Most people remain blissfully ignorant of a growing global crisis in safe investment assets. There are fewer and fewer “safe havens” for investors to park their money. Why should you care? Let me explain…
One of the critical components of our modern global economic system is the ability of investors to park their money in safe places where the value of the principal is guaranteed. As we saw in Greece recently, Greek bonds became increasingly unsafe and eventually investors were forced to take a 50% “haircut” (or loss) on their investments. This is what the rating agencies are supposed to do for investors. Identify which investments are safe (“AAA – A”) and which are not so safe but will offer higher rates of return. The trouble brewing now is that there are fewer and fewer of these safe parking lots.
Since 2001 the demand for these safe assets has grown but the supply has dwindled as more and more formerly “safe” assets were re-evaluated by the rating agencies as less-than-safe. That cyan part of the bar chart? Those were CDOs (Colateralized Debt Obligations), our old friends the Mortgage-Backed Securities which imploded in 2008 and wrecked the US economy. Also notice the vanishing grey area of the chart. That was the non-German / non-French European bonds, all of which have been downgraded below AAA.
The mix of available investment-grade debt has morphed dramatically since 2007.
Fast-forward to 2011…
As you can see from these two charts, the total availability of A or better assets shrank from 52% of the total to just 44% of the total. This is a huge drop in available assets for purchase. So what does this mean for you and me?
Okay, so why does this safe asset shortage ultimately matter? The first reason is that many of these safe assets serve as transaction assets and thus either back or act as a medium of exchange. AAA-rated MBS or sovereigns have served as collateral for repurchase agreements, which Gary Gorton has shown were the equivalent of a deposit account for the shadow banking system. The disappearance of safe assets therefore means the disappearance of money for the shadow banking system.
These assets are, in effect, money. Their disappearance from the stage means that there is literally less money available to the system. This reduction in the monetary base will have a knock-on effect into the commercial an retail lending space.
Thus, a shortage of acceptable collateral would have a negative cascading impact on lending similar to the impact on the money supply of a reduction in the monetary base. Thus the first round impact on the real economy would be from the reduction in the “primary source” collateral pools in the asset management complex (hedge funds, pension and insurers etc), due to averseness from counterparty risk etc. The second round impact is from shorter “chains”—from constraining the collateral moves, and higher cost of capital resulting from decrease in global financial lubrication.
So what can we do? Well, given the byzantine complexity of the banking system and the reality that modern banking is built on a house-of-cards backed by “safe assets” that we saw from experience in Europe that weren’t exactly safe, we need to create more safe assets. One proposed solution is to have the U.S. Treasury print them.
The upshot: the global economy needs more babysitting scrip. Since money issuers continue to labor under the gold-standard fallacy that they can’t just create money, issue more scrip like the babysitting co-op did — that they have to “borrow” it (and this stricture is inscribed in law) — the only way to create that scrip is for governments to issue more bonds. So banks can issue money using those bonds as collateral, allowing shadow banks to keep their collateralized towers from teetering.
It’s fascinating that the very forces of supply and demand (in this case, for money which is a commodity like any other) which drive the “free market” are being constrained by the very people (Republicans) who claim to be such advocates of that “free market?” The market is demanding greater liquidity, yet we, wearing our “gold colored glasses,” cannot see the simple answer is to simply print more money. Instead we force the market into ever greater gyrations to create a shadow money system so that it can in turn drive higher levels of growth.
There’s not much else we can do but supply the demand for these assets. Failure to do so will result in yet another monetary shock to the global economic system, one which would likely tip us all over into a 1930s-style depression. And who wants that?