A relationship between external public debt and economic growth
On the Causal Relationship between Public. Debt and GDP Growth Rates in Panel Data. Models. Josip Tica [email protected] Faculty of Economics and Business . We hear a lot in the media about debt/GDP ratios and how the rise and fall of them is an indicator of a country's economic health. In particular in. But what is the relation between debt and long term growth? And, is there when that ratio (externally held government debt to national GDP) hits 60%. Growth.
Since the reduction of public debt is being done at the expense of private citizens and economic growth, it's actually a completely rational reaction by citizens and bond holders to run for the hills as a country attempts to cut its deficit through cuts to its programs. It's just as rational as it is for corporate bond holders to raise rates on a company that is shutting down its offices and plants.
Noahpinion: How can debt affect GDP?
No one wants to lend to a sinking ship even if that ship is shedding weight. If a company or an individual is in debt, they can easily reduce that debt by reining in their spending because the spending is not directly related to their income. This means that if John Smith spends less, this does not affect how much John Smiths employer pays him.Former Treasury Staffer: US Debt-to-GDP Doesn't Matter (But Greece's Does)
If a company spends less, it may or may not affect its income depending on whether that spending was generating immediate income. However, if a government cuts its spending in an economy where unemployment is high, it is directly and immediately affecting the country GDP and in-turn its own revenues. In the US right now, that velocity is 1. Why do I say "at least"? It is not even economics, it's just simple mathematics. Now of course if the economy was strong and employers were having difficulty finding people to take jobs, any reduction in spending by the government would be quickly offset by hiring in the private sector.
The Relationship Of The Debt/GDP Ratio And Economic Growth | Seeking Alpha
However, somehow I don't think the argument from the deficit hawks is that the economy is growing too strongly and the unemployment is too low. Companies are not exactly starved for job applicants and the job market is anything but tight.
The most likely effect of the cuts to public spending is to simply add those people cut to the already large waiting line in the unemployment offices. To be fair, a closer look at US employment figures over the past few years reveals that while government spending cuts have been devastating to overall employment figures, they have been offset by a surprisingly strong private sector. This is not to say the private sector is firing on all cylinders, but it is certainly doing far more good for the economy then the currently popular government policies of deficit fighting.
This article here shows just how much a drag the government has been during this recovery as compared with other recoveries, though I disagree with the author that more spending is not necessary. In fact, it's very likely that without the deficit cutting measures enacted in so many countries all at once, and if government spending in the US was maintained at the same level as in previous recoveries, we would have a solid recovery underway already.
From an investment perspective, it is very important to understand this difference since it shows that the great US economic engine is anything but dead.
The Relationship Of The Debt/GDP Ratio And Economic Growth
The private sector is doing a great job thus far in the recovery, which is driving the profit and stock market price increases, but it needs the government to at minimum maintain if not outright grow. Therefore, the investment rate rises in the first scenario, before falling in the second and third scenarios. Thus, the relationship between external debt and investment and growth is non-linear. In addition, Cohen concludes that the third scenario would correspond to the concept of debt overhang, where external debt acts as a tax on investment, hurting economic growth.
Moreover, Saint-Paul shows an endogenous growth model with overlapping generations, where an increase in public debt reduces the growth rate of the economy.
Adam and Bevan develop a model of endogenous growth with individuals who live two periods. They study various ways to finance public deficits.
An increase in domestic public debt slows growth, while an increase in external public debt, financed in concessional terms, but rationed, helps growth. Aizenman, Kletzer and Pinto show a model of endogenous growth with restrictions in tax revenues and public debt.
In general, they find that the higher the public debt the lower the growth. Finally, Checherita-Westphal, Hallett and Rother present a growth model with public capital and debt, where the public deficit is equal to public investment.
In their model, the relationship between debt and growth is nonlinear. So, in the steady state, the optimal debt to GDP ratio can be determined where growth is maximized. In order to study the relationship between external public debt and economic growth, this article presents an endogenous growth model for a small open economy.
The economy produces two goods, tradable manufacturing and non-tradable non-manufacturing. The tradable sector produces domestic technological knowledge through learning by doing Romer, This knowledge is used in the non-tradable good sector. Therefore, in this model there are two learning externalities. The foreign lenders perceive a country risk that depends positively on the level of external public debt.
More-over, the government collects taxes through another lump-sum tax on households to finance the purchase of non-tradable goods. Households consume a constant fraction of their disposable income, and own the two types of capital. They can borrow abroad, subject to a foreign credit constraint. In this article, country risk is fully transferred to the private sector.
I study how the economy responds, in the steady state, to an increase in the proportion of external public debt to GDP and I obtain a nonlinear relationship between the ratio of external public debt to GDP and the growth rate.
That is, my results show an inverted U-shaped curve connecting external public debt and economic growth. This nonlinearity is the result of two opposite effects on the growth rate of the economy when the proportion of external public debt to GDP increases. The positive effect is as follows: Therefore, the proportion of labor employed in the manufacturing sector increases and the ratio of non-tradable to tradable capital diminishes, increasing the growth rate of the economy.
The negative effect is as follows: Therefore, household disposable income falls, the proportion of savings to GDP declines and resources for capital accumulation decrease, thus the growth rate of the economy decreases. At a high external public debt to GDP ratio, the economic growth that is stimulated by the depreciation of the real exchange rate and the attraction of resources towards the tradable sector, is offset by the exit of resources to the exterior due to the burden of external debtand the consequent decrease in the savings to GDP ratio.
The results of this paper are related to Cohen and Checherita-Westphal, Hallett and Rotherwhere nonlinear relationships between debt and growth are also presented, although in their models, the external debt affects economic growth through different channels than those presented here.
The result that public spending on tradable goods leads to a depreciation of the real exchange rate, stimulating the tradable sector, is related, inversely, with Korinek and Serven They affirm that the accumulation of international reserves the extension of credit to foreigners for the purchase of domestic tradable goods leads to a depreciation of the real exchange rate, stimulating the tradable sector and triggering the desired learning effects.
The results I obtained for an economy with endogenous growth, with two goods, two learning externalities, where the external public debt acts positively and negatively on economic growth, are not present in the literature and contribute to a better understanding of the relationship between external public debt and economic growth.
Moreover, the existence of a maximum level of external public debt means that those responsible for public finances should be prudent in handling external public debt, to avoid high debt levels and prevent the kind of situations that occurred in Latin America in the s and in the European periphery in recent years.
In the empirical literature, there is evidence showing the existence of this non-linearity between public debt and growth, for both developing and developed countries. Thus, Pattillo, Poirson and Riccistudy the contribution of the proportion of external debt to GDP to the growth of per capita GDP for 93 developing countries between the years They find that the contribution of external debt current net value on growth is nonlinear, in the form of an inverted U.
The negative impact of the high level of external debt on growth operates through adverse effects on the formation of physical capital and total factor productivity see Pattillo, Poirson and Ricci Analyzing 55 low-income countries between the years toClements, Bhattacharya and Nguyen argue that the servicing of external debt negatively affects public investment and, indirectly, growth.
Similarly, Caner, Grennes and Koehler-Geib determine the critical level, where an increase in average public debt ratio to GDP decreases the average annual growth for developed and developing countries between the years They conclude that for the total sample of countries, the threshold stands at Also, Checherita-Westphal and Rother show that the relation between public debt to GDP ratio and growth in per capita income has an inverted U shape, for a sample of 12 countries in the euro area, with data since