Session 20: Fiscal Sustainability

Unfunded fiscal shocks are a significant source of risk premia in Treasury markets when central banks and governments decide to insulate taxpayers and expose bondholders' wealth to government funding needs. We illustrate this bond risk premium mechanism analytically in a two-agent model featuring monetary-fiscal interactions and a fraction of constrained agents. Surprise government transfer spending devalues real Treasury payoffs through fiscal inflation, while fiscal redistribution makes these high marginal utility states for bond investors, leading to risky government debt. We show that this fiscal redistribution mechanism can quantitatively explain the nominal term premium in a TANK framework.

This paper studies price stability and debt sustainability when the real rate exceeds trend growth (r > g) in a New Keynesian model with endogenous growth through R&D. Fiscal deficits not backed by future surpluses are partly paid for through technology-led growth, which attenuates fiscal inflation. A dynamic r – g stability criterion characterizes feasible monetary-fiscal frameworks. If surpluses do not adjust to stabilize debt, the central bank must permit r−g to fall with inflation. Monetary policy which follows the Taylor principle can be consistent with a unique stable equilibrium under active fiscal policy, as growth creates fiscal capacity by expanding long-run aggregate supply.

We examine the role of government investment in defense capital as a deterrence tool. Using an optimal fiscal policy framework with endogenous disaster risk, we allow for an endogenous determination of geopolitical risk and defense capacity, which we discipline using the Geopolitical Risk Index. We show both analytically and quantitatively that financing defense primarily through debt, rather than taxation, is optimal. Debt issuance mitigates present tax distortions but exacerbates them in the future, especially in wartime. However, since additional defense capital deters future wars, the expected tax distortions decline as well, making debt financing a welfare-improving strategy. Quantitatively, the optimal defense financing in the presence of heightened risk involves a twice higher share of debt and backloading of tax distortions compared to other types of government spending.

US federal debt plays a special role in the US economy and so gives the US government a funding advantage, often summarized by the spread between the yield on high-grade US corporate bonds and comparable US treasuries. Why? One reason is that government regulation (and/or repression) of the financial sector influences asset pricing and helps make long term US federal debt an endogenously “safe-asset”. We study the mechanics, limitations, and macroeconomic trade-offs involved with generating a government funding advantage through restrictions on the financial sector. We show the government cannot choose all three of: (i) high funding advantage, (ii) a well-functioning financial sector, and (iii) fiscal policy that leads to systematic debt devaluation. We relate our theories to new US historical corporate and treasury yield curve data from 1860-2024

We measure the effect of deficits on inflation using a “high frequency narrative approach”. We identify an event that released news about the 2021 deficits—the Georgia Senate election runoff—and size the shock using new narrative data from investment banks. We then study the high frequency response of inflation forecasts from asset prices. We estimate that the price level was expected to increase by 22-38 basis points over 2021-22, meaning the 2021 deficits caused a significant share of the 2021-22 inflation. Standard models—such as the Fiscal Theory of the Price Level and the heterogeneous agent New Keynesian model—match the inflation response.

Historically high debt-to-GDP levels in the U.S. have raised concerns about future financial market stability and fiscal sustainability. We use high-frequency data to identify debt supply shocks by considering Treasury futures price changes within narrow windows around auction announcements. We identify two distinct Treasury supply shocks: debt volume shocks that capture changes in the level of public debt, and maturity adjustment shocks that reflect changes in the maturity structure. We find that debt expansion shocks raise yields across the curve by increasing term premia and lowering the convenience yield of Treasuries, leading to tighter financial conditions. These shocks crowd out private sector activity by reducing investment and production, particularly during periods of rapid debt growth. In contrast, maturity extension shocks steepen the yield curve while easing credit and fiscal risks. By increasing the supply of long-duration safe assets and lowering the excess bond premium, these shocks stimulate investment and production, despite modest increases in long-term borrowing costs. We also show that the impact of Treasury supply shocks depends on the broader fiscal and monetary context.

This paper proposes a novel framework for analyzing the risks surrounding the public debt outlook, the “Debt-at-Risk.” It employs a quantile panel regression framework to assess how current macro-financial and political conditions impact the entire spectrum of possible future debt outcomes. Many of these factors—including financial conditions and economic variables such as initial debt and GDP growth—predict both the expected level and the uncertainty of future debt, implying pronounced variations in risks, especially in the upper tail of the distribution. By combining the roles of these factors, we find that in a severely adverse scenario—the 95th percentile of the future debt distribution, or debt-at-risk—global public debt could be approximately 20 percentage points higher than currently projected. The magnitudes and sources of debt risks vary over time and across countries, with high initial debt amplifying the effects of economic and financial conditions on debt-at-risk. Furthermore, empirical estimates indicate that debt-at-risk is a key variable for predicting fiscal crises.

We append the expectation of a monetary-fiscal reform into a standard New Keynesian model. If a reform occurs, monetary policy will temporarily aid debt sustainability through a temporary burst in inflation. The anticipation of a possible reform links debt levels with inflation expectations. As a result, interest rates have two effects: they influence demand and affect expected inflation in opposite directions. The expectations effect is linked to the impact of interest rates on public debt. While lowering inflation in the short term is possible through demand control, inflation tends to rise again due to its impact on inflation expectations (sticky inflation). Optimal monetary policy may allow low real interest rates after fiscal shocks, temporarily breaking away from the Taylor principle. We assess whether the Federal Reserve's “staying behind the curve” was the right strategy during the recent post-pandemic inflation surge.

This paper proposes a theory of large-scale government bond purchases by central banks in an environment with endogenous information acquisition. More information production lowers sovereign bond yields by reducing uncertainty, and makes prices more responsive to new information. I show that asset purchases by the central bank crowd out private information acquisition. When the sovereign can be subject to self-fulfilling debt crises, however, this can be beneficial. I show that by impairing price informativeness, asset purchases can avoid the occurrence of roll-over crises, generating large welfare gains. A key property of the model is that substantial purchases may be required, while small interventions have ambiguous welfare consequences. When the sovereign expects the central bank to carry such programs, it leads to excessive indebtedness, forcing the central bank to run an inflated balance sheet to avoid roll-over crises, with equilibrium prices largely disconnected from fundamentals. Using the case of Italian bonds and the start of ECB purchases in 2015, I document through various measures that price informativeness indeed significantly declined with purchases.