The Relationship Between Debt and Growth

The debt-growth nexus has received renewed interest among academics and policy makers alike in the aftermath of the recent global financial crisis and the subsequent euro area sovereign debt crisis. Discuss whether there exists a tipping point, for public indebtedness, beyond which economic growth drops off significantly; and more generally, whether a build-up of public debt slows down the economy in the long run.

This essay explores the effects of debt on growth, by first examining the theoretical mechanisms that high debt can lead to lower growth before examining some of the empirical literature to see whether we observe such a relationship. Throughout we highlight that there is an endogeneity issue in that the exact relationship may be low growth causing high debt, or that there is an omitted variable driving the result.

High debt can theoretically lead to lower growth due to a private investment crowding out effect or due to a debt-overhang effect. The debt-overhang effect occurs when at large levels of debt investors become wary of lending to a government for fear that they cannot repay, as a consequence they hike up the interest rate and this causes the government to reign in fiscal spending which leads to lower growth. It is not immediately clear however, why investors would become wary of the government as they have the ability to tax citizens in perpetuity and also have the ability to print money. The crowding out effect occurs when the government is “hogging” available sources of funding which means it cannot be used by private firms to invest in real assets (Elmendorf and Mankiw). This effect is likely to be small, especially as crowding out simply means the government is instead doing what the private sector could be doing (and doesn’t indicate why government activity should be less fruitful in generating output). These mechanisms suggest a negative effect to high levels of debt, whilst De Long and Summers point out that high levels of debt accumulated during a depression because the government is using fiscal policy to expand can have positive effects for the economy, particularly when we consider hysteresis.

Panizza and Presbitero believe this question can only be answered empirically and not theoretically and they study the literature and conclude that there is no paper which can make a strong case for a causal relationship between debt and economic growth. They highlight that threshold effect findings are very sensitive to small changes in data coverage and empirical techniques.

Reinhart and Rogoff exploit a panel dataset of countries’ public spending and growth and conclude that median growth rates for countries with public debt over 90% of GDP experience 1% less growth than otherwise whilst average growth is 4% lower, but there is no link to growth and debt before this threshold effect. This result is stable for both advanced and developing countries. However, these results are produced by putting countries in bins depending on their debt levels and then examining the overall effects, and so treats countries homogenously, and ignores error cross-sectional dependencies across countries arising from global factors and spill-overs from a recession in one country on another. Further we should be aware that the difference between median and mean results suggests that the finding is being strongly driven by a few outliers.

To overcome these issues, Mohaddes et al employ a heterogeneous panel study and allow for error dependencies across countries, and find contrary evidence to Reinhart and Rogoff that there is no evidence of a universally applicable threshold effect when we take into account global factors and their spill-over effects. But interestingly they do find evidence of negative long run effects of public debt build up on output, although if the debt trajectory is downwards then a country with a high level of debt can grow just as fast as its peers. This suggests that it might be the trajectory of debt that effects growth, and not the absolute level. Further, they find statistically significant evidence of a threshold effect in countries with an upward trajectory in debt beyond 50-60%.

Their results “imply that the Keynesian fiscal deficit spending to spur growth does not necessarily have negative long-run consequences for output growth, so long as it is coupled with credible fiscal policy plan backed by action that will reduce the debt burden back to sustainable levels”.

In conclusion it seems that there is no clear relationship in the absolute level of debt and economic growth, but recent evidence suggests that an upward trajectory in debt reduces economic growth and there is a threshold effect when debt exceeds 50-60%. Caution is required in undertaking empirical studies, ensuring we don’t suffer from omitted variable bias or reverse causality.

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