CFA Institute Journal Review August 2010 Volume 40 Issue 3
Growth in a Time of Debt (Digest Summary)
American Economic Review
The authors investigate the effects of government debt levels on growth and inflation rates. They find that growth rates fall in advanced and emerging market economies when the public debt-to-GDP ratio exceeds 90 percent and that high debt levels are correlated with higher inflation only in emerging markets.
In the wake of the 2007–2009 financial crisis, governments globally are running historically large fiscal deficits, making the authors’ study of the correlation between government debt levels and growth and inflation a timely one. They use a new government debt dataset that includes 44 countries and spans about 200 years. The main goal of the authors’ research is to determine the long-run macroeconomic implications of significantly higher levels of public and external debt on both advanced and emerging economies.
The authors sort annual GDP growth and inflation observations into four categories based on the prevailing debt-to-GDP ratio: less than 30 percent, 30–60 percent, 60–90 percent, and more than 90 percent. They focus first on 20 advanced economies in the post-WWII period, although their findings are similar for the 200-year sample period. GDP growth is uninhibited until public debt levels breach 90 percent, beyond which the median and mean growth rates decline by 1 and 4 percentage points, respectively. In contrast, inflation shows no sign of increasing as debt levels rise, with a few exceptions, such as the United States.
The authors repeat their analysis on 24 emerging market (EM) countries from 1900 to 2009. Somewhat surprisingly, the effect of public debt on GDP growth in EM countries mirrors the effect in the developed world in terms of both the 90 percent debt-to-GDP threshold and the degree of growth inhibition above this threshold. The rate of inflation in EM countries, however, exhibits a strong positive relationship with the level of outstanding public debt. The authors find that inflation increases from an average of 7 percent when public debt is less than 30 percent of GDP to 16 percent when public debt exceeds 90 percent of GDP, a difference they attribute to fiscal dominance.
EM countries’ often heavy dependence on external borrowing leads the authors to consider the effect of total (public and private) external debt on growth and inflation rates. Using World Bank data to gauge the level of external debt, the authors find that average growth is 2 percentage points lower above the 60 percent debt threshold and negative above the 90 percent debt threshold. Inflation is, however, less sensitive to the level of external debt; effects are observed only above the 90 percent debt threshold. This finding is consistent with the difficulty of inflating away external debt often denominated in a hard currency. Limited data availability prevents the authors from studying external debt in advanced economies.
The authors conclude that the unprecedented levels of public debt, a legacy of the recent financial crisis, will likely have a dampening effect on global growth. In advanced economies, inflation is less of a concern. Although the study does not encompass private debt, the authors note that deleveraging of the private sector, which normally occurs after a financial crisis, is likely to further weaken growth prospects in the medium term.