One consequence of the financial crisis is that economists have stopped talking about cash and money in the bank and begun talking about “safe assets” instead.
Everybody understands the usefulness of cash. Most know about the convenience and relatively few limitations of money in the bank. But safe assets require some explanation. The term has come into use only in the decade since the crisis.
With a view to explaining the logic behind the phrase, Gary Gorton, of Yale University’s School of Management, has written a primer, The History and Economics of Safe Assets., available as a working paper on its way to its home in a journal. Gorton is a leader of the informal little college of economists that introduced the term.
A “safe asset,” says Gorton, is an asset that is valued (almost always) at face value, without expensive and prolonged analysis. It is expected to change hands among transactors, in the telling phrase of Massachusetts Institute of Technology economist Bengt Holmström, with “no questions asked,”
Safe assets are designed in such a way there should no benefit to producing (private) information about a safe asset’s value, Gorton explains – at least for long periods of time. They are the basis of the saving and transactions machinery of society – platelets in the “life’s blood” of money and credit.
But human nature inevitably takes over. Once it begins to pay to distinguish between genuinely safe assets and potentially less valuable ones, the machinery breaks down: it’s time for a financial crisis. The rate and quality of the production of safe assets therefore has implications for both growth and economic stability. Until relatively recently, though, their existence was all but taken for granted
The search for safe assets goes back a long way, Gorton writes. The first assets deemed safe were coins made of precious metals. As a technology, coins had many problems: they could be clipped or, debased by the sovereign. They had to be assayed and weighed to determine their value in the best of times; whole currencies would collapse in the worst, when the “fraudulent arts” gained the upper hand. Coins were bulky, too, and vulnerable to theft. But they worked: they were always liquid, their edges could be milled to prevent clipping; and, for long periods of time, coins served as fairly reliable stores of value.
As trade expanded, problems with coins gradually led to the creation of paper money – privately-produced circulating debt in all its early forms: moneys of account; bank notes and bills; goldsmith notes; and merchants’ bills of exchange, all of them convertible on short notice into coins.
Nomenclature had become more complicated: debt to an issuer is, after all, to the acquirer an asset. A loan to a sovereign is an asset to the lender; money deposited in a bank creates debt the banker owes to the depositor. The sovereign backs his borrowing with promises. The banker backs his debt with some form of collateral: gold in the goldsmith’s vault, sovereign debt in the bank’s reserves; or, ultimately, in the case of today’s fiat money, the “full faith and credit” of the government. Safe debt produces safe assets, and there are only two ways to produce both, says Gorton: back the debt with the government’s taxing power, or else use collateral.
In his essay, Gorton deftly sketches the rise of banks in the eighteenth century, “private producers of safe debt,” as he puts it, their charter inevitably accompanied by public regulation, because banks were understood to be vulnerable to runs. Regulation aims to turn banks’ short-term debt into safe assets, Gorton says. Government deposit insurance, pioneered by the British in the nineteenth century and adopted in the United States after 1933, is a straightforward example.
For sixty-five years deposit insurance worked so well that almost everyone was lulled into thinking that run that would spread to the entire banking system could no longer be a problem. Then came the Panic of 2008, when financial institutions of all sorts ran on each other, desperately seeking to turn their supposedly safe assets into cash.
Emergency lending by central banks, backed by their respective national treasuries, averted a second Great Depression, by persuading stakeholders that safe assets were still safe. But considerable damage seems to have been done to a banking system that few at the outset of the crisis even knew existed. The “shadow banking system” was discovered to be mostly a collateral-backed system, improvised on the fly for big institutional investors: money market funds, pension funds, mutual funds, hedge funds, insurance companies, corporations, and the like
It was in 2012 that Gorton and Andrew Metrick, also of Yale’s School of Management, reported a remarkable regularity: since 1952, the percentage of total safe assets – that is, the sum of all government debt and the component of private debt generally deemed to be information-insensitive, meaning not likely to be vulnerable to adverse selection –– has remained stable at around 33 percent of GDP, year after year. Meanwhile, the total volume of financial assets, including stocks, had exploded, from around four times GDP in 1952 to around ten times GDP in 2010.
Yet while this “safe asset share” of the whole had remained stable over the years, its composition had changed dramatically. In the beginning, US Treasury securities and bank deposits constituted most of the total. Sixty years later, the government wasn’t borrowing nearly as much proportionately; and people were no longer putting their money in insured banks. Instead the fledgling shadow banking system had produced the rest of the safe asset share.
How? Through what was conventionally described as financial innovation, ways of lending and borrowing that seemed new under the sun: money market mutual fund shares, commercial paper, federal funds, and repurchase agreements (“repo”) and securitized debt, in the form of asset-backed and mortgage-backed securities. In what otherwise might have been considered a shortage of public safe debt, the private sector had over thirty years produced close substitutes of its own – in effect, creating a wholesale banking system in order to serve those enormous new institutional investors, pension funds and the rest, grown flush since the 1980s with cash.
It is this improvised wholesale banking system that seems to have been damaged by the crisis and the regulatory response to it — everything FROM? the Dodd-Frank Act and reserve requirements imposed by the Bank for International Settlements to quantitative easing in monetary policy – in ways that nobody quite understands, by shrinking the share of safe assets.
For instance, in Mobile Collateral vs. Immobile Collateral, Gorton and his Yale colleague Tyler Muir, have warned that the imposition of a “liquidity coverage ratio,” requiring that banks back their short-term debt dollar-for-dollar with Treasuries, risks both lowering interest rates and making panics more frequent. And in The Safety Trap, Ricard Caballero, of MIT, and Emmanuel Fahri, of Harvard University, have described how a self-reinforcing demand for a shortage of safe assets might turn a lengthy recession into outright stagnation.
All this IS well above the level of interest of a newspaper column. More complicated forms are required – Gorton’s explicatory essay, for example. So far the optimal information-insensitivity of debt is mainly a matter of research going forward, not yet a matter of expert reform, much less a suitable topic for the breakfast table.
Soon enough, attention at breakfast will shift back to cash. In The Costs and Benefits of Phasing Out Paper Currency, Kenneth Rogoff, of Harvard University, speculated on the possibility of gradually eliminating paper money altogether, beginning with large-denomination notes. It would make it easier to implement a negative-interest-rate policy, for one thing, by nicking off a little bit of all balances; it would go hard on drug barons who now store their assets in suitcases of $100 bills for another.
True, abolition of paper money would ride roughshod over other cherished attributes, Rogoff acknowledges: its anonymity; its solidarity-enhancing appeal. His book, Cashlessness, is expected to appear in the autumn. In an age of proliferating digital payments and block-chain accounting, Rogoff’s ideas are much less farfetched than they sound. Look for them to cause a row. But the shortage of safe assets is the deeper problem.