How do countries with low/high debt levels grow?

Every year at the AEA annual meeting, there is a Rogoff-Reinhart special. In 2008, they said the sub-prime crisis is similar to previous crisis. In 2009, they followed it up with aftermath of a crisis. This led to vast literature on what happens after the crisis, comparison of performances with financial crisis driven recession vs normal recession etc.

In 2010, they have released another paper looking at growth rates of economies at various debt levels. They look at advanced and emerging economies differently.

We study economic growth and inflation at different levels of government and external debt. Our analysis is based on new data on forty-four countries spanning about two hundred years. The dataset incorporates over 3,700 annual observations covering a wide range of political systems, institutions, exchange rate arrangements, and historic circumstances. Our main findings are:

First,  the relationship between government debt and real GDP growth is weak for debt/GDP ratios below a threshold of 90 percent of GDP. Above 90 percent, median growth rates fall by one percent, and average growth falls considerably more. We find that the threshold for  public debt is similar in advanced and emerging economies.

Second,  emerging markets face lower thresholds for external debt (public and private)—which is usually denominated in a foreign currency. When external debt reaches 60 percent of GDP, annual growth declines by about two percent; for higher levels, growth rates are roughly cut in half. 

Third,  there is no apparent contemporaneous link between inflation and public debt levels for the advanced countries as a group (some countries, such as the United States, have experienced higher inflation when debt/GDP is high.) The story is entirely different for emerging markets, where inflation rises sharply as debt increases.

A very timely paper. For advanced economies it is only when debt levels reach above 90% of GDP do we see some impact on growth.  For emerging economies both public debt and external debt levels matter.

For Emerging economies, the impact is much higher as debt levels rise (both public and external). We also see a significant impact on inflation which is absent in the case of developed economies. Perhaps the answer is that developed economies’ central banks are seen as more credible.

So as expected, the emerging economies are the ones which face higher costs of rising debt levels.

In the end they make three additional points:

Why are there thresholds in debt, and why 90 percent? This is an important question that merits further research, but we would speculate that the phenomenon is closely linked to logic underlying our earlier analysis of “debt intolerance” in Reinhart, Rogoff, and Savastano (2003). As we argued in that paper, debt thresholds are importantly country-specific and as such the four broad debt groupings presented here merit further sensitivity analysis. A general result of our “debt intolerance” analysis, however, highlights that as debt levels rise towards historical limits, risk premia begin to rise sharply, facing highly indebted governments with difficult tradeoffs. Even countries that are committed to fully repaying their debts are forced to dramatically tighten fiscal policy in order to appear credible to investors and thereby reduce risk premia.

Of course, there are other vulnerabilities associated with debt buildups that depend on the composition of the debt itself. As Reinhart and Rogoff (2009b, ch. 4) emphasize and numerous models suggest, countries that choose to rely excessively on short term borrowing to fund growing debt levels are particularly vulnerable to crises in confidence that can provoke very sudden and “unexpected” financial crises. Similar statements could be made about foreign versus domestic debt, as discussed.

Finally, we note that even aside from high and rising levels of public debt, many advanced countries, particularly in Europe, are presently saddled with extraordinarily high levels of total external debt, debt issued abroad by both the government and private entities. In the case of Europe, the advanced country average exceeds 200 percent external debt to GDP. Although we do not have the long-dated time series needed to calculate advanced country external debt thresholds as we do for emerging markets, current high external debt burdens would also seem to be an important vulnerability to monitor.

A very simply written paper with loads of insights.