A recent paper of Antje Berndt, assistant professor of finance; Sevin Yeltekin, associate professor of economics; and Hanno Lustig, associate professor at the UCLA Anderson School of Management, examines ways in which the government of the United States finances fiscal shock. It is also the key question the authors are trying to answer with their research.
Reviewed by Laurence Ales, assistant professor of economics, who holds the Frank A. and Helen E. Risch Faculty Development Professorship in Business.
To understand the nature of the question, I find it useful to compare the government to an average household. Think about a sudden and unexpected increase in household’s expenditures. How can the household cover these expenditures? It has mainly two channels. It can raise revenues, for example, by working overtime; it can also finance the expenditures using debt, perhaps through a short-term loan.
The government has at its disposal similar instruments. Unexpected fiscal shocks can be insured in two ways: first, with what the authors call the “surplus channel,” the value of current and future primary surpluses; and second, the “debt channel,” the value of current and future debt returns.
In order to estimate how much of a shock gets absorbed with one channel or the other, the authors must first identify shocks that are unexpected. To do this they focus on unexpected defense spending. The main result is that in the postwar period, for every dollar of unexpected spending, the U.S. government has financed roughly 10 cents via the debt channel and 73 cents via the surplus channel.
This result highlights the importance of debt management as an instrument for the government to insure against unforeseen expenditures. The authors push the analysis further. They find that long-term rather than short-term debt is the most effective instrument in absorbing fiscal shocks.
In a period of high budget deficits and high debt, understanding how the U.S. government has historically insured itself against fiscal shocks is of paramount importance. This is one of the few papers in the literature that accomplishes this.
Back to Tepper School homepage