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. [...]

What is the WACC?

The weighted average cost of capital (WACC) is simply an average cost of the two types of capital: debt and equity. It tells us the amount an investor would need in compensation to invest in a project. Therefore if we were to offer a lower return than the WACC, we would find that we have no investors; a return greater than WACC would lead to a situation where we have excess demand for our project.

To theoretically calculate the rate of return on a project we would need to compare it with existing returns on projects which have similar risk characteristics, and then set the return similar to these projects to ensure that we can attract finance. [...]

US Default

There has been a lot in the news recently about the possibility of a US default – what does this mean? A default is a term used for when a country refuses to pay its debt. Generally this is because they can no longer afford to, however there could be other reasons, e.g. a change of government brings in a socialist regime whose policy was to default. A default may not be of the entire debt, debtors may be required to take a ‘haircut’ – which is considered a default – meaning they wont be paid back the entire amount they are owed. [...]

Why does the UK Government have such low interest rates on its debt?

Like the US the UK is facing low interest rates, despite having a high budget deficit and public debt. Why is this?

The UK Government issues its debt in the form of Guilts, currently the interest rate the government has to pay on a year guilt is 0.32%. This is lower even than the base rate, surely investors would be better off just putting their money in a bank account? Well to start with large financial institutions and investors can’t simply put all their money in a bank account, if the bank collapses they will loose all their money (and the government only insures £85,000). [...]