New IMF Working Paper: high public debt-to-GDP can limit Growth

Ever since the Reinhart–Rogoff paper in 2010, Growth in a Time of Debt, (mostly Keynesian) economists have been gunning for data to show that public spending and debt is a great way to get out of a recession and put an economy back on its feet.  It’s as if some of us have either forgotten Thatcherism or are afraid to read the history books.  With new research, published by the IMF, we have some findings that will please all on both sides of this argument.

In a new IMF working paper published yesterday, Is There a Debt-threshold Effect on Output Growth?, the authors Alexander Chudik, Kamiar Mohaddes, M. Hashem Pesaran, and Mehdi Raissi find the following:

  • No evidence for a universally applicable threshold effect in the relationship between public debt and economic growth, once we account for the impact of global factors and their spillover effects. 
  • And regardless of the threshold, there are significant negative long-run effects of public debt build-up on output growth. 
  • 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 in the long run.

The first finding speaks critically against the original paper in 2010, and so that paper may now be jettisoned to the history books and study may now start from here.  The authors of this paper explain that the complicating factors, from “feedback effects from GDP growth to debt, and most importantly, error cross-sectional dependencies that exist across countries, due to global factors (including world commodity prices and the stance of global financial cycle) and/or spillover effects from one country to another which tend to magnify at times of financial crises” are missing from the earlier work.  So the original conclusion was that a public debt-to-GDP ratio of over 90% could be a ceiling above which economic growth would be strongly curtailed.  So that’s the end of Reinhart–Rogoff, right?  Wrong.

While the authors state, “[w]e do not find a universally applicable threshold effect in the relationship between debt and growth, for the full sample, when we account for error cross-sectional dependencies”, they go on to say, “Nonetheless, 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. Provided that debt is on a downward path, a country with a high level of debt can grow just as fast as its peers in the long run.”  So there is no absolute threshold, but there is certainly a relationship between high public debt and low growth.

The final conclusion states the following:  “…[I]f the debt level keeps rising persistently, then it will have negative effects on growth in the long run. On the other hand, if the debt-to-GDP ratio rises temporarily (for instance to help smooth out business cycle fluctuations), then there are no long-run negative effects on output growth. The key in debt financing is the reassurance, backed by commitment and action, that the increase in government debt is temporary and will not be a permanent departure from the prevailing norms.”   

I think this is logical and somewhat self evident.  The questions is, what defines ‘temporary’?  All we seem to have discovered here is that there us no absolute threshold of public debt-to-GDP level to avoid; and worse, a level of between 50-60% with the wrong trajectory can damage the opportunities for growth.

The concluding remarks strike a polically correct pose:

“These results suggest that the debt trajectory can have more important consequences for economic growth than the level of debt-to-GDP itself. Moreover, we showed that, regardless of debt thresholds, there is a significant negative long-run relationship between rising debt-to-GDP and economic growth.”  So far, so good.  This makes intuitive sense.  But the next and final sentence is:

“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.”  Over what time frame is this temporary spending and debt maintained?  Who defines ‘credible’ fiscal policy?  The reality, when you relate this topic to real world situations, helps.  If I am short a few dollars for a loaf of bread and a pint of milk, a short term loan from a friend might work out OK.  Taking out a multi-year loan for a degree that is if no use to anyone is quite another matter.  What such public debt is spent on is as politically charged as the level of the debt.  I guess the debates will continue.


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