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In Search of a Theory of Debt Management

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  • Elisa Faraglia
  • Albert Marcet
  • Andrew Scott

Abstract

A growing literature integrates debt management into models of optimal fiscal policy. One promising theory argues the composition of government debt should be chosen so that fluctuations in its market value offsets changes in expected future deficits. This complete market approach to debt management is valid even when governments only issue non-contingent bonds. Because bond returns are highly correlated it is known this approach implies asset positions which are large multiples of GDP. We show, analytically and numerically, across a wide range of model specifications (habits, productivity shocks, capital accumulation, persistent shocks, etc) that this is only one of the weaknesses of this approach. We find evidence of large fluctuations in positions, enormous changes in portfolios for minor changes in maturities issued and no presumption it is always optimal to issue long term debt and invest in short term assets. We show these extreme, volatile and unstable features are undesirable from a practical perspective for two reasons. Firstly the fragility of the optimal portfolio to small changes in model specification means it is frequently better for fear of model misspecification to follow a balanced budget rather than issue the optimal debt structure. Secondly we show for even miniscule levels of transaction costs governments would prefer a balanced budget rather than the large and volatile positions the complete market approach recommends. We conclude it is difficult to insulate fiscal policy from shocks using the complete markets approach. Due to the yield curve's limited variability maturities are a poor way to substitute for state contingent debt. As a result the recommendations of this approach conflict with a number of features we believe are integral to bond market incompleteness e.g. allowing for transaction costs, liquidity effects, robustness etc. Our belief is that market imperfections need to be explicitly introduced into the model and incorporated into the portfolio problem. Failure to do so means that the complete market approach applied in an incomplete market setting can be seriously misleading.

Suggested Citation

  • Elisa Faraglia & Albert Marcet & Andrew Scott, 2011. "In Search of a Theory of Debt Management," CEP Discussion Papers dp1083, Centre for Economic Performance, LSE.
  • Handle: RePEc:cep:cepdps:dp1083
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    Cited by:

    1. Niepelt, Dirk, 2014. "Debt maturity without commitment," Journal of Monetary Economics, Elsevier, vol. 68(S), pages 37-54.
    2. Javier Bianchi & Juan Carlos Hatchondo & Leonardo Martinez, 2012. "International Reserves and Rollover Risk," NBER Working Papers 18628, National Bureau of Economic Research, Inc.
    3. Ellison, Martin & Scott, Andrew, 2017. "Managing the UK National Debt 1694-2017," LSE Research Online Documents on Economics 86148, London School of Economics and Political Science, LSE Library.
    4. Ricardo Nunes & Davide Debortoli, 2007. "Political Disagreement, Lack of Commitment and the Level of Debt," 2007 Meeting Papers 725, Society for Economic Dynamics.
    5. Hans J Blommestein & Philip Turner, 2012. "Interactions between sovereign debt management and monetary policy under fiscal dominance and financial instability," BIS Papers chapters,in: Bank for International Settlements (ed.), Threat of fiscal dominance?, volume 65, pages 213-237 Bank for International Settlements.
    6. Stéphane Guibaud & Yves Nosbusch & Dimitri Vayanos, 2013. "Bond Market Clienteles, the Yield Curve, and the Optimal Maturity Structure of Government Debt," Review of Financial Studies, Society for Financial Studies, vol. 26(8), pages 1914-1961.
    7. Faraglia, Elisa & Marcet, Albert & Scott, Andrew, 2014. "Modelling Long Bonds - The Case of Optimal Fiscal Policy," CEPR Discussion Papers 9965, C.E.P.R. Discussion Papers.
    8. 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.
    9. Albert Marcet & Katharina Greulich, 2008. "Pareto-Improving Optimal Capital and Labor Taxes," UFAE and IAE Working Papers 733.08, Unitat de Fonaments de l'Anàlisi Econòmica (UAB) and Institut d'Anàlisi Econòmica (CSIC).
    10. S. M. Ali Abbas & Laura Blattner & Mark De Broeck & Asmaa A ElGanainy & Malin Hu, 2014. "Sovereign Debt Composition in Advanced Economies; A Historical Perspective," IMF Working Papers 14/162, International Monetary Fund.
    11. Davide Debortoli & Ricardo Nunes & Pierre Yared, 2017. "Optimal Time-Consistent Government Debt Maturity," The Quarterly Journal of Economics, Oxford University Press, vol. 132(1), pages 55-102.
    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. Equiza-Goni, Juan & Faraglia, Elisa & Oikonomou, Rigas, 2016. "Union Debt Management," CEPR Discussion Papers 11181, C.E.P.R. Discussion Papers.
    14. Dottori, Davide & Manna, Michele, 2016. "Strategy and tactics in public debt management," Journal of Policy Modeling, Elsevier, vol. 38(1), pages 1-25.
    15. Julius Aidoo-Buameh, 2014. "The Effect of NHIA Debt on Accounts Payables Management in Public Hospitals," Asian Economic and Financial Review, Asian Economic and Social Society, vol. 4(8), pages 1001-1015, August.
    16. Rigas Oikonomou & Albert Marcet & Elisa Faraglia, 2016. "Long term Government Bonds," 2016 Meeting Papers 565, Society for Economic Dynamics.
    17. Dirk Niepelt, 2009. "Sovereign Debt Maturity without Commitment," 2009 Meeting Papers 231, Society for Economic Dynamics.
    18. 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.
    19. 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.
    20. Mark Aguiar & Manuel Amador, 2013. "Take the Short Route: How to Repay and Restructure Sovereign Debt with Multiple Maturities," NBER Working Papers 19717, National Bureau of Economic Research, Inc.
    21. Bank for International Settlements, 2011. "Interactions of sovereign debt management with monetary conditions and financial stability," CGFS Papers, Bank for International Settlements, number 42.
    22. Massimo BERNASCHI & Alessandro MISSALE & Davide VERGNI, 2009. "Should governments minimize debt service cost and risk? A closer look at the debt strategy. Simulation approach," Departmental Working Papers 2009-53, Department of Economics, Management and Quantitative Methods at Università degli Studi di Milano.

    More about this item

    Keywords

    Complete markets; debt management; government debt; maturity structure; yield curve;

    JEL classification:

    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy

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