Government Debt and Economic Growth Decomposing the Cause and Effect Relationship

Abstract

The rising government debt levels in the aftermath of global financial crisis and the ongoing euro zone debt crisis have necessitated the revival of the academic and policy debate on the impact of growing debt levels on growth. This study provides a data–rich analysis of the dynamics of government debt and economic growth for a longer period (1960–2009). It spans across different debt regimes and involves a worldwide sample of countries that is more representative than that of studies confined to advanced countries. This study observes a negative relationship between government debt and growth. The point estimates of the range of econometric specifications suggest a 10-percentage point increase in the debt-to-GDP ratio is associated with 23 basis point reduction in average growth. Our results establish the nonlinear relationship between debt and growth. Further, by employing panel vector auto regressions (PVAR) approach, this study decomposes the cause and effect relationship between debt and growth and offers an answer to the question – Does high debt lead to low growth or low growth leads to high debt? The results derived from the impulse–response functions and variance decomposition show the evidence of long-term effect of debt on economic growth. The results indicate that the effect is not uniform for all countries, but depends mostly on the debt regimes and other important macroeconomic variables like; inflation, trade openness, general government final consumption expenditure and foreign direct investment.