Government Debt and Risk Premia

Abstract

This paper shows that risk premia increase with government debt. Debt-to-GDP ratios positively predict risk premia at short and long horizons, in the U.S. and other advanced economies. Higher debt is also associated with higher credit risk premia and lower risk-free rates. Major government debt theories (liquidity, safety, crowding out) do not address or are inconsistent with these findings. New evidence suggests that the increased risk premia provide compensation for higher fiscal risk: during periods of elevated debt, fiscal policy becomes less certain, less countercyclical, and less effective, and can even lead to debt crises. I quantify these mechanisms in an equilibrium model.

Keywords: Government debt, risk premia, fiscal policy risk

JEL Classification: E62, G12, G17, H63