A global shortage of safe assets could easily turn into a big glut
PremiumAn oversupply of government bonds could prove highly disruptive
The safe-asset shortage is over. Should we worry? A safe asset is any asset that you can sell at any time and be sure to get your money back. That often means short-term government bonds or bank deposits. Hence, when demand for government-issued securities outstripped supply, economists called it a ‘safe-asset shortage’. The phrase ‘safe asset’ may sound boring—more speculative assets like Bitcoin and derivatives on Tesla stock seem sexier—but safe assets are the most important and in some ways the riskiest assets available.
And they touch everything. They appear in nearly every asset-pricing model, they’re used as collateral and are necessary for regulation and for managing currencies. They influence how much your bank pays in interest, your mortgage rate, how much debt the country can issue and where the US Federal Reservesets interest rates.
For decades, economists argued there was a shortage of safe assets in America, which may have caused the financial crisis and depressed growth. Now it appears the shortage is over, but that doesn’t mean you don’t have to worry anymore.
Bonds of big stable governments like the US’s or Germany’s are considered the safest of assets. With individuals wanting to keep their money secure, banks needing safe assets for regulatory reasons, and foreign governments wanting to manage their currencies, demand for these assets always outruns supply. When that happens, the private sector steps up and offers alternatives, like a money-market fund or bank deposit.
But sometimes it turns out that safe assets from the private sector aren’t so safe, like we saw with mortgage-backed securities in the 2008 housing market crash. And because supposedly risk-free assets are spread all over the economy, the consequences of failure are potentially catastrophic.
The safe-asset shortage was presumed to pose just such a dilemma. Some economists and pundits argued governments should issue more debt just to satisfy market demand. Other economists insisted that issuing debt in response to demand may cause more trouble in the future.
The whole shortage problem arose when banks started doing more wholesale instead of retail banking, which meant they needed to buy more bonds. Another new source of demand came from foreign governments that wanted to manage their currencies and their capital flows following the Asian financial crisis. For about 20 years, there was much more demand for safe government assets than governments could issue. As a result, interest rates fell and there was a boom in the creation of private-sector alternatives, like mortgage-backed securities. Investors desperate for safety suspended their better judgment and bought assets that weren’t so safe, like Greek debt.
But with very little fanfare, the safe-asset shortage now appears to be over, at least for US Treasury bills. This is in part because the Fed started paying interest on the reserve accounts they hold on behalf of the country’s banks. The Fed started doing this after the financial crisis, creating a new interest-paying, risk-free option for banks to stash their money—which they’ve increasingly taken advantage of. The US government is also issuing much more debt to manage the pandemic just as foreign governments appear to have lost their appetite for US Treasuries.
It’s worth noting there may still be a shortage of European safe assets, because countries like Germany and the Netherlands are not joining in on America’s debt-fuelled spending spree.
But a safe-asset glut could be as problematic as a safe-asset shortage. Suppose the current inflation spike turns out to be not-so temporary. Then the Fed will have to use its tools to contain prices, which means selling instead of buying bonds. That would mean even more safe assets on the market, and interest rates will start to rise.
This may be welcome for some savers, but the US economy has become accustomed to low rates. Returning to 8% mortgage rates now seems unthinkable, and it could cause serious problems for the housing market. A glut of low-risk assets could also make them harder to sell, which could cause many dislocations in the bond market, since low-risk bonds are effectively used as currency.
Two decades with shortages means a generation of policymakers have come to take low rates for granted. An insatiable appetite for bonds meant the government could issue as much debt as it wanted for very low rates. This explains why the US is now considering a $3.5 trillion spending package when we aren’t even in a recession.
But if we’re now facing a safe-asset glut, rates will rise, and so will the cost of all the new debt, and the obligations we already have will suddenly turn much more expensive. And then a shortage will seem like a nice problem to have.
Allison Schrager is a senior fellow at the Manhattan Institute and author of ‘An Economist Walks Into a Brothel: And Other Unexpected Places to Understand Risk’.
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