New technical NBER Paper: "A Model of the Safe Asset Mechanism (SAM): Safety Traps and Economic Policy" (Ricardo J. Caballero, Emmanuel Farhi)
ABSTRACT: "The global economy has a chronic shortage of safe assets which lies behind many re- cent macroeconomic imbalances. This paper provides a simple model of the Safe Asset Mechanism (SAM), its recessionary safety traps, and its policy antidotes. Public debt plays a central role in SAM as long as the government has spare fiscal capacity to back safe asset production. We show that Quantitative Easing type policies have positive effects on spreads and output. In contrast, Operation Twist type policies, where the duration of public debt held by the public is reduced, can be counterproductive. Mon- etary policy commitments work if they support future bad states of nature. All these policies depend on fiscal capacity. Once the latter runs out, short term cyclical policy becomes ineffective. In contrast, credible long run fiscal consolidation relaxes the fiscal capacity constraint and enhances the effectiveness of short term policy. An economy that is near its fiscal limits is susceptible to runs on its public debt and to destabilizing feedback loops. We also show that in a SAM world, safe asset producer economies can continuously run trade deficits supported by global demand for safe assets, but they do so at the risk of exhausting their fiscal capacity."