Winner of the New Statesman SPERI Prize in Political Economy 2016

Wednesday 16 January 2013

Safe Assets and Government Debt

In my last post I outlined why a world in which the government owned assets rather than issued debt might be better, because it would allow us to reduce distortionary taxation. There is an alternative argument that appears to come to a completely different conclusion, and that is what I want to talk about here. It is the argument that we need more safe assets. As the safe assets argument relates directly to the recent financial crisis, it is also rather more immediate in focus than questions about what we should do about debt in the very long run when the recession is over.

Let me start with a caricature of the argument. The financial system, partly as a result of the entry of emerging markets, has a large and increasing desire for safe assets. This led, before the recession, to low real interest rates (supply and demand: if the demand for an asset rises faster than its supply, the return from it will fall): this was the topic of Bernanke’s savings glut story. (In terms of monetary policy, it influences what theory calls the natural interest rate, which is the medium term reference point for policy.) In an effort to satisfy this growing demand, the private sector attempted to create its own safe assets through securitisation and the like. This failed spectacularly, and we got a financial crisis. Only governments with their own central bank can create really safe assets. So we need more, not less, government debt. (For more discussion of longer term trends, see here. For whether there is continuing evidence of a safe assets shortage, see here)

Some aspects of this argument are not contentious. Government debt is safer because government has a unique ability to generate revenues to fund interest payments (taxation), and crucially it has a central bank behind it that can deal with panics. Obviously there are limits, and I’ll assume here that the government remains with those.

One response to the point that the financial sector failed to create its own safe assets, and that this led to the crisis, is that that sector should be better regulated. However, as Ricardo Caballero points out here, while a (well regulated) financial sector may be able to successfully handle micro risk, it will always struggle with macro risk. However there is still plenty of scope for disagreement on the ability of the private sector to manufacture safe assets: see for example here and here.

More problematic is the idea that government debt and private debt are complements rather than substitutes. In macro there are two benchmark approaches to this issue.

(1) The Ricardian model says that government debt does not crowd out productive capital: it is just deferred taxation, and so it creates its own demand. Consumers will not hold less private assets (like equities) just because there is more government debt around – instead they will just save more.

(2) The OLG (overlapping generations) model says government debt will crowd out private debt. Consumers hold assets to fund their retirement, and if the (risk adjusted) returns are the same, then they are happy to replace equity with government debt. Less equity debt means less productive capital, which will push up interest rates, but while this will mitigate any crowding out (if it increases savings), it will never altogether prevent it. Unless there is too much productive capital in the world (which few believe), crowding out productive capital is bad for society because we produce and consume less. This is a second reason, besides distortionary taxation, why government debt should be radically reduced.

In neither of these frameworks is government debt helpful in facilitating the creation of private debt. However this may just reflect the very simplistic view of the financial sector in macro. In reality collateral is all important in enabling the creation of risky financial assets. (One of the causes of the financial crisis was that large financial institutions had too little of it, and regulation is now forcing them to have more.) This idea is completely missing from the OLG framework.

A recent paper by Gourinchas and Jeanne which has received some attention online (e.g. here and here) suggests how the two views might be reconciled. (Non-economists can probably skip this paragraph, particularly as I am extrapolating from their Section 3 model in a way that may not be justified.) Default risk can be an increasing function of the ratio of private to public assets, because of this collateral effect (for some evidence, see here). Their paper suggests that, in general equilibrium terms, less default risk may increase the risk free real interest rate in an OLG type framework. So if increasing public debt reduces default risk, it may also encourage additional saving by raising the risk-free real interest rate. However (and this is the speculative bit on my part), unlike the basic OLG case, this higher risk-free rate may be associated with a lower risky rate, because the risk premium has fallen, so this additional saving may fund both extra public debt and additional productive capital.      

It seems to me, as we academics like to say, that this is a promising avenue for future research. Yet two (additional, and perhaps related) things remain unclear to me. First, is producing government debt the most efficient way for the government to reduce risk? Caballero in the piece referenced above suggests it may not be. Second, is the distinction between net and gross debt important here? Suppose a government did reduce its long term need to raise taxes by reducing its net debt position, but did this by buying assets rather than reducing its gross debt. Obviously by holding private sector assets it increases its exposure to macro shocks, but it retains its ability to cover those through either taxation or money finance, so its gross debt may remain safe. (Some of the commentary I have seen suggests it could just hold more cash at the central bank, but this does not seem tenable if we think, as seems appropriate here, about a consolidated government and central bank.) Could we this way have the best of both worlds in the long run: fewer distortionary taxes but also plenty of safe assets?


  1. The whole riskfree concept imho needs urgent revision.
    There are simply no real riskfree assets. What is considered riskfree has the full inflationrisk attached to it.
    Eg look at countries like Spain (eg re Basel stuff) assets that are deemed riskfree have a substantial default risk attached to it.

    Take Spanish gov. bonds overall they have default, inflation and exchange risk attached to them while for several purposes (and important purposes) they are assumed riskfree.
    And this huge problem is 'covered' effectively by the local CB and regulators.
    Printing your way out is no real option. Spanish example again. Legal part of default risk is gone but economic part therof is simply transformed into inflatioris. Other risks basically remain (original inflationrisk and exchangerisk).

    This looks now imho one of the main dangers in the current system. The eg Spanish state (Spain probably the most clear example and btw having an own CB only solves part of the problem (effectively the legal part of the deffaultrisk)). And has all the potential to become as big a problem as the rather dodgy bundling we have seen before.
    Effectively it already is. Eg Spanish bust banks are chained to the equally bust Spanish government if one goes the other will follow. Nothing riskfree or better free of risk about that.

    You can imho never have a properly working low risk system if these risks remain in the fundamentals of the system.

    Of course changing that will be a huge job, but it will have to happen one way or another.
    There are several options possible probaly leading to different outcomes re the long term debt system.
    But as it is a very long term issue, it is hard to see how any system can work that is built on basically garbage (the present concept, better concepts, of riskfree all through the system).

    The main underlying reason why the concept doesnot work and bears huge risks is imho the following: It is an economic concept that is for practical use being legalised. Legalised in the way that it could be officially legal or more unofficially in say the way banks operate.
    And basically the day-to-day users subsequently start working with the legal or legalised (the outcome of a formula is the deciding factor not the real world (as that one is too complicated)).
    And ending up with things that have hardly anything to do with the original economic concept and all through the system.
    Example. Sov bonds seen as safe in basically all situations (for bankreserve/capital purposes). A system that doesnot work with the EuroZone. A system that also doesnot work with most EMs and 3rd world, as they (still) have a lot of debt in foreign currencies etc.
    Leading to things like the ECB making a profit on Greek bonds they bought for 70 while the market price is 30. Or banks not able to sell sov debt as the market value is substantially
    below the bookvalue and they cannot afford to make the bookkeeping loss.
    In other words the system becomes legalised and the players (the important ones) start to play with the legal rules and forget all about the economic concept.
    And as far as riskfree is concerned this has gone allthrough the system.

    1. This comment has been removed by the author.

    2. I agree with the initial sentence, but I don't understand your reasoned justification for it. I get hung up on the ideas of a productive asset and a financial asset. A productive asset is, I suppose, one that produces an income stream to its owner. A financial asset is, I suppose, is one from which the income is in the form of money rather than some manufactured good.

      Money income that is generated merely by virtue of holding title to an asset is generally described as rent, and the accumulation of such assets seeking as a rent seeking. Rent seeking has a long history of being question as a socially useful activity. Right or wrong, this criticism won't go away, IMO. I think I understand why rent seeking is said to be bad, and I don't understand how the financial sector can exist without seeking rent.

      If the government were to purchase productive assets, thereby injecting money into the economy, would this really work? If the purchased assets were financial, the government would be engaged in rent seeking. Does this really help society? I dread to see the tortured reasoning of an argument justifying this action. And if the purchased assets were productive of actual commercial goods, the government would become a competitor in some commercial market. I fail to see how this could ever happen.

      So we are in a pickle, a very sour pickle.

  2. I am not very convinced by this 'safe assets' approach. Neither did I find your previous post on public debt very convincing. I think that we should think about public debt levels in function of domestic savings and domestic private sector borrowings.

    In Japan, public debt has become very high because domestic savings have remained high while domestic private sector borrowings have collapsed. In Australia and Canada, if I am correct, we have low public debt but high domestic private sector borrowings. Finland has low levels of public and private debt, but also a low level of domestic savings. Europe as a whole and the US are somewhere in between.

    What is better? What is worse? I feel that Japan is not in an optimal situation, as public debt tends to finance consumption rather than investments. But the subprime crisis has also demonstrated that high levels of private sector debt is not always healthy either. But perhaps that it is the level of savings that needs to come down.


  3. Can the experience of countries like Saudi Arabia, where oil provides the govt with all the resources one can hope for, add something to this debate?

  4. Why wouldn´t a government with net positive holdings be more able to produce “safer” assets that a government with net negative holdings? And as you say in the end, the amount of safe assets that the state produce should be viewed as orthogonal to its net holdings (not that it is today – but it should be a (almost) completely separate decision). The state could be leveraged in risky assets, financing it with safe assets.

    In the limit, a set of diverse competing mutually independent government investing firms holds the equity of all the means of production, and risk adverse individuals save through safe assets.
    (i.e. like “pragmatic market socialism”)

  5. PS: I dare you to name your next post about this “Should we move towards a socialist economy?”. That would be legendary.

  6. How is a stock of government assets that pay a yield different to a Georgist Land Tax? The land tax seems to be equivalent of the government decreeing that it owns all land and receiving rents from it, i.e. having a paying asset.

  7. Hi Simon. I agree that my presumption that government would place excess cash on deposit at the central bank would create problems. Are you thinking that the government might for example take stakes in private enterprises, thus building up a stock of risky financial assets? Although government wouldn't be running a deficit, wouldn't the presence of those assets on the government balance sheet represent an increase in risk threatening the safety of the debt? After all, in the end it is the government's ability to tax its population that makes the debt safe - but those same taxpayers would also be on the hook if the value of the government's stock of risky assets fell, say due to corporate failures. In the end people can only be taxed so much.

    1. Frances - Yes, I am thinking about the government investing in risky assets. One question is whether it could do so in a way that avoids being captured by special interests i.e. whether it could avoid choosing which companies to invest in. Even if it could, I think you are right to be concerned that this would make government debt riskier, but I'm not sure by how much. In a sense we have just seen an experiment along these lines, where the UK government took large stakes in banks that otherwise would have crashed. This does not seem to have had a major impact on the interest rate the government has to pay on its debt.

    2. Simon,

      No, there doesn't seem to have been much effect on interest rates, though of course QE has been distorting yields. However, the government has maintained throughout that the presence of RBS and Lloyds on its balance sheet is a temporary phenomenon and the intention is to return them to the private sector - as it has already done with Northern Rock. I don't think a temporary acquisition with a clearly-stated intent to divest as soon as practicable would have much effect on long-term borrowing costs - if it did, it would indicate that investors simply don't believe government statements. But deliberate acquisition with the intention of holding it indefinitely surely would have more impact. Do we have any information from the past, or from other countries, on the effects of nationalisation on interest rates?

      The "picking winners" problem is the usual argument against government taking stakes in the private sector, of course. I'm not entirely sure why government is supposed to be so much worse at this than the private sector. But if it is, then the obvious thing to do would be to use private sector expertise to manage what would be the government's investment portfolio.

  8. [...] Although the debate appears to be dying down, at least momentarily, Simon Wren-Lewis and Frances Coppola (see here, here, and here) have added worthwhile readings. [...]

  9. Solving the position of the outside world looks to me for a century long modell more important than solving the lack of risk free assets. As said earlier it is hard to see that the present concept of riskfree will survive that long with all the weak points it shows.

    Or come up with an other better concept for riskfree first if you likley need it.
    At least start with a proper and consistent definition of default. And not the quasi legal one now used. Markets look mainly at economic issues and not legal ones. A 30% haircut isnot much different from losing 30% on inflation not taken into consideration. There is a difference an official (and what is official in this respect for countries) default gives a bigger mess so you likely need a higher rebate to compensate that.
    Anyway the way it is done now is simply heavily oversimplifying and again makes a modell using it practically probably pretty useless. A modell should include all relevant issues complicated or not and not as it looks now leave the things that are too complicated out forr being simply too complicated.
    Anyway no practical situation doesnot have a huge foreign influence, assuming that it isnot that way simply rubbishes any modell.

    On the present interest. Doubtfull if the present situation can be used as a standard example. Basically there are 2 forces printing on one side (or fear thereof) and deleveraging on the other. Combined with limited other safehaven (safehaven could be riskfree but is not necessarily that btw) options and the present CB policies, this summarises the present situation. Doubtful if that is all applicable in other situations.
    It could even be a temporary thing. In the way that markets everything else being equal (with the debtor) looks at it differently in a few years time. It happened with Spain and Italy.
    Problem being that if that happens there will be not enough time as things show now to adjust. A thing that the present situation shows is that adjustments go very slowly and if the marketconception changes a country can be dumped in weeks.

  10. Government debt is not a net asset. It’s matched by a liability - “held” by non-debt holders to pay interest (via tax) and a liability to eventually repay the capital. Now that’s a conundrum - to which I think I have the answer, but not enough space here. Might put something on my own blog.

    Next point: if there really were a serious shortage of safe assets, the private sector would hoard an obvious safe asset, namely cash, and we’ have serious paradox of thrift unemployment. Now we don’t have much unemployment of that sort do we?

    Of course unemployment is higher than we’d like, but so too is inflation, thus it looks as thought that unemployment is caused more by a deterioration in the relationship between inflation and unemployment rather than paradox of thrift.

  11. Nice article, thanks for the information.


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