Sunday, January 20, 2013
I must be a dummy for not understanding the shortage of safe asset argument
I've never understood the global shortage of safe asset meme. I'm willing to be educated.
I know that Ricardo Caballero and Gary Gorton have written about the safe asset shortage problem. In the blogosphere it pops up in David Beckworth and David Andolfatto, and the folks at FT Alphaville can't talk about much else.
First, there seems to me to be definitional issues. What is a safe asset? Beckworth, for instance, describes them as "those assets that are highly liquid and expected to maintain their value." But liquidity and riskiness are separate concepts. There are many financial instruments that are very liquid yet risky—take the S&P mini futures contract, the most liquid futures contract in the world. There are many low-risk instruments that are illiquid—a 5 year non-cashable Canadian GIC being a good example. How are we to reconcile these oppositions into one definition?
Second, it seems to me that the concept of a safety is misspecified. How do we go about classifying safety? Is it a spectrum, or are there discrete categories of safety? If a spectrum, how are we supposed to measure degrees of safety or the lack thereof? Where do we get this safety data? Next, how do we get economy-wide gradiations of safety data?
If, on the other hand, assets are to be categorized into discrete buckets of safe and non-safe, how can anyone possibly know what asset goes in each bucket? Take a vote? Whatever Gorton says? Best 4 out of 7 rock paper scissors? At what point did Italian debt go from the safe into the non-safe bucket? Or the Zim dollar? The whole process seems ad hoc and impossible to empirically verify.
But ignore all these epistemological points for now.
Let's deal first with the word shortage. If society faces a shortage of safe financial assets, won't the prices of those safe assets immediately rise and thereby remedy the shortage?* If so, where's the problem?
Imagine a basic economy in which gold is the only safe asset and everything else is risky. There's a sudden demand for safety which means that a shortage of gold simultaneously appears in individuals' portfolios. What happens? The shortage can't be filled by gold production, supply is more or less fixed. So the gold price immediately triples. There's now enough gold to satisfy everyone's demand for safe assets.
A big part of the safe asset shortage meme seems to apply specifically to collateral. In our simple economy, if for some reason the gold market is broken, just convert risky assets into safe collateral by requiring a slightly bigger haircut than before. This is RebelEconomist's point here. Next, recruit formerly uncollateralized risky assets like pianos and grandfather clocks into serving as collateral and slap a bigger hair cut on them. Do this until the demand for collateral is met. End of story.
What does a shortage in financial asset markets even look like? I've seen shortages at Toys R Us when some new item arrives and the store manager hasn't properly anticipated demand. Lineups and unhappy customers are the result. But has anyone ever seen a lineup at the bid-ask spread for AAPL? The idea is odd. If you want to buy AAPL now, just take whatever is on offer at 601. Then take whatever is on offer at 602. Then 603. Repeat until you've bought every share that has ever been issued. The same with t-bond markets. Your demand will never go unsatisfied. No shortage here.
But maybe I'm putting too much weight on the word shortage. Maybe the problem is not a shortage per se, but the underlying increase in preferences for safety. If people's taste for risk changes, market prices adjust to a new equilibrium in order to satisfy those tastes. Why must this new distribution of prices be considered an aberration? Does the safe asset problem apply equally when people express their demand for more safety by purchasing fire extinguishers, guns, and home alarm systems? Would we then be talking about a shortage of safe consumables?
And lastly, back to the epistemological issue. I don't think we can get proof that we've got too few safe assets because we haven't properly specified the concept of safety, which means we don't have good data. Without good data, we can't be confident in any pronouncements concerning safe asset shortages.
So tell me why I'm a dummy.
[Update: David Beckworth responds]
*put aside the idea that some of those assets are "money", and therefore may be sticky.