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Elevated levels of US government debt in the aftermath of the great recession have raised concerns about their effects on long-term growth prospects. By empirically identifying measures of government indebtedness as risk factors priced in stock returns, we document and theoretically evaluate a novel risk channel at work shaping this link.In the cross-section, stocks earn positive premia for their exposure to movements in government debt, while these predict high stock returns going forward in the time series. A substantial return spread between the most and the least innovative firms is increasing in the debt-to-gdp ratio. We show that rises in the cost of capital for innovation-intensive firms associated with elevated government debt bring about declines in R&D activity and economic growth. We interpret these findings through the lens of a production-based asset pricing model with endogenous innovation and fiscal policy. The model emphasizes the role of political and fiscal uncertainty in shaping the empirical relationships.

Elevated levels of US government debt in the aftermath of the great recession have raised concerns about their effects on long-term growth prospects. By empirically identifying measures of government indebtedness as risk factors priced in stock returns, we document and theoretically evaluate a novel risk channel at work shaping this link.In the cross-section, stocks earn positive premia for their exposure to movements in government debt, while these predict high stock returns going forward in the time series. A substantial return spread between the most and the least innovative firms is increasing in the debt-to-gdp ratio. We show that rises in the cost of capital for innovation-intensive firms associated with elevated government debt bring about declines in R&D activity and economic growth. We interpret these findings through the lens of a production-based asset pricing model with endogenous innovation and fiscal policy. The model emphasizes the role of political and fiscal uncertainty in shaping the empirical relationships.

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