The Supply Of ‘Safe’ Assets And Fiscal Policy
ludger schuknecht
Bundesministerium der Finanzen
July 15, 2016
CFS WP No. 532
Abstract:
This study looks at the interrelationship between fiscal policy and safe assets as there is surprisingly little analysis about this beyond fleeting references. The study argues that from a certain point more public debt will not “buy” more safety: countries face a kind of “safe-assets Laffer curve” with a maximum amount of safe assets at some level of indebtedness. The position and “stability” of this curve depend on a number of national and international factors, including the international risk appetite and, as a more recent factor, QE policies by central banks. The study also finds evidence of declining safe assets as reflected in government debt ratings.
The Supply Of ‘Safe’ Assets And Fiscal Policy – Introduction
There is a lively debate about the role and provision of so called safe assets. Safe assets are needed as a benchmark against which one can measure the riskiness of other assets (a kind of reference unit of account), as liquidity service for companies and banks, and as an investment device (storage of value).
Some economists argue that there is a scarcity of safe assets while others doubt this claim (for a survey see Portes, 2013). The implicit assumption of most studies, however, is that government debt is always safe. Hence, more expansionary fiscal policies and higher deficits raise public debt and, thus, the supply of safe assets (Gorton and Ordonez,2013 or from a policy perspective, Gosse Steffen 2014 and Tober, 2016). Public debt sustainability does not play much of a role for “safety” especially in the policy debate—if governments have difficulties it is because there are liquidity problems, not solvency problems. The euro crisis in 2011/12 was “fuelled by the absence of a union?wide safe asset” and not primarily by solvency concerns about the sovereigns in distress (Brunnermeier et. Al, 2012).
There is surprisingly little analysis about the fact that public finances need to be sustainable for there to be any safe assets. (For rather general references to this constraint see Caballero and Farhi, 2013, Obstfeld, 2013 or IMF 2013). At the same time and independently from the safe asset debate, it is frequently argued that current public debt levels, especially when considering contingent liabilities from high private debt and population aging, may already be too high to be sustainable in some countries. The current low interest environment may create an illusion of safety that could disappear when the inflation?interest environment becomes less favourable. Therefore, public finances need to be brought on a sustainable path with declining deficits and public debt to enhance the safety of government debt/assets.
This paper looks at the interrelationship between fiscal policy and safe assets more closely. It argues that from a certain point more public debt will not “buy” more safety: countries face a kind of “safe assets Laffer curve” with a maximum amount of safe assets at some level of indebtedness. The position and “stability” of this curve depend on a number of national and international factors,
including the international risk appetite and, as a more recent factor, QE policies by central banks. The study also finds evidence of declining safe assets as reflected in government debt ratings. The data confirms that a) higher public debt ceteris paribus means lower ratings, b) AA/A instead of AAA seems to be the new normal for “safe” industrial country debt, c) a number of emerging economies have “moved up” the rating ladder and may provide the “safe assets” of the future, d) even industrial countries can slide, at times rapidly, out of safe territory as was conceivable only for emerging economies in the past, and e) central banks’ QE policies further reduce the supply of safe assets available in markets.
The study first discusses some conceptual issues around safe assets. It then assesses empirically whether the financial?fiscal crisis and post?crisis period has led to more or less safe assets before concluding with some policy considerations.
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