DP11362 Government as Borrower of First Resort

Author(s): Gilles Chemla, Christopher Hennessy
Publication Date: June 2016
Keyword(s): asymmetric information, corporate debt markets, governmet debt, issuers, speculators, uninformed investors
JEL(s):
Programme Areas: Public Economics, Financial Economics, Industrial Organization
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=11362

We examine optimal provision of riskless government bonds under asymmetric information and safe asset scarcity. Paradoxically, corporations have incentives to issue junk debt precisely when intrinsic demand for safe debt is high since uninformed investors then migrate to risky overheated debt markets. Uninformed demand stimulates informed speculation which drives junk debt prices closer to fundamentals, encouraging pooling at high leverage. Acting as borrower of first resort, the government can issue safe bonds which siphon off uninformed demand for risky corporate debt and reduce socially wasteful informed speculation. Thus, government bonds either eliminate pooling at high leverage or improve risk sharing in such equilibria. The optimal quantity of government bonds is increasing in intrinsic demand for safe assets and non-monotonic in marginal Q.