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

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  • Benjamin M. Friedman
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    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.

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    Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 1565.

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    Date of creation: Feb 1985
    Publication status: Published as "Crowding Out or Crowding In? Economic Consequences of Financing Government Deficits", BP, Vol. 9, no. 3 (1977): 593-641.
    Handle: RePEc:nbr:nberwo:1565
    Note: ME
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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. 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.
    4. Friend, Irwin & Blume, Marshall E, 1975. "The Demand for Risky Assets," American Economic Review, American Economic Association, vol. 65(5), pages 900-922, December.
    5. Paul A. Samuelson, 1970. "The Fundamental Approximation Theorem of Portfolio Analysis in terms of Means, Variances and Higher Moments," Review of Economic Studies, Oxford University Press, vol. 37(4), pages 537-542.
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