“All Models Are Wrong, But Some Are Useful”: Safe Asset Shortage Edition

“The national debt as a share of gross domestic product has more than doubled since 2007, to around 75%, but net interest payments on the debt have actually declined,” the Wall Street Journal reported earlier this week about the U.S.

This is why we desperately need a model that includes the portfolio balance channel (PBC) as well as the safe asset mechanism. If the safe asset effects outweigh the PBC, the Treasury should be taking this opportunity to supply those safe assets at today’s low interest rates and avoid refinancing risk for the next 50-100 years the way many countries already have this year: by issuing long-term debt.

If, however, the PBC is the dominant stimulus channel, the government should not be issuing long-term debt as it would partially offset the benefits of the long-term investment that would be “crowded in” now with long-term yields near record-lows.

Arguably, a compromise could be found in issuing more short-term debt and/or making the Fed’s newly-created overnight reverse repurchase (ONRRP) mechanism a more permanent, accessible fixture; the result would be a higher supply of safe assets without increasing the total duration risk of outstanding government debt and crowding out long-term investment.  To be sure, this would increase long rates, but not by tightening financial conditions; long rates would rise as a result of a decreased demand for safe assets at the long end (to the extent that short-term safe assets are a substitute), making any given federal funds rate target more stimulative.

(Note: while T-bills (or ONRRP assets) would be a substitute for longer-dated debt to some extent, they wouldn’t be perfect substitutes.  They are zero beta assets but are not quite the negative-beta T-Bonds which are safer and can be used as a better hedge, especially long-term.  Too, the government would not get to reap the benefits of the currently-negative term premium.)

The Financial Times Alphaville team has argued that issuing short-term debt instead of long-term debt is no solution because financial engineers will then create phony long-term assets like the Alt-A and subprime mortgage-backed securities of the pre-crisis era that merely created an illusion of safety.  However, that concern ignores the fact that the firms securitizing and selling those securities were largely financing that process by using them as collateral in the asset-backed commercial paper market—a short-maturity market which, since proving in the financial crisis to lack the safety it once advertised, has withered (see figure).

AB Comm. Paper Outstanding.jpg

Higher short-term, government liability issuance would have satiated investor demand for short-term safe, money-like assets and prevented their flight to the privately created commercial paper assets that proved to be only superficially safe.  When housing assets turned toxic, this private, not-federally-insured maturity mismatch contributed to a market-wide run on assets and credit crunch that gave us the Lehman Brothers collapse and even led a money market mutual fund to “break the buck.”

The world economy has a safe asset shortage but is not ready for higher rates or a stronger dollar.  Given the knock-on effects of weak global growth on the U.S. and the Fed’s proximity to the zero lower bound, the U.S. government should should embrace its exorbitant privilege as the world’s most important safe asset creator and boost its liability issuance at the short end of the yield curve.


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