At a time when many EU governments have implemented harsh austerity budgets in the face of the euro area sovereign debt crisis despite a slow recovery in the aftermath of the 2007/08 financial crisis, the significance of the relationship between public debt and economic growth has assumed particular policy relevance.
The academic debate has mainly revolved around whether there exists a public indebtedness tipping point beyond which countries carrying high levels of debt experience significant costs in terms of GDP growth, with high levels of public debt thereby assumed to impose a sharp GDP growth penalty. At the core of this debate, is the work by Reinhart and Rogoff (2010) suggesting that countries experience considerable costs in terms of GDP growth if they allow their public debt to rise above 90% of GDP. The significance of these findings cannot be overstated as they have indirectly provided strong empirical backing for the austerity measures implemented in the United States, and even more so in Europe since 2010, particularly insofar as the management of government debt and fiscal policy is concerned.
However, Reinhart and Rogoff’s result of a 90% threshold has not gone unchallenged. Since its publication, a spurt of studies focusing on whether there exists, in fact, a universally valid tipping point in the debt/GDP ratio above which growth prospects are dramatically compromised, has ensued, causing much controversy (see, e.g., Herndon et al., 2013; Égert, 2015).
Adjudication of the debate notwithstanding, even the absence of a specific common threshold beyond which public debt penalises economic growth, of course, would not mean
that countries do not invite trouble by running irresponsible budgets, or that debt levels and economic performance are not statistically correlated. Yet, by focusing on the corroboration or refutation of Reinhart and Rogoff’s findings, much of the subsequent literature has failed to redirect the debate towards the critical question of the direction by which the implicit causality runs, namely, does high public indebtedness cause slower GDP growth or does low GDP growth increase public debt?
Significantly, most related literature follows the assumption that causality runs from debt to growth. The few studies considering the possibility of reverse causality can be counted on one hand (Ferreira, 2009; Di Sanzo and Bella, 2015; Gómez-Puig and Sosvilla-Rivero, 2015; Puente-Ajovín and Sanso-Navarro, 2015).
In a recent paper (De Vita, Trachanas, and Luo, 2018), we contribute to this debate by revisiting the bi-directional causality between debt and growth for the original EMU-11 countries (with the exclusion of Germany, for which consistent data are not available) along with the US, UK and Japan, over a sample period from 1970 to 2014. The analysis accounts for the nonlinear properties of both public debt and GDP growth, and their causal relation in both directions. In addition to conventional linear Granger causality tests and a relevant cointegration method to address endogeneity concerns, we employ state-of-the-art nonlinear techniques on the individual countries’ time series dimension and, unlike any previous study using time series methods, robustness causality tests are performed within a panel SYS-GMM framework that can satisfactorily deal with potential problems stemming from serial correlation, small-sample bias, measurement error and endogeneity.
The results show no robust evidence of long-run causality in most (8) of the countries in the sample, linearly or nonlinearly. The data suggests that the causal relationship between debt and growth, in either direction, is weak at best. Only for Austria bi-directional causality is found (with a stronger effect from growth to debt) while for France, Luxembourg and
Portugal, causality runs solely in the direction of debt to growth, but with very small estimated long-run coefficients. These results survive a wide range of robustness checks.
So how do our findings contribute to theory? And what policy implications flow from them? Effects varying according to country most likely reflect the possibility that the many positive and negative effects postulated theoretically with respect to the potential influence of debt on growth as well as hypotheses advanced in relation to a possible impact of growth on debt levels, assume relative significance and possibly cancel each other out depending on country-specific characteristics. The existence of such postulated effects may also be contingent on possible differences in the structure and composition of the debt across countries, country-specific production technologies, and the way in which different policy-driven regimes across countries may themselves affect the response of one variable to changes in the other.
These caveats notwithstanding, different recommendations are called for depending on the country in question, whether any evidence of causality is in fact present and, if so, its direction and associated sign and magnitude of the long-run coefficient. That said, given our results, any benefits stemming from confronting fiscal imbalances and excessive levels of public indebtedness via harsh austerity programs would appear to be at best marginal and thus unlikely to boost economic growth.
De Vita G., Trachanas E., Luo Y. (2018). Revisiting the bi-directional causality between debt
and growth: Evidence from linear and nonlinear tests. Journal of International Money and
Finance, 83, 55-74. Available at: https://www.sciencedirect.com/science/article/pii/S026156061830069X
Di Sanzo S., Bella M. (2015). Public debt and growth in the euro area: evidence from parametric and nonparametric Granger causality. The B.E. Journal of Macroeconomics 15(2), 631–648.
Égert B. (2015). The 90% public debt threshold: the rise and fall of a stylized fact. Applied
Economics 47(34-35), 3756–3770.
Ferreira C. (2009). Public debt and economic growth: a Granger causality panel data approach. Working Paper no. 24, Technical University of Lisbon: Lisbon.
Gómez-Puig M., Sosvilla-Rivero S. (2015). The causal relationship between debt and
growth in EMU countries. Journal of Policy Modeling 37(6), 974–989.
Herndon T., Ash M., Pollin R. (2013). Does high public debt consistently stifle economic growth? A critique of Reinhart and Rogoff. Cambridge Journal of Economics 38(2), 257–279.
Puente-Ajovín M., Sanso-Navarro M. (2015). Granger causality between debt and growth: evidence from OECD countries. International Review of Economic and Finance 35, 66–77.