Apr 23, 2018

Daniela Gabor on Safe Assets and Shadow Banking

Are assets really ever safe, and can Europe produce a safe asset?
David Beckworth Senior Research Fellow , Daniela Gabor

Hosted by David Beckworth of the Mercatus Center, Macro Musings is a new podcast which pulls back the curtain on the important macroeconomic issues of the past, present, and future.

Daniela Gabor is a professor of economics and microfinance at the University of the West of England at Bristol. She is a monetary economist who specializes in shadow banking, capital markets and transnational banking. Daniela joins the Macro Musings podcast to discuss her new paper, ‘Chasing Unicorns: The European Single Safe Asset Project.’

Read the full episode transcript:

Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to macromusings@mercatus.gmu.edu.

David Beckworth: Daniela, welcome to the show.

Daniela Gabor: Hello David, thank you for inviting me. I'm very honored to be in such esteemed company.

Beckworth: It's great to have you on. Another person who I've met through Twitter, the internet has really opened up doors in terms of networking and meeting industry people. You're one of them, so it's great to get you on the show, and you've written actually quite a bit on this topic of safe assets. You have another paper or two actually on shadow banking. We'll talk about that as well, because that's part of the conversation in understanding what a safe asset is and its implications, but let's begin first by asking about your background. How did you get into economics, and then how did you ultimately get into monetary economics?

Gabor:  Okay, so when I think about my journey, I would say if I had to say this in a nutshell, in a sort of part conversation, it would be that my father is an applied economist and my mother is a teacher, so you could say I chose the path of least resistance and I became an academic economist.

Beckworth: Okay. Fair enough.

Gabor:  To make it a bit more interesting, I would start by my undergrad degree, business economics in Bucharest, Romania. When I graduated, I then failed the final interview for the graduate scheme at PricewaterhouseCoopers. I wanted to work there, and having failed to enter, then I applied and got a scholarship to study development economics in Holland at the Institute for Social Studies, and what I did at the ISS was to write a thesis or master thesis on inflation in Romania.

Gabor:  I wanted to understand theoretically what I had experienced growing up in post communist Romania, a country that had persistently high levels of inflation after 1990, after the fall of communism, and roughly until 2000. I found I had to engage very closely with the structural features of the Romanian economy, from how production was organized under central planning, and I had to understand the critical role played by exchange rates, and very important I think, I had to engage with the efforts to create a capitalist central bank and financial market after 1990s, and then this became my PhD thesis.

Gabor:  In my PhD thesis, I theorized the role that central banks play in engineering the transformation of a centrally planned economy into a capitalist economy, so I then came to Hyman Minsky and his insight, that in order to understand the challenges that are confronting central banks in delivering either price stability or financial stability, you have to start with evolutionary changes in finance. In other words, you have to study finance first. I later discovered that I was working in a tradition pioneered by several great, and I think by now unfortunately largely forgotten women economists, and I want to mention a few.

Beckworth: Sure.

Gabor:  Your listeners can go and dig them out. The first one that I recently came across is a US economist called Anna Youngman, who in 1906, that is quite a long time ago, wrote a very sharp analysis of the rise of financial banking before the creation of the Fed, theorizing the link between banking and securities market through the New York Stock Exchange.

Gabor:  Then Margaret Myers is also very important to mention, who I think her 1931 book remains to my mind one of the most impressive accounts of New York money markets that we have, and the last one to mention is Marcia Stigum's classic repo and reverse repo book.

Gabor:  What I hope in the book that I'm writing now, on new forms of money that come from shadow banking or associated with shadow banking, I want to resurrect the tradition that is women economists are part of starting to understand of finance and how it operates, in order to then theorize money and macro issues including safe assets.

Beckworth: Very interesting, so this is taking a long ways from your home in Romania to the streets of New York and London, where you are looking at shadow banking money, and part of that story is of course the increased securitization of finance and how those assets are in turn being used as a form of money. In some of papers you get into this, different degrees of liquidity and moneyness to base on the assets.

Beckworth: Let's get into this conversation though, about safe assets, because your paper is on that, and as listeners will know, this is something we've talked about on the show before, but this is a very interesting perspective, because it's focused on Europe and the quest for a safe asset in Europe, so let's begin by asking exactly what is a safe asset?

Gabor:  Okay, so I want to quote Gary Gorton here, who I think is a very inspiring theoretician. He has this wonderful quote that says all human history can be written as the search for and the production of different forms of safe assets. Now, to my mind, the history of safe assets is really the history of money. I think sometimes we tend to separate the two. That is the history of efforts to create new debt instruments or promises to pay back that remain a good store of value during good times and during bad times.

Gabor:  Now, if you look at the literature, financial economists, and I think you have some on your show, they conceive of safe assets through the lens of information sensitivity, so the idea is an asset is truly safe if no new information can change the willingness to hold it. For example, a safe asset is a no questions asked asset, I found a quote somewhere.

Gabor:  I think Anna Gelpern and Erik Gerding summarized well the problem with this approach of information sensitivity. It is a super-collider view of safe assets that come into being through fully understood processes, and I think if we push this information sensitivity framework to its logical conclusion, then we have a world of naïve investors that at some point realize that they made a mistake in treating some assets as safe assets.

Gabor:  I'm not so much interested in this or find this view compelling, of naïve investors. Instead, I want to take Gary Gorton's quote into a different direction. That is to ask how safety is engineered through political and legal processes by central banks and other financial, private or public institutions. That is, if I can paraphrase in this context, and I want to, because I'm feminist, I would say that an asset is not born, but it becomes safe in order to accommodate evolutionary changes in finance that require new safe assets, all right?

Beckworth: Okay.

Gabor:  To give you an example, for you and I a bank deposit is a safe asset, as long as the cash that we hold in it is less than the deposit guarantee that is provided by the state, but for a large institutional investor, a bank deposit, that is money for us or safe asset for us, is unsecured exposure to the bank above the deposit guarantee, so the incentive for that institutional investor is to find other debt instruments that do what bank deposits do for retail depositors like you and am.

Gabor:  I think there is also an incentive for the bank to move away from bank deposits, in order to continue its business relationship with institutional investor, but also because guarantees are expensive. They come with certain rules that we think are under a social contract, that include for example capital requirements or broader regulation, so when we ask where does an institutional investor go if he can't go into a bank deposit? You will find I think the typical answer in the literature government debt, right? Government debt instruments, or bond, or treasury instruments. They have become the safe assets.

Gabor:  However, in the paper, we argue that the story is more complicated, in that there is a broader range of debt instruments that can make a claim to safe asset status, and in order to capture the broader range, in order not to treat government bonds as the best substitute for a bank deposit, we make a distinction between moneyness and liquidity.

Gabor:  I would say that very simply moneyness captures the ability to convert any debt or any asset into traditional money or money that settles debt, like bank deposit or bank note, so the ability to convert an asset at par and on demand. That is I convert my bank deposit, my $30 in a bank deposit into $30 bank notes whenever I want. That is at par and on demand.

Gabor:  Liquidity means the ability to buy or sell a product in a desired quantity and at a desired place and time without materially impacting the product's price. That is liquidity is also something that captures the ability to convert that securities into payment money on demand, but you don't get par necessarily.

Gabor:  You can get, you will get par with maturity, when that government bond matures, and in the paper we show that this distinction between moneyness and liquidity is helpful, because it can allow us to explore a broader range of assets that are created by both banks and shadow banks. Assets that have a strong claim to moneyness, but they are not liquid. Not liquid in the traditional sense. For example, money is one example, and repurchase agreement or repos are another.

Beckworth: Let me mention something you say in the paper, which I found very useful. It was a very nice summary of a safe asset. I believe you were quoting someone else, or maybe you weren't, but you said a safe asset is something that is resilient to adverse systemic events, so it's an asset, a financial asset that can withstand a great recession or the global financial crisis, and that's of course a tall order.

Beckworth: That's something that's tough to do, and I love your quote from Gary Gorton that you mentioned, that the history of safe assets is basically all of human history. This quest for producing safe assets, so I found that amusing. That's like Milton Friedman seeing money everywhere, it seems like Gary Gorton sees safe assets everywhere he looks in history, but your focus in the paper is on Europe and how this idea applies to Europe, right?

Gabor:  Mm-hmm (affirmative).

Beckworth: The question is can Europe produce a safe asset? Just for comparison's sake, here in the US we look at US Treasury bills and US treasure securities as the safest asset, and around the world a lot of people do. They come to the US, buy our treasuries as safe assets, so what you're getting at is this discussion that's going on in Europe, about whether Europe can have something similar, and we'll get into the details a little bit later, but that's the idea, right? Can you produce a safe asset that is similar to what the US Treasury security offers here, is that right?

Gabor:  Yes, I think that's right, and this is something for your listeners who are based in the US. They might not have been following this closely, but for us here in Europe this is a very important question, that is in a sense you can find it almost daily on the pages of the Financial Times, you hear it often in Brussels, now that President Macron and the new German government are trying to work through some of the systemic fault lines that the euro zone area still has, and when we'll come to this we'll discuss it in greater detail, but creating a truly safe asset in Europe is a political question, and it's a political question that doesn't have a very simple political answer, and therefore it has generated all sorts of innovations. Trying to work with markets to create something that really European politicians and European countries, members of the euro area should be doing on a political level.

Beckworth: Yeah, and there is a real sense of urgency though. That's one big takeaway from your paper and from reading some of the related stories on this topic. Is the recession over there is far worse than it was in the US, in terms of how long and how deep it was, and so there is this sense of urgency to really step up the game and get a safe asset put into Europe.

Beckworth: Now, I want to go back, one other thing on Gary Gorton, and you mentioned this as well. I think it's part of your research agenda, is this ongoing quest to find safe assets through history. Find these stores of value, some place you can put your money, your earnings, your labor income, and save it without worry, so do you see this as a basic part of human nature? Is this desire to get fixed nominal debt contracts that are liquid, is this something that's just a part of our human psyche? Do you think this is going to be with us for a long time?

Gabor:  Well, I would say that as long as we live in capitalism, that is not necessarily a feature of individuals as much it is a structural feature of capitalism. That the way in which we organize financial markets then influences the kind of safe assets that are available for us, and I think if there is one important message to the paper, it is that truly, if you look through the history of safe assets, there can't be any privately produced safe assets that remain resilient in crisis when they come under pressure without a central bank to backstop them. I think that is the main message of the paper, and it's the message of the paper that then we think has a particularly important echo in the euro area, because of the legal constraints and political constraints on the ECB's mandate.

Beckworth: Yeah, so it's much more complicated over there. You've got many countries. You don't have a true federal treasury like we do here, but going back to this point. I bring this up, because I've had John Cochrane on the show and I've talked to other people about this, but there are some folks out there who want to go 100% equity based banking, so basically you would have your money backed by equity, as opposed to by some kind of debt, so for example make this concrete for our listeners, you take out your debit card and you go to take out some money from your bank account.

Beckworth: Well, the amount of money in your bank account would vary, right? If all of your funds were invested in say an equity fund of some kind, like equity mutual fund, maybe an ETF, basically your checking account, the equivalent of a checking account, if it was equity based, would go up and down in value, so used a great analogy. He compared it to a Las Vegas slot machine. You don't know for sure what your equity, your value would be day to day. Do you think that's something that just we'll never get to, because humans done like, we don't feel comfortable with that uncertainty, or is it just something you think that, is that just a feature of capitalism?

Gabor:  Well, this ideas remind me of the history of the United States financial system before the creation of the Fed. I've been reading up about it recently, before this book that I'm writing on shadow money, and I think it's quite striking. This is the kind of idea that would probably come out of the US, as opposed to somewhere else, and it's striking in the sense that there is this notion that we need to somehow anchor the production of money in something real or in something bound by some way of fixing supply, and you could think cryptocurrencies, reflect the same sort of drive or idea.

Gabor:  That you shouldn't let either private financial institutions or the state run amok with this playing with money, and to my mind the repeated financial crisis that the US experienced before the Fed showed the limit to this. It doesn't matter to what asset you link it on your balance sheet, the production of safe assets on the liability side always requires the state to back it up somehow, so I don't see any panacea that comes from some fixed supply of some sort.

Beckworth: You don't see equity based money thriving in the future. Well, let me ask you a different question. Someone might push back, well, you want the state to back it, but states themselves don't always have great histories. Some states do, some states don't. Therefore, is there really ever a true safe asset? Even in the limit the US government could have a hyper inflation, some extreme scenario here, but is there really such a thing as a safe asset and a limit?

Gabor:  Well, let me answer this question by taking us back to the global financial crisis, right?

Beckworth: Mm-hmm (affirmative).

Gabor:  The global financial crisis can be described as the result of many different types of processes with many different causal mechanisms, but the literature on safe asset tends to say, well, the problem or the causes of the global financial crisis should be found in an imbalance between the supply and the demand for safe assets, and to explain that I want to use, I promised my students I would use this if I'm ever going on a podcast like yours

Beckworth: Okay.

Gabor:  I want to sue the example of Stranger Things, right?

Beckworth: Okay.

Gabor:  The TV show, have you seen it?

Beckworth: Netflix show, yes.

Gabor:  Yes, you have, so if you remember in Stranger Things we have the Upside Down, right? That is an alternative dimension that exists in parallel to the human world and closely mirrors it, so when I teach my students about safe assets and states and public debt, I tell my students, look, your textbook says that government debt is created to meet the fiscal needs of the state, right? But government debt also has a financial life, in the upside down if you want, where it is used for a variety of reasons, including to meet demand for safety, as high quality collateral in wholesale funding markets, to price other debt, and what drives this upside down?

Gabor:  The standard story in the safe asset literature is China or other emerging markets in Asia, but that have created a global savings club, and that global savings club basically preferred safe storage into US government debt, and then to a lesser extent into European government debt. Now, because the US government doesn't have a mandate to meet demand for safe assets from the rest of the world, then you get shadow banking. This is a sort of Demogorgon, to use the metaphors of the Stranger Things, so shadow banking is the Demogorgon of the world of finance that emerges to create debt instruments that appear as safe as US government debt.

Gabor:  For example, AAA rated mortgage backed securities, and then the story is the global financial crisis occurs precisely because shadow banking cannot credibly create assets that store value during bad times, and you still need one institution of the human world, the central bank, to do it, to preserve safety during crises. There are many of the unconventional policies that the US Federal Reserve adopted after 2008, you could tell them as a story of the central bank propping up the safe assets produced through shadow banking, so when we ask questions about what is the role of the state there?

Gabor:  I think that we can have a persuasive narrative that the state actually doesn't produce enough of safe assets, and if it did, Zoltan Pozsar, who's a famous theoretician of shadow banking, he argues that we should use public debt as a macro prudential tool, in order to make sure that the demand for safety is not met by more fragile private financial innovation, that then requires the state to extend the safety net and to backstop with it.

Beckworth: I agree with that point, that it seems pretty evident anyhow, from what markets are telling us. Look at interest rates on treasuries, their prices. It indicates there's a huge appetite for US government debt. That the US maybe in some ways [inaudible 00:22:31] the world's knocking at the door of the US Treasury asking for more government debt, and this is the kind of Triffin dilemma for the US, right?

Beckworth: The world needs more US Treasury securities for the global financial system to work well, more than is needed domestically in terms of government operations, and so we have this safe asset we're providing to the world, the US government's providing to the world, and arguably it's not provided enough.

Beckworth: There used to be a joke, and I mentioned this on the show before as well, what is the US's comparative advantage to the world? We used to joke, and this is back in the early 2000s, when there was talk of a dollar crisis in the US. The joke was our comparative advantage is exporting debt. We'd all get a good laugh, ha-ha-ha, but it's true. There's some truth in that, right?

Beckworth: We have the institutions, the markets and particularly US Treasury securities, but going back to my question though, so I agree, I think you can make a reasonable case that the world wants even more debt than the US government is producing and some have argued for a US sovereign wealth fund along those lines, but let me step back from that.

Beckworth: Let's say though, we produce and we satiate, we create all the safe assets the world wants, and then go beyond that. Is it possible to go beyond that, to the point where the US Treasury is no longer safe, no longer is a risk free asset? And in that case, could you make the argument that there truly is no safe asset?

Gabor:  Yes. I think that the US is the safe asset issue or for the world, because of the virtue of the dollar or because of the position of the dollar in international as a reserve currency, right?

Beckworth: Yeah.

Gabor:  In a sense, you can think that an asset is safe, not because there's some theoretical justification for it, but because multi financial institutions need to run somewhere when they run in a crisis, and they would run to the safety of whoever we think is the most economy in the world economy. Now, does it mean that the US Treasury would always, or government bond created by the United States will always stay safe?

Gabor:  My answer will be no. One can think of many political configurations under which this may not be the case anymore, or many political configurations under which the euro or the Chinese yuan overtakes the US in terms of the importance of its currency. They may be farfetched scenarios, they may be far away, but there is no reason why we cannot make a mental exercise, so if your question is can there be too much public debt created that in a sense would undermine the safe asset status?

Gabor:  The answer there is somehow more complicated and it requires us to think about the relationship between public debt, shadow banking and what I call shadow money, so I don't know if you wanted to get to that at some point.

Beckworth: Let's hold off on that right now. I think you've answered my question, but it's an interesting one and I agree with this point you just made about being a bank run of sorts, so if the US is the supplier of safe assets to the world, the main supplier, where else do you go, right?

Beckworth: It's one thing if you think of a traditional bank for you and me. If we have questions about that bank we'll go to the other bank, right? A bank run means you run from one bank and you put your assets somewhere else, but in the case of the global economy there is no other place, so it's not easy.

Beckworth: Your point is yes, in the limit you find the dollar, the treasury no longer the safe asset, but that's an unusual case with a lot of complications, because it currently is the main banker to the world, given the current setup of the global economy.

Beckworth: This also raises, of course, interesting questions about the US running budget surpluses like they did in the late 1990s, right? That puts a strain on global financial system, which again that's very hard for many people to hear. They think the US has a debt problem, but what they don't appreciate is how important that debt is to the global financial system.

Beckworth: Now, let's move on from this. We're talking a lot about the US. Let's move back to Europe, all right? Europe also needs a safe asset. They've been using the dollar, the treasury bills. They've been using German bonds, there are some Switzerland bonds, some UK bonds, but it hasn't had a truly unified single safe asset for Europe, and we want to get into maybe answering why that is the case.

Beckworth: Before we do that though, maybe it's good that we talk a little bit more about the shadow system. You've touched on it earlier, but remind us again, how does the shadow banking system fix the current shortage of safe assets in Europe? What is it doing to provide a workaround solution?

Gabor:  Okay, so let's take a step back and remember that 10 minutes ago I described the universe of safe assets as the Upside Down of the real economy, and I said there that the literature on safe asset attribute the shortage of safe assets both in the US and elsewhere, to China and emerging markets, right?

Beckworth: Right.

Gabor:  To the global savings club, but what we argue in the paper is that story of the Demogorgon is just one part of the picture. The picture is much more complex, and the picture that we draw in the paper is the picture of a global financial system in which we live, a global financial system that is increasingly organized around securities markets and around derivative markets.

Gabor:  What we now call market based finance, and it's a world where we have institutional investors, where we have asset managers who are stepping into the void left by the gradual withdrawal of the welfare state, so to my mind shadow banking also reflects some of the choices that we're making, in terms of how we collectively organize to provision for future uncertainties, but that aside-

Beckworth: Interesting.

Gabor:  When I think about the demand, the structural drivers of the demand for safe assets, I think about BlackRock for example. BlackRock has assets under management of around six trillion US dollars, which is three times as large as the largest global bank we have, so when I think about safe assets I think with Zoltan Pozsar, the world of BlackRock, of leveraged investors and institutional cash pools for whom money and safe assets begins where bank deposits end, right?

Beckworth: Yeah.

Gabor:  In the previous definition, and this is where shadow banking and what we call shadow money comes into the story, so to think about shadow money, this is a bit trickier to explain, and I've done this exercise many times. I don't know if I've perfected it yet, but perhaps the easiest starting point to define shadow money is to think about an asset manager whose daily cash needs have to take into account potential sudden redemption, but also margin maintenance related to derivatives trading and to securities finance, all right?

Gabor:  This asset manager needs [inaudible 00:30:31] instrument that can be easily converted into settlement money to meet these commitments related to possible redemption and margin maintenance. What we know from recent research, and this is where the question of government debt becomes more interesting and complicated, what we know from recent research is that for many asset managers the monetary service is provided by repos or repurchase agreements are preferable to those provided by government bond.

Gabor:  To put that simpler is that for some asset managers, or for most asset managers actually, a repo is a safer instrument than a government bond, because it provides better monetary services.

Beckworth: Essentially, shadow money is money for these institutional investors, like the money we have at a bank account, right? We have a checking account. I can draw that on demand. It's often called demand deposit, so I never have any question that the money is there. What you're saying is there are financial firms that have these liabilities, which effectively act like a checking account in what it delivers for these bigger institutions. You mentioned BlackRock. What did you say, five trillion dollars? Did you say-

Gabor:  6.2.

Beckworth: 6.2 trillion, and they also have need for something like a checking account, but they can't go down to the local bank and open a checking account like us, so shadow banking is effectively filling the gap, right? Shadow banking is a way to provide that service for them, and then the danger we get into with shadow banks is that they're very large. $6.2 trillion, you're getting to big numbers and potentially there can be runs on shadow banks, just like there have been runs in the past on traditional retail banking.

Beckworth: In fact, that's the argument of what happened during the great recession, so it's an importance concept, and the argument I believe you're making and that's been made by others is that the great recession, there was a demand for safe assets that wasn't being completely met by US government securities and other safe government securities, and as a result shadow banks filled in. For example, BlackRock may have wanted to have acquired more treasury securities, but they couldn't, so it went to repo instead to fill the gap and the concern is that may not be a sustainable solution, given that they aren't ultimately safe.

Beckworth: Now, let's take that understanding and let's move on to Europe, and let's talk about Europe's quest for a safe asset, so let's first just go back and walk us through the history, quickly summarize the history of the safe asset that was attempted prior to 2008, when everything blew up.

Gabor:  Okay, so in a nutshell what we argue in the paper is that what we had in Europe as a solution to political problem was shadow euros, so taking shadow money and putting into a European context, but before we get there, just to remind your listeners, the euro area has a very interesting monetary history for monetary historians and for monetary theoreticians, and that monetary history can also be written as a search for safe assets. And it's a history complicated by the politics of having a currency area that shares one central bank, but it doesn't have a centralized fiscal authority to create a single safe asset.

Gabor:  If it had the centralized fiscal authority, we would have a eurobond, and that eurobond would reflect market perceptions about the economic and financial health of the euro zone as a whole. And this is why we call the single safe asset a unicorn in our paper, because there have been numerous political obstacles that have impeded the political creation of a truly safe asset, and the creators of the euro, I now have in mind here both the institutions designing the European Central Bank and also the European commission.

Gabor:  They were very clear about the fact that the euro needed a single safe asset, but of course getting political agreement on Germany and Greece sharing or joining liabilities, or sharing risk, is much more difficult. And the ambition of the creators of the euro was to have, and I think it's very important, was to have a currency and financial markets that could compete with the US dollar and with US financial markets. This is something that competition for becoming an issue of safe assets for the world shouldn't be underestimated, the role of this.

Gabor:  Since this ambition was there, but the political means to deliver this ambition were not there, then what the Europeans came up with was a sort of alternative solution that says we can use markets in order to ensure that an American asset manager like BlackRock would treat a German government bond and a Greek government bond as equally safe assets, so they said let's create a project and let's think of measures to integrate existing government bond markets, to make sure that we break down barriers between the government bond markets and we don't need to centralize fiscal authority.

Gabor:  In a sense, before 2008, the solution to this question of how do you come to a single safe asset without a central treasury was to say, well, let's rely on markets. Now we know that this solution didn't work out. That since, for a while, it seemed that it did, until 2008. Not many investors saw much difference between a German and a Greek government bond, at least in terms of yield. Also, we see in terms of how they treated them as collateral to create shadow euros, but after the collapse of Lehman Brothers, we have the European banking crisis that then morphs into the European sovereign debt crisis, and here we are in 2018. I think nowhere closer to having a single safe asset in the euro area than we were in 1998, 20 years ago, just before on the eve of the creation of the euro.

Beckworth: And the quest continues for that unicorn, huh?

Gabor:  Yes.

Beckworth: To create that safe asset, but you guys do a great job telling the history. It's a really fascinating paper. We'll have it linked on our webpage, but you go through and talk about the ECB did try to create this safe asset, and you mentioned it set a standard by accepting collateral at its window, were treated German debt, government debt equivalent to Greece government debt, and that set the standard for the market, right?

Gabor:  Mm-hmm (affirmative).

Beckworth: In terms of creating a shadow safe asset, so what you tell in your paper is that there was effectively a single European safe asset, but it was formed partially in the shadow banking system and it worked, as long as everything was going great. Once everything blows up, you have this great phrase that the ... It says the single safe asset morphs into a northern safe asset, which means instead of there being a repo asset, which had all kinds of collateral behind it including Greek and German debt.

Beckworth: Now, it was German debt that became the focus, so once fear kicked in markets froze up. This single safe asset dream was no longer happening, and now they're trying to work around fixing that, and there's been several solutions. Now, let's just quickly again summarize, why has this been so hard? Who's been holding out against the push toward a truly safe asset?

Gabor:  Well, there are many moving parts to this story.

Beckworth: Okay.

Gabor:  I would say before 2008, what you've summarized very succinctly and I think very sharply, is that the ECB said, "Okay, maybe we will not get a single safe asset created by the European state as it were, but we can use shadow euros, that is we can use the shadow banking and the European repurchase or repo markets, in order to both accelerate the integration of government bond markets," because you have more demand for repos, means more demand for high quality collateral like government bonds, and you also create a safe asset for institutional investors who treat repos as strong in their safety, as they would treat government bonds.

Gabor:  It was in a sense a masterstroke from the ECB, because you can serve this as a political project to almost every constituency that you have in the euro area. To the European Commission, you can argue, well, the shadow euros are improving our monetary transmission mechanism, because of course we need government bond markets to be integrating in the euro area for the monetary policy to work. To each member state and to their debt management offices, you can sell them with the promise of liquidity.

Gabor:  Saying, well, if we create a truly European repo market that is truly European shadow Europe or a truly European single safe asset to shadow banking, then this comes with liquidity benefits for you. Telling anybody who's not from Germany, you don't have to worry that the German bond market will absorb all demand for high quality collateral in the euro area, because here we have this magic instrument called the repo, who will make sure that the barriers are broken down with our politicians actually sitting on a table and signing a treaty, right?

Gabor:  I think what we detailed in the paper is how this political project had a lot of support from everywhere, but when the crisis came what became very clear is that the ECB thought about this as simply a liquidity enhancing product or a safe product that would not have its safety tested in the crisis. And its safety was tested in the crisis, and for the ECB it was very difficult to do what other central banks were doing in order to stabilize their own shadow money. The treasury ...

Gabor:  Sorry, the US Federal Reserve did it, the Bank of England did it, but the ECB could not do it, because to stabilize debt produced to shadow banking that involves government bonds you have to directly intervene and prop up government bond markets. That is if you want a Greek government bond to be treated as high quality collateral indiscriminately or equally to a German government bond, the ECB would have had to step in and basically preserve the liquidity, preserve the good collateral status of Greek government bond.

Gabor:  This runs counter to the legal mandate that the ECB has, because for reasons that have to do with the monetary history of the euro area, the monetary financing of government debt is prohibited through the European treaties, so this is where you have the lawyers meeting the economists with not very happy consequences, because the lawyers do not ask questions like we do, which is, is it possible that the world of finance has changed so much, that the Central Bank that needs to adapt to it?

Gabor:  What they're saying is we have one central bank. It's already been very clearly designed what the rules are. Financial markets have to adapt to them, so in this kind of confrontation between the lawyers and the economists, unfortunately, the lawyers won for a long time. At least until 2012, when Mario Draghi said, "We'll do whatever it takes."

Gabor:  And one of the strong messages, the strongest message of the paper and of my research in general is that the ECB stopped the erosion of financial stability in Europe and basically the disintegration of the Europe, when it said, "We will do whatever it takes," and that whatever it takes moment was a commitment to make shadow euros safe in crisis, by preserving the liquidity of sovereign collateral, okay?

Gabor:  Now, this has happened, but it's not a very well known story, at least not outside the world of central banking and private financial institutions. When I go and talk to private finance, retail or otherwise, they will accept that this is a very valid and very persuasive narrative. That in order to think about the crisis in the euro area you have to think in terms of the crisis in European repo markets that is connected to the sovereign debt crisis, but it's a difficult story to sell, because it's a very technical story, as you well said, right?

Gabor:  So then we still live with the consequences of the difficulties of telling this story in political terms, and where are we now, what came out of this whole debacle of shadow euros and the single European repo market, is that we have a sovereign bank loop or we have this very dangerous, unhealthy codependent relationship between banks and governments that need immediate and radical treatment.

Gabor:  I am paraphrasing here how most German officials would put it, and they argue, look, the problem is that governments will not put their house in order, as long as they can get their own banks to buy their debt. Therefore, governments will always be prepared to bail out banks and to create moral hazard.

Gabor:  Then on the bank side the story is that banks are distracted from the real task of lending to productive private activity, because they are focusing too much on government bond markets and extracting short-term profits from them. Plus, when a crisis comes, the problems in government bond markets immediately travel to their balance sheets.

Gabor:  Not only on the asset side, but also on the liability side, because they find themselves with shadow euros, so the idea is, the general solution is let's stop all of these now. Let's return to a rule based financial system and a rule based Europe. One of the things that we could do is to attach, for example, risk weighed to government debt in capital requirements, or to put a cap on how much government debt banks can hold.

Gabor:  Of course, you can imagine that there is a lot of political resistance to this German and northern position in general from the south of the euro area, and I think there are merits in the southern periphery position, right? I think there are merits, because southern banks were encouraged, including by the ECB, to think that it doesn't matter whose government debt your holding, as long as you can pledge it to the ECB in shadow euros and get results for it, it doesn't matter which government debt, and now they are told, well, it actually matters and it shouldn't be your own government.

Gabor:  Then the second very significant worry is that any rules, like the ones Germany is thinking of, will erode liquidity in government bond markets again with the possible exception of Germany, who is at the moment the defacto safe asset issuer in the euro zone.

Beckworth: Okay, so let me summarize all of that, and again, the key question being why hasn't the safe asset been created? Basically, it's the Germans, is that right? The Germans have been reluctant to take that next step, in terms of more centralized fiscal operations, larger share treasury, larger shared budget, and they are reluctant to do that, because they're worried about other Europeans free riding off of them. They've also been concerned about democracy, so basically it's the challenge of trying to integrate very different countries, and it's one thing to get the monetary union going, but it's much more challenging to get the fiscal union going.

Gabor:  Mm-hmm (affirmative).

Beckworth: That really is the big hold up. Compare that to the US, where it's easy to have these safe assets, because you've got 50 states all using one common treasury, so that's the first thing. You mentioned also, though, that since 2012 the ECB, the European Central Bank has put a backstop to money markets, and therefore has propped up this shadow euro again, so that's for the time being been held in place, but that's a temporary solution you argue in the paper, and so moving forward what you want to see is a truly genuine safe asset.

Beckworth: Along these lines, you have another great quote in your paper where you say the crisis illustrates powerfully that the sum is greater than its parts in microfinance and in the European and Monetary Union. A collection of national safe assets does not make a single safe asset, so even though all these countries' government debts before were serving as collateral for safe assets when bad times hit they don't all work, and so what's been proposed and time we've got left to talk about is a securitization of these government securities into a safe asset, so there are several names that have been thrown around.

Beckworth: I want to begin by getting the name straight and then we can talk about what they actually would do, but there's been one name I've seen thrown around a lot called the European safe bonds, the ESBies. In your paper, you talk about the sovereign bond backed security, the [SBs 00:48:53] I guess, so which term should we use when we want to think about the future safe asset of Europe?

Gabor:  Well, basically, they're one and the same thing. It's just-

Beckworth: Okay, they're the same thing. All right.

Gabor:  This is an idea that has been fleshed out by several economists, academic economists led by Markus Brunnermeier, and at the time Philip Lane, who is now the Governor of the National Bank of Ireland, and they were originally called Europe safe bonds I think for the purposes of clarity, and also for political reasons. They renamed them sovereign bond backed securities to capture more clearly the fact that the idea is to use securitization. That is to use the markets again, as we did before 2008, in order to arrive at the single safe asset.

Beckworth: Okay, and the idea would be, you mentioned doing securitization, but in this case there'd be tranches, there'd be a safe asset. In your mind, would this be truly a safe asset?

Gabor:  Very briefly, the idea is you take sovereign bonds issued by the all the euro area members, as long as they meet certain conditions. You put them in a securitization [inaudible 00:50:24] and then you issue three tranches. A senior tranche 70% of the portfolio, then a mezzanine tranche 20% and junior 10%, and the idea is the senior tranche would serve as a single safe asset for the euro area. It would be likely eurobond, but without joint liability of governments.

Gabor:  I am skeptical that this is, the senior tranche of ESBies or SBBSs can stay truly safe in a crisis, and it's not only me that is skeptical about. Most debt management offices in the euro area are very reluctant to the idea, and I haven't met many market participants who think that this is a viable project, and if we have time to just go through why this is a problem-

Beckworth: Sure, please do. Yes.

Gabor:  The question is how do you engineer through markets a single safe asset that does not repeat the pre crisis mistakes that were made with the shadow euros, right? To my mind, the biggest mistake was to assume that shadow euros would support the liquidity, and therefore the safety of the underlying government bonds through good and bad times. We saw that was not the case. Not for Southern Europe, and the doubts that are hanging over ESBies are similar.

Gabor:  What would be the liquidity impact on euro area government bond markets? This is something that every debt management office in the euro area is asking, when they're invited to public or I assume also private events, and the ESRB, the European Systemic Risk Board that is pushing this project, has published a couple of studies back in January and they're saying, "These concerns are misplaced. We can show that liquidity would not be affected," but I think the studies are working with some questionable assumptions, including the fact that ESBies, they assume that ESBies would preserve their safe asset status in a crisis.

Gabor:  In other words, why? If we accept that theoretically not even the US government debt is safe and it requires the central bank to sit behind it in times when its safety is tested, why would ESBies stay safe in crisis without the ECB? I think it wouldn't be possible. If the ECB is involved, it would be very easy for ESBies to stay safe, but that is true of any asset I can think of. As long as it has the firepower of the ECB behind it, it will stay safe. Of course, unless we have a very serious balance of payment crisis, and then no asset in the euro is safe.

Beckworth: Well, isn't the argument that the bond, which would be backed by all these different securities from governments, it'd be diversified? Idiosyncratic risk would be spread out, so therefore you wouldn't have the issue that you've had before, so let me reframe the question this way; would it be safer than the previous arrangement?

Gabor:  I'm not that convinced about the argument that it would be diversified, and what market participants typically say, well, there is a very strong correlation between the government bonds, between the assets that would go into the cover board, so they're saying, "We're not quite sure that this diversification argument works." They're also not very sure about how do you actually organize the issuance of this asset? If it's a state that issues it or that is ... Sorry, not a state-

Beckworth: That's fair. Who gets to be the security dealers that actually issues the ... That's a fair point. I guess, let me just, on their behalf, and I see your concern, but on their behalf let me make this case. Just like in the US, the argument was you're going to have a mortgage backed security and the idea is some peoples' homes will go under, some people will lose their jobs, some don't. On balance, it's a wash.

Beckworth: I guess the way you'd apply it to Europe, and I know it'd be a lot harder, because you're not dealing with as many different underlying economies as you are underlying homes and mortgage backed security, but it does seem to be the case, and correct me if I'm wrong on this, that Germany's economy did relatively well while the other ones did not. Periphery is doing poorly, Germany does better, and earlier during the boom period, in the early 2000s, Germany's economy was doing relatively poor and the periphery was doing better, so would there not be some diversification from that observation, or is it just that there's too many parts to really diversify meaningfully?

Gabor:  Well, I think you're right, in that obviously there is a close relationship between the health of the state and the fate of its sovereign debt, right?

Beckworth: Right.

Gabor:  We know that sovereign debt doesn't only reflect the fiscal position or the underlying sort of conditions of the issuer. It also reflects, for example, speculative position tradition, or what we had in the euro area. We have, even in 2005, something called breakup trade, which is you buy Germany and you sell Portugal, and see whether the ECB steps in or not, so if I was convinced that it is possible to live in a world where the cost of government debt simply reflects a market view of the fiscal trajectory of the country, I would say then yes.

Gabor:  There is a potential for diversification, but we live in an upside down world where government debt reflects a broader set of conditions, including, for example, how leveraged the institutions that are holding that debt are, and whether they would need to resolve to fire sales in a crisis. If they do result to fire sales in a crisis, it's not very clear to me how would ESBies deal with that?

Gabor:  For example, what happens and there are some provisions now in the new ESBies proposals that say we will keep government bonds in the ESBies or the SBBSs, as long as the state has primary market access and there is liquidity, some liquidity in the secondary market. Now, imagine a scenario in which Italy loses primary market access and it doesn't have any liquidity in the secondary market. I don't think that's farfetched. What happens to ESBies then?

Beckworth: That's a good question.

Gabor:  How do you keep out Italy from a single safe-

Beckworth: Right, and it's such a large part of the ESBies, right? It's such a large component going into it.

Gabor:  Yes.

Beckworth: I think that's a good point. This is not the same as a mortgage backed security, because mortgage backed securities literally can have hundreds, thousands of homes, and here we're dealing with a few big pieces, right? Few big countries, so if Italy goes out, you're right, that would really mess up your security. Well, let me ask this, so you're not very helpful. This is a unicorn, as your paper says, so what would be your solution then? What would be the solution to solving the safe asset problem in Europe?

Gabor:  Yes, this is where I run into political difficulties, because I think my solution goes against the spirit of what is happening in euro at the moment. In Europe, what we're living through is in some ways similar to the US, but in other ways different. We're living through a populist moment that is interrupted in Brussels as the people do not want more Europe. That is we want control to be reverted back to national capitals and things will get better. We will manage to stave off the far right or the right that has made inroads in various countries, including Italy.

Gabor:  Unfortunately, the implication of our paper is that if you look at the way in which financial markets are wired in Europe, you need a single safe asset. This is the condition, is a single safe asset that requires ECB backstopping and that requires joint liabilities of the state, and this is the political appetite for a public single safe asset is basically inexistent.

Gabor:  You could say France is pushing for it a little bit, but that it would be very difficult to convince Germany that a single safe asset is a solution, because Germany also has narrated crisis, is a crisis of irresponsible governments in the south. I think our story is that the crisis was a crisis of the lack of political will to address the question of single safe assets, otherwise then through markets, and markets, for reasons that have to do with how financial markets work, they cannot provide safe assets.

Gabor:  It is just not possible, so my solution has basically zero political appeal at the moment, which is a bit concerning, but then I take some solace from studying the history of the US financial system who got a truly functioning central bank after, I don't know, six or seven crisis between 1880 and 1913, and then had to have a really serious crisis in 1929 for the central bank to actually assume a more powerful role, so maybe it's just history takes longer for things to happen.

Beckworth: Well, you do have a long history to work against. There's strong feeling across national boundaries in Europe that may take time, as you said, to heal and to get over, but basically your outlook's very bleak. You've described a situation where there's not going to be any near term solution to the safe asset shortage in Europe, and then more broadly around the world, so if you could provide that safe asset, it would take the pressure off the US treasuries, which would then maybe return interest rates to more normal levels, so in the absence of that we're going to have a persistent safe asset problem for some time. Not just in Europe, but around the world.

Gabor:  I would say one thing. My skepticism is related to Europe, because I think the political dis-functionalities are still quite prevalent, and part of it is also the responsibility of economists like myself and others who have failed to make a political case that we need a single safe asset, because this is how modern financial markets work.

Beckworth: On that note, our time is up. Our guest today has been Daniela Gabor. Daniela, thank you for coming on the show.

Gabor:  Thank you David.

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