The Cyclical Dimension Of The Safe Asset Problem

An important problem facing the global economy is the shortage of safe assets, assets that facilitate transactions at both the retail and institutional level. There is both a long-term, structural dimension to this problem as well as a short-term, cyclical one. 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, a point first noted by Ricardo Cabellero. The cyclical dimension is that the shortage of safe assets was intensified by the Great Recession, a point stressed by Gary Gorton. I previously made the case that both the Fed and the ECB were an important part of the cyclical story by failing to restore nominal incomes to their expected, pre-crisis paths. In other words, since 2008 the Fed and the ECB passively tightened monetary policy which caused some of the safe assets to disappear while at the same time increasing the demand for them.

I still hold this view, but after reading some papers on safe assets and talking with Josh Hendrickson I have come up with a more general view to the cyclical dimension of the safe asset problem. It goes as follows.

Gorton, Lewellen, and Metrick (2012) show that safe assets have constituted a relative stable share of all assets since the 1950s. They also show, as does Bansal, Coleman, and Lundblad (2011), that public and private safe assets tend to act as substitutes in providing liquidity services. Given these findings, it stands to reason that when the central bank is doing its job and nominal GDP (NGDP) is growing at its appropriate trend, then there will be enough safe assets being privately provided. If, however, the central bank slips and NGDP falls below its expected path, then some of the privately produced safe assets disappear, creating a shortage of safe assets. The government steps in and creates safe assets that, if produced sufficiently, would restore NGDP back to its expected path. In other words, if monetary policy does not do its job then fiscal policy could substitute for it, but in a way not normally imagined. It would do so not by increasing aggregate demand via higher government spending, but by making up for the shortage of safe assets that facilitate transactions. All this requires is running a budget deficit which may or may not imply higher government spending (i.e. it could also come from tax cuts). Debates about Ricardian equivalence, crowding out, and other fiscal policy concerns become moot. What matters is if there are enough safe assets, and if not, whether fiscal policy can provide them in the absence of a NGDP-stabilizing monetary policy.

This understanding may serve as the basis for a paper, so I look forward to any feedback you can provide.