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Valuing Government Obligations When Markets Are Incomplete

Jasmina Hasanhodzic and Laurence J. Kotlikoff

Valuing future government spending commitments and tax receipts, whether they are sure or risky, is critical to assessing the sustainability of fiscal policy. If markets were complete it would be an easy matter to determine if the present value of projected spending exceeded the present value of projected receipts. But such markets don’t exist for numerous reasons including the inability of the living to trade with the unborn. Nor can one use prevailing security prices since they don’t span long-term states of nature let alone cover all relevant contingencies in the short and medium runs. How then should one value state-contingent government payments and taxes, or, equivalently, discount their expected values?

The approach taken here posits and simulates a ten-period overlapping generations model and uses it to determine the immediate payments – the compensating variations – agents would require to forego promised government future net payments. “Agents” include future generations who are assumed to discount their utility while alive for the number of years it will take for them to be born. Our metric for pricing the compensating variations is agents’ expected utility functions. I.e., we determine what immediate payment will deliver the same expected utility as the government’s promised net payments.