By Don Alexander, MBA
Associate, RSD Solutions Inc.
Mr. Alexander also lectures at NYU and SunySB
The notion that the global economy could be faced with a shortage of safe assets has become a significant theme in recent policy debates. Safe assets are a cornerstone of modern financial systems. They provide a reliable store of value, serve as collateral in financial transactions, and serve as a pricing benchmark. Should they disappear, the danger is that the financial system itself might crumble. Markets for collateralized transactions (repos) would collapse; financial institutions would have difficulties meeting their prudential requirements, and the pricing and well-functioning of riskier segments of the financial system could be derailed altogether. Without a safe anchor, the financial system would experience greater systemic instability.
This is a link that Pierre-Olivier Gouchinas and Olivier Jeanne seek to examine in a recent BIS WP (Dec. 2012) called Global Safe Assets. The authors suggest a link between macroeconomic shortages of safe assets and some of the most disturbing features of our recent global financial history. This shortage has depressed world interest rates and fueled ‘global imbalances.’ This growing external demand for safe stores of value also proved a powerful stimulant for US and European financial markets as they manufactured large amounts of ‘private label’ safe assets through the securitization of riskier assets .
The global financial crisis arose when many of these ‘private label’ safe assets –perceived as safe because they were bestowed with a AAA rating– lost that quality. The sudden realization that many of the safe assets undergirding the entire financial system were of questionable value led to a ‘sudden financial arrest’. In the subsequent unraveling, most of these ‘private label’ safe assets disappeared. In the euro area, the strains associated with the crisis quickly morphed into concerns about the safety of sovereign debts, as governments simultaneously tried to shore up their financial sector and to sustain domestic economic activity. This led to further shrinkage in the global supply of safe assets at the same time that deleveraging financial institutions, panicked investors and anxious reserve managers all tried to fly to safety.
In short, macroeconomic shortages of safe assets can create financial instability. Crises, when they occur, further exacerbate the shortage that gave rise to it. Policy responses designed to cope with the crisis such as liquidity injections and monetary easing prolong the conditions for financial instability and delay the necessary balance sheet adjustment of households and financial institutions. However, it ignores that the global economy also exhibits powerful stabilizing mechanisms such as a decline in the natural real interest rate, resulting from the excess demand for stores of value.
Monetary policy plays two important roles. First, it will need to accompany the decline in the natural rate that occurs when the scarcity of stores of value becomes more acute. Second, monetary policy can also play an important role as a backstop for public securities.
The more interesting question lies in the composition of this asset supply and how to make it less ‘fragile.’ It is of the essence of a safe asset that it cannot become unsafe. The definition of safe assets has a key impact on the financial sector and should not be left entirely to the private sector. The authorities should commit themselves to a clear definition of safe assets and back it with a policy regime that makes those assets credibly safe. Claims on the private sector are inherently risky and should stay so to limit moral hazard: for this reason they may not provide a good basis to produce safe assets. Besides money, government debt remains the best candidate for the status of safe asset. Central banks, furthermore, have a role to play in making government debts safe.
The previous analysis has a number of implications for the global economy. First, it suggests that global banking will naturally take place in the currency that offers an appropriate supply of safe assets. This role is fulfilled now primarily by the US dollar. Second, there are important distinctions to be made between inside and outside liquidity and between public and private liquidity. In tranquil times, these different forms of liquidity are close substitutes and trade at similar prices. In times of global stress, all liquidity dries up, as counterparty risk rises. The only relevant form of liquidity comes from the public sector, through liquidity injections of the monetary authorities, or the injection of public funds in troubled financial institutions.
The global scarcity of safe assets is bound to increase as the global demand for safe assets—-tied to global economic growth—-outstrips the supply—tied to US economic growth and fiscal sustainability. This might be resolved by the emergence of new safe assets. One question is how multiple safe assets will compete on a global stage. This can be done by increasing the supply of safe assets, a multipolar world will remove some sources of financial instability. However, the feedback loop that supports the status of safe assets may also turn vicious, and the arbitrage between safe assets might generate rather than reduce volatility. In other words, the transition to a more multipolar world may not be monotonous, nor smooth, if and when it occurs. A multipolar world may therefore itself need a global backstop such as the IMF.
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