Economic Research Forum (ERF)

When is debt a drag on economic growth?

1975
Is there a tipping point for public indebtedness beyond which growth drops off significantly; and does a build-up of public debt slow the economy in the long run? This column reports the results of an empirical analysis of these questions for 40 advanced and developing economies over nearly half a century.

In a nutshell

There is no simple tipping point in the relationship between public debt and growth.

Nonetheless, countries that have substantial government debt loads and rising debt-to-GDP ratios grow substantially slower.

Deficit spending needs to be coupled with a credible medium-term fiscal policy plan backed by action in good times to reduce the debt burden back to sustainable levels.

The relationship between changes in public debt and economic growth is central to the debate on the design of prudent fiscal policies, especially in countries with limited fiscal space. The key question revolves around balancing the short-run gains from fiscal expansion in downturns (to reignite growth) with possible adverse effects on growth of elevated debt levels in the long run.

This topic has received renewed interest among economists and policy-makers in the aftermath of the global financial crisis, the euro area sovereign debt crisis and, more recently, in the Middle East and North Africa following the sharp fall in oil prices in 2014.

Generally speaking, economists tend to agree that a debt-financed fiscal expansion in downturns could stimulate aggregate demand and raise growth in the short run, but there is no consensus as to the eventual effect of increases in public debt on potential growth and the safe debt level.

There is also some controversy over the threshold level of debt to GDP beyond which growth is severely compromised. For example, Reinhart and Rogoff’s analysis, which has been very influential and is cited extensively by policy-makers on both sides of the Atlantic, seems to suggest that public debt in excess of 90% of GDP is unsafe and harmful to growth in advanced countries.

These threshold results, however, are obtained under strong assumptions and suffer from a number of methodological shortcomings. First, while some economies have run into debt difficulties and experienced subdued growth at relatively low debt levels, others have been able to sustain high levels of indebtedness for prolonged periods and to grow strongly without experiencing debt distress.

This suggests that the effects of public debt accumulation on growth and safe levels of debt varies across countries, depending on country-specific factors and institutions such as the degree of financial development, track records in meeting past debt obligations, and the stance of economic and political cycles. Given these diverse historical and institutional differences, it is important to take account of such cross-country differences.

Second, it is implicitly assumed that individual economies are not globally interdependent and that debt problems in one country do not spill over to other economies and/or they cannot be triggered by adverse events in a third country. This is likely to be problematic as there are a number of factors – such as trade and financial linkages, external debt financing of budget deficits, the stance of global financial cycle and exposures to common shocks (such as oil price disturbances) – which could invalidate such an assumption.

Third, while a high load of public debt may slow economic growth, low GDP growth (by reducing tax receipts and increasing government spending on unemployment benefits and other social safety spending) could also lead to higher ratios of debt to GDP. Perhaps surprisingly, these possible feedback effects are not taken into account rigorously by the empirical work on this topic to date.

In a recent study, addressing these shortcoming, we investigate whether there exists a tipping point for public indebtedness beyond which economic growth drops off significantly. More generally, we explore whether a build-up of public debt slows the economy in the long run. Our empirical examination is based on data on 40 countries, as well as two sub-groups of advanced and developing economies, over the period 1965-2010.

Allowing for global interdependences and spillover effects, we do not find a tipping point in the relationship between public debt and growth. Since global factors (including interest rates in the United States, cross-country capital flows, global business cycles and world commodity prices) play an important role in precipitating sovereign debt crises with long-lasting adverse effects on economic growth, it is not surprising that neglecting these leads to false detection of threshold effects.

Nevertheless, we do find that countries that have substantial government debt loads (varying across developing and advanced countries) and rising debt-to-GDP ratios grow substantially slower. These results suggest that the debt trajectory has more important consequences for economic growth than the level of debt-to-GDP itself. In other words, provided that debt is on a downward path, a country with a high level of debt can grow just as fast as its peers.

Finally, regardless of debt thresholds, we find a significant negative long-run association between rising debt-to-GDP ratios and economic growth. This suggests that a temporary increase in the debt-to-GDP ratio (for example, to help smooth business cycle fluctuations), does not play a role in the long-run relationship between economic growth and public debt. On the other hand, countries that experience persistent increases in their debt-to-GDP ratios also experience lower output growth in the long run.

The Managing Director of the International Monetary Fund (IMF) noted in her opening remarks at the ‘Rethinking Macro Policy III‘ conference that many countries with large negative output gaps prematurely tightened fiscal policy after the global financial crisis (to slow the rate of debt accumulation after a relatively successful initial period of fiscal expansion).

Overall, our results are very much in line with this as they imply that 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 a credible fiscal policy plan backed by action in good times that will reduce the debt burden back to sustainable levels. What matters most is not a magic threshold target for debt to GDP, but rather the trajectory of debt – high and rising or high and falling.

Note: The views expressed are those of the authors and do not necessarily represent those of the Federal Reserve Bank of Dallas, the Federal Reserve System, the IMF or IMF policy.

Further reading

Chudik, A, K Mohaddes, MH Pesaran and M Raissi (2017) ‘Is There a Debt-threshold Effect on Output Growth?’ Review of Economics and Statistics 99(1): 135-50.

Chudik, A, K Mohaddes, MH Pesaran and M Raissi (2013) ‘Debt, Inflation and Growth: Robust Estimation of Long-Run Effects in Dynamic Panel Data Models’, Federal Reserve Bank of Dallas, Globalization and Monetary Policy Institute Working Paper No. 162.

Reinhart, CM, and KS Rogoff (2010) ‘Growth in a Time of Debt’, American Economic Review 100(2): 573-78.

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