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

Abstract

The common assumption in economics is that the debt issued by the government of a country like the United States is risk-free. This project builds on the notion that 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 and should earn a risk premium. The proper discount rate must exceed the risk-free interest rate. This project develops a model for pricing government debt considering the risk in cash flows and assesses the implications of this for taxpayers and for bondholders.

This research points to the important distinction that risk-free rate should not be compared to the GDP growth rate, but to the risk-adjusted growth rate. The project has potential deep and broad contributions to policies on government debt capacity and sustainability of fiscal policies.

In any equilibrium model with permanent shocks to output and reasonable asset pricing implications for the returns on stocks and bonds, the time series properties of the surplus that are consistent with the U.S. data result in government debt that is risky. Assumption of risk-free debt impose tight restrictions on the government’s surplus dynamics such that these restrictions are violated in the data.

This 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 gives rise to key questions that are explored in this project. First, the project looks at why the returns on the U.S.

Treasury portfolio are so low if the surpluses are risky. Second, the research explores other developed countries in this regard to understand whether U.S. is different, and then considers the role of the demand for safe assets and the role of the U.S. as the world’s main supplier of safe assets within this context.

This award reflects NSF's statutory mission and has been deemed worthy of support through evaluation using the Foundation's intellectual merit and broader impacts review criteria.