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In Search of a Theory of Debt Management

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  • Albert Marcet

    ()

  • Elisa Faraglia
  • Andrew Scott

Abstract

A growing literature integrates theories of debt management into models of optimal fiscal policy. One promising theory argues that the composition of government debt should be chosen so that fluctuations in the market value of debt offset changes in expected future deficits. This complete market approach to debt management is valid even when the government only issues non-contingent bonds. A number of authors conclude from this approach that governments should issue long term debt and invest in short term assets. We argue that the conclusions of this approach are too fragile to serve as a basis for policy recommendations. This is because bonds at different maturities have highly correlated returns, causing the determination of the optimal portfolio to be ill-conditioned. To make this point concrete we examine the implications of this approach to debt management in various models, both analytically and using numerical methods calibrated to the US economy. We find the complete market approach recommends asset positions which are huge multiples of GDP. Introducing persistent shocks or capital accumulation only worsens this problem. Increasing the volatility of interest rates through habits partly reduces the size of these simulations we find no presumption that governments should issue long term debt ? policy recommendations can be easily reversed through small perturbations in the specification of shocks or small variations in the maturity of bonds issued. We further extend the literature by removing the assumption that governments every period costlessly repurchase all outstanding debt. This exacerbates the size of the required positions, worsens their volatility and in some cases produces instability in debt holdings. We conclude that it is very difficult to insulate fiscal policy from shocks by using the complete markets approach to debt management. Given the limited variability of the yield curve using maturities is a poor way to substitute for state contingent debt. The result is the positions recommended by this approach conflict with a number of features that we believe are important in making bond markets incomplete e.g allowing for transaction costs, liquidity effects, etc.. Until these features are all fully incorporated we remain in search of a theory of debt management capable of providing robust policy insights.

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Bibliographic Info

Paper provided by Unitat de Fonaments de l'Anàlisi Econòmica (UAB) and Institut d'Anàlisi Econòmica (CSIC) in its series UFAE and IAE Working Papers with number 743.08.

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Length: 49
Date of creation: 07 May 2008
Date of revision:
Handle: RePEc:aub:autbar:743.08

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Keywords: Complete Markets; Debt Management; Government Debt; Maturity Structure; Yield Curve;

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References

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  1. V. V. Chari & Patrick J. Kehoe, 1999. "Optimal Fiscal and Monetary Policy," NBER Working Papers 6891, National Bureau of Economic Research, Inc.
  2. Bohn, Henning, 1990. "Tax Smoothing with Financial Instruments," American Economic Review, American Economic Association, vol. 80(5), pages 1217-30, December.
  3. Bernheim, B Douglas, 1991. "Optimal Fiscal and Monetary Policy: Some Recent Results," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 23(3), pages 540-42, August.
  4. Elisa Faraglia & Albert Marcet & Andrew Scott, 2007. "Fiscal Insurance and Debt Management in OECD Economies," Working Papers 333, Barcelona Graduate School of Economics.
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  8. Scott, Andrew, 2007. "Optimal taxation and OECD labor taxes," Journal of Monetary Economics, Elsevier, vol. 54(3), pages 925-944, April.
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  12. Marcet, Albert & Scott, Andrew, 2009. "Debt and deficit fluctuations and the structure of bond markets," Journal of Economic Theory, Elsevier, vol. 144(2), pages 473-501, March.
  13. George-Marios Angeletos, 2002. "Fiscal Policy With Noncontingent Debt And The Optimal Maturity Structure," The Quarterly Journal of Economics, MIT Press, vol. 117(3), pages 1105-1131, August.
  14. Fernando Broner & Alberto Martin & Jaume Ventura, 2006. "Sovereign Risk and Secondary Markets," NBER Working Papers 12783, National Bureau of Economic Research, Inc.
  15. Elisa Faraglia & Albert Marcet & Andrew Scott, 2006. "Debt Management Under Complete Markets," 2006 Meeting Papers 540, Society for Economic Dynamics.
  16. Emmanuel Farhi, 2007. "Capital Taxation and Ownership when Markets are Incomplete," NBER Working Papers 13390, National Bureau of Economic Research, Inc.
  17. Wachter, Jessica A., 2006. "A consumption-based model of the term structure of interest rates," Journal of Financial Economics, Elsevier, vol. 79(2), pages 365-399, February.
  18. Robert E. Lucas Jr. & Nancy L. Stokey, 1982. "Optimal Fiscal and Monetary Policy in an Economy Without Capital," Discussion Papers 532, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
  19. Robert J. Barro, 1999. "Notes on Optimal Debt Management," Journal of Applied Economics, Universidad del CEMA, vol. 0, pages 281-289, November.
  20. V.V. Chari & Lawrence J. Christiano & Patrick J. Kehoe, 1991. "Optimal fiscal and monetary policy: some recent results," Proceedings, Federal Reserve Bank of Cleveland, pages 519-546.
  21. Constantinides, George M, 1990. "Habit Formation: A Resolution of the Equity Premium Puzzle," Journal of Political Economy, University of Chicago Press, vol. 98(3), pages 519-43, June.
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  23. den Haan, Wouter J & Marcet, Albert, 1990. "Solving the Stochastic Growth Model by Parameterizing Expectations," Journal of Business & Economic Statistics, American Statistical Association, vol. 8(1), pages 31-34, January.
  24. Siu, Henry E., 2004. "Optimal fiscal and monetary policy with sticky prices," Journal of Monetary Economics, Elsevier, vol. 51(3), pages 575-607, April.
  25. Yves Nosbusch, 2008. "Interest Costs and the Optimal Maturity Structure Of Government Debt," Economic Journal, Royal Economic Society, vol. 118(527), pages 477-498, 03.
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Citations

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Cited by:
  1. Hans J. Blommestein & Philip Turner, 2012. "Interactions Between Sovereign Debt Management and Monetary Policy Under Fiscal Dominance and Financial Instability," OECD Working Papers on Sovereign Borrowing and Public Debt Management 3, OECD Publishing.
  2. Alessandro Missale, 2012. "Sovereign debt management and fiscal vulnerabilities," BIS Papers chapters, in: Bank for International Settlements (ed.), Threat of fiscal dominance?, volume 65, pages 157-176 Bank for International Settlements.
  3. Hans J Blommestein & Anja Hubig, 2012. "Is the standard micro portfolio approach to sovereign debt management still appropriate?," BIS Papers chapters, in: Bank for International Settlements (ed.), Threat of fiscal dominance?, volume 65, pages 141-155 Bank for International Settlements.
  4. Niepelt, Dirk, 2008. "Debt Maturity without Commitment," CEPR Discussion Papers 7093, C.E.P.R. Discussion Papers.
  5. Davide Debortoli & Ricardo Nunes, 2008. "Political disagreement, lack of commitment and the level of debt," International Finance Discussion Papers 938, Board of Governors of the Federal Reserve System (U.S.).
  6. Bank for International Settlements, 2011. "Interactions of sovereign debt management with monetary conditions and financial stability," CGFS Papers, Bank for International Settlements, number 42, January.
  7. Guibaud, Stéphane & Nosbusch, Yves & Vayanos, Dimitri, 2013. "Bond Market Clienteles, the Yield Curve, and the Optimal Maturity Structure of Government Debt," CEPR Discussion Papers 9407, C.E.P.R. Discussion Papers.
  8. Hans J. Blommestein & Anja Hubig, 2012. "A Critical Analysis of the Technical Assumptions of the Standard Micro Portfolio Approach to Sovereign Debt Management," OECD Working Papers on Sovereign Borrowing and Public Debt Management 4, OECD Publishing.
  9. Marcet, Albert & Scott, Andrew, 2009. "Debt and deficit fluctuations and the structure of bond markets," Journal of Economic Theory, Elsevier, vol. 144(2), pages 473-501, March.
  10. Katharina Greulich & Albert Marcet, 2008. "Pareto-Improving Optimal Capital and Labor Taxes," Working Papers 337, Barcelona Graduate School of Economics.
  11. Dirk Niepelt, 2009. "Sovereign Debt Maturity without Commitment," 2009 Meeting Papers 231, Society for Economic Dynamics.

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