Government, Household and Corporate Debt - The Effect on Growth

Abstract: According to Reinhart and Rogoff (2009), credit booms have been associated with financial instability and crisis for as long as 800 years. Notwithstanding, the debate on the sustainability of increased indebtedness in the world economy has regained importance, as trends for both public and private debt show rapid rises in the last three decades. To understand the effect of debt accumulation on growth, there is a need to look comprehensively at all forms of non-financial debt – household, corporate and government debt. Using panel data on 20 advanced economies between the years 1980-2014, this essay investigates the relationship between public (government) and private (household and corporate) debt growth and economic growth. This is done through a dynamic panel data model that is estimated using both a system GMM estimator and a bias corrected OLS estimator. Both short- and long-term effects are considered in the model. Potential non-linear effects are studied as well. In addition to GDP growth, the effect of debt on capital growth, TFP growth and private consumption growth is modeled in an effort to examine potential channels through which debt is likely to affect growth. The results show that there is a relationship between both public and private debt and growth. However, the relationship differs in the short- and long-term and is more complex for private debt. The main finding is that public debt growth seems to pose a larger problem for economic growth in the short-term, while there should be a greater concern regarding household debt growth in the longer run. Furthermore, this thesis finds nonlinear relationships between growth of public and private debt and GDP growth, both in the short-term and long-term analysis. Hence, reductions of debt are associated with higher GDP growth, while debt accumulation is associated with lower GDP growth. However, the results are only significant on the short-term basis. The negative effect on GDP growth from both public and private debt primarily operates through lower capital and TFP growth. In regards to private consumption, some evidence is provided to the notion that both public and private debt growth crowds out private investments, reducing capital accumulation and long run growth.