Safe keeping

By G.I. | WASHINGTON

THE purpose of all financial systems is to match savers who crave safety with investors who take risk. When savers discover the assets they thought were safe are in fact risky, crisis ensues. We all know what happened when the instruments meant to disperse American mortgage risk broke down. The most acute phase of Europe's sovereign-debt crisis can be traced to the insistence of politicians at Germany's behest that private-sector investors would henceforth have to take losses on the debt of any bailed-out country, not just Greece.

The flight from the assets formerly known as safe is only one side of the coin; the other side is what happens to those remaining assets still deemed safe. The Free exchange column in this week's print edition explores how this phenomenon affects the most widely held safe asset, American Treasury debt.

It notes:

[D]emand for American government debt is driven by much more than a hunger for returns. Financial-market participants use Treasury bonds and bills as collateral to secure lending, for instance. And for risk-averse investors such as foreign central banks, money-market funds and retirees, America's debt is uniquely suited to storing savings without much due diligence. In short, its government debt is a lot like money.

Arvind Krishnamurthy and Annette Vissing-Jorgensen of Northwestern University have sought to quantify the money-like character of Treasuries by looking at how various measures of safety and liquidity responded to changes in the supply of Treasury debt from 1926 to 2008. They conclude that when the supply of debt goes down, the premium for both safety and liquidity goes up; this, over time costs investors some 73 basis points in foregone interest, which of course is a saving to the American taxpayer.

But that's not the whole story. By rights, the premium should have deteriorated when issuance of Treasury debt soared in the last three years. Why didn't it? One reason is that the Federal Reserve has committed to keeping interest rates near zero through 2014 and is buying up huge wads of Treasury paper. But this can't explain, for example, why German bund yields are just as low, or why corporate bond yields have not enjoyed as much of a drop in yields. Something else is going on. There seems to have been either a structural increase in the demand for safe assets, or a structural decline in the supply, or both. The market for private mortgage-backed securities has all but disappeared, as has asset-backed commercial paper, while the repo and credit default swap markets are a shadow of their former selves. The implicit federal guarantee behind Fannie Mae and Freddie Mac has been called into question, and many formerly safe sovereign bonds in Europe no longer are.

In other words, what has happened to Treasury debt is very analogous to a surge in safe-haven driven demand for money, or “extreme liquidity preference” as economists put it. In 2008 the Federal Reserve met this demand for liquidity by lending out trillions of dollars and supersizing its balance sheet. Treasury has done something similar, albeit unintentionally, by borrowing so heavily, particularly in the short end. America has always enjoyed the “exorbitant privilege” of borrowing in the world's reserve currency, but that privilege is clearly more exorbitant than ever.

This demand for safety throws some light on the consequences of unconventional monetary policy. There is a popular fear that the money created, in the form of reserves, by the Federal Reserve, the Bank of England, and the European Central Bank will eventually be re-lent, leading to ballooning credit and inflation. This is off the mark: bank lending doesn't depend on reserves, since even in normal times the central bank will supply as much of them as banks want at the going interest rate. And even if you were to (wrongly) interpret the rise in reserves as driven by the demand for money rather than supply, it could easily be interpreted as store-of-value (i.e.safe haven) demand rather than transactions demand. The Fed, according to the Wall Street Journal, is mulling “sterilized” QE, that is mopping up the reserves created during bond purchases by issuing certificates of deposit or similar short-term instruments to banks. This would be potentially quite useful as it supplies the system with a safe-haven asset very similar to Treasury bills.

There is a critical lesson in this for American policy makers: you monkey with an asset's reputation for safety at your peril. There was a lot of loose talk last year that it would be no big deal if Treasury failed to pay interest and principal on time if the debt ceiling wasn't raised. Damaging the safe-haven status of Treasury debt would not just raise American taxpayers' borrowing costs; it would roil the financial system in ways very difficult to predict. It's worth noting that long after Europe's politicians repudiated their earlier demand that investors risk losses on all sovereign debt, Italy and Spain are still forced to borrow at significantly higher costs than Germany. The feeling of safety, once lost, is not easily recaptured.