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Government Debt as Insurance against Macroeconomic Risk

Author

Listed:
  • Barbie, Martin

    (University of Karlsruhe)

  • Hagedorn, Marcus

    (University of Oslo)

  • Kaul, Ashok

    (Saarland University)

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.

Suggested Citation

  • Barbie, Martin & Hagedorn, Marcus & Kaul, Ashok, 2001. "Government Debt as Insurance against Macroeconomic Risk," IZA Discussion Papers 412, Institute of Labor Economics (IZA).
    • Handle: RePEc:iza:izadps:dp412
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    References listed on IDEAS

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    Cited by:

    1. Qin, Duo & Cagas, Marie Anne & Ducanes, Geoffrey & Magtibay-Ramos, Nedelyn & Quising, Pilipinas, 2006. "Empirical assessment of sustainability and feasibility of government debt: The Philippines case," Journal of Asian Economics, Elsevier, vol. 17(1), pages 63-84, February.
    2. Knolle, Julia, 2020. "Prosperity in a Low Interest Environment," MPRA Paper 104332, University Library of Munich, Germany.
    3. Julia, Knolle, 2014. "An Empirical Comparison of Interest and Growth Rates," MPRA Paper 59520, University Library of Munich, Germany.
    4. Qin, Duo & Cagas, Marie Anne & Ducanes, Geoffrey & Magtibay-Ramos, Nedelyn & Quising, Pilipinas, 2006. "Empirical assessment of sustainability and feasibility of government debt: The Philippines case," Journal of Asian Economics, Elsevier, vol. 17(1), pages 63-84, February.
    5. Kevin Luo & Tomoko Kinugasa & Kai Kajitani, 2018. "Dynamic efficiency in world economy," Discussion Papers 1801, Graduate School of Economics, Kobe University.

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    More about this item

    Keywords

    Stochastic OLG model; government debt; macroeconomic risk; dynamic;
    All these keywords.

    JEL classification:

    • D61 - Microeconomics - - Welfare Economics - - - Allocative Efficiency; Cost-Benefit Analysis
    • H63 - Public Economics - - National Budget, Deficit, and Debt - - - Debt; Debt Management; Sovereign Debt
    • H55 - Public Economics - - National Government Expenditures and Related Policies - - - Social Security and Public Pensions
    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects

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