Why do we *need* more safe assets? Why don’t we just let the existing ones rise in value, thereby providing safety? If we wanted to express our desire for safety by buying fire extinguishers, then I’d agree that we need to produce more safe assets. After all, only some sort of increase in the supply of extinguishers will be able to meet that demand.
But things are different if we express our demand for safety by turning to financial markets. The great thing about t-bonds is that unlike fire extinguishers, we don’t need to fabricate more of them to meet our demands for safety… we just need a higher real value on the stock of existing t-bonds. This can be entirely met by shifts in prices. Where is the problem that needs to be rectified?
In addition, the heightened economic uncertainty and the ZLB means the demand for these transaction assets (i.e. money and treasuries) becomes almost insatiable. Investors, therefore, shy away from other higher yielding, riskier assets that normally would lure them. Portfolios get overly weighted toward liquid assets.
Note what is happening here: treasuries and money become increasingly close substitutes as they approach the ZLB, while the overall transaction asset market becomes increasingly segmented from other asset markets. In other words, as arbitrage becomes more powerful among transaction assets like money and treasuries, it becomes less powerful between the market for transaction assets and other asset markets. The short answer to Koning’s question, then, is that the ZLB has segmented the transaction asset market and this is preventing the safe asset market from clearing.
Below is my initial attempt to show this graphically. It shows that while treasury and money assets substitutability is always responsive to interest rate changes, market segmentation is not and only kicks in after some threshold close to the zero bound is reached. In other words, at some point when treasuries and money become close enough substitutes, the market for transaction assets begins to segment from other markets. Where this actually occurs is unknown and the way I have drawn it is arbitrary. But hopefully you see the point.
Now market segmentation is a controversial idea. Many observers don’t accept it. But it seems like a compelling story for the transaction asset market at the ZLB. Empirically, it provides an easy explanation for why BAA-AAA corporate yield spread, junk bond spread, and other non-transaction asset spreads are getting closer to historical norms, while theBAA yields-10 treasury yield spread and the S&P500 earnings yield-20 year treasury yield spread remain inordinately high.Welcome to the strange new world of transaction asset market segmentation.
P.S. Market Monetarists, including myself, typically downplay the importance of the ZLB for monetary policy. We argue the ZLB is really just an artifact of doing monetary policy with an interest rate; it should have no actual bearing on the efficacy of monetary policy. Here, in the case of the safe asset shortage, it does seem to be a non-trivial phenomenon that needs to be taking seriously.