Manufacturing Risk-free Government Debt
Governments face a trade-off between insuring households who pay taxes and receive transfers and bondholders against aggregate output risk. Insulating bondholders by keeping the debt risk-free imposes tight restrictions on the expected primary surplus process and its covariance with aggregate shocks. Through counter-cyclical debt issuance, the government can protect taxpayers against adverse economic shocks over short horizons, but not over longer horizons. The restrictions imposed by risk-free debt on expected surpluses are rejected in US data. If the portfolio of U.S. Treasurys were risk-free, then Treasury investors would have been expecting large primary surpluses since the GFC. Such surpluses never materialized even though r < g.
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