1932

Abstract

This review revisits the literature on fiscal capacity using modern tools from asset pricing. We find that properly accounting for aggregate risk substantially reduces fiscal capacity. In this environment, the gap between the risk-free rate and the expected growth rate is not a sufficient statistic for fiscal capacity. To borrow at the risk-free rate when aggregate growth is risky, governments need to ask taxpayers to insure bondholders against aggregate risk, but governments in advanced economies tend to insure taxpayers against aggregate risk. We use this asset pricing perspective to review alternative mechanisms to boost fiscal capacity that have been explored in the literature.

Loading

Article metrics loading...

/content/journals/10.1146/annurev-financial-110921-103651
2023-11-01
2025-02-16
Loading full text...

Full text loading...

/deliver/fulltext/financial/15/1/annurev-financial-110921-103651.html?itemId=/content/journals/10.1146/annurev-financial-110921-103651&mimeType=html&fmt=ahah

Literature Cited

  1. Acalin J, Ball L. 2022. Did the U.S. really grow its way out its WWII debt? Work. Pap Cent. Econ. Policy Res. London:
    [Google Scholar]
  2. Aguiar M, Amador M, Arellano C. 2021. Micro risks and Pareto improving policies with low interest rates NBER Work. Pap. 28996
    [Google Scholar]
  3. Aiyagari SR, Marcet A, Sargent TJ, Seppälä J. 2002. Optimal taxation without state-contingent debt. J. Political Econ. 110:61220–54
    [Google Scholar]
  4. Alvarez F, Jermann UJ. 2005. Using asset prices to measure the persistence of the marginal utility of wealth. Econometrica 73:61977–2016
    [Google Scholar]
  5. Angeletos G-M, Collard F, Dellas H. 2020. Public debt as private liquidity: optimal policy NBER Work. Pap. 22794
    [Google Scholar]
  6. Backus D, Boyarchenko N, Chernov M. 2018. Term structures of asset prices and returns. J. Financial Econ. 129:11–23
    [Google Scholar]
  7. Bai J, Collin-Dufresne P. 2019. The CDS-bond basis. Financ. Manag. 48:2417–39
    [Google Scholar]
  8. Ball LM, Mankiw NG. 2021. Market power in neoclassical growth models NBER Work. Pap. 28538
    [Google Scholar]
  9. Bansal R, Yaron A. 2004. Risks for the long run: a potential resolution of asset pricing puzzles. J. Finance 59:41481–509
    [Google Scholar]
  10. Barro RJ. 1979. On the determination of the public debt. J. Political Econ. 87:5 Part 1 940–71
    [Google Scholar]
  11. Barro RJ. 2020. r minus g. NBER Work. Pap. 28002
    [Google Scholar]
  12. Bassetto M, Cui W. 2018. The fiscal theory of the price level in a world of low interest rates. J. Econ. Dyn. Control 89:5–22
    [Google Scholar]
  13. Bhandari A, Evans D, Golosov M, Sargent T. 2017. The optimal maturity of government debt. Work. Pap. Univ. Minn.
    [Google Scholar]
  14. Blanchard O. 2019. Public debt and low interest rates. Am. Econ. Rev. 109:41197–229
    [Google Scholar]
  15. Blanchard OJ, Watson MW. 1982. Bubbles, rational expectations and financial markets NBER Work. Pap. w0945
    [Google Scholar]
  16. Bohn H. 1995. The sustainability of budget deficits in a stochastic economy. J. Money Credit Bank. 27:1257–71
    [Google Scholar]
  17. Bohn H. 1998. The behavior of US public debt and deficits. Q. J. Econ. 113:3949–63
    [Google Scholar]
  18. Borovička J, Hansen LP, Scheinkman JA. 2016. Misspecified recovery. J. Finance 71:62493–544
    [Google Scholar]
  19. Boudoukh J, Israel R, Richardson MP. 2021. Biases in long-horizon predictive regressions. J. Financ. Econ. 145:3937–69
    [Google Scholar]
  20. Brunnermeier M, Merkel S, Sannikov Y. 2022. Debt as a safe asset NBER Work. Pap. 29626
    [Google Scholar]
  21. Campbell JY, Shiller RJ. 1988. The dividend-price ratio and expectations of future dividends and discount factors. Rev. Financ. Stud. 1:3195–228
    [Google Scholar]
  22. Chen Z, Jiang Z, Lustig HN, Van Nieuwerburgh S, Xiaolan MZ. 2022. Exorbitant privilege gained and lost: fiscal implications SSRN Work. Pap. 4096091
    [Google Scholar]
  23. Chernov M, Schmid L, Schneider A. 2020. A macrofinance view of U.S. sovereign CDS premiums. J. Finance 75:52809–44
    [Google Scholar]
  24. Chien Y, Wen Y. 2019. The determination of public debt under both aggregate and idiosyncratic uncertainty. Work. Pap. Fed. Reserve Bank St. Louis:
    [Google Scholar]
  25. Choi J, Kirpalani R, Perez DJ. 2022. The macroeconomic implications of US market power in safe assets. Work. Pap. Univ. Wisconsin–Madison Madison, WI:
    [Google Scholar]
  26. Cochrane JH. 2011. Presidential address: discount rates. J. Finance 66:41047–108
    [Google Scholar]
  27. Cochrane JH. 2019. The value of government debt NBER Work. Pap. 26090
    [Google Scholar]
  28. Croce MM, Kung H, Nguyen TT, Schmid L. 2012. Fiscal policies and asset prices. Rev. Financ. Stud. 25:92635–72
    [Google Scholar]
  29. Croce MM, Nguyen TT, Schmid L. 2012. The market price of fiscal uncertainty. J. Monet. Econ. 59:5401–16
    [Google Scholar]
  30. D'Erasmo P, Mendoza EG, Zhang J 2016. What is a sustainable public debt?. Handbook of Macroeconomics, Vol. 2 JB Taylor, H Uhlig 2493–597. Amsterdam: Elsevier
    [Google Scholar]
  31. Diamond PA. 1965. National debt in a neoclassical growth model. Am. Econ. Rev. 55:51126–50
    [Google Scholar]
  32. Du W, Im J, Schreger J. 2018. The US Treasury premium. J. Int. Econ. 112:167–81
    [Google Scholar]
  33. Dumas B, Ehling P, Yang C. 2021. The debt capacity of a government NBER Work. Pap. 29434
    [Google Scholar]
  34. Elenev V, Landvoigt T, Shultz PJ, Van Nieuwerburgh S. 2021. Can monetary policy create fiscal capacity? NBER Work. Pap. 29129
    [Google Scholar]
  35. Farhi E, Maggiori M. 2018. A model of the international monetary system. Q. J. Econ. 133:1295–355
    [Google Scholar]
  36. Fleckenstein M, Longstaff FA, Lustig H. 2014. The TIPS-Treasury bond puzzle. J. Finance 69:52151–97
    [Google Scholar]
  37. Furman J, Summers L 2020. A reconsideration of fiscal policy in the era of low interest rates. Discuss. Draft, Brookings Inst. Washington, DC: accessed Dec. 27, 2020. https://www.brookings.edu/wp-content/uploads/2020/11/furman-summers-fiscal-reconsideration-discussion-draft.pdf
    [Google Scholar]
  38. Hall GJ, Payne J, Sargent TJ, Szöke B. 2021. Costs of financing US federal debt: 1791–1933. Work. Pap., Brandeis Univ. Waltham, MA:
    [Google Scholar]
  39. Hall GJ, Sargent TJ. 2011. Interest rate risk and other determinants of post-WWII US government debt/GDP dynamics. Am. Econ. J. Macroecon. 3:3192–214
    [Google Scholar]
  40. Hall GJ, Sargent TJ 2021. Debt and taxes in eight U.S. wars and two insurrections. The Handbook of Historical Economics A Bisin, G Federico 825–80. Amsterdam: Elsevier
    [Google Scholar]
  41. Hansen LP, Roberds W, Sargent TJ 1991. Time series implications of present value budget balance and of martingale models of consumption and taxes. Rational Expectations Econometrics LP Hansen, T Sargent 121–61. Boca Raton, FL: CRC Press
    [Google Scholar]
  42. Hansen LP, Scheinkman JA. 2009. Long-term risk: An operator approach. Econometrica 77:1177–234
    [Google Scholar]
  43. He Z, Krishnamurthy A, Milbradt K. 2019. A model of safe asset determination. Am. Econ. Rev. 109:41230–62
    [Google Scholar]
  44. Hellwig C, Lorenzoni G. 2009. Bubbles and self-enforcing debt. Econometrica 77:41137–64
    [Google Scholar]
  45. Jiang W, Sargent TJ, Wang N, Yang J. 2022. A p theory of government debt and taxes NBER Work. Pap. 29931
    [Google Scholar]
  46. Jiang Z. 2021. US fiscal cycle and the dollar. J. Monet. Econ. 124:91–106
    [Google Scholar]
  47. Jiang Z, Krishnamurthy A, Lustig H. 2021. Foreign safe asset demand and the dollar exchange rate. J. Finance 76:31049–89
    [Google Scholar]
  48. Jiang Z, Krishnamurthy A, Lustig H. 2022. The rest of the world's dollar-weighted return on US Treasurys NBER Work. Pap. 30089
    [Google Scholar]
  49. Jiang Z, Lustig HN, Van Nieuwerburgh S, Xiaolan MZ. 2019. The U.S. public debt valuation puzzle SSRN Work. Pap. 3333517
    [Google Scholar]
  50. Jiang Z, Lustig H, Van Nieuwerburgh S, Xiaolan MZ. 2020. Manufacturing risk-free government debt NBER Work. Pap. 27786
    [Google Scholar]
  51. Jiang Z, Lustig H, Van Nieuwerburgh S, Xiaolan MZ. 2021a. Quantifying U.S. treasury investor optimism SSRN Work. Pap. 3769510
    [Google Scholar]
  52. Jiang Z, Lustig H, Van Nieuwerburgh S, Xiaolan MZ. 2021b. What drives variation in the U.S. debt/output ratio? The dogs that didn't bark NBER Work. Pap. 29351
    [Google Scholar]
  53. Jiang Z, Lustig H, Van Nieuwerburgh S, Xiaolan MZ. 2022. Measuring U.S. fiscal capacity using discounted cash flow analysis SSRN Work. Pap. 4058541
    [Google Scholar]
  54. Jiang Z, Richmond RJ, Zhang T. 2022. A portfolio approach to global imbalances. NBER Work. Pap. 30253
    [Google Scholar]
  55. Koijen RSJ, Yogo M. 2020. Exchange rates and asset prices in a global demand system NBER Work. Pap. 27342
    [Google Scholar]
  56. Krishnamurthy A, Vissing-Jorgensen A. 2012. The aggregate demand for Treasury debt. J. Political Econ. 120:2233–67
    [Google Scholar]
  57. Krishnamurthy A, Vissing-Jorgensen A. 2015. The impact of Treasury supply on financial sector lending and stability. J. Financ. Econ. 118:3571–600
    [Google Scholar]
  58. Liu Y, Schmid L, Yaron A. 2020. The risks of safe assets SSRN Work. Pap. 3699618
    [Google Scholar]
  59. Longstaff FA. 2004. The flight-to-liquidity premium in US Treasury bond prices. J. Bus. 77:3)
    [Google Scholar]
  60. Lucas D. 2012. Valuation of government policies and projects. Annu. Rev. Financ. Econ. 4:39–58
    [Google Scholar]
  61. Lucas R. 1978. Asset prices in an exchange economy. Econometrica 46:61429–54
    [Google Scholar]
  62. Maggiori M. 2017. Financial intermediation, international risk sharing, and reserve currencies. Am. Econ. Rev. 107:103038–71
    [Google Scholar]
  63. Mehra R, Prescott E. 1985. The equity premium: a puzzle. J. Monetary Econ. 15:2145–61
    [Google Scholar]
  64. Mehrotra NR, Sergeyev D. 2021. Debt sustainability in a low interest rate world. J. Monet. Econ. 124:S1–18
    [Google Scholar]
  65. Mendoza EG, Ostry JD. 2008. International evidence on fiscal solvency: Is fiscal policy responsible?. J. Monet. Econ. 55:1081–93
    [Google Scholar]
  66. Mian AR, Straub L, Sufi A. 2021. A Goldilocks theory of fiscal deficits NBER Work. Pap. 29707
    [Google Scholar]
  67. Nagel S. 2016. The liquidity premium of near-money assets. Q. J. Econ. 131:41927–71
    [Google Scholar]
  68. Pallara K, Renne J-P. 2019. Fiscal limits and sovereign credit spreads SSRN Work. Pap. 3475425
    [Google Scholar]
  69. Reis R. 2021. The constraint on public debt when r < g but g < m Work. Pap. London School Econ:.
    [Google Scholar]
  70. Reis R. 2022. Debt revenue and the sustainability of public debt. J. Econ. Perspect. 36:4103–24
    [Google Scholar]
  71. Samuelson PA. 1958. An exact consumption-loan model of interest with or without the social contrivance of money. J. Political Econ. 66:6467–82
    [Google Scholar]
  72. Stambaugh RF. 1986. Bias in regressions with lagged stochastic regressors. Work. Pap. Univ Chicago:
    [Google Scholar]
  73. Tabova AM, Warnock FE. 2022. Preferred habitats and timing in the world's safe asset NBER Work. Pap. 30722
    [Google Scholar]
  74. Talvi E, Vegh CA. 2005. Tax base variability and procyclical fiscal policy in developing countries. J. Dev. Econ. 78:1156–90
    [Google Scholar]
  75. van Binsbergen JH. 2020. Duration-based stock valuation: reassessing stock market performance and volatility NBER Work. Pap. 27367
    [Google Scholar]
  76. van Binsbergen J, Brandt M, Koijen R. 2012. On the timing and pricing of dividends. Am. Econ. Rev. 102:41596–618
    [Google Scholar]
  77. van Binsbergen J, Diamond W, Grotteria M. 2022. Risk-free interest rates. J. Financ. Econ. 143:11–29
    [Google Scholar]
  78. van Wijnbergen S, Olijslagers S, de Vette N. 2020. Debt sustainability when r − g < 0: no free lunch after all. Discuss. Pap. 15478 Cent. Econ. Policy Res London:
    [Google Scholar]
  79. Willems T, Zettelmeyer J. 2022. Sovereign debt sustainability and central bank credibility. Annu. Rev. Financ. Econ. 14:75–93
    [Google Scholar]
/content/journals/10.1146/annurev-financial-110921-103651
Loading
/content/journals/10.1146/annurev-financial-110921-103651
Loading

Data & Media loading...

  • Article Type: Review Article
This is a required field
Please enter a valid email address
Approval was a Success
Invalid data
An Error Occurred
Approval was partially successful, following selected items could not be processed due to error