A Visible Hand? Bond Markets, Political Parties, Balanced Budget Laws, and State Government Debt

Recent empirical work demonstrates that fiscal institutions in American states have real effects on state government bond rates, but the causal mechanisms have not been identified. We show how laws that restrict state governments' ability to carry forward a deficit improve the ability of investors to extract information from noisy signals. This affects the response of bond markets to repeated deficits in states that have these laws. We argue that partisan preferences for higher spending also increase risk for investors, leading to higher interest rates. We provide empirical support for our hypotheses using data from 1973–1995.