Douglas Holtz-Eakin and Avik Roy: "You Know All That Stuff We Have Been Saying for Four Years? Nevermind!"
Paul Krugman: Paul De Grauwe and the Rehn of Terror

Readings from Jérémie Cohen-Setton and Martin Kessler of Bruegel: Safe Assets, the Downturn, and the Recovery

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Jérémie Cohen-Setton and Martin Kessler: Bruegel - The Brussels-based think tank: The excess demand for safe assets and the excess supply of goods:

Brad DeLong [says]… "John Stuart Mill… saw that excess demand for some particular set of assets in financial markets was mirrored by excess supply of goods and services in product markets, which in turn generated excess supply of workers in labor markets. If you relieved the excess demand for financial assets, you also cured the shortfall of aggregate demand" [for a recent formulation of these arguments, see Ricardo Caballero and Emmanuel Farhi].

  • When the excess demand is for liquid assets used as means of payment – for “money” – the natural response is to have the central bank buy government bonds for cash.
  • When the excess demand is for longer-term assets – bonds to serve as vehicles for savings that move purchasing power from the present into the future – the natural response is to induce businesses to borrow more and build more capacity, and encourage the government to borrow and spend.
  • When excess demand is for high-quality assets – places where you can park your wealth and be assured that it will still be there when you come back – the natural response is to have credit-worthy governments guarantee some private assets and buy up others. One way to understand European austerity is to say that yes having governments spend more money and continue to run large deficits will increase the supply of bonds and will thus relieve the shortage of longer-term assets. But if a government’s debt emissions exceed its debt capacity, all of that government’s debt will become risky and will thus create a shortage of high-quality assets.

And a lot more:

What’s at stake: Safe… information insensitive assets… do not suffer from the types of financial frictions… play a major role in facilitating transactions for institutional investors… [and] in triggering financial crises when they loose their safety status…. As central bankers start backpedalling "search for yield", there has been a renewed discussion…

The role and evolution of safe assets

The demand for safe assets and financial crises

  • Gary Gorton (HT Timothy Taylor) thinks… really big events… are more than a shock… a regime switch… [as] debt that is information-insensitive to information-sensitive…

  • Carola Binder helps us walk through the new paper by Gary Gorton and Guillermo Ordoñez…. Shocks to the average quality… lenders need to check… resulting in economic inefficiency and a financial crisis…. Government bonds can also be used as collateral, and they don't suffer losses in value…

  • David Beckworth explains that safe assets facilitate transactions for institutional investors…

Excess demand: why isn’t the price of these assets just adjusting?

  • JP Koning (HT David Beckworth asks a great question: Why do we need more safe assets? Why don't we just let the existing ones rise in value, thereby providing safety?…. David Beckworth writes that the problem is that safe assets… cannot make this adjustment when they are up against the zero lower bound (ZLB)…. Market segmentation is a controversial idea. Many observers don't accept it. But it seems like a compelling story for the transaction asset market at the ZLB. Empirically, it provides an easy explanation for why BAA-AAA corporate yield spread, junk bond spread, and other non-transaction asset spreads are getting closer to historical norms, while the BAA yields-10 treasury yield spread and the S&P500 earnings yield-20 year treasury yield spread remain inordinately high.

  • Paul Krugman considers that the search for safety is a distinctly secondary factor in explaining the low interest rates that we observe…

Excess demand: why isn’t there more supply?

  • Why then, is it hard to create safety? Ricardo Caballero writes… even credible private actors which transform financial micro-, localized risks are not equipped to create safe assets which cover macro-, aggregate risks…

  • Should we worry about public deficits becoming too small? Matthew C. Klein writes that by providing collateral, government bonds are complements, not substitutes, of private debt. Such concerns had already surfaced under the Clinton administration: Carolina Binder refers to a report written in the late 1990s when economists started to fear that public surpluses would starve the market of safe public instruments and lead to instability…. But of course, governments are themselves limited by a sustainability constraint on their debt. FT Alphaville even terms ‘most important chart of the world’ this picture of government bonds disappearing from the ‘safe’ category.

  • Another way to picture it comes from the IMF:

International causes and consequences

  • This perspective also brings many insights in the working of international economics. As described by Ricardo Caballero, the lack of saving vehicles for savers in emerging market countries… financial institutions began to search for mechanisms to generate triple-A assets from previously untapped and riskier sources. As shown by Hyun Song Shin… the global banking glut, rather than saving glut, is to blame for the build-up leading to the financial crisis.

  • Olivier Gourinchas and Olivier Jeanne argue that eventually a safe assets had to be backstopped by a monetary authority that the euro area lacks. They thus conclude that in the aftermath of the crisis, the dollar was reinforced as currency of denomination for safe assets (and global banking).