The potential effect of public debt on government bond yields is an important issue for economists and policy makers. If government bond yields include risk premiums, increasing indebtedness may cause bond yields to go up, thus raising the cost of borrowing and imposing discipline on governments. Market discipline of this kind may be especially relevant and important in a monetary union, such as the US or the new European Monetary Union (EMU), in which the governments of the member states can issue debt, but do not have the possibility to monetize and inflate away excessive debts.
Whether such risk premiums can be identified empirically and how large they are has attracted considerable interest in recent literature. A first line of research estimates the effect of fiscal variables on interest rate levels. Gale and Orszag (2002), in a comprehensive review of the evidence for the US, conclude that expected deficits affect long-term interest rates positively, a result confirmed by Laubach (2003, 2004) and Gale and Orszag (2004). Faini (2004) estimates a positive impact of government debt on expost real interest rates in 10 European countries. Ardagna, Caselli, and Lane (2004) use a panel of 16 OECD countries over several decades and both static and dynamic econometric models.
They find a significant positive effect of primary deficits on long term interest rates. They also find a non-linear effect of government debt on interest rates: Only when countries have above-average debt ratios does an increase in the debt ratio cause the interest rate to rise. As explained by Gale and Orszag (2002), however, there are many reasons why interest rates may respond positively to rising government debts and deficits, and an increase in sovereign risk premiums is just one of them. Therefore, looking at the response of interest rate levels does not necessarily yield evidence of how markets price sovereign risk.