We already knew that budget consolidations following surges in government debt hamper long run growth through higher tax pressure, raises in inflation, and political uncertainty. New research by Bocconi’s Mariano Max Croce and colleagues finds that public debt is bad for growth also because it hinders innovative firms’ investment. “By affecting their cost of capital, movements in government debt impact firms’ investment and, critically, innovation decisions”, Max Croce, Professor of Finance at Bocconi University, says.
Analyzing 6,000 firms listed in the US through the 1975-2013 period, the scholars find that around one third of the premium that innovative firms have to pay to their investors compared to run-of-the-mill companies depends on the exposure to fiscal variables. “This spread is huge”, Prof. Croce says, “at around 7.5% per year and it could decline to 5% if there were no fiscal uncertainty”.
When public debt is on the rise, spikes in interest rates and uncertainty on future fiscal pressure, the argument goes, make future cash flow less predictable and suggest caution to both investors and managers. When it comes to select which projects to invest in, uncertainty forces managers to choose only the most profitable, dropping the riskiest ones, lest investors could switch to firms perceived as safer”. The net result is a GDP growth drop in 4/5 years, when the lack of innovation starts to affect the national economy. A public debt of 100% means a decline in GDP growth of 4% after five years compared to a “normal” debt of 60%.
“Our results mean that a policy of `prudential austerity’, that is, a commitment to reduce public debt during good economic times paired with fiscal policies that prevent long-run tax uncertainty, could be the most effective”, Prof. Croce says. “On the one hand, a systematic use of budget deficits undermines growth and, on the other, indebted countries risk to experience down cycles with no leeway for fiscal stimuli”.
Mariano Croce, Thien T. Nguyen, Steve Raymond, Lukas Schmid, Government Debt and Returns to Innovation, in press in Journal of Financial Economics, DOI: 10.1016/j.jfineco.2018.11.010.
