Crowding out or crowding in? : A study on the effects of the public debt ratio on private investments of countries in the euro area

Abstract: The evolution of public debt in the euro area into unsustainable levels is discussed now more than ever after the recent financial crisis of 2008 and the European sovereign debt crisis that followed. With countries like Greece and Italy hovering around the level of 181.2- and 134.8 percent of GDP in public debt in 2018 (AMECO database), it is hard not to be worried about the future. Macroeconomic theory predicts that increased bond-financed government expenditure will crowd out private investment. This paper tests the credibility of this theory by empirically examining the effect of public debt ratios on private investment in 26 countries in the euro area from 1999 to 2018. By using panel data regression, accounting for fixed effects, it emerged that public debt ratios are negatively correlated with private investment as is predicted by the crowding out theory. However, no statistically significant negative correlation was found when introducing an instrumental variable, military expenditure.