The Long-Run Relationship Between Public Debt and Economic Growth in Advanced Economies

University essay from Lunds universitet/Nationalekonomiska institutionen

Abstract: This study revives a heavily debated relationship between government debt accumulation and economic growth. Although indebtedness levels stay high, current economic growth forecasts seem optimistic not only in the euro area but in other advanced countries, as well. 24 advanced OECD economies are investigated to understand if financial outcomes are detrimental to the real economic variables in the long-run. In effect, three related hypotheses are tested. H1: existence of the long-run negative public debt effect; H2: possibility of the impact through crowding out stock of capital; H3: existence of thresholds beyond which the effect changes. Methodologically, this study builds on the recent panel techniques and the work of Pesaran et al. (2013) to employ a dynamic model which accounts for a cross-sectional dependence of interconnected countries. The results show a negative relationship between debt/GDP growth and real GDP per capita growth in the long-run for the OECD economies. The impact is larger for the euro area sub-sample. According to the threshold study for H3, countries with 90% ratio or higher tend to grow slower in the long-run, but this result is not robust. Importantly, despite the growth theory suggesting that capital accumulation transmits negative debt effects in the long-run, H2 is rejected. A seeming absence of crowding out effect in long horizons motivates the search for alternative explanation of causality and to explore impacts of real interest rates or Total Factor Productivity channels in the future research.

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