From FT Alphaville:
A recent paper by Ricardo Caballero and Emmanuel Farhi challenges some of the assumptions underpinning the current stance of monetary policy in the developed world, arguing that both quantitative easing and forward guidance are unlikely to be very effective.
The authors also add new dimensions to the commonly accepted New Keynesian wisdom on liquidity traps and fiscal policy, which they only partly agree with.
The paper discusses a model of what the authors call a “Safe Asset Mechanism” — essentially a safe asset shortage characterised by a period of “excess” demand for safe assets.
Below is a summary of the main points we took away from the paper, excerpting from it along the way, after which we add our own brief thoughts:
1) When in recession, a big enough shortage of safe assets leads to a “safety trap”.
Caballero and Farhi distinguish a safety trap from the Keynesian liquidity trap as follows:
On the aggregate supply side, corporations (including the financial sector) trade less potential production for safer revenue. On the aggregate demand side (the side we highlight), the Safe Asset Mechanism [SAM] is characterized by the strong downward pressure it puts on safe interest rates. If there is a limit on how much these rates can drop, a safety-trap emerges, akin to the Keynesian liquidity trap. In this context, a recession restores equilibrium in asset markets by reducing the wealth of safe-savers and hence their asset demand. Overall, SAM provides a parsimonious account for symptoms also found in environments experiencing the combined eff ect of a credit crunch and a liquidity trap....MUCH MORE
