Emmanuel Farhi’s Safety Trap

Emmanuel Farhi, considered by many to be the brightest economist of his generation, passed away in July 2020, aged only 41. Farhi, a PhD from Massachusetts Institute of Technology (MIT) and amongst the youngest to receive tenure as Professor at Harvard University, was known to challenge traditional economic concepts that people would often take as given. Take, for example, one of his most cited works, The Safe Asset Shortage Conundrum, written on safe assets and the lack thereof, in 2008 with Ricardo Caballero of MIT and Pierre-Oliver Gourinchas of UC Berkeley. This paper augmented Keynes’ classical theory of the ‘Liquidity Trap’ and developed it to suit the modern connotation of capital markets, and is more relevant now than ever.

The world seemed to have reasonably recovered from the short run curable shocks of the Great Financial Crisis of 2008 by 2018-19, when many first-world nations, including the world’s de-facto economic capital, the US, were considered to have achieved ‘full employment’. There was, however, something anomalistic about this status, when despite high productivity, inflation seemed suppressed. This dormant status of inflation, often explained by the unorthodox policy measures taken for recovery, has evidently trickled into the prolonged COVID-19 induced recession. Monetary policy as a tool might appear crippled at this point, with nominal rates reaching their zero levels bound in most first-world economies.

Conventional jargon would explain the situation as follows: what has basically happened in this liquidity trap is the flattening of our LM curve (a curve showing the relationship between real output and interest rates in the money market), a consequence of a high ‘h’ (which is the proportion of change in money demand, when the interest rates change by a percent). In classical (Keynesian) economic sense though, the policy decision is to change the money supply first, and the interest rate change is a consequence of that. Once a decision to increase the money supply, in hopes to revive demand, is implemented, it is accompanied by an equal increase in money demand in order for the market to equilibrate. Money demand, without an increase in income levels, can only rise if the interest rate moves down. But in case of a high ‘h’, a negligible downward movement of rates should be able to compensate for the money demand increase. Coming back to the real world, where money demand is adjusted by moving the nominal interest rates, such a scenario would render the monetary policy useless, once the zero levels bound of interest rates is reached.

The conventional solution to this dilemma, as given by Keynes in The General Theory of Employment, Interest and Money was to make gracious use of fiscal policy in a targeted manner. But as concerns of deficit consolidation popped up, economists at the Fed came up with other heterodox mutations of conventional monetary policy to tackle the issue. It wasn’t until Farhi’s paper on ‘Safety Traps’ was published that the policymakers found a more logical chain of response to the problem. A certain category of assets, often considered immune in periods of depressed market spirits, is called ‘Safe Assets’. During recessions, their markets evidently boom leading to price hikes and consequent fall in the yields. But the yields have a lower bound of zero percent, beyond which they cannot fall, and therefore prices cannot rise. This situation of people acting in private interest, leading to a net consequence of a market failure is a classic example of ‘Fallacy of Composition’. This happens since the asset market does not equilibrate in response to the high demand. And due to nominal rigidities, this equilibrium manifests in the form of output reduction. The output during recessionary periods is entirely demand determined, and the 0-yield on the safe assets is not low enough to encourage agents to move towards consumption.

Typically the solutions offered to do away with this complication include negative interest rates, forward guidance, quantitative easing, etc. However, in his paper, Farhi accounted for the fact that the market rates do not uniformly equilibrate across all assets, and a certain risk premium remains attached to equity assets, while the safe ones get to zero. This tends to dilute the policy impact.

What we want as our end result, is that despite the high ‘Safe Asset’ demand, we generate enough supply to ensure the yields do not get to zero and there is some scope to utilise the monetary policy. This sudden paucity of safe assets is often attributed to a savings glut, accumulation of reserves by the emerging markets, and to the fact that many assets which shaped the housing market bubble were once considered safe, but were not so at all.

One popular policy response which was an attempt to untie the hands of monetary policy, but failed to an extent was ‘Quantitative Easing’, which allowed the Fed to pump up the market with fresh money supply while purchasing bonds in return. This measure would not revive demand to its potential if safe assets are the ones being purchased in its return. This is because a proportion of the newly printed money will look for more safe assets, which have now shrunk in supply! Instead, soaking up the risky assets in return for the newly printed money, while simultaneously issuing newer safety assets is the proper way to go about quantitative easing.

Forward guidance, by ensuring to keep the future rates low was also said to work, because, if the Government’s word on the policy is reliable, lower future yields will imply higher future asset prices, creating current demand for the assets. When the self-fulfilling prophecy works out, the wealth effect naturally generates demand. However, Farhi’s paper found out the misconceptions associated with the effectiveness of this policy. If assets are seen in terms of the two designated classes, then it is likely that the risky assets, with a positive risk premium, will dissipate the impact of anticipated lower rates, and the effect will not trickle to revive the output market. However, one measure that is likely to render the monetary policy free is creating a very high inflation target, which would then allow the economy to run on an output-inducing negative real rate while being on the 0-nominal rate. But then again, this has its long-run ramifications.

The existence of a high-risk premium is concrete evidence for the existence of a ‘safety trap’, rather than a liquidity trap. It is indicative of the fact that people are rushing towards safe assets, while equity returns remain stable and decoupled from the economic situation, as is the current case. A fiscal policy response by issuing sovereign bonds to address the scarcity of safe assets is now being encouraged with the popularisation of the ‘Modern Monetary Theory’, though Farhi considered the US’ role as the world’s banker to be unsustainable due to higher issuance of sovereign bonds leading many to question their debt levels.

While this paper played an instrumental role in forwarding the scope of the monetary policies of the first world countries, Emmanuel Farhi’s other papers are just as revolutionary, if not as cited. In another one of his works, Dealing with the Trilemma: Optimal Capital Controls with Fixed Exchange Rates he challenged the ‘Impossible Trinity’ by providing partial capital controls as a solution for emerging markets battling the exchange rate volatility. His research is a perfect amalgamation of academia and policy solutions, and he truly believed that research only made sense when it could be put in real service towards progress. Safe to say that the world of academics and research was in for a shock on his passing on the 23rd of July, 2020. Gita Gopinath, a fellow colleague at Harvard, poignantly wrote, “Imagine the loss to economics if Samuelson had died at the age of 41, that is what we have lost with Emmanuel’s passing”. His best was truly yet to be seen.


Riya Kaul

Studying economics at Delhi University. That's pretty much it.

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