consolidation.The literature, in particular the empirical part, on the relationship between government debtand economic growth is scarce. The theoretical literature tends to point to a negativerelationship. The empirical evidence is primarily focused on the impact of external debt ongrowth in developing countries, while for the euro area, several studies analyse the impact offiscal variables, including government debt, on long-term interest rates or spreads against abenchmark, as an indirect channel affecting economic growth.This paper investigates the average relationship between the government debt-to-GDP ratioand the per-capita GDP growth rate in a sample of 12 euro area countries (Austria, Belgium,Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal, andSpain) for a period of roughly four decades starting in 1970.The basic empirical growth model is based on a conditional convergence equation that relatesthe GDP per capita growth rate to the initial level of income per capita, theinvestment/saving-to-GDP rate and population growth rate. The model is augmented toinclude the level of gross government debt (as a share of GDP). The basic estimationtechnique is panel fixed-effects corrected for heteroskedasticity and autocorrelation. Giventhe strong potential for endogeneity of the debt variable, especially reverse causation (low ornegative growth rates of per-capita GDP are likely to induce higher debt burdens), we alsouse various instrumental variable estimation techniques. In addition, we find that the resultsremain robust when cyclical fluctuations in the dependent variable are eliminated by usingthe growth rate of potential or trend GDP.The results across all models show a highly statistically significant non-linear relationshipbetween the government debt ratio and per-capita GDP growth for the 12 pooled euro areaECBWorking Paper Series No 1237August 20105countries included in our sample. The debt-to-GDP turning point of this concave relationship(inverted U-shape) is roughly between 90 and 100% on average for the sample, across allmodels (the threshold for the models using trend GDP is somewhat lower). This means that,on average for the 12-euro area countries, government debt-to-GDP ratios above suchthreshold would have a negative effect on economic growth. Confidence intervals for thedebt turning point suggest that the negative growth effect of high debt may start already fromlevels of around 70-80% of GDP, which calls for even more prudent indebtedness policies.We also find evidence that the annual change of the public debt ratio and the budget deficit-to-GDP ratio are negatively and linearly associated with per-capita GDP growth.The channels through which government debt (level or change) is found to have an impact onthe economic growth rate are: (i) private saving; (ii) public investment; (iii) total factorproductivity (TFP) and (iv) sovereign long-term nominal and real interest rates. For the firstthree channels – private saving, public investment and TFP – a non-linear (concave)relationship also predominates across the various models used. As regards the channel oflong-term sovereign interest rates, a strong and robust impact on nominal, as well as real,interest rates is found to come from the change in the debt ratio (first difference) and fromthe primary budget balance ratio. The level of the public debt ratio (in either linear orquadratic forms) is not found to be significant on average in determining long-term interestrates in our sample. The change in the public debt ratio and the primary budget balance proveto be highly statistically significant and remain robust even after controlling for short-terminterest rates as a proxy for monetary policy effects.Overall, a robust conclusion of our paper is that above a 90-100% of GDP threshold, publicdebt is, on average, harmful for growth in our sample. The question remains whether publicdebt is indeed associated with higher growth below this turning point. The additionalevidence in this analysis, i.e. that (i) the debt turning points for the first two channels (privatesaving and public investment) seem to be much below the range of 90-100%; (ii) governmentbudget deficits and the change in the debt ratio are found to be linearly and negativelyassociated with growth (and the long-term interest rates), may point to a more detrimentalimpact of the public debt stock even below the threshold.6ECBWorking Paper Series No 1237August 2010The view is sometimes expressed [Professor Aba P. Lerner and Professor Domar] that adomestic national debt means merely that citizens as potential taxpayers are indebted tothemselves as holders of government debt, and that it can, therefore, have little effect uponthe economy […]. It is my purpose to refute this argument [and] to show that, quite apartfrom any distributional effects, a domestic debt may have far-reaching effects uponincentives to work, save, and to take risks.J.E. Meade (1958), Oxford Economic Papers1.IntroductionGovernment debt rose considerably over the past decades and this trend was generallyaccompanied by an expansion in the size of governments. For many industrial countries, thegrowth of general government expenditure was enormous in the 20 th century. As shown inTanzi and Schuknecht (1997), the average size of government for a group of thirteenindustrial countries 4 increased from 12% of GDP in 1913 to 43% of GDP in 1990. At the endof the period, average public debt-to-GDP ratio was 79% for the big governments, 60% formedium-seized governments and 53% for small governments. 5The manner in which debt builds up can be important from the perspective of its economicimpact, as well as of the subsequent exit strategy. Reinhart and Rogoff (2010) argue that wardebts may be less problematic for future growth partly because the high war-timegovernment spending comes to a halt as peace returns, while peacetime debt explosions maypersistent for longer periods of time.Before the 20 th century, the accumulation of government debt was in general slow andoccurred mainly in relation to wars. According to the Encyclopaedia Britannica, the nationaldebt of England was initiated to finance the British participation in the war of the GrandAlliance with France during 1689-1697. In the United States, the newly-formed federalgovernment assumed the debts of the states incurred during the American Revolution, all ofwhich were pooled into a single debt issue in 1790. Government debt, especially at locallevels, was contracted to a smaller extent also for other purposes. According to the samesource, government borrowing in its modern form first occurred in medieval Genoa andVenice when the city governments borrowed on a commercial basis from the newly45Australia, Austria, Canada, France, Germany, Ireland, Japan, New Zeeland, Norway, Sweden, Switzerland, UnitedKingdom and United States.Where big governments are defined as those with public expenditure-to-GDP ratio higher than 50%; medium-sizedgovernments: between 40-50% and small governments: less than 40


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