Government Debt and the Returns to Innovation

Elevated levels of US government debt in the aftermath of the great recession have raised concerns about their effects on long-term growth prospects. By empirically identifying measures of government indebtedness as risk factors priced in stock returns, we document and theoretically evaluate a novel risk channel at work shaping this link. In the cross-section, stocks earn positive premia for their exposure to movements in government debt, while these predict high stock returns going forward in the time series. A substantial return spread between the most and the least innovative firms is increasing in the debt-to-gdp ratio. We show that rises in the cost of capital for innovation-intensive firms associated with elevated government debt bring about declines in R&D activity and economic growth. We interpret these findings through the lens of a production-based asset pricing model with endogenous innovation and fiscal policy. The model emphasizes the role of political and fiscal uncertainty in shaping the empirical relationships.