The Risks of Safe Assets

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.