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A quantitative study of debt and growth [ClearOnMoney]
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A quantitative study of debt and growth

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Commentary

A quantitative study of debt and growth

5 Jan 2012 by Jim Fickett.

A study from the Bank for International Settlements suggests that once sovereign debt rises above 85% of GDP, each additional increase of 10 percentage points reduces annual growth by 10+ basis points. (US government debt is now at about 95% of GDP.)

In a research paper from last August, entitled The real effects of debt, S. Cecchetti, M. S. Mohanty and F. Zampolli at the Bank for International Settlements attempt to measure how much debt must accumulate before the effects are significantly negative. There were a few headlines about this paper when it came out, but I never saw a serious layman's summary. I just got around to reading the paper and would like to provide a quick summary here.

The data set the authors look at is the debt in each of the household, non-financial corporate, and government sectors, in each of the OECD countries, from 1980 to 2006. Their study is motivated by the idea that at low levels, debt facilitates economic growth, for example by allowing companies to start major new projects before earning all the necessary capital, but at high levels it makes the whole economy less resilient to shocks and can stifle growth. Here is the simplest possible look at the actual data, just using total (non-financial) debt, divided into four quartiles:

Now to try to get some more quantitative estimates, the authors do a fairly sophisticated regression. In this regression, the dependent variable is average growth over 5 years. The explanatory variables are, for the beginning of each 5-year period,

  • gross saving (public and private)
  • population growth
  • number of years spent in secondary school
  • total dependency ratio (non-working to working people)
  • openness to trade, measured by the absolute sum of exports and imports over GDP
  • CPI inflation, as a measure of stability
  • the ratio of liquid liabilities to GDP, as a measure of financial development
  • the level of debt in each of the three sectors, as a fraction of GDP

In one variant of the analysis, there is an additional variable for the occurrence of a financial crisis.

The regression assumes that there is some threshold (a different one for each sector) at which debt changes from a positive to a negative influence for growth. So the regression process only needs to estimate one coefficient for most of the explanatory variables, for example population growth or gross saving. But for each sector's debt three estimates must be made, one for the threshold, one for the coefficient below the threshold, and one for the coefficient above the threshold.

To boil it all down a bit, the authors are taking standard influences known to affect growth, like population, saving and education, adding debt into the equation, and then asking how each of these things correlates with growth over three decades of data in 18 countries. Here is their conclusion:

While the attention of policymakers following the recent crisis has been on reducing systemic risk stemming from a highly leveraged financial system, the challenges extend beyond that. Our examination of debt and economic activity in industrial countries leads us to conclude that there is a clear linkage: high debt is bad for growth. When public debt is in a range of 85% of GDP, further increases in debt may begin to have a significant impact on growth: specifically, a further 10 percentage point increase reduces trend growth by more than one tenth of 1 percentage point. For corporate debt, the threshold is slightly lower, closer to 90%, and the impact is roughly half as big. Meanwhile for household debt, our best guess is that there is a threshold at something like 85% of GDP, but the estimate of the impact is extremely imprecise.

A clear implication of these results is that the debt problems facing advanced economies are even worse than we thought.

The paper goes on to analyze the relevant policy questions. Given the demographic trends, the difficulty of decreasing deficits and overall debt is just going to get worse. The authors sound worried:

Given the benefits that governments have promised to their populations, ageing will sharply raise public debt to much higher levels in the next few decades. At the same time, ageing may reduce future growth and may also raise interest rates, further undermining debt sustainability. So, as public debt rises and populations age, growth will fall. As growth falls, debt rises even more, reinforcing the downward impact on an already low growth rate. The only possible conclusion is that advanced countries with high debt must act quickly and decisively to address their looming fiscal problems. The longer they wait, the bigger the negative impact will be on growth, and the harder it will be to adjust.

Get ready for inflation.