The benefits of large-scale government bond purchases
In this paper, Paul Fontanier explores the impact of large-scale government bond purchases by central banks on sovereign debt markets, particularly focusing on the phenomenon of rollover crises. He proposes a three period model where a government issues bonds and also seeks to smooth consumption by rolling over some of its debt. The model’s innovation is that it allows for endogenous information production which guides how investors trade the newly issued bonds.
- Impact of Information Acquisition: Fontanier argues that information acquisition by private investors generally reduces the uncertainty in bond markets, which lowers the risk premium on sovereign bonds. However, this also makes bond prices more sensitive to new information, potentially leading to volatility and instability in the bond market.
- Role of Central Bank Purchases: Central bank purchases of sovereign bonds can lead to a reduction in private information acquisition. This is because these purchases decrease the amount of risk that private investors need to manage, making it less economically viable for them to invest in costly information gathering. While this reduction in information acquisition impairs the price discovery process in the bond market, it can also prevent rollover crises by stabilizing bond prices in the face of negative news. This is because less information-sensitive pricing can prevent drastic price drops that trigger crises.
- Welfare Implications: The model suggests that central bank interventions in the bond market can have significant welfare implications. By preventing rollover crises, central banks can generate substantial welfare gains, even though these actions may impair market efficiency in terms of price discovery.
But:
A key property of the model is that substantial purchases may be required, while small interventions have ambiguous welfare consequences. When the sovereign expects the central bank to carry such programs, it leads to excessive indebtedness, forcing the central bank to run an inflated balance sheet to avoid roll-over crises.
Sovereign Bond Purchases and Rollover Crises
Author: Paul Fontanier
From: Yale University
