Friday, February 22, 2013

The Safe Asset Shortage: A Review of the (Blog) Literature

There is a glaring omission in this look at what folks are saying. Can you spot it?
From the Bruegel blog:
What’s at stake: Safe debts – or what is often called information insensitive assets, as they do not suffer from the types of financial frictions that are characteristic to other financial assets – play a major role in facilitating transactions for institutional investors. And, as we have learned in the recent years, they also play a major role in triggering financial crises when they loose their safety status and turn into information sensitive assets. As central bankers start backpedalling on their commitments to increase the supply of safe assets and start worrying about the negative effects of the “search for yield”, there has been a renewed discussion in the blogosphere about the role of safe assets and whether they remain in short supply.
The role and evolution of safe assets
Gary Gorton, Stefan Lewellen, Andrew Metrick write that to the extent that debt is information-insensitive, it can be used efficiently as collateral in financial transactions, a role in finance that is analogous to the role of money in commerce. It is in this respect that information-insensitive or “safe” debt is socially valuable. In a chapter of the Global Financial Stability Report, the IMF writes that safe assets have four main functions: they are a reliable store of value, they provide safe collaterals, they serve as benchmarks to measure the relative risks of other assets, and have become a key ingredient to the prudency framework for banks.

Timothy Taylor send us to Gary Gorton, Stefan Lewellen, Andrew Metrick who have written a rare academic papers with a basic empirical finding that shakes up your mental landscape. They note that over the past sixty years, the total amount of assets in the United States economy has exploded, growing from approximately four times GDP in 1952 to more than ten times GDP at the end of 2010. Yet within this rapid increase in total assets lies a remarkable fact: the percentage of all assets that can be considered “safe” has remained very stable over time. Specifically, the percentage of all assets represented by the sum of U.S. government debt and by the safe component of private financial debt, which we call the “safe-asset share”, has remained close to 33 percent in every year since 1952.

The demand for safe assets and financial crises
Gary Gorton (HT Timothy Taylor) thinks that the way we think of crises in mainstream macroeconomic models – as being the result of a shock that then gets amplified – is misleading. We see a few really big events in history: the recent crisis, the Great Depression, the panics of the 19th century. Those are more than a shock being amplified. It’s a regime switch — a dramatic change in the way the financial system is operating. This notion of a kind of regime switch, which happens when you go from debt that is information-insensitive to information-sensitive, is conceptually different than an amplification mechanism.

Carola Binder helps us walk through the new paper by Gary Gorton and Guillermo Ordoñez called "The Supply and Demand for Safe Assets." In the model, there are normal times and crisis times. In normal times, the average land quality (a modeling simplification that basically encompasses all types of private collateral) is high enough that lenders are better off NOT paying the fixed cost to check the quality of the land (they’re information insensitive). The inefficiency from the financial friction is, therefore, avoided. However, there can be shocks to the average quality of land. Land quality may get low enough that lenders need to check the land quality before they accept it as collateral, resulting in economic inefficiency and a financial crisis. This is where Treasuries come in. Government bonds can also be used as collateral, and they don't suffer losses in value like land does....MORE
Here's the omission.