Pierre Collin-Dufresne (Swiss Finance Institute)

Admissible Surplus Dynamics and the Government Debt Puzzle

Abstract. 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 ‘bubbles,’ then it should equal the present value of future government surpluses. This relation seems to fail when the surplus process is calibrated to historical data in the US (Jiang, Lustig, van Nieuwerburgh, and Xiolan (2022)). However, we show that when the government issues only safe government bonds in an incomplete but arbitrage-free market, then not all surplus processes are admissible in the sense that they are consistent with both the dynamic budget constraint and with a transversality condition. We propose a class of admissible surplus processes that matches empirical properities of US government spending and tax claims without generating a ‘debt valuation  puzzle.’