expected NGDP growth from falling more than 2 percent below target in late 2008, that performance would be very poor in a finan- cial sense (allowing significant risk-adjusted excess returns), but highly effective at promoting macroeconomic stabilization. Actual NGDP fell about 9 percent below trend in 2008–09, to give some sense of the magnitudes involved. And yet, even an expected 2 percent deviation from target would boost the expected return on NGDP futures by 20 percentage points (i.e., 2,000 basis points) if investors had a margin requirement of 10 percent.

Here is something else which just gets my goat, because it is so lazy. Scott didn’t even bother to figure out what a reasonable margin level for these financial futures would be:

University of Pennsylvania economist Justin Wolfers and Dartmouth economist Eric Zitzewitz find that prediction markets can be highly effective even when there is a relatively low volume of trading. Nevertheless, it would be possible to promote increased trading in NGDP futures markets if the Fed wished to create a deeper market. The central bank could set up and subsidize trading in an NGDP futures market by creating a fund that would be divided evenly among all market partici- pants—perhaps as an add-on to interest payments on the margin accounts of NGDP traders. Assume that traders put 10 percent into a margin account so that the Fed would not be exposed to significant default risk. The Fed could pay interest on that account equal to the yield on one-year T-bills, plus the trader’s share of the subsidy. If only one individual participated, then that trader would receive the entire subsidy. That sort of highly profitable outcome would not be the market equilibrium, and thus market size would depend on the size of the trading subsidy. Given the importance of sound monetary policy, where mistakes in stabilization policy can generate costs in the hundreds of billions of dollars, it is difficult to see how the cost of a trading subsidy could be an important constraint on the adoption of NGDP.

As far as I can tell, 10% margins would be the highest margins on any futures product in the world. It’s totally unreasonable as a margin – I’d expect something closer to 2% or even 1%.

Note Scott has moved away from his prior idea to add an additional percentage return on to the T-Bill rate. The reason for his movement to a new structure is simple: in a market where prices don’t move, getting a higher rate on T-Bills creates a 2 tier market for T-Bills. People speculating in NGDP futures would get a higher rate than plain T-Bills, with no downside risk to the speculation. The short end of the yield market is hugely sensitive to even small changes in yields, so quickly the entire T-Bill market would be speculating on NGDP futures.

Again, if you take Scott’s proposal to have a fixed price, there would be no downside to speculating in NGDP futures. So the entire T-Bill market would be distorted by the incentive of extra yield in NGDP futures.

This happens even if there is some type of fixed incentive. I guess a few dollars wouldn’t mean much to the bills market, but I can’t imagine them passing up even a few dollars of extra yield on these. If there were meaningful amounts of incentive, the entire market would shift to speculating in NGDP futures.

Of course, people would go long or short NGDP futures in a way which would force the fed to act in a way to maximize the value of the rest of their bond position, instead of trying to make a good prediction of NGDP.

These are huge problems with NGDP futures. I am sorry to see Scott did not address them with more care. However, I believe there are no solutions for these problems. Nobody has given me even the smallest reason to think there are solutions for these problems, not even a shred of hope they might be solved, so the reason he didnt’ address them might be because he couldn’t address them. Still, hand waving about there being no manipulation is pretty lame.

I am a futures market guy so seeing something like NGDP futures actually work would be great to me. I like new futures products. I’d spent a huge amount of time thinking about how they might possibly work even before I read about Scott’s ideas for NGDP futures, and worked with people at MacroMarkets on possible product launches. (Yep, that MacroMarkets. Never met him though heard he was a super guy. The people I did work with were responsible for inventing things like…the ETF.)

Heck, I’d be really famous if I proposed the structure which solved these problems. I geeked out on trying to get this to work. But there just isn’t a structure which isn’t prone to being manipulated or would be a viable market.

 

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Guest
3 years 4 months ago
I’m really struggling to get my head around Scott Sumner’s stuff. He says, “For market expectations to determine monetary policy, there must be a link between NGDP futures purchases and sales, and the quantity of money. This link can be achieved by requiring parallel open-market operations for each NGDP contract purchase or sale. Because investors buying NGDP futures are expecting above-target growth in NGDP, the Fed should automatically reduce the monetary base each time an investor buys an NGDP futures contract, and it should automatically expand the base each time an investor sells an NGDP contract short. For instance, each $1 purchase of a long position in an NGDP futures contract might trigger a $1,000 open-market sale by the Fed. A purchase of a $1 short position would trigger a $1,000 open-market purchase by the Fed. In that case, investors would be effectively determining the size of the monetary base.” This all seems to imply a belief that increasing or decreasing the monetary base influences NGDP in a constructive way. Is there any indication that it does? The whole NGDP futures idea just seems to be a way to have QE directed by NGDP futures traders. If QE doesn’t do anything useful then what is the point of having such a fancy way to decide the extent of QE? If the idea is that the Fed would dole out money to all of those who predicted that NGDP would be below target -then that would be a fiscal stimulus which would only help if the people/institutions getting the money were those who had a propensity to spend. If they were simply vampire squid types, then they would channel all of that money back into the next round of betting that NGDP would be below target (and perhaps into Wonga style… Read more »
Guest
Bill Woolsey
3 years 4 months ago
Sumner has never proposed having the prices vary. It has been fixed prices all along. I think you are unable to think about the fixed price scenario. You seem unable to conceive a market with no possibility of short term trading profits. Anyway, suppose margin accounts pay more than T-bill rates, and everyone who would otherwise hold T-bills hold futures contracts. Their intention is to close their position just before the central bank quits trading the future. So, there are huge open interest, but whether anyone investing in margin accounts has a long or short position is irrelevant. No one has any intention of maintaining the position. Your error was to claim that they would choose a position based upon the rest of their bond portfolio rather than their expectation of nominal GDP. No, if they plan to close out right before the peg ceases, whether they are long or short is irrelevant. Sumner proposed this notion because of worries that no one would trade. And now you say it would work too well. No one would hold T-bills and everyone would margin accounts. That suggests that the interest rate on the margin accounts is too high, right? You need to describe some scenarios about market manipulation. Remember, it is the fixed future price scenario. You go long on the futures, and then…. what? Generally, Sumner goes towards some kind of quasi-future where everyone puts in orders at the fixed price. Then you get whatever position you want. But there is no chance to close out at the fixed price. At one time, he had little interest in any trading after the central bank was done, but lately he has suggested that is important. And so, investors could hold positions or close them out at market prices as they see… Read more »
Guest
3 years 4 months ago

Likewise, this bueprint: http://www.lettersofnote.com/2009/09/to-top-scientist.html has the essential phrase : “YOU PUT IN OTHER DETAILS”

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