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

Jun 2017 | 827

Authors: Jemima Peppel-Srebrny



The reasons for and underlying composition of government budget deficits are often disregarded both by the academic literature about the links between fiscal policy and interest rates and by the policy debate about fiscal sustainability. However, we show that, from the perspective of financial markets, not all budget deficits are created equal: bond markets do discriminate between deficits that are the result of higher government current spending and those that stem from higher government investment, penalising the former significantly more than the latter. To do so, we apply a reduced-form regression approach to a panel of 31 OECD economies from 1960 to 2014 with data from the European Commission on the decomposition of the government budget deficit into its current spending, investment spending and revenue components. Quantitatively, 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 austerity policies should focus more on current spending than investment spending and that fiscal rules in individual countries and monetary unions should distinguish budget deficits that are the result of investment from those that are not.

JEL Codes: E44, E62, H54, H62

Keywords: Government budget deficits, government investment, fiscal policy, longterm interest rates, OECD countries

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