A lesson from history: the safety of government debt depends on private sector liquidity

Narayana Kocherlakota brings up the safe asset meme: “The demand for safe financial assets has grown greatly since 2007. … At the same time, the supply of the assets perceived to be safe has shrunk over the past six years.” This he argues has reduced the market-clearing interest rate.

What is missing from his analysis is the fact that both the increase in demand and the decrease in supply are caused by deep seated dysfunction in the financial system, which is no longer performing its prime duty: creating safe assets by lending to credit-worthy borrowers. (In fact, after the 2008 crisis there is good reason to doubt that banking system still fosters the development of the underwriting skills that are essential to the issue of safe assets.) Let me explain this view in three steps.

As J.P. Koning pointed out the first problem with the “safe asset” meme is one of definition: What is a “safe asset”? The answer I think is that the “safe asset” argument is derived from individuals with economics training confusing their idealized economic models with reality.  In an economic model, the asset that has a “risk-free” rate is government debt, so it’s obvious that a safe asset is government debt.[1]  Tipping their hats to reality, these economists will quickly concede that not just any government debt qualifies, but that issued by the U.S., Germany and a few other countries surely qualifies.

The next problem is that the evidence points to the fact that the safe asset shortage is in no small part created by the collateral demands of our largest financial institutions. That is, our banks – more often than not prodded by their regulators (see here p. 59 ff.) — no longer have enough confidence in the financial system to lend to each other on an unsecured basis. Unsecured short-term paper issued by our largest banks should be part of the “safe asset” supply – and this should be true not because of government support, but because of the unquestionable quality of our largest banks’ balance sheets and the knowledge within the industry that they are well-managed institutions. Given our modern financial structure, this obvious source of “safe” private sector assets has been thrown into doubt.

This leads into the real problem with the “safe assets” meme: people who cut their teeth on models where government (which is equivalent to a hybrid of the central bank and treasury) is modeled as a benevolent social planner that enables the economy to function perfectly, end up holding a deep-seated belief that is founded on little more than an assumption in the models they use, that a central bank cum treasury actually is a deus ex machina that can solve all our problems. Thus, their policy prescriptions rely in an entirely unrealistic manner on government-backing of the financial system.*

An understanding of our financial system that is founded on history, not economic models would recognize that the development of “safe” privately issued assets (e.g. the bill of exchange) precedes the issuance of “safe” government debt by centuries. The classic example of the ability of a democratic government to bear a heavy debt burden is Napoleonic Britain when facing the threat of Napoleon. The ability of the government in late 18th century Britain to issue trusted government debt depended on the support of British merchants and bankers, who literally convened and signed a resolution agreeing to accept Bank of England notes when the Bank went off the gold standard in 1797.[2] No such resolution was signed with respect to English country bank notes (which relied heavily on the London market and Bank of England notes for finalizing payment), and the courts acknowledged that country bank creditors had the legal right to demand gold in payment.  As the Lord Chief Justice remarked in his decision: “Thank God few such creditors as the present plaintiff have been found since the passing of the [Bank Restriction] Act!”[3] (Does anyone doubt that if Goldman Sachs and J.P. Morgan Chase could be transported to 1800s England, they would definitely demand to receive the gold that they are “due”.)

In short, just as public sector liquidity in the form of central bank loans is necessary to support private debt in times of crisis, private sector liquidity is necessary to support public sector debt in times of crisis. Unlike the idealized world of economic models where the government is the ultimate source of liquidity, liquidity in the real world is a two way street that is sustainable in the long-run only if there is a source of private sector “safe” assets that is willing and able to support the government in times of trouble. Thus to the degree that there is a “safe” asset shortage, the question is what is preventing the private sector from issuing safe assets.  Until the structural problems in the private-sector financial system that prevent it from generating safe assets endogenously are addressed, there is little hope that the liquidity of assets to which we, in the United States, have become accustomed can be maintained in the long run.


[1] The sense in which it is true that this debt is risk-free is that the government in the model also issues money, so the government can never be forced into default. Of course once one adds multiple governments with multiple inflation rates to the model, the meaning of the term “risk-free debt” suddenly becomes so constrained that it effectively loses all meaning.
* I don’t mean to be too hard on Caballero here. He is wise enough to acknowledge the structural weaknesses in the DSGE framework and also that government guarantees won’t work if the government is viewed as risky.  My main difference with Caballero is my view that the government can easily be made risky by offering liquidity to financial markets.  The point here is that liquidity is a fine tuned public-private mechanism that will be destroyed by counting on one side to act as a liquidity provider.
[2] Andreades (1966). History of the Bank of England 1640 to 1903 reprint of 1909 edition, Augustus M. Kelley, New York, p. 198. Clapham,(1945).The Bank of England: A History, volume I, Cambridge University Press, Cambridge, pp. 271-2.
[3] Grigby v. Oakes, 126 E.R. 1420, 1421 (C.C.P. 1801). Cited in Horsefield (1944) “The Duties of a Banker II: the effects of inconvertibility,” Economica, p. 20-21.
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2 thoughts on “A lesson from history: the safety of government debt depends on private sector liquidity”

    1. Thank you for the link to your post. It’s good to see that there are others who recognize that the safe asset problem is essentially a private sector problem.

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