The Safety Trap – The Financial Market And Macroeconomic Consequences Of The Scarcity Of Safe Assets

Daniel Horvath

Magyar Nemzeti Bank

Robert Szini

Magyar Nemzeti Bank

March 30, 2015

Financial and Economic Review, Vol. 14. Issue 1. pp. 111-138.


Despite near-zero interest rates set by large central banks and other steps towards monetary easing in recent years, the economic environment has been characterised by low inflation globally and deflationary fears in some regions, while real economic activity has remained moderate. Although symptoms of this phenomenon are similar to that of the liquidity trap, important differences may be identified, which suggests that other factors may be important as well. One of the new approaches to appear in the literature identifies the structural excess demand of safe assets as a background factor that was aggravated by cyclical effects in the crisis. The mechanism of the so-called safety trap is similar to that of the liquidity trap, but it can be observed among safe assets; therefore, it can be considered a special type of liquidity trap. Financial market tensions trigger an economic downturn and a deflationary spiral in both cases, but different types of monetary policy responses may be effective. While forward guidance may be effective in the case of a liquidity trap, certain quantitative easing policies may provide a solution in the case of a safety trap.

The Safety Trap – The Financial Market And Macroeconomic Consequences Of The Scarcity Of Safe Assets – Introduction

Due to the recent economic crisis, financial market returns have stabilised at a permanently low level. This phenomenon and its possible consequences have received ample attention from decision-makers of economic policy, and several analyses published in understand the processes. One of the proposed approaches was an in-depth study of the supply-and-demand factors related to safe assets. According to the safety trap model, increased demand for risk-free and safe financial assets (“safe assets”) may result in substantial macro-economic effects in extreme cases, due to the scarcity of these assets. The phenomenon may be regarded as a special case of the well-known liquidity trap; it can be studied in a similar way, but there is a substantial difference in terms of its consequences and effective economic policy responses.

The return is so low in a liquidity trap situation that economic actors may become indifferent to holding cash versus holding other low-return investment assets.1 Due to the ensuing low nominal interest rate, over time monetary policy will have limited options to ease monetary conditions by means of its classical toolkit, although this would be justified by the deflationary processes and the decline in real economic output. Due to the fall in risk appetite, the demand for safe assets is stronger in a safety trap scenario; therefore, their return will be close to zero. After reaching this limit, the equilibrium of the risk-free asset market can be restored by a fall in real economic activity, not the decrease in the interest rate.

Even though the consequences of the two cases are similar, there are important differences regarding their underlying cause and, hence, economic policy responses. According to theoretical results, forward guidance and commitment of the central bank may be effective in liquidity traps; however, the use of quantitative easing may prove more useful in safety traps. The situation is further complicated by the fact that the two trap situations may be simultaneously present in a crisis, and different effects may predominate during various phases of the crisis. Therefore, the effective economic policy responses may also vary over time.

We deal with the causes and consequences of the scarcity of safe assets in our article, covering both the theoretical and practical aspects and placing particular emphasis on monetary policy implications.

Section 2 of this article introduces the New-Keynesian Liquidity Trap as a reference. Section 3 deals with safe assets and the causes of their scarcity. Section 4 summarises the modelling attempts and conclusions to date in the literature. Section 5 presents in more detail the work of Caballero et al. (2014), which may be regarded as the most developed model of the phenomenon. Section 6 summarises monetary policy and emerging market implications.

Definition of liquidity trap

According to the original definition of Keynes (1965), a liquidity trap is a situation in which interest rates fall to such low levels in a given economy that savers become indifferent to holding cash versus holding debt instruments. The theoretical background of the phenomenon is explained by the speculative money demand motive of Keynes’s liquidity preference theory, according to which the demand for cash becomes infinitely elastic at a positive “lower limit” of cash demand (i.e. the excess liquidity injected into the economy will be fully held as cash savings, so it has no effect on the interest rate and real economic activity). In this case, the effectiveness of monetary policy drastically decreases in the sense that, through an increase in money supply, it becomes unable to substantially influence the prevailing interest rate in the economy. It is worth noting that such a situation may also arise in the case of a sudden change in the willingness of savers to hold cash, without the drop of the interest rate to zero, which may be mostly observed in times of crisis when investor confidence is seriously undermined.

Safe Assets

Due to experiences gained in Japan and during the global crisis, the concept of a liquidity trap has been further developed over the past two decades, and it is now used in a slightly different sense than in the original definition of Keynes.2 In current economic literature, the term is usually used in connection with the zero lower bound of the central bank’s base rate. At the zero lower bound, monetary policy is no longer able to ease monetary conditions by means of conventional tools in spite of the fact that this would be justified by an environment characterised by low inflation (and/or recession). It should be stressed that, in contrast to the original approach, the cause of the problem in this case is not directly an increase in willingness to hold cash, but the zero lower bound of the short-term interest rate.

Safe Assets

Although the definition and underlying reasons of the liquidity trap are different in the traditional and modern views, the two approaches are quite similar in terms of their consequences: the conventional instruments of monetary policy lose their effectiveness and interest rates become “stuck” at a low rate, while aggregate demand falls further and recession and deflationary processes worsen. An important difference, however, is that the two approaches of the liquidity trap call for different economic policy responses. According to the traditional approach, monetary policy loses its effectiveness in the case of a liquidity trap and only fiscal policy can stimulate the economy. In contrast, modern approaches recommend the use of unconventional central bank instruments, and most of these models focus on studying the effectiveness of the possible instruments.

Safe Assets

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