Debt and growth: Decomposing the cause and effect relationship

• Date: 01 April 2020
• Published date: 01 April 2020
• DOI: http://doi.org/10.1002/ijfe.1729

RESEARCH ARTICLE

Debt and growth: Decomposing the cause and effect

relationship

Vighneswara Swamy

IBS–Hyderabad, ICFAI Foundation for

Higher Education, Hyderabad, India

Correspondence

Vighneswara Swamy, IBS–Hyderabad,

ICFAI Foundation for Higher Education,

Hyderabad, 501204, Telangana, India.

Email: vighneswar@ibsindia.org

Funding information

Institute of Economic Growth, Delhi

Abstract

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 repre-

sentative 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 that a 10‐

percentage point increase in the debt‐to‐gross domestic product ratio is associ-

ated with 23 basis point reduction in average growth. The results establish the

nonlinear relationship between debt and growth. Further, by employing panel

vector autoregressions 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 decomposi-

tion show the evidence of the 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.

KEYWORDS

Country groupings, economic growth, government debt, nonlinearity, panel data

JEL CLASSIFICATION

C33; C36; E62; H63; O40

1|INTRODUCTION

Postglobal financial crisis, the debt trajectories in several

economies around the world, are felt to be unsustain-

able. Many countries in the euro zone (and more partic-

ularly Greece) are struggling with a combination of high

levels of indebtedness, budget deficits, and frail growth.

This has necessitated the revival of the academic and

policy debate on the impact of rising levels of govern-

ment debt on economic growth. There is a growing con-

cern among the policy makers, central banks, and

international policy organizations to understand the

effects of government debt on economic growth. An

important policy question in this context has been

—“Do sovereign countries with high government debt

tend to grow slowly?”

Received: 21 January 2018 Accepted: 21 March 2019

DOI: 10.1002/ijfe.1729

Int J Fin Econ. 2019;1–16. © 2019 John Wiley & Sons, Ltd.wileyonlinelibrary.com/journal/ijfe 1

Int J Fin Econ. 2020;25:141–156. wileyonlinelibrary.com/journal/ijfe © 2019 John Wiley & Sons, Ltd. 141

Reinhart and Rogoff (RR), in some of their influential

articles, argue that higher levels of government debt are

negatively correlated with economic growth, but there is

no link between debt and growth when government debt

is below 90% of gross domestic product (GDP; Reinhart,

Reinhart, & Rogoff, 2012; Reinhart & Rogoff, 2010a). RR's

findings have sparked a new literature seeking to assess

whether their results were robust to allow for nonarbitrary

debt brackets, control variables in a multivariate regres-

sion setup, reverse causality, and cross‐country heteroge-

neity. After the publication of the (critique) article by

Herndon, Ash, and Pollin (2014) challenging some of

RR's findings, the discussion on the relationship between

debt and growth in advanced economies has become more

animated. Krugman (2010), citing the case of Japan, argues

that the link between debt and growth could be driven by

the fact that it is low economic growth that leads to high

levels of government debt. This argument needs an empir-

ical investigation.

The evolving empirical literature reveals a negative

correlation between government debt and economic

growth. This correlation becomes particularly strong

when government debt approaches 100% of GDP (Kumar

& Woo, 2010; Reinhart & Rogoff, 2010a, b; Cecchetti,

Mohnty, & Zampolli, 2011). Empirical research, of late,

has begun to focus on possibilities of nonlinearities

within the debt‐growth nexus, with specific attention to

high government debt levels. The empirical literature on

this issue remains sparse as very few studies employ non-

linear impact analysis

1

and do not provide an examina-

tion of the cause–effect relationship to reveal the

government debt‐economic growth nexus.

We notice three inadequacies in the empirical

literature on debt–growth nexus. First, there is a need to

expand the horizon of the data sample, as averaging across

Organization for Economic Cooperation and Develop-

ment/advanced countries alone would make such infer-

ences difficult. Second, I do not find studies emphasizing

the need for establishing the presence of a causal link going

from debt to growth and finding what economists call an

“instrumental variable”(IV). Third, I do not find studies

that decompose the cause–effect relationship between gov-

ernment debt and economic growth.

This study endeavours to fill the above research gap

by providing a sound empirical investigation based on

well‐established theoretical considerations. I first exam-

ine the debt–growth nexus, and then employing panel

vector autoregression (PVAR) analysis, provide a solu-

tion to the question—Does high debt lead to low growth

or low growth leads to high debt? This study is unique as

it overcomes the issues related to data adequacy, cover-

age of countries, heterogeneity, endogeneity, and nonlin-

earities. I contribute to the current strand of literature on

government debt and economic growth by extending the

horizon of analysis by exploring a considerably large

worldwide sample covering 122 countries. I provide a

thorough econometric analysis that allows nonlinearity

estimation. The data‐intensive approach offers stylized

facts, which is well beyond the selective anecdotal evi-

dence. This paper makes a distinct contribution to the

debate by offering new empirical evidence based on a

sizeable dataset.

The paper is organized as follows. I present the data

in Section 2, and a detailed econometric analysis of the

government debt–economic growth relationship in Sec-

tion 3. Section 4 describes the vector autoregression anal-

ysis to know whether debt causes growth or vice versa.

Section 5 concludes.

2|DATA

Our data set explores annual macroeconomic data on 252

countries, over the period 1960–2009. To maintain homo-

geneity, as it is for a large sample of countries over the

course of five decades, I employ a primary source—

World Development Indicators (WDI) database 2014 of

World Bank. I strengthen the data with the use of sup-

plementary data sourced from International Monetary

Fund, World Economic Outlook 2014 database, Interna-

tional Financial Statistics and data files, and RR's data

set on debt‐to‐GDP ratios.

I group the sample countries into five debt regimes: 0–

30%, 31–60%, 61–90%, 91–150%, and >151% comparable

to RR groupings based on the average debt/GDP levels

(Table 1). I place each of the 252 countries in the WDI

list into its relevant category of debt regime. However,

each country's entry into the group is dependent on the

data adequacy. Exclusion of any country of the WDI list

from the sampling is solely due to data considerations

(either nonavailability or inadequacy of data). The list

of countries covered in the analysis is provided in

Appendix A. I provide in Table 2 the description of vari-

ables and data sources.

Subsampling

We explore the dimension of historical specificity by

examining real GDP growth by government debt cate-

gory for subsampled periods of the data: 1960–2009,

1970–2009, 1980–2009, 1990–2009, and 2000–2009. I do

not extend the data set beyond 2009, in view of the sud-

den and significant rise in government debt levels conse-

quent to the government interventions in response to the

global financial crisis.

2

2SWAMY

142 SWAMY