It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.
-- Mark Twain
Do high levels of public debt reduce economic growth? This is an important policy question. A positive answer would imply that, even if effective in the short-run, expansionary fiscal policies that increase the debt-to-GDP ratio may reduce long-run growth, and thus partly (or fully) negate the positive effects of the fiscal stimulus.
Most policymakers do seem to think that debt reduces growth. This view is in line with the results of a growing empirical literature which shows that there is a negative correlation between public debt and economic growth, and finds that this correlation becomes particularly strong when public debt approaches 100% of GDP (Reinhart and Rogoff 2010a, 2010b; Kumar and Woo 2010; Cecchetti et al. 2011).
Debt and growth, what causes what?
Correlation, however, does not imply causation. The link between debt and growth could be driven by the fact that it is low economic growth that leads to high levels of public debt (Krugman 2010).1 Establishing the presence of a causal link going from debt to growth requires finding what economists call an ‘instrumental variable’.2
In a new paper (Panizza and Presbitero 2012), we propose a novel instrument variable that allows us to reject the notion that debt causes slower growth in OECD countries. We do confirm the oft-noted negative correlation between debt and growth, but show that debt does not have a causal effect on growth (see Figures 8 and 9 in our paper). The discussion of the instrument is somewhat technical, so we omit it here; interested readers can find all the details in Section 2 of our paper.
To answer the question "Do high levels of public debt reduce economic growth?" we follow the econometric procedure of trying to reject the proposition that “debt has no growth effects”. Our research shows that this proposition cannot be rejected, so it may well be that it is true. We cannot, however, be sure. Think of a murder trial where the jury finds the man has not been proven guilty “beyond a reasonable doubt”. This certainly suggests that he is innocent, but establishing innocence is not what the trial was about, so technically, we cannot claim that the jury declared him innocent.
Indeed, none of the papers in the literature on debt-growth links can make a strong claim the debt has a causal effect on economic growth.
In this light, we refer readers back to Mark Twain’s wisdom. There is a value in assessing the degree of our economic ignorance.
Policy implications: Responsible fiscal stance and lenders of last resort
We believe that our findings are important for the current debate on fiscal policy (see the Vox Debate started by Corsetti 2012). There might be many good (or bad) reasons for fiscal austerity, even during recessions. We do not want to enter that debate here. However, we do not find any evidence that high public debt hurts future growth in advanced economies. Therefore, given the state of our current knowledge, we believe that the debt-growth link should not be used as an argument in support of fiscal consolidation.
The fact that we do not find a negative effect of debt on growth does not mean that countries can sustain any level of debt. There is clearly a level of debt beyond which debt becomes unsustainable, and a debt-to-GDP ratio at which debt overhang, with all its distortionary effects, kicks in. What our results seem to indicate, however, is that the advanced economies in our sample are still below the country-specific threshold at which debt starts having a negative effect on growth.
We believe that there is a subtle channel through which high levels of public debt can have a negative effect on growth. In the presence of multiple equilibria, a fully solvent government with a high level of debt may decide to put in place restrictive fiscal policies aimed at reducing the probability that a change in investors’ sentiments would push the country towards the bad equilibrium. These policies, in turn, may reduce growth (Perotti 2012), especially if implemented during a recession (such policies may even be self-defeating and increase the debt-to-GDP ratio, DeLong and Summers 2012, UNCTAD 2011).3 In this case, it would be true that debt reduces growth, but only because high debt leads to panic and contractionary policies.
While such an interpretation justifies long-term policies aimed at reducing debt levels, it also implies that countries should not implement restrictive policies in the middle of a recession. These policies are the reason for the negative effect of debt on growth. Yet, policymakers under pressure from market participants might not have an alternative. This is why we need prudent fiscal policies and lenders of last resort that can rule out multiple equilibria (De Grauwe 2011).
Our reading of the empirical evidence on the debt-growth link in advanced economies is:
- There are many papers that show that public debt is negatively correlated with economic growth.
- There is no paper that makes a convincing case for a causal link going from debt to growth.
- Our new paper suggests that such a causal link does not exist (more precisely, our paper does not reject the null hypothesis that there is no impact of debt on growth).
We realise that our results are controversial. While we are convinced of the soundness of our findings, we know that sceptical readers will find ways to challenge our identification strategy. However, the first two points are uncontroversial. The case that public debt has causal effect on economic growth still needs to be made.
Cecchetti, Stephen, Madhusudan Mohanty, and Fabrizio Zampolli (2011), "The real effects of debt", BIS Working Papers No. 352, Bank for International Settlements.
Corsetti, Giancarlo (2012), “Has austerity gone too far? ”, VoxEU.org, 2 April.
De Grauwe, Paul (2011), "The European Central Bank as a lender of last resort ", VoxEU.org, 18 August.
DeLong, Bradford J and Lawrence H Summers (2012), "Fiscal Policy in a Depressed Economy", The Brookings Institution.
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.
Panizza, Ugo and Andrea F Presbitero (2012), "Public Debt and Economic Growth: Is There a Causal Effect? ", MoFiR working paper No. 65.
Perotti, Roberto (2012), "The “Austerity Myth" Gain Without Painx?", in Fiscal Policy after the Financial Crisis, NBER Chapters, National Bureau of Economic Research.
Reinhart, Carmen M and Kenneth S Rogoff (2010a), "Debt and Growth Revisited", VoxEU.org, 11 August.
Reinhart, Carmen M and Kenneth S Rogoff (2010b), "Growth in a Time of Debt", American Economic Review: Papers and Proceedings, 100(2):573-578.
UNCTAD (2011), Trade and Development Report 2011, Geneva: United Nations.
1 The observed correlation between debt and growth could also be due to a third factor that has a joint effect on these two variables.
2 This is something that is correlated with the debt, but uncorrelated with the random errors in the economic linkage between growth and debt.
3 We do not find evidence of such a channel because before the creation of the euro most OECD countries could rule out multiple equilibria by using their own central banks as lenders of last resort.