Abstract
AbstractUsing an international data set, this article documents a negative association between increases in the central government debt‐to‐GDP ratio and dollar‐denominated stock index returns. Depending on the estimation method, raising the debt ratio by 1 percentage point diminishes the stock returns by between 39 and 95 basis points. We show that this result cannot be explained by changes in the investment risk. Instead, government debt issuance exerts upward pressure on private interest rates and appears to signal a greater tax burden in the future. These two factors coincide to produce a fall in stock market prices.
Highlights
For fear of losing popular support, democratically elected governments may be reluctant to embark on fiscal consolidation initiatives involving the raising of distortionary taxes or cutting expenditure
Popular anxieties, expressed recently in politicians' public statements and in the press, centre on countries' abilities to service their debts and the possibility of sovereign debt default. Such concerns appear to be well founded, as the average central government debt to GDP ratio for OECD countries has risen from 38.7% in 1990 to 100.0% in 2015.1 Lane (2012) points out that economies laden with debt are characterized by multiple equilibria with the distinct possibility of a self-fulfilling speculative attack
This article contributes to the vigorous debate on the impact of fiscal policy by showing that stock price performance is weakened by the issuance of additional public debt
Summary
For fear of losing popular support, democratically elected governments may be reluctant to embark on fiscal consolidation initiatives involving the raising of distortionary taxes or cutting expenditure. Increasing the stock of public debt exerts an upward pressure on interest rates and results in a larger tax burden in the future. Barro (1974) shows that, in the presence of operative intergenerational transfer, increasing government borrowing leaves interest rates unaffected To put it differently, given a certain level of public spending, agents are indifferent to whether the government chooses to finance itself by levying taxes or by issuing debt. The net effect of the forces involved is difficult to predict and needs to be assessed empirically For this reason, we empirically evaluate to what extent the jumps in the level of prevailing risk, as measured by changes in stock market volatility, are related to increases in public debt. In the regressions that follow, we use the first difference of this variable (ΔDebt)
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