An exploratory analysis of the impact of budget deficits and other factors on the ex post real interest rate yield on tax-free municipal bonds in the United States

Using over a half century of data, this empirical study adopts a simple loanable funds to investigate the impact of the federal budget deficits and other factors, chiefly financial market factors, on the ex post real interest rate yield on high-grade municipal bonds in the United States. Two autoregressive two-stage least squares (AR/2SLS) estimates for the 1960 to 2011 study period and another for the 1971 to 2011 study period find that the ex post real interest rate yield on high-grade municipal bonds is an increasing function of the ex post real interest rate yield on Moody's Baa-rated corporate bonds, the ex post real interest rate yield on 3-year US Treasury notes, the real value S&P 500 stock index and the federal budget deficit (relative to the GDP level). Based on these results, it is observed that factors elevating the federal budget deficit appear to raise the real cost of borrowing to the cities (of all sizes), counties and states across the United States. Given the time period studied, 1960 through 2011, this relationship appears to be an enduring one, one that responsible policy-makers should not overlook. Over the long run, failure to address the federal budget issue could have profound negative impacts on the finances of US cities, counties and states and their economic activities.