Santa Clara University

Debt and Taxes

How a Disconnect Could Explain Federal Bond Yields

Conventional economic models have had a difficult time making sense of a federal debt phenomenon: Several empirical analyses have shown that from the 1980s onward, it has often been the case that a rise in government debt has resulted in an increase in yield rates on U.S. government bonds of differing maturities, which are the means of financing that debt.

Arunima Sinha, assistant professor of Economics, has developed a model to explain what may be going on.

Sinha says that the households, businesses and countries that buy government bonds actually “forget” past experience with respect to the correlation between government debt and future higher taxes. “They don’t correctly understand how much taxes are apt to go up, so they consume more and that in turn affects interest rates and the economy. Increases in holdings of government bonds are perceived as an increase in net wealth of the agent, or bond holder. That creates a sense of false security.

“Since my model can explain the debt- yield correlation, it opens up a new channel to explore: How important are household expectations about future taxes, and how do these expectations affect consumption and savings decisions today?”


A “bounded rationality” model, which factors in that misconception, is laid out in Sinha’s working paper, “Learning, Fiscal Policy and the Yield Curve.” That model, she says, partly explains the actual connection between bond yields and debt over a 25-year period from 1984 to 2009.

That model looks at a larger yield curve that takes into account the rates on three- month, five-year and ten-year bonds. The shorter-term bonds reflect the interest rates that will be charged by commercial banks on quick-turnaround loans, while the longer-term bonds reflect the rates that will be charged on mortgages and major commercial investments.

While Sinha looked at the entire curve, she particularly focused on ten-year bonds and treasury notes, because those longer-term instruments are more likely to be affected by the increase in government debt as that debt is dealt with during the term of the bond.

In the bounded rationality model developed by Sinha, investor forgetfulness is factored in by assuming that the investing agents don’t place enough weight on past experiences of future tax liability in relation to government debt.

“In this case,” she writes, “while it is still true that the present value of the agents’ future tax obligations is equal to the value of government debt, the agents no longer understand this” and thus consume more, which drives up bond yields.

Sinha has a background in both finance and macroeconomics. Finance, she says focuses primarily on explaining asset prices, while macro attempts to explain statistical properties of variables such as consumption and investment. Using a macro-finance model she attempts to explain both variables in this situation (asset prices and consumption choices) when they are caused by factors inside the system.

“A lot of analyses up to now have focused on the effect of changes in government spending or taxes on interest rates, whereas my model emphasizes the effect of changes in total holdings of government debt,” Sinha says. “It’s a general equilibrium model in which the government issues riskless debt and the optimizing agents (the bond purchasers) are adaptive learners.

“This is a fairly flexible theoretical framework,” she says. “Few analytical tools let you do what it does. This lets us take a new approach to some old questions.”

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