Government Debt and Economic Growth – Decomposing the Cause and Effect Relationship

Swamy, Vighneswara (2015): Government Debt and Economic Growth – Decomposing the Cause and Effect Relationship.

Abstract

The rising government debt levels in the aftermath of global financial crisis and the ongoing euro zone debt crisis have necessitated the revival of the academic and policy debate on the impact of growing debt levels on growth. This study provides a data–rich analysis of the dynamics of government debt and economic growth for a longer period (1960–2009). It spans across different debt regimes and involves a worldwide sample of countries that is more representative than that of studies confined to advanced countries. This study observes a negative relationship between government debt and growth. The point estimates of the range of econometric specifications suggest a 10-percentage point increase in the debt-to-GDP ratio is associated with 23 basis point reduction in average growth. Our results establish the nonlinear relationship between debt and growth. Further, by employing panel vector auto regressions (PVAR) approach, this study decomposes the cause and effect relationship between debt and growth and offers an answer to the question – Does high debt lead to low growth or low growth leads to high debt? The results derived from the impulse–response functions and variance decomposition show the evidence of long-term effect of debt on economic growth. The results indicate that the effect is not uniform for all countries, but depends mostly on the debt regimes and other important macroeconomic variables like; inflation, trade openness, general government final consumption expenditure and foreign direct investment.

• Item Type: MPRA Paper
• Language: English
• Keywords: Government Debt, economic growth, panel data, nonlinearity, country groupings
• Subjects: C - Mathematical and Quantitative Methods > C3 - Multiple or Simultaneous Equation Models ; Multiple Variables > C33 - Panel Data Models ; Spatio-temporal Models; C - Mathematical and Quantitative Methods > C3 - Multiple or Simultaneous Equation Models ; Multiple Variables > C36 - Instrumental Variables (IV) Estimation; E - Macroeconomics and Monetary Economics > E6 - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook > E62 - Fiscal Policy; H - Public Economics > H6 - National Budget, Deficit, and Debt > H63 - Debt ; Debt Management ; Sovereign Debt; O - Economic Development, Innovation, Technological Change, and Growth > O4 - Economic Growth and Aggregate Productivity; O - Economic Development, Innovation, Technological Change, and Growth > O4 - Economic Growth and Aggregate Productivity > O40 - General; O - Economic Development, Innovation, Technological Change, and Growth > O5 - Economywide Country Studies > O50 - General

References

Abbas S M Ali, and Christensen, Jakob. (2007). The Role of Domestic Debt Markets in Economic Growth: An Empirical Investigation for Low–Income Countries and Emerging Markets. IMF Working Paper No. 07/127

Adam C S and Bevan D L. (2005). Fiscal deficits and growth in developing countries. Journal of Public Economics 4: 571–597.

Aizenman J, Kletzer K and Pinto B. (2007). Economic growth with constraints on tax revenues and public debt: implications for fiscal policy and cross-country differences. NBER Working Paper 12750

Baum A, Checherita C W and Rother P. (2013). Debt and growth: New evidence for the euro area. Journal of International Money and Finance 32: 809–821

Barro R J. (1979). On the determination of the public debt. The Journal of Political Economy 87 (5): 940–971.

Barro R and X Sala-i-Martin. (2004). Economic growth, second edition, MIT Press

Checherita Cristina-Westphal and Rother Philipp. (2012). The impact of high government debt on economic growth and its channels: An empirical investigation for the euro area. European Economic Review 56: 1392–1405

Cecchetti Stephen, Madhusudan Mohanty and Fabrizio Zampolli. (2011). The real effects of debt. BIS Working Papers No. 352, Bank for International Settlements.

Egert Balazs. (2015). Public debt, economic growth and nonlinear effects: Myth or reality? Journal of Macroeconomics 43: 226–238

Elmendorf Douglas W and Gregory Mankiw N. (1999). Government Debt. In (J. B. Taylor & M. Woodford (ed.)) Handbook of Macroeconomics 1(3): 1615-1669.

Easterly W and Rebelo S. (1993). Fiscal Policy and Economic Growth: An Empirical Investigation. Journal of Monetary Economics 32(3): 417-58.

Greiner Alfred. (2013). Debt and Growth: Is there a non-monotonic relation? Economics Bulletin 33 (1): 340-347

Herndon T, Ash M, Pollin R. (2014). Does high public debt consistently stifle economic growth? A critique of Reinhart and Rogoff. Cambridge Journal of Economics 38(2): 257–279.

Islam N. (1995). Growth empirics: a panel data approach. Quarterly Journal of Economics 110: 1127–70.

Kristensen Ida Pagter and Wawro Gregory. (2003). Lagging the Dog? The Robustness of Panel Corrected Standard Errors in the Presence of Serial Correlation and Observation Specific Effects. Working Paper No. 54. Washington University in St. Louis. Extracted from http://polmeth.wustl.edu/mediaDetail.php?docId=54

Krugman, Paul (2010). “Reinhart and Rogoff Are Confusing Me.” New York Times, 11 August.

Kumar Manmohan S and Jaejoon Woo. (2010). "Public Debt and Growth", IMF Working Papers, No. 10/174, International Monetary Fund

Lof Matthijs and Malinen Tuomas. (2014). Does sovereign debt weaken economic growth? A Panel VAR analysis. Economic Letters 122(3): 403–407

Modigliani F. (1961). Long-Run Implications of alternative Fiscal Policies and the Burden of the National Debt. Economic Journal 71 (284): 730-755.

Panizza Ugo and Presbitero Andrea F. (2014). Public debt and economic growth: Is there a causal effect? Journal of Macroeconomics 41: 21–41

Reinhart Carmen M and Kenneth S Rogoff. (2010a). “Debt and Growth Revisited", VoxEU.org, 11August.

Reinhart Carmen M and Kenneth Rogoff S. (2010b). Growth in a Time of Debt. American Economic Review: Papers and Proceedings 100(2): 573-578.

Reinhart Carmen M, Vincent R Reinhart and Kenneth S Rogoff (2012). Public debt overhangs: Advanced economy episodes since 1800. Journal of Economic Perspectives 26(3): 6986.

Saint-Paul (1992). Fiscal Policy in an Endogenous Growth Model. Quarterly Journal of Economics 107(4): 1243–59.

Teles V K and Cesar Mussolini C. (2014). Public debt and the limits of fiscal policy to increase economic growth. European Economic Review 66: 1–15.