U.S. Asset Returns and Fiscal Policy: New Empirical Investigation

By Lee, Unro | Quarterly Journal of Business and Economics, Summer-Autumn 2004 | Go to article overview

U.S. Asset Returns and Fiscal Policy: New Empirical Investigation


Lee, Unro, Quarterly Journal of Business and Economics


Introduction

The United States and other industrialized countries have been plagued by persistent, ballooning government budget deficit since the early 1970s. Although the United States briefly enjoyed a period of federal budget surplus between 1998 and 2001, it is currently experiencing a swelling budget deficit, partly due to a recession in 2001, to extended bearish stock markets triggered by the dot.com bust in 2000, and to deep income tax cuts and a significant boost in government spending to finance a war against terrorism. (1)

For the United States, the ratio of public debt (i.e., total value of government indebtedness due to sustained budget deficit) to annual GDP (gross domestic product) declined from over 100 percent immediately after World War II to 25 percent in 1974. The ratio rose steadily to 44.7 percent in 1998. The trend for the public debt/GDP ratio for the major OECD (Organization for Economic Cooperation and Development) countries such as Belgium, France, Germany and Japan exhibited a similar pattern during the same period--that is, falling from the late 1940s to a low point in 1973 and then steadily rising thereafter. (2)

If financial markets are informationally efficient with respect to fiscal policy, (3) then asset prices should capture any changes in fiscal policy quickly and fully once this information becomes publicly available. (4) Past information on fiscal policy would be of no use in explaining current fluctuations in security prices in an efficient market because this information has been impounded in past prices. On the other hand, in an informationally inefficient market, past information on fiscal policy should be useful in explaining current movements in security prices because there is a lag in the adjustment of security prices to new information.

Several studies (Barnhart and Darrat, 1989; Darrat, 1988 and 1990; and Darrat and Brocato, 1994) provide evidence that stock markets of the United States and Canada are not informationally efficient with respect to fiscal policy. (5) Ewing (1998) also finds that the stock markets of Australia and France are not efficient with respect to publicly available information on fiscal policy, while Lee (1997) demonstrates that stock markets of four Asian countries--Hong Kong, Singapore, South Korea and Taiwan--are not informationally efficient with respect to both monetary and fiscal policies.

These findings are particularly puzzling, given that there is overwhelming empirical evidence indicating that stock markets of the United States and other industrialized countries are informationally efficient with respect to salient macroeconomic variables, such as money supply, inflation rate, and real economic activity (e.g., Darrat, 1988 and 1990; Darrat and Brocato, 1994; Fama, 1981; Geske and Roll, 1983; Wasserfallen, 1989; and Jensen, Mercer, and Johnson, 1996).

The current literature is replete with studies (e.g., Fama and French, 1989; Campbell and Ammer, 1993; Jensen, Mercer, and Johnson, 1996; and Booth and Booth, 1995) asserting U.S. stock and bond excess returns move together over time because they are both affected by a common set of variables that closely track macroeconomic conditions--namely dividend yield, default spread, term spread, and money supply. (6) Accordingly, if fiscal policy proxied by federal budget deficit significantly and unambiguously affects U.S. stock returns as documented by previous studies, then one can surmise that U.S. corporate bond returns also could be significantly affected by fiscal policy.

The objective of this study is to determine whether the U.S. corporate bond market is informationally efficient with respect to fiscal policy proxied by the federal budget deficit. If fiscal policy is found to significantly affect excess U.S. corporate bond returns, then such evidence would strengthen the claim that financial assets are not informationally efficient with respect to fiscal policy. …

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