Harvard’s Carmen Reinhart and Kenneth Rogoff famously argued in the American Economic Review that rising debt would hurt economic growth—and politicians worldwide used the argument to justify austerity measures.

But research by Chicago Booth’s Zhiguo He, Stanford’s Arvind Krishnamurthy, and Northwestern’s Konstantin Milbradt indicates that a higher level of debt can make government bonds a safer investment.

In periods marred by financial turmoil, investors and even central banks worldwide pile into government-debt securities, particularly those issued by the United States and Germany. These safe assets serve as collateral in financial transactions, provide a reliable store of value, and perform even better when markets get jittery—features that are all enjoyed by US Treasuries. He, Krishnamurthy, and Milbradt take a step back and ask what makes government debt a safe investment vehicle, and pose a broader question: What makes an asset safe?

The appeal of safe assets
US government debt is the world’s premier safe asset, the researchers say, while Germany holds a similar status within Europe. During times of turmoil, the values of US and German bonds rise as central banks and other investors search for quality.

The researchers consider two countries that each issue government bonds but differ in their soundness as well as in the amount of debt issued. “We can think of the large country as the US and the small country as Canada,” they write. All investors look to maximize their future profits but have the option of putting their money into either country’s debt. The question is, into which country’s debt should investors pile their savings?

“This framework emphasizes the intriguing coordination issue that arises in determining which government bond is the safer asset,” says He. A bond becomes safe if other investors think that bond is safe and therefore invest in it. The analysis reveals a number of attributes that determine the safety of an asset, including the ability of each country to service its debt, and the risk associated with refinancing debt.

Interestingly, the model suggests that the country issuing a larger absolute amount of debt tends to earn a safety premium. Even when all investors coordinate and put their savings into one country’s debt, the country that is issuing a larger absolute amount of debt is able to offer a higher rate of return. The US, for example, with an enormous amount of government-debt securities outstanding, has a deep financial market of Treasuries that is better able than that of other countries to meet the coordinated demand for a safe asset. Of course, a country with more debt also takes on more rollover risk.

In a global savings glut, when investors are searching for safe assets, “US government debt is likely to continue to be the safe asset,” the researchers write, adding two caveats. First, US debt would be less attractive if US fundamentals were to deteriorate significantly relative to other countries. Second, if another country were to issue a larger amount of debt, that could cause those country’s bonds to become the dominant safe asset.

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