Gary Gorton and his co-authors have produced a large literature on what they calls safe assets (assets whose prices are informationally insensitive). They published two new papers this month on collateral crises and on the constant share of safe assets through the last half century. Their earlier papers on being slapped by the invisible hand and the run on repo are quite well known. The basic argument of this literature is that:
- Safe assets serve an important social function
- Safe assets are in short supply – the demand for these assets exceeds the stock of government securities and other obvious safe assets.
- The shadow banking system is an important source of supply of safe assets
- The shadow banking system and the safe assets that they create must be protected from “runs” in the same way that bank deposits are protected.
A more radical version of this idea can be found in a paper by Morgan Ricks which argues that only licensed money-claim issuers should be permitted to issue short term debt and that all this debt should then be explicitly insured by the government.
Much of what we know about the demand for safe assets come from the work of IMF economist Manmohan Singh (not to be confused with the Indian Prime Minister!). In a series of papers on the use of collateral in OTC derivatives, counterparty risk and central counterparties, collateral velocity, rehypothecation, and the reverse maturity transformation by asset managers, Singh and his co-authors have documented the need for safe assets in derivative markets and asset management.
What emerges from this discussion is that much of the demand for safe assets comes from sophisticated financial institutions and sovereign reserve managers. To my mind, this completely weakens the case for any form of subsidy for the creation of safe assets. The literature on participation in equity markets (which can be regarded as a proxy for risk taking in financial markets) demonstrates that participation is determined to a great extent by intelligence (Grinblatt et al), cognitive ability (Christelis et al), education (Cole and Shastry) and financial literacy (Rooij et al).
Most of the demanders of safe assets are big institutions (according to Manmohan Singh’s work), and one would expect them to possess a sufficient pool of intelligence, cognitive ability, education and financial literacy to be able to invest in risky assets. In some cases, portfolio risk may actually be lower if safe assets are replaced by equities. For example, Manmohan Singh explains how the security lending activities of asset managers creates a reverse maturity transformation – it converts the long term investment portfolio of households into a demand for short term assets (collateral). To the extent to which equities are correlated with each other, it is plausible that collateral in the form of stocks similar to those that are lent out might reduce risk. To the extent to which the borrower of the stocks is engaged in a “pair trade”, a natural supply of such collateral might exist.
I suspect that the demand for safe assets is better explained by a rational tradeoff between the costs and benefits of risk assessment (in a manner that bears some similarities to the rational inattention model of Sims). I therefore look at the huge demand for safe assets as a consequence of the moral hazard engendered by repeated bail outs of the financial sector. Even sophisticated investors may find it optimal not to make a serious risk assessment of any asset which has little idiosyncratic risks and is exposed only to systemic risks if the probability of such an asset (or rather its investors) being bailed out is quite high.
When one reads Gorton carefully, it becomes apparent that that the safe (or informationally insensitive assets) are not risk free – they are only free of idiosyncratic risk. Systemic risk is less subject to information asymmetry and therefore does not pose the problems that Gorton attributes to risky assets in general. But then the ability of the state to insure against systemic risk is highly suspect because if such an insurance is attempted in sufficiently large scale, the result is likely to be a sovereign debt crisis when the systemic risk event materializes. Capitalism to my mind is about accepting and dealing with failure, while the path that Gorton and Ricks are proposing is the path of socialism.
I see a similarity between the desire of the rentier class for safe assets and the desire of the working class for defined benefit pension plans. In both cases, the desire is to shift the risks to the taxpayers and thereby avoid the cognitive burden of making informed choices. In the case of the working class, society has over the last few decades rejected the demand for “informationally insensitive” pensions (defined benefit plans) despite the fact that lower levels of financial education might make the cognitive burden quite high for many of these people. I see no reason why the rentier class should receive a more favourable treatment.