Government Debt as Insurance against Macroeconomic Risk
by
Martin Barbie, Marcus Hagedorn, Ashok Kaul
(December 2001)
Abstract:
Is there a role for debt beyond curing overaccumulation of capital? Does dynamic efficiency
and the infeasibility of debt Ponzi schemes eliminate any Pareto-improving role for a
government in a competitive economy with complete markets? Is there an optimal maturity
structure of public debt? Using a stochastic Diamond OLG model, we tackle these questions.
We show that government debt can Pareto-improve upon market allocations through a
mechanism that resembles a Ponzi scheme. But instead of rolling over safe debt, we can
interpret our scheme as one that rolls over an insurance contract generation for generation.
This kind of dynamic risk-sharing can provide insurance against macroeconomic risk. Using
the widespread welfare concept of interim Pareto optimality, we ensure that all generations
voluntarily participate in our insurance scheme. Yet, the scheme cannot be replicated on
capital markets. Exploiting information from the term structure of interest rates, we derive
testable conditions both for dynamic efficiency and for interim Pareto optimality in terms of
interest rates. We provide evidence that real world economies, while being dynamically
efficient, are likely not to be interim Pareto optimal. We conclude that there may be a welfare-improving
role for a well-designed maturity structure of debt.
Text: See Discussion Paper No. 412 
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