Remarks on Safe Assets
The issue of “safe assets” is important and complex. I have a lot of thoughts on the topic, but they do not yet cohere into a whole.1. People really like safe assets. A lot of effort, both in the private sector and in the public sector, goes into creating assets that are safe or that appear to be safe.
2. Examples of safe assets include insured deposits, expected benefits from Social Security and Medicare, short-term Treasuries, and inflation-index Treasuries. Are there examples of purely private safe assets, or do all assets now considered safe have government guarantees attached to them?
3. When the financial crisis hit, assets that had been considered safe were suddenly deemed to be unsafe. There are people who blame the private sector for stupidity and deception in turning high-risk mortgages into safe assets. There are some who blame the Fed for keeping interest rates too low. There are some who blame government housing policy. My own view, as you know, is that capital regulations explicitly told banks that AAA-rated assets were safe, which means that in my account capital regulations play a significant role. Financial innovation served to manufacture AAA-rated assets out of risky mortgages. The regulators mostly applauded this.
4. Do ordinary investors understand risk? I tend to think not. I find that when people ask me for financial advice, they seem to expect me to be able to provide suggestions for ways in which returns can be high and certain. When I suggest an index fund, a person might ask, “How much interest does that earn?” When I infer that they want to earn a certain rate of interest, I suggest an inflation-indexed bond. When I explain that the return on that is less than 2 percent, adjusted for inflation, they think they are being cheated. Because very few people really understand risk, there tends to be a lot of potential profit to be made by taking advantage of people’s desire for assets that appear safe, even if they are not.
5. There is a popular conception that stocks are less risky in the long run than in the short run. This cannot possibly be correct. As Zvi Bodie points out, any option pricing model would break down if stocks were less risky in the long run than in the short run. I notice that the popular conception that stocks are less risky in the long run is rarely challenged by professional economists. Either they do not know any better, or they are not willing to play the skunk at the party.
6. A fair amount of real-world risk is risk of malfeasance. That is, if I invest in Phil’s fruit tree, I have to worry about all sorts of things that Phil could do to take advantage of me. A lot of the value created by financial intermediaries involves following customs and adhering to contracts that minimize the costs of preventing malfeasance.
7. Once you have the most cost-effective anti-malfeasance approach given the state of technology, about the only thing you can do to make assets safer is to diversify. It seems that just about everyone is under-diversified. Perhaps this is due to high costs of guarding against malfeasance with a diversified portfolio. Or perhaps it is due to the presence of lots of government-guaranteed assets, which gives people an alternative to diversification if they want safe assets.
8. Does government have a comparative advantage in diversification? One can argue that government is able to guarantee assets because it is able to diversify across more states of the world. So, the government can guarantee its promised benefits under Social Security, while any private annuity would be subject to the insurance company failing under some scenarios.
9. Alternatively, government’s ability to guarantee assets rests on its ability to redistribute wealth by force, using taxation. I am inclined to think that this is the more important source of the government’s ability to issue credible guarantees.
10. I suspect that the result of government guarantees is to increase the amount of saving and investment. Because banks can invest in risky assets and, with the government’s help, issue safe liabilities, we have more capital investment than we would otherwise.
11. What is the optimal amount of safe assets provided by the government? If you want to say “none,” that means you have to put up with a lot less capital investment. Maybe that is optimal, but I suspect otherwise. I suspect that, up to a point, creating safe-seeming assets out of risky investments makes us better off. On the other hand, it could be that we typically have way too much risky investment, because government errs on the side of creating too many safe-seeming assets.