The concept of "safe" (i.e. risk-free) assets has existed for a long time. Pricing models base themselves on the "risk-free rate". The instrument that is usually used as the proxy for "risk-free asset" is the United States Treasury (UST), but until recently all sovereign debt was regarded as risk-free, at least for bank capital adequacy requirements.
This led to banks loading up on the debt of Greece, Spain, Portugal etc. because those assets required no capital allocation but gave a better return than German bunds or UK gilts. They should have paid more attention to the yield. Yield is a much better indication of real risk than any regulatory view of an asset class. "If it pays better, it's riskier" is axiomatic in financial markets. It is unfortunate that in recent years investors and banks alike forgot this basic rule and believed that they could get high returns for zero risk. And even more unfortunate that retail bank depositors thought so, too.
Gary Gorton notes that one of the main drivers of the 2007/8 financial crisis was the failure of supposedly "safe" assets created by the private sector. This is a much neglected matter. The popular perception is that mortgage backed securities and their derivatives were known to be risky assets that banks and others chose to trade because they believed they would be bailed out if the assets went sour. The last statement here is correct - the financial sector did indeed believe it would be bailed out. But the first statement is not. The financial sector believed that these instruments were safe, because they were backed by property which (in the US) had been a stable appreciating market for a very long time. The UK does of course have a history of property market crashes, so it is slightly surprising that banks in the UK were fooled: perhaps they thought that the US property market was not subject to the same instability as the UK - or perhaps they just had short memories.
So Gorton argues - correctly - that it is not possible for the private sector to create safe assets. But he then states that only governments can create "safe" assets. This is in my view where he comes unstuck, for reasons that I shall explain shortly.
Gorton is not the only one who thinks government debt is "safe". John Kay also thinks so - or at least he used to. His "narrow banking" proposal would back all bank deposits with gilts. However, in his recent evidence to the Banking Standards Committee at the House of Commons, he was questioned about this by former Chancellor of the Exchequer Lord Lawson, and was forced to concede that gilts could not be regarded as 100% safe.
A quick look at the history of sovereign debt defaults gives the lie to the idea that sovereign debt is in any way "risk free". However, there is no doubt that some sovereigns are "safer" than others: the UK and the US have never defaulted on their sovereign debt. So why shouldn't their debt be regarded as "risk free"?
On the face of it, this weakens Kay's proposal and gives greater weight to cash-based 100% reserve banking proposals such as those from the IMF and Lawrence Kotlikoff. And although it doesn't completely wreck Gorton's ideas (since UK and US government debt is probably safer than private sector assets) it does mean that absolute safety of cash deposits in the shadow banking system cannot be guaranteed.
But a quick look at the inflation records of the US and the UK gives the lie to the idea that cash is "safe" either. Some people argue that "safe" means "won't suffer loss of principal" rather than "won't decline in value". But since the sole purpose of cash is to buy real goods and services, if £1 buys you a large loaf of bread today but only a small one tomorrow, the effect is that you have lost half your money. You still have £1, but you can only buy half as much with it. The value of cash depends on the willingness of government (via its central bank, usually) to control inflation. And that depends on a range of political and economic factors.
And it's not just cash whose value is affected by inflation. The value of government debt is, too. I've noted before the equivalence between yields on government debt and the inflation rate. Generally speaking, the higher the inflation rate, the higher the yield on government debt (and therefore the lower its value). This equivalence doesn't hold on daily basis, of course - government debt and currency values fluctuate independently of each other - and it doesn't hold in fixed currency systems such as the Eurozone, but over time it is a useful rule of thumb for floating exchange rate systems with no restrictions on movement of capital.
So is anything safe? Well, proponents of gold think so. Those who support gold as a currency point to the stability of the "true" Gold Standard period of the late 19th century as a time when cash held its purchasing power. But in this article from Economic History (EH), the author questions why the gold standard during that time was stable, because on the face of it it shouldn't have been - and he concludes that there were two reasons: firstly, there were no major wars at that time, and secondly, both the private sector and the principal governments involved were fully committed to ensuring its stability. In other words, gold ITSELF is no more stable in value than any other sort of currency - as indeed the gold price chart shows. It is the backing of governments and trust from private agents that makes it so. EH notes that the "backing of governments" involves a commitment to settle trade deficits in gold: but the UK defaulted on its international trade obligations when it abandoned the gold standard in 1931, and the US did likewise when it ended the Bretton Woods system in 1971. The UK and US may not have defaulted on sovereign debt, but that doesn't mean they have never defaulted.
We also know from history that gold standard currencies don't survive major economic shocks, such as wars. The gold standard was suspended in the UK during the Napoleonic Wars, the First World War and the Depression: in the US during the Civil War, the First World War and the Depression: in France during the French Revolution and the First World War....I could go on, but do we need more evidence? Wars and major economic shocks need governments to create money in large quantities, which they can't do if they are locked into a gold standard - or any other kind of fixed currency regime, for that matter. And wars and major economic shocks disrupt international trade, which also undermines the gold standard. Returning to the gold standard at the pre-shock price is almost never achievable in reality. Abandoning the gold standard - which inevitably happens when there are major exogenous shocks - results in debasement of cash savings.
Those who support gold as an investment, but not as a currency, point to the rising value of gold over time. It is true that over the long term, gold does tend to appreciate in value - though so do property and land. But as a short-term investment it is volatile, which makes it completely unsuitable as collateral in a fast-moving financial marketplace or as backing for transaction accounts. And as a vehicle for personal savings it carries another risk - it is a target for thieves. In those countries where for cultural reasons people tend to put their savings into gold, theft (often violent) is a constant threat - which is why the World Bank is trying to encourage people to put their savings into banks rather than gold or cash. To the people of the West, scarred by recent events and fearful of bank failures, this looks like madness. But in developing countries, banks are definitely safer places to keep savings than mud huts. Gold stashed under the mat may not lose its value, but it can be lost.
So, over the long-term there may be assets that can be regarded as "safe".....but on a short-term basis, there is no such thing as a completely safe asset. Which brings me to my final concern about the search for assets that are "safe".
The belief that certain assets are "safe" encourages risk-averse investors to buy them. This pushes up the price and reduces the return on these assets. We saw in the run up to the financial crisis how the demand for assets that were considered "safe" drove production of these assets, leading their creators to take on more and more risk. The nature of the asset changed: it was no longer low-risk, but the investors did not know that, so continued to buy it until the rising tide of defaults in the underlying property portfolios caused a massive price correction. Once the true risk of these assets was fully exposed, their price collapsed and they became worthless.
The same is possible if either government debt or currency is produced in sufficient quantities to meet demand without domestic production rising to match. If this happens to government debt, eventually the price drops and the yield rises: if it happens to currency, the exchange value drops and there is high inflation.
However, I want to make it clear at this point that I do not believe we are anywhere near this state of affairs in Western economies generally at the moment, except for some members of the Eurozone. We have the opposite problem, namely that governments are unwilling to produce either debt or cash in sufficient quantities to satisfy the demand for "safe" assets, so we are seeing the price of government debt and the value of currency rising (and yields on debt and trend inflation falling) in those countries that are considered "safe havens". Once yields are in negative territory, investors LOSE MONEY. And that is what is happening at the moment. Investors are so concerned not to lose their principal that they are loading up on supposedly "safe" assets which actually cost them money to hold. Remember I said that, for cash, loss of value due to inflation is just as real a loss as principal wipeout in bank default? In the same way, negative yields on government debt are just as real a loss as principal wipeout due to government debt default. No way are they "risk free".
And one final thought. We do not know what causes asset bubbles, but Austrian theory of business cycles suggests that the next bubble starts to form during the aftermath of the bursting of the previous one. In the aftermath of a major crash, investors are understandably risk-averse - as we are seeing at the moment, with their flight to traditional "safe havens" and their willingness to accept principal erosion rather than risk total wipeout. That suggests that, rather than greed and the hope of a high return, it may be fear and the search for safety that drives the creation of asset bubbles. In seeking the illusion of safety, investors may set up the very disaster they wish to avoid.