Wednesday, 16 May 2012

Debt Kills Growth

The massive overhang of public and private debt in advanced capitalist countries (public debt to GDP levels exceeds the critical 90% threshold while "private debt is showing a marked upward trend and remains near pre-crisis levels") and its damaging effect on growth are analysed in this paper by Reinhart and Rogoff   (referenced in the Irish Economy blog).

The impairment of growth by debt overhang is both marked and long-term.  It is  made clear too that causality does not run from  growth to debt "the multi-decade long duration of past public debt overhang episodes suggests that at very least the association is not due to recessions at business cycle frequencies."

Unnervingly, even continued ability to access  capital markets at relatively low interest rates by debtor countries does not ameliorate the growth-killing capacities of large debt overhangs.   Consoling thoughts that at least the UK took a Euro-use opt out are ill-founded insofar as  "growth-reducing effects of high public debt are apparently not transmitted exclusively through high real interest rates."


Ralph Musgrave said...

If debt kills growth, what's the cause / effect chain - i.e. what's the "transmission mechanism". I'm baffled.

We currently pay a NEGATIVE real rate of interest on national debt. I.e. the UK government makes a profit out the national debt. Where's the problem?

Caronte said...

A plausible channel of transmission/causation, Ralph, is of course the impact of high debt on interest rates, except that Reinhart-Reinhart-Rogoff are adamant that the negative impact of high debt (over 90% of GDP) on growth is the same regardless of high or low interest rates. The authors claim causation goes from debt to growth because their association is long term and not cyclical; they do not explain likely transmission mechanisms, presumably amounting to the familiar arguments of public expenditure crowding out private investment, Ricardian equivalence of debt and taxation in public expenditure finance, the adverse impact of debt on expectations and so on. Familiar, and controversial. Those arguments have been considerably discredited, especially over the last couple of years.

Two qualifications: on the one hand, a negative real interest rate on government borrowing may not necessarily make public debt sustainable when GDP is also recording a negative real growth rate. On the other hand one should not forget that, as the authors carefully stress, their paper "should not be interpreted as a manifesto for rapid public debt deleveraging in an environment of extremely weak growth and high unemployment. However, [their] read of the evidence certainly casts doubt on the view that soaring government debt is a non-issue simply because markets are presently happy to absorb it.”