Economic Growth and Public Debt: Beyond Debt-Thresholds. Theoretical and Empirical Issues.

The idea that public debt may represent a burden for the economic system as a whole has distant origins and focuses on who and how should pay for debt, and with what consequences on the economy. Nevertheless, particularly influential both for academic research and the implementation of the fiscal corrective policies was the empirical paper proposed by Reinhart and Rogoff in 2010 at the dawn of the crisis. Reinhart and Rogoff (2010), in a large panel of countries, identified a critical threshold of 90% of the debt-to-GDP ratio beyond which debt is harmful to growth. Several countries in the world were fast approaching that threshold or already were well beyond it. Though Reinhart and Rogoff’s work was affected by many flaws, it has spurred buoyant empirical research in search of the general debt thresholds above which growth is jeopardised by public debt. Further works have supported the existence of critical debt-to-GDP ratios under various time and space observational fields, but results of these researches are inconclusive or controversial, as discussed in Chapter 2. Country-specific characteristics and contingencies play in fact a prominent role, thus prompting a branch of literature that attempts to comprehensively understand the debt-growth relationship and its determinants (see for instance Panizza and Presbitero, 2014; Eberhardt and Presbitero, 2015). In contrast with the findings of the broad threshold literature and of many theoretical models, the idea that public debt is always harmful to economic growth has partially been reconsidered in the last few years. Nevertheless, the existence of a linkage between debt and growth has not been rejected: the long-run relationship between such macroeconomic variables is inevitably and broadly affected by heterogeneous factors. However, in retrospect and as emerges in Chapter 1, one may say that the empirical pursuit of the debt-to-GDP threshold harmful to growth lacks deeper foundational work: why should we expect a negative public debt-growth relationship? In addition, if such a relationship exists, why should it take the specific form of a threshold of the debt-to-GDP ratio, and why should we expect this threshold to be equally valid across time and space? These questions are the starting point of this Doctoral Thesis, which is organised as follows. Chapter 1 surveys the theoretical literature concerning public debt and economic growth, aiming at finding a theoretical foundation for the debt-threshold literature. Overall, there is no clear and straightforward answer to the questions of why we should expect a negative public debt-growth relationship in the first place, why it should take the specific form of a threshold of the debt-to-GDP ratio, and why we should expect this threshold to be equally valid across time and space. Or, from another perspective, there are many possible answers and many elements affecting them, thus reflecting the complexity of the argument, as well as the variety of the empirical situations. In particular, the literature that I examine, on the one hand offers a rich variety of explanations and insights to researchers of the debt-growth relationship but, on the other, it does not provide any one-way conclusion: the relationship may be negative, positive, or even no relationship may exist, both from a theoretical and an empirical point of view. Even less is theoretically founded the existence of a general debt-to-GDP threshold above which growth is consistently stifled. Each country’s specific characteristics, circumstances, and events have an overwhelming importance that cannot be encapsulated in a single general law. In Chapter 1, I also present a fiscal model of endogenous growth that may help address the theoretical issues in an orderly and consistent manner along two specific coordinates of debt assessment: sustainability/unsustainability, and efficiency/inefficiency. The thrust of the model is that no meaningful assessment of debt and its effect on growth at any point in time is possible without reference to the whole debt trajectory and the specific state of the economy along the trajectory. Chapter 2 reviews the empirical literature and focuses on the debt-growth relationship from an econometric point of view. As before, it is difficult to derive a univocal conclusion on the nature of such a relationship on the basis of the literature’s findings: the existence of a significant negative relationship between debt and growth is the predominant thinking, though in contrast with the conclusions of several works. For these reasons, the aim of Chapter 2 is to go to the roots of the debt-growth relationship, to investigate whether the outstanding debt and the GDP are linked. To this end, I have adopted a research methodology that differs from the most common employed in the literature on debt-to-GDP thresholds. First, my analysis does not hinge on any specific theory, and it should not be considered as a proof of a specific theoretical statement. Rather, it is based on the approach outlined by Hoover et al. (2008) and aims at understanding "what the data say" without imposing aprioristic theoretical structures. A second methodological choice consistent with this approach is to treat the (growth of the) amount of public debt and (the growth of) GDP as the two genuine primitives, without imposing the debt-to-GDP ratio as a primitive itself. In fact, for this to be possible, the two underlying primitives should display well defend statistical properties, namely cointegration and convergence towards a long-term equilibrium value, which are usually not tested in the literature. Third, I believe that the heterogeneity, or non-generality, of results that I have pointed out before should be taken as an intrinsic feature of the problem at hand, so that a viable strategy is to restrict, rather than expand, the observational field. I have set time and space limits to my dataset by purpose: my analysis is based on a panel dataset including quarterly data for 25 Eastern and Western European countries from 1999Q1 to 2015Q4. The Eurozone represents a unique "field experiment" of a large number of countries where some key conditioning factors of fiscal policy are common and exogenous, namely fiscal targets and rules, monetary policy, and the exchange rate with the rest of the world. The main result is that a long-run equilibrium relationship between GDP and debt exists for some countries ? and debt and GDP tend to adjust towards it ? but it is not generalisable. Where a relationship exists, it does not always imply that the debt-to-GDP ratio may be the appropriate variable for describing it. Moreover, cross-country heterogeneity and the role of the financial crisis and of the austerity periods remain substantial and overwhelming factors. Therefore, a unique equation describing the GDP-debt relationship does not seem to exist, which entails the impossibility to derive a meaningful general debt-to-GDP threshold. Thus far I have focused on the general relationship between debt and growth from both the theoretical and the empirical points of view. Turning to the analysis of the Sovereign Debt Crisis and of the austerity period, Chapter 3 attempts to explain what has driven austerity ? measured as the first difference of the cyclically adjusted structural primary balance ? within a dataset of 28 European countries. In the first part of this chapter I present a correlation analysis that describes the relationship between the variable austerity and each of the considered determinants, that are brought back to four main sets of variables: fiscal discipline, market discipline, fiscal consolidation, and macroeconomic stabilisation. The second part implements a panel econometric analysis based on the principal component factor analysis and on the pooled partial common correlation effect estimator. Results show that the variables and factors of the analysis are not able to fully explain austerity, though an important contribution is provided by the enforcement of the Eurozone fiscal rules (the adoption of excessive deficit procedures) and is partially counterbalanced by the cyclical position of the economy. The last chapter, Chapter 4, aims at gaining insight into the role of debt and government expectations and their impact on growth under uncertainty conditions. In fact, it is possible that the effects of austerity measures in some countries, for instance the so-called PIIGS, were amplified by uncertainty. My ambition is to relate austerity with consumers’ expectations, thus studying whether and when consumers’ beliefs about public debt and government intervention affect their consumption, savings, and tax compliance choices with a direct impact, at the aggregate level, on economic growth. Therefore, Chapter 4 implements a laboratory experiment to study how people react in a generalized framework in which public debt may be unexpectedly reduced. The debt dynamics arises endogenously: within a public good game, taxes are collected from all participants and are used to cover a given level of public expenditure, which is then equally distributed to the same participants at the beginning of each round. If the collected amount of taxes is lower than what the public expenditure would require, a deficit is generated. Moreover, reproducing a forced withdrawal, the outstanding amount of public debt can be reduced upon accessing subjects’ savings. Within this setting, expectations are directly elicited by asking subjects if they believe that public debt is going to be reduced, and if they think that the other subjects believe that public debt is sustainable. Therefore, it is possible to identify whether and how agents’ allocations and expectations are affected by the public debt path. As mentioned above, a peculiarity of my approach is the endogenous dynamics of public debt: not only it avoids introducing predetermined dynamics, but also increases the ecological validity of the experiment. Participants are indeed more psychologically involved in the debt mechanism and they might feel responsible for the raise in debt. On the other hand, an exogenous dynamics could depict public debt and tax compliance as irrelevant. Results show that this experimental framework is characterized by relatively high and often increasing aggregate savings and relatively low and decreasing aggregate consumption. Interestingly, an increase in the debt-reduction expectations and a decrease in the perceived debt sustainability are also found to explain savings and consumption behaviours, as is shown in the econometric part of Chapter 4.