Financial Crowding Out

Using a novel dataset of accounting and market information that spans most publicly traded firms over the last century, we show that government deficit financing crowds out nonfinancial corporate debt financing and investment. Specifically, an increase in the supply of treasury debt is associated with a significant reduction in corporate leverage, debt issuances, and investment, but no significant change in corporate equity issuances. Further, this crowding out effect is present across industries and is more pronounced for larger, less risky firms whose debt is a closer substitute for treasuries. The channel through which this effect appears to operate is financial intermediaries, whose balance sheets reveal a substitution between lending to the federal government and lending to the corporate sector. How does government debt affect the economy? The “conventional view,” as summarized by Elmendorf and Mankiw (1999), is that government debt stimulates aggregate demand and economic growth in the short-run, but retards growth in the long-run via increased real interest rates and reduced private capital formation. To test the latter implication, numerous studies have empirically examined the link between government debt and interest rates. The results of these studies have been described as lacking consensus (Hubbard (2005, 2011)), and “largely uninformative” (Elmendorf and Mankiw (1999)) in surveys of the literature. However, even if one accepts a significant relation between debt and interest rates, this relation by itself provides little insight into the effect of government debt on economic quantities. For example, whether the link between debt and interest rates is economically meaningful for output requires knowledge of the aggregate production function. Thus, despite much evidence, it remains unclear how government debt impacts the economy and, consequently, what policy implications follow. In this study, we examine the link between government debt and the economy from a financing perspective that exploits a novel, panel dataset containing accounting and market information for U.S. nonfinancial publicly traded firms over the last century. In particular, we study the linkages between the quantity of public debt and the quantity of corporate debt, equity, and investment. Our approach of focusing on quantities, as opposed to prices, is motivated by a large literature highlighting the importance of financing frictions for real activity (Stein (2003)) and the limitations of the price mechanism to clear markets (Wojnilower (1980), Stiglitz and Weiss (1985)). Indeed, there is now a large empirical literature emphasizing the importance of an imperfectly elastic supply of financial capital for corporate behavior (Baker (2009)). We further motivate our approach by showing that other non-price dimensions of debt contracts, such as maturity and control right allocations, contain important cyclical components that are indicative of their role in clearing credit markets. In our main analysis, we document a sizeable and robust relation between government debt, corporate financing, and corporate investment. Specifically, we find a significant contemporaneous negative relation between public and corporate debt, in both the stocks and flows. A one standard deviation increase in government leverage (i.e., the ratio of US federal 1 An alternative view is that the mode of public finance – taxes or debt – is irrelevant because of Ricardian Equivalence (Barro (1974)).