Was the financial crisis caused by too little government debt?
Cardiff Garcia at FT Alphaville outlines the findings of a paper presented at the annual meetings of the Allied Social Science Associations a couple of weeks ago in Chicago. The paper’s authors — Gary Gorton, Stefan Lewellen and Andrew Metrick — calculate that the share of “safe assets” in the U.S. economy has been a relatively constant 33 percent.
What they find is the financial system seems to require the same percentage of safe assets over time, regardless of underlying conditions. Of course, this placid result conceals a far more volatile picture of the changing composition of the safe assets.
The findings are preliminary but one implication may be that the dearth of federal government securities in the era when Bill Clinton was president and Newt Gingrich was House Speaker contributed to the buildup of “safe assets” like agency debt, mortgage-backed securities and other financial products. This buildup, in turn, contributed to the financial crisis when these assets suddenly lost their safe status.
To put it differently, the Gorton-Lewellen-Metrick paper suggests the United States economy has a persistent demand for savings —t hat is, non-speculative, low-risk financial investment. If deprived of government securities — that is, Treasury bonds — it finds new types of securities to fill this void.
Take a look at this chart showing GDP compared to the total amount of federal government debt held by the public. What you’ll see is that the two rise together on similar trend lines, with federal debt lagging a bit. But in the mid nineties, the federal debt breaks the trend line and actually declines. It doesn’t return to trend until after the financial crisis.
Another implication of this may be that attempts to social engineer investment behavior — for instance, to push investors out on the risk curve by lowering interest rates on safe-haven investments — are doomed.
The demand for safety — which is to say, savings — is constant. The only way to get savers out of safe havens is to actually deprive them of the safe havens — by running a budget surplus. But this creates various distortions as savers try to substitute other securities or assets for the safe havens.
This seems to explain why demand for Treasury bonds remains so elevated despite low interest rates—because no other class of safe securities has arisen to replace the safe assets that collapsed during the financial crisis.
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