Aurora Borealis
1 November 2015 CFA Institute Journal Review

A Comparative-Advantage Approach to Government Debt Maturity (Digest Summary)

  1. Marc L. Ross, CFA

The government’s choice of shorter-maturity debt issuance may complement prudential financial regulation by crowding out private issuance, thereby limiting excess private money creation. Although greater short-term government debt increases rollover risk because of a reduction in private short-term debt, the government’s optimal debt maturity choice can reduce the social cost of excessive private debt issuance.

What’s Inside?

Investors are attracted to the liquidity and safety of short-term US government debt (the monetary convenience premium). The private sector’s ability to produce similar debt investments (e.g., commercial paper) may be susceptible to social excess because of the risk of forced liquidations (and the consequent asset fire sales) and their associated negative externalities for the economy. The authors explore the policy implications of the government’s choice of optimal debt maturity (i.e., short-term versus long-term debt) and the effects of this maturity choice on competing private short-term debt issuance.

How Is This Research Useful to Practitioners?

Government debt issuance can serve as an implicit regulatory tool. Private money creation in the form of short-term (commercial paper) issuance may be excessively risky, possibly resulting in the socialization of losses (asset fire sales) as a result of long-term assets collateralizing short-term liabilities. The government’s decision to increase issuance of bills over notes and bonds could crowd out private short-term debt, the risks of such government issuance notwithstanding. These risks include rollover risk, which can lead to undesirable future tax volatility.

The authors’ model initially considers the case in which only the government can issue short-term liquid debt. Although these short-term securities generate lower financing costs, they do so at the expense of the previously mentioned refinancing risk. The model then adds private sector agents (e.g., banks) that can also issue short-term liquid debt, although backed by longer-term assets. Such a mismatch could carry heavy social costs if forced asset sales were to occur. Short-term government issuance would make sense as long as the government has a comparative advantage over the private sector by creating social costs that are less severe than those of private issuers. This expansion of the model assumes partial fungibility of Treasury bills and privately issued short-term debt. Consistent with the model, the authors observe an empirical inverse correlation between T-bill and commercial paper issuance.

The authors’ work carries important lessons for economists, government budgetary policymakers, and regulators. Understanding how government debt issuance can moderate macroeconomic risks introduces a powerful indirect and potentially more efficient and less costly regulatory tool that complements current regulatory machinery.

How Did the Authors Conduct This Research?

The authors build on five areas of existing research: (1) the money-like features of US Treasury securities, (2) the private sector’s attempt to capture similar benefits through short-term debt issuance, (3) the impact of government debt changes on private sector issuance (e.g., crowding out effects), (4) the effect of government debt maturity on tax volatility, and (5) the rationale for varying government debt maturity over time.

The authors’ model starts by considering the trade-offs of short-term government debt issuance through the perspective of only households, the government, and financial intermediaries. The authors then expand the model to evaluate iterations of private sector issuance that consider multiple maturities. The dataset used includes Treasury auction dates from 1983 to 2009. Commercial paper data are from the Fed.

From the body of research, the authors consider the convenience premium of short-term Treasury securities, how the private sector responds to the government’s choice of maturity issuance, how such maturity correlates with the quantity of debt issued in relation to GDP, and how the data (fail to) support a series of successive propositions regarding the importance of short-term government debt’s importance in mitigating risks associated with private sector money-like debt sales. The authors provide helpful summary statements to clarify critical concepts.

Abstractor’s Viewpoint

The power of the government to constrain private sector short-term debt creation through issuance of its own short-term debt is, in a certain sense, more effective than written regulations that can be evaded (e.g., shadow banking). The authors’ analysis considers what the proper governmental response should be to money demand shocks or the private sector’s provision of liquid claims, such as commercial paper. Their work, although perhaps too mathematical for many readers, carries important public policy implications.

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