To stop markets getting stuck in a cashflow rut, what can policymakers do to oil the wheels? Liquidity crises disrupt the smooth running of markets, potentially bankrupting healthy firms and threatening the collapse of entire financial systems. The Sustainable Finance Center was set up to explore such problems, investigating ways to improve the safety and stability of firms and institutions. In a new study, TSE’s Fabrice Collard joined George-Marios Angeletos (MIT) and Harris Dellas (University of Surrey) to study how best to use public debt as a collateral or liquidity buffer.
What suggests that public debt can play a role in preventing liquidity crises?
Economic theory has emphasized that public debt issuance may ease liquidity shocks by contributing to the supply of assets that can be used as collateral or buffer stock. Similarly, empirical studies have shown that, even after controlling for default risk, the spread between government and private bonds is both substantial and sensitive to the quantity of public debt.
Our research develops a model in which fiscal policy, through public debt issuance, can be used to regulate the amount of collateral or liquidity in the market. This helps to ease the reallocation of a consumption good across households, or of capital across firms. Our findings suggest that debt issuance is a useful policy tool, but one that comes with important trade-offs.
What are the implications for fiscal policy and public debt targets?
The optimal policy is dictated by the interplay of three forces. The first is the desire to smooth taxes. This means that the government runs a budget surplus when expenditure is expected to increase; and runs a deficit when spending is expected to fall. The second is the desire to ease financial friction so as to improve private allocations. The third is the desire to maximize the rents the government can extract from the private sector by squeezing debt issuance and hence keep interest low so as to reduce the cost associated with servicing public debt.
The relative importance of these three forces varies across time. Issuing more public debt raises welfare by easing financial frictions, but it also tightens the government budget by raising interest rates. This trade-off is the key determinant of the steady-state level of public debt. It illustrates the importance of borrowing costs: the government could optimally restrict liquidity levels in order to keep the cost of debt finance low.
In our model, the government could simply eliminate financial friction by issuing enough public debt. But this would lead to a budgetary squeeze by eliminating the “profit” that the government enjoys by paying interest on public debt below the social discount rate. This trade-off does not just depend on taxation being distortionary, but also on the fact that the price of public debt varies negatively with its quantity. It necessitates a departure from tax smoothing in the short run to help attain an appropriate long-run level of debt.
How do these considerations shape the optimal response to shocks?
Policy responses must take into account the trade-off between liquidity provision and borrowing costs. During transitory financial shocks, it becomes optimal to run smaller deficits so as to contain the increase in interest rates. During financial crises, we show that larger deficits are warranted because such episodes are associated with cheap borrowing opportunities.
Consider an unanticipated, uninsured, increase in government spending. In the standard paradigm, this triggers a permanent increase in taxes. In our setting, taxes increase relatively more early on to keep interest rates on debt low, enabling a smaller tax burden later on.
Now consider a recession with severe financial frictions that reduces aggregate output and tax revenue, and motivates a fiscal stimulus in the form of a temporary “payroll tax cut”. This has an ambiguous effect on our key trade-off: while the larger friction encourages greater provision of liquidity, a higher profit can be made by preserving the shortage of collateral. However, higher deficits do not translate into faster debt accumulation because the government can roll over its original debt at lower interest rates and pay less interest on newly issued debt. For the same reason, the government can afford a larger fiscal stimulus.
This supports the idea that financial crises such as the Great Recession call for high deficits not only to stimulate aggregate demand but also because low interest rates make borrowing “cheap”. Unlike the textbook paradigm, this proposal makes sense in our analysis insofar as a lower interest rate signals an acute shortage of collateral and, hence, a higher spread between the market price of public debt and the social discount factor. Our paper draws attention to the policy implications of both the cyclicality of this spread and its interaction with the quantity of public debt.
FURTHER READING ‘Public Debt as Private Liquidity: Optimal Policy’ and other publications by Fabrice are available to view on his TSE web page.
Article published in TSE Reflect, February 2024
