EVERYONE needs to save. People need to be able to cover unexpected expenses and income reductions, to say nothing of retirement. To accomplish this, we buy equities and bonds, hoard gold coins and physical currency, open bank accounts, accumulate real estate, purchase insurance coverage, and even stock up on canned food. All of these savings vehicles help us hedge out different risk exposures we face in our daily lives. For example, an unleveraged position in shares can be expected to generate higher absolute returns over very long periods of time relative to an unleveraged position in government bonds. Investors who cannot use leverage should therefore own some equities to hedge against long-term liabilities like the cost of retirement. But shares’ higher returns over very long periods are offset by greater volatility. Moreover, shares generally lose value whenever the economy slows, which makes them a particularly poor hedge against the risk of job loss. So investors need to own things besides shares to hedge against the vicissitudes of life. However, relative to what people want right now, there may not be enough of these “safe assets” available. This would help explain the negative real yields on TIPS and inflation-indexed government bonds issued by other countries. Why would there be a relative shortage of safe assets?
One reason is that people are more aware of downside risk than in the past, thanks to the collapse in middle class wealth and the massive increase in joblessness; there is more demand for safe assets. This is actually healthy and overdue. In fact, there is good reason to think that the process still has a long way to go.* The safe asset shortage can also be attributed to the fact that many assets previously thought of as “safe” are no longer seen that way, whether they are Italian government bonds or subprime mortgage securities. Thus, the supply of safe assets declined even as the demand for them soared. Izabella Kaminsky has written many thoughtful posts on this subject in the context of the collateralised lending markets. I was reminded of this because of a conversation I had over Twitter with David Beckworth, an economist who writes the Macro and Other Market Musings blog. We agreed that there are too few safe assets relative to the demand. But where I thought the government ought to issue more Treasury bonds to satiate investors, he thought that the solution was to induce the private sector to “create” more safe assets. I doubted whether that is possible.
To see why, it helps to understand what makes for a genuinely safe asset. They are liquid—you can always sell them at short notice for goods and services without needing to offer a discount on price—and they have no credit risk. Safe assets may sometimes pay investors less than inflation but they always pay out what they say they will. The most extreme example is a piece of physical currency, which in America is described as “legal tender for all debts public and private”. As long as the government is able to enforce the law, those pieces of paper and metal will always be worth what they say they are, no matter what. Gilts with face values of £100 always pay £100 in principal upon maturity, even if that is worth less than you might like relative to goods and services. (The value of a gilt can be quite volatile before it reaches maturity, however, depending on its duration.) This is because the government can always print the money it needs to prevent default. Assets that only sometimes keep their promises cannot be called safe, however, even if they fool people into believing otherwise for significant periods of time.
So, can the private sector issue genuinely safe assets? I don’t see how, since private borrowers always have some default risk. Moreover, this risk changes depending on economic conditions. The market reflects this by charging private debtors a premium over the government’s borrowing costs. This premium adjusts according to investors’ beliefs about how likely they are to get their money back. Of course, the transition is rarely smooth. In practice, investors in private credit act as if there is almost no risk for long periods of time before suddenly freaking out. When everyone decides to sell their loans at the same time, it becomes very difficult for any individual investor to dump his holdings. Thus, private debt also has a nasty tendency to become illiquid. These are not the characteristics of a safe asset.
Consider what happened in the summer of 2007. Senior tranches of subprime mortgage CDOs had been viewed as safe. The ratings agencies had rated them as AAA. Their spread against Treasury bonds was basically nothing. But as news spread about rising default rates for subprime mortgages, the prices of those bonds plummeted as the spreads blew out:
Understandably, investors reacted by questioning the value of all the other non-government assets previously regarded as safe, including student loans, car loans, and credit-card receivables. This was effectively a bank run on the so-called “shadow” banking system of securitised finance. Many economists believe that this was the proximate cause of the recession, which started at the end of 2007. If you want more details on how this system worked and how it broke down, I highly recommend reading Gary Gorton’s work. You can read our review of his excellent new book here.
The euro crisis can be thought of in a similar way. Greece’s sovereign debt problem spooked investors about Italian debt because, despite the fact that Italy has one of the world’s largest primary budget surpluses and has been steadily lowering its debt/GDP ratio for decades, Italy cannot print its own currency. Thus, money flowed out of Italian sovereign debt into so-called “core” Europe, the Nordics, and Switzerland, which responded with a massive campaign of currency intervention. The consequent rise in Italian sovereign borrowing costs flowed through to the rest of the economy and choked off the supply of credit.
One would think that this would be the end of the discussion, but Mr Beckworth has a different definition of “safe” than I do, which, to be fair, comes from Mr Gorton and his colleagues:
Our definition of “safe” assets includes assets that are either directly or indirectly used in an information-insensitive fashion, i.e. as money. The key components of “safe” debt include bank deposits, money market mutual fund shares, commercial paper, federal funds and repurchase agreements (“repo”), short-term interbank loans, Treasuries, agency debt, municipal bonds, securitized debt, and high-grade financial-sector corporate debt. The latter five categories of debt are commonly used as collateral in repo transactions and the asset-backed commercial paper market, and prior to the financial crisis, repo lenders did not demand excess collateral (“haircuts”) from borrowers when these assets were deposited as collateral. Hence, at least until the crisis, these assets were information-insensitive.
The bolded sentence explains the nature of the disagreement. People who want genuinely safe assets are not helped by using things that are only sometimes safe, or even “mostly” safe, which is similar to the difference between being dead and being “mostly dead”. Mistaking a “mostly” safe asset for a genuinely safe one is worse than simply using a risky asset. If you know an asset is risky, you can try to protect yourself. If you think it is safe, you won’t. Therefore, the finding that the proportion of American financial assets that fits the paper’s definition of “safe” has stayed constant since 1952 is less meaningful to me than the paper’s description of what has changed, especially since the late 1970s:
The classic form of safe financial debt is bank deposits. But while bank deposits comprised the vast majority of safe financial debt before 1980, the share of deposits has dropped by more than one half from its peak. Figure 3 plots the details. In the figure, “money-like debt” refers to commercial paper, net repurchase agreements, federal funds, money market mutual fund assets, interbank transactions, broker-dealer payables, and broker-dealer security credits.
There is a big difference between bank deposits and these other instruments: deposits are guaranteed by the government. As Mr Gorton explains so well in his latest book, the creation of the government guarantee ended the bank runs caused by people trying to redeem their deposits for cash, just as the creation of national banknotes ended the runs caused by people trying to redeem their paper currency for specie. Without the guarantee, bank deposits would not be safe. In fact, bank deposits above a certain threshold are not safe. As Sheila Bair, the former head of the Federal Deposit Insurance Corporation, recounts in her memoir of the crisis, savers at Indymac had to endure steep haircuts on anything over the FDIC’s limit. Anticipation of the expiration of the Transaction Account Guarantee has led to flows out of large, interest-free bank deposits into t-bills. All of this means that, rather than staying constant, the proportion of genuinely safe assets was collapsing—the economy became increasingly leveraged and therefore more vulnerable to the type of crisis we actually endured.
Mr Gorton is well aware of the changing nature of "safety" and believes that the government needs to play a role. His preferred solution is to have the state make certain types of unsafe assets genuinely safe by regulating and guaranteeing them. Of course, that would mean that the government is the one creating the safe assets, rather than the private sector operating alone. So, to return to the original disagreement with Mr Beckworth, it seems that there are only two ways to relieve the shortage of safe assets: the government could issue more debt or the government could guarantee private debt, thereby transferring the liability to the state. One can disagree about which of those two approaches is better, but the effect on the government’s balance sheet is the same.
*Defined-benefit pension plans usually have liabilities that can be perfectly hedged through purchases of government bonds denominated in local currency. (The exception is if they have to cover healthcare costs.) This makes these funds very easy to manage, in theory. All that would be needed is to have an actuary determine the size of the liability and its duration, which would then be fully funded by buying the appropriate quantity of government bonds. But pension funds almost never do this. Instead, they “underfund” their schemes. To compensate, they buy risky assets, like stocks, that are poor hedges for their liabilities. This has started to change in the wake of the crisis, but most of the world’s pension money is still under-invested in sovereign debt.