Greg Ip has a new article in The Economist where he discusses how U.S. treasuries and other safe assets can serve as medium of exchange:
[D]emand for American government debt is driven by much more than a hunger for returns. Financial-market participants use Treasury bonds and bills as collateral to secure lending, for instance. And for risk-averse investors such as foreign central banks, money-market funds and retirees, America’s debt is uniquely suited to storing savings without much due diligence. In short, its government debt is a lot like money.
I agree with the central premise of the article, but would add a few points.
First, I would frame the discussion in this way: there are retail money assets and institutional money assets. Retail money assets are the traditional money assets measured by the M2 money supply and are used by households and small businesses. Institutional money assets go beyond M2 and includes treasuries, commercial paper, repos, GSEs, and other safe assets used to facilitate exchange in the shadow banking system. Since most of the creditors to the shadow banking system are institutional investors, these assets should be called institutional money assets.
Second, institutional money assets include both privately-produced and publicly-produced safe assets. If the Fed is doing its job and and providing sufficient aggregate demand to keep the economy at full employment, then there should be plenty of privately-produced safe assets. Only if the Fed allows nominal spending to crash, which would reduce privately-produced safe assets, is there a need for the government to step in and create safe assets. To put it differently, if the Fed were to announce today that it was adopting a nominal GDP level target and planned to restore it to its pre-crisis trend, then there would be most likely be a recovery and an increase in the private supply of safe assets. As a result, the institutional money asset supply would increase and there would be less need to produce treasuries.
Third, the broader context for this discussion is that there is currently a shortage of safe assets for the global economy. And, as I noted before, there is both a long-term, structural dimension to this problem as well as a short-term, cyclical one:
The structural dimension is that global economic growth over the past few decades has outpaced the capacity of the world economy to produce truly safe assets, a point first noted by Ricardo Cabellero. The cyclical dimension is that the shortage of safe assets was intensified by the Great Recession, a point stressed by Gary Gorton. I previously made the case that both the Fed and the ECB were an important part of the cyclical story by failing to restore nominal incomes to their expected, pre-crisis paths. In other words, since 2008 the Fed and the ECB passively tightened monetary policy which caused some of the safe assets to disappear while at the same time increasing the demand for them.
This failure of the world’s major central banks means U.S. treasuries will remain in hot demand. This seemingly insatiable demand is evidenced by the low yields on treasuries.
Fourth, there is a Triffin dilemma for U.S. debt. The global financial system in its current setup needs increasing amounts of U.S. treasuries. This means the U.S. government must continue to run large budget deficits. Over time, however, these large budget deficits may jeopardize the safe-asset status of U.S. treasuries, the very thing driving the insatiable demand for them. So a tension exists between providing enough treasuries to keep the global economy going and maintaining the safe-asset status of treasuries.
Finally, the New Monetarists like David Andolfatto have been making some of these points for awhile. Greg Ip should spend some time talking to them as well.
This post originally appeared at Macro and Other Market Musings and is posted with permission.