New Theory on Treasury Supply

Government debt dries up financial markets

Annette Vissing-Jørgensen
Prof. Annette Vissing-Jørgensen

Economists teach that when the federal government borrows on a big scale, the financial sector can take a hit. The standard explanation is that more government borrowing boosts interest rates, which cuts into private sector loan demand. But Annette Vissing-Jørgensen has another idea.

Government borrowing makes it costlier for banks to issue debt, squeezing profits. Vissing-Jørgensen, the Arno A. Rayner Chair in Finance and Management, won the Swiss Finance Institute’s 2015 Outstanding Paper Award for “The Impact of Treasury Supply on Financial Sector Lending and Stability,” published in the Journal of Financial Economics. She shares the prize with her co-author, Stanford Prof. Arvind Krishnamurthy.

They argue that bank deposits and other financial sector short-term debt share a critical quality with government debt: Both satisfy investor demand for safe assets easily turned into cash. Because such debt is safe and liquid, people are willing to accept low interest rates, the key to bank profits. Financial institutions use the funds they get from issuing low-interest-rate debt to make risky higher-rate loans, making money on the spread between their borrowing and lending.

The paper predicts that when the government steps up its borrowing, the financial sector cuts back the quantity of lending funded with short-term debt—what’s called “crowding out.” The increased supply of government debt pushes down the profitability from bank lending funded with short-term debt. As a result, banks issue less debt and make fewer loans.

The authors examined U.S. data from 1875 to 2014. As predicted, when the supply of government securities rose, the quantity of financial sector short-term debt fell.

In a nutshell, increased government debt can reduce financial sector debt-financed lending, thus increasing financial stability, but potentially slowing economic growth.