Monday, January 14, 2013

Resolving the Safe Asset Shortage Problem

One of the biggest challenges facing the global economy is the shortage of safe assets, those assets that are highly liquid and expected to maintain their value.  This shortage matters because safe assets facilitate exchange and effectively function as money. AAA-rated CDOs, for example, served as collateral for repurchase agreements which were the equivalent of a deposit account for institutional investors in the shadow banking system. Therefore, when many of these CDOs disappeared during the financial crisis, a large part of the shadow banking system's money disappeared too. This precipitous decline in institutional money assets declined occurred, of course, just as the demand for them were increasing because of the panic. This problem bled over into retail banking, since it was funded by the shadow banking system, and forced many retail financial firms and households to deleverage.  This deleveraging, in turn, meant fewer retail money assets just as panic was kicking in at the retail level.  In short, the shortage of safe assets is a big deal because it means there is an excess demand for both institutional and retail money assets.  This broad excess money demand is why aggregate nominal expenditures in many countries remain depressed. A full recovery, then, will not happen until there is a sufficient stock of safe assets.1

So what can be done about this problem?  Matthew C. Klein of The Economist believes the solution is for the government to create more safe assets until this excess demand is satiated.  He argues that governments who control their own currency are the only producers of safe assets since there is no chance they will default.  They can always create money to pay off their creditors. He sees privately created safe assets, on the other hand, as only having transitory "safeness"as evidenced by the history of AAA-CDOs and other private-label assets that went bust during the financial crisis. Private debt instruments, therefore, cannot solve the safe asset shortage problem according to Klein. Instead, the road to full recovery can only be paved with fiscal policy creating more safe assets.

I take a different view: a robust recovery can only occur if there is an increased confidence in the safety of private debt instruments (i.e. a drop in the risk premium) and, as a result, an increase in demand for them. A full recovery, therefore, requires a restoration of the market for privately-produced safe assets.  Klein does not believe this is possible, I do. Here is why I hold this view.

First, there are no truly safe assets, only ones with varying degrees of safeness.  This is true even for governments that control their own currency. Yes, they will never explicitly default since they can create money to redeem their liabilities, but they can still implicitly default by creating higher-than-expected inflation. In other words, investors worry about inflation risks too when looking for safe assets. The U.S. learned this lesson the hard way in the 1970s as seen in the figure below. It shows foreigners reduced their holdings of treasuries when inflation soared:

We are a long way from the 1970s as evidenced by the ongoing demand for U.S. treasuries and the resulting low yields (and no, the Fed is not behind this development). Still, the U.S. government faces a tension. It can run larger budget deficits to meet the global demand for safe assets, but doing so may eventually jeopardize its risk-free status, the very thing driving the demand for its securities. This is the modern version of the Triffin dilemma and it reminds us that there is a limit to how much safe asset creation can be done by the government.

This point is underscored by the fact that the supply of U.S. private safe assets has been significantly larger than the stock of U.S. government safe assets, according to the Gorton et al. (2012) measure of safe assets:

Consequently, it would be unlikely that the U.S. Treasury could create enough securities to fill the gap created by the shortage of private safe assets without undermining the safe asset status of treasuries. To be concrete, if we follow Michael Belongia and Peter Ireland's recent paper, where they solve for the optimal amount of money (or safe assets) by plugging in potential Nominal GDP (as estimated by the CBO) and actual trend money velocity (as estimated by the Hodrick-Prescott filter) into the equation of exchange (i.e. M*t= NGDP*t/V*t ), the safe asset shortfall for the U.S. economy at the end of 2011 was just over $4 trillion. Can the U.S. government really run up 4 more trillion dollars in debt, on top of the existing debt run up since 2008,  without raising concerns about its safe asset status?  And that is before we even consider the non-U.S. demand for U.S. safe assets.

It seems unlikely, therefore, that the U.S. government can produce enough safe assets without harming its risk-free status. But then it does not have to do so.  As I noted above, the public's perception about the safety of private assets can change given the right impetus and lead to an increase demand for privately-created safe assets.  Another way of saying this, is the relatively high risk premium on private debt is probably not the result of long-run economic fundamentals. It is more likely the result of self-fulfilling excess pessimism that has put the economy in a suboptimal equilibria (as shown in Roger Farmer's work).

If this is this case, then what is needed is a major slap to the market's face. I believe an ambitious NGDP level target that significantly raised expected nominal income growth would do just that. If credible, it would both reduce the excess demand for safe assets (because of greater nominal income certainty going forward) while at the same time catalyze financial firms into making more safe assets (because of the improved economic outlook and the related increased demand for financial intermediation).  For example, imagine how the public would respond if the Fed suddenly announced Scott Sumner's proposal of raising their asset purchase amounts by 20% per month until some NGDP level target was hit.2 That would be the monetary policy equivalent of shock and awe and should catalyze the market for privately produced safe assets.

But don't take my word for it. The figures found here show the estimated dynamic relationships between positive shocks to expected NGDP growth rate and a number of economic variables, including the Gorton et al. (2012) supply of private and public safe assets for the period of 1968:Q4 - 2011:Q4.3  It shows for this period, that a sudden and permanent rise in the expected growth of NGDP leads to a rise in the supply of private safe assets and a decline of public safe assets. The former response makes sense for the reason laid out above, while the latter response follows from the fact that a large part of the budget balance is cyclical. The results also show that the risk premium (10 year treasury yield minus Moody's corporate AAA yield) and unemployment rates decline after the shock.  The second figure at the link shows the same system now estimated with the private and public safe assets combined into one series. It reveals that overall safe assets increase. 
The resolution to the safe asset shortage problem, then, is monetary policy catalyzing the private sector into recovery. Fiscal policy can help, but is limited by the size of the problem.

Update: Using the same estimated system above, here are the responses to a positive unemployment rate shock (i.e. an unexpected increase in the unemployment rate). Now public safe assets increase, private safe assets fall, and the risk premium rises. These results and the ones above are  consistent with studies such as Bansal et al. (2011) that show public and private safe assets serve as complements in providing liquidity services.

1What I am describing here a recovery from a cyclically-induced shortage of safe assets. This is different than the longer-term, structural safe asset problem that existed prior to the crisis.  This longer-term problem is the result of global economic growth over the past few decades that has outpaced the capacity of the world economy to produce sufficient safe assets. See this earlier post for more on this point. 

2 The key here is to do (or at least threaten to do) open market operations (OMOs) that permanently raise the expected level of the monetary base. When this happens, expected nominal incomes will be higher too and lead to the responses outline above. Thus, even though OMOs at the zero lower bound might be trading near substitutes--monetary base for treasuries earning 0%--the belief that they won't stay near substitute because of the permanence of the monetary base injection will trigger a portfolio rebalancing effect that will lead to higher nominal spending. 

3This is estimated using a vector autoregression (VAR). The data are quarterly, in log levels unless already in growth rates, and estimated using 5 lags.  The generalized impulse response function is used here so that ordering of the variables in the VAR does not change the outcome. The sample begins in 1968:Q4 because that is the earliest data point for the expected NGDP growth series. This series comes from the Survey of Professional Forecasters.


  1. There are a few assumptions which may have held true in the past, but I think you need to explore before your solution can hold water.

    1) The relationship between nominal income growth and NGDP may not be as strong as it once was or have particular skews , so GDI might be better, but even then there may be a skew towards saving income rather than wages. The concern would be that you give an incentive to save, resulting in no increase in NGDP or GDI as the increased money supply does not go into consumption. You may need to lean so hard into the wind to achieve your target that inflation or more likely stagflation will result.

    2) The argument about public's perception about the safety of private assets may be limited to a small selection of the public who are aware of asset riskiness. This I think is important because the public's perception about economic well being has more to do with the relationship between wages, taxation and inflation than the availability of safe assets. The concern would be that you set up a disconnect between asset price and risk and the state of the economy.

    3) Even if you target NGDP there is no guarantee that you will get an expectation of increase in NGDP, or conversely there could be an over estimation of increases in NGDP. The concern here would be that you set up a roller coaster ride for the economy, the friction of which could act like a tax on the economy.

    I am not saying the argument presented here is wrong just that any assumption about economic relationships in the past has to be examined in the context of today and the side effects and unexpected consequences need to be explored.

  2. The yield on "safe assets" has traditionally been higher than the yield on checkable deposits. This provides an incentives for firms to hold them rather than money. Similarly, borrowing by selling "safe assets" is cheaper (often, much cheaper) than obtaining bank loans.

    So, for some firms, quite large ones, can reduce holdings of low (or zero) interest checkable deposits and instead hold "safe assets" or issue and sell "safe assets" to cover tempory differences betweene expenditures and receipts.

    Rather than hold enough checkable deposits to cover differences between expenditures and receipts, they use active cash management.

    The brokers and dealers for "safe assets" earn their income from this activity.

    Suppose there is a "shortage" of safe assets. What normally happens with a shortage is that price rises. With securities, that means yields fall. So, now there is no longer a shortage.

    But, of course, this makes holding these "safe assets" less attractive relative to just holding funds in checkable deposits. The cash management department of firms make less money. The brokers and dealers of the assets have much less business. It is a crisis!

    Of course, it is cheaper to borrow by issuing the "safe assets." But suppose there are not many firms than can issue safe assets. Sure, lots of firms borrow in place of holding sufficient funds, but they need collateral--other safe assets. (Of course, this doesn't really add up, since any firm could sell the safe assets they are using as collateral rather than sell their own securities and tie up the safe assets they own.)

    Suppose instead that firms just held checkable deposits and had lines of credit at banks? It seems to me that the resource cost would be less than having cash management departments and brokers and dealers of safe assets.

    What if there are not enough checkable deposits for all the businesses to hold? Lower interest rates will reduce the demand for them while allowing banks to lower interest rates on loans and so create more.

    What if the banks need more capital? Pay lower interest rates on deposits relative to what is charged on loans so that banks increase earnings. (This is what the "safe assets" trade avoids.)

    Consider the claim that the government must borrow more and fund it by selling T-bills so that there will be T-bills available for collateral for short term borrowing, and so that the T-bills or the other debt secured by T-bills can be held in place of checkabe deposits?

    Increased borrowing to fund government spending has a real resource cost. Increased borrowing to fund tax cuts shifts the burden of government. Having the government borrow short rather than long shifts risk to government.

    Think about it.

    Oh, suppose we had a gold standard and gold served as money. Trading securities to economize on gold holdings would reduce a resource cost. Trading securities to economize on holding bank deposits does not reduce a resource cost.

  3. Can you please post the link for the complete paper where you calculate the shocks to NGDP and unemployment.

    1. Bozhidar, that paper is currently being formed. Writing this post motivated me to do the estimate the vector autoregression and do the impulse response functions. But given the interesting results I am putting these and some other results into a paper. Footnote 3 has a few more details on the VAR.

      All the data is easy to get, except for the safe asset data. One has to follow the table in the Gorton et al. (2012) paper and tediously collect the data from the flow of funds database.

    2. I am doing my master thesis on the safe asset shortage problem. I've collected Gorton's data on the safe asset share so I wanted to do VAR and Impulse Response Functions analysis. This means I am very interested in your work as it can be my guide. Can you tell me approximately when the working paper will be available, or is it still too early to make such predictions.

      Your blog has been essential to my understanding of the problem.
      Thank you!

  4. Can the U.S. government really run up 4 more trillion dollars in debt, on top of the existing debt run up since 2008, without raising concerns about its safe asset status?
    Yes -- if it is based on temporary tax cuts, so workers have less tax taken. And they have $4 tril to reduce their debts / add to savings / consume more.

    Too many economists want some specific multi-person response: more consumption, no change to savings nor production. This might match the unrealistic assumptions in their models, but such academics should be far more humble about their ability to calculate the real response to a real policy, because of the multi-human variables.

    The Krugman-DeLong failure of fiscal stimulus was because of wasted crony capitalism, WASTED stimulus, rather than pure and only tax cuts.

    Further, rather than borrow the gov't should print money to cover the deficit of (much too high) gov't spending - (too high) gov't tax collection.

    As long as the Dems want wasteful gov't spending for crony capitalist (Dem donors!), it would be silly for Reps to support any such fiscal policy.

    1. The "stimulus" was tax cuts. Barely any investment. Either you get that or you don't. Hence "Reps" are the one behind crony capitalism.

      The US needs trillions in that "wasteful" government spending, understand that, trillions. A gap that gets wider every day.

  5. I have not followed it in detail, but I suspect that this safe asset meme is based on a poor knowledge of finance. Abstracting from default correlations, if you take a big enough haircut, you can make safe loan assets out of practically any asset. If anything, liquidity is more important than "safety". I'd rather place a loan collateralised with US blue chip equities with, say a 30% haircut, than with a AAA CDO with a 10% haircut.

    1. RebelEconomist, the safe asset literature is largely written by folks who do know finance. Gary Gorton, for example, is a finance professor for Yale knows a lot about the industry (he worked in it). He is one of the leading researchers in the field.

    2. Interesting. I had a look at Gorton's paper and he does include the possibility of safe assets produced by private sector funds. In that case, I wonder whether part of the problem is that the return on risky assets is too low. For example, safe as a moneymarket deposit secured by heavily haircut equities might be, the return on the equities would simply be too low to pay the moneymarket fund to produce the secured deposit facility, even it it paid no interest at all. The same probably applies to CDOs, assuming that the idea has not just fallen into disrepute: ie it does not pay to produce AAA CDOs, because the lower-rated tranches do not yield enough to sell.

  6. "First, there are no truly safe assets, only ones with varying degrees of safeness."

    You note correctly, I think, that safety is a range, not a dichotomy. Yet the Gorton chart you've posted falls prey to what I see as the false dichotomy between unsafe and safe. Definition tensions at the core of the safe-asset theory lead to measurement concerns. If defining the phenomenon of safety is so wrought, how can we gather good statistics about safety? How are we to empirically verify the safe-asset theory without good statistics?

    1. JP Koning, it is hard to know for sure just where the safe asset line can be drawn. Gorton et al. (2012) note that their measure is a conservative one, probably understating the stock of safe assets. So my estimates above are on the low side.

  7. [i]Can the U.S. government really run up 4 more trillion dollars in debt, on top of the existing debt run up since 2008, without raising concerns about its safe asset status?[/i]

    One of the oft overlooked factors of the governments ability to create new safe assets - and then unwind them is the nature of the spending to be undertaken.

    There is a big difference from lets say $4 trillion in a one time "shovel ready" infrastructure/military/space expenditure, which requires yearly appropriation and authorization and say $4 trillion in new Social Security and Medicare expenditure which is almost impossible to unwind.

    So I don't think its really a question of nominal amount (though $4 trillion sure sounds a a lot to most people), but the EXPECTED DURATION of expenditure.

    On a side note I think Tom Grey raises (probably by happenstance) an interesting point. Total annual federal government outlays are approx. $3.5 trillion. The evidence is clear that at the margin tax cuts are used to primarily to pay down debt, however, I think its an unanswered question what would happen if we say had a massive tax cut; say 35% of fed expenditures x3 years, kept fed spending stable, and created safe assets that way.

    Crazy? Sure. A lot more would certainly be stuffed into bank accounts/mattreses/jars than if we spent $4 trillion on "shovel ready" projects. But in crazy times like these, it almost becomes more realistic to argue for a massive temporary across the board tax holiday than trying to realistically $4 trillion worth of infrastructure to improve (and the labor and machinery to actually make it happen).

    Its the classic helicopter drop of money in a different way... at some point in time people may just happen to yell uncle and start spending all the cash they are not being taxed on. An extra $6,000 for the median household to spend is nothing to sneeze at.

  8. Generally agree with the aggressive actions needed to promote higher inflation (either through nominal gdp level targeting as you promote, or by price level)

    However I take issue with part of the analysis. You question the ability for the government to pile on more debt and avoid putting safe-asset status in jeopardy. My contention is that the safe asset status won't change if there's more debt piling on.

    The risk of default is zero, and provision of dollars is only constrained by inflationary pressure. There's no reason for any knowledgeable investors to be spooked by nominal debt levels, unless there's a credible risk of there being no political will to produce adequate currency to meet obligations. But, in terms of raw ability to service its debt, this is not an issue.

    The solution doesn't have to be through NGDP targeting, but my approach is actually rather simple, borrow and spend in the public sector to offset private deleveraging, jolt sales to incentivize businesses and households to spend/invest. There's nobody talking about this option in DC because it has simply become a foregone conclusion that DEBT AND DEFICIT AND HIGH SPENDING is the problem. However, the evidence isn't there to support their concerns and it's really just a soundbite line pushed by the aristocratic elites.

    Eventually this will lead a less risk-averse economic enironment as the economy heats up from so much spending into the economy.

    So you're right in that the risk premium needs to shrink. But, instead of reducing the risk premium by bringing down the "riskiness" of the private assets, you should be focusing more on reducing the risk premium by increasing the yield on public safe assets (that is, boosting inflation) so that the risk premium shrinks because the yield on safe assets is higher due to a heating economy.

    Generating inflation will change the game, there's just no will to achieve it....yet.

  9. "(and no, the Fed is not behind this development)"

    The Fed doesn't have to actually own a large or larger portion of the debt in order to have a greater effect on interest rates.

  10. Gofx here. David, what about the role of derivatives and hedging in "creating" safe assets or making a given asset class "safer". Isn't this private safe asset "creation"?

  11. I found this blog post to be very informative blog post (at least for me). Thanks for posting.

  12. Hi, I have written a post on this topic as well, at