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DALLASFED
VOL. 13, NO. 3 • MARCH 2018

Economic
Letter
Rising Public Debt to GDP
Can Harm Economic Growth
by Alexander Chudik, Kamiar Mohaddes, M. Hashem Pesaran
and Mehdi Raissi

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ABSTRACT: The debt–growth
relationship is complex,
varying across countries
and affected by global
factors. While there is no
simple universal threshold
above which debt to GDP
significantly depresses growth,
high and rising public debt
burdens slow growth in the
long term, data from the
past four decades indicate.

T

he relationship between public
debt expansion and economic
growth has attracted interest in
recent years, spurred by a sharp increase
in government indebtedness in some
advanced economies following the global
financial crisis.
Economists tend to agree that in the
short run, an increase in public debt arising
from fiscal expansion stimulates aggregate
demand, which should help the economy
grow. The longer-term economic impact
of public debt accumulation, in contrast, is
subject to a more expansive debate.
Some argue there is a negative long-term
relationship between debt and economic
growth, others doubt there is a long-term
association between the two for low or
moderate levels of public debt. Still others
disregard any long-term association.
A careful empirical examination of this
relationship using a panel of 40 advanced
and emerging economies and four
decades of data indicates that a persistent
accumulation of public debt over long
periods is associated with a lower level
of economic activity. Moreover, the evidence suggests that debt trajectory can
have more important consequences for
economic growth than the level of debt to
gross domestic product (GDP).

Continuous debt accumulation can
harm economic growth through several
channels, such as “crowding out” private
investment, higher long-term interest rates,
more aggressive future taxation, and possibly weaker investor sentiment and greater
uncertainty.

Global Financial Crisis Responses
The global financial crisis hit many
economies, shaving more than 5 percentage points off world growth in 2008–09
(Chart 1).
The subsequent economic recovery
has been disappointingly slow. With the
exception of 2010, global growth has surprised on the downside each year since the
crisis. Sovereign debt problems in some
advanced countries and a slowdown in
key emerging economies accompanied
the sluggish pace of recovery.
The large drop in real output growth in
2008–09 and the subsequent disappointing
recovery was accompanied by a sizable fiscal response, especially among advanced
economies. Postcrisis fiscal expansion
resulted in a considerable government
debt build-up in advanced economies,
from an already elevated level of 71 percent of GDP in 2007 to 107 percent of GDP
at year-end 2016 (Chart 2).

Economic Letter
High levels of public debt and the sovereign-debt problems in the euro area,
where policymakers worked to achieve a
delicate balance between austerity and
pro-growth policies, fueled the discussion
about the effects of debt accumulation on
economic growth.

complex, and economic theory alone does
not provide clear guidance.
The main argument for a negative relationship between the two is the “crowding
out” of private investment by government.
Another explanation relates to confidence: An upward-sloping debt trajectory
beyond certain levels could lead investors
to worry about the country’s debt sustainability. Reflecting this risk, economic
agents would be willing to hold govern-

Debt–Growth Relationship
The relationship between public debt
accumulation and economic growth is
CHART

1

Global Economy Hard Hit After Global Financial Crisis
World real output growth

Rate
6.0

IMF WEO forecast
(made in spring previous year)

5.0
4.0
3.0
2.0
1.0
0.0
-1.0

’02

’03

’04

’05

’06

’07

’08

’09

’10

’11

’12

’13

’14

’15

’16*

*Estimated.
NOTES: The chart shows the annual growth rate of the world’s real output (gray bars). The definition of the world aggregate is
taken from the International Monetary Fund (IMF) World Economic Outlook (WEO)) report. The last data point (striped bar) is the
estimate reported in the April 2017 update of the WEO report. The dashed line shows IMF WEO projections made in the spring of
the previous year.
SOURCES: International Monetary Fund, WEO report; Haver Analytics.

ment securities only at a higher borrowing
cost. The lower demand and investment
due to higher interest rates, in turn, can
have negative consequences for economic
growth in the long run. Because the higher
cost of government borrowing poses an
additional strain on fiscal balances, an
increase in government bond yields could
lead to further loss of confidence and
become self-fulfilling. In an extreme case,
a crisis could occur.
While it is theoretically possible for governments to inflate away local-currencydenominated debt by monetizing (printing
money), this is impossible for foreigncurrency-denominated debt. In the latter
case, a public debt crisis could also trigger
currency and/or banking crises with more
profound consequences for economic
growth. High and increasing public debt
might also constrain the ability of fiscal
authorities to smooth economic cycles.
All of the arguments so far abstract from
the composition of additional government
spending—that gives rise to higher public
debt. Such additional government spending could be invested in productive public
capital (such as infrastructure, education
or health) and could be growth enhancing. Consequently, the net effect of debt
accumulation on economic growth cannot
be established theoretically and requires a
careful empirical analysis.

Estimation Challenges
CHART

2

Fiscal Stimulus in Advanced Economies
Leads to Record Levels of Public Debt

Debt as a percent of GDP
100

Advanced economies

80
60
40
Emerging and developing economies

20
0

’02

’03

’04

’05

’06

’07

’08

’09

’10

’11

’12

’13

’14

’15

’16*

*Estimated.
NOTES: The chart shows gross public debt as a percent of gross domestic product (GDP). Gross debt comprises the stock
(at year-end) of all government gross liabilities (both to residents and nonresidents). The country classification and country
aggregation are based on the World Economic Outlook (WEO) report.
SOURCE: International Monetary Fund, WEO report, April 2017; Haver Analytics.

2

Estimating the debt–growth relationship
is no easy task. Many technical complications must be tackled.
First, the interactions between debt and
growth are dynamic. Clearly, the shortand long-run impacts are quite different,
and there are feedback effects between the
two variables.
Second, the long-run relationship
between debt and growth could depend on
the level of debt itself (threshold effects) as
highlighted by the confidence factors.
Third, the absence of a sufficient number of historical observations makes it difficult to obtain a reliable individual-country statistical inference on the debt–growth
relationship.
Instead, a panel of countries forms the
basis here for such an analysis.

Economic Letter • Federal Reserve Bank of Dallas • March 2018

Economic Letter
Use of Panel Data

Advanced, Emerging Economies

The panel data bring two additional
technical challenges. First, individual
countries are subject to country-specific
factors and institutions. Clearly, there are
significant differences between countries
with regard to the degree of financial deepening (typically, the availability of financial
services), track record in meeting past debt
obligations, composition and maturity profile of public debt, and nature of political
systems.
Second, individual economies are globally interdependent. Such interdependencies arise from global factors, including
world commodity prices and the stance of
the global financial cycle, and/or spillover
effects from one country to the next that
tend to be magnified at times of financial
crises.
The limited availability and quality of
data pose another challenge. A large sample of countries spanning a long time period would be ideal. In an effort to obtain
comprehensive country coverage, “gross
government debt” is used. It includes
intragovernmental holdings, as opposed
to the net debt held by the public, which
would be more appropriate. Taking these
into consideration, 40 economies were
reviewed, with annual observations covering 1966 to 2010.
Table 1 summarizes the results. Individual
columns report findings for two estimation methods, CS-ARDL and CS-DL, each
capable of dealing with the noted technical
challenges.1 For each method, we consider
different specifications and compute two
different statistics for testing the significance of the debt-threshold effect (labeled
as SupT and AveT).2
While no evidence is found for a universally applicable threshold effect in the
relationship between public debt and economic growth (top panel of Table 1), the
findings show that countries with rising
debt-to-GDP ratios exceeding 60 percent
tend to have lower real output growth rates
(bottom panel of Table 1). These results
suggest that debt trajectory is probably
more important for growth than the level
of debt itself.

Similar evidence of no simple debt
threshold is found after splitting the panel
into advanced and emerging economies
subgroups. Evidence of the debt-trajectory effects weakens once the two groups
of countries are considered separately.
Regardless of threshold effects, the relationship with output growth can be
strongly negative when there is a persistent
increase in debt to GDP.
TABLE

1

Importantly, long-run relationships do
not provide any indication about the direction of causality but merely provide a statistical association between the variables
in the long run. In fact, the causality can
run both ways.
On one hand, an unexpected increase
in output following a positive technology
shock will result in larger fiscal revenue
and an improved debt-to-GDP ratio. On
the other hand, an increase in the level of

Statistical Evidence of Threshold Effects Appears Weak
Threshold definition:
Estimation method:
Maximum lag order:

Estimated threshold level

Debt to GDP exceeds the threshold level
CS-ARDL

CS-DL

1

2

0

1

2

40%

30%

40%

40%

40%

Statistical signifiance of the threshold effect (at 5% or 1% level):
Based on SupT test statistics

no

no

no

no

no

Based on AveT test statistics

no

no

no

no

no

Threshold definition: Debt to GDP exceeds the threshold level and is rising
Estimated threshold level

60%

60%

60%

60%

60%

Statistical signifiance of the threshold effect (at 5% or 1% level):
Based on SupT test statistics
Based on SupT test statistics

no
yes: 1%

no

no

yes: 5%

yes: 5%

yes: 1%

yes: 1%

yes: 1%

yes: 1%

NOTES: Lag order refers to the number of lags of the dependent and explanatory variables. These lagged terms are used to capture
dynamics. Higher lag orders allow for more complex dynamics but are more difficult to estimate. SupT and AveT are tests for the
presence of threshold effects. No rejection means no evidence of threshold effects. Statistical significance of 5 percent or 1 percent
refers to the nominal size of the tests (that is, the probability of falsely rejecting the null hypothesis).
SOURCE: “Is There a Debt-Threshold Effect on Output Growth?” by Alexander Chudik, Kamiar Mohaddes, M. Hashem Pesaran and
Mehdi Raissi, Review of Economics and Statistics, vol. 99, no. 1, 2017, pp. 135-50.

TABLE

2

Estimates of (Mean) Long-Run Effects of Public Debt
on Output Growth Are Statistically Significant
Estimation method:
Maximum lag order:

CS-ARDL

CS-DL

1

2

0

1

2

All countries

-0.082
(0.012)

-0.086
(0.014)

-0.085
(0.012)

-0.080
(0.013)

-0.068
(0.014)

Advanced economies

-0.081
(0.021)

-0.093
(0.024)

-0.094
(0.019)

-0.093
(0.023)

-0.081
(0.020)

Emerging economies

-0.082
(0.013)

-0.080
(0.014)

-0.077
(0.014)

-0.069
(0.015)

-0.057
(0.021)

NOTES: Standard errors are provided in parentheses. All estimates are statistically significant at the 1 percent level.
SOURCE: “Is There a Debt-Threshold Effect on Output Growth?” by Alexander Chudik, Kamiar Mohaddes, M. Hashem Pesaran and
Mehdi Raissi, Review of Economics and Statistics, vol. 99, no. 1, 2017, pp. 135–50.

Economic Letter • Federal Reserve Bank of Dallas • March 2018

3

Economic Letter

debt following an expansionary fiscal policy shock (such as a lowering of the income
tax rate) will improve domestic demand
and, thus, raise output.
Table 2 shows the corresponding estimates of the (average) long-run impact
of public debt accumulation on output
growth. All estimates are statistically significant at the 1 percent level and robust
across different specifications, estimation
methods and country groupings. These
estimates are all negative and in the range
of -5.7 to -9.4 percent, suggesting that a persistent accumulation in the debt-to-GDP
ratio at an annual pace of 3 percent is eventually associated with annual GDP growth
outcomes that are 0.2 to 0.3 percentage
points lower on average.

Understanding Fiscal Policies
The post-1965 experience of 40 advanced
and developing economies reveals a statistically robust long-term relationship
between a persistent accumulation of public debt and economic growth.
Moreover, estimates of the corresponding long-run coefficients are all negative,
implying that countries that incurred persistent increases in the debt-to-GDP ratio
over long periods also experienced lower
output growth. However, a temporary
increase in the ratio (for instance, to help
smooth out business-cycle fluctuations)
does not play a role in the long-term relationship between public debt and economic growth.

The analysis does not provide any indication about the direction of causality
between public debt and growth, and in
fact it allows for causality to run both ways.
Consequently, it is often difficult to provide
generic policy advice based on estimated
relationships using a large set of diverse
economies.
The mere fact that there is a negative
long-term relationship between a persistent accumulation of debt and economic
growth in the last four decades of available data calls for a better understanding
of the economic implications of fiscal policies leading to persistent accumulation of
public debt.
The key to prudent debt financing is the
reassurance, backed by commitment and
action, that the increase in government
debt is temporary and will not be a permanent departure from the prevailing norm.

Notes
For full details of the empirical analysis and related literature,
see “Is There a Debt-Threshold Effect on Output Growth?” by
Alexander Chudik, Kamiar Mohaddes, M. Hashem Pesaran
and Mehdi Raissi, Review of Economics and Statistics, vol.
99, no. 1, 2017, pp. 135–50, and “ Long-Run Effects in
Large Heterogeneous Panel Data Models with Cross-Sectionally Correlated Errors,” by Chudik, Mohaddes, Pesaran
and Raissi, Advances in Econometrics, vol. 36, 2016, pp.
85–135.
1

CS-ARDL stands for cross-sectionally augmented autore-

gressive distributed lag approach, and CS-DL stands for
cross-sectionally augmented distributed lag approach. The
approaches are explained in Chudik et al. (2016).
2

SupT and AveT are tests for threshold effects. These test

statistics are developed in Chudik et al. (2017).

Chudik is an economist in the Research
Department at the Federal Reserve Bank of
Dallas; Mohaddes is a senior lecturer, fellow and director of studies in economics at
Girton College, University of Cambridge;
Pesaran is the John Elliott Distinguished
Chair in Economics at the University of
Southern California; and Raissi is an economist at the International Monetary Fund.
The views expressed here are those of the
authors and do not necessarily represent
those of the Federal Reserve Bank of Dallas,
the International Monetary Fund (IMF) or
IMF policy.

DALLASFED
Economic Letter

Marc P. Giannoni, Senior Vice President and Director of Research

is published by the Federal Reserve Bank of Dallas. The views expressed are those of
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Federal Reserve System.

Michael Weiss, Editor

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