Government Debt in Mature Economies. Safe or Risky?
**Hanno Lustig, Howard Kung, Roberto Gomez Cram – **
Government have a choice to either protect / insure (1) taxpayers or (2) bondholders against government spending shocks (which naturally reduces the value of Treasury securities):
- Taxpayer protection: Yields increase in response to unfunded fiscal expansion, value of debt declines, hurting bondholders. The value of debt declines because investors rationally mark them down in response to reduced or risky government cash flows (taxes minus spending, i.e. surpluses). Inflation increases. Large scale asset purchases by the central bank come from desire support the value of the bonds. Government debt has some associated beta, as yield co-move with discount rate innovations, generating a positive correlation between stock and bonds (“risky debt” regime, fiscal dominance)
- Bondholder protection: Government promises to pay for increasing spending with additional taxation. Yields do not move. Inflation expectations do not move. To the degree the central bank acts, it’s to provide liquidity to ensure well-functioning markets. Zero beta (“safe debt” regime, monetary dominance)
The value of government debt is marked down via three channels:
- Increase in long-term expected inflation, particularly in response to an increase in long-term debt
- Decline in convenience yields due to the increased supply of Treasuries compressing the “narrow” convenience yield
- Increased risk-free real rates due to increased supply of safe assets
Empirical results: the risky debt / fiscal dominance paradigm seems to be a better fit for recent U.S. data and other advanced economies. Spending shocks induce a devaluation of the government bond portfolio.
- Yields increase substantially in the COVID era, suggesting markets did not believe the fiscal expansion to be supported by future taxation. Bondholders experienced substantially negative real returns due to devaluation of the U.S. government debt portfolio.
- The stock-bond correlation turned positive during the COVID era after being largely positive for the last two decades.
References
https://www.gsb.stanford.edu/insights/united-states-borrowing-binge-about-burst