Knowledge that Transforms

We present a novel empirical benchmark for analyzing credit risk using “pseudo firms” that purchase traded assets financed with equity and zero-coupon bonds. By no-arbitrage, pseudo bonds are equivalent to Treasuries minus put options on pseudo firm assets. Empirically, like corporate spreads, pseudo bond spreads are large, countercyclical, and predict lower economic growth. Using this framework, we find that bond market illiquidity, investors' overestimation of default risks, and corporate frictions do not seem to explain excessive observed credit spreads but, instead, a risk premium for tail and idiosyncratic asset risks is the primary determinant of corporate spreads.

Governments are present-biased toward spending. Fiscal rules are deficit limits that trade off commitment to not overspend and flexibility to react to shocks. We compare coordinated rules, chosen jointly by a group of countries, to uncoordinated rules. If governments’ present bias is small, coordinated rules are tighter than uncoordinated rules: individual countries do not internalize the redistributive effect of interest rates. However, if the bias is large, coordinated rules are slacker: countries do not internalize the disciplining effect of interest rates. Surplus limits enhance welfare, and increased savings by some countries or outside economies can hurt the rest.