Why the Global Shortage of Safe Assets Matters

One of the key problems facing the world economy right now is a shortage of assets that investors would feel comfortable using as a store of value.  There is both a structural and cyclical dimension to this shortage of safe asset problem, with the latter being particularly important now given the recent spate of negative economic shocks to the global economy.  These shocks have elevated the demand for safe assets and, as David Andolfatto argues, is probably the key reason why we see such low yields on U.S. treasuries.  Of course, these same shocks have also destroyed many of the once-safe assets (e.g. European sovereign bonds) adding further strain to this asset-shortage problem.  This shrinking stock of safe assets can seen in the figure below created by Credit Suisse (ht FT Alphaville):

This figure shows that if one does not count French bonds as safe assets (a reasonable assumption), then about half of the safe assets disappeared by 2011. That is a tremendous drop and, as I see it, matters for two reasons.  Before getting into them, though, it is worth briefly reviewing the structural and cyclical dimensions to the asset-shortage problem.   

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.   Ricardo  Caballero, the author of this view, argues that it probably started with the collapse of Japaneses assets in the early 1990s, was exacerbated  by emerging market crises throughout the 1990s, and got heightened by the rapid economic growth of the Asia in the early-to-mid 2000s. These developments along with the fact that most of the fast growing countries have lacked the capability to produce safe assets made the assets shortage a structural problem.

The cyclical dimension is that the demand for and disappearance of safe assets was intensified by the failures of the Fed and the ECB over the recent business cycle.  In the early-to-mid 2000s, the Fed exacerbated the asset-shortage problem as its loose monetary policy got exported via fixed exchange rates to much of the emerging market world which in turn recycled it back to the U.S. economy via the "global saving glut" demand for safe assets.  (For more on this point see this post and my paper with Chris Crowe.)  Since late 2008, both the Fed and the ECB have worsened the asset-shortage problem by failing to first prevent and then restore nominal income in each region to its expected path.  In other words, since 2008 both the Fed and the ECB have passively tightened monetary policy and this has caused some of the AAA-rated securities to disappear. (Yes, some of the AAA-rated MBS and sovereign debt would have defaulted on their own, but some of them like French sovereigns would have maintained their safe asset status were it not for insufficient aggregate demand caused by passively tight monetary policy.)

Okay, so why does this safe asset shortage ultimately matter?  The first reason is that many of these safe assets serve as transaction assets and thus either back or act as a medium of exchange.  AAA-rated MBS or sovereigns have served as collateral for repurchase agreements, which Gary Gorton has shown were the equivalent of a deposit account for the shadow banking system.   The disappearance of safe assets therefore means the disappearance of money for the shadow banking system.  This creates an excess money demand problem for institutional investors and thus adversely affects nominal spending.  The shortage of safe assets can also indirectly cause an excess money demand problem at the retail level if the problems in the shadow banking system spill over into the economy and cause deleveraging by commercial banks and households.  All else equal, such retail level deleveraging causes bank assets like checking and money market deposits to fall relative to the demand for them.  In other words, the broad money supply falls relative to the demand for it.  The scarcity of safe assets matters, then, to the extent it creates an excess money demand problem that  adversely affects nominal spending. 

The second reason the assets shortage matters is that it creates a Triffin dilemma for the producers of safe assets.  The original Triffin dilemma says that a country with the reserve currency of the world has to produce more money than is needed domestically to meet the global demand for it.  This, however, requires running  current account deficits that over time may jeopardize the very reserve currency status driving this dynamic.  Francis Warnock summarizes this paradox nicely: 

To supply the world’s risk-free asset, the country at the heart of the international monetary system has to run a current account deficit. In doing so, it becomes more indebted to foreigners until the risk-free asset ceases to be risk-free.

Now apply this reasoning to the U.S. government that currently seems to be the preferred producer of safe assets for the world. If it is to meet the excess demand for safe assets it must run a larger budget deficit, a point made recently by David Andolfatto: 

[G]iven the huge worldwide appetite for U.S. treasury debt (as reflected by absurdly low yields), this is the time to start accommodating this demand. Failure to do so at this time will only drive real rates lower.

But running larger budget deficits over time may jeopardize the safe-asset status of U.S. treasury debt, the very thing currently driving the insatiable demand for it. The global economy thus faces a Triffin dilemma for  the U.S. treasury, its go to safe asset.

There is way out of these problems.  Both the Fed and the ECB need to return aggregate nominal incomes in their regions to their pre-crisis trends and do so using a nominal GDP level target.  Being a level target it would keep long-run inflation expectations anchored while still allowing for an aggressive monetary stimulus in the short-run (i.e. until the pre-crisis trends were reached).  It would also stabilize nominal spending expectations and add more certainty to long-run forecasts.  More importantly, it would spur a sharp recovery that would that would lower the demand for safe assets and increase the stock of safe assets.  Both of these developments would in turn reduce the excess money demand problem and minimize the problems with the Triffin dilemma for U.S. treasury debt.  Unfortunately, we are a long way from either central bank adopting nominal GDP level targets.

Which Graph Best Summarizes the Eurozone Crisis?

Niklas Blanchard sends us to the BBC where "top economists" are sharing their most important economic graphs of the year.  Here, for example, is an interesting graph from Vicky Price of FTI Consulting:

Price explains its importance:

"For a long time the perception was that the creation of the euro meant sovereign risk was effectively the same across all countries. That of course proved to be wrong. The Lehman's crisis and financial meltdown that followed affected the deficits and debt levels of different countries in different ways. Interestingly it is much the same countries now with very high yields as it was pre-euro, suggesting little has changed fundamentally in a decade."

I agree that long-term interest rates should not have converged across all sovereign debt in the Eurozone, but I also believe that the huge spreads that have now emerged are more than risk premiums simply returning to their normal levels.  Rather, they are the result of effectively tight monetary policy that has caused public finances to worsen and that, in turn, is driving the sharp rise in spreads.  Nicklas Blanchard agrees and notes that one graph conspicuously absent from the BBC feature is the one that shows the all-important deviation of actual nominal income from its expected path.  That graph shows the main story behind the crisis. 

My BBC Interview

As part of BBC Radio's coverage of the big Eurozone summit yesterday, I was interviewed by the BBC's Stephen Evans.  We talked about Germany's role in the crisis and what it and the ECB could do if they really wanted to save the Eurozone.  And yes, I was able to mention nominal GDP level targeting a few times on air (though I wish I had explained it better).  

My part starts around 8 minutues into the show, but there are other interesting segments on his show.  First, Stephen interviews some average Germans who all applaud Chancellor Angela Merkel's actions and seem blithely unaware that an economic disaster could be right around the corner for them too. He then interviews a consultant to Merkel whose advice is ignored and finally, plays the ECB's own online monetary policy game and learns that is rigged with a low-inflation-at-any-cost bias. 

Here is the link to the podcast of the show. [Update: The link is now directly connected to a permanent MP3 file.]

Update: One thing I mentioned in the interview is there is a lack of urgency for most Germans regarding the crisis  because they are in better economic shape, a point I have made before.  Now Floyd Norris makes a similar point n the  New York Times: 

For Germany and, to a lesser extent, the countries that some have speculated could join it in a new common currency if the euro zone collapses, recent years have been a time of relative prosperity. At the end of 2006, the unemployment rate in Germany was 9.6 percent and nearly four million people were out of work. Now the rate is down to 5.5 percent and just 2.3 million people are classified as out of work. 

[...] 

In recent months, the euro crisis has led some depositors to move their euros to German banks out of fear that other countries might leave the zone and convert to a less valuable currency. That has helped to lower borrowing costs for German companies while raising them for foreign competitors, if they can borrow at all.

Evidence for the Monetary View of the Eurozone Crisis

Some observers argue that the current problems in the Eurozone are actually the result of a monetary crisis not a sovereign debt crisis.  They acknowledge there are structural problems with European currency union but point back to the failure of the ECB to stabilize and restore nominal spending to expected levels during the crisis of 2008-2009 as the real culprit behind the Eurozone crisis.  This failure to act by the ECB--a passive tightening of monetary policy--has been devastating because it means nominal incomes are far lower than were expected when borrowers took out loans fixed in nominal terms.  European borrowers, both public and private, are therefore not able to pay back their debt and the result is a fiscal crisis.

But it gets worse.  The reduced ability for Europeans to payback debt also means that risk premiums on countries with lots of debt or ones perceived to have debt problems increases, further raising these country's debt burden with higher financing costs.  The fiscal crisis gets bigger, and being easy to observe, gets wrongly credited as the cause of the Eurozone's problems.  Consequently, the Eurozone crisis is prescribed with the fiscal solution of austerity.  The real solution, however, implied by the monetary view of crisis is restoring nominal incomes to their originally expected values. Thus, David Glasner argues that "Europe is having a NGDP crisis not a debt crisis" and Ambrose Evans-Pritchard claims that the Eurozone crisis "is a monetary crisis caused  by a jejune central bank [.]"

I find this monetary view a compelling explanation--though there are deeper structural and political problems that make me question the long-term viability of the Eurozone--for the current crisis in Europe.  It can be summed up in one figure:

This figure shows a remarkably strong relationship between (1) the deviation of nominal income from its expected level and (2) the growth of the debt burden lagged by four quarters.  Thus, if European nominal incomes are less than expected then eventually higher debt burdens increase for the reasons outlined above.

Now lest you think the strong relationship is simply the result of nominal GDP being in the denominator of the the debt burden measure take a look at the following figure.  It shows actual  nominal GDP for the Eurozone and its trend for 1995:Q1-2006:Q4 which are used to construct the percent deviation of nominal income from its expected level in the figure above.  The trend provides an indicator of what nominal income growth expectations were prior to the 2008-2009 crisis.

Note that nominal income falls sharply between 2008:Q2 and 2009:Q3, but actually grows thereafter.  Thus, the ongoing rise in the debt-to-GDP ratio (see figure below) is not just because of the sharp fall in nominal income.  It is because monetary policy has not allowed nominal income to grow fast enough to restore it to expected levels where the debt burden is more manageable.  This in turn, has caused Eurozone debt burden to take off with no end in sight as seen in the figure below of the government debt-to-GDP ratio for the Eurozone:

So yes, the Eurozone crisis is a monetary crisis, a crisis catalyzed by the failure of the ECB to stabilize and restore nominal spending to its expected level.  Again, though, there are longer-term structural and political problems with the Eurozone that arguably are behind the monetary crisis.  Still, if the Eurozone experiment is to be salvaged, then a proper monetary diagnosis of the current crisis has to be realized so that the currency union can survive long enough for it to be salvagable.

Update I: Martin Wolf similarly notes that for many of the crisis-stricken countries in the Eurozone, their fiscal positions did not look that bad prior to the crisis:

Take a look at the average fiscal deficits of 12 significant (or at least revealing) eurozone members from 1999 to 2007, inclusive. Every country, except Greece, fell below the famous 3 per cent of gross domestic product limit. Focusing on this criterion would have missed all today’s crisis-hit members, except Greece. Moreover, the four worst exemplars, after Greece, were Italy and then France, Germany and Austria. Meanwhile, Ireland, Estonia, Spain and Belgium had good performances over these years. After the crisis, the picture changed, with huge (and unexpected) deteriorations in the fiscal positions of Ireland, Portugal and Spain (though not Italy). In all, however, fiscal deficits were useless as indicators of looming crises (see charts).

Now consider public debt. Relying on that criterion would have picked up Greece, Italy, Belgium and Portugal. But Estonia, Ireland and Spain had vastly better public debt positions than Germany. Indeed, on the basis of its deficit and debt performance, pre-crisis Germany even looked vulnerable. Again, after the crisis, the picture transformed swiftly. Ireland’s story is amazing: in just five years it will suffer a 93 percentage point jump in the ratio of its net public debt to GDP.

 So most of the fiscal problems are a result, not the cause, of the Eurozone crisis.

Update II:  Ezra Klein also shows that the Eurozone crisis at its core is not a debt crisis.  

The Merkelian Reich

We learn that Mario Draghi, head of the ECB, has made a deal with Germany that would allow the central bank to open the monetary spigot only if Germany gets its desired fiscal union.  This development reinforces the widely held view that the Germans are playing the Eurozone crisis to their benefit.  Of course, the evidence suggests that the Germans have always been playing the currency union to their liking, but the Eurozone crisis is a chance for Germany to take this game to another level.  Tony Corn makes this point in an very interesting article titled "Toward a Gentler, Kinder German Reich?"  Here are some excerpts:

For the third time in less than twenty years, Germany is trying to force down the throat of Europe a federal “political union” which, in the eyes of too many European observers, eerily resembles a gentler, kinder Anschluss.  While Europeans were able to push back against the first two attempts, the two-year long financial crisis has created within Europe a “German unipolar moment” and provided the kind of leverage that had eluded Germany earlier. With the German Chancellor as a de facto “EU Chancellor,” German elites are leveraging the crisis by playing a game of chicken in order to make their federal vision prevail. 

Demographically and economically, Germany is one third larger than either Britain or France. In the past ten years, this predominance has already been reflected in EU institutions, both quantitatively (Germany has the largest representation in the EU parliament) and qualitatively (the European Central Bank is a clone of the Bundesbank).  But that’s apparently not good enough for Berlin, who has deliberately let the crisis move from the periphery (Greece and Portugal) to the center (Italy and France) in order to extract the maximum of concessions from the rest of Europe. 

Germany’s ideal, if unstated, goal? A constitutionalization of the EU treaties, which would irreversibly institutionalize the current “correlation of forces,” and allow German hegemony in the 27-member European Union to approximate Prussian hegemony in the 27-member Bismarckian Reich.  German elites have become so fixated on this goal that they are now talking about changing the German constitution itself in the event the German Constitutional Court decides to get in the way of the New European Order. 

From a socio-political standpoint, to be sure, this would-be Merkelian Reich would have none of the negative features associated with the autocratic Bismarckian Reich.  In all likelihood, the new Reich would be a benign, metrosexual, post-modern (pick your favorite) polity, one that would not be any less “democratic” than the technocratic European Union of today. And from a monetary-fiscal standpoint, one could argue that a Merkelian Reich would probably represent a significant improvement over existing “hybrid” arrangements. 

I am less certain than the author that a Merkelian Reich would really lead to better monetary policy given the vast differences in the European economies.  The Eurozone is not an optimal currency area and Germany has consistently shown itself to care more about domestic monetary conditions than European monetary conditions.  Still, if this is the path the European Union is headed then creating the fiscal union would be a step in the right direction toward making the Eurozone a functional currency union.  

HT Milan Brahmbhatt

The Eurozone Crisis is a Monetary Crisis, Not a Fiscal One

So argues Ambrose Evan-Pricthard:

This is a monetary crisis, caused by a jejune central bank that aborted a fragile recovery by raising rates earlier this year, allowed the money supply to collapse at vertiginous rates in southern Europe, and caused a completely unnecessary recession — and a deep one judging by the collapse in the PMI new manufacturing orders in November.

Needless to say, drastic fiscal austerity is making matters a lot worse. You cannot push two-thirds of the eurozone into synchronized fiscal and monetary contraction without consequences.

Another way of saying this is that the ECB allowed nominal spending and thus nominal incomes to drastically fall in the Eurozone--a passive tightening of monetary policy--and this, in turn, made it difficult for European countries to service their debt. As a result, a fiscal crisis has emerged in the Eurozone.  To make matters worse, the fiscal crisis is viewed as the cause of the Eurozone's problems and is therefore being treated with the fiscal solution of austerity.  The fiscal crisis should, instead, be viewed as a symptom of tight money and treated appropriately with monetary easing.

 Here, again, is, Evan-Pritchard:

This crisis can be stopped very easily by monetary policy, working through the old-fashion Fisher-Hawtrey-Friedman method of open-market operations to expand the quantity of money, ideally to keep nominal GDP growth on an even keel. 

[...] 

What they should be doing is quantitative easing, which is perfectly legal under EU treaty rules and the bank's mandate. Doesn't the ECB's twin pillar doctrine say that M3 money should be growing at 4.5pc? Well it is not doing so. It contracted in October, month-on-month. So get on with it.

The crisis canundoubtedly be halted immediately by the ECB. The bank can reflate Club Med off the reefs. It chooses not to act for political reasons because this mean higher inflation for Germany. That is the dirty secret. Everybody must be crucified to keep German internal inflation under 2pc.

Yes, nominal GDP is crashing in Eurozone's periphery while it is close to trend in Germany.  This is nothing new for Germany which has a history of maintaining stable monetary conditions at home no matter the cost to the rest of the Europe.  The question now is whether Germany values the Eurozone project enough to allow the monetary solution to be implemented.  So far it has not been terribly interested in the monetary solution.

The Great Diversion

George Selgin makes an important point:

We should not wish to see spending stabilized as a rough-and-ready means for "getting at" stability of P or stability of y or stability of some weighted average of P and y: we should wish to see it stabilized because such stability is itself the very desideratum of responsible monetary policy.

In other words, monetary policy should aim to stabilize aggregate demand and not worry about how it breaks down into changes in output and inflation.  This has always made sense to me.  Why focus on inflation, a symptom of aggregate demand, when one can directly stabilize aggregate demand?  Moreover,  inflation is at best a sometimes-indicator of aggregate demand since inflation can be contaminated by aggregate supply shocks.  

Most macroeconomists, however, are fixated on the inflation-output breakdown of aggregate demand.  Selgin considers this to be one of the great diversions in modern macroeconomics.

The belief, on the other hand, that stability of either P or y is a desirable objective in itself is perhaps the most mischievous of all the false beliefs that infect modern macroeconomics. Some y fluctuations are "natural," in the sense meaning that even the most perfect of perfect-information economies would be wise to tolerate them rather than attempt to employ monetary policy to smooth them over. Nature may not leap; but it most certainly bounces. Likewise, some movements in P, where "P" is in practice heavily weighted in favor, if not comprised fully, of prices of final goods, themselves constitute the most efficient of conceivable ways to convey information concerning changes in general economic productivity, that is, in the relative values of inputs and outputs. A central bank that stabilizes the CPI in the face of aggregate productivity innovations is one that destabilizes an index of factor prices.

A great example of how this mischevious belief causes problems can be seen in how the Fed acted in its September, 2008 FOMC meeting. Instead of attempting to stabilize aggregate demand, the Fed was more concerned about balancing the trade-off between growing inflation and falling output.  The Fed ignored the forward-looking indicators that were signalling aggregate demand was falling and decided to do nothing. And we all know what happened next.

Maybe one day the Fed will start targeting nominal GDP and do so using nominal GDP futures.  What a better world this would be. In the mean time, go read the rest of George Selgin's article.