Government as Borrower of First Resort

We examine optimal supply of safe government bonds accounting for their e¤ect on corporate debt markets. Government bonds are shown to inuence leverage under asymmetric information regarding corporate cash ows and safe asset scarcity. Corporations have incentives to issue junk debt in response to safe asset scarcity since uninformed investors then migrate to junk debt markets. Uninformed demand stimulates informed speculation which drives junk debt prices closer to fundamentals, encouraging pooling at high leverage. Acting as borrower of rst resort, the government can issue safe bonds which siphon o ¤ 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. An optimal supply of government bonds is increasing in both marginal Q and the intrinsic demand for safe assets. In recent years the set of safe stores of value has contracted. A number of factors are responsible. The credit crisis of 2007/8 revealed the exposure of senior tranches of securitizations to correlated defaults. The Eurozone crisis called into question the safety of some sovereign debts. Finally, \u85 scal weakness undermined con\u85dence in deposit insurance in some jurisdictions. At the same time, it has been argued, these crises stimulated investor demand for safe stores of value in a ight-to-quality. The perceived combination of diminished supply and increased demand for safe assets has led some to argue that there is a scarcity of safe assets. In this vein, a recent Global Financial Stabilit