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A theory of safe asset shortage

Ricardo Caballero and Emmanuel Farhi from MIT and Harvard propose an interesting and relevant formal model of safe asset shortage. While safe asset supply is constrained by the fiscal capacity of sovereigns and financial innovation, demand may be in a secular ascent (driven for example by collateralization and population aging). The resulting shortfall can result in a structural drag on economic growth and impair the effectiveness of fiscal and monetary policies, with some resemblance to the Keynesian liquidity trap.

A Model of the Safe Asset Mechanism (SAM): Safety Traps and Economic Policy
Ricardo J. Caballero and Emmanuel Farhi, August 2013


The below are excerpts from the paper. Cursive lines and emphasis have been added.

The trouble with safe asset shortage

One of the main structural features of the global economy in recent years is the apparent shortage of safe assets. This deficit provided the macroeconomic force for the financial engineering behind the subprime crisis, is a paramount factor in determining the spike in funding costs when European economies switch from the core to the periphery, and has put new constraints on the effectiveness of monetary and fiscal policy.”

This financial market problem spreads to the real economy through multiple channels. On the aggregate supply side, corporations trade less potential production for safer revenue. On the aggregate demand side…[excess demand for safe assets] is characterized by the strong downward pressure it puts on safe interest rates. If there is a limit on how much these rates can drop, a safety-trap emerges, akin to the Keynesian liquidity trap. In this context, a recession restores equilibrium in asset markets by reducing the wealth of safe-savers and hence their asset demand.”

“As in the more conventional credit crunch mechanism, a wedge develops between the risky and riskless rate. However…it is the safe rate drop that drives this wedge and it is this rate that is the main sign of trouble. Although in practice both mechanisms are likely to operate in conjunction, it is important to establish their differences as they do not respond equally to different policy packages.”

“Given the faster growth of safe-asset-consumer economies than that of safe-asset-producer economies, absent major financial innovations, [safe asset shortage] is only likely to get worse over time. Aside from temporary cyclical recoveries in spreads and output, it is our conjecture that [safe asset shortage] will remain as a structural drag, lowering safe rates, increasing safety spreads, straining the financial system, and weakening the effectiveness of conventional monetary policy.”

The importance of “fiscal capacity”

“The central concept here is that of fiscal capacity: How much public debt can the government credibly pledge to honor, should a major macroeconomic shock take place in the future? The key issue is that the government owns a disproportionate share of the capacity to create safe assets, and the private sector owns too many risky assets. As long as the government has spare fiscal capacity to back safe asset production, the government can increase the supply of safe assets by issuing public debt.”

Once fiscal capacity runs out, that is, once the government’s ability to create safe assets runs out, short term fiscal policy becomes less effective… the only way for the government to increase its supply of safe assets is to engage in credible future fiscal consolidation. This allows the government to sustain higher debt, enhances the government’s ability to create safe assets, and therefore boosts the economy.”

“Indeed, proponents of fiscal stimulus in recessions typically favor a two-pronged approach combining short term fiscal stimulus for Keynesian reasons with long-term fiscal restraint to avoid generating doubts about fiscal sustainability. The short-term stimulus is the central piece of the argument, and long-run fiscal responsibility is added for robustness, almost as an afterthought. Our model identifies the same levers but reverses the pecking order by making long-run fiscal consolidation the key policy instrument since in its absence the government may not be able to create the safe debt that is in short supply.”

It is also possible for the government to successfully stimulate the economy by reducing the demand for safe assets. Indeed, the government can stimulate the economy by simply taxing away the wealth of the agents with the highest demand for safe assets, and either rebating the proceeds to agents with a lower demand for safe assets, or using them to increase government spending.”

Monetary policy and the safety trap

“Monetary policy commitments in a safety trap alleviate the shortage [of safe assets] only if they support future bad states of nature (a policy put). The reason is, again, that in a [safe asset shortage] environment the main problem is the very low equilibrium safe rate, not the large risk-spread.”

Forward guidance type policies (commitments to low future interest rates)…are usually advocated in the context of standard New-Keynesian liquidity trap models. They involve committing to keeping interest rates low once the economy recovers. We show that such commitments are ineffective at stimulating output in a safety trap since they are powerless at increasing the value of safe assets and hence alleviating the safe asset shortage. Instead, they simultaneously increase the future value of risky assets and the risky interest rate, leaving the current value of risky assets unchanged. As a result, aggregate demand and output remain unchanged.””

In a safety trap, policy commitments that work support future bad states [quantitative easing or long-term refinancing operations]. This is a higher level of requirements than in the standard New-Keynesian liquidity-trap mechanism where any future wealth increase has the potential to stimulate the economy. Indeed, it is natural to question whether monetary authorities would have the ability to lower interest rates in future bad states, since they might coincide with yet another safety or liquidity trap.”


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