An important problem facing the global economy is the shortage of safe assets, assets that facilitate transactions at both the retail and institutional level. There is both a long-term, structural dimension to this problem as well as a short-term, cyclical one. The structural dimension is that global economic growth over the past few decades has outpaced the capacity of the world economy to produce truly safe assets, a point first noted by Ricardo Cabellero. The cyclical dimension is that the shortage of safe assets was intensified by the Great Recession, a point stressed by Gary Gorton. I previously made the case that both the Fed and the ECB were an important part of the cyclical story by failing to restore nominal incomes to their expected, pre-crisis paths. In other words, since 2008 the Fed and the ECB passively tightened monetary policy which caused some of the safe assets to disappear while at the same time increasing the demand for them.
I still hold this view, but after reading some papers on safe assets and talking with Josh Hendrickson I have come up with a more general view to the cyclical dimension of the safe asset problem. It goes as follows.
Gorton, Lewellen, and Metrick (2012) show that safe assets have constituted a relative stable share of all assets since the 1950s. They also show, as does Bansal, Coleman, and Lundblad (2011), that public and private safe assets tend to act as substitutes in providing liquidity services. Given these findings, it stands to reason that when the central bank is doing its job and nominal GDP (NGDP) is growing at its appropriate trend, then there will be enough safe assets being privately provided. If, however, the central bank slips and NGDP falls below its expected path, then some of the privately produced safe assets disappear, creating a shortage of safe assets. The government steps in and creates safe assets that, if produced sufficiently, would restore NGDP back to its expected path. In other words, if monetary policy does not do its job then fiscal policy could substitute for it, but in a way not normally imagined. It would do so not by increasing aggregate demand via higher government spending, but by making up for the shortage of safe assets that facilitate transactions. All this requires is running a budget deficit which may or may not imply higher government spending (i.e. it could also come from tax cuts). Debates about Ricardian equivalence, crowding out, and other fiscal policy concerns become moot. What matters is if there are enough safe assets, and if not, whether fiscal policy can provide them in the absence of a NGDP-stabilizing monetary policy.
This understanding may serve as the basis for a paper, so I look forward to any feedback you can provide.
This post originally appeared at Macro and Other Market Musings and is posted with permission.
4 Responses to “The Cyclical Dimension of the Safe Asset Problem”
[...] – The shortage of safe assets is both structural and cyclical. [...]
“Safe assets” are safe only if the interest and principal payments are reliable and sufficient to maturity. What we observed in 2008 was the realisation that structured “safe assets” such as RMBS and interbank debt were not safe at all because the interest and principal payments were not reliable to maturity. This was due to poor origination standards at the time the underlying mortgage loans were made and poor securitisation standards that obscured credit risks with misleading credit ratings when the “safe assets” were issued. The information indifference created by the AAA label was illusory.
What we see now in the second stage of the crisis is that sovereign debts are not “safe assets” either. There are limits to government powers to raise taxes or inflate currencies to raise funds for sovereign debt interest and principal payments. The information indifference created by AAA labels and the Basel Accord zero weighting of sovereign debt are proving illusory as well. Hence a shortage of “safe” sovereign debt as “safe assets” too.
Bottom line is that “safe assets” can only exist where loan origination standards are rigorous enough to ensure performance to maturity. Lax lending by private issuers and lax borrowing by state issuers are behind the dearth of “safe assets”. Lax lending by private issuers has led to a crisis. Realisation that the “safe assets” relied on as bank capital were unsafe led to state bailouts. The states are now lax borrowers as they haven’t figured out how to fund interest and principal payments except through unsustainable taxation policies and inflationary currency debasement. So sovereign debt is now unsafe too.
Safe assets cannot be magically created just because the demand is there. Safe assets start with sound origination and persist with sound governance and performance. In both public and private sectors, the dearth of safe assets is likely to last for some time to come.
Those who want to invest in safe assets in a shrinking economy are asking others to pay for storing money. They not only want to keep their share of the of the pai, they want to ensure that their slice of the pai will not shrink in size even if the economy shrinks as a whole. It's the difference between storage and lending. If I need what you have, I'll pay you for borrowing it, if I have no present use for it you have to pay me for storing it.
I think the scarcity and negative yield in the TIPS market is your answer to the "safe asset" question. There are a limited number of truly safe assets, due to the problem that origination has to be controlled, otherwise they cease to be truly safe.
Flight to safe assets is a valuation problem as well. If the premium to hold these goes high enough, then the feedback loop kicks in, e.g. they're overvalued now, and should take losses at some point.