Research
The U.S. Public Debt Valuation Puzzle. Econometrica, Vol 92, Issue 4, 2024 [Link]
Zhengyang Jiang, Hanno Lustig, Stijn Van Nieuwerburgh and Mindy Xiaolan.
Abstract: The government budget constraint ties the market value of government debt to the expected present discounted value of fiscal surpluses. We find evidence that U.S. Treasury investors fail to impose this no-arbitrage restriction in the U.S. Both cyclical and long-run dynamics of tax revenues and government spending make the surplus claim risky. In a realistic asset pricing model, this risk in surpluses creates a large gap between the market value of debt and its fundamental value, the PDV of surpluses, suggesting that U.S. Treasurys may be overpriced.
Exorbitant Privilege Gained and Lost: Fiscal Implications. Journal of Political Economy, forthcoming, 2024 [Link]
Zefeng Chen, Zhengyang Jiang, Hanno Lustig, Stijn Van Nieuwerburgh and Mindy Xiaolan.
Abstract: We study three centuries of U.K., U.S. and Dutch fiscal history. When a country is the dominantsafe asset supplier, it can issue more debt than what is justified by its future primary surpluses.This pattern holds for the Dutch Republic in the 17th and 18th, the U.K. in the 18th and 19th,and the U.S. in the 20th and 21st centuries. When the Dutch Republic’s and the U.K.’s fiscalfundamentals deteriorated, they lost their dominant position as the safe asset supplier. Afterlosing their exorbitant privilege, their debt became fully backed by primary surpluses. Theseresults support theories of safe asset determination in which investors concentrate extra fiscalcapacity in a single safe asset supplier based on relative macro fundamentals, allowing its debtto exceed its fiscal backing.
What Drives Variation in the Debt/Output Ratio? The Dogs that Did Not Bark. Journal of Finance, Vol 79, Issue 4, 2024 [Link]
Zhengyang Jiang, Hanno Lustig, Stijn Van Nieuwerburgh and Mindy Xiaolan.
Abstract: A higher U.S. government debt-to-output (D-O) ratio does not forecast higher surpluses or lower returns on Treasurys in the future. Neither future cash flows nor discount rates account for the variation in the current D-O ratio. The market valuation of Treasurys is surprisingly insensitive to macro fundamentals. Instead, the future D-O ratio accounts for most of the variation because the D-O ratio is highly persistent. Systematic surplus forecast errors may help account for these findings. Since the start of the Global Financial Crisis, surplus projections have anticipated a large fiscal correction that failed to materialize.
The review article that summarizes our work:
Fiscal Capacity: An Asset Pricing Perspective. Annual Review of Financial Economics, Vol 15, 2023 [link]
Zhengyang Jiang, Hanno Lustig, Stijn Van Nieuwerburgh and Mindy Xiaolan
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.
Measuring U.S. Fiscal Capacity using Discounted Cash Flow Analysis. The Brookings Papers on Economic Activity, 2022 [Link][NBER Digest]
Zhengyang Jiang, Hanno Lustig, Stijn Van Nieuwerburgh and Mindy Xiaolan.
Abstract: We use discounted cash flow analysis to measure the projectedfiscal capacity of the US federal government. We apply our valuation method tothe Congressional Budget Office (CBO) projections for the US federal government’s primary deficits between 2022 and 2052 and projected debt outstandingin 2052. The discount rate for projected cash flows and future debt must includea GDP or market risk premium in recognition of the risk associated with futuresurpluses. Despite current low interest rates, we find that US fiscal capacity ismore limited than commonly thought. Because of the back-loading of projectedprimary surpluses, the duration of the surplus claim far exceeds the duration ofthe outstanding Treasury portfolio. This duration mismatch exposes the government to the risk of rising interest rates, which would trigger the need for highertax revenue or lower spending. Reducing this risk by front-loading primarysurpluses requires a major fiscal adjustment.
Manufacturing Risk-free Government Debt [SSRN]
Zhengyang Jiang, Hanno Lustig, Stijn Van Nieuwerburgh and Mindy Xiaolan.
Abstract: Governments face a trade-off between insuring households who pay taxes and receive transfers and bondholders who finance cyclical government deficits against aggregate output risk. We analyze this trade-off in an incomplete-markets economy with idiosyncratic income risk and aggregate disaster risk. If the government manufactures risk-free zero-beta debt, then it cannot insure long-lived households against disasters by lowering tax rates or raising government spending. Households can only be insured over short horizons by backloading the aggregate risk through counter-cyclical debt issuance. As the world’s safe asset supplier, the U.S. has availed itself of strongly counter-cyclical debt issuance to provide more short-run insurance to its households.
Bond Convenience Yields in the Eurozone Currency Union [SSRN]
Zhengyang Jiang, Hanno Lustig, Stijn Van Nieuwerburgh and Mindy Xiaolan.
Abstract: In a monetary union, the risk-free rate cannot respond to country-level fiscal positions, leaving only default spreads and convenience yields to respond. Empirically, we find that convenience yields explain a large share of the variation in Eurozone sovereign bond yields. Eurozone countries earn larger convenience yields when they experience larger surpluses, suggesting convenience yields are important fiscal shock absorbers. Since convenience yields generate substantial seigniorage revenue from debt issuance, our estimates imply economically large fiscal costs from low convenience yields for peripheral countries in the Eurozone.
Quantifying U.S. Treasury Investor Optimism [SSRN]
Zhengyang Jiang, Hanno Lustig, Stijn Van Nieuwerburgh and Mindy Xiaolan.
Abstract: When the government commits to a debt policy, the future value of government primary surpluses at all horizons is dictated by the debt dynamics under the risk-neutral measure. We compare the present discounted value of future surpluses implied by the U.S. federal government debt dynamics in a no-arbitrage bond pricing model to the PDV of actual government surpluses. Since the late 1990s, the debt-implied PDV of surpluses have consistently and persistently exceeded realized surpluses. They have also exceeded surplus forecasts resulting from tax and spending policy rules. U.S. Treasury investors appear to have been overly optimistic when assessing future surpluses.
Paper prepared for Jackson Hole Economic Symposium:
Government Debt in Mature Economies. Safe or Risky? [SSRN]
Roberto Gomez-Cram, Howard Kung, and Hanno Lustig.
Abstract: Governments and central banks can protect either taxpayers or bondholders from government spending shocks. When they choose to insulate taxpayers, government bond yields need to increase in response to unfunded fiscal expansions as the government debt is marked to market. The risks of unfunded spending shocks are then borne by bondholders who demand a bond risk premium. This risky debt regime is a better fit for the recent experience of the U.S. and other mature economies. We provide high-frequency evidence from the COVID episode that links U.S. Treasury yield increases to bad news about future government surpluses. In this risky debt regime, large-scale asset purchases in response to large government spending provide temporary price support to government bonds, a net loss for taxpayers.