Optimal Government Debt Maturity∗ PRELIMINARY AND INCOMPLETE

This paper develops a model of optimal government debt maturity in which the government cannot issue state-contingent bonds and the government cannot commit to fiscal policy. In contrast to an environment with full commitment, there is a tradeoff between the cost of funding and the benefit of hedging. Borrowing long term provides the government with a hedging benefit since the value of outstanding government liabilities declines when shortterm interest rates rise. However, borrowing long term lowers fiscal discipline for future governments unable to commit to policy, which leads to higher future short-term interest rates. Therefore, lack of commitment ex post increases the government’s cost of borrowing long term ex ante. A consequence of this tradeoff is that the slope of the yield curve is increasing in the maturity of newly issued debt. Our main theoretical result is that, as in the case of full commitment, the optimal maturity structure of government debt is tilted to the long end, but it is more flat than in case of full commitment. Our quantitative analysis shows that, in contrast to debt positions under full commitment—which involve a short-term asset position and a long-term debt position, both extremely large relative to GDP—debt positions under lack of commitment are positive at all maturities, much smaller relative to GDP, and have a nearly flat maturity.