Government borrowing cost and budget deficits: is investment spending different?

Working paper

We find that bond markets charge significantly higher interest rates for deficits due to higher government current spending than for deficits due to higher government investment. Thus, from a sovereign risk perspective, not all government budget deficits are created equal. To show this, we use a panel regression approach on European Commission data for 31 advanced economies from 1990 onwards. Econometrically, we address potential endogeneity by using forecasts of fiscal variables and by instrumental variable methods. Based on our preferred specifications, a higher deficit solely due to higher government investment would in fact decrease long-term government bond yields. These findings suggest that the policy debate about fiscal sustainability and fiscal rules should, at the very least, distinguish budget deficits that are the result of investment from those that are not. Revised September 2020

Authors: Peppel-Srebrny, J

• Publication status: Published
• Publisher: University of Oxford
• Series: Department of Economics Discussion Paper Series
• Publication date: 2020-10-20
• Paper number: 827
• Keywords: government budget deficits; OECD countries; fiscal policy; government investment; long-term interest rates