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Crowding Out or Crowding In? Evidence on Debt-Equity Substitutability

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  • Benjamin M. Friedman

Abstract

When the composition of assets outstanding in the market changes, the pattern of expected asset returns also changes, shifting to whatever return structure will induce investors to hold just the new composition of exisiting assets. The object of this paper is to determine, on the basis of the respective risks associated with the returns to broad classes of financial assets in the United States, and hence on the basis of the implied portfolio substitutabilities among these assets, how government deficit financing affects the structure of market-clearing expected returns on debt and equity securities traded in U.S. markets.The empirical results indicate that government deficit financing raises expected debt returns relative to expected equity returns, regardless of the maturity of the government's financing. More specifically, financing a single $100 billion government deficit by issuing short-term debt lowers the expected return on long-term debt by .06%, and lowers the expected return on equity by .33%, relative to the return on short-term debt. Financing a $100 billion deficit by issuing long-term debt raises the expected return on long-term debt by .10%, but lowers the expected return on equity by .24%,again in comparison to the return on short-term debt. These per-unit magnitudes are not huge, but in the current U.S. context of government deficits approximating $200 billion -- year after year -- they are not trivially small either.These results have immediate implications for the composition of private financing. In addition, in conjunction with some assumption (for example, about monetary policy) to anchor the overall return structure,they bear implications for the total volume of private financing, as wellas for capital formation and other interest sensitive elements of aggregate demand.

Suggested Citation

  • Benjamin M. Friedman, 1985. "Crowding Out or Crowding In? Evidence on Debt-Equity Substitutability," NBER Working Papers 1565, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:1565
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    1. Feldstein, Martin & Dicks-Mireaux, Louis & Poterba, James, 1983. "The effective tax rate and the pretax rate of return," Journal of Public Economics, Elsevier, vol. 21(2), pages 129-158, July.
    2. Grossman, Sanford J & Shiller, Robert J, 1981. "The Determinants of the Variability of Stock Market Prices," American Economic Review, American Economic Association, vol. 71(2), pages 222-227, May.
    3. Benjamin M. Friedman, 1978. "Crowding Out or Crowding In? Economic Consequences of Financing Government Deficits," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 9(3), pages 593-641.
    4. Benjamin M. Friedman, 1978. "Crowding Out Or Crowding In? The Economic Consequences of Financing Government Deficits," NBER Working Papers 0284, National Bureau of Economic Research, Inc.
    5. Paul A. Samuelson, 1970. "The Fundamental Approximation Theorem of Portfolio Analysis in terms of Means, Variances and Higher Moments," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 37(4), pages 537-542.
    6. Roley, V Vance, 1983. "Symmetry Restrictions in a System of Financial Asset Demands: Theoretical and Empirical Results," The Review of Economics and Statistics, MIT Press, vol. 65(1), pages 124-130, February.
    7. Benjamin M. Friedman & V. Vance Roley, 1979. "A Note on the Derivation of Linear Homogeneous Asset Demand Functions," NBER Working Papers 0345, National Bureau of Economic Research, Inc.
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    Cited by:

    1. Pindyck, Robert S, 1988. "Risk Aversion and Determinants of Stock Market Behavior," The Review of Economics and Statistics, MIT Press, vol. 70(2), pages 183-190, May.
    2. Chang, Tsangyao & Chiang, Gengnan, 2012. "Transitional Behavior of Government Debt Ratio on Growth: The Case of OECD Countries," Journal for Economic Forecasting, Institute for Economic Forecasting, vol. 0(2), pages 24-37, June.
    3. Friedman, Benjamin M & Kuttner, Kenneth N, 1992. "Time-Varying Risk Perceptions and the Pricing of Risky Assets," Oxford Economic Papers, Oxford University Press, vol. 44(4), pages 566-598, October.
    4. McClain, Katherine T. & Humphreys, H. Brett & Boscan, Atahualpa, 1996. "Measuring risk in the mining sector with ARCH models with important observations on sample size," Journal of Empirical Finance, Elsevier, vol. 3(4), pages 369-391, December.
    5. Gerdesmeier, Dieter, 1996. "Die Rolle des Vermögens in der Geldnachfrage," Discussion Paper Series 1: Economic Studies 1996,05, Deutsche Bundesbank.
    6. Benjamin M. Friedman, 1987. "New Directions in the Relationship Between Public and Private Debt," NBER Working Papers 2186, National Bureau of Economic Research, Inc.
    7. Chang, Tsangyao & Chiang, Gengnan, 2011. "Regime-switching effects of debt on real GDP per capita the case of Latin American and Caribbean countries," Economic Modelling, Elsevier, vol. 28(6), pages 2404-2408.
    8. Gerdesmeier, Dieter, 1996. "The role of wealth in money demand," Discussion Paper Series 1: Economic Studies 1996,05e, Deutsche Bundesbank.

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