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.