The background to this is the catastrophic failure of supposedly "safe" assets twice in the last five years - first residential mortgage-backed securities (RMBS) in the financial crisis of 2007-8, then Eurozone sovereign debt. Gary Gorton, in response to the failure of private sector "safe" assets, remarked that only governments can create "safe" assets. But not all governments can. The Eurozone crisis shows us that those that don't issue their own currency, those that are perceived by markets as being profligate, and those that are suffering severe political or economic stresses - none of these can produce "safe" assets. There is a diminishing number of countries that can produce assets that are reliably regarded as "safe", while global demand for safe assets is skyrocketing due to increased regulatory requirements for financial institutions, shortening collateral chains in shadow banking, and investor risk aversion.
There have been numerous attempts to explain the declining yields on US, UK and Japanese debt, since in all three of these the debt/GDP ratio is considerable and rising, which should force their yields up. Pessimistic commentors have been warning for years that these debt assets are overvalued and collapse is imminent, but there is still no sign of this. The US downgrade is now a year old and yet US Treasuries are trading at the lowest yields in history. The UK faces probable downgrade in the spring, but the markets don't seem to care. And the most inexplicable of the lot is Japan, which has the highest debt/GDP ratio in the world but pays the lowest borrowing costs. Markets really don't seem that bothered about high debt/GDP ratios in these countries. It seems grossly unfair that a country such as Italy, which in economic fundamentals is rather similar to the UK, pays much more to borrow. But the difference is that Italy has no central bank. Yes, I know it has something CALLED a central bank - but it is part of the Eurosystem and subject to the ECB's rules. It cannot issue currency except with the ECB's permission and has no control of monetary policy.
The BIS paper makes it very clear that a country that has no central bank, does not issue its own currency and has no control of monetary policy cannot create "safe" assets - although it seems to make an exception for Germany, probably because its dominance in the Eurozone means that effectively it runs the place. The crucial determinant of markets' attitude to debt is the existence of a credible monetary backstop. BIS recommends that central banks should act as investor of last resort for their own countries' debt - monetizing freely on demand. This is not to shore up government finances (I shall return to this in a minute), nor to adjust monetary policy. No, it is to instil confidence in the debt. If investors know that the central bank will always exchange government debt for money, they can regard that debt as 100% safe.
Well, almost. There is of course currency risk. The central bank may be able to buy unlimited amounts of debt, but if the currency is under pressure then the value of that backstop is eroded and the debt cannot be regarded as 100% safe. So the other side of this is the critical importance of inflation control to protect the currency. All central banks currently target inflation, although they also have a secondary responsibility to ensure financial stability and the Fed's "dual mandate" targets full employment as well as inflation. But there have been calls for central banks' inflation targets to be raised, eliminated or replaced. This is anathema if the purpose of government debt is to provide safe assets. Inflation erodes the value of both the debt and the currency: it is effectively taxation of safe assets. In a high inflation economy (by "high" I don't mean 3% or so - I mean heading for double digits) government debt is not a safe asset. In fact in a high inflation economy there can be NO safe assets other than physical ones (such as gold). Hence the emphasis on inflation control. Investors don't give a stuff about unemployment unless it becomes high enough to threaten political stability, which itself puts safe assets at risk. But maintaining the value of safe assets is crucial. Safe assets CANNOT EVER BECOME UNSAFE - or they are not safe assets. As BIS puts it:
"It is of the essence of a safe asset that it should not become unsafe."Therefore, governments whose debt is regarded as a safe asset must operate monetary and fiscal policy in such a way that their debt retains its value. They cannot allow inflation to rise significantly, and they must maintain control of public spending to ensure that they can always meet their liabilities when they fall due. The very existence of safe assets relies on the soundness of sovereign monetary and fiscal policy.
From a national economic perspective, this looks completely ridiculous. On the one hand, government must produce unlimited amounts of debt to meet the financial system's demand for safe assets, and allow the central bank to exchange this debt freely for new money. But on the other hand, they must maintain strict control of inflation and government spending so that the safe assets they are producing remain safe. So the debt/GDP level can rise to the skies, though they will pay nothing much for it: in fact debt/GDP would become a completely meaningless measure of the soundness of public finances. But woe betide any government that ran a deficit. The BIS paper envisages governments running primary surpluses to fund debt issuance:
....each major economy could ensure the safety of their domestically-issued public debt instruments through sound fiscal policy (ensuring that the present value of future real primary surpluses is sufficient to cover outstanding real liabilities in most states of the world)....It is an extraordinary reversal of the way we normally think of government finances. But I did say the financial system is a looking-glass world. In the financial world, the purpose of government debt is not to fund government spending. It is to provide safe assets.
The BIS proposal for ensuring the supply of global safe assets in effect treats currency-issuing governments - especially the US - as the world's savings banks. We can regard this proposal as a form of full reserve banking: government provides a safe deposit facility for investors, borrowing large amounts of money but putting it safely in a vault so there is no possibility of not being able to return it. This is not simply an analogy: producing debt in excess of spending needs will mean that governments become cash-rich, and if governments are running primary surpluses as well then they will be awash with surplus funds which they dare not release into the economy for fear of triggering inflation and a run on their supposedly safe assets. They will inevitably place these funds on deposit at their central banks, which amounts to putting them in a vault. Meanwhile - BIS assumes - these governments will continue to maintain strict control of public spending. Quite how the public would respond to a government that was borrowing heavily and placing excess funds on deposit at the central bank while holding down investment in the real economy would be interesting. Sometimes I think bankers forget that governments are elected by real people, who don't give a stuff about safe assets when they are facing unemployment.....
However, there is one very important point to the BIS proposal. It eliminates once and for all the idea that monetizing public debt inevitably leads to hyperinflation. The BIS model shows that monetizing debt can be done at at little risk of inflation. And for BIS, sovereign default is a disaster, because it destroys safe assets and risks the stability of the financial system. That reason alone is sufficient to justify debt monetization, given central banks' responsibility for financial stability. The IMF, the EU and - especially - the Bundesbank should take note. Better to load the central bank up to the skies with its own government's debt than risk a catastrophic sovereign default and global financial system meltdown.
And the other thing to note is this. In the BIS model, each currency-issuing nation has a public savings bank - government - and a public fractional reserve lending bank - the central bank. The fractional reserve lending bank acts as lender of last resort for the savings bank - hence debt monetization. And it is itself backed by government, because as a last resort government would use tax income to recapitalise the central bank. There are two massive assumptions underlying this: firstly, that central bank insolvency is never an issue because it can always meet its liabilities by creating money, and secondly, that populations can always be taxed sufficiently to meet all government liabilities including (if necessary) central bank recapitalisation. I don't propose to discuss either here, though I have serious reservations in particular about unlimited taxation: people can only be taxed to the extent that they are willing and able to pay that tax. And the whole thing looks dangerously circular to me. I can't help feeling that if the world is really so dependent on safe assets remaining safe, there may be a need for a supra-national monetary backstop.
Actually BIS does note that there may be a need for a global monetary backstop for safe assets, not because of central bank or government insolvency but because of competition between different safe assets setting up arbitrage loops and creating destabilising volatility in the financial system. Yet another role for the IMF, it seems. Which means that it would have to become a fractional reserve lending bank in its own right. Welcome to the new World Central Bank.
Or perhaps, more accurately, welcome to the World Central Government. For if governments are banks, and are backstopped by banks, and exist primarily to serve banks and investors, then who is it who really runs this show?