Is modern finance the source of secular stagnation?

The recent discussion of secular stagnation has once again brought up the question of whether there is a “savings glut” that is aggravating our problems. To the degree that a savings glut exists, it generally has the property that it is focused on the safest assets. That is, for reasons that remain unclear, the collapse of returns on safe assets has not be sufficient to turn this “savings glut” into a vast flow of funds into real-economy risky assets.

I believe that there has been too little discussion of the possibility that the marginal “investors” who have created the savings glut are to be found in the financial industry itself. Although it is certainly true that after the Asian crisis developing countries became net savers — and I do not discount this factor in the flow of savings — at the same time there was a significant transformation of the financial industry. The growth of derivatives was accompanied by the growth of the collateralization of derivatives and the latter phenomenon accelerated after the LTCM crisis which took place one year after the Asian crisis. Thus a non-trivial component of the “savings glut” is likely to be the demand for collateral of the financial industry itself. This source of demand can also explain the strong preference for “safe” assets, since risky assets can easily become worthless as collateral in a liquidity crisis.

If my thesis is right, then Basel III is probably aggravating the “savings glut” problem by increasing the demand for collateral on the part of financial institutions. Thus there has recently been discussion of the existence of a collateral shortage, which sounds to me like the mirror view of a savings glut. (Note that the question of a collateral shortage is complicated by the fact that collateral circulates just like deposits in a banking system, but this issue goes beyond what I want to address in this post.)

One problem with a “savings glut” that is generated in significant part by a demand for assets to be used as collateral is that it is likely to create a segmented markets effect: that is, a significant demand for highly rated assets can coexist with very tepid demand for typical, real-economy, somewhat risky assets that don’t have good characteristics as collateral. This kind of demand for assets is unlikely to play a part in economic recovery by supporting an increase in lending.

The basic problem is this: If the role of the banking system in the economy is to manage and to bear risk for the rest of the economy, then trying to make the banking system “safe” by requiring it to hold vast amounts of collateral and by making it distribute to others the risk that it is supposed to be bearing may actually prevent it from performing its role in the economy. If our banking system is no longer capable of bearing good old-fashioned credit risk, but must find others upon whom to lay that risk, then we should not be surprised that the outcome is low levels of lending to the real economy, low investment, and poor growth. In short, we cannot make the financial system “safe,” by discouraging it from carrying real economy risk, because that undermines economic growth and the performance of all assets.

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