The Sustainability of Budget Deficits in a Stochastic Economy

The transversality condition on government debt requires a zero limit of discounted future debt. The paper shows that, in a stochastic economy, the relevant discount rate depends on the probability distribution of future debt over states of nature. Discount rates on future government debt, spending, and taxes are generally not related to the rates of return on government debt. The correct choice of discount rates is important because debt discounted at the safe interest rate may well diverge to infinity under sustainable policies. This result raises questions about some recent empirical papers testing the sustainability of U.S. fiscal policy. Copyright 1995 by Ohio State University Press.