Public Debt and Growth

Discover how initial government debt impacts subsequent economic growth in advanced and emerging economies

The United States now carries an unprecedented level of government debt approximately $38.15 trillion. Wow. That number is staggering. In 2024, for the first time, federal interest payments even exceeded military spending. I was shocked to learn that this amounts to about $111,000 per person in the U.S. Is this path sustainable? Is the United States also beginning its own “lost 30 years,” like Japan? These concerns raise a fundamental question: what is the real cost of high government debt?

Paper reviewed: Kumar, Manmohan and Woo, Jaejoon, Public Debt and Growth (July 2010). IMF Working Paper No. 10/174, Available at SSRN: https://ssrn.com/abstract=1653188

Summary

Government debt can be devastating for countries, sometimes even leading to defaults such as Russia’s in the late 1990s. This study reveals a significant inverse relationship between initial government debt and subsequent economic growth, with high debt levels hindering labor productivity growth and investment. The findings have crucial implications for businesses and policymakers.

Key Findings

The study found an inverse relationship between initial government debt and subsequent economic growth in a panel of advanced and emerging economies over nearly four decades.
A 10 percentage point increase in the initial debt-to-GDP ratio is associated with a slowdown in annual real per capita GDP growth of around 0.2 percentage points per year.
The impact of debt on growth is somewhat smaller in advanced economies compared to emerging economies.
High levels of initial debt (above 90% of GDP) have a proportionately larger negative effect on subsequent growth.
The adverse effect of debt on growth largely reflects a slowdown in labor productivity growth, mainly due to reduced investment and slower growth of capital stock.

Implications

Business and Policy Implications

Businesses and policymakers should be aware that high government debt can have long-term negative effects on economic growth.
Fiscal policymakers should aim to reduce debt to sustainable levels to promote economic growth.
Emerging economies should be particularly cautious about high debt levels due to their potentially larger negative impact on growth.
Companies and investors should consider the level of government debt when making investment decisions, as high debt can lead to reduced economic growth and increased uncertainty.

Introduction

Governments can default on their debt, as Russia did in the late 1990s. Long-Term Capital Management never expected that a major country could fail, and this miscalculation contributed to its collapse. The global economic and financial crisis has led to a sharp increase in sovereign debts in advanced economies, raising concerns about fiscal sustainability and broader economic impacts. A key issue is the extent to which large public debts affect capital accumulation, productivity, and economic growth. This paper explores the impact of high public debt on long-run economic growth, examining a panel of advanced and emerging economies over almost four decades.

Background and Context

The conventional view is that government debt can stimulate aggregate demand in the short run but may crowd out capital and reduce output in the long run. High public debt can adversely affect growth through various channels, including higher long-term interest rates, higher future distortionary taxation, inflation, and greater uncertainty. Despite these considerations, there is limited systematic analysis of the impact of high public debt on GDP growth in advanced economies. Previous studies have primarily focused on the impact of external debt on growth in developing economies.

Relevant Industry/Field Context

The study is set against the backdrop of a significant increase in government debt in many countries following the global financial crisis. Understanding the relationship between government debt and economic growth is crucial for policymakers aiming to promote sustainable economic growth and stability.

Previous Research or Current State of Knowledge

Previous research has explored the determinants of long-term economic growth and the impact of external debt on growth, particularly in low-income countries. However, there is a gap in the literature regarding the impact of high public debt on growth in advanced economies.

Why This Research is Needed

This research is necessary to fill the gap in understanding how high public debt levels affect economic growth in both advanced and emerging economies. The findings can inform fiscal policy decisions and help policymakers manage debt levels to promote economic growth.

The analysis begins with a comprehensive examination of the relationship between initial government debt and subsequent economic growth, controlling for other determinants of growth. The study utilizes a variety of econometric techniques and pays particular attention to estimation issues such as reverse causality, endogeneity, and outliers. The results suggest that high initial debt is associated with slower economic growth, with a more significant impact in emerging economies. The adverse effect on growth is primarily due to reduced investment and slower capital stock growth.

The study's findings have important implications for businesses and policymakers. High government debt can have long-term negative effects on economic growth, and reducing debt to sustainable levels is crucial for promoting growth. Emerging economies, in particular, should be cautious about high debt levels due to their potentially larger negative impact on growth. Companies and investors should also consider government debt levels when making investment decisions.

The remainder of this part has set the stage for a detailed discussion of the empirical analysis and findings. The next part will delve into the specifics of the econometric analysis, exploring the channels through which government debt influences growth and discussing the robustness of the results.

Main Results

The study's empirical analysis is based on a panel of 38 advanced and emerging economies over the period 1970-2007. The results suggest an inverse relationship between initial debt and subsequent growth, controlling for other determinants of growth.

Baseline Regression Results

The baseline panel regression results are presented in Table 1. The coefficients of initial debt are negative and significant at the 1% level across various estimation techniques, including between estimator (BE), pooled OLS, fixed effects (FE), and system GMM (SGMM). The BE regression suggests that a 10 percentage point increase in initial debt-to-GDP ratio is associated with a slowdown in subsequent growth in real GDP per capita of around 0.26% per year.

Robustness Checks

The study conducts various robustness checks to ensure the results are not driven by specific samples or time periods. The results remain robust when restricting the sample to the period 1990-2007 or when including additional countries without the population size restriction.

Nonlinearities and Differences between Advanced and Emerging Economies

The study explores potential nonlinearities in the debt-growth relationship and differences between advanced and emerging economies. The results suggest that high debt levels (above 90% of GDP) have a disproportionately larger negative effect on growth. The negative effect of initial debt on growth is also found to be larger in emerging economies than in advanced economies.

Methodology Insights

The study employs a range of econometric techniques, including BE, pooled OLS, FE, and SGMM, to address various estimation issues. The SGMM estimator is used to address endogeneity concerns, and the results are found to be robust to different estimation techniques.

The use of initial debt levels helps to mitigate reverse causality concerns, as it is less likely that subsequent growth would affect initial debt levels. However, the study acknowledges that endogeneity may still be a concern if third variables jointly determine both debt and growth.

Analysis and Interpretation

The findings suggest that high government debt can have significant negative effects on economic growth, particularly in emerging economies. The results imply that a 10 percentage point increase in initial debt-to-GDP ratio is associated with a decline in real GDP per capita growth of around 0.2% per year.

The study's growth accounting exercise suggests that the adverse effects of initial debt on growth largely reflect a slowdown in labor productivity growth, mainly due to reduced investment and slower growth of capital per worker.

Implications for Businesses and Policymakers

Companies and investors should also consider government debt levels when making investment decisions, as high debt levels can increase uncertainty and reduce economic growth. Policymakers should prioritize fiscal discipline and debt reduction to promote sustainable economic growth.

The results also suggest that policymakers should be cautious about the potential nonlinear effects of high debt levels on growth. The findings imply that debt levels above 90% of GDP can have disproportionately larger negative effects on growth, highlighting the need for prudent fiscal management.

Overall, the study's findings emphasize the importance of maintaining sustainable government debt levels to promote economic growth and stability.

Practical Implications

The findings of this study have significant practical implications for businesses, investors, and policymakers. The inverse relationship between initial debt and subsequent growth suggests that high government debt levels can have a negative impact on economic growth.

Real-World Applications

Businesses and investors should consider government debt levels when making investment decisions, as high debt levels can increase uncertainty and reduce economic growth.
Policymakers should prioritize fiscal discipline and debt reduction to promote sustainable economic growth.

Strategic Implications

Companies should be cautious about investing in countries with high government debt levels, as this can increase the risk of reduced economic growth and decreased returns on investment.
Policymakers should implement policies that promote fiscal sustainability and reduce debt levels to create a more favorable business environment.

Who Should Care

Businesses and investors: High government debt levels can increase uncertainty and reduce economic growth, making it essential to consider debt levels when making investment decisions.
Policymakers: Prioritizing fiscal discipline and debt reduction is crucial to promote sustainable economic growth and create a favorable business environment.

Actionable Recommendations

Specific Actions

Reduce debt levels: Policymakers should prioritize debt reduction to promote sustainable economic growth.
Implement fiscal discipline: Governments should implement policies that promote fiscal sustainability and reduce debt levels.
Monitor debt levels: Businesses and investors should closely monitor government debt levels when making investment decisions.

Implementation Considerations

Gradual debt reduction: Policymakers should aim to reduce debt levels gradually to avoid sudden economic shocks.
Fiscal policy reforms: Governments should implement fiscal policy reforms that promote sustainability and reduce debt levels.
Investment diversification: Businesses and investors should consider diversifying their investments to minimize the impact of high government debt levels.

Conclusion

Main Takeaways

High government debt levels can have a negative impact on economic growth.
Policymakers should prioritize fiscal discipline and debt reduction to promote sustainable economic growth.
Businesses and investors should consider government debt levels when making investment decisions.

Final Thoughts

The study's findings emphasize the importance of maintaining sustainable government debt levels to promote economic growth and stability. By prioritizing fiscal discipline and debt reduction, policymakers can create a more favorable business environment and promote sustainable economic growth. Businesses and investors should remain cautious about investing in countries with high government debt levels and consider diversifying their investments to minimize risk.

The results of this study are based on a comprehensive analysis of the relationship between government debt and economic growth, using a panel of advanced and emerging economies over the period 1970-2007. The findings suggest that a 10 percentage point increase in the initial debt-to-GDP ratio is associated with a slowdown in annual real per capita GDP growth of around 0.2 percentage points per year. The impact is smaller in advanced economies, around 0.15 percentage points. The study also finds evidence of nonlinearity, with high (above 90% of GDP) levels of debt having a significant negative effect on growth.

The adverse effect of high debt on growth largely reflects a slowdown in labor productivity growth, mainly due to reduced investment and slower growth of the capital stock per worker. On average, a 10 percentage point increase in initial debt is associated with a decline of investment by about 0.4 percentage points of GDP, with a larger impact in emerging economies. Various robustness checks yield largely similar results, underlining the need to take measures to not just stabilize public debts but to place them on a downward trajectory in the medium and long term.

Overall, the study's findings have significant implications for policymakers, businesses, and investors, highlighting the importance of maintaining sustainable government debt levels to promote economic growth and stability.