The U.S. Public Debt Valuation Puzzle

Abstract

The government budget constraint ties the market value of government debt to the expected present discounted value of fiscal surpluses. Bond investors fail to impose this no-arbitrage restriction in the U.S., resulting in a government debt valuation puzzle. Both cyclical and long-run dynamics of tax revenues and government spending make the surplus claim risky. In a realistic asset pricing model, this risk in surpluses creates a wedge of 2.5 times GDP between the value of debt and that of the surplus claim, and implies an expected return on the debt portfolio that far exceeds the observed yield on Treasuries.

Keywords: government debt maturity, fiscal policy, term structure, interest rate risk

JEL Classification: E44, E62, G12, H6