The Risks of Safe Assets
64 Pages Posted: 13 Nov 2020
Date Written: September 25, 2020
How much safety and liquidity can the US government provide? Should it accommodate demand for these attributes because high convenience yields in Treasuries lower its cost of borrowing? We evaluate a novel fiscal risk channel limiting the government's capacity to provide such services. Rising government debt lowers liquidity premia, but creates excess tax volatility through fiscal amplification, raising risk premia and credit spreads as well as firms' cost of capital thereby crowding out real activity. Our general equilibrium model suggests that this channel leads to significantly depressed growth prospects and rising Treasury yields. We use our model to quantitatively evaluate current proposals on unconventional stabilization policies and find that these effects are exacerbated in times of fiscal stress. Increasing safe asset supply can thus be risky, and have a significant fiscal cost.
Keywords: Government debt, safe assets, liquidity premium, uncertainty, growth, fiscal costs, risk premia, credit spreads, cost of capital, unconventional stabilization policies
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