Nobel laureate Robert E. Lucas will be awarded the University of Chicago’s rare and prestigious Division of Social Science Phoenix Prize in recognition of his influential contributions to changing the field of economics.
To commemorate this award, the Becker Friedman Institute, the Department of Economics, and the Division of the Social Sciences are hosting a conference in his honor at the University of Chicago. Distinguished colleagues and coauthors will participate in this research conference exploring the impact of Lucas’s work.
Agenda
On the Optimality of Financial Repression
V.V. Chari presented a paper that asks if this is an efficient way to raise money, and if so, under what circumstances. He shows that if a government can commit to repaying its bonds, this is not an efficient way to raise government revenue. A government would be better off taxing capital directly. Forcing banks to hold government debt at below-market rates has the same distorting effects as a tax on capital, but also leaves the banks more collateral-constrained than before, thus reducing investment even further.
However, if the government cannot commit to repaying its bonds, forcing banks to hold government bonds may be a useful policy tool. Why? A government bond default has different effects depending on whether the bonds are held by individuals or by banks. Defaults on individual holdings are costless socially, but defaults on banks reduce capital investment. If the government forces the banks to hold its bonds, it places itself in a position where default is more costly. Thus, constraining banks to hold government bonds is a way governments can raise barriers and disincentives for future defaults.
The resulting pattern emerges: when there is a very high need for government spending—due to a major war, for example—the government will force banks to hold its bonds. This constraint is only needed when the outstanding supply of bonds is very high, and will typically be removed when government spending returns to normal levels.
Governments facing wide swings in spending are more likely to need to use this strategy. But if the swings are high enough, financial repression can help the government retain the credibility of its bonds.