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.

Interest rates and gold

Nick Rowe recently asked what the point of repoing an object was when you could just sell it, repurchasing it later. He could see three reasons. Firstly, you might repo a particluar thing because you hold it dear and want it back. It might not be available were you to simply try buying it back. Secondly, you might repo an asset because future liquidity might be an issue. Thirdly, you might repo an asset rather than sell it because future prices are uncertain. My comment used gold markets as an analogy:

Nick, I think for financial assets you are right about points 2 and 3. In gold markets, for instance, you'd rather lend or swap (ie. repo) your gold than sell it (upon the anticipation of buying it back at some future point) because you might fear that, come time to buy the gold back, the future price could be much higher, or that the gold market could be illiquid and you might not be able to buy.

Incidentally, you can also sell your gold and buy a futures contract. Selling spot and buying a futures contract is financially equivalent to swapping (repoing) gold - in both transactions you'll lock in a guaranteed price and will avoid the risk of illiquidity. So your question: why repo? is similar to the question: should I sell some asset and simultaneously buy a futures contract or sell it and take the risk of buying back at spot at some future point in time.

Some people might recognize these various gold transactions. A gold swap — a temporary exchange of gold for cash — is transacted at the GOFO (gold forward) rate. A gold loan, which is an unsecured and temporary exchange of gold for nothing but a promise to repay, is transacted at the gold lease rate.

You can actually conceptualize both transactions as swaps. In the first, gold is temporarily swapped for a liquid and safe financial promise (cash). In the second, gold is temporarily swapped for an illiquid and safe financial promise (a promise to repay the gold ie. "paper gold"). Lingo-wise a swap is no more than a repo.

The different rates at which these two swaps are conducted — GOFO and the lease rate — will be determined by the relative subjective value gold owners place on the swapped-for assets. Because liquid financial promises provide more services to their holders than illiquid promises, anyone swapping away gold will prefer the former to the latter. That's why the gold lease rate — the rate paid by the person taking the gold to the person foregoing that gold - has always been higher than GOFO. After all, the party swapping away gold needs some increased financial incentive to take the illiquid "paper gold" asset rather than the liquid cash.

Indeed, liquid and safe financial assets are so valued, and so easily storable, that in general, anyone swapping away their gold will not receive a fee for foregoing the metal. Rather, they will pay a fee for the advantages of getting cash. This fee is what GOFO represents.

These ideas can be tough to conceptualize. A while ago I caught the folks at FT Alphaville mixing them up. For instance, the author maintained that a dearth of cash in markets now meant that

since their cash had become more valuable to the market than their gold, they could now make a return from lending cash against gold, as opposed to gold against cash.

The above comment implies that the gold swap rate — cash for gold, or GOFO rate — has somehow switched. But in actuality, those swapping away cash for someone else's gold always earn a return (GOFO). This is because they are foregoing liquidity. The gold lease rate has switched, but that is a different rate, and a different story altogether.

On the topic of gold, David Glasner asks why gold markets are rising due to hyperinflation fears but bond markets aren't:

Now my question — and it’s primarily directed to all those believers in the efficient market hypothesis out there — is how does one explain the apparently inconsistent expectations underlying the bond markets and the gold markets. Should there not be a profitable trading strategy out there that would enable one to arbitrage the inconsistent expectations of the gold markets and the bond markets?

I don't think there is any discordance to explain:

I think gold prices and bond prices have been rising over the last three years for similar reasons. In general, the economy-wide expected rate of return has been falling (towards zero, perhaps below it) as investors grow fearful of the future. This pushes people into safe bonds. It also pushes them into assets like gold that have very low storage costs, since buying some easily-storable durable asset and holding it over time provides a 0% return, better than most risky alternatives which are expected to fall.

So I don’t think there are segmented expectations in these two markets, nor do I think it is worthwhile trying to arbitrage them.

Returning to the discussion of GOFO, if today's gold markets were actually dominated by those who believed in the inevitability of hyperinflation rather than (fairly) rational actors, then GOFO would be inverted... in essence, anyone who swapped away their gold for cash would expect to receive the GOFO rate rather than pay it. The current practice, as I pointed out above, is to pay that rate, not receive it. The reason for the inversion would be because the destiny of cash in a hyperinflation is demonetization and, as a result, it will lose all of its liquidity premium, whereas gold's destiny is to be remonetized and gain a relative liquidity premium. As a result, any gold-for-cash swap based on a universal expectation of hyperinflation would require whoever foregoes the benefits of gold's inevitable superior liquidity to be compensated by a return. Needless to say, GOFO has not inverted. Those foregoing  their gold still pay up to those foregoing cash.

Gold lease rates, GOFO, gold

FT Alphaville commented on gold lease rates in Make your own (collateralised) gold standard.

My comment pointed to the fact that much of the conversation on negative lease rates is not considering the fact that storage costs are rising. These rising costs encourage gold owners to lend gold out temporarily so they save themselves the hassle of footing a hefty storage bill, and they may be so eager to avoid this bill that they are willing to pay others a fee to take on the burden. Thus negative interest rates.

Relavent links:

See Negative Lease Rates at Gold Chat

Target2, ECB, and Euro NCBs

Commented at FT Alphaville on How Germany is paying for the Eurozone crisis anyway:

There are some good bits in the VOXeu article, although I have a few quibbles.

"“that the Bundesbank will soon exhaust the stock of securities that it can sell to fund further loans to the Eurosystem.”"

The Bundesbank doesn’t need to fund its loan to the ECB by selling off assets. Effectively, German banks are deserting the PIIGS banks in droves. Reserves are flowing from the accounts of PIIGS banks at their domestic PIIGS NCBs to the German reserve accounts at the Bundesbank . Thus the Bundesbank’s reserve accounts (a liability to its domestic banking system) are rising even as its credit to the ECB (an asset on its balance sheet) rises. This is more or less automatic. So in order to balance a rapidly increasing credit item to the ECB, the Bundesbank doesn’t need a declining quantity of assets to act as the balancing mechanism; increasing reserves held at the Bundesbank will do the trick. There is nothing to exhaust. They don’t have to sell their gold.


Note that I think Karl Whelan's rejoinder "Worse than Sinn" available here is the best rejoinder to the FT Alphaville post.