Manufacturing Risk-free Government Debt
Governments face a trade-off between insuring bondholders and taxpayers. If the government decides to fully insure bondholders by manufacturing risk-free debt, then it cannot insure taxpayers against permanent macro-economic shocks over long horizons. Instead, taxpayers will pay more in taxes in bad times. Conversely, if the government fully insures taxpayers against adverse macro shocks, then the debt becomes at least as risky as un-levered equity. Only when government debt earns convenience yields, may governments be able to insure both bondholders and taxpayers, and then only if the convenience yields are sufficiently counter-cyclical.
We are very grateful to Peter Demarzo and Jonathan Berk for their feedback and advice. We also acknowledge helpful comments from Luigi Boccola, Saki Bigio, Sebastian DiTella, Francois Gourio, Patrick Kehoe, Arvind Krishnamurthy, and Matteo Maggiori. Yuan Tian provided outstanding research assistance. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.