A Cointegrating Regression Analysis of the Impacts of Greater Economic Freedom and Perceived Risk from a Larger National Debt-to-GDP Ratio on the Real Cost of Borrowing for Corporations in the U.S

This study empirically investigates two main hypotheses: (1) the higher the level of economic freedom, the greater the demand for Moody’s Baa-rated corporate bonds, and, consequently, the higher the price of and the lower the real interest rate yield on those bonds; and (2) a higher national debt-to-GDP ratio level elevates perceived default risk and thereby reduces the private sector demand for Moody’s Baa-rated corporate bonds, with the results then being lower-prices on such bonds and hence a higher ex post real interest rate yield on them. Moreover, this study not only finds consistent empirical support on behalf of both of these hypotheses but also for the argument that the federal budget deficit (expressed as a percent of GDP) per se places upward pressure in financial markets on the real cost of borrowing for firms. It is noteworthy that the budget deficit variable considered in this project, effectively plays two roles insofar as raising the real interest rate yield on Moody’s Baa-rated corporate bonds. First, it plays a direct role in pressuring the yield upwards by directly competing for funds in the financial markets against households, other governmental bodies, firms, and other entities. This increased yield in turn can lead to crowding out through elevation in the interest rate. Second, a pattern of budget deficits over time adds to the magnitude of the national debt. To the extent that this growth in the national debt exceeds the GDP growth rate, the national debt-to-GDP ratio increases and can elevate perceived riskiness of default in the financial markets. Accordingly, policymakers in the public sector should make very thoughtful and circumspect efforts to reduce the size and growth of federal budget deficits. In addition, a concerted effort to raise the overall level of economic freedom would be well advised.