Absence of safe assets and fiscal crisis

Masaya Sakuragawa, Yukie Sakuragawa

Research output: Contribution to journalArticle

1 Citation (Scopus)

Abstract

This paper develops a fiscal crisis model that explains a mechanism under which low interest rates can coexist with Japan's large outstanding debt. The key idea is that when there is a strong home bias in the asset portfolio of domestic bondholders, these investors turn out to have no access to any assets that hedge fiscal risk. This explains why domestic investors do not request a risk premium on government bonds. In this environment, the interest rate and the default probability are low, and the government can sustain its large debt even under adverse fiscal conditions. As the interest rate does not rise fully to reflect the risk premium, the low interest rate is not always a signal of sound fiscal conditions. The welfare implications of financial market reform are mixed. This reform can improve welfare so long as the government can sustain the debt, but at the same time, it makes it difficult to sustain the debt because the interest rate rises. Quantitative easing is effective in lowering the risk premium.

Original languageEnglish
Pages (from-to)59-76
Number of pages18
JournalJournal of the Japanese and International Economies
Volume40
DOIs
Publication statusPublished - 2016 Jun 1

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Keywords

  • E00
  • Fiscal crisis
  • G12
  • H63
  • Risk premium
  • Safe asset
  • Sustainability

ASJC Scopus subject areas

  • Economics and Econometrics
  • Finance
  • Political Science and International Relations

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