The Safety Trap
Description:... Recently, the global economy has experienced recurrent episodes of safe asset shortages. In this paper we present a model that shows how such shortages can generate macroeconomic phenomena similar to those found in liquidity trap scenarios. Despite the similarities, there are also subtle but important differences which carry significant impacts on the relative effectiveness of economic policy and potential market solutions to the underlying problem. For example, while forward guidance policies are typically more effective than quantitative easing ones in the standard liquidity trap environment, the opposite holds in safety trap contexts. Also, while asset bubbles (market solutions) and public debt are both effective in liquidity traps, only the latter are in safety traps. Essentially, a safe asset shortage is a deficit of a particular form of wealth (safe wealth), which the government has comparative advantage in supplying. Forward guidance and financial bubbles, which increase risky wealth and stimulate the economy in liquidity traps, fail to do so in safety traps as they are dissipated through higher spreads. JEL Classification: E0, E1, E5, E52.
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