The authors study the effects on economic growth of the ratio of sovereign debt to GDP (debt/GDP) at both a theoretical and an empirical level. They argue that the stress level in financial markets is an important variable that is needed to explain the link between sovereign debt and economic growth. If debt and GDP levels are considered in isolation and the state of financial markets is ignored, high levels of debt do not cause problems. Meanwhile, financial stress is an important cause of the nonlinearity between debt and growth. Debt/GDP has a negative effect on economic activity only at high levels of financial stress. In addition, the authors argue that membership in a monetary union may be the cause of low growth when the country is faced with high debt levels.

The crisis in public finances that followed the 2007–08 global recession, which was particularly severe in a number of member countries of the EU, sparked a great amount of research on the relationship between the level of sovereign debt and economic activity. Of particular interest is the issue of regime dependence. The question is, Does a threshold level exist beyond which sovereign debt levels start to interfere with growth?

The authors make two contributions to this debate. First, they show both theoretically and empirically that macroeconomic amplifications crucially depend on the level of financial market turbulence, as measured by a financial stress index. It is the interaction between the level of debt and the level of financial stress that matters for the debt­–growth nexus. This finding is also consistent with the idea that financial stress increases risk premiums, which, in turn, reduces economic growth. The authors’ findings are in direct contrast to the findings of Reinhart and Rogoff (American Economic Review: Papers & Proceedings 2010). Second, the growth-reducing effect of high levels of debt is found only for those countries in the sample that are part of a monetary union. It appears that risk spreads are particularly sensitive to investor sentiment inside a monetary union.

As motivation for the empirical section, the authors initially present a theoretical model that describes differences in the dynamic interactions of indebtedness with economic growth in regimes of low and high financial stress. For the empirical study, they collect quarterly data from the beginning of 1981 until the second quarter of 2013 for the following 16 Organisation for Economic Co-Operation and Development (OECD) countries: Australia, Austria, Belgium, Canada, Denmark, France, Germany, Greece, Italy, Japan, the Netherlands, Portugal, Spain, Sweden, the United Kingdom, and the United States. The main variables of interest in the empirical analysis are the growth rate of real GDP, debt/GDP, and the financial stress index. The control variables are the growth rate of the labor force, the interest rate on long-term government bonds minus the growth rate of the GDP deflator, the nominal effective exchange rate, and the growth rate of the GDP deflator.

Another interesting aspect of this research is the use of the nonlinear model predictive control method to solve the theoretical model. This method is a control technique that has been used in industrial applications since the 1980s and was introduced into economics in 2011. Country-specific and panel threshold regressions are used to assess how the level of debt and the level of financial stress affect the impact of debt/GDP on GDP growth in European Monetary Union (EMU) and non-EMU countries. The following groupings are considered for the panel estimations: all countries, EMU countries, non-EMU countries, and southern EMU countries. The authors estimate three sets of regressions: (1) debt/GDP as the only threshold variable, (2) the financial stability index as the sole threshold variable, and (3) both debt/GDP and the financial stability index as threshold variables. These sets of regressions support the main result, namely the importance of the state of financial markets in the link between debt levels and growth.

The finding that sovereign debt greater than 90% of GDP tends to reduce growth, which was introduced to the literature a few years ago, appears to be overly simplistic. The authors’ focus on the state of financial markets is plausible and helps to provide a fuller understanding of the transmission mechanism at work. The finding that membership in a monetary union magnifies the effects seems to be based primarily on one episode and a handful of countries. This focused result opens up avenues for further investigation.