MANUFACTURING RISK-FREE GOVERNMENT DEBT

Governments face a trade-off between insuring bondholders and insuring taxpayers. If they insure bondholders by manufacturing risk-free zero-beta debt, then they can only provide limited insurance to taxpayers against macroeconomic shocks, whether the shocks are permanent or temporary. Taxpayers will pay more taxes in bad times. How limited depends on the cyclicality and persistence of government debt and spending. Permanent shocks limit taxpayer insurance by imputing long-run risk into the debt, while transitory shocks impute interest rate risk that must be offset through taxation to keep the debt safe. Conversely, if governments insure taxpayers against adverse macro shocks, then the debt becomes risky. Convenience yields on government debt temporarily alleviate the trade-off.

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