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Sunday, April 22, 2012

Public Debt and Economic Growth: Correlation is Not Causation

Do high levels of public debt reduce economic growth?:

Is high public debt harmful for economic growth?, Ugo Panizza and Andrea F Presbitero, Vox EU: ... Most policymakers do seem to think that debt reduces growth. This view is in line with the results of a growing empirical literature which shows that there is a negative correlation between public debt and economic growth, and finds that this correlation becomes particularly strong when public debt approaches 100% of GDP (Reinhart and Rogoff 2010a, 2010b; Kumar and Woo 2010; Cecchetti et al. 2011).
Correlation, however, does not imply causation. The link between debt and growth could be driven by the fact that it is low economic growth that leads to high levels of public debt (Krugman 2010).1 Establishing the presence of a causal link going from debt to growth requires finding what economists call an ‘instrumental variable’.2
In a new paper (Panizza and Presbitero 2012), we propose a novel instrument variable that allows us to reject the notion that debt causes slower growth in OECD countries. We do confirm the oft-noted negative correlation between debt and growth, but show that debt does not have a causal effect on growth (see Figures 8 and 9 in our paper). ...
We ... do not find any evidence that high public debt hurts future growth in advanced economies. Therefore,... we believe that the debt-growth link should not be used as an argument in support of fiscal consolidation.
The fact that we do not find a negative effect of debt on growth does not mean that countries can sustain any level of debt. There is clearly a level of debt beyond which debt becomes unsustainable, and a debt-to-GDP ratio at which debt overhang, with all its distortionary effects, kicks in. What our results seem to indicate, however, is that the advanced economies in our sample are still below the country-specific threshold at which debt starts having a negative effect on growth. ...
Conclusion
Our reading of the empirical evidence on the link debt-growth link in advanced economies is:
  • Many papers that show that public debt is negatively correlated with economic growth.
  • No paper that makes a convincing case for a causal link going from debt to growth.
  • Our new paper suggests that such a causal link does not exist (more precisely, our paper does not reject the null hypothesis that there is no impact of debt on growth).
We realize that our results are controversial. While we are convinced of the soundness of our findings, we know that skeptical readers will find ways to challenge our identification strategy. However, the first two points are uncontroversial. The case that public debt has causal effect on economic growth still needs to be made. ...

    Posted by on Sunday, April 22, 2012 at 09:49 AM in Budget Deficit, Economics | Permalink  Comments (16)

          


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