The U.S. Public Debt Valuation Puzzle
(co-authored with Zhengyang Jiang, Stijn Van Nieuwerburgh and Mindy Z. Xiaolan)
The government budget constraint ties the market value of government debt to the expected present discounted value of fiscal surpluses. Bond investors fail to impose this no-arbitrage restriction in the U.S., resulting in a government debt valuation puzzle. Both cyclical and long-run dynamics of tax revenues and government spending make the surplus claim risky. Under a realistic asset pricing model, this risk in surpluses creates a wedge of 299 % of GDP between the value of debt and that the surplus claim, and implies an expected return on the debt portfolio that far exceeds the observed yield on Treasuries.