Non-technical summary of ESM Working Paper 78: Too much of a good thing? Safe assets, spillovers, and fiscal policy coordination

Safe assets, such as highly rated government bonds, play a central role in the financial system because they provide investors with a safe store of value and can be used as collateral in financial transactions. When several governments issue such assets, their borrowing decisions affect not only their own financing conditions but also those of other issuers. As a result, a lack of international fiscal coordination can lead to either too little or too much safe debt being issued: governments may restrict issuance to preserve the value of their bonds, or issue excessively without taking into account the fiscal costs imposed on other countries.

In this paper, we study the interactions of multiple safe asset issuers through the lens of a model of financially integrated economies. The model highlights two opposing forces. On the one hand, governments may issue too little debt because they seek to preserve the scarcity and value of their own safe assets. On the other hand, they may issue too much because they do not internalise how additional borrowing lowers the value of other countries' safe assets and increases their financing costs. We show that the balance between these forces depends primarily on public spending needs and the degree of spillovers between sovereign bond markets. In particular, high public spending needs and strong bond market spillovers amplify the fiscal externality, making excessive safe asset issuance more likely.

A quantitative analysis – calibrating the model to the euro area over 2015–2023 – suggests that prevailing conditions give rise to an over-issuance of safe sovereign debt of around 5% of GDP. High public spending needs and strong spillovers between euro area sovereign bond markets mean that the fiscal spillover dominates governments' incentives to restrict issuance. We also find that introducing common debt, by itself, does not eliminate this inefficiency and can modestly increase aggregate debt issuance, highlighting that common debt is not a substitute for fiscal policy coordination.