Fiscal Policy and the Mehra-Prescott Puzzle: On the Welfare Implications of Budget Deficits when Real Interest Rates are Low

Historically, average real returns on U.S. government debt have been far below the rate of economic growth, allowing the U.S. government to roll over its debt at a rather low cost. At the same time, the rate of return on capital has generally been above the growth rate, suggesting that the U.S. economy is dynamically efficient. The paper shows that the welfare implications of budget deficits in this scenario depend critically on why interest rates have been so low. If the government can offer low returns on its debt because of some unique ability to create default-free claims, persistent primary budget deficits may be unproblematic. But if low interest rates are due to high risk aversion, policies that exploit the low cost of government debt to run frequent budget deficits will impose significant risks on future taxpayers. In essence, safe government debt is safe for the debt holders, but it is very risky for the taxpayers who are implicitly taking a short position in the safe security.