Ricardo Caballero on the Safe Asset Conundrum

We’re currently experiencing a global safe asset shortage problem, and its downward pressure on interest rates is having a discernable impact on the real economy.

Ricardo J. Caballero is a professor of economics at MIT and is widely published in the fields of macroeconomics and international economics. Ricardo joins Macro Musings to discuss his work on the “Safe Assets Shortage Conundrum” and why this is important to macroeconomic growth and stability.

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 [email protected].

David Beckworth: Our guest today is Ricardo Caballero. Ricardo is a professor of economics at MIT and is published widely in the field of macroeconomics and international economics. Ricardo joins us today to talk about the safe asset conundrum and why we should care about it. Ricardo, welcome to the show.

Ricardo Caballero: Thank you David. Thank you for having me on your program.

Beckworth: Oh, it's a real treat to have you on. I've followed your work. I've cited your work and we've talked about your work previously on the show, so it's great to have you on here to join the conversation. With all my guests, I always begin with the question, how did you get into economics and eventually into macroeconomics?

Caballero: Oh, a trip into memory lane, I guess. I mean back in the seventies, in Chile, I'm Chilean, if you were a good student, you could either go to law school, to med school or become an engineer. But the seventies were also a time where the Chicago Boys were a big thing in Chile. And they created a fourth option for math oriented people, which was called commercial engineering. And that was split into sort of a business track or an econ track. And I went in for the business track, but very quickly became addicted to sort of the economics logic and I shifted tracks. And that was the beginning. Then when I finished my undergrad, actually, I tried to stay and go back to financial sector but then we got into the financial crisis in Latin American and then my opportunity cost went down, so I decided to immigrate to the US and the rest is history.

Beckworth: Okay. So today we're going to talk about the safe asset shortage problem. And you're one of the original authors. You're the founders of this literature, is that right? I mean you got this conversation going before Bernanke got his savings glut conversation going? Is that right?

Caballero: Well I was giving talks, informal talks about it. My moles came after that. But the literal informal talks, yes, I was talking about this. I did not call it, to be fair, the safe as a shortage initially, I called it an asset shortage initially. I was seeing bubbles and all these things as a result of that problem and then it migrated into safe asset shortages, but initially it was an asset shortage more generally.

Beckworth: Okay. So, but it's safe to say, fair to say that you were kind of the original one thinking about this issue, which now has gone mainstream. Lots of people that are talking about it and we see it in an amazing way manifested around the world. It's great to have your perspective because you've been here the whole time, right? You've seen this from the beginning to the end. You've been very capable in recognizing this issue long before others did. Let's begin our conversation on this by first defining what is a safe asset?

What is a Safe Asset?

Caballero: Well, that's a fascinating question in itself. I think because there's no fixed definition for that, no? It's a concept that is very elusive because it depends on, it changes over time, it depends on the economic environment. I mean, what do we need in the form of safety, it depends on whether you're in a high inflation environment and a no inflation environment, in a crisis prone environment or not. It changes and it depends on what other people think is an asset when other people thinking sometimes that is safe or not. It depends on conventions, on many, many things. Who knows? I mean, even Bitcoin may become a safe asset in the future, but I think that in current times, the preferred flavor seems to be an asset whose value sort of is resilient to a deep systemic crisis, especially financial crisis. So US treasuries, German bonds, seem to be particularly safe from that perspective.

Beckworth: Yes. We're going to draw from your Journal of Economics Perspectives article you've co-authored in the summer of 2017 issue, titled *The Safe Asset Shortage Conundrum*, you use a very similar definition there. You say it's, for the sake of the paper, and we use it for our conversation today, a debt instrument expected to preserve its value during adverse systemic events, so something like the 2008, 2009 crisis. Is that right?

Caballero: Yes, indeed. Exactly. Or the European crisis and…

Beckworth: Okay. Now you mentioned treasuries, German government bonds. Would cash be considered a safe asset too?

Caballero: Yes, absolutely.

Beckworth: Okay. Now, those are all the public sector provided safe assets and they're the ones that seem to be more resilient relative to the other option that's privately provided safe assets. And in your paper you go on a call many of them pseudo safe assets. Speak to us about that. What would be an example of a private sector provided safe asset?

Caballero: Well bank deposits or certainly all the offered trenches of the CEOs that were created before the crisis. And I think what we learned again in this crisis, as in the previous crisis, is that the private sector is fantastic at producing microeconomics safe assets, but not macroeconomics safe assets. So you can produce things that if there's no systemic risks, they can be very safe. I mean, you have a AAA corporate bond probably is very safe to assume that there would be no default. So absent any major event, it would be very safe. But in a systemic event, it changes. I think that's the major lesson of this crisis, is that ultimately in a very large systemic event, the private sector is simply not designed to produce safety.

Beckworth: Yeah. One of the things you often heard going into the crisis with some of these AAA rated mortgage-backed securities that they had done a great job eliminating idiosyncratic risk, right? You package them in such a way-

Caballero: Absolutely.

Beckworth: ... that if one household loses its job, bad health, can't pay its mortgage, you're not going to be hammered. But what it failed to recognize, and understandably so since it's been a long time since we had something as severe as the great recession, but it didn't account for systemic or a nationwide crisis. And so that's this distinction you're making that private sector provided safe assets aren't as durable or resilient as once provided by the public sector.

Caballero: To that kind of events. Also, we have to be careful, because remember that the Italian debt and Greek debt was also once considered a safe asset and the positive status during the European crisis. It is true that governments that have deep pockets are able to produce them better than the private sector. But there are some sovereign-ists out there that do not. And in fact, I think that the shortage of safe passage really began, we're going to talk about this probably later, but it began from emerging markets and they also produce local assets, but they were not deemed to be safer in the sense of what describing here.

Beckworth: Okay. So kind of speaking to your point about Italy, I mean in the limit, nothing is perfectly safe then, even US treasuries at some point could become risky assets, right?

Caballero: Absolutely, right. Absolutely right. I mean as I said earlier on, this depends on what you and I believe and what I believe and you believe and things of that kind. You're right, but at any point in time, there's sort of a hierarchy, there's a ranking and at this point the ranking seems more or less clear sort of at the top.

Beckworth: Yeah and I mean it makes sense too, right? At the end of the day, General Electric might go bankrupt, but the US government still has, the printing press, it can still force us to pay taxes. The US government will go bankrupt after GE.

Caballero: Absolutely.

Beckworth: It will be the last institution to go belly up. Therefore, we have more confidence as a creditor to lend to it. Okay. Well let's move on then to the problem itself. So first, kind of give us a summary. What is this safe asset shortage problem?

The Safe Asset Shortage Problem

Caballero: Well, that's another very good question because there seems to be a confusion out there. A shortage doesn't mean that there is a gap. That there is no equilibrium and that we have more demand than we have safe assets. I mean, at the end, we have an equilibrium and so everyone has what it needs, but the shortage means really the colony has to do a variety of very costly adjustments to ensure the equilibrium, so that's in the sense, it's not the base and this equilibrium, there's a gap, but that in order to have that equilibrium, in order to close that shortage, the economy has to go through very unnatural routes. And that's what it means to have a shortage. And the specific natural routes I think... For a while, this shortage was generally was very benign, I would say. When the interest rates were declining steadily, that was a benign part of an adjustment in that market.

Caballero: But then we fell into sort of incentive programs, which we were recently discussing in the financial system. And eventually we fell into sort of a liquidity trap type environment, a very acute form of liquidity trap. So basically the equilibrium in the safest market, but one that has the sort of very valuable incentives for the private sector. And at the same time it leads into a macroeconomic problem of the kind of we're seeing today when most large economies around the world are very close to the effective lower bound.

Beckworth: Yeah. So just to put some numbers on this, in your Journal of Economic Perspectives article, which we'll put on our website with the podcast, you have some rough estimates of the supply of safe assets. In 2007, you estimated to have been about 20 trillion. And then after the crisis, some years later in 2011 it had fallen to 12 trillion. And so the supply has fallen and we know for a fact that the demand for safe assets rose sharply during the crisis in addition to just normal growth of the global economy. So that's in absolute dollar terms that is a severe reduction in the supply of safe assets.

Caballero: Yes, it was very traumatic. But I think this is very interesting because I think that the underlying trend, I mean, was there pressing before that and we could see it in rates and the spreads and so on, but somehow there was such a large increase in the supply of safe assets, pseudo safe assets, if you will. But that masked the trend and what the crisis deities put us back into what should have been the trend from the beginning plus the extra, as you mentioned extra demand safe assets that come from the specific aspects of the crisis, uncertainty and all that. But from the point of view, the supply, I think it just put us back into something that we have essentially masked for a while through financial engineering.

Beckworth: Yeah. So all the AAA rated mortgage-backed securities, well, not all but many of the AAA rated mortgage backed securities are what you would call the pseudo safe assets. We thought they were safe and then when the push came to shove, the crisis emerged, we realized they really weren't that safe.

Caballero: Yeah. And also the postponements or the European impact of the crisis, which Italy and these continue to be showing enormous amount of debt…

Beckworth: That's right, also mentioned the European countries is another example. But just, just to flush this idea out a little bit more... And some of your other research you've talked about this idea... Let's step back. We'll get to the specifics in a minute, the developments, but there's both kind of a long run trend story you tell as well as the more cyclical 2008, 2009 story and kind of the long-term trends story you've shared in your literature is that the global economy has taken off and as a consequence, the demand for saving vehicles, safe saving vehicles has also grown, but the capacity of the global economy to produce them has not kept up. And so we look at the emerging markets.

Beckworth: Another way of framing this, I think you've written about is that we've had financial globalization. So suddenly the whole world has opened up. There's big discussions today about gross capital flows becoming more and more important. Instead of looking at net capital flows, we want to look at gross capital flows because of financial globalization. So funds are flowing rapidly across borders, but that massive flow of funds has outstripped the financial deepening or the markets to produce reliable, safe assets. And so there's been this trend that's always been there. And as you mentioned a few minutes ago, it was masked by the private sector producing these safe assets. So my question is, who is the main producer of safe assets to the world? If we want more safe assets, who do we turn to?

Caballero: That's a very good question. I think without a doubt, the US is the main producer of safe assets. And Europe is very close behind and Japan, but Japan is an island. There's no declarations and so it self-consumes its safe assets and so there is little to share with the world for that. But for the world, the surplus has been given mostly by the US and Europe.

Beckworth: Some of your colleagues had a paper Gourinchas and Rey had a paper in 2007 I believe, but they talked about the US as a banker to the world. I actually wrote something that followed up on that. And I think it's a very powerful analogy or way of thinking about this, that the US has effectively become a financial intermediary to the rest of the world. And what they highlight is if you look at the US balance sheets, so if you consolidate both the public and private sector and you look on the liabilities side, what do we owe the rest of the world? You find that foreigners come and they buy up and they want to hold our safe assets, so treasury bills, commercial paper, bank accounts, bank deposits and the liabilities to the rest of the world for the US is disproportionately those type of claims on us, those types of assets where if you look on our asset side, what do we do? We go and invest in riskier assets. So we're kind of funding or borrowing, short term lending long term, there's a nice spread there. But effectively the US is like this massive bank to the world. So what do you think about that argument?

The US as a Banker to the World

Caballero: Oh, I love that paper. Yeah, that's about gross flows. And I think they got it just right. And in fact, during the crisis we sort of flipped them. And the French have always envied the US for being able to be the bank of the world. But I think during the crisis we saw the flip side of that, which is that the US had a massive transfer of resources to the rest of the world. The US is sort of charging an insurance premium for always selling insurance to the rest of the world all of the time. Well there are times when it has to pay back and the crisis was that time. And a big part of it happened through the appreciation of the dollar. That's a very strange situation. A country that is in the middle of a crisis and ends up appreciating its currency. So yes, the US is sort of the insurer of last resort. There's no doubt of that. And again, I think Europe is now emerging as the second one.

Beckworth: If I look at a bank or an actual bank, I'm going to really flush this analogy out, look at a regular bank, they are in some sense running current account deficits with their local communities, right? They're taking in more funds than they're paying out. That's how bankers earn their living and their income. The profit of the bank, right?

Caballero: Sure.

Beckworth: So if a country is one of the main providers of safe assets, look at the US, you can also look at Europe and it makes sense. We've got deep capital markets in the US we got relatively better rule of law. All the things you'd want to provide your safe assets. Shouldn't we expect the US on the margin to run more current account deficits. And thus should we be as concerned about the current account deficits the US is running?

Caballero: No, wait to start, I mean we should be running a trade deficit for sure because we have an income spread there that we can fund, differential so no that's very consistent. We wrote a few papers indeed with Pierre-Olivier and Emmanuel Farhi about those global imbalances and that being sort of a natural equilibrium, it's what is supposed to happen. Now the question is, this relates to a point you raised earlier which is, you can run it, you can build enormous amount of debt as Japan has done, for example, that not external debt in the case of Japan, but at some point people may decide to switch, in terms of that's erased. Now I don't worry about that too much for now, I must say. Because for people to be able to switch, they need a substitute.

Beckworth: Exactly.

Caballero: And at this point, there isn't a clear substitute. So in fact, there was a big, I remember many people talking about the deficits of the other six percent of US GDP. Remember before the crisis as a source of concern by analogy with the sign that stops an emerging market experience when they have very large current account deficit and they always argue that, that was not the source of fidelity because there wasn't enough sort of French real estate as a substitute. When you have this problem in Chile, then it's very easy to go to Argentina, Brazil or Russia if you want to find a substitute asset. But in the case of the US there were no natural substitutes at the time, so I didn't worry too much. And I don't worry still now. Maybe in a few years from now, more than a few years, if China becomes sort of a great safe asset producer then you may have to worry about it. But I don't see it as a major source of concern now. My rival is Europe, but it's a mild rival.

Beckworth: Yeah, that's a fascinating point. Again, if you go back to the bank analogy, the US is a banker to the world, if you're going to run on your bank because you don't think it's no longer safe, you should have an alternative bank to go to, right? And deposit your funds-

Caballero: Absolutely.

Beckworth: ... and what you're saying is, “Well, what's the alternative?” Right? There is no other bank like the US for the world. So for better or for worse, we are the banker to the world and so it's not likely. And the other thing is, your prediction was right. I recall a lot of people talking about a dollar crisis before 2008. I got caught up. I was like, “Oh man. Yeah, this is serious.” But you were right. It wasn't really, that wasn't the issue, obviously that came back to haunt us.

Caballero: I appreciate it actually.

Beckworth: Yeah. So let me ask this question. If the US is being the banker to the world, providing the safe assets to the world, what happens if the US starts running budget surpluses? And this actually happened the late 1990s right?

Caballero: Yeah, you're absolutely right. I was thinking that, that was one of the things that put pressure on interest rate, which is that the US began to run current budget surpluses. Yes, indeed. And that's for instance, supply plus. Now it depends a lot on timing, no?

Beckworth: Sure.

Caballero: Because if the economy's going through a very good momentum as it's currently going on, for example, and the risk premium starts declining and so on, then it doesn't matter very much, but if things get a little dicey again then it will matter a lot.

Beckworth: And that's one of the-

Caballero: Now having said that, I don't think that the US will run sort of budget surpluses for a while.

Beckworth: ... yeah, we want to be careful, don't take things for granted, but this definitely kind of relaxes the budget constraint on the US government. I mean it's-

Caballero: Oh for sure. It makes it a little cheaper for sure.

Beckworth: ... yeah absolutely. On the margin, it makes it easier for Congress to spend money. They're not facing the pressure of higher interest rates, but someone wants to joked, before the crisis, back when people were worried about the dollar crisis, people were joking, “What is the US' true comparative advantage?” And the joke was issuing debt. Ha-ha-ha. But it is, I guess, this discussion says, “Yes, it actually is our comparative advantage.” Some countries have comparative advantages.

Caballero: They're very good at it.

Beckworth: Yeah. I mean we have the institutions, we have the rule of law, we have the experience, the deep capital markets. We are good at issuing debt and the world comes to us and you in your paper you talk about the Triffin Dilemma. So maybe speak to that. It'd be a good time to speak to that if you can.

The Triffin Dilemma

Caballero: Well the Triffin Dilemma wasn't about Bretton Woods and about the demand for dollars. That's when France was complaining the demand for dollars, but dollars were backed by gold. And obviously there was a limited supply of gold. So, at some point, either that broke down or the world would have to go into a recession because there was not going to be enough demand for the dollars for the enormous amount we had out there and there's an analogy with that today, in that they will need certain amount of safe assets to function. And if that expansion doesn't take place then you need some other adjustment mechanism for a while, that was an increase in the value of those assets, which happened mostly through the declining interest rates, but there's a small lodging for that left. And so it has to happen through some other means. Another means could be sort of an opposition of the currencies in which those assets are denominated, so the dollar, the euro and currencies like that. But that causes other problems, external account problems and things like that. So eventually that can happen, then it becomes a constraint on growth and causes a recession.

Beckworth: Yeah. So the Triffin Dilemma as you mentioned was initially applied to the dollar, but I think in your paper you apply it to the US debt, right? US safe assets, treasuries?

Caballero: Yes, exactly.

Beckworth: The world effectively wants us to produce more debt than we actually need. They want our dollars and US treasuries they want to hold and so there's this tension between, we have this incentive now to create more debt issue more liabilities to the world than we actually need ourselves to fund. And this creates this tension. And I guess the tension is at some point, we could issue so much debt that no longer the treasures would be a safe asset. But we haven't hit that point yet.

Caballero: We haven't hit the point, but I think back way induction is sort of the most overrated concept in economics. But at some point people may worry, they'll say, “Well, if China keeps growing at twice the rate of the US and they keep demanding a constant share of their output in the form of safe assets, then the system, it has to give up somehow.” By the way, I've been making that calculation in the case of Japan for many, many years and nothing has happened yet.

Beckworth: Yeah, that's true.

Caballero: Many people have lost their shirts betting against the Japanese debt.

Beckworth: Yeah, Japan is really an amazing story. The amount of debt that they've issued and the appetite is still strong and that's something that is sometimes hard to explain to people to let them say, “Hey, there is this bigger capacity's appetite for safe assets.” Well, let's go through some of the specific developments in this story. We've kind of talked about it in general terms, but I believe you begin the safe assets story with the crashing of the Japanese bubble. Is that right?

The Crashing of the Japanese Bubble

Caballero: Well, yes. But again, at that time I did not call it the safe assets shortage, I called the asset shortage. And it was indeed the collapse of the bubble in Japan and then later on actually the Asian crisis that I think sort of you said crisis... In emerging markets, the truth is, I came from this literature from the emerging market side initially thinking that this is a pretty recurrent phenomenon. Emerging markets are economies that always have shortage of assets. They can be very good at producing goods, but they don't have the institutions and so on to produce good financial assets, so there's always some sort of shortage and those shortages get covered temporarily by real estate bubbles and things of that kind. And then when they crash, you have the hole again because there's a demand for assets but you don't have that artificial supply and then you see these gaps.

Caballero: I think Japan is not an emerging market, but they did go through an episode of that kind. Enormous savings rate, very high savings rate, they needed assets. Those were created, well, they went abroad, they brought enormous amount of assets. I remember coming to the US when they were buying Rockefeller Center and stuff like that, but also they had an enormous domestic bubble. When that collapsed, that indeed destroyed wealth, but it also destroyed the big part of the supply of assets and that created an imbalance. And Asia and an emerging market Asia went through something very similar than in the late '90s and unlike Latin American economists, we have gone through these things many, many times in the past. Then unlike Latin American economists, sort of Asian economists decided that this was not going to happen to them again. So they on top of the destruction of assets, they went on to sort of increase their saving rate enormously and especially as safe assets saving rate. And that I think is sort of the beginning of this massive trend.

Beckworth: Yeah, that's fascinating. What was that 1989 when the bubble burst in Japan?

Caballero: Yeah, '97, it was Asia and '98 is when it spread to Russia to the rest of the market. And to the US midway to the ASEAN, remember? But we stopped it quickly.

Beckworth: Yeah, there's this story is happening over several decades. It starts in Japan when their bubble burst and then the emerging market crisis you mentioned also adds to that. So bringing us to the late '90s then at the same time, we just talked about earlier, the US running budget surpluses, bringing down instead. And, and again, this is so counterintuitive, right? Most people would say, “Hey, that's a great thing. We were getting to retire our debt.” And what they're missing is the world actually needs this debt to function, right? It actually needs …

Caballero: Yes and for a while, it was a great thing because it just lowered the cost of capital. Again, initially it was fine. It was almost fine because we had this little incentive problem within the financial system that led us to a crisis. But yes, it's an input we need. And remember also that at the same time as deficits where sort of close and in the US, China was coming into play and growing at a very fast rate, with very high saving rates, with a controlled capital account. But essentially with the government doing the international saving for the local agents. They had much higher saving rates and investment rates, both of them very high, but savings rates higher than investment rates. And then all this was intimidated to the rest of the world through the Central Bank, but the Central Bank was very specialized in buying safe assets. That really put enormous pressure on that market.

Beckworth: Okay. Well, let me ask this question. In the early 2000s, when the US begins its Iraq War, 2003 invades and this blows up the budget deficit in the US did, did the Iraq War helped the safe asset shortage probably?

Caballero: I never thought about it, but yeah, I guess he was a collateral benefit of that. By the way, and you mentioned this issue before, it's not that the US needs to generate fiscal deficits to do this thing. I mean it is true the way debt is almost always created by sovereigns is as a counterpart of deficits. It's not an act of financial engineering, but you could imagine making it an act of financial engineering. Doesn't mean you could issue debt, safe debt to buy assets, not to buy goods. You could buy assets.

Beckworth: Well that's a great idea. Actually I was going to ask you about that. You're talking of a sovereign wealth fund for the United States, is that right?

Caballero: For example, yeah. For example, you could do that. I think that ultimately that's what we have to have happen. And you can see it. I mean, I always look at Japan because they're ahead of us in all these things. They're buying equity, literally. They're doing it in sort of industrial policy through equity or environmental policy through equity interventions. They buy ETS that are green for green ETS. I'm not advocating for that, but in a sense, what a safe asset shortage means is the private sectors doesn't want to absorb the risk that is being generated by when the private sector plus emerging market and so on, it does not want to absorb the risk that has been generated by the proactive capacity. Someone has to absorb that risk ultimately. And I think temporarily, it can be governments, it doesn't even have to be through debt, meaning it could be at the private sector generators but the banks are going to do the same things they were doing before.

Caballero: They now need to systemic insurance and pay for it in advance in which case the liabilities is a very different form, it's not the debt that is out there, but there's a commitment that the public sector has to support the financial system if we run into another crisis. There are many ways of improving deficiency which we do this, but ultimately, the problem is someone has to absorb the risk and the world seems to be running out of options there.

Beckworth: Well come back to that in a little bit later talking about the solutions. I want to flush this out a little bit more though. Going back to the early 1990s, when the Iraq War happens and you agree that at least potentially it offset some of the safe asset shortage. So I guess an interesting counterfactual would be if the US had not done the Iraq War and there hadn't been all these added safe assets created by the US government, would the housing boom been even bigger? Would the private financial sector had to produce even more and mortgage backed securities. We've seen an even bigger bubble and as a consequence of bigger bust?

The Iraq War’s Potential Impact on the Safe Asset Shortage

Caballero: I want to agree with you, but I have to be careful. I don't want people to get into wars and things like that.

Beckworth: No, no, no….very clear. We're not advocating war as a way to solve our problems, but-

Caballero: But you're absolutely right. I think that that was a collateral benefit probably. That's an interesting concept as well, whether you want to crowd out the private sector, so some incentives to do these kind of things. And how do you do so?

Beckworth: ... okay. And I guess this is interesting to me because I mentioned this with some, some folks on Twitter. I was like, “One of the collateral fallouts from the GOPs new tax plan is a huge big budget deficit.” I said, “Might this address some of the safe assets shortage?” And they weren't too enthusiastic about the idea. And your point is there's more efficient ways to address it than running big deficits, fighting wars and other distortionary approaches.

Caballero: Yes. But having said that, I think that there are still temporary solutions. I mean, unless something changes structurally, even there, there's a limited capacity to do that. We can buy a few years, but something has to change. Now, long-term forecasts are always tricky here, but China could become a powerful supplier of these assets and so on. But as it looks now, yes, we can do things that can improve things in the short term. Again, good momentum for the global economy helps a lot because if risk-aversion sort of declines that reduces the problem significantly. But it seems at this moment that we're in the face of a structural problem.

Beckworth: Okay. Well let's dig a little deeper into why does this actually all matter. Why do we care so much about the safe asset shortage problem? You've already kind of touched on it in different places, but let's really focus in on it. And you talk about in particularly in your papers, why it really becomes a problem with the zero lower bound problems. Talk us through again why a shortage can affect the real economy.

The Safe Asset Shortage’s Impact on the Real Economy

Caballero: Yes, to me there are two big reasons why these matters. The first one we already talked about these incentives. We shouldn't believe that the private sector will not try to re-engineer safe assets if a problem continues and I think we will see a lot of that. But the second one is, as you correctly point out, this is I don't know if it's the zero lower bound, people call it now the effective lower bound because we have seen negative interest rates with Europe and so on, but still the scales they cannot go very, very low. So these are sort of limit down there. And the mechanics of this is sort of very similar to a liquidity trap. The problem is that it's harder to get out of it. What happens in a liquidity trap? In a liquidity trap, really what you have is that people want to save more and the economy doesn't have the assets for that. And what you need to do is create that wealth and that takes the economy out. Most of the policy is to get us out of a liquidity crisis are policies in which you try to inflate wealth somehow and to the point in which people feel rich enough and they demand and raises and you get out of it.

Caballero: Well, in a safety trap, there's something very similar that goes on. But the difference is not that people want wealth, people want a particular form of wealth. If you don't create that, aggregate demand contracts because people want to save more in the foremost, this is very a very difficult asset which is difficult to find, therefore it's expensive and so on. The situation is very similar. The equilibrium will happen by lowering, if you look at the flow side, you look at the output side and the equilibrium will happen by depressing the demand for safe assets. How do you depress the demand for safe assets? Well, by lowering output, lowering income, lowering savings. That's a bad adjustment that happens in a case like this. And again in a liquidity trap, if you think about the flow side, it's very similar. The way you restore equilibrium is, well you reduce the amount for savings by genetic savings by reducing income. Now think of what happens in a safety trap if there's a bubble in financial assets. Well in a liquidity trap, if a bubble emerges, then all of a sudden, people feel richer, they can satisfy the demand for savings and aggregate demand goes up, that pulls out, put aggregate out.

Caballero: Think what happens in a very strict situation that the constraint is really a shortage of safe assets. Now you get a bubble. People look at the bubble and say, “Well, that's not the problem I have at this moment. My problem is a shortage of safe assets,” so that doesn't pull me out of the system. Many of the policies that central banks have to pull an economy out of a liquidity trap, out of the wealth inflating time. When wealth inflation by itself, all the dashing and the strict liquidity safety trap environment increases the risk premium, but it does not satisfy the basic needs of safe assets and therefore doesn't pull the economy out. You will only do so when you increase the supply of safe assets.

Caballero: Now that's a very strong and extreme characterization. What happens in reality is that everything is sort of a high rate of a safety trap and a liquidity trap in the middle of a big crisis is mostly affected trap as you go, as the recovery progresses then it morphs into a liquidity trap, but I think that's the reason we have seen such a stubborn and slow recovery. By now we're doing well, but this is almost a decade after the crisis. What has happened is that all, sort of the traditional tools to take us out of a liquidity trap, really had a very mild affect because it was not a matter of a shortage of wealth, but it was a matter of a shortage of safe wealth.

Beckworth: That's very interesting. You bring this out in your Journal of Economic Perspectives paper, I'm sure in your other ones as well, but that even if you can get out of the liquidity trap, you can still have a safety trap. Correct? That's the problem.

Caballero: Yes. The problem is that it looks like it's a liquidity trap in the sense that your rates don't go up. They remain at zero despite the fact that you may begin to see speculation and you may see some assets going up, real estate recovering, stock market going very high, but the economy is still stuck there and the rates continued to be low. So you could call it a liquidity trap, but it's interesting but differentiated it from the safety is that yes, we are in a liquidity trap, a liquidity trap is very stubborn because the normal ways of getting out of it are not very effective. And I think that's a big reason why we see these very high valuations today in the equity market. In the US for example, is that there was very little traction to that. Aggregate demand was very unresponsive to that mechanism which otherwise would have been very responsive had it been only a liquidity trap. It would have been of that kind, but you kept seeing sort of the rates very, very low and it's not because the Fed decides that, it's the market-

Beckworth: Absolutely.

Caballero: ... wants those rates very low. Valuation going very, very high. The equity risk premium remaining very, very high in some case and some places of the globe has even increased, but aggregate demand was very sluggish.

Beckworth: Yeah. Now this makes a lot of sense in this kind of responds to the quick comment Larry Summers made on the podcast earlier that I shared with you. But this, I think this kind of fits, brings all the pieces of the puzzle together in a nice way. And I want to touch on something you mentioned a minute ago. People often will blame the Federal Reserve for the low interest rates, but as you pointed out the market, it's this very nature of this problem that's driving the rates down, right? For the economy, the fundamentals are pulling the rates down. This appetite for safe assets is pulling the rates down and it's getting stuck at the effective lower bound. And what I often like to tell people who have a hard time because they think the fed is artificially lowering rates is, I like to tell them “This is just capitalism 101. Econ 101,” right? We need markets to clear and how do markets clear? Markets always clear by prices adjusting. And this is a case where markets aren't adjusting. If you want markets to work, let prices do their magic, but we're not able to do that with the zero lower bound or effective lower bound.

Beckworth: Here's a kind of a follow-up question to that is, I often get a critique when this safe asset conversation came up, I'd often get this critique, people would say, “What do you mean there's a safe asset shortage? If people want more treasury bonds, why can't they just bid up the price of the bond? Right? What's stopping the bond market from seeing bigger and bigger valuations of bond prices for treasury securities?” In my response, I want you to critique this, see what you think. My response is, “Look, if the interest rate can't go down, then the bond price can't fully go up because those two things are linked. Therefore, bond prices on treasures would be even higher if we didn't have this effective lower bound.” Is that reasonable?

Caballero: Yeah, that's very reasonable. By the way, this is not something that's only happening now. Remember the Greenspan Conundrum. This one was trying to raise interest rates and the loan rates were coming down. It was a reflection of this and it is the case that indeed, the price of safe assets is extremely high. In the front end, when there's no more space and the preferred substitute for cash, well there's a limit of how high they can go. On the back end, it's a little different story and indeed we have seen where you go to Europe, like 80 percent of their long-term sovereign bonds that I think have negative rates. They can decline and that has been part of the shockers absorb and I think part of the effectiveness of QE has been in convincing people that they already have a negative better asset that will help. Yes, prices have adjusted, but they haven't adjusted a lot, that's part of the point.

Beckworth: Yeah. And that's kind of a hard story to tell, right? You're saying, “Look, to get a full recovery, we need treasury prices to go even higher.” And people like-

Caballero: At some point, by the way, you can get into a different kind of mechanism, which is, some people, me, I mean at some point if you want, if you need safe assets, but the price goes very, very high, you have to increase the savings rate because how am I going to retire with those kinds of rates. You can get into very perverse feedbacks in which-

Beckworth: ... that's interesting.

Caballero: ... savings rates go up, the aggregate demand comes down even more and you start getting deeper into a liquidity crisis. I think the world is very bipolar at this moment. We are going through a good time, but we're very close to another nasty episode because of all these forces that are so close.

Beckworth: That's very interesting. It's bipolar. We're on a knife-edge here, it could go one way or the other.

Caballero: Yeah, exactly. Exactly. It looks good, but we have very small buffers and so I think this is happening at the very same time in which volatility is extremely low. And I think that's part of the equilibrium as well. If you're a risk-taker or a reluctant risk-taker, well this is perfect conditions because you have a large equity risk premium and you have almost low volatility in the markets. But I also say, “Well, we need an equilibrium.” Look in order to be in the current situation, where we finally seem to be at sort of a natural rate of output, whether that is an under rate of unemployment although that's debatable, but we're doing this with extraordinary, extraordinary risk conditions. Very favorable. Realize volatility if the equity market below five percent and weeks at eight or nine and very large equity risk premium. Imagine what happens if volatility goes up to 15 percent. I think that the problem would come back with a vengeance. And these central banks, they are the central banks have done a lot which they have created an environment that seems very, very friendly to risk taking because it's what we need. The mental problem is one in which people, investors and consumers and so on, do not inference. Do not want to take risks. You need them to take more risk and so we have a very stretch risk markets because of that.

Beckworth: Well let's look more at these solutions. You're, we're talking about solutions to the problem. One potential solution is to find a way to decrease the demand for these safe assets. Is that possible? Could you lower the appetite for safe assets by, I don't know, making people less risk averse… or maybe that's not possible. What are your thoughts?

Increasing the Demand for Safe Assets

Caballero: Well, I think that there's some low hanging fruits out there, which central banks are sitting on an enormous amount of safe assets. I think they could release a few of those, especially those using QE. I think QE a very useful tool when the Central Bank buys risky assets. But if it's buying safe assets for all it's not helping a lot of this moment.

Caballero: Now if the 430 doesn't matter because the other side of it is reserves, so it's a wash. When you start buying sort of long-term safe assets, I don't like it as much. That's for developed economies. For American markets, we have enormous amount of international reserves and that more efficient mechanism to do that. We could develop swap lines and things like that, that reduce sort of all those safe assets that are stored at central banks' balance sheets. That I think, those are the main drivers.

Caballero: Then there are regulatory issues that have to do with bustle three and other things that could also release some demands for safe assets, but I see all these things as temporary solutions that can buy us a few years and so on, but that demographic forces and that I see them as very strong in any way, but yes, we can buy time and reduce that, but that's the point and again, even an economic recovery by itself will very naturally reduce the amount for safe assets.

Beckworth: Okay, so the fundamental problem then behind the safe asset shortage problem then is several I think one, you just mentioned is demographics. So demographics is just the force of nature that it's not going to go away anytime soon. And as the population ages. They want to have more fixed income type assets. That's going to increase the demand. And this is something we're going to have to contend with. The other one that we've talked about earlier is just that the global economy has not built up its capacity to structurally or permanently produce more safe assets. And I'm guessing that's the long-term solution is somehow put ourselves-

Caballero: Yes.

Beckworth: ... okay, yeah. One of the, one of the suggestions we mentioned earlier-

Caballero: Again, we need to align the risk produced by the proactive capacity with what people want to demand, but there's this old literature on collateral, De Soto used to talk about this in Latin America that there's so much collateral that has been wasted, there's real estate, there is oil but there isn't a financial industry that can transform those things into financial-ess assets that can be used for restorative value, for safe restorative value. There's a lot of space there. There's a lot of potentially time travel assets that can generate that safety. That has to be a big part of it. And hopefully what'll happen from those places that are growing very fast and that have the potential to produce a lot of assets. I mean, if you're growing very fast, that means that also have the potential to produce a lot of assets. That in itself producing assets, financial assets is difficult. It requires the kind of things you have mentioned earlier in this show, but also producing safe assets just requires even more institutional strength and so on. But there's an enormous amount of assets around the world that could, in principle become the vacuum for the safe assets if we supplement them by the right financial institutions and institutions more broadly. But that has to be the long run solution.

Beckworth: ... so, make sure I understand this. You're saying we need to find a way to incorporate all these existing assets that are already out there and convert them, transform them into some kind of safe asset?

Caballero: Yes. I mean that's a great [inaudible] story-

Beckworth: Securitization, yep.

Caballero: ... that's behind the… Was a good story. It happened that the buffer was too small for this kind very systemic assets. We can improve there. Maybe the chance that you can get is not as big as we're getting there, but there's a lot that can be chanced out and so son. But again, that requires to have the financial institutions that can support that and the monetary institutions that can support that, it requires a lot of financial development for which ultimately is the issue.

Beckworth: Okay, so we have a lot of work cut out for us institutionally moving forward. That's not the most encouraging story. Let me ask another angle on the safe asset story. I have monetarist route, I like thinking about money and the role money place and Gary Gorton paints this picture of the run on the shadow banking system and he kind of, I think weaves a story about the safe asset issue in terms of money, so that there's retail users of money like you and me and maybe small businesses that use money assets, you'd find like a Measure M2, or M1 and then there's institutional money asset users, corporations and big governments, money market funds. And they use treasury bills, they use repos as a form of money for them. My question is this, is part of this conversation about the shortage of money, transaction assets, it's not just safe assets but transaction assets?

The Role of Transaction Assets

Caballero: Well I love Gary's work and I think he has done great work on this area, but I think of them as a little different in the sense that I think there's no doubt that sort of regulatory requirements and even sort of conventions within the financial system, are an important story behind the demand for safe assets, but the particular aspect you are describing at this moment, I also see it more to an issue of velocity. The question is there, could we find a way of generating more velocity out of the same stock?

Beckworth: That's a good point.

Caballero: And if velocity sort of slowed down because of regulatory, we need to dare think about regulatory changes that allow us to use the stock that is allocated to these things more efficiently in the sense that we can move it around a bit more. They do miracles already, you can see lots. Velocity is pretty high within the financial system but that's more about velocity than about the stock, I would say.

Beckworth: Okay, fair enough. Yeah. I mean that's true.

Caballero: And related, of course, I mean there's risk because the risk associated to very high velocity, but there's an extra margin of adjustment of potential solution there which has to do with this velocity.

Beckworth: Yeah, okay. That's a good perspective on that. Let's see, in the time we have left I want to go want to go back to a point we made earlier about a country that's acting as a banker to the world, they're going to run current account deficits. My question is can a country perpetually run a current account deficit? I mean if there are no other bankers to the world, how long could the current account deficit running go on?

Possibility of a Perpetual Current Account Deficit

Caballero: Well, the issue is always the current account deficit. By the way, we could do banking in the sense you described before and have no current account deficit in the sense that you could be buying the same amount of risky assets abroad than you're selling safe assets.

Beckworth: That's true, that's true.

Caballero: There's a lot of space there in gross flows that don't require a net flow. But the issue of the current account deficit is one relative to your own GDP, no? That's the constraint constraining because the producers of these assets are growing at a lesser pace that the demanders, the net demanders of these assets, so that's the tension because you can imagine the current account deficit over GDP that is growing that is more stable, that would mean that maybe it's ten percent of GDP, but it eventually cannot derail the rate of growth of GDP. And you cannot run infinitely leave ten percent of GDP type current account forever. There's no problem.

Caballero: The problem is, is China is going to press the pace and they keep demanding these assets, then they're asking you to really increase your current account, they should be in on that and the truth is that at the global level, that is sustainable in the sense that what puts a limit is the current account deficit of the US relative to the growth of China, not of the US, no? But that would require that the current account deficit of the US balloons and at some point, somebody may change their mind. So it's a risk. We don't know where that point is because we don't have any parallel to this so we can see. We had some of that actually in the transition from the UK to the US, but you don't see an equivalent transition happening today towards China perhaps, but you could see... I would not be surprised of seeing another sort of round of global imbalances happening and to be sustainable, what is the level, what is the limit? I don't know.

Caballero: From the point of view of you think of money as this is a problem of money and you think of money as a bubble, as a convention and we know from the theory of bubbles that you can do it as long as it doesn't grow faster than the rate of growth of the economy and the rate of the economy, this has been done by China, then it's going to be higher than the US so that would mean that the US can face some increasing current account deficit. Before, in the US actually, we should start closing the European current account surplus and so on. There's space here.

Beckworth: One of the interesting countries that has been running a current account deficit for a long time is Australia and it has been running for decade, after decade, after decade. So it must be offering some kind of service to the world as well that they allows it to go on or its capacity is larger than many even might think.

Caballero: But remember, one of the good things about Australia is that they go very fast. The current account deficit over GDP hasn't blown up. It is true, they have never run a surplus but that doesn't matter. As long as it does, Australia can keep growth. There are always the issues with growth and Australia is a bad example. I think they haven't had a recession in the last 20 years.

Beckworth: Yeah. They're amazing.

Caballero: Yeah. So, and they always complaining about the value of their real estate and that's, again, people that are richer, they need to save.

Beckworth: That's a great point.

Caballero: And I also the city is such a beautiful city. But they have the dictorum there, exactly. Is Chinese going to Sydney to buy property as a store of value?

Beckworth: Yeah. Australia is a fascinating place. They didn't experience the great recession. They hadn't made the same problems the US had. They had like you mentioned high real estate prices, a lot of household debt. They had the highly leveraged balance sheets but they didn't experience the great recession. Okay. I think we need to end in a few minutes here, but I want to end on the sovereign wealth fund. I'm want to go back to that, I mentioned it earlier. You talked about potentially the US government running a sovereign wealth fund. Tell us again a little bit more about how that would work and then talk about potential drawbacks to using it.

Drawbacks of Utilizing a Sovereign Wealth Fund

Caballero: Well, no you proposed the US to run a sovereign wealth, I was talking about the concept, meaning that the type of interventions you need, certainly in the crisis is one in which the government broadly defined needs to buy risky assets, remove risk from the system and supply safe assets and that you could describe it as a sovereign wealth fund. But I'm not advocating one for the US. During crisis, that's what should happen. In fact, I always defended, for example, the Hong Kong stock market integration in '97 we've talk about the crisis. They had a massive intervention in their equity market, which was incredibly successful by the way. But those are the kinds of things that you may need to think about in an environment of this kind.

Beckworth: In other words, the sovereign wealth fund would be more of a temporary feature, wouldn't be like Norway has its sovereign wealth fund because it has oil.

Caballero: For the US yes, exactly. I think for the US that's the nature of the thing, but the bottom line is that someone needs to take more risk. And the question is whether you want this to be sort of workers through the government. That would be sort of the kind of things you're talking about or someone else. But anyway, I think this is permeating even the labor market, I mean, I think that if you look at the labor share, part of it also has to do with this. Somehow we have to migrate to a society where viscous is spread more broadly. Now maybe it's more efficient that the government does it. I don't know.

Beckworth: Yeah. Very fascinating. Well, our time is up and our guest today has been Ricardo Caballero. Ricardo, thank you for coming on the show.

Caballero: It has been a pleasure David.

About Macro Musings

Hosted by Senior Research Fellow David Beckworth, the Macro Musings podcast pulls back the curtain on the important macroeconomic issues of the past, present, and future.