Government as Borrower of First Resort

41 Pages Posted: 6 Oct 2010 Last revised: 16 Oct 2016

See all articles by Gilles Chemla

Gilles Chemla

Imperial College Business School; CNRS ; Centre for Economic Policy Research (CEPR)

Chris Hennessy

London Business School

Multiple version iconThere are 2 versions of this paper

Date Written: December 8, 2015

Abstract

We examine optimal provision of riskless government bonds under asymmetric information and safe asset scarcity. Paradoxically, corporations have incentives to issue junk debt precisely when intrinsic demand for safe debt is high since uninformed investors then migrate to risky overheated debt markets. Uninformed demand stimulates informed speculation which drives junk debt prices closer to fundamentals, encouraging pooling at high leverage. Acting as borrower of first resort, the government can issue safe bonds which siphon off uninformed demand for risky corporate debt and reduce socially wasteful informed speculation. Thus, government bonds either eliminate pooling at high leverage or improve risk sharing in such equilibria. The optimal quantity of government bonds is increasing in intrinsic demand for safe assets and non-monotonic in marginal Q.

Keywords: safe assets, high-yield debt, speculator, uninformed investors, information, overheated debt markets

JEL Classification: G21, G28, G32, D82

Suggested Citation

Chemla, Gilles and Hennessy, Christopher, Government as Borrower of First Resort (December 8, 2015). Available at SSRN: https://ssrn.com/abstract=1687003 or http://dx.doi.org/10.2139/ssrn.1687003

Gilles Chemla (Contact Author)

Imperial College Business School ( email )

South Kensington Campus
London SW7 2AZ, SW7 2AZ
United Kingdom
+44 207 594 9161 (Phone)
+44 207 594 9210 (Fax)

CNRS ( email )

Dauphine Recherches en Management
Place du Marechal de Lattre de Tassigny
Paris, 75016
France
331 44054970 (Phone)

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Christopher Hennessy

London Business School ( email )

Sussex Place
Regent's Park
London, London NW1 4SA
United Kingdom

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