In search of a theory of debt management

• Published in: Journal of monetary economics Vol. 57; no. 7; pp. 821 - 836
• Main Authors: Faraglia, Elisa, Marcet, Albert, Scott, Andrew
• Format: Journal Article
• Language: English
• Published: Amsterdam Elsevier B.V 01-10-2010; Elsevier; Elsevier Sequoia S.A
• Series: Journal of Monetary Economics
• Subjects: Budgetary policy; Debt management; Debt policy; Economic theory; Maturity; National budget; Portfolio investments; Portfolio management; Public debt; Public finance; Public finance situation; Studies; Transaction costs; Volatility
• ISSN: 0304-3932; 1873-1295
• DOI: 10.1016/j.jmoneco.2010.08.005

The complete market approach to government debt management argues that a portfolio of non-contingent bonds at different maturities should be chosen so that fluctuations in market value offset changes in expected future deficits. However, this approach recommends huge fluctuations in positions, enormous changes in portfolios for minor changes in maturities and no presumption it is always optimal to issue long and invest short term in a wide array of model specifications. These extreme, volatile and unstable features are undesirable for two reasons. Firstly fragility of portfolios to small changes in assumptions means that it is often better to follow a balanced budget rather than issue the optimal debt portfolio under some possibly misspecified model. Secondly for even miniscule transaction costs, governments prefer a balanced budget rather than the large positions complete markets recommends. The complete market recommendations conflict with a number of features we believe are integral to bond market incompleteness, e.g. transaction costs, liquidity effects, robustness, etc. and which need to be explicitly incorporated into the portfolio problem.
► When government can only issue non-contingent bonds the complete market approach to debt management is unreliable. ► The complete market approach recommends implausibly large positions to compensate for limited yield curve variability. ► Adding capital accumulation and habits makes this problem worse and adds additional concerns—positions become very volatile. ► The complete market approach does not produce qualitatively stable recommendations to issue long debt and short assets. ► Complete market approach is so sensitive that misspecification errors or miniscule transaction costs lead governments to prefer balanced budgets to optimal debt management. ► We need a theory of debt management that explicitly factors in reasons for market incompleteness.