The Interest Rate Effect of Government Debt and Deficits: Does Domestic Borrowing Have a Different Impact Than Foreign Borrowing?

This paper investigates the relationship between government debt and interest rates in advanced economies. We consider two separate, yet closely related puzzles in the data. Since the Global Financial Crisis, OECD countries have experienced a dramatic surge in government debt-to-GDP ratios, yet there was not a corresponding surge in sovereign bond yields. In addition, across countries there is no relationship between government debt levels and interest rates, and a country like Japan has the highest government debt level among advanced economies yet the lowest sovereign bond rates. To address both of these puzzles, we propose that the effect of government borrowing on interest rates depends critically on who finances that debt. We extend the work of previous studies that have estimated the effect of expected government debt or deficits on interest rates, and we add an international dimension by incorporating forecasts of the current account balance or net foreign asset position. We find that an increase in government debt financed from domestic savings has less of an effect on interest rates than an increase in government debt financed by foreign borrowing, and government debt has less of an effect on interest rates in a country that is a net international creditor than one that is a net international debtor.