Government Debt and the Returns to Innovation

Abstract

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.

The U.S. Public Debt Valuation Puzzle

“…Liu, Schmid, and Yaron (2020) argue that increasing safe asset supply can be risky as more government debt increases corporate default risk premia despite providing more convenience. Croce, Nguyen, Raymond, and Schmid (2019) study cross-sectional differences in firms' exposure to government debt. Corhay, Kind, Kung, and Morales (2018) study how quantitative easing affects inflation by changing the maturity structure of government debt.…”

Government debt and fiscal execution efficiency

“…It turns out that when economic growth exceeds interest costs, financial stability cannot be ensured. Croce et al (2019) used cross‐sectional data on U.S. stock returns to explore the relationship between government debt and future economic growth. The research results showed that (i) high R & D companies bear more government debt than low R & D companies, and are willing to pay higher expected returns; (ii) those whose government debt accounts for more than GDP, the risk premium of high R & D companies will be higher.…”

“…In the past, the literature mostly used static and regression methods to analyze influencing factors, ignoring the optimal allocation efficiency of central subsidies (the local government maximizes self‐raised financial resources and central financial resources under the optimal scale of current expenditure and capital expenditure to achieve the goal of minimizing debt). Some scholars study the relationship between government debt and national economic growth, such as Chorafas (2014), Casalin et al (2019), Croce et al (2019), Bal and Rath (2014), Nakamura (2017), Rathnayake (2020), Afonso and Jalles (2020), Chen and Wu (2018), De Jong and Gilbert (2020), and Qureshi and Liaqat (2020). Studies have pointed out the impact of fiscal decentralization on regional health policies (Di Novi et al, 2019), and some scholars have explored the benefits of government tax collection on fiscal decentralization to local governments and residents' poverty (Bellofatto & Besfamille, 2018; Sanogo, 2019), but these studies still focus on the static and causal relationship.…”

Benefits and Costs of Debt: The Dose Makes the Poison

“…Higher interest rates and uncertainty would tend to crowd out productivityenhancing private investment and weigh on output growth. By using data on U.S. stock returns, Croce et al (2018) find that an increase in the cost of capital for innovationintensive firms results in declines in productivity and economic growth. As a result, a rise in government debt is associated with a decline in corporate investment and R&D. Crowding-out of private investment due to high public debt is also shown in Huang, Pagano, and Panizza (2017), with data for China, and Panizza, Huang, Varghese (2018), with firm-and industry-level data across 69 countries.…”