Short-term Debt and Financial Crises: What We Can Learn from U.S. Treasury Supply

We present a theory in which the key driver of short-term debt issued by the financial sector is the portfolio demand for safe and liquid assets by the non-financial sector. Households' demand for safe and liquid assets drives a premium on such assets that the financial sector exploits by owning risky and illiquid assets and writing safe and liquid claims against these assets. The central prediction of the theory is that government debt should be a substitute for the net supply of privately issued short-term debt. We verify this prediction with data from 1914 to 2011 by showing the net supply of government debt, predominantly Treasuries, is strongly negatively correlated with the net supply of private short-term debt, defined to be the private supply of short-term safe and liquid debt, net of the financial sector's holdings of Treasuries (and reserves and currency). A second set of predictions of the model concern the quantity of money (i.e. liquid bank liabilities such as checking accounts). The theory predicts that when government supply is large, banks should hold more of the supply and use it to back issuance of more liquid bank liabilities. We confirm this prediction as well. Moreover, we show that accounting for the impact of Treasury supply on bank money results in a stable estimate for money demand and can help resolve the "missing money" puzzle of the post-1980 period. Finally, the theory predicts that the quantity of short-term debt issued by the financial sector should predict financial crises better than standard measures such as private credit/GDP. We also confirm this prediction.