ECONOMIC FOCUS : SAFETY THIRST / THE ECONOMIST ( A MUST READ )

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Safety thirst

A shortage of safe assets helps to explain why some government-bond yields are so low

May 5th 2011
from the print edition

LAST month Standard & Poor’s, a ratings agency, lowered its assessment of American public debt from “stable” to “negative”, saying there was a one-in-three chance that it would lose its triple-A credit rating within two years. The warning was the first since S&P started to grade Treasury bonds 70 years ago, and it reflected concern that a workable plan to cut America’s huge budget deficit would not soon be agreed upon.


The rebuke was stern but the response from financial markets was a jaw-breaking yawn. Treasuries rallied after a momentary wobble. The yield on the ten-year bond ended the day lower. Stockmarkets fell but regained the lost ground within days. With the fiscal crisis in parts of the euro zone barely contained, such insouciance seemed odd.

But it has not been confined to America. Last year Japan’s public debt climbed to 220% of its GDP. Yet the yield on ten-year Japanese government bonds fell below 1% in the summer, and the yen soared against other currencies.


Yields on some sovereign bonds seem to offer little protection against the risk of future inflation or default. Why don’t investors demand more? One answer is that the desire to set aside money may be so strong that savers do not require high prospective returns. Japan’s private saving has been high enough to absorb all its government’s debt issuance with plenty left over to buy foreign assets. The poor in parts of Africa and India even pay deposit collectors a fee (ie, a negative interest rate) to mind their rainy-day cash. Where finance is rudimentary and trustworthy stores for saving are scarce, people are often willing to pay to save.


In a similar vein, some economists believe that persistently low bond yields are explained by a worldwide shortage of safe assets. They argue that fast-growing emerging economies, with underdeveloped financial markets, have not been able to create enough trustworthy instruments (bank deposits, bonds and so on) to absorb their high savings. That has created excess demand for apparently safe stores of value in the rich world, such as American government bonds, pushing up their value and lowering yields. Much of this is held as foreign-exchange reserves.


These ideas were set out in 2008 by Ricardo Caballero of Massachusetts Institute of Technology, Emmanuel Farhi of Harvard University and Pierre-Olivier Gourinchas of the University of California, Berkeley*. Their work was part of a literature that sought to explain why poor countries were sending their savings to rich countries. Its genesis came in 2005 when Ben Bernanke, now the Federal Reserve’s chairman, argued that America’s lack of thrift was a response to a global “saving glut” seeking a home.


In a more recent paper, Mr Bernanke revealed that saving gluttons had indeed shown a marked preference for AAA American assets—but so had investors from richer regions. Four-fifths of China’s excess savings between 2003 and 2007 were used to buy either Treasuries or bonds guaranteed by government-backed mortgage agencies.

The capital washing from economies with surplus savings was less than a quarter of the AAA assets issued in America in that period—perhaps not enough to fully explain low bond yields. Inflows from Europe (financed by borrowing from other regions) provided additional demand for American bonds, putting further downward pressure on yields. In an intriguing twist, Europeans in search of higher yields bought “private-label” mortgage bonds that proved less safe than the agency-backed and sovereign debt that Asian investors plumped for.


The financial crisis did not end the asset shortage, say the theory’s proponents. Instead it became more acute. There is now extra demand for safe assets. Rich-world consumers are saving harder to pay down debts and cautious businesses need somewhere to park their surplus cash. Meanwhile, the supply of assets seen as safe has shrunk, as Mr Caballero notes in a recent paper. Cautious investors now shun mortgage-backed securities and the riskier sort of euro-area government bonds. Central-bank purchases have further reduced the available stock of safe assets.


No safety in numbers


A troubling finding of the literature is that attempts to soak up excess savings serve only to undermine the safety of the assets supplied. Faced with strong foreign demand for AAA-rated securities, American banks had a strong incentive to create supposedly safe ones from packages of risky home loans. The continuing scramble to buy sovereign bonds means there is little pressure on some governments to put in place the kind of medium-term fiscal discipline needed to keep those assets safe. As long as bond yields stay low, warnings from ratings agencies can be ignored.


Indeed the rapid growth of emerging-market economies may in time create a demand that America’s government cannot safely meet. That is one conclusion of a report prepared for the French presidency of the G20 by Mr Farhi, Mr Gourinchas and Hélène Rey of London Business School. They highlight a new version of a tension that Robert Triffin, a Belgian economist, identified in 1960. He predicted that the growing world demand for dollars to finance trade would mean that the currency could not maintain its fixed value against gold. The modern Triffin dilemma is that strong foreign demand for Treasuries for saving purposes might eventually outstrip America’s fiscal capacity.


A more optimistic view is that the saving glut is temporary. Ageing in China will curb its saving and a spreading investment boom in emerging markets will soak up what is left. If that happens, economists will stop worrying about scarce assets and start fretting about scarce capital. A single idea cannot explain everything, but the asset-shortage theory helps with some current puzzles, such as the strong demand for both government bonds (a bet on low inflation) and gold (a hedge against high inflation). It is also a warning: what is safe now may not always be so.


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“An Equilibrium Model of ‘Global Imbalances’ and Low Interest Rates” by Ricardo Caballero, Emmanuel Farhi and Pierre-Olivier Gourinchas, American Economic Review (2008)


“The Global Saving Glut and the US Current-account Deficit (http://www.federalreserve.gov/boarddocs/speeches/2005/200503102/) ” by Ben Bernanke (2005)


“ International Capital Flows and Returns to Safe Assets in the United States (http://www.banque-france.fr/gb/publications/telechar/rsf/2011/rsf_1102.pdf) ” by Ben Bernanke, Banque de France Financial Stability Review (February 2011)


“A Caricature (Model) of the World Economy (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1724897) ” by Ricardo Caballero, MIT Department of Economics Working Paper 10-17 (November 2010)

“ Reforming the International Monetary System (http://socrates.berkeley.edu/~pog/academic/FGR_march2011.pdf) ” by Emmanuel Farhi, Pierre-Olivier Gourinchas and Hélène Rey (March 2011)