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When is public debt a problem for growth?

A new empirical analysis quantifies the (historic) link between public debt and economic growth. Critical thresholds depend on country features, such as access to financing. Average thresholds might be 60% and 80% of GDP for emerging and developed countries respectively. Importantly, debt dynamics matter more than levels. High debt is less of a drag when it is on a declining trajectory.

Chudik, Alexander, Kamiar Mohaddes, Hashem Pesaran, and Mehdi Raissi (2015), “Is There a Debt-threshold Effect on Output Growth?”, Federal Reserve Bank of Dallas, Globalization and Monetary Policy Institute, Working Paper No. 245, July 2015.

The below are excerpts from the paper. Headings, cursive text and references to other posts have been added.

Some background

The IMF estimates that the general government debt stock of the advanced economies will peak at above 105% of GDP in 2015, up from below 77% at the end of 2007 (view post here). Public debt levels are unlikely to recede much in coming years, implying the governments’ financial situation is critically exposed to increases in real interest rates or sovereign credit spreads. A particular concern is Japan, whose gross government debt ratio stands close to 250% .

Problematic debt thresholds

“We provide a formal statistical analysis of debt-threshold effects on output growth, using a relatively large panel of 40 countries over the period 19652010. We allow for country-specific heterogeneity in dynamics, error variances, and cross-country correlations, but assume homogeneous threshold parameters. To shed some light on possible heterogeneity of the threshold effects across countries, we also report separate results for the 19 advanced and 21 developing economies.”

“Overall, there appears to be some support for debt-threshold effects…with the estimates of the thresholds being 6080 percent for the full sample, 80 percent for the advanced economies, and between 30-60 percent for the developing countries…Interestingly, the threshold effects for advanced economies at 90 percent and for developing countries at 60 percent calculated in Reinhart and Rogoff (2010) and elsewhere in the literature are close.”

“However…once we account for the impact of global factors and their spillover effects, there is only a weak evidence for a universally applicable threshold effect in the relationship between public debt and economic growth, with the threshold variable being statistically significant only when it is interacted with a positive change in debt-to- GDP.”

“The effect of public debt on growth varies across countries, depending on country-specific factors and institutions such as the degree of their financial deepening, their track records in meeting past debt obligations, and the nature of their political system.”

Mind the debt dynamics

“Debt trajectory is probably more important for growth than the level of debt itself…We find significant negative long-run effects of public debt build-up on output growth…We find a statistically significant threshold effect in the case of countries with rising debt-to-GDP ratios beyond 50-60 percent, stressing the importance of debt trajectory.”

“Regardless of debt thresholds, there is a significant negative long-run relationship between rising debt-to-GDP and economic growth. Our 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.”

“Provided that public debt is on a downward trajectory, a country with a high level of debt can grow just as fast as its peers.”

A previous IMF paper based on a broad panel of countries going back to 1875 supports these findings (view post here). It suggests that high debt does not per se reduce growth. Only if debt levels are both elevated and rising, growth tends to suffer. Also on its own high debt does often entail greater output volatility.


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