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?