MIT economist Ricardo Caballero has a really fascinating proposal to shore up the stability of the financial system. His basic argument is that financial volatility is driven by a shortage of safe assets. He outlines two broad strategies for addressing the shortage.

The first is for governments in safe-asset-producing countries to produce a lot more of them. The second is to let the private sector create the AAA assets and for the governments (at a fair price) to absorb only that part of the risk the private sector cannot handle; this being the risk that arises during extreme systemic events, especially when compounded by panic.

The first strategy is about creating new public debt, and funding fiscal deficits really is inexpensive at the moment. But that doesn’t make it a sound long-term strategy. The second strategy, Caballero argues, is the better way to go in the medium-term. I do wonder, however, about the precedents for Caballero’s proposal, which he describes as follows:

The private sector is much more efficient than the government in producing micro-AAA assets, but the opposite is true for macro-AAA asset production. Issuing public debt leaves the government in charge of bundling and producing both the micro- and the macro-AAA assets. Instead, if the government only provides an explicit insurance against systemic events to the micro-AAA assets produced by the private sector, we could have a significant expansion in the supply of safe assets without the corresponding expansion of public debt. Of course there would a significant expansion of the notional liabilities of the government, but it is nearly certain that the ex-post cost would be much less than in any of the real alternatives.

I have to say, this idea gives me the willies. But if the alternative is limitless expansion of public debt, it might make sense to give it due consideration.