Fiscal Policy with Non-Contingent Debt and the Optimal Maturity Structure

Abstract

Two puzzling observations have motivated this paper: First, the standard paradigm of optimal fiscal policy, following Lucas & Stokey (1983), assumes counterfactually that public debt is held in state-contingent securities. Is the existing theory as irrelevant as it is silent about fiscal policy with non-contingent debt? Second, when debt is assumed state-contingent, the maturity structure is irrelevant for tax smoothing and thus indeterminate. Are we left with no theory for the optimal maturity structure? The resolution we propose to both puzzles is reassuring: We show that the maturity structure can substitute for state-contingent debt. Our argument exploits the endogenous state dependence of the equilibrium term structure of interest rates. In general equilibrium we can implement almost every Arrow-Debreu allocation with just non-contingent debt. This in turn provides us with a novel theory for the optimal maturity structure of public debt.