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1 1 THE OPTIMAL MATURITY OF GOVERNMENT DEBT Robin Greenwood, Samuel G. Hanson, Joshua S. Rudolph, and Lawrence H. Summers The central task of debt management is to decide which debt instruments the government should issue in order to finance itself over time. What programs the government should pursue and whether the government should finance its current expenditures by collecting taxes or by borrowing are outside the purview of debt management. Historically, U.S. debt managers had three main instruments available to them: Treasury bills with a maturity of less than one year, intermediatematurity notes with maturities up to ten years, and long-term bonds. Inflationprotected securities were introduced in 1997 and floating-rate notes were added in 2014. The maturity structure of the government debt has fluctuated significantly over time in response to the evolving fiscal outlook and changing debt management practices. The average maturity of Treasury marketable securities outstanding went from sixty-eight months in January 2000 to fiftyfive months in January 2007, before the onset of the financial crisis, to sixtyeight months in December 2014.1 1. See 2015Q1 Quarterly Data Release ( -chart-center/quarterly-refunding/Documents/2015%20Q1%20Quarterly%20 Data%20Release.xls). 2 R. Greenwood, S. G. Hanson, J. S. Rudolph, and L. H. Summers In this chapter we address optimal government debt management policy on a consolidated basis. We begin by describing the considerations the government must weigh in deciding the optimal maturity structure of the debt. We then show how similar considerations can help determine other features of the debt structure, such as the mix between inflation-protected securities and traditional bills, notes, and bonds. The Optimal Maturity Structure of the Net Consolidated Government Debt Standard economic theory offers surprisingly little guidance as to how officials should manage the government debt. In the textbook theory of government financing, it is irrelevant whether the government decides to finance itself using debt or taxes, or whether the government borrows using short-term or long-term debt. This surprising view—known as “Ricardian equivalence”—was first postulated by David Ricardo in 1820 and formalized by Robert Barro in 1974. Barro’s proposition identifies a set of strict assumptions under which the manner in which the government finances its expenditures using taxes and various types of debt has no effect on household consumption and well-being.2 Theories of optimal government debt management hinge on failures of one or more of these assumptions. The strict assumptions underlying Ricardian equivalence proposition are that (1) taxation creates no deadweight losses, (2) government debt is valued by investors solely for its cash flows in different states of the world (i.e., investors do not prize the liquidity of government debt in the same way they value the liquidity of cash or checking deposits), and (3) capital markets are frictionless (Barro 1974).3 If Ricardian equivalence holds, then not only is 2. Ricardian equivalence is the public finance analog of the Modigliani-Miller (1958) theorem, which states that, under certain strict conditions, the way that a corporation finances itself has no effect on the firm’s total value. 3. Formally, the assumption that financial markets are frictionless means that any agent’s marginal utility of income must price all assets in the same way. Thus, there cannot be important constraints to participating in financial markets, borrowing constraints, short-selling constraints, agency frictions, or other segmentation that leads agents to assign different values to the same asset. Proofs of Ricardian equivalence also assume that agents have infinite horizons, which is often cited as a reason that Ricardian equivalence may fail. However, lifetimes are long enough that The Optimal Maturity of Government Debt 3 the maturity structure of the debt economically irrelevant, but deficitfinanced spending is also irrelevant. A simple example illustrates the Ricardian logic. Consider a government with an initial accumulated deficit and no future expenditures that must decide whether to finance its deficit by issuing short- or long-term bonds. If the government finances itself solely through the issuance of short-term debt, then the government will have to raise taxes if short-term interest rates rise. However, the rise in interest rates will leave a household that is lending short-term to the government with a bit more in its bank account. Since the government’s sources of funds (taxes and proceeds from issuing new debt) must equal its uses of funds (paying off maturing debt), the gain in the household’s bank accounts...


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