The Valuation of Public Debt in the U.S. and Across Countries

In macro-economics and public finance, economists commonly assume that the debt issued by the government of a country like the United States is risk-free. This assumption is unlikely to hold. The public debt is like an asset whose cash flows are the government’s future primary surpluses. Because surpluses are cyclical in the short run and track the country’s output in the long run, this cash flow is risky. Standard finance implies that this asset should earn a risk premium. The proper discount rate must exceed the risk-free interest rate. To assess the sustainability of fiscal policies, we cannot simply compare the risk-free rate to the GDP growth rate. Instead, we should compare the risk-free rate to the risk-adjusted growth rate.

This insight applies to any equilibrium model with permanent shocks to output and reasonable asset pricing implications for the returns on stocks and bonds. In any such model, the time series properties of the surplus that are consistent with the U.S. data result in government debt that is risky. Conversely, insisting on risk-free debt impose tight restrictions on the government’s surplus dynamics, restrictions that are violated in the data. Our project analyzes the underlying trade-off between the insurance provided to bondholders by keeping the debt risk-free and the insurance provided to taxpayers and transfer recipients. This insight has deep and broad implications for the government’s debt capacity. It gives rise to two key questions that we plan explore in this proposal. First, if the surpluses are risky, why are the returns on the U.S. Treasury portfolio so low? Second, is the U.S. different from other developed countries in this regard? What is the role of the demand for safe assets and the role of the U.S. as the world’s main supplier of safe assets?