While it has already become a cliché to say that there is no such thing as a risk-free asset, policy makers and market participants are only just beginning to recognise what a major shift this is.
If we are to get back to anything like the traaditional financial system, renewing the supply of such assets must be a priority for official policy. On the other hand, if governments leave the financial system without such assets, i.e. without an effective official backstop (and such a view is implicit in the lack of urgency they show in recovering risk-free status for their debt) then it is time to dust down all those books about how “free” banking systems have worked. In such a world, central banks would either be confined to an oversight role, or be eliminated entirely. They would not have the credit to backstop the system.
A belief that some assets are risk-free has been a bedrock of trust in the financial system ever since the dawn of banking and central banking. To qualify, an asset should be liquid, have a negligible perceived default risk, and be regarded as a reliable store of value. For centuries, monetary gold and silver played that role. With the development of banking and central banking, cash, liquid assets eligible for discount at the central bank and reserves at the central bank qualified, to be joined later by short-term government securities. Then, in the second half of the 20th century, the concept was extended to selected long-term government bonds, notably the 10-year US treasury bond; German and UK treasury bonds were also treated as risk-free.
Risk-free assets have played several key functions. They provided the reserves of banking system and benchmarks for pricing other assets. The store of value property facilitated payments transactions – holders were happy to park their cash reserves in bank accounts and other liquid forms confident that they will still be there, intact, when needed. All these habits of mind were inherited from the gold standard and largely taken for granted. But with the end of the gold link, the structure came to rest wholly on the credit of the state. The ability of central banks to manufacture safe assets by giving privately-created assets an official stamp of approval depended on the official backstop.
True, central banks can always guarantee final settlement of a payment across their books, but they cannot control the value of the unit of account in which the payment is made without the support of the state (latterly provided under the paradigm of central bank independence).
Some see the financial crisis as resulting from a shortage of such assets and the (unsuccessful and risky) efforts of the private sector to produce stores of value. Others view it as having accelerated changes already taking place. Some economists believe that a shortage of risk-free assets explains the difficulty of getting out of the recession. The increase in asset demand, combined with the fall in asset supply, implies that households and firms spend less at any level of the real interest rate—that is, the interest rate net of anticipated inflation. Peter Fisher, senior managing director of Blackrock (formerly of the New York Fed) points out in a recent BIS publication that ‘the implication of losing the status of base asset is that monetary conditions are effectively tightened as the supply contracts of what is accepted as a reserve asset and good collateral.’
If the political economy of fiscal policy means that states no longer have a comparative advantage in the supply of risk-free assets, then a new financial system will emerge. In that event the global financial crisis will be seen as signalling such a regime change. Then the private sector will have to develop substitutes for risk-free assets (though if they get close to achieving that the state will probably grab them back). One implication seems to be that banking and financial intermediation – for centuries in effect subsidised by the provision of safe assets and an official backstop by the State – will become much more expensive to end-users. Advocates of free banking regimes would argue, however, that the real social costs would be lower than under current state-dominated, volatile, financial systems.
The alternative is for states to give priority to re-establishing fiscal positions so they can again provide credibly risk-free assets – even if that means tightening fiscal policy when economic activity remains weak.
If they want to save the traditional banking system, state-dominated and unstable as it is, developed country governments must rehabilitate their pubic finances, no matter what the cost. But – surprise, surprise – they have yet to show any understanding of the issues at stake. The prospects for free banking – and for a complete change in the dominant form of financial institutiion, as advocated in The Money Trap – are better than they have been for a long time.
This is based on my article posted on CentralBanking.com under “RP’s Viewpoint” (subscription)
Where have all the safe assets gone?
Shortage may usher in new banking system
While it has already become a cliché to say that there is no such thing as a risk-free asset, policy makers and market participants are only just beginning to recognise what a major shift this is.
If we are to get back to anything like the traaditional financial system, renewing the supply of such assets must be a priority for official policy. On the other hand, if governments leave the financial system without such assets, i.e. without an effective official backstop (and such a view is implicit in the lack of urgency they show in recovering risk-free status for their debt) then it is time to dust down all those books about how “free” banking systems have worked. In such a world, central banks would either be confined to an oversight role, or be eliminated entirely. They would not have the credit to backstop the system.
A belief that some assets are risk-free has been a bedrock of trust in the financial system ever since the dawn of banking and central banking. To qualify, an asset should be liquid, have a negligible perceived default risk, and be regarded as a reliable store of value. For centuries, monetary gold and silver played that role. With the development of banking and central banking, cash, liquid assets eligible for discount at the central bank and reserves at the central bank qualified, to be joined later by short-term government securities. Then, in the second half of the 20th century, the concept was extended to selected long-term government bonds, notably the 10-year US treasury bond; German and UK treasury bonds were also treated as risk-free.
Risk-free assets have played several key functions. They provided the reserves of banking system and benchmarks for pricing other assets. The store of value property facilitated payments transactions – holders were happy to park their cash reserves in bank accounts and other liquid forms confident that they will still be there, intact, when needed. All these habits of mind were inherited from the gold standard and largely taken for granted. But with the end of the gold link, the structure came to rest wholly on the credit of the state. The ability of central banks to manufacture safe assets by giving privately-created assets an official stamp of approval depended on the official backstop.
True, central banks can always guarantee final settlement of a payment across their books, but they cannot control the value of the unit of account in which the payment is made without the support of the state (latterly provided under the paradigm of central bank independence).
Some see the financial crisis as resulting from a shortage of such assets and the (unsuccessful and risky) efforts of the private sector to produce stores of value. Others view it as having accelerated changes already taking place. Some economists believe that a shortage of risk-free assets explains the difficulty of getting out of the recession. The increase in asset demand, combined with the fall in asset supply, implies that households and firms spend less at any level of the real interest rate—that is, the interest rate net of anticipated inflation. Peter Fisher, senior managing director of Blackrock (formerly of the New York Fed) points out in a recent BIS publication that ‘the implication of losing the status of base asset is that monetary conditions are effectively tightened as the supply contracts of what is accepted as a reserve asset and good collateral.’
If the political economy of fiscal policy means that states no longer have a comparative advantage in the supply of risk-free assets, then a new financial system will emerge. In that event the global financial crisis will be seen as signalling such a regime change. Then the private sector will have to develop substitutes for risk-free assets (though if they get close to achieving that the state will probably grab them back). One implication seems to be that banking and financial intermediation – for centuries in effect subsidised by the provision of safe assets and an official backstop by the State – will become much more expensive to end-users. Advocates of free banking regimes would argue, however, that the real social costs would be lower than under current state-dominated, volatile, financial systems.
The alternative is for states to give priority to re-establishing fiscal positions so they can again provide credibly risk-free assets – even if that means tightening fiscal policy when economic activity remains weak.
If they want to save the traditional banking system, state-dominated and unstable as it is, developed country governments must rehabilitate their pubic finances, no matter what the cost. But – surprise, surprise – they have yet to show any understanding of the issues at stake. The prospects for free banking – and for a complete change in the dominant form of financial institutiion, as advocated in The Money Trap – are better than they have been for a long time.
This is based on my article posted on CentralBanking.com under “RP’s Viewpoint” (subscription)
Written on September 15, 2013 at 7:31 pm, by robert
Categories: Banking, Homepage, News and Comment, RP's Diary | Tags: banking, central banking, global financial system, Peter Fisher