Debt, interest rates, and integration of financial markets

It is commonly believed that higher budget deficits raise interest rates. However, these crowding out effects of increasing public debt have usually been found to be small or non-existent. One explanation is that on globalised bond markets interest rate differentials are offset due to financial integration. This paper tests crowding out, and measures the degree of integration of government bond markets, using spatial modelling techniques. Our main finding is that the crowding out effect of public debt on domestic long term interest rates is small: a 1% increase in the debt ratio pushes up domestic rates by 2 pp at most. Financial integration implies an important spillover effect via international bond markets, but only between OECD, and in particular EU, countries. The feedback effect from these markets on long term interest rates is as important as the domestic crowding out effect of higher public debt. Emerging markets are not as well integrated into international capital markets, causing a stronger crowding out effect. ► Higher budget deficits raise interest rates, but financial integration offsets interest rate differentials. ► We test crowding out and the degree of integration of government bond markets using spatial modelling techniques. ► The crowding out of long term interest rates is limited: a 1% increase in the debt ratio raises domestic rates by 2 pp. ► Financial integration implies an important spillover effect via international bond markets of OECD countries. ► Emerging markets are not as well integrated into international capital markets, causing a stronger crowding out effect.