Abstract
Safe asset shortages can expose the economy to liquidity traps. The nature of these traps is determined by the cyclicality of the bond premium. Self-fulfilling liquidity traps are associated with a counter-cyclical bond premium. Small issuances of government debt crowd out private debt and exacerbate these pessimism-driven recessions. In contrast, fundamental liquidity traps arise under a pro-cyclical bond premium and government debt is expansionary. In the data, we find evidence of a counter-cyclical bond premium and a pro-cyclical supply of safe assets. We propose robust policies that prevent the existence of self-fulfilling traps and are expansionary in fundamental traps.
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