Government Debt Valuation and Sustainability

We show that quantitative easing (QE) worsens government debt sustainability. In our model, the government has a negative primary balance and downward-sloping debt demand that makes interest rates endogenous. The central bank has long-term capital and remits profits to the fiscal authority. QE depletes this capital stock, reducing future remittances and crisis-fighting reserves. Contrary to Sargent and Wallace (1981), where greater monetary accommodation lowers the steady-state debt level, we show that QE increases the steady-state level of debt and shifts the default boundary inward, thus heightening fragility and reducing debt sustainability. Moreover, while QE can keep interest rates low for extended periods, each round worsens the fiscal position and requires progressively larger interventions to maintain low rates, until financing costs rise sharply. Under certain parameters, large-scale QE makes previously sustainable debt levels unsustainable, leading ultimately to sovereign default.

What ultimately supports the market value of U.S. government debt? We measure valuation frameworks: the perceived channels that back debt value. We survey bond investors, registered voters, and economics or finance graduate-degree holders, asking them to allocate debt value across six sources derived from open-ended answers and the literature. Global safe-asset demand and permanent rollover together account for almost half of perceived value in every group, so debt value heavily relies on investor absorption rather than on conventional fiscal fundamentals. Future primary surpluses, the textbook debt backing, receive about 16% even among the graduate-trained; roughly one-third say they provide little or no support. Allocations concentrate within respondents but disperse across them, forming belief archetypes that vary little with fiscal knowledge. A model shows why belief elicitation matters: identical debt quantities and price schedules can conceal differences in saleable public backing and in investors’ willingness to hold government debt under stress. These differences imply different degrees of debt sustainability. Concern about debt sustainability is widespread, and all three groups put the ten-year crisis odds near 50%. However, among respondents expressing concern, 90% of voters report that it is not decisive in their voting decisions, and 72% of investors report no concrete portfolio change.

How resilient is the U.S. Treasury market to foreign selling, inflation, and quantitative tightening? We answer this question by embedding an empirically estimated sector-level Treasury demand system in a forward-looking equilibrium model with risk-averse arbitrageurs who price expected future demand. Equal-sized foreign dollar retrenchments from different countries generate heterogeneous yield responses because countries differ in their maturity composition, yield elasticities, and macroeconomic sensitivity. Inflation affects long-term yields through opposing portfolio reallocations: falling foreign official demand amplifies the response, while the Fed’s demand response offsets it. Retrenchment by foreign official holders therefore reduces Treasury yields’ sensitivity to subsequent inflation shocks. At longer maturities, the yield impact of QT depends more on expected state-contingent Fed support than on the immediate reduction in the Fed’s Treasury holdings. Treasury-market resilience therefore depends on who absorbs the shock, whether it persists, and how policy responds, not on the size of the shock alone.

We document that U.S. Treasury convenience yields moved positively with inflation during the inflationary second half of the 20th century but not before WWII or after 2000. A macro-asset pricing model explains this shift through two channels. Inflationary supply shocks raise the opportunity cost of holding money and money-like assets, endogenously increasing convenience yields. In contrast, exogenous liquidity demand shocks elevate convenience but depress consumption and inflation. The model estimates an increased relative importance of liquidity demand shocks after 2000. This channel weakens the convenience–inflation comovement and contributes to negative bond-stock betas, as distinct from non-liquidity demand shocks.

Bank-created money, shadow-bank money, and Treasury bonds all satisfy investors’ demand for a liquid transaction medium and safe store of value. We measure the quantity of these forms of liquidity and their corresponding liquidity premia over a sample from 1934 to 2016. We empirically examine the links between these different assets, estimating the extent to which they are substitutes, and the amount of liquidity per-unit delivered by each asset. Treasury bonds and bank transaction deposits are imperfect substitutes, in contrast to the finding of perfect substitutes of Nagel (2016). Bank and shadow-bank non-transaction deposits are closer substitutes for Treasuries, but provide less liquidity per-unit of asset than Treasuries. The results are directly relevant to the monetary transmission mechanism running through shifts in asset supplies, such as quantitative easing policies. Our results on the imperfect substitutability of bank and shadow-bank money also inform analyses of the coexistence of the shadow-banking and regulated banking system. We construct a new broad monetary aggregate based on our estimates and show that it helps resolve the money-demand instability and missing-money puzzles of the monetary economics literature.