Because this "insatiable demand for safe debt instruments," as Caballero has called it, was not wholly absorbed by the traditional safe haven of U.S. Treasury notes, it helped spur the growth of the mortgage-backed bond market. But these bonds, backed by subprime loans, turned out to be unsafe despite their AAA ratings, exploding en masse. Financial markets are still feeling the aftereffects.
As a solution to this imbalance, Caballero -- an expert on global capital markets, financial panics and risk who is among the 100 most-cited economists worldwide -- has proposed the idea of government-issued investment insurance meant to help spur financial activity. Without such policies, he has warned, we could see the "recurrent emergence of bubbles," as capital chases emerging investment areas.
Remember my aphorism about finance. The nonfinancial sector wants to issue risky, long-term liabilities and to hold riskless, short-term assets. The financial sector accomodates this by doing the reverse.
One question is, how much of this financial intermediation is optimal? Up to a point, financial institutions can use specialized knowledge, monitoring arrangements, and diversification to perform their function relatively safely. However, beyond that point, they are relying more and more on signaling and confidence. This is true for governments as well as for financial intermediaries.
Since 2008, my reading has been that the amount of financial intermediation needs to decrease, with whatever painful consequences that follow. This includes a reduction in government-backed intermediation, rather than a new form of government backing of the sort that Caballero is suggesting.
The Austrian perspective would be that government support for financial intermediation is the disease, not the cure. In this case, I believe that is correct.