DP16304 Manufacturing Risk-free Government Debt

Author(s): Zhengyang Jiang, Hanno Lustig, Stijn van Nieuwerburgh, Mindy Xiaolan
Publication Date: June 2021
Keyword(s): Convenience Yield, debt maturity, Fiscal policy, term structure
JEL(s): E62, G12
Programme Areas: Public Economics, Financial Economics, Macroeconomics and Growth
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=16304

Governments face a trade-off between insuring bondholders and insuring taxpayers against output shocks. If they insure bondholders by manufacturing risk-free zero-beta debt, then they can only provide limited insurance to taxpayers. Taxpayers will pay more taxes in bad times regardless of whether output shocks are permanent or temporary. Permanent shocks impute long-run output risk to the debt while transitory shocks impute interest rate risk, all of which must be offset through taxation to keep the debt safe. Conversely, if governments insure taxpayers against adverse macro shocks, then the debt becomes risky. Convenience yields on government debt temporarily alleviate the trade-off.