Category / Economic Theory

Community service, and economics too December 3, 2012 at 6:53 am

The University of Missouri at Kansas City has its own currency. It’s called the buckaroo, and it teaches students about currencies, while encouraging them to do community service. Warren Mosler explains:

  • All students are required to submit 20 buckaroos by the end of the semester to get their grades. Buckaroos can be earned by doing designated community service jobs.
  • There is no limit to how many buckaroos a student may earn.
  • Buckaroos are freely transferable.

UMKC, being a fiat issuer, can create as many buckaroos as it wishes: and it creates one whenever a student completes an hour of community service. There is a zero interest rate policy in effect, and the value of the buckaroo vs. the dollar depends on what a student will spend to evade an hour of community service. Moreover, not only does UMKC’s deficit exactly equal the buckaroos saved by the students, the value of the currency depends entirely on UMKC’s ability to tax students in buckaroos. Educationally neat, methinks.

Dilution-based monetary transmission November 2, 2012 at 8:17 am

From the Economist:

In Britain, the monetary base is 334% higher than it was six years ago, reserves at the central bank are 909% higher but broad money is only up 47% and bank lending to the private sector has risen just 31%, In other words, the money multiplier has collapsed.

So how can central banks encourage commercial bank lending?

Charles Goodhart has an interesting suggestion: any bank which failed to increase lending by a certain percentage would be forced to issue equity to the government, a kind of backdoor nationalisation. Nice.

Doug’s excellent comment – impossible stability October 27, 2012 at 7:43 pm

Regular commenter Doug made a particularly insightful comment to my post last week about safe assets. His basic point is that

Many people would be able to shift economic consumption across time and different states of the world. If I’m a pension fund I want to secure access to aggregated medical care for my pensioners between 65 and death. If I’m a homeowner I want to obtain be able to get a new house in case of natural disaster. If I’m saving for retirement I want a condo in Florida 30 years from now.

It is the function of the financial system to do this.

We simply choose our maturity, risk, terms of payment, etc from an array of standard contracts at listed prices. Then … we can rely on major banks or insurance companies to deliver what they’ve promised 99.99% of the time.

We can’t expect this to happen 100% of the time. If the Borg make it to earth, or the Yellowstone caldera blows, or there is a civil war in China, all bets are off.

The point, though, is that there are tail risks which we have a choice about. We can either back them by the state (assuming that the state can afford them), bear them without backing, or redesign the system to mitigate them. A good example is pensions: we try to help people save for retirement through a combination of regulation and tax breaks, but we also provide the pensions protection fund to mitigate the tail risk of fund insolvency.

The key observation in the safe asset hypothesis (that the supply and demand for safe assets are important macro economic variables) is that if genuinely safe assets are not available to support a financial system function, then pseudo-safe ones will be substituted, possibly leading to disaster – or at least calls for a bail-out. (Some) states can fix this by proving safety, either in the form of a guarantee, or by providing more safe assets. I’m not saying that they always should: merely that there is a choice about which risks the government backstops, and that by observing the risks that the system tries to hedge, useful macro prudential information can be gleaned.

I see CCPs as a (flawed) attempt to move risk further out in the tail. Instead of the failure of one OTC derivatives dealer, we have the failure of enough of them to bring down the CCP. Naively* we have substituted a higher probability lower (not low) impact risk for a lower probability higher impact one. The interfluidity proposal on stochastic failure I posted about a week or so ago is equivalent to the argument that we should go the other way – try to create a financial system with more, lower impact failures.

Doug’s right, we can’t reduce failure probability of either institutions or the system to zero. But we can change both who bears the costs of mitigation, and how much mitigation, to what risks, is done. Yes, a sufficiently big shock will cause any system to fail, but clever design can help improve robustness under less severe shocks. In many ways we over-emphasize the study of crises: we also need to remember when something went wrong and the system coped, for those occasions have valuable lessons too.

*Whether it is lower probability or not is of course debatable.

The self destruction of the 1% October 22, 2012 at 6:57 am

I’m late to this, and out of the office today, so let me leave you with Chrystia Freeland’s fascinating New York Times opinion piece from a week ago, The Self-Destruction of the 1 Percent. Happy creeping Serrata.

Meet the world’s worst central banker September 29, 2012 at 5:59 am

I won’t keep you in anticipation: the title is from the Atlantic, and it’s the Bundesbank’s Jens Weidmann. Now, worst is perhaps a stretch, but he is certainly the world’s most dangerous central banker. As the article explains:

As Germany’s member of the European Central Bank’s (ECB) governing council, Weidmann has opposed doing anything to solve the euro crisis. Because, inflation! (Pay no attention to the core inflation behind the curtain of 1.5 percent in September). Weidmann is one of those people who thinks it’s always 1923

Given that Weidmann is, pace 1923, unlikely to get a dose of new objectivity, the best we can hope for is for his credibility to fall further. That makes commentary like the Atlantic’s particularly valuable.

What’s good for the goose August 21, 2012 at 12:33 pm

Aditya Chakrabortty makes an interesting point in today’s Guardian:

After the drubbing in Atlanta in 1996, from which Steve Redgrave and Matthew Pinsent brought home Britain’s single gold, lottery money was pumped into elite sports… The result? Dramatic improvements at every Games since, with 29 golds scored at London this summer. Much of this is down to remarkable talent and gruelling training, for sure. But it is also one of the most significant public-sector successes in recent British history: £511m was spent in the run-up to these games, most of it from either the Lottery or the Exchequer…

I can think of lots of private companies less exacting with their cash than UK Sport. Its Investment Policy and Principles speak of a “no-compromise” approach and “a willingness to realign funding in the light of persistent under- or over-performance”. In other words, only potential medallists need apply – a philosophy that applies to whole sports, such as handball, as well as athletes… There is no denying that this policy – of picking winners and backing them – works.

There are lessons to be learned from our Olympics achievements. Britain’s economy is mired in a historic slump, which the government is making worse by cutting spending… Cabinet ministers bang on about growing our manufacturing base, and yet their solution is to spread a little bit of money very thinly. To do otherwise, they claim, would be to pick winners and we know how badly that ends. Really, there’s something wrong with picking winners? Tell that to Bradley Wiggins.

But of course while it is acceptable to the Tories to support sporting success, manufacturing or industrial winners are another matter entirely: they could not be more mistaken. Still, with the worst chancellor of the modern era, is it any wonder that we have yet again fallen into deficit?

Below zero August 18, 2012 at 2:11 pm

An interesting observation from the Bond Vigilantes, which moreover has implications for interest rate models that are floored at zero:

As investors we get used to living within certain recognised bounds. For example, it has been commonly assumed that interest rates cannot be sub-zero. There has been the odd historical quirk when we’ve seen negative rates (Switzerland in the 1970s), but that’s more for amusement than general investment consumption. However, there now appears to be the potential for a major investment climate change… Theoretically, a negative interest rate sounds simple – you put £100 in the bank and you get £99 back a year later if the rate is -1%. A rational investor would of course have the alternative of simply keeping their cash under the mattress and not suffering the negative rate, although the incentive to behave rationally would be limited by the administrative burden and security risk of holding cash. The central bank could simply limit this activity by basically not printing enough cash. Therefore the vast majority of money would have to be held electronically and could therefore suffer a penal negative rate. Implementation of sub zero rates is possible.

Their point about the mechanics of negative rates is interesting; absent enough hard cash for investors who wish to hold it, it’s easy to implement negative rates. One does rather wonder what would happen if a lot of cash was tied up under beds though; would the relevant central bank find themselves pressured by cash liquidity issues into printing (somewhat) more cash, much of which would immediately disappear from circulation?

It’s all about the carry July 17, 2012 at 9:13 am

I have long argued that there are (at least) two things missing from the traditional account of bank credit creation:

  • Capital, because you can’t make a loan without having capital to support it; and
  • Carry, because the real asset/liability mismatch is that in making a loan you expect its cost of funding to be less than its return, so you are creating future profits. In other words, the action is going on not in the present – where the asset (the loan) and the liability (the deposit) match – but in the future, where the cost of ongoing funding is less than the income of the loan.

The as-ever-excellent Steve Randy Waldman at Interfluidity points out the power of banks lies in their ability “to issue liabilities that are widely accepted as near-perfect substitutes for whatever trades as money despite being highly levered.” In other words, what makes banks unique is that they can fund themselves cheaply and thus have a positive spread on loans which accrues to a relatively thin slice of capital.

Why does this work?

  • Banks take interest rate risk in funding – borrow short and lend long – which on average makes money if yield curves point up.
  • Banks are diversified pools of credit risk, so as long as diversification works, then the pool is better of credit quality than the component loans especially once you add in a small amount of equity as credit support.
  • Banks can fund themselves cheaply via deposits because many deposits enjoy government support – i.e. there is an implicit state subsidy.

Bank profitability is vital to the creation of high powered money, because profits (once audited) can become retained earnings and hence capital. Thus in the steady state the dynamic is capital supports risk which supports a high rating which gives a low cost of funds which creates profitability which creates more capital.

This pleasant (for bank shareholders at least) spiral breaks down if

  1. Capital requirements go up;
  2. The amount of capital the market requires to support a given cost of funds goes up;
  3. The yield curve flattens; or
  4. loans become less profitable (either because demand falls, credit spreads fall or defaults go up).

If you want to understand the parlous state of banking it suffices to observe that all four of those things have happened in the last four years.

Quote of the day July 8, 2012 at 10:56 am

From John Hempton:

There is no reason at all to think the market clearing real interest rate has to be positive – indeed given the nature of the incremental savings pool in the world there is a reason to think the reverse.

Very true.

Update. As if on cue, FT alphaville reports

After the ECB lowered it’s interest and deposit rates on Thursday, the Danish central bank, Nationalbanken, followed a few hours later… The new rates are 0.2% for the lending rate, zero for the discount rate, and minus 0.2% for the CD rate.

Rehypothecation as a money multiplier July 4, 2012 at 6:38 am

The title says it all, really, and Manmohan Singh – in a truly excellent post on VoxEU – goes through the details.

re-use of pledged collateral creates credit in a way that is analogous to the traditional money-creation process, i.e. the lending-deposit-relending process based on central bank reserves. Specifically in this analogy, the bonds [pledged] are like high-powered money, the haircut is like the reserve ratio, and the number of re-pledgings (the ‘length’ of the collateral chain) is like the money multiplier.

To get an idea on magnitudes, at the end of 2007 the world’s large banks received about $10 trillion in pledged collateral; since this is pledged for credit, the volume of pledged assets is a good measure of the private credit creation. For the same period, the primary source collateral (from hedge funds and custodians on behalf of their clients) that was intermediated by the same banks was about $3.4 trillion. So the re-use rate of collateral was around 3 times as of end-2007. For comparison to the $10 trillion figure, the US M2 was about $7 trillion in 2007, so this credit-creation-via-collateral-chains is a major source of credit in today’s financial system.

Singh then points out that in rehypothecation-as-credit-creation, there are three distinct ways of reducing credit:

  • Increase the haircut;
  • Reduce the supply of assets that can be used for pledging; or
  • Short the re-pledging chain.

Singh claims, plausibly

With fewer trusted counterparties in the market owing to elevated counterparty risk, this leads to stranded liquidity pools, incomplete markets, idle collateral and shorter collateral chains, missed trades and deleveraging.

…the ratio of pledged-collateral (which is a measure of the credit thus created) to underlying assets falls as this onward pledging, or interconnectedness, of the banking system … decreased from about 3 to about 2.4 as of end 2010… These figures are not rebounding

This is about a 20% reduction, or $2 trillion of liquidity departing the system.

Unsafe into safe: the transubstantiation of risk (revised) June 29, 2012 at 11:51 am

Izzy Kaminska has a truly excellent post on FT alphaville about government policy in a downturn, safe assets, and investor perceptions. This very much fits with the central bank policy on the asset side theory that I have discussed before.

To see her point, let’s split the totality of investable assets into two classes, safe and unsafe. Now ‘safe’ can’t mean absolutely safe – no asset has any value if the earth is hit by a comet the size of the moon – but rather ‘thought of as safe enough’. This is of course a simplification, but a useful one.

At any time investors have a certain amount of money to invest (or divest), and a preference as to the proportion of safe assets they want.

What Izzy points out is if there is a substantially greater demand for safe assets than supply of them, there will be two effects. The first is obvious – safe assets get more expensive (think Bunds). The second is less so – that if governments let investors withdraw too far from risk, then the economy tanks, tax take tanks, and so government bonds become less safe. In other words, as Izzy says, the flight from risk can ‘compromise the safety of supposedly risk-free assets’.

There is no escape here: doing nothing, or even worse being austere, has its own dangers (as Krugman and DeLong among many others have pointed out).

How should governments respond? One possibility is a kind of Keynesian stimulus where the government steps in and buys risky assets, while providing more safe assets. In other words, they effect a transubstantiation in order to ensure that investors’ preferences are (closer to being) met. Of course, if they do this too much, government bonds become risky, but since ‘risky’ is an opinion not an objective fact, they can do some of it. Moreover the bigger the government, the more they can do of it. The Central Bank of Estonia can’t do much about risk in its economy by itself, but the ECB issuing jointly guaranteed Eurobonds could do a great deal.

If you buy this account, then you have to accept that QE isn’t a good tool. In particular it does nothing to address the mismatch between the supply and demand of risky assets. Indeed, buying long maturity treasuries with new base money arguably makes the problem worse by removing some safe assets from the system. What the central bank should consider instead is buying risky assets with that new money.

A good first step here would be having some idea of what investors’ aggregate safe/unsafe asset preference is at any given point. A comparison of that with the relative proportions of safe and unsafe assets in the local investable universe would at very least be an interesting piece of information for a central banker to have.

Balanced economic analysis May 21, 2012 at 8:57 am

New Bank of England

With all the recent gloom on the UK’s economic prospects if the Eurozone goes into meltdown, it is a relief to read a balanced, nuanced analysis. From the Daily Mash:

Britain will be a prehistoric barter economy within two years, the Bank of England has predicted.

The bank’s latest projections show that negative growth and the collapse of the eurozone will create an economic system based on flint axes, chickens and shiny stones.

Is this really much less plausible than some of the Bank’s predictions? Therefore, in the spirit of providing a helpful tail risk hedge, let me present a possible new location for the Bank if things do get really bad. It needs a bit of work, true, what with the missing roof and all, but you could store quite a few shiny stones there.

Reserve substitution and the money multiplier May 10, 2012 at 7:40 am

In an important and interesting article on VoxEU, Singh and Stella discuss a new and to my mind convincing analysis of the money multiplier (or the lack thereof). It is well known that, despite a massive increase in central bank money, there has not been anything like the concommitant increase in credit that the multiplier would predict. Singh and Stella have two explanations:

The first relies on a correct interpretation of the liquidity needs and management of a modern financial system which comprises not only conventional banks but also financial institutions operating in their shadows. Such non-bank financial institutions do not have access to monetary base as they hold no reserves at the central bank. Instead they rely on their access to the repo market predicated on their ownership of what is perceived to be highly liquid collateral.

Due to this shift, the liquidity fulcrum of the pre-crisis US financial market was composed only partly of central bank liabilities—and it was a very small part. More importantly, the magnitude of the liquidity fulcrum was determined not by the monetary policy authorities but instead by market practice. The nature and volume of assets determined by the market to be acceptable collateral is the key.

I absolutely agree with this, which is why in the past I have suggested that the central bank consider not one but three policy tools; the rate at which it provides money (as usual), but also the amount and the collateral against which it will lend. Central banks should explicitly the implications of their definition of eligible collateral and, if necessary, change it. That is because collateral is in competition between being used at the central bank and being used in repo. As S&S explain:

The enormous increase in bank reserves reflects a substitution of monetary base largely for highly liquid government securities in private-sector portfolios. But as government securities serve as collateral in the private-credit market, the effective size of the market liquidity fulcrum is unchanged by such operations. Little wonder then that market liquidity conditions remain tight despite the increase in bank reserves. That is, although quantitative easing which merely swaps bank reserves for US Treasury bills increases the textbook monetary base and “should” lead to an increase in market credit, in our view this accomplishes virtually nothing in terms of easing liquidity pressures. It merely changes the composition of assets within a given sized liquidity fulcrum.

Central bank operations only create new liquidity if they take as collateral assets that are no longer accepted at full value as collateral in the market.

The part of the story that S&S are missing is the impact of capital. Banks don’t just need funds to lend, they also need capital to support the risk of lending. Add in that dynamic (and understand the impact of rehypothecation), and I think you have a much more convincing account of the money (de-) multiplier than the textbook one.

(HT FT Alphaville.)

What are companies for? April 7, 2012 at 1:54 pm

This is really a placeholder for something I want to get back later: the question of what corporations are for. It’s inspired by an article by Ken Jacobson on the Salon website:

“It is literally – literally – malfeasance for a corporation not to do everything it legally can to maximize its profits. That’s a corporation’s duty to its shareholders.”

Since this sentiment is so familiar, it may come as a surprise that it is factually incorrect: In reality, there is nothing in any U.S. statute, federal or state, that requires corporations to maximize their profits. More surprising still is that, in this instance, the untruth was not uttered as propaganda by a corporate lobbyist but presented as a fact of life by one of the leading lights of the Democratic Party’s progressive wing, Sen. Al Franken. Considering its source, Franken’s statement says less about the nature of a U.S. business corporation’s legal obligations – about which it simply misses the boat – than it does about the point to which laissez-faire ideology has wormed its way into the American mind.

The notion that the law imposes a duty to “maximize shareholder value” – a phrase capturing the notion that profits are mandatory and it is the shareholders who are entitled to them – is so readily accepted these days because it jibes perfectly with assumptions about economic life that constantly come down to us from business and political leaders, from academia, and from the preponderance of the media. It is unlikely to occur to anyone under the age of 40 to question this idea – or the idea that the highest, or even sole, purpose of a corporation is to make a profit – because they have rarely if ever been exposed to an alternative view. Those in middle age or beyond may have trouble remembering a time when the corporation’s focus on shareholders’ interests to the exclusion of all other constituencies –customers, employees, suppliers, creditors, the communities in which it operates, and the nation – did not seem second nature.

This narrow conception of corporate purpose has become predominant only in recent decades, however, and it flies in the face of a longer tradition in modern America that regards the responsibilities of a corporation as extending far beyond its shareholders.

What I want to know, specifically, is whether the claim ‘there is nothing in any U.S. statute, federal or state, that requires corporations to maximize their profits’ is true. It’s just that, shockingly, there are some seemingly factual statements on the internet which aren’t actually true. And I would be really interested to know if it is true.

Fair value gains as monetary base – even better than the real thing April 3, 2012 at 6:25 pm

An old speech of Paul Tucker’s, made me think. (Danger, Will Robinson.)

To begin, two unconnected facts.

First, fair value gains are unlike most (not quite all, but run with me) other accounting gains, in that there isn’t necessarily a matching loss. If I issue 100 shares, and you buy 50 for $1, then I sell a further ten for $1.50, you can mark your 50 up to $1.50 without anyone having lost anything. Thus unlike a growth in credit (where there is an obligation to repay and hence a liability matching the asset), fair value gains are asymmetric.

Second, the monetary base is asymmetric; the central bank can create (or destroy) it out of nothing. When the central bank opens the window to repo in assets, it usually creates new money.

Thus in a certain sense, fair value gains are like the monetary base in that they are money with no matching liability. Both are forms of money that banks can use without worrying about liquidity risk. Indeed, fair value gains are in a sense even better than M0 in that audited FV gains count as retained earnings and hence as part of a bank’s capital. They can thus be used to lever broad money (that is, deposits), something central bank liquidity doesn’t do.

This of course means that asset price growth has inherent leverage: buy a share for $1, mark at $1.50, take $0.50 as P/L, count that as capital, use it and borrowed money to buy some more shares.

This leads me to suspect that you can’t really think about money and the Ms without thinking about capital too. Broad money creation – as we said before
here – doesn’t just depend on credit demand, it also requires both funding and capital.

Update. More on the modern view of money multipliers (and that whole Krugman vs. the Minskians thing) can be found here, here and here.

Stop hunting equilibria (because they are as rare as snarks) March 21, 2012 at 7:52 am

Steve Randy Waldman has a typically intelligent post about partial equilibria and choice. Amongst other things, he quotes Nick Rowe on how rational actors react to change:

[P]eople can solve partial equilibrium problems a lot more easily than they can solve general equilibrium problems. When a shock hits, each individual can solve for how his own reaction function should shift in response to that shock. But he can’t easily solve for the new Nash equilibrium point, because that requires him to figure out how every individual’s reaction function has shifted, solve for the new intersection point of all those reaction functions, assume everyone else will do the same, and expect everyone else will move to the new Nash equilibrium too. That’s hard.

I think the insight is right, but framing it in terms of equilibria is unhelpful. Here’s why.

A ball lying in a dip is in equilibrium. It won’t move. Add some energy – give it a kick – and it might find another equilibrium. But this game is stop go: kick, wait for the ball to stop, observe, kick again. The economy isn’t like that at all. It’s more like tetherball. There is never time to find an equilibrium before the ball gets another wack. What is interesting is not where the final equilibrium might be, but the dynamics of the ball. Part of that dynamics is driven by forces which tend to equilibrium – gravity in this case – but there are also the repeated strokes from the players which keep the ball from ever finding equilibrium. (Note too, incidentally, that there are multiple equilibria corresponding to the ball lying at different points around the circumference of the pole, and predicting which one it will end up at even if the players stop hitting the ball is very hard.)

Non equilibrium problems are hard: much harder than equilibrium ones typically. But recognising that much of macro is a dynamical systems problem where the frequency of forcing is faster than the relaxation time is important. If it ain’t anywhere close to equilibrium, modelling it as if it was might well not help.

That said, though, the Rowe quote is interesting as it points out that we can relatively easily estimate our own first response to a change – our own first swing of the bat when the ball has changed direction if you will – but we can’t easily predict others’ reactions and hence understand the dynamics of the complete system. As the Streetwise Professor wisely said recently (a propos clearing, and kindly referencing an earlier paper of mine):

For decades the Corps [of Engineers] has intended to impose order on a complex system of rivers. The results have been less than happy. The imposed order has too often proved illusory, and attempts to control the system have resulted in an increased likelihood of catastrophic floods and the destruction of valuable natural ecosystems. Attempts to control complex systems are usually futile, and tend to result in the replacement of more frequent small crises with a few mega-crises

The US output gap March 18, 2012 at 7:16 am

Greg Ip has an interesting post on the Economist website. He explains that there are three puzzles in the US currently; stubbornly high inflation, slow GDP growth, and unemployment falling faster than GDP would suggest it should. There is an unpleasant explanation for all three:

both the level and growth rate of American potential output is much lower than we think. This would resolve all these puzzles: GDP growth of 2.5% is above, not at, trend, the output gap is closing, and it was probably smaller than we thought to begin with. That would explain why unemployment is falling so quickly, and why core inflation hasn’t fallen further. The excess supply of workers and products that ought to be holding back prices and wages is not as ample as we thought.

Now here’s a conjecture, albeit a highly speculative one that I am not sure I believe myself. What if the secret sauce is financial leverage? That is, could credit supply (and cost) be depressing US GDP growth? Or, to put it another way, how would you test this hypothesis (without being credibly accused on being pro- or anti-bank)?

Demanding answers March 15, 2012 at 7:07 am

From The Money Illusion, via Brad DeLong:

In late 2008 the markets were telling us that the Fed was making a tragic mistake by allowing NGDP expectations to plunge. But the economics profession didn’t listen, as they view stock investors as being irrational. Economists were obsessed with the notion that the real problem was banking distress, and that fixing banking would fix the problem. No, the real problem wasn’t banking, the real problem was nominal.

That goes a little far for me – it’s pretty hard to have rising aggregate demand if the credit supply is falling due to a broken banking system (and in particular a broken transmission mechanism) – but there is more than a grain of truth to this.

So many choices (but none of them are good) February 14, 2012 at 7:01 am

No, dear reader, not my Valentine’s day, but rather macroeconomic models. Volker Wieland and Maik Wolters has a nice post on VoxEU where they look at the performance of a goodly number of the leading macroeconomic models. This picture in particular struck me:

Macroeconomic model performance

In other words, of the models studied, none – zero, nada, niente – predicted anything like the recession we got, and all the models predicted a materially stronger and swifter recovery than we got. Honestly given this performance shouldn’t there be rather more wailing and knashing of teeth from the economics profession than (with a few honourable exceptions) we have seen?

Safe by fiat February 8, 2012 at 3:01 pm

Macro and other market musings has an important and interesting posting on safe assets. The proposition is

If, however, the central bank slips and NGDP falls below its expected path, then some of the privately produced safe assets disappear, creating a shortage of safe assets. The government steps in and creates safe assets that, if produced sufficiently, would restore NGDP back to its expected path. In other words, if monetary policy does not do its job then fiscal policy could substitute for it, but in a way not normally imagined. It would do so not by increasing aggregate demand via higher government spending, but by making up for the shortage of safe assets that facilitate transactions.

I think that’s broadly speaking right. There are two main forms of demand for safe assets:

  • Buy-and-hold investors who want to take no risk, such as some pension fund investments; and
  • Investors who want the asset to facilitate transactions, mostly repo either bilaterally, trilaterally, or with the central bank.

The relative attractiveness of safe assets can therefore rise in three ways: more safe savings looking for a home; a higher volume of securitized financing needs; or ‘some of the privately produced safe assets disappear’. All of these deserve policy action.

There are profound consequences from this model. It highlights the importance of repo as determining the marginal cost of liquidity to the financial system, and hence the importance of targeting GC repo, rather than e.g. FED funds, as the rate to be managed. It also suggests that what is GC is of vital interest: a fact that was already obvious when we observe how the ECB’s recent actions has brought in Italian bond repo rates. By defining the basket of assets acceptable at the central bank window, a lot of pressure can be exerted for an asset to be considered if not safe, then at least ‘safe enough to repo’. This tool is extremely helpful, as the ECB has discovered.