Study: ‘Debt reduces growth, but only because high debt leads to panic and contractionary policies’

at 03:44 PM ET, 04/22/2012

There’s growing evidence that low economic growth tends to accompany high levels of government debt, leading many policymakers to believe that high debt itself impedes growth. But Ugo Panizza and Andrea Presbitero say many policymakers are misunderstanding what’s really going on, as they explain in a new paper for VoxEU:
Drachma coins, Greece's former currency. (Kostas Tsironis - Bloomberg)

We do confirm the oft-noted negative correlation between debt and growth, but show that debt does not have a causal effect on growth ... we do not find any evidence that high public debt hurts future growth in advanced economies. Therefore, given the state of our current knowledge, we believe that the debt-growth link should not be used as an argument in support of fiscal consolidation.

In other words, high debt levels aren’t directly responsible for the economic slowdowns that typically accompany them. Instead, the economy can slow because high debt often prompts policymakers to impose fiscal austerity measures that can hamper the economy, particularly one that’s already in recession:

[A] fully solvent government with a high level of debt may decide to put in place restrictive fiscal policies aimed at reducing the probability that a change in investors’ sentiments would push the country towards the bad equilibrium. ... These policies, in turn, may reduce growth (Perotti 2012), especially if implemented during a recession (such policies may even be self-defeating and increase the debt-to-GDP ratio, DeLong and Summers 2012, UNCTAD 2011).3 In this case, it would be true that debt reduces growth, but only because high debt leads to panic and contractionary policies.

To be sure, Panizza and Presbitero believe there is a point at which debt becomes unsustainable, but they think most of the advanced economies they’ve examined are still below that threshold. The takeaway, they say, is that countries should aim to curb long-term debt levels but “should not implement restrictive policies in the middle of a recession.”

That’s the argument driving the Democratic opposition to major GOP budget cuts in the U.S. — as well as anti-austerity advocates in Europe resisting further major cuts.

 
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