The Supply and Demand for Safe Assets

Gary Gorton is a Professor of Finance at Yale School of Management.

In the recent NBER working paper, my co-author, Guillermo Ordoñez of the University of Pennsylvania, and I develop a model to examine the important role collateral plays in the economy. Where do safe assets come from? Empirical evidence suggests that the private sector creates more near riskless assets when the supply of government debt is low and reduces privately-created near riskless assets when the supply of government debt is high. Krishnamurthy and Vissing-Jorgensen (2012) show that the net supply of government debt is strongly negatively correlated with the net supply of private near-riskless debt.

The substitution between public and private safe debt is also shown by Krishnamurthy and Vissing-Jorgensen (2012) who document that changes in the supply of outstanding U.S. Treasuries have large effects on the yields of privately created assets. Gorton, Lewellen, and Metrick (2010) also find this relationship between government debt and privately produced substitutes. They document that the share of safe assets in the U.S. economy, including both U.S. Treasury debt and privately created near-riskless debt has remained constant as a percentage of all U.S. assets since 1952. Xie (2012) shows that the issuance of asset-backed securities tends to occur when the outstanding government debt is low and Sunderam (2012) documents the same phenomenon with respect to asset-backed commercial paper.

By “safe assets,” we mean government debt and privately created high quality debt, in particular, asset-backed securities. Such safe assets are used to collateralize repo, derivative positions, and are needed as collateral in clearing and settlement. See IMF (2012). Further, because they are ”information-insensitive” (in the nomenclature of Dang, Gorton, and Holmstrom (2012)), they are highly liquid and hence can store value without fear of capital losses in times of stress, a form of private money.

The evidence that the private sector fills in privately created debt when the outstanding amount of government bonds is low suggests that Ricardian Equivalence (i.e., Barro (1974)) does not always hold. There is a demand for government bonds to use as collateral. In this paper we provide a rationale for why this is the case based on the details of the role of collateral in the economy. Using a model of information acquisition about collateral values, based on Dang, Gorton, and Holmstrom (2012) and Gorton and Ordonez (2012), privately produced bonds can be used as collateral, potentially relaxing borrowing restrictions for firms. Collateral is needed to enable borrowing by firms, borrowing such that the lenders do not produce information about the collateral, but simply lend. Government bonds are preferred to privately-produced collateral if that collateral is not of sufficiently high quality to enable the optimal borrowing. In this case government bonds are not neutral because they can be used as collateral, increasing production towards the optimal borrowing.

In normal times, lenders do not have incentives to acquire information about the value of privately produced assets that firms use as collateral for borrowing. Hence, a large volume of assets can be used to sustain borrowing in the economy. As in Gorton and Ordonez (2012), a ”crisis” occurs when there is a public arrival of bad news such that lenders have incentives to acquire information about the value of the privately-produced assets, only lending to firms with assets of high value, reducing the volume of assets that can be successfully used as collateral. This is also the definition of crises adopted by Gourinchas and Jeanne (2012).

In our paper, we show that government bonds have a (non-Ricardian) benefit during crises. In normal times, it may not matter whether the government finances its expenses with taxes or bonds, if government bonds do not relax borrowing constraints. In contrast, during crises the private assets that can be successfully used as collateral to back borrowing declines. Then government bonds can replace private assets that do not sustain borrowing anymore, constituting positive wealth and breaking Ricardian equivalence since financing with bonds become superior to taxes, consistent with the evidence of Hrung and Seligman (2011). Even if government bonds are not net wealth normally, Ricardian Equivalence breaks down exactly during times in which bonds may be needed, during a crisis.

However, there are limits to the use of government bonds as collateral. On the one hand, taxes reduce the incentives to work and invest in the economy. On the other hand, when bonds are used as collateral and some lenders are foreign, some bonds end up outside the (domestic) economy, increasing the tax pressure domestically since those bonds are not used to cover taxes.

In our model, household lenders make loans directly to firms, and the loans must be collateralized. We abstract from financial intermediaries for the sake of simplicity, but we have in mind financial contracts like sale and repurchase agreements (repo), which involve a lender making a loan against collateral that can be either a government bond or a private asset. Also, more generally loans are made against collateral, as senior secured bank loans for example.

Our results clearly differ from the well-known Ricardian Equivalence result, which states that under certain conditions households internalize the government’s budget constraint; hence it does not matter whether a government finances its spending with debt or with taxes. It does not matter for consumption plans of households whether the government finances public spending using current taxes or future taxes. The reason is that households would reduce current consumption either to pay taxes or to save to pay future taxes.

One of the main conditions for Ricardian Equivalence to hold is that capital markets are perfect. In essence, under liquidity constraints, government bonds can additionally provide liquidity services, increasing households’ wealth because they relax liquidity constraints. In his paper, Barro (1974) explores this possibility in a very reduced way. We provide the details of how liquidity is created with safe assets, how the value of such liquidity is determined, and provide conditions under which Ricardian Equivalence does not hold. There is a very large literature on Ricardian Equivalence, with mixed empirical evidence.

Closest to our work is Saint-Paul (2000) who also shows that government debt can relax borrowing constraints because it can be used as collateral. In his setting, financial contracts involve costly state verification (i.e., Townsend (1979)). When the borrowers wealth includes government debt, the need for monitoring is reduced, although government debt ”crowds out” private investment. Costly state verification is necessary in an environment where the production of information by a lender can be necessary because borrowers may not report the truth about unobservable project outcomes.

There are significant differences between Saint-Paul’s setting and ours. The raison d’être for debt is different in the two models. We adopt the concept of debt from Dang, Gorton, and Holmstrom (2012) who show that information production is not desirable; information-insensitive debt, that is debt where it is not desirable to produce private information ex ante, can optimally support more borrowing and hence higher output and consumption. In Townsend, it may be optimal to produce information ex post. The difference in the concept of debt is important because another difference concerns the possibility of a financial crisis. There are no crises in Saint-Paul’s model whereas in our setting it can happen that information is produced about the collateral (as in Gorton and Ordonez (2012)), leading to a financial crisis with decreased output and consumption.

The full paper is available for download here.

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