Debt as Safe Asset
The price of a safe asset reflects not only the expected discounted future cash flows but also future service flows, since retrading allows partial insurance of idiosyncratic risk in an incomplete markets setting. This lowers the issuers’ interest burden. As idiosyncratic risk rises during recessions, so does the value of the service flows bestowing the safe asset with a negative b. The resulting exorbitant privilege resolves government debt valuation puzzles and allows the government to run a permanent (primary) deficit without ever paying back its debt, but the government faces a “Debt Laffer Curve”.
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