From Caballero and Fahri:
The global economy has a chronic shortage of safe assets which lies behind many recent macroeconomic imbalances. This paper provides a simple model of the Safe Asset Mechanism (SAM), its recessionary safety traps, and its policy antidotes. Safety traps share many common features with conventional liquidity traps, but also exhibit important differences, in particular with respect to their reaction to policy packages. In general, policy-puts (such as QE1, LTRO, fiscal policy, etc.) that support future bad states of the economy play a central role in the SAM environment, while policy-calls that support the good states of the recovery (e.g., some aspects of forward guidance) are less powerful. Public debt plays a central role in SAM as long as the government has spare fiscal capacity to back safe asset production.
Our model illustrates the essence of SAM and its implications for standard macroeconomic policy tools, but it leaves untouched critical considerations for the dynamics of the world economy in the medium term.
Given the faster growth of safe-asset-consumer economies than that of safe-asset- producer economies, absent major financial innovations, SAM is only likely to get worse over time. Aside from temporary cyclical recoveries in spreads and output, it is our conjecture that SAM will remain as a structural drag, lowering safe rates, increasing safety spreads, straining the financial system, and weakening the effectiveness of conventional monetary policy.
There is significant incentive to produce major financial innovations to address the safety gap, which can be a source of concern in itself, as the financial system capacity to extract safe tranches from risky assets is likely to get stretched along lines similar to those behind the subprime crisis. However, it is important to recognize that this is a chronic structural and macroeconomic problem that does not get remedied, but only reallocated, with standard regulatory pressure (which may have merits on its own). Instead, what is needed is public- private cooperation in increasing the efficiency of production of safe assets, as well as policies that reduce the demand for such assets.
What are these policies? What are the political limits on pre-paid “bailout” agreements and cross-country insurance arrangements that may be needed to reduce the SAM problem? What are the intergenerational transfers that SAM requires and, are these acceptable, espe- cially for current retirees? Will SAM lead to widespread “gambling for resurrection” type mechanisms from those institutions and corporations whose implicit liabilities are inconsis- tent with depressed safe rates of return? How much of the adjustment will take place on the supply side of the economy via reduced entrepreneurial risk taking? We are just beginning to comprehend the implications of SAM for macroeconomic policy and politics, but it is already apparent that these are broad and significant.