The Need To Pump Out Safe Assets At A Much Faster Pace

by: Brad DeLong

Full-employment equilibrium in the demand and supply of currently-produced goods and services requires that there be enough cash to grease all the transactions so that sellers are happy selling to would-be buyers. If not--if there is a liquidity squeeze--we see a downturn and the shortage of cash reflected in low asset prices of (and high interest rates on) pretty much all other financial assets as people scramble to dump other assets for cash and do so until they can no longer bear the cost of letting value go at fire-sale prices.

Full-employment equilibrium in the flow of funds through financial markets requires that businesses (and governments) issue enough liquid savings vehicles to absorb all the planned full-employment saving in financial assets. If not--if there is a savings vehicle shortage--we see a downturn and not low but high prices of financial assets and we see what should be the transactions balances of the economy diverted as cash is transformed into a savings vehicle.

Right now, however, it is not the case that we are in a liquidity squeeze: the debts of credit-worthy governments are not at a discount but at a premium. Right now, however, it is not the case that we have a shortage of liquid savings vehicles: equities and corporate and junk bonds--and the bonds of non-credit worthy governments--are selling not for high prices but for low ones.

There is, however, a third market equilibrium condition: a credit-channel equilibrium condition. The economy must possess enough AAA-rated assets suitable to serve as collateral to keep the moral hazard associated with lending your wealth to somebody who knows more about the deal than you do from causing a Minsky meltdown. If not we see a downturn and what we see now: relatively low asset prices for risky assets and assets perceived as safe selling at values far above any reasonable estimate of long-run fundamentals that does not take account of their value as collateral for greasing financial-intermediation transactions.

It is in that context that we need to look at what has happened to the global supply of suitable AAA assets as shown in Cardiff Garcia's unwanted mutant offspring of the most important chart in the world: