A Model of Safe Asset Determination

February 2017
Zhiguo He, Arvind Krishnamurthy, Konstantin Milbradt

What makes an asset a “safe asset?"  We study a model where two countries each issue sovereign bonds to satisfy investors' safe asset demands.  The countries differ in the
float of their bonds and their resources/fundamentals available to roll over debts.  A sovereign's debt is more likely to be safe if its fundamentals are strong relative to other possible safe assets,  but not necessarily strong on an absolute basis.  Debt
float can enhance or detract from safety:  If global demand for safe assets is high, a large float can enhance safety. The large float offers greater liquidity, which increases demand for the large debt and thus reduces rollover risk. If demand for safe assets is low, then large debt size is a negative as rollover risk looms large. The model sheds light on the effects of “Eurobonds" —i.e.  a coordinated Euro-area-wide safe bond design. Eurobonds deliver welfare benets only when they make up a suciently large fraction of countries' debts. Small steps towards Eurobonds may hurt countries and not deliver welfare benets.