Safe Assets, Collateral, and Portfolio Preferences

Matthew Klein and Mayank Seksaria had an interesting Twitter conversation yesterday in response to a Stephanie Kelton tweet. Read it here.

Here’s my understanding of the financial mechanisms they’re talking about.

Government deficit spending deposits fixed-price securities (“money,” checking and money-market holdings) ab nihilo onto private sector balance sheets. These are perfectly “safe assets” in the sense that you always know what they’re worth relative to the unit of account (The Dollar). A $1 checking-account balance is always worth one dollar — if the holding account contains less than the FDIC-insured maximum. But for big finance players with big cash balances, they’re not as safe as…

Treasury bills/bonds. And since Treasury is required to “sop up,” re-absorb, burn those newly-created cash balances by swapping them for bonds (“borrowing”): deficit spending + bond issuance, consolidated, effectively deposits new Treasuries, ab nihilo, onto private-sector balance sheets.

Now to the portfolio effects, which are driven by the market’s portfolio preferences (a broader and IMO more aptly descriptive term than “liquidity preferences”).

If deficit spending delivers cash onto private-sector balance sheets, the market is overweight cash. (Assuming portfolio preferences are unchanged.) It can’t get rid of cash because cash is (by its very definition) fixed-price. There’s a fixed stock, unaffected by capital gains and losses. (Yes, net bank lending changes this stock, but very slowly.)

So to adjust their portfolios, market players bid up variable-priced assets: mainly bonds, equities, and titles to real estate. Voila, cap gains: there are more total assets, and portfolio preferences are achieved.

But wait: deficit spending + bond issuance, consolidated, doesn’t make the market overweight cash. It’s overweight bonds. Portfolio balancing is more complicated here, because bonds have variable prices (though they’re less variable than equities).

The market could just sell bonds, driving down their prices and reducing total assets, to achieve its portfolio preference — less bonds, same amount of cash and equities. Or it could sell less bonds but also bid up equities to hit its portfolio prefs; the first reduces total assets, while the second increases that measure. (As they say, further research is needed.)

But none of this, in my opinion, has a whole lot to do with the value of “safe assets” as “collateral” (except when asset prices are diving and all correlations go to one). That seems peripheral and secondary to me, a hamster-wheel of financial shenanigans, sound and fury signifying…

Another takeaway from this: Government deficit spending & bond issuance delivers new assets (Treasuries) onto private-sector balance sheets. But no new liabilities. So it creates more net worth.

But the portfolio balancing that ensues generally also drives up equity (and real-estate) prices, yielding a deficit-spending multiplier effect on wealth by driving cap gains that wouldn’t happen otherwise. One dollar of deficit spending/bond issuance results in more than one dollar in new private-sector wealth, assets, net worth.

That’s how I see it…