DP19427 Admissible Surplus Dynamics and the Government Debt Puzzle
Is it possible to reconcile the procyclical Government surplus dynamics with the ‘safe asset status’ of sovereign Debt? In an arbitrage-free market, if the aggregate debt value satisfies a transversality condition that rules out ‘bub- bles’, then it should equal the present value of future government surpluses. This relation seems to fail when the surplus process is calibrated to histor- ical data in the US (Jiang, Lustig, van Nieuwerburgh, and Xiolan (2022)). However, we show that when the government issues only safe bonds in an incomplete but arbitrage-free market, then not all surplus processes are ad- missible in the sense that they are consistent with both the dynamic budget constraint and a transversality condition. We propose a class of admissi- ble surplus processes that matches empirical properties of US government spending and tax claims without generating a ‘debt valuation puzzle.’
