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.

The Central Bank is not a Deus ex Machina 2

Brad DeLong muddles his history of central banking.  First he starts by discussing central bank support of government debt and then he supports his argument with evidence that the central bank was lender of last resort to the private sector.

The Bank of England was founded in the 1690s to fund the British debt.  In 1711 the Bank was required by law to discount exchequer bills on demand.  As North and Weingast observed in their seminal paper, the Bank’s support of government debt (e.g. through discounting exchequer bills) was crucial to the British ability to finance (and win) the Napoleonic Wars.  This is indubitably an important role of a central bank — but then every British county wasn’t issuing its own debt and the Bank certainly wasn’t buying the debt of the counties.   The modern European situation is more complicated than the early British case.

The lender of last resort role that DeLong claims “got its start” in 1825 was played by the bank in 1763 at end of the Seven Years War, in 1772 not altogether willingly after causing the collapse of the speculative activities of Alexander Fordyce’s bank, in 1783 at the end of the American Revolution (anticipating the normalization of trade the Bank in fact conserved gold reserves that fell to 8% by favoring private credit and restricting discounts of exchequer bills) and of course in 1797 when the strains of financing the wars led the Bank to seek authority for an emergency suspension of gold payments from the Privy Council (later confirmed by Parliament).  (See Clapham’s history of the Bank of England and Jacob Price’s articles on the Bank.)

Finally, once again we see that DeLong grossly misinterprets the point of Lombard Street.  Bagehot most definitely did not support lending against assets independent of the quality of their origination.  He states explicitly:

The cardinal maxim is, that any aid to a present bad Bank is the surest mode of preventing the establishment of a future good Bank.

It happens, however, that in 19th century England the combination of personal liability of the banker and capital calls on shareholders to honor the debts of bankrupt joint banks was sufficient to ensure that origination practices were extremely careful.  Needless to say when origination practices are sound, a central bank’s practices do not need to be “over-nice.”  However, when rot has been allowed to grow in the financial system to the degree that the largest banks are being sued for fraud over their origination practices of their loans, central bank practices will have to be more careful than those of the19th c. Bank of England — at least if the goal of the central bank is to preserve financial stability (and not simply to bail out the banks).

The Central Bank is not a Deus ex Machina

Prominent commentators, whose positions of respect are well-earned, are calling for the ECB to take on the role of lender of last resort.  While I agree that this is part of a complete solution to the Eurozone crisis, I think it is far from clear that now is the time for the ECB to take on this role.

The underlying problem in the Eurozone is the intra-European balance of payments problem.  Until a politically feasible plan to manage European imbalances is in place, the aggressive action by the ECB, called for by Martin Wolf and Paul DeGrauwe, may well turn out to be nothing more than a palliative.  Such palliatives are dangerous, because the need for political action is so great that anything that lulls Europe’s politicians into a sense that they do not need to act boldly today, may have the effect of aggravating the fissures leading to crisis and create a problem that is even harder to resolve.

My reference point in these thoughts is the central bankers’ decision in 1925 to work with the Bank of England in its project of maintaining the peg to gold.  Over six years the imbalances that made the peg unsustainable did not resolve, but instead were aggravated by politicians making parochial decisions and by a general sense of stability that allowed imbalances to grow ever greater.  In 1931 when Britain finally abandoned the peg to gold, the world economy faced a greater crisis than it probably would have faced in 1925.

I think the ECB is doing a good job of making sure that the politicians know that they are the ones who need to act.  While none of us can be sure that Europe’s politicians will successfully muddle through and give birth to a stronger Eurozone, the likelihood of success is much greater while the pressure of looming financial crisis bears heavily on the shoulders of the politicians.

Assume a can-opener …

Chris Edley (via Mark Thoma) writes that Treasury should advance funds to the states:

Of course, when Treasury eventually collected what it was owed, the state would have to cut spending or find new revenue sources. But that would happen after the recession, when both tasks would likely prove easier economically and politically.

Arguments that are premised on the inevitable return of economic growth to rescue us from our folly sound remarkably similar to what was being said in the 20s and early 30s.  (Revisions of German reparation plans and the CreditAnstalt’s bailout of the Bodencreditanstalt bank were expected to work because of the coming economic recovery.)

Given the state of the world economy right now doesn’t it makes sense to work on a solution that can have a moderate degree of success even if we have economic stagnation for a decade or two.

Will the rescue of Greece just be another bank bailout?

EBRD Head Warns Against Banks Absorbing Costs Of Greek Rescue

This is in response to German objections to a plan that would require the loans to be junior to existing bondholders (via ZeroHedge).

Query:  Has the IMF ever given a developing country a loan that was junior to existing bondholders?

As in the ’30s it looks like the bailouts will continue — until economic forces make them impossible (e.g. CreditAnstalt).

Who really thinks that postponing crises solves them?

On Lords of Finance 2

Having finished Lords of Finance over the holidays, I conclude that it is an excellent introduction to the role of reparations and war debts in the problems of the 1920s and 30s.  While I have always been told that reparations played a crucial role in the unravelling of Europe’s economies and polities, because these are problems of macroeconomic payment flows, the level of abstraction at which they are usually discussed has always left me in a state of incomprehension muddled with disbelief.

That Ahamed manages to present the problems of reparations in a down to earth manner that simply makes sense is an achievement in itself.

In short, despite its faults I would recommend Lords of Finance to students of the Depression because it presents the big picture of the interrelated macroeconomies with the full gamut of complex payments issues in a very accessible manner and thus can be used as a framework in which to place the pieces of a more careful study of the period.

In one sentence:  First read Lords of Finance; then you’ll be ready to absorb the overwhelming detail of Eichengreen’s Golden Fetters.

On the maturity distribution of the public debt

In 2009 we reached the point where almost 50% of the debt outstanding was due in one year or less.   (Table B88 of the 2009 Economic Report of the President indicates that from November 2007 to November 2008 the fraction of the debt due in one year or less increased from 34% to 48%.)  In 2009 Treasury has worked at restoring balance to the maturity distribution of the debt, which since the late 80s has been approximately one-third less than one year maturity, one-third one to five year maturity and one-third long-term debt.

Given that this transition has been taking place throughout 2009 and that it does not appear to have adversely affected the prospects of recovery (such as they are), returning the maturity distribution of the debt to its historic norm seems to be a reasonable goal.