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The Sustainability of Budget Deficits in a Stochastic Economy (Revised: 17-91)

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  • Henning Bohn

Abstract

The paper derives the government budget constraint and studies the sustainability of deficits in a stochastic, dynamically efficient economy. Contrary to the intuition based on certainty models, policies with permanent expected primary deficits can be sustainable. Even an infinite string of realized primary deficits does not necessarily provide evidence against sustainability. Moreover, one has to be careful in discounting future fiscal variables. Even if the government finances deficits by issuing safe debt, the safe interest rate cannot be used in transversality conditions and in computing present values. The stochastic setting allows one to reconcile dynamic efficiency with a safe interest rate below the average rate of economic growth. Evidence that the U.S. government has run average primary deficits and that government bond returns have been below the growth rate over long periods combined with evidence on dynamic efficiency from Abel et.al. (1989) suggests that the sustainability results for the stochastic, dynamic efficient economy are highly relevant for assessing U.S. fiscal policy.

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Paper provided by Wharton School Rodney L. White Center for Financial Research in its series Rodney L. White Center for Financial Research Working Papers with number 06-90.

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Handle: RePEc:fth:pennfi:06-90

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