A Comparative‐Advantage Approach to Government Debt Maturity

• Author: JEREMY C. STEIN,ROBIN GREENWOOD,SAMUEL G. HANSON
• DOI: http://doi.org/10.1111/jofi.12253
• Published date: 01 August 2015
• Date: 01 August 2015

THE JOURNAL OF FINANCE •VOL. LXX, NO. 4 •AUGUST 2015

A Comparative-Advantage Approach

to Government Debt Maturity

ROBIN GREENWOOD, SAMUEL G. HANSON, and JEREMY C. STEIN∗

ABSTRACT

We study optimal government debt maturity in a model where investors derive mon-

etary services from holding riskless short-term securities. In a setting where the

government is the only issuer of such riskless paper, it trades off the monetary pre-

mium associated with short-term debt against the refinancing risk implied by the

need to roll over its debt more often. We extend the model to allow private finan-

cial intermediaries to compete with the government in the provision of short-term

money-like claims. We argue that, if there are negative externalities associated with

private money creation, the government should tilt its issuance more toward short

maturities, thereby partially crowding out the private sector’s use of short-term debt.

IN THIS PAPER, we study how the government should optimally determine the

maturity structure of its debt. We focus on situations in which there is no ques-

tion about the government’s ability to service its obligations, so the analysis

should be thought of as applying to countries like the United States that are of

exceptionally high credit quality.1The primary novelty of our approach is that

we emphasize the monetary benefits that investors derive from holding risk-

less short-term securities, such as Treasury bills. These benefits lead T-bills

to embed a convenience premium, that is, to have a lower yield than would be

expected from a traditional asset pricing model.

We begin with the case in which the government is the only entity able to

create riskless money-like securities. In this case, optimal debt maturity turns

on a simple trade-off. On the one hand, as the government tilts its issuance

to shorter maturities, it generates more monetary services that are socially

valuable; this is reflected in a lower expected financing cost. On the other

∗Greenwood and Hanson are with Harvard Business School. Stein is with Harvard University.

We thank Robert Barro, Markus Brunnermeier, John Campbell, Martin Eichenbaum, Michael

Fleming, Ken Froot, Kenneth Garbade, Julio Rotemberg, Andrei Shleifer, Ken Singleton (the

Editor), Erik Stafford, Adi Sunderam, Matt Weinzierl, an anonymous referee and Associate Editor,

and seminar participants at 2010 NBER Corporate Finance Meetings, Bocconi University,Federal

Reserve Board, Harvard University,London School of Economics, New York University,Ohio State

University, University of California Berkeley, University of California Los Angeles, University of

California San Diego, and University of Miami for helpful comments and suggestions and we are

grateful to Peggy Moreland for editorial assistance.

1This is in contrast to the literature (e.g., Blanchard and Missale (1994)) arguing that countries

with significant default or inflation risk may have a signaling motive for favoring short-term debt,

or may have little choice but to issue short-term.

DOI: 10.1111/jofi.12253

1683

1684 The Journal of Finance R

hand, a strategy of short-term financing exposes the government to rollover

risk, given that future interest rates are unpredictable. As a number of previous

papers observe, such rollover risk leads to real costs insofar as it makes future

taxes more volatile.2

This trade-off yields a well-defined interior optimum for government debt

maturity,unlike traditional tax-smoothing models that imply government debt

should be very long term. It also implies a number of comparative statics

that are borne out in the data. Most notably, it predicts that government debt

maturity will be positively correlated with the ratio of government debt to

GDP, a pattern that emerges strongly in U.S. data. The intuition is that, as

the aggregate debt burden grows, the costs associated with rollover risk—and

hence with failing to smooth taxes—loom larger.

The simple trade-off model also captures the way in which Treasury and Fed-

eral Reserve practitioners have traditionally framed the debt maturity prob-

lem. According to former Treasury Secretary Lawrence Summers:3

I think the right theory is that one tries to [borrow] short to save money

but not [so much as] to be imprudent with respect to rollover risk. Hence

there is certain tolerance for [short-term] debt but marginal debt once

[total] debt goes up has to be more long term.

Our focus on the monetary services associated with short-term T-bills is cru-

cial for understanding Summers’s premise that the government should borrow

short to “save money.”4As we demonstrate formally below, if short-term T-bills

have a lower expected return than longer term Treasury bonds simply because

they are less risky in a standard asset pricing sense (i.e., because they have a

lower beta with respect to a rationally priced risk factor), this does not amount

to a coherent rationale for the government to tilt to the short end of the curve,

any more than it would make sense for the government to take a long posi-

tion in highly leveraged S&P 500 call options because of the positive expected

returns associated with bearing this market risk.

After fleshing out the simple trade-off model, we examine the case in which

the government is not the only entity that can create riskless money-like

claims, but instead competes with the private sector in doing so. Following

Gorton (2010), Gorton and Metrick (2012), Stein (2012), and Krishnamurthy

and Vissing-Jorgensen (2013a), we argue that financial intermediaries engage

in private money creation, thereby capturing the same monetary convenience

premium, when they issue safe short-term debt that is collateralized by long-

term risky assets. As Stein (2012) observes, the incentives for such private

2See, for example, Barro (1979), Lucas and Stokey (1983), Bohn (1990), Angeletos (2002),

Aiyagari et al. (2002), and Nosbusch (2008).

3Private email correspondence April 28, 2008, also cited in Greenwood, Hanson, and Stein

(2010).

4In a similar spirit, Bennett, Garbade, and Kambhu (2000) explain the appeal of short-term

financing by saying that “Minimizing the cost of funding the federal debt is a leading objective of

Treasurydebt management. . . liquidity is an important determinant of borrowing costs . . . Longer-

maturity debt is inherently less liquid than short-term debt .. . .”

Government Debt Maturity 1685

money creation can be excessive from a social point of view, as individual inter-

mediaries do not fully take into account the social costs of the asset fire sales

that can arise from heavy reliance on short-term financing.

In the presence of these fire-sale externalities, there is an additional moti-

vation for the government to shift its own issuance toward short-term bills:

by doing so, it reduces the equilibrium money premium on short-term instru-

ments, thereby partially crowding out the private sector’s socially excessive

issuance of short-term debt. This is desirable as long as the marginal social

costs associated with government money creation—making future taxes more

volatile—remain lower than the marginal social costs associated with private

money creation, which stem from fire sales. In other words, the government

should keep issuing short-term bills as long as it has a comparative advantage

over the private sector in the production of riskless short-term securities.

This line of reasoning adds what is effectively a regulatory dimension to the

government’s debt maturity choice. An alternative way to address the fire-sale

externalities associated with private money creation would be to try to control

the volume of such money creation directly, for example, with either a regula-

tory limit or a Pigouvian tax on short-term debt use by financial intermediaries.

However, we show that, to the extent that such caps and taxes are difficult or

costly to enforce—say because some of the money creation can migrate to the

unregulated “shadow banking” sector—there will also be a complementary role

for a policy that reduces the incentive for private intermediaries to engage in

money creation in the first place, by lowering the convenience premium that

money commands. The more costly are such direct regulations, the larger is

the role for government debt management in reducing private money creation.

To be clear, we intend for this comparative-advantage argument to be taken

in a normative rather than positive spirit. That is, unlike with the simple

government-only model, we do not mean to suggest that the comparative-

advantage aspect of the theory provides further testable predictions regard-

ing how governments have historically chosen their debt maturity structures.

Rather, we offer it as a framework for thinking about policy going forward—

albeit one grounded in an empirically relevant set of premises. In this sense, it

is like other recent work on financial regulatory reform.

The ideas here build on five strands of research. First, our paper relates to

the literature that documents significant deviations from the predictions of

standard asset pricing models—patterns that can be thought of as reflecting

money-like convenience services—in the pricing of Treasury securities gener-

ally, and in the pricing of short-term T-bills more specifically (Krishnamurthy

and Vissing-Jorgensen (2012), Greenwood and Vayanos (2014), and Duffee

(1996)). Second, we build on the set of recent papers alluded to above that

emphasize how private intermediaries try to capture the money premium

by relying heavily on short-term debt, even when this creates systemic

instabilities (Gorton and Metrick (2012), Gorton (2010), Stein (2012), and

Krishnamurthy and Vissing-Jorgensen (2013a)). Third, we expand evidence

that changes in government debt maturity influence private-sector debt matu-

rity choices, consistent with a crowding-out view: when the government issues