18 Jan 2018

SAFE Policy Lecture: “Financial Dominance, Safe Assets and Global Reserve Holdings"

Markus K. Brunnermeier regards ESBies as a solution for fundamental issues on the European sovereign debt market

The first SAFE policy lecture of the year, held on 11 January, addressed the topic “Financial Dominance, Safe Assets and Global Reserve Holdings”. Markus K. Brunnermeier, faculty member of the Department of Economics at Princeton University and Director of its Bendheim Center for Finance started his lecture by explaining the difference between the German and the French perception of the European Euro crisis and the consequences for the banking regulation. According to Brunnermeier, Germans rather have a “Solvency” view that favors restructuring to prevent future economic crises. In contrast, French economists and politicians perceive the Euro crisis rather as a liquidity problem that has put the Eurozone into a bad equilibrium, requiring financial support rather than restructuring.

Subsequently he analyzed the interaction between sovereign debt and banking, as well as important mechanisms during the recent Euro crisis more closely by presenting a “toy model" of contingent sovereign debt. In this model, selling bonds to domestic banks may be used as a commitment device by the government to decrease funding costs. A public default in the future would not only harm the reputation of the government but also the banking sector. This “commitment mechanism” is more pronounced in bad times, when banks have a more important role in refinancing the economy. It makes a failure of the financial system much worse for the real economy. A strong exposure of banks to domestic sovereign debt may further crowd out lending to the real economy if the sovereign is struggling to repay its debts.

Brunnermeier further stated that a safe asset fulfills important insurance mechanisms during crises due to its negative correlation with real economic values. However, in a multi country world, an asymmetrical provision of such a safe asset may lead to a “flight to safety” across borders in bad times and ultimately results in a situation in which the poorer countries insure the richer countries. According to Brunnermeier, this circumstance largely fueled the recent Eurozone crisis.

To counteract these problems and rechannel the insurance role of safe assets, he proposed Sovereign Bond Backed Securities (SBBS) in the form of so-called European Safe Bonds (ESBies) as the golden way forward. In short, ESBies are formed from the senior tranche of financial securities backed by a portfolio of sovereign bonds of European countries. According to Brunnermeier, this approach would result in a vertical capital flight in unstable times, namely from the more risky junior tranche to the less risky senior tranche rather than in a horizontal, i.e. cross-border “flight to safety”.