How Irish pubs helped cure a shortage of safe assets

By way of David Andolfatto's comment on my earlier post on safe assets, I stumbled onto a talk by John Moore and Nobuhiro Kiyotaki called Evil is the Root of All Money, which in turn invokes a 1978 paper by Antoin Murphy called Money in an Economy Without Banks: The Case of Ireland (pdf link). For anyone interested in the conjunction of history of economic thought and economic history, Murphy is a great resource. I definitely suggest his The Genesis of Macroeconomics.

Murphy's paper describes an interesting episode in Irish financial history. From May 1 to November 17, 1970, all banks in Ireland went on strike. This meant that Irish bank deposits were indefinitely frozen. Despite being deprived of a large chunk of their safe and liquid assets, the Irish populace managed to soldier on with little economic difficulty—according to Murphy, retail sales were barely affected by the bank closures.

Ireland filled the void vacated by frozen deposits by using uncleared cheques as a circulating medium. Cheques are normally accepted with the intention of quickly cashing or depositing them. During the strike, an Irish family could now sign and spend a cheque at the grocer for food, and the grocer in turn could pass off that family's cheque to the local pub for a beer, who in turn was free to spend it onwards. Thus cheques boomeranged around the economy, even though they could not be cleared and no one knew when the banking system would reopen.

The genius of this system is that it resorted to an unused asset to create the new circulating medium: personal credit. Says Murphy:

In a normal banking system cheques are readily acceptable because it is believed that they are drawn against known accounts and will be cleared quickly. During the bank disputes they were drawn, not against known credit accounts or allowed overdraft limits, but against the value of other uncleared cheques and/or the transactor’s view as to his creditworthiness.

The tight-knit nature of Irish society allowed for an informal credit-rating network which, according to Murphy, was underpinned by Irish public houses. At the time, there was one pub for every 190 adults. The information that various retail outlets had about their customers allowed them to verify the ability of individuals to stand by their credit. This system had a degree of sophistication, since cheques were not universally accepted but rather were graded by risk.

This illustrates one of the ideas that I was (perhaps ineptly) trying to explain in my previous post. Just as the Irish quickly fabricated safe and liquid assets when their existing ones disappeared, wouldn't a modern shortage of safe assets be remedied in a few weeks, maybe months? What is blocking the same set of powerful market forces that quickly resupplied the Ireland with safe assets from operating today? Won't a rise in existing safe asset prices provide the economy with the desired level of safety? An excess demand for safe assets just doesn't sound like it can be a chronic problem to me.

In any case, give the Murphy paper a read. It has some gems in it.

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.

Asset shortages, scarcity of safe collateral

Have commented on a few blogs that bring up the meme of collateral shortages.

Commodity money: It's back! (and it sucks) at Macromania
Is the Fed our savior in financial regulation? at Marginal Revolution
Why the Global Shortage of Safe Assets Matters at Macro and Other Market Musings

The idea of a scarcity of shortage of safe assets is nonsensical to me.

I just don't think this can be a real issue. If the quantity of "safe assets" somehow collapses, then the prices of remaining "safe assets" will rise to meet the market's demand for safe collateral and stores of value. You can't have shortages in financial markets. Do you think you can?

and

The idea that there can be a shortage of good collateralizable financial assets sounds fishy to me. Prices for those assets will simply rise until their price is sufficient to meet the demand for good collateral. The same with an excess demand for money - prices will simply fall to meet that demand.