Government Debt and Risk Premia

58 Pages Posted: 19 May 2022

See all articles by Yang Liu

Yang Liu

The University of Hong Kong - Faculty of Business and Economics

Date Written: May 1, 2021

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

Suggested Citation

Liu, Yang, Government Debt and Risk Premia (May 1, 2021). Available at SSRN: https://ssrn.com/abstract=2870973 or http://dx.doi.org/10.2139/ssrn.2870973

Yang Liu (Contact Author)

The University of Hong Kong - Faculty of Business and Economics ( email )

Pokfulam Road
Hong Kong
China

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