What Has Financed Government Debt?

Abstract

Equilibrium models imply that the real value of debt in the hands of the public must equal the expected present-value of surpluses. Empirical models of fiscal policy typically do not impose this condition and often do not even include debt. Absence of debt from empirical models can produce non-invertible representations, obscuring the true present-value relation, even if it holds in the data. First, we show that small VAR models of fiscal policy may not be invertible and that expanding the information set to include government debt has quantitatively important implications. Then we impose the present-value condition on an identified VAR and characterize the way in which the present-value support of debt varies across types of fiscal shocks. The role of expected primary surpluses in supporting innovations to debt depends on the nature of the shock. Debt is supported almost entirely by changes in the present-value of surpluses for some fiscal shocks, but for other fiscal shocks surpluses fail to adjust, leaving a large role for expected changes in discount rates. Horizons over which debt innovations are financed are long-on the order of 50 years or more.

Fiscal Stimulus with Spending Reversals

“…It also matches a similar earlier result documented by Chung and Leeper (2007). Importantly, these authors compare results from relatively small VAR systems to those from a more comprehensive VAR which includes government debt.…”

“…This assumption is clearly at odds with estimates of fiscal policy rules, which show not only taxes but also spending to be sensitive to the debt stock-see, for example, Galí and Perotti (2003) and Canova and Pappa (2004). In the same vein, Chung and Leeper (2007) and Favero and Giavazzi (2007) show that omitting debt from VAR models of fiscal policy may lead to substantial bias in the estimated dynamics of government spending shocks. This combined evidence also squares well with political economy arguments whereby governments face constraints in their capacity to raise taxes.…”

“…Estimating a VAR model on U.S. time series, we identify government spending shocks drawing on the methodology proposed by Blanchard and Perotti (2002), but also accounting for a recent critique by Ramey (2008). Consistent with our theoretical analysis, and in line with Chung and Leeper (2007) and Favero and Giavazzi (2007), we include public debt in the VAR. While confirming wellknown findings concerning private consumption and the exchange rate, we also find that government spending exhibits statistically significant reversals, associated with a time path of real interest rates in close accord with our theoretical results.…”

“…The new military variable data, instead, contain additional episodes, such as the fall of the Berlin Wall. 23 In fact, Chung and Leeper (2007) apply the criterion of Fernández-Villaverde et al (2007) to show that small VAR systems are likely to be non-invertible relative to more comprehensive VAR systems which include public debt. This finding again mirrors results that have been reported elsewhere in the literature, but have long been regarded as difficult to reconcile with the presumed theoretical case for a persistent interest rate increase.…”

“…Chung and Leeper (2007) and Favero and Giavazzi (2007) provide evidence suggesting that the omission of debt from the VAR model may lead to substantial bias in the estimated dynamics of fiscal policy shocks. Our theoretical analysis lends further support to this concern, as we emphasize the important feedback channel between debt and government spending.…”