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THE HUGE FEDERAL BUDGET DEFICITS in recent years have raised significant concerns about the long-run sustainability of US fiscal policy. This has motivated a number of empirical studies that have examined whether US fiscal policy has been consistent with an intertemporal budget constraint. 1 This paper reexamines the theoretical foundations of the sustainability question by studying government policies in an explicitly stochastic general equilibrium model. Its main message is that the existing empirical tests are based on too simple and inappropriate theoretical models.

I use a stochastic model to examine the sustainability of budget deficits not just because it is more general than a deterministic model, but primarily because of an empirical observation: Historically, interest rates on" safe" US government bonds have been significantly below the average rate of economic growth. In a deterministic steady state …