Government Debt Management: The Long and the Short of it

70 Pages Posted: 8 Dec 2014

See all articles by Elisa Faraglia

Elisa Faraglia

London Business School

Albert Marcet

Universitat Autònoma de Barcelona - Institut d'Anàlisi Economica CSIC

Rigas Oikonomou

Catholic University of Louvain (UCL)

Andrew Scott

London Business School - Department of Economics; Centre for Economic Policy Research (CEPR)

Date Written: December 2014

Abstract

Our aim is to provide insights into some basic facts of US government debt management by introducing simple financial frictions in a Ramsey model of fiscal policy. We find that the share of short bonds in total U.S. debt is large, persistent, and highly correlated with total debt. A well known literature argues that optimal debt management should behave very differently: long term debt provides fiscal insurance, hence short bonds should not be issued and the position on short debt is volatile and negatively correlated with total debt. We show that this result hinges on the assumption that governments buy back the entire stock of previously issued long bonds each year, which is very far from observed debt management. We document how the U.S. Treasury rarely has repurchased bonds before 10 years after issuance. When we impose in the model that the government does not buy back old bonds the puzzle disappears and the optimal bond portfolio matches the facts mentioned above. The reason is that issuing only long term debt under no buyback would lead to a lumpiness in debt service payments, short bonds help offset this by smoothing out interest payments and tax rates. The same reasoning helps explain why governments issue coupon-paying bonds.

Solving dynamic stochastic models of optimal policy with a portfolio choice is computationally challenging. A separate contribution of this paper is to propose computational tools that enable this broad class of models to be solved. In particular we propose two significant extensions to the PEA class of computational methods which overcome problems due to the size of the model. These methods should be useful to many applications with portfolio problems and large state spaces.

Keywords: Computational methods, Debt Management, Fiscal Policy, Incomplete Markets, Maturity Structure, Tax Smoothing

JEL Classification: C63, E43, E62, H63

Suggested Citation

Faraglia, Elisa and Marcet, Albert and Oikonomou, Rigas and Scott, Andrew, Government Debt Management: The Long and the Short of it (December 2014). CEPR Discussion Paper No. DP10281. Available at SSRN: https://ssrn.com/abstract=2535418

Elisa Faraglia (Contact Author)

London Business School ( email )

Sussex Place
Regent's Park
London, London NW1 4SA
United Kingdom

Albert Marcet

Universitat Autònoma de Barcelona - Institut d'Anàlisi Economica CSIC ( email )

Edifici B
Bellaterra, 08193
Spain

Rigas Oikonomou

Catholic University of Louvain (UCL) ( email )

Place Montesquieu, 3
Louvain-la-Neuve, 1348
Belgium

Andrew Scott

London Business School - Department of Economics ( email )

Sussex Place
Regent's Park
London NW1 4SA
United Kingdom
+44 20 7706 6780 (Phone)
+44 20 7402 7875 (Fax)

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Register to save articles to
your library

Register

Paper statistics

Downloads
0
Abstract Views
842
PlumX Metrics