The safe asset shortage after Covid-19

This is a summary of a column that appeared in the FT on 28 June 2020.

The full column appears here:

https://www.ft.com/content/b98078c0-6acc-43e6-929b-13883c211288

Demand for safe assets has far out-stripped supply since 2009 but the latest crisis may help redress the balance.

One of the long-term consequences of the 2008 financial crisis was a lack of safe assets that could be used by institutions to store their wealth, meet regulatory requirements and provide collateral to borrow additional funds. This problem has been identified as an important reason for low capital investment and the slow growth rate in the global economy in the past decade. It was also a prime cause of the European sovereign debt crisis, which peaked in 2012.

A silver lining from the Covid-19 shock is that the policy response may actually alleviate the safe-asset shortage, according to new research by Fulcrum economists (see table). That’s because it will leave a legacy of much higher government debt in the most advanced economies, including the US, which is the main global source of these assets.

Economists including Ricardo Caballero and Emmanuel Farhi have established that in some models a shortage of safe asset supply can result in a “safety trap” that affects the global economy. This is a close cousin of the “liquidity trap” that appears in many New Keynesian models. Because interest rates cannot fall enough to balance the supply and demand for safe assets, national income and wealth shrink to eliminate the excess demand for them.

The Covid-19 crisis will help because government debt in the US and other advanced economies is surging. Although central bank and private sector demand for safe assets may offset some of this extra supply, the overall effect may be to reduce the safe asset shortage for a while as the global economy recovers.

Will public debt be a problem when the Covid-19 crisis is over?

This is a summary of a column that appeared in the FT on 21 June 2020.

The full column appears here:

https://www.ft.com/content/da150515-a5e9-4237-9b70-757dd958bf0d


There is unanimity about macro-economic policy for now, but not about the exit strategy

The major change in the major economies that is certain to follow the Covid-19 shock is a large and permanent rise in public debt ratios, including a rise in the US debt ratio to a new high for the series in the entire history of the Republic.

Macro-economists have been almost unanimous in agreeing that the stimulus packages to protect economic activity during the lockdowns have been appropriate, but an important debate is developing about the long term impact of higher debt ratios on the global economy.

Mainstream New Keynesian macro-economists (for example, Larry Summers and Paul Krugman) are not concerned about possible damage from higher public debt per se, and some appear to believe that this will actually be a positive, because it may offset the forces of secular stagnation. They also believe that debt servicing costs (ie bond yields) will probably remain below nominal GDP growth rates indefinitely, so high public debt and borrowing will be sustainable.

However, there is an important group of macro-economists, led by Ken Rogoff and John Cochrane, who believe that high debt ratios can lead to “runs” in public debt markets, even in advanced economies with their own central banks. They are therefore concerned that high and rising debt may result in financial calamity.

Although the New Keynesians are almost certainly right in the short and medium term, the debt school should not be ignored. A new strategy for the exit needs to be developed to mitigate these risks.

Managing Covid debt mountains is a key task for the next decade

This is a summary of a column that appeared in the FT on 7 June 2020.

The full column appears here:

https://www.ft.com/content/a371909e-a3fe-11ea-92e2-cbd9b7e28ee6

Summary:

The recent surge in public debt in all of the major advanced economies is almost without precedent, even in wartime. In the US, for example, the government's financing requirement from April-June 2020 will reach $3tn, equal to 15% of this calendar year's GDP.

The IMF estimates that US government debt will exceed 130 per cent of GDP after the recession, more than 30 percentage points higher than a decade ago. These public debt mountains will need to be managed indefinitely, with little immediate prospect of reducing their size. The larger the scale, the greater the economic costs of debt mismanagement.

So far, there has been no panic about the sustainability of government debt, either in the US or elsewhere. This is a big success story for debt management policy. 

However, much of the funding has been accomplished by the sale of Treasury Bills, which has shortened the duration of the debt. This exposes the US government to increased interest rate risk, which can only be alleviated by extending the maturity of the debt over time.

In the 2010s, the US Treasury succeeded in extending duration, at a time when the Federal Reserve was attempting to shorten duration because it wanted to reduce long dated bond yields as part of its QE programme. This led to a tug-of-war between the two institutions, and their actions came close to negating each other entirely.

As the Treasury and the central bank are two parts of a single public sector balance sheet, it makes little sense for them to pull in entirely different directions. If secular stagnation deepens in coming years, as many expect, the Treasury should focus on shorter-term funding to help the Fed reduce bond yields and support economic growth. This would be likely to result in lower long term bond yields, and flatter yield curves, than those seen in the 2010s.

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John Cochrane has commented on the FT column here:

https://johnhcochrane.blogspot.com/2020/06/perpetuities-debt-crises-and-inflation.html

The effects of Covid-19 could deepen secular stagnation

This is a summary of a column that appeared in the FT on 31 May 2020.

The full column appears here:

https://www.ft.com/content/d60cdc40-9fec-11ea-b65d-489c67b0d85d

Summary:

When former US Treasury secretary Lawrence Summers delivered his famous address on the return of secular stagnation at the IMF in 2013, he revived interest in a Keynesian construct that had fallen into disuse since the 1940s. He argued that a chronic excess of savings, relative to capital investment, may be developing in the global economy, forcing long-term interest rates down and threatening a persistent shortage of demand.

Mr Summers’ warnings have proven largely justified in the last 7 years. He now believes that the COVID-19 crisis may deepen secular stagnation, because risk aversion in the private sector will increase permanently, leading to more precautionary savings by households, and less investment by businesses. As he puts it, “just in case will replace just in time”.

A permanent state in which the equilibrium nominal interest rate throughout the developed world is at or below the central bank policy rate is, to put it mildly, really worrying.  Traditional monetary policy would become impossible, without major policy reforms to change the situation. There are three possible consequences of this.

The first is that the world could be stuck at zero. All the advanced economies may follow the example of Japan since 2016, with interest rates across the entire yield curve stuck at zero, and fiscal policy battling against a continuous rise in government debt ratios. For asset markets, this would represent a low-return world, with demand management becoming increasingly hamstrung in recurring recessions.

The second could involve permanent fiscal stimulus and rising debt. By reversing the trend decline in interest rates, this policy may result in an immediate period of negative returns for both bonds and equities.

And the third could give us very negative interest rates. Negative rate policy could only succeed if pursued aggressively, taking policy rates to minus 3 per cent, or even lower, in recessions. By extending the decades-long downward trend in interest rates, this approach would probably prolong high returns from both bonds and equities. 

The political feasibility of these extremely radical fiscal and monetary policy changes seems highly questionable. But if Mr Summers is right about the deepening of secular stagnation, such reforms might be needed to avoid Japanese-style deflation in Europe, and even the US.