Bond Premium Cyclicality and Liquidity Traps

Abstract Safe asset shortages can expose an economy to liquidity traps. The nature of these traps is determined by the cyclicality of the bond premium. A counter-cyclical bond premium opens the possibility of expectations-driven liquidity traps in which small issuances of government debt crowd out private debt and reduce output. In contrast, when the bond premium is pro-cyclical and the economy is in a liquidity trap, government debt is expansionary. In the data, we find evidence of a counter-cyclical bond premium. Large interventions can prevent the emergence of self-fulfilling traps, but they require sufficient fiscal capacity. In a quantitative model calibrated to the Great Recession, a promise to increase the government debt-to-GDP ratio by 20 percentage points precludes the possibility of self-fulfilling traps.