Working Paper: CEPR ID: DP16407
Authors: Lukas Schmid; Yang Liu; Amir Yaron
Abstract: 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 borrowing cost? We evaluate a novel fiscal risk channel limiting the government's capacity to issue debt through the lens of a general equilibrium asset pricing model with a rich fiscal sector. Expanding safe asset supply lowers safety premia and improves liquidity in financial markets, but creates tax and consumption volatility, raising risk premia, credit spreads, and firms' cost of capital. Our model predicts that this risk channel leads to depressed growth prospects, rising Treasury yields, and elevated consumption risk, for which we find strong empirical evidence. We use our model to quantitatively evaluate current proposals on stimulus and stabilization packages and find that the risk channel is 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; fiscal costs; risk premia
JEL Codes: G0; F0
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| supply of safe assets (E41) | safety premiums (J28) |
| supply of safe assets (E41) | liquidity in financial markets (E44) |
| supply of safe assets (E41) | tax and consumption volatility (H29) |
| tax and consumption volatility (H29) | risk premiums (G19) |
| tax and consumption volatility (H29) | credit spreads (G12) |
| government debt (H63) | consumption risk (D11) |
| government debt (H63) | growth prospects (E66) |
| government debt (H63) | future tax obligations (H29) |
| future tax obligations (H29) | tax base (H20) |
| tax base (H20) | adverse shocks (E32) |
| adverse shocks (E32) | taxes (H29) |
| taxes (H29) | growth (O40) |