Government Debt as Insurance against Macroeconomic Risk

Martin Barbie (), Marcus Hagedorn and Ashok Kaul ()
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Martin Barbie: University of Karlsruhe
Ashok Kaul: Saarland University

No 412, IZA Discussion Papers from Institute of Labor Economics (IZA)

Abstract: Is there a role for debt beyond curing overaccumulation of capital? Does dynamic efficiency and the infeasibility of debt Ponzi schemes eliminate any Pareto-improving role for a government in a competitive economy with complete markets? Is there an optimal maturity structure of public debt? Using a stochastic Diamond OLG model, we tackle these questions. We show that government debt can Pareto-improve upon market allocations through a mechanism that resembles a Ponzi scheme. But instead of rolling over safe debt, we can interpret our scheme as one that rolls over an insurance contract generation for generation. This kind of dynamic risk-sharing can provide insurance against macroeconomic risk. Using the widespread welfare concept of interim Pareto optimality, we ensure that all generations voluntarily participate in our insurance scheme. Yet, the scheme cannot be replicated on capital markets. Exploiting information from the term structure of interest rates, we derive testable conditions both for dynamic efficiency and for interim Pareto optimality in terms of interest rates. We provide evidence that real world economies, while being dynamically efficient, are likely not to be interim Pareto optimal. We conclude that there may be a welfare-improving role for a well-designed maturity structure of debt.

Keywords: Stochastic OLG model; government debt; macroeconomic risk; dynamic (search for similar items in EconPapers)
JEL-codes: D61 E43 H55 H63 (search for similar items in EconPapers)
Pages: 58 pages
Date: 2001-12
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Citations: View citations in EconPapers (6)

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