CAN EXCESSIVE PUBLIC DEBT REDUCE ECONOMIC GROWTH

CAN EXCESSIVE PUBLIC DEBT REDUCE ECONOMIC GROWTH? January 2020 Università Degli Studi di Bergamo Obed Jojo Ahiati 1 Contents Can Excessive Public Debt Reduce Economic Growth? ................................................1 Introduction. ..............................................................................................................1 The Impact of The Global Financial Crisis on Public Debt.............................................2 Relationship Between High Public Debt Levels, Economic Growth and Inflation. ........4 Debt, Growth and Inflation in Advanced economies ...............................................6 Debt, Growth and Inflation in Emerging market economies ....................................8 Conclusion ..................................................................................................................9 References ..................................................................................................................9 Can Excessive Public Debt Reduce Economic Growth? Introduction. No individual wants to be in debt but in the case where a person’s expenses exceeds his/her income, then there is a high propensity to borrow. When the topic of public debt is mentioned, it is of much concern to a nation because it has a lot to do with taxpayers and can have a lasting effect on future generations and future of economic expectations. The financial crisis of 20071 had plunged many great economies in the world into economic recession with many suggesting that writing-down subprime debts would have been the best approach to resolve the crisis although difficult to do, however, countries and regions that are very successful ay emerging from financial crises have debt write-downs. The conventional view is that having higher public debt-to-GDP can stimulate aggregate demand and output in the short run but crowds out private capital spending and reduces output in the long run. 2 According to a historical analysis of Reinhart and Rogoff (2009, 2010)3 for 44 countries, for the past 200 years, the relationship between public debt and real GDP growth is characterized by strong nonlinearities. This paper is based on the impact of public debt on economic growth, and whether a debt ratio is harmful for growth of a country. 1 Which may have begun in the USA banking sector but trickled down to give way to the deepest global recession since the great depression. 2 (Alexander, Kamiar, Hashem, & Mehdi, 2015) 3 (Carmen & Keneth, 2010) The Impact of The Global Financial Crisis on Public Debt Public debt or sovereign debt how much a country owes its lenders who are mostly other governments, businesses or sometimes individuals. Regardless of how it is called, public debt is simply the accumulation of budget deficits. The management of this debt is one of the most important tasks of the economic policies of any sovereign state/ country. The topic of public debt cannot be mentioned without the global financial crisis of 2008/9 looking at its impact in the global economy since the oil price shocks in the 1970s. This crisis posed a serious threat to the global financial sector when the sector was on a brink of total collapse. The system was ultimately saved by the economically developed countries by taking over the debts of their private banks and then revive their economies. Bailing out of financial institutions in the various countries resulted in significant deterioration of the pubic deficits in these countries and this increased public debt. Although debt in general is not of a positive economic value, sovereign debts help to accumulate physical capital in the long run when interest rates are low; however, it can avert capital accumulation when interest rates increase. If there is a need to use a large share of current revenues to fund interest payments on the debt, fiscal policy will be limited. The average level of gross public debt of OECD countries in 2015 reached 112% of GDP, from 73% before the financial crisis in 2007.4 During this period, Spain recorded the highest gross debt (75. 1 p.p),5 Slovenia (73 p.p), Portugal (711.1 p.p) and Greece (68.8 p.p). while the OECD countries with the lowest levels of public debt were Estonia (13%, Chile (24.5%) and Luxembourg (30.7%). According to Fig 1 shown below, OECD countries recorded general government debt as percentage of GDP of 72.86 in 2007, 78.86 in 2009 and 111.97 in 2015, this trend showed a much less difference between 2007 and 2009 (before and after the financial crisis) and the increase in government debt in 2015. In the EU-27 the government debt-to-GDP ratio increased from 80.0% at the end of 2010 to 82.5% at the end of 2011, and in the euro area from 85.3% to 87.2%. A total of 14 Member States reported a debt ratio above 60% of GDP in 2011. At the end of 2011, the lowest ratios of government debt-to-GDP were recorded in Estonia (6.0%), Bulgaria (16.3%) and Luxembourg (18.2%) (Eurostat, 2012)6. Government debt-to-GDP ratios shot up to levels higher than the 60% of GDP at the end of 2010 of the upper limit criteria stipulated by the Maastricht. In 2011, government debt-to-GDP ratios increased for 21 EU Member States when compared with 2010, while government debt ratios decreased for six Member States: Germany, Estonia, Latvia, Luxembourg, Hungary and Sweden. The highest increases of debt ratios from 2010 to 2011 were observed in Greece (20.4 percentage points), Ireland (15.7 points), Portugal (14.4 points) and Cyprus (10.2 points). 4 (OECD, 2017) P.P = percentage point is the difference between two percentages. 6 Source: Eurostat yearbook 2012: Economy and finance - See figure 2 5 Fig 1 General government gross debt as a percentage of GDP, 2007, 2009, 2015 and 20167 Fig 2 General government debt, 2010 and 2011 (general government consolidated gross debt, % of GDP)8 Source: OECD. (2017). Government at a Glance. Paris: OECD Publishing.9 8 9 Data extracted on 23.04.2012; note that the y-axis is cut. Retrieved from https://doi.org/10.1787/gov_glance-2017-en. Fig 3 Development of total expenditure and total revenue, 2001-201110 (% of GDP) The graph in fig 3 shows a total government revenue in EU-27 amounting to 44.6% of GDP in 2011 (up from 44.1% in 2010) while expenditure in 2010 amounted up to 50.6% and moved down to 49.1% of GDP in 2011. In all, the euro area generated a total of 49.4% of GDP in expenditure in 2011 while accumulating a total revenue of 45.3% of GDP. Relationship Between High Public Debt Levels, Economic Growth and Inflation. While the relationship between economic growth, inflation and public debt is weak. Which is to say that public debt however does not have a linear correlation with economic growth and equally no systematic relationship between high debt levels and inflation for advanced economies as a group.11 But in comparison, high public debt levels coincide with higher inflation for emerging markets according to (Reinhart & Rogoff, 2010). According to (Reinhart, Rogoff, & Savastano, 2003), the non-linear effect of debt on growth is comparable with “debt intolerance”12 and presumably is related to a non linear response of market 10 11 Data extracted on 23.04.2012; note that the y-axis is cut. (Reinhart & Rogoff, 2010) Debt intolerance: is a term coined by Carmen Reinhart, Kenneth Rogoff and Miguel Savastano referring to the inability of emerging markets to manage levels of external debt that, under the same circumstances, would be manageable for developed countries, making a direct analogy to lactose-intolerant individuals. 12 interest rates as countries reach debt tolerance limit. And so for this purpose, I will analyze the relationship between public debt and economic growth in both advanced economies and also in emerging economies without touching the genesis of these debts but the influence it has on economic growth based on (Reinhart & Rogoff, 2010)’s findings. Fig 4 Cumulative Increase in Real Public Debt; 2007-2009 for Selected Countries. Source: (Reinhart & Rogoff, 2010) Fig4 indicates the increase in public debt13 that has occurred between 2007 and 2009. For the first five countries14 with systemic financial crises, their average debt at the end of the period summed up to 75 per cent. While countries that did not experience a major financial crisis, debt rose to about 20% in real terms. The general increase in public debts between 2003-2006 can be attributed to the direct bailout by the governments of the various countries to mitigate the shortfalls of the global recessions in countries that saw the decline in government revenues. Rising interest rates force fiscal adjustments to be made which can translate into higher taxes and subsequent reduction in spending. We can also conclude that unanticipated high inflation can reduce the real cost of debt servicing because “the efficacy of the inflation channel is quite sensitive to the maturity structure of the debt.”15 13 Inflation adjusted. Iceland, Ireland, Spain, the United Kingdom, and the United States. 15 See (Reinhart & Rogoff, 2010) 14 Debt, Growth and Inflation in Advanced economies16 Fig 5. Government Debt, Growth, and Inflation: Selected Advanced Economies, 1946–2009 Source: (Reinhart & Rogoff, 2010). Fig 5 summarizes inflation and GDP growth across 20 countries17 (of which 1,186 annual observations were looked at)18 with varying levels of debt between the periods of 19462009. This group includes Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Japan, Netherlands, New Zealand, Norway, Portugal, Spain, Sweden, the United Kingdom, and the United States. The observations are grouped into four categories, according to the ratio of debt to GDP levels during that particular year as follows: years when debt to GDP levels were below 30 per cent (low debt); years when debt to GDP was 30-60 percent (medium debt), years when debt to GDP level was 60-90 per cent (high debt); and the years when GDP was above 90 per cent (very high). From this graph, it is evident that there is no related link between public debt and growth except for the when public debt reaches the 90 per cent threshold. The line in the fig 5 shows the median inflation for the different groupings and this further point out that there is no simultaneous pattern in the level of inflation and public debt. Table 1 shows the growth experiences for the 20 countries for between one to two centuries and with the longer time series analysis, similar conclusion could be drawn. “Over the past two centuries, debt in excess of 90 percent has typically been associated with mean growth of 1.7 percent versus 3.7 percent when debt is low (under 30 percent of GDP), and compared 16 Figures and graphs are from (Reinhart & Rogoff, 2010) This group includes Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Japan, Netherlands, New Zealand, Norway, Portugal, Spain, Sweden, the United Kingdom, and the United States. 18 Refer to table 1 below. 17 with growth rates of over 3 percent for the two middle categories (debt between 30 and 90 percent of GDP). Of course, there is considerable variation across the countries, with some countries such as Australia and New Zealand experiencing no growth deterioration at very high debt levels.” (Reinhart & Rogoff, 2010) Table 1 Real GDP Growth as the Level of Government Debt Varies: Selected Advanced Economies, 1790–2009 (annual percent change)19 Source: (Reinhart & Rogoff, 2010) 19 An n.a. denotes no observations were recorded for that particular debt range. There are missing observations, most notably during World War I and II years; further details are provided in the data appendices to Reinhart and Rogoff (2009b) and are available from Reinhart and Rogoff. Minimum and maximum values for each debt range are shown in bolded italics. Sources: International Monetary Fund, World Economic Outlook, OECD, World Bank, Global Development Finance. Extensive other sources are cited in Reinhart and Rogoff (2009). Debt, Growth and Inflation in Emerging market economies20 The same exercise was conducted by Reinhart and Rogoff21 for 24 emerging markets between 19462009 and 1900-2009 using comparable central government debt to those used for the advanced economies. The result is similar to the computation of those of the advanced economies22 with median and average GDP growth around 4.5 per cent for levels below 90% of GDP but median records a fall to 2.9% for high debts, and a further decline in average growth rate to 1%. However higher debt levels in emerging economies translates into significant increase in the level of inflation. Fig 6. External Debt, Growth, and Inflation: Selected Emerging Markets, 1970-2009 In Fig 6 highlights Reinhart & Rogoff highlights the connection between gross external debt as reported by World Bank and growth and inflation where it can be seen that, the growth thresholds for external debt are considerably lower than the thresholds for total public debt. And so economic growth exercebates as exteral debt levels over 60%, and further when the external debt levels exceed 90% with outright decline records. Therefore inflation becomes significantly higher only for groups of observations with external debt over 90%. 20 Based on findings from (Reinhart & Rogoff, 2010) In their publication in 2010 (Growth in time of Debt) 22 Refer to the NBER working paper version of (Reinhart & Rogoff, 2010) for the computation on the merging economies. It is not reproduced here because of the number of pages limit. 21 Conclusion Based on the findings of both Reinhart & Rogoff, (2010) and Gómez-Puig & Sosvilla-Rivero, (2015)23, there is no is no concrete case of causal bi-directional relationship between public debt and economic growth. However, much lower levels of external debt to GDP (60percent) are associated with adverse outcomes for merging market growth. Referring to the phenomenon developed by Reinhart, Rogoff, and Savastano (2003), the non linear response of growth to debt as debt grows towards historical boundaries is reminiscent of “debt intolerance”. References Alexander, C., Kamiar, M., Hashem, P. M., & Mehdi, R. (2015). Is There a Debtthreshold Effect on Output Growth? IMF working paper. Carmen, R. M., & Keneth, S. R. (2010). Growth in a Time of Debt. DUDÁŠ, T. (2013). The Impact of The Global Economic Crisis On The Public Finances of Central And Eastern European Countries. Eurostat. (2012). Eurostat Yearbook 2012: Economy and finance. Retrieved from https://ec.europa.eu/eurostat/documents/3217494/5760673/CH_01_2012EN.PDF/e0fa80e9-efa5-42ed-b41a-795e194dca04 Gómez-Puig, M., & Sosvilla-Rivero, S. (2015). Causal Relationship Between Debt and Growth in EMU Countries. Journal of Policy Modeling. Kenneth, R., & Chainey, R. (2019). Agenda: An economist Explains What Happens If There’s Another Financial Crisis. Retrieved from World Economi Forum: https://www.weforum.org/agenda/2019/04/an-economist-explains-whathappens-if-there-s-another-financial-crisis/ OECD. (2017). Government at a Glance. Paris: OECD Publishing. Retrieved from https://doi.org/10.1787/gov_glance-2017-en. 23 Much reference is not made to their analysis in this report – it focuses on only EMU countries. Reinhart, C. M., & Rogoff, K. S. (2010). Growth in a Time of Debt. American Economic Review: Papers & Proceedings 100. Reinhart, C. M., Rogoff, K. S., & Savastano, M. A. (2003). Debt Intolerance. NBER Woerking Paper Series. Villaume, S., & Tokofai, A. (2008). Structure of Government Debt In Europe. EUROSTAT.