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2015
On Government Debt and Economic Growth
Nathan Rijsdijk - 358332
IndexIndex 1
1. Introduction 2
2. Theoretical Framework 4
2.1 Ricardian Equivalence & neoclassicism 4
2.2 Keynesian and new Keynesian view 7
2.3 Tipping Point 10
2.4 The Role Of Banks 14
2.5 Remarks 16
2.6 Summary 16
3. Empirical Literature 18
3.1 Multiplier Studies 18
3.2 Tipping Point 21
3.3 The Role of Banks 25
4. Conclusion 28
4.1 Summary 28
4.2 Empirical Part 29
4.3 Conclusion 29
References 31
1. IntroductionThe financial crisis has left a legacy of high and rising debt levels across the advanced economies
(Reinhart, Reinhart, & Rogoff, 2012). Countries like the United States and countries in Europe
are seeking to lower their debt by applying austerity measures. This is mostly based on the
belief that public debt is at some point causing GDP to fall or at least to grow less. Reinhart &
Rogoff find in their study that public debt to GDP ratio’s over 90% are accompanied with lower
growth of GDP (Reinhart & Rogoff, 2010).
This correlation is worth investigating. Reinhart & Rogoff themselves find that “…the
relationship between public debt and growth is nonlinear, but at high levels, often at a debt/GDP
ratio around 90 percent of GDP, public debt overhang does seem to have a negative effect on
growth.” (Reinhart, Reinhart, & Rogoff, 2012). This finding is based on a number of studies which
investigated the relationship between debt and economic growth.
However, there seem to be a number of problems in the calculations of Reinhart & Rogoff
themselves and the papers they cite to prove the causality of public debt leading to lower
economic growth. It is important to keep in mind that the paper from 2010 is the one that is
criticized. The paper of 2012 is more of an overview paper. In research of Thomas Herndon et al.
a number of flaws are found in the Reinhart & Rogoff research. There are three flaws found in
the paper: coding errors, selective exclusion of data, and unconventional weighting of summary
statistics (Herndon, Ash, & Pollin, 2013). Herndon et al. replicate the research of Reinhart &
Rogoff and find different results. There is a negative relationship, but it is weaker than the result
found in Reinhart & Rogoff. Another important finding in the research of Herndon et al. is that
they do not found a clear tipping point of debt, where Reinhart & Rogoff found such a tipping
point on a debt to GDP ratio of 90 percent. (Herndon, Ash, & Pollin, 2013)
The current austerity policy in Europe and the United States is largely justified by the findings of
Reinhart & Rogoff in their research, even when there are strong points made that weaken the
results of the research. It seems relevant to look at the relationship between Government Debt
and the economic growth. Therefore, the question I would like to investigate is:
What is the relationship between Government Debt and Economic Growth?
The answer on this question basically describes nature of the relationship. I will look at a
number of theories that try to explain the mechanisms between the relationship between
government debt and economic growth and I will relate this to the empirical literature. Based on
that I will conclude whether this relationship is likely to be positive, negative, or is there not
significant at all. After that I take a look at the characteristics of the relationship. Is it linear or is
it diminishing or increasing? This part will be the same in structure as the part before. Some
theoretical mechanisms will be explained and linked to empirical literature on the matter. I will
conclude the findings of this part by answering the question:
Does a tipping point exist in the relationship between Government Debt and Economic Growth?
This question seems relevant, because due to the belief of Reinhart & Rogoff that there is such a
tipping point, Europe and the United States started using austerity measures to get out of the
economic recession we are in now.
To do research on the relationship between debt and economic growth, I will start with an
analysis of a number of theories that will relate to this mechanism. The underlying assumption
that has to be kept in mind in this paper is that government debt means future taxation. In this
framework I would like to look at Ricardian Equivalence and neoclassicism, the Keynesian, and
the New Keynesian approach. To broaden the scope there will be some attention to the role of
banks in the relationship between government debt and economic growth.
The second research question is about whether there exists a tipping point in the relationship
between government debt and economic growth. The theoretical explanation for this will start
with the Laffer curve, which relates to the idea that government debt now means future taxation.
Also there will be a focus on a phenomenon called excessive debt, where governments gain more
debt than they can allow themselves, leading to financial markets that react on this excessive
debt.
When I examined the theories I would expect a relationship that is not really significant, but I
would expect a tipping point in the relationship. I do not expect that there is a certain percentage
that is the threshold for all countries, like Reinhart & Rogoff find in their research.
2. Theoretical FrameworkAs said before, the theoretical framework will start with the statement that government debt in
the present means a raise in taxes in the future. The reason that this assumption is stated here is
because of the theories that will be examined. I will start with Ricardian Equivalence and
neoclassicism, followed by the Keynesian and the new Keynesian approach, where this
assumption is key to understanding the mechanism.
2.1 Ricardian Equivalence & neoclassicism
The first theory that will be discussed found its origin in the famous economist David Ricardo.
The theory of Ricardian Equivalence has been taken over and enhanced by Robert Barro and by
others. The basic idea is that a government faces an intertemporal budget constraint. This two-
period equation will help to explain:
(1) G1+G2
(1+r )=T1+
T2(1+r )
In this equation Gi stands for government spending in the first or second period and Ti stands for
tax income in the first or second period respectively. This intertemporal budget constraint
shows what the possibilities of the government in a two-period model are. The government has
the option to spend a certain amount of money in the first period and finances this spending by
the taxes that are collected in the first period and it can do the same in the second period.
Another option is that the government borrows from the future, which means that the spending
of the government in the first period is higher than the tax income in the first period, but this
needs to be compensated by higher taxes in the future or lower government spending in the
second period (Barro, 1988). Of course, the reverse is also possible, i.e. that the government
saves money for the future, so that the spending in the second period can be higher or that the
taxes in the second period can be lowered.
It is clear that the assumption that is stated at the beginning of this theoretical framework is
very important here. Government debt in the present means a raise in taxes in the future.
Another important assumption that is key in understanding the Ricardian Equivalence model is
that consumers in this model are rational. They live in both periods, and they have perfect
information on their income and their taxes in both periods (Feldstein, The Effects of Fiscal
Policies When Incomes Are Uncertain: A Contradiction To Ricardian Equivalence, 1986).
When these assumptions are kept in mind, we can look at the effect of the government
borrowing expenditures from the future. Consumers see this increase in government spending
in the first period and know that this spending will lead to an increase in taxes in the future.
Since consumers anticipate rationally, they will save extra money to pay the extra taxes that they
need to pay in the future. Therefore, this increase in government spending in the first period will
not have an effect on the net wealth of an economy (Burda & Wyplosz, 2009).
However, Ricardian Equivalence has faced a lot of critique and this critique is mainly based on
the assumptions where this theory is built upon. There are four points that I would like to focus
on:
First of all the infinite life of consumers. It is important that consumers are alive in both periods
of the two-period example, otherwise the results will be different. When consumers only live in
the first period and the government decides to borrow money from the second period,
consumers are likely to consume all they can, because they are not there to pay the increase in
taxes in the second period. The second point that I would like to discuss is the assumption that
consumers have perfect information and perfect foresight. For this theory to hold, consumers
need to have perfect information on their incomes, the government spending, and the taxes they
need to pay for all periods. Of course this is quite a strong assumption and in a paper of Martin
Feldstein (1986) the Ricardian Equivalence model is adjusted in such a way that consumers face
uncertainty. The outcomes are different from the original predictions of the Ricardian
Equivalence model (Feldstein, 1986).
Another important addition to the points of critique is the idea that consumers not always will
save more when the government raises its debt-financed spending. Especially in a situation of an
economic crisis, consumers could face liquidity problems. They are not able to pay for their
needed expenditures. When a government decides to increase debt-financed spending, these
consumers are not likely to save the extra money they get, it is more likely that they will spend
the extra money. This is in contrast to the theoretical predictions of the Ricardian Equivalence
theorem.
The final issue I would like to discuss is the distortionary nature of taxes. In the Ricardian
Equivalence model taxes are assumed to be non-distortionary. Standard economic theory
predicts that in a market of perfect competition taxes create a so called ‘dead weight loss’, which
shows that taxes are distortionary. This means that when a government borrows money from
the future and wants to finance the debt by increasing taxes in the future, that when these taxes
are distortionary, the effect of such a form of government debt has a negative effect on economic
growth (Ramey, 2011).
2.1.1 Neoclassical view
Another way of looking at the effect of government purchases on economic growth is by looking
at the equilibrium of an economy in the long run. In this neoclassical view the equilibrium
consists of the real interest rate, national saving, and investments. We use figure 1 to illustrate
this reasoning. In this framework the output of an economy is fixed by its factors of production
(generally these are labor and capital). In this framework we are dealing with a closed economy,
where output consists of consumption, investment, and government spending. The interest rate
is on the y-axis of the figure below and on the x-axis saving and investment are measured,
denoted as S and I respectively. We can see that savings are constant, since the output of the
economy is fixed. Investment rises when the interest rate declines. The intuition behind this is
that investing requires the borrowing of money and the costs of borrowing money generally
consist of the interest payments. So when the costs of investment go up, the desired investment
declines and vice versa. Given the slope of this desired investments curve, the savings determine
the investment and the equilibrium interest rate. The savings determine the money that is
available for lending, which can be seen as a supply curve of loanable funds. The desired
investment curve can be seen as a demand curve for loanable funds. Therefore, given the fixed
amount of savings, the equilibrium interest rate is formed by the choice of investment, which
corresponds with the desired investment curve.
In this framework we can analyze the impact of an increase in government borrowing. When a
government borrows money, the demand for loanable funds increases. Due to this increase, the
equilibrium interest rate will rise as well, which leads to a decline in investment. This way the
government crowds out investment by increasing its borrowing. This increase in government
spending also makes the interest rate increase via the S curve in the figure above. We know that
the S represents national saving, which consists of private saving, which is basically income
minus taxes and consumption. The other element is public saving, which consists of the tax
revenues minus the government spending. When a government increases its spending by
borrowing, it decreases its savings, which makes the slope of the national savings move to the
left, leading to a higher equilibrium interest rate (Mankiw, 2015).
Figure 1 - Neoclassical equilibrium of a closed economy in the long run
So when we look at both views that are discussed above, we can see that government debt has a
neutral to negative effect on economic growth when looking at the Ricardian Equivalence,
depending on the distortionarity of the taxes that are issued in the future to repay the debt.
When we look at the neoclassical framework we see that an increase in government borrowing
has an effect on the equilibrium interest rate, crowding out investment. This means that an
increase in government spending has no effect on national income, due to the fall of investments
via the equilibrium interest rate. Summarizing these two points, the effect of government debt
on economic growth would strongly depend on the timing and distortionarity of taxes that arise
when the government repays the debt that has been made (Ramey, 2011).
2.2 Keynesian and new Keynesian view
The relationship between government debt and economic growth will also be viewed from a
Keynesian point of view as well as from a new Keynesian perspective. This part will have
roughly the same structure as the part above, which means that the focus lies on the effect of
extra government spending, since government debt means an increase in government spending
financed by a future raise in taxes.
One of the most famous economists of the twentieth century is John Maynard Keynes. A well-
known macroeconomic theorem is the Keynesian cross. In figure 2 there is a graphical
representation of the Keynesian cross. The y-axis represents the aggregate demand (AD) and the
x-axis represents the output of an economy (Y). The so called 45°-line consists of the connection
of points where the economy is in an equilibrium. The equilibrium of an economy is found where
the aggregate demand curve intersects the 45°-line. The slope of the aggregate demand curve is
the marginal propensity to consume (MPC). For every extra unit of output, there is a fraction
that is added to the aggregate demand.
Figure 2 - Keynesian cross with 45°-line and Aggregate Demand curve
The aggregate demand curve in a closed economy consists of consumption, investments, and
government expenditures. The government receives taxes, which makes the basic identity that
we work with as follows, given that in equilibrium this curve is equal to the actual output Y:
(2) Y=C (Y−T )+ I+G
This equation sheds a light on the effect of an increase in government spending in this Keynesian
view, which is quite different from the mechanisms that are described above. The initial effect of
an increase in government spending is that income Y increases with the exact same amount.
However, an increase in Y triggers an increase in consumption C. The increase in consumption in
its turn makes that income rises, leading to an increase in consumption. This circle repeats itself
infinitely, which means that the effect of an increase in government spending can be measured in
terms of a multiplier (Mankiw, 2015). Mathematically this means that the multiplier can be
calculated by adding all the effects that are repeated to infinity.
(3)1
(1−mpc )
The expressions above is the multiplier for government expenditures. The term mpc stands for
the marginal propensity to consume. This is basically the C in the expression that explains Y.
When G increases with 1, the effect is can be calculated as follows:
(4)∂Y∂G
=1+ mpc(1−mpc)
Expression 4 is reflects what has been explained before. The two parts in the equations show the
initial impact of an increase in G, namely 1 and the next part shows the infinitely repeated
impact on consumption, which has an impact on Y et cetera. When expression 4 is rewritten, it
becomes expression 3. We can do the same for the multiplier of taxes. By calculating what an
increase in T does to the value of Y the multiplier for taxes is found to be:
(5)−mpc
(1−mpc )
Combining equation 3 and 5 can tell something about the effect of government debt on economic
growth. Where the neoclassical view predicts neutrality or even a negative effect, the Keynesian
view predicts a positive effect. An increase in government expenditures will always be higher
than an increase in taxes in the future. One of the differences between the neoclassical view and
the Keynesian view is that in the Keynesian view interest rates are assumed to be constant in the
short run. Given this constant interest rate, the Keynesian cross is deducted, which is the
foundation of this reasoning. To broaden the spectrum of views on government debt and
economic growth, the New Keynesian view will be discussed.
2.2.1 New Keynesian view
New Keynesian economics is a school of thought which strives to find microeconomic
foundations for macroeconomic phenomena (Romer, 1993). In this case of the effect of
government spending, somewhat the same framework as the neoclassical one is used for
analysis. Upon this foundation the assumption of sticky prices is added. To explain how this
works the neoclassical foundation will be discussed. After that, there will be a short explanation
on the sticky prices assumption and in the end both components will be combined, resulting in
the new Keynesian view on the effect of government spending. The neoclassical framework is
graphically represented in figure 3 on the right hand side.
In the graph there are several components found that build this framework. Aggregate demand
and aggregate supply make up an equilibrium which consists of real GDP and the average price
level. In the long run aggregate supply is assumed to be constant, which is also explained in the
section above concerning the neoclassical view. The aggregate demand of an economy is
assumed to be negative related to the average price level, which is one of the most basic
assumptions in economics. When prices are high, demand is lower than prices are low. An
increase in government spending comes as a shock in the aggregate demand curve, which is
shown in the graph, which makes the AD2 go to AD1. Since aggregate supply and aggregate
demand make up the equilibrium and aggregate supply is constant, the only effect of an increase
in aggregate demand through an increase in government spending, is that the average price level
will go up and the GDP in the equilibrium remains the same.
An important assumption that is part of the new Keynesian way of thinking is the assumption of
real rigidities. In the paper of David Romer (1993) an example of a single firm is given where,
when demand falls, the firm has only a little incentive to lower its price, but it is likely that the
firm will hold its price constant. Also imperfect information and market externalities have the
effect of ‘sticky’ prices, which do not adjust immediately when demand falls or they will not
Figure 3 – The neoclassical diagram (right) and the new Keynesian diagram (left)
change at all (Romer, 1993). The consequence of these sticky prices is the shape of the aggregate
supply curve. In Figure 3 the difference is quite clear between the neoclassical aggregate supply
curve and the new Keynesian one. When an economy produces below its maximum output and
prices are sticky, an increase in aggregate demand will lead to a higher output level in this
model. In this case government debt can have a positive relationship on GDP, because of the
increase in output in the long run. This relationship is augmented by some other theories where
other effects like ‘hysteresis’ are taken into account. This hysteresis effect is the damage dealt on
an economy in the long run when an economy produces below its potential output. When this
effect is taken into account, the positive effect of government debt on GDP will increase (DeLong
& Summers, 2012).
It is clear that there are two main thoughts about extra government spending. Where the
neoclassical view states that the effect of government debt will be neutral or even negative, due
to distortionary taxes. Where the (new) Keynesian view points out that government spending
can have a positive effect on economic growth when this spending is applied at the right time. In
this view government debt can have a positive effect on economic growth. The next elements
that will be added are the theories that are behind the existence of a tipping point in the
relationship between government debt and economic growth. Also I would like to discuss the
role of the banking sector in this relationship.
2.3 Tipping Point
The question whether the relationship between government debt and economic growth is non-
linear or in other words: whether there exists a tipping point is a relevant question to examine.
Reinhart & Rogoff (2009) find this relationship, but a decent theoretical explanation behind it
seems to be relevant. I will start by introducing an accounting identity that is stated in several
papers such as the paper of Willem Buiter (2012) and the paper of Jay Shambaugh (2012). This
equation will be the foundation where the two drivers that are going to be discussed are being
built upon. This equation is the following:
(6) ∆ d=(r−g )d−s
This equation represents the determination of the change in the debt-to-GDP ratio of a country
d, which is determined by r, which represents the actual real interest rate. Variable g represents
the economic growth rate of real GDP and s is the primary surplus (i.e. tax revenues minus non-
interest government spending) as a percentage of GDP. This equation becomes important when
the tipping point in the relationship between government debt and economic growth is being
discussed. Another important equation is the equation that can be created when the equation
above is being rewritten, this is the budget constraint of a government, which means that the
change in debt is equal to zero:
(7) s= (r−g )d
To explain what these identities have to do with the tipping point that is being discussed, I will
start by explaining a straightforward theory on tax revenues and after that the phenomenon of
excessive debt, as described by Buiter (2012), will be discussed.
2.3.1 Laffer Curve
When tax revenues are concerned, the Laffer curve is one of the most well-known theories that
is available. The basic idea is that there exists a revenue maximizing taxation rate at which the
government can maximize its tax income. The graphical image of this curve is well known and
therefore it will not be included. The y-axis represents total tax revenue and the x-axis
represents the tax rate that the government can choose, from zero percent to one hundred
percent, obviously. When the basic idea behind this revenue maximizing tax rate is that when
the tax rate is set at zero, the government will not receive any tax revenues. When the tax rate is
rising, the government will receive more tax revenues. This effect is not the only effect at work.
When taxation rates are in some way too high, especially in the extreme case of a hundred
percent, people are not likely to work anymore, which means that the tax revenues will be
approaching zero again. So somewhere in the middle is the revenue maximizing tax rate where
the government receives the highest tax revenues possible (Burda & Wyplosz, 2009).
So according to this Laffer curve, there is a certain limit of tax revenues that a government faces.
These tax revenues seem important in the two equations that are stated above, since they are an
important part of the primary surplus. Especially when we look at the first equation, it is clear
that there is a certain maximum amount of government debt that can be realized in a year.
Although the maximum tax revenue can be realized in theory, in real life a government would
never choose this tax rate. Only a dictator would do so, so it is important to keep in mind that the
maximum tax revenue of the government will never be realized. Before the relationship of this
Laffer curve to the tipping point is going to be explained, I will first examine the phenomenon of
excessive debt, which has been described in the paper of Buiter (2012).
2.3.2 Excessive Debt
The paper by Buiter (2012) starts by stating that the debt levels have been growing since the
1980’s until the present. First in private debt and later on in public debt as well. Although debt
levels of public and private debt are historically high, there is a process of deleveraging going on
in the private sector, but the public is not really deleveraging like the private sector. In this
research the focus will be on public debt, because of the research question. It is important to
understand why there is such a high amount of public debt and it is also important to know why
deleveraging is sometimes necessary as well as it is important to understand how deleveraging
can be done (Buiter & Rahbari, 2012).
There were a number of important drivers in the period of leveraging up to now. It is important
to know that debt for a long time is considered as a financial asset due to the promise of future
payments. This makes debt attractive to many, even though these future payments imply risk.
An important factor in the leveraging that lead to the point that we are now is the liberalization
of the financial sector. This is linked with a number of other factors that played a role in this
leveraging. These other factors are the falling of lending standards, which can be linked with the
boom in real estate prices. Also fast real economic growth is a factor that is mentioned as well as
a fall in real interest rates, which makes in more attractive to borrow money. As far as the public
sector goes, the financial crisis has caused a governments to borrow money, for example for
saving banks that were in danger (Buiter & Rahbari, 2012).
After the brief description of the leveraging process that is going on, it is quite relevant to
explain when debt levels can turn into excessive debt. Debt becomes excessive when financial
markets react to the level of debt by increasing the interest rate that is on the debt. The interest
rates will reach such a high level that the country with the excessive level of debt is not able to
pay its interest costs and therefore it will default. By simply looking at numbers and figures
across countries one can see that the debt levels per country differ quite significantly. So the
question that rises is the question when are debt levels becoming excessive and what are the
consequences of this?
There are mainly two things that can be the consequence of excessive debt. First of all, high debt
levels make agents vulnerable to crises. The second important aspect is that countries or other
agents can be unable to repay their debt, because it is not sustainable anymore. It will be hard to
repay and therefore interest rates on the loans might rise, which makes it even harder to repay a
loan. A good example of this is Greece in the current Euro crisis.
Let’s focus on both mechanisms a little more. The first mechanism is that high debt levels can
lead to economic crises. Especially in the world we live in now, the financial system can be quite
complicated. Many agents are linked to each other and that means that the risk of debt is spread
widely across agents in the economy. The financial crisis of 2008 is a good example where the
connection between different financial institutions is a reason for an economic shock to be
influential for the economy. The financial products became more complex and because of the
default on loans, the consequences where enormous.
The other mechanism is that agents are unable to repay their debt, because of the high level of
debt and the interest rate that comes along with such a high level. I will focus especially on
governments, because the research is about government debt. We see in equation 3 and 4 that
are described above, that governments face a certain constraint of how much they can borrow. It
might be the case that government debt reaches a level where the government is not very likely
to repay the loan, because of high interest costs. When this happens, financial markets react,
which is made clear by a rise in interest rates. A good example of this is the situation in Greece,
where solvability issues that were not necessarily noticed led to financial trouble. The interest
rates grew enormously and Greece itself was not able to repay any of the debt because of the
high interest costs (Buiter & Rahbari, 2012).
2.3.3 Ability & Willingness To Pay
Several theoretical mechanisms are discussed about the effect of government debt on economic
growth. All of these theories have an underlying assumption which seems to make sense, but is
not necessarily realistic. In the neoclassical and the (new) Keynesian framework it is always
assumed that governments repay the debts that they make. It is of course important to
investigate whether this is the case in reality. Do governments have a reason to repay their debt?
In their book Reinhart & Rogoff (2009) comment on this issue. It seems that a government is less
in need of leverage to borrow money, due to its reputation of repayment. This is different
compared to borrowing money in the private sector where repaying penalties are significantly
higher (Reinhart & Rogoff, 2009). If governments are not really willing to pay back their debt, it
might well be that their debt becomes excessive.
2.3.4 Is There A Tipping Point?
There are theoretical arguments that are in favor of the existence of a tipping point. The Laffer
curve shows that the government is not able to borrow infinitely and the other part shows that
debt can reach certain levels where the risk can be too high and widespread in a way that it can
cause a crisis. Also financial markets can react on a sovereign debt that is so high that the risk of
default becomes real. In that case interest rates will rise and the government will not be able to
repay the debt because of enormous interest costs. Whether this tipping point appears to be the
same for every country is the question that needs to be dealt with in the empirical part of this
research.
2.4 The Role Of Banks
The theories that are discussed before were mainly based on the relationship between
government debt and economic growth. For a broader view, the role of banks in the relationship
between the two variables is going to be examined. It seems quite interesting, since banks have a
link with government debt as well as with economic growth. These links will be discussed
theoretically. The framework that is going to be used is a framework that is written down by Jay
Shambaugh (2012) in his paper. In his paper he investigates the relationship between the three
crises that Europe faces at the moment. The graphical representation of this framework can be
found in Figure 4.
The three crises that are discussed in his paper are the sovereign debt crisis, the growth crisis,
and the banking crisis. The connection between these crises are being discussed and the
underlying mechanisms are explained. In this section I will explain the mechanisms behind the
relationships of government debt with the banking sector and economic growth and the banking
sector respectively.
2.4.1 Banks & Government Debt
The relationship between the banking sector and government debt works in both ways. I will
first explain the mechanism where the banking sector is influenced by government debt. In this
case it is necessary to state the fact that banks typically have government bonds on their balance
sheet. When government debt is becoming excessive and there is a serious possibility of default,
banks can be damaged because of the bonds that are on the balance sheet of the bank. The risk of
banks is often linked to the amount of government bonds on the balance sheet (Acharya,
Drechsler, & Schnabl, 2011).
When banks encounter solvency problems, it is likely that the government needs to step in and
provide liquidity to banks through funds and guarantees. A more extreme case is a bailout,
where for example a government takes over a bank. This can have a significant influence on
Figure 4 - The graphical representation of the framework in the paper of Shambaugh (2012)
government debt. It does also mean that, besides the fact that sovereign risk is present in the
financial sector, risk of the financial sector is being transferred to governments (Shambaugh,
2012). This means that when banks find themselves with solvency problems, the government
needs to spend money on these banks, which means that government debt is likely to grow.
2.4.2 Banks & Economic Growth
The relationship between the banking sector and economic growth is also going to be explained
in both ways. I will start with the impact of the banking sector on economic growth. First of all it
is important to state that economic theory predicts that a well-functioning financial system (i.e.
stock markets and banking sector) has an influence on economic growth (Levine & Zervos,
1998). Banks provide loans so consumers and firms are able to consume and invest. In an ideal
case, a healthy financial system allocates capital to productive uses (Shambaugh, 2012).
What happens when a bank finds itself in a crisis? Banks are likely to lend less to consumers and
firms. The positive effect that the lending of banks has on economic growth becomes less and
theoretically economic growth will fall due to this behavior of banks. It is important to keep in
mind that these two assumptions are made: banks lend less when they find themselves in a
crisis. The second assumption is that banks in normal times have a positive effect on economic
growth. An effect that is associated with this is that banks are likely to weaken the effect of
monetary policy in an economy.
To understand how the effect works in reverse (i.e. how economic growth affect the banking
sector) it is necessary to focus on the assets of banks. As said earlier, banks have certain assets
and liabilities. The assets that play a role in the relationship between economic growth and
banks are: loans of consumers and firms and sovereign bonds (Burda & Wyplosz, 2009). When
the economy is in a depression, consumers and firms are more likely to default on their loans.
Banks have these loans as assets on their balance, which means that banks are harmed by these
defaults and become more prone to liquidity risks. The same goes for the sovereign bonds. In
times of economic downturn, governments might encounter solvency problems on their loans.
Banks that have government bonds on their balance sheet are in this case harmed by a decline in
economic growth.
So we see that banks play a role in the relationship between government debt and economic
growth. Although these explanations are mostly theoretical, later on there will be empirical
foundations for these theoretical explanations. Mainly by looking at the current crises that are
going on in Europe.
2.5 Remarks
The theories that are explained above are mostly about the effect of government debt on
economic growth. An important addition to this is that, when we speak in terms of causal effects,
the effect might as well be the other way around. Shocks in economic growth can have influence
on government debt. The Euro sovereign debt crisis is a good example where government debt
levels not necessarily predicted the upcoming crisis (Lane, 2012). Equation 3 shows the
determinants of a change in government debt. When a country faces a negative shock in
economic growth, the tax revenues that the government receives will drop, which causes the
primary surplus to drop. This will cause the change in government debt to rise. The theories that
are discussed before have the assumption that government debt is the rise in government
spending in the present which is financed by a raise in future taxes. But it is good to mention that
the relationship can also be the other way around.
2.6 Summary
Concluding, there are a number of main theories discussed that may help in discovering the
driving forces that work within the relationship between government debt and economic
growth. The Ricardian Equivalence theorem as well as the neoclassical point of view on
government debt and economic growth predicts that the influence will be neutral, but if taxes
appear to be distortionary the influence of government spending financed by future taxes will be
negative on economic growth. The (new) Keynesian view is somewhat different in assumptions
compared to the neoclassical view. There is also a difference in outcome when it comes to the
effect of government spending. In the (new) Keynesian framework government spending might
have a positive effect on economic growth and multipliers of government spending are typically
higher when compared to the neoclassical framework. The main difference in assumptions
between the two views is the view on short term flexibility of prices.
The question whether there exists a tipping point in the relationship between government debt
and economic growth will be answered, according to the theories that are discussed in this
paper, with a positive answer. The main reasons are the existence of a certain maximum in tax
revenues. When government debt means an increase in spending now financed by an increase in
taxes in the future, this is implies that there is a maximum in the change in government debt. The
Laffer curve supports the view that a government faces a maximum in tax revenues that are
possible. An implication of this is found in the literature that explains the phenomenon of
excessive debt. Some reasons that leverage takes place where discussed, as well as the possible
consequences of this great leveraging. This phenomenon of excessive debt, where Greece in the
current Euro crisis is a good example, gives reason to assume that there is a tipping point in the
relationship between government debt and economic growth.
Another aspect in the research question is investigated, namely the relationship with the
banking sector. We have seen that banks can have an amplifying effect on crises. The
relationship of banks with government debt as well as with economic growth have been
discussed. Some theoretical mechanisms have been explained. Banks and government debt are
related due to the fact that banks have government bonds on their balance sheet, which makes
them vulnerable when governments face solvency issues. The other way around, when banks
face solvency or liquidity issues, the government might step in, which might have an effect on
government debt.
Banks and economic growth are related in the idea that banks have an important role to play in
the allocation of capital to productive uses. When banks neglect this role due to a crisis in the
banking sector, economic growth is likely to decline. The other way around, when the economy
faces a negative shock, banks can be harmed through the inability of governments, household
and firms to repay their debts. The assets on the balance sheet of a bank are declining in value,
which harms the banking sector. As said earlier, banks might amplify the effects of government
debt on economic growth. To determine which mechanisms have a significant impact on the real
world, I will select some empirical literature. Based on these outcomes it might be possible to
shed some light on the relevance of these mechanisms.
3. Empirical LiteratureThis part of the research focusses on empirical literature that concerns the theories that are
named in the theoretical part. This part will be roughly divided in a couple of sections. The first
section will focus on empirical literature on the government spending multiplier. I will discuss
papers with different methods and different outcomes. These papers will shed a light on the
theories that were neoclassical and Keynesian. The other empirical literature will concern the
Laffer curve, which has an influence on the budget constraint of a government.
Another part of the empirical literature will be about excessive debt. The empirical papers will
be about the relationship between high debt and financial markets reacting by high interest
rates on government bonds. Is there such a thing as excessive debt and when does it occur?
Also some extra papers will be examined to broaden the spectrum, for example the ‘willingness
to repay’ government debt will be discussed empirically.
3.1 Multiplier Studies
The first section is about the magnitude of the multiplier on government expenditures. This part
will mainly test the hypotheses of the first theories, namely: Ricardian Equivalence,
neoclassicism, and (new) Keynesian thinking. The effect of government spending is a debate that
is going on for quite a while and it seems to be relevant today in Europe, but also in the United
States. I will discuss a number of papers with different methods and different outcomes. I will
focus on the differences between them. This might shed a light on the mechanisms that are
working in the real world concerning government debt and economic growth.
The papers that are being discussed here are quite recent papers which are based on the
selection that is made in the overview paper of Ramey (2011). This will give an overview on the
general results concerning the multiplier. To broaden the view on multipliers there will also be
some attention to a paper by Alesina & Ardagna (2010), which describes a mechanism where
fiscal austerity works in an expansionary way. This is quite a different way of looking at the
multiplier in terms of theoretical framework and results. There will also be a paper that
contradicts the results of Alesina & Ardagna. At the end of this section there will be a short
discussion on the impact of the multiplier on the effect of government debt on economic growth.
3.1.1 Overview of the Evidence
There are quite a lot of studies that investigate the value and significance of the multiplier. In
this section a number of papers will be discussed that are mentioned in the literature review of
Ramey (2011). The first paper that will be discussed is a paper of Nakamura & Steinsson (2014),
which uses a method that is quite commonly used in multiplier studies, namely looking at an
increase in military spending. This is a good way to look at a shock in government spending,
since military spending can be seen as an exogenous shock, because of the fact that it is not
necessarily related to the state of the economy. The authors look at the increase in military
spending in different states of the United States and try to estimate the effect on the GDP of that
state respectively. By using a dataset of the years 1966 to 2006 on military spending and on
GDP, they run a regression where they try to find the effect of relative increase in military
spending two years ago on the relative increase in income of the state in the present compared
to two years earlier. In this research they find a multiplier of 1.5 (Nakamura & Steinsson, 2014).
Another research that uses a different approach is the research of Chodorow-Reich, Feiveson,
Liscow, and Woolston (2012). In this paper the focus lies on the American Recovery and
Reinvestment Act (ARRA) of 2009, where $88 billion dollars of aid was administered to states
through the so called Medicaid reimbursement process. The authors estimate a regression
where the change in employment over one period in time in a state relative to the state’s
population is explained by the amount of aid the state receives relative to the state’s population
and some control variables. Their results are measured in a way that they calculate the amount
of jobs created through a $100,000 increase in aid received by a state. The outcome of this is that
on average 3.8 jobs are created through this amount of spending. The value of a job is set at the
average compensation for a job in 2008, which is $56,000. With these figures they are able to
calculate a government spending multiplier, which is in this research found to be 2 (Chodorow-
Reich, Feiveson, Liscow, & Woolston, 2012).
3.1.2 Expansionary Austerity
The two papers that are discussed above have a somewhat high multiplier, which indicates that
the effect of the multiplier that is described in the theoretical part seems to be at work in the real
world. The paper that will be discussed now is a very influential paper by Alesina & Ardagna
(2010). The paper is different in structure, in method, and in outcome when compared to the
papers that are discussed before. The reason that this paper is interesting is that it focusses on
the idea that fiscal adjustments, or contractionary policy, might have a positive effect on
economic growth. In the beginning of the paper this is being explained. There are two
mechanisms at work according to Alesina & Ardagna: First of all the reaction of agents on a
contractionary policy. Agents might have the belief that because of the relatively small amount of
extra tax will result in the avoidance of a larger tax burden in the future. This could have a
positive effect on economic growth. The other mechanism that is explained is that agents gain
more trust in the government, what makes that interest rates on government bonds go down.
When this causes the real interest rate to go down, which might result in higher consumption
and higher investments.
The methodology is quite straightforward. Regression is used to estimate the effect of certain
changes in fiscal policy on economic growth. The data consists of several episodes where fiscal
policy changed significantly and this data is put in a regression where the distinction is made
between episodes where the policy was expansionary and when the policy was contractionary.
The results of this research are presented in two OLS estimations: one for periods of fiscal
stimulus and the other for periods of fiscal adjustment. Their findings can be summarized as
follows: periods of fiscal adjustment are often associated with higher economic growth, while
fiscal stimulus does not seem to have an effect on economic growth (Alesina & Ardagna, 2010).
Even though this paper is quite influential, there is also some critique on the methods that
Alesina and Ardagna used.
One of the papers that has critique on the paper of Alesina & Ardagna will be discussed now. The
paper is written by Guajardo, Leigh, and Pescatori (2011). This paper compares the method that
is used by Alesina & Ardagna among some other studies and another method that they
introduced called the historical method. The difference in method mainly lies in the way that
fiscal contraction is defined. In the paper by Alesina & Ardagna the measure for fiscal
contraction is found in a decrease in the cyclically adjusted primary balance (CAPB), which is
basically the non-interest revenues of a government minus its non-interest expenditures
subtracting the estimated effect of the business cycle at point in time. The problem with this
measure is that it contains quite a significant bias. There are two main reasons for this discussed
in their paper. The first reason being that the change in CAPB often is related to shocks in
economic activity, rather than in the change of fiscal policy. Another bias lies in the fact that
governments tend to raise taxes to prevent the economy from overheating and from inflation to
rise excessively. This could lead to the problem of reverse causality, since an increase in taxes is
indeed correlated with high economic growth, but the mechanism of expansionary austerity is
not really at work. The historical approach that the authors of the paper use is based on episodes
in history when a government decides to raise taxes or to cut spending where the goal is to
reduce the budget deficit in an economic downturn. The results are quite different from Alesina
& Ardagna, namely that austerity is indeed contractionary (Guajardo, Leigh, & Pescatori, 2011).
3.1.3 Summary
A few different empirical papers regarding the government spending multiplier have been
discussed here. When we look at these papers it is clear that different approaches empirically
will lead to different outcomes. Especially in the case of government spending is clear that
economists differ in opinion. What can be said when the papers that are discussed above are
taken into account, is that the multiplier can differ in different economic situations. The
multiplier of government debt is typically between 0.8 and 1.5 (Ramey, 2011). Also the effect of
government spending in times where the interest rate does not react on government spending is
worth investigating more. Especially in the economic crisis that we are in now. Another
mechanism that is discussed is the so called ‘expansionary austerity’ that is introduced by
studies like the one of Alesina and Ardagna. Despite the fact that their study seems to prove their
theoretical foundations for the existence of this mechanism, their results are refuted by a
number of papers, which point out that their empirical analysis contains a bias.
3.2 Tipping Point
In the theoretical part of this research the issue of the tipping point in the relationship between
government debt and economic growth has mainly been divided into two parts: the first part
examines the Laffer curve and the second part is about excessive debt. The first part will be
discussed empirically with papers that investigate the validity of the Laffer curve. Also the
findings will be linked to the question whether there might exist a tipping point. The other part
will be about excessive debt. The main idea of this part is that I will discuss the current Euro
sovereign debt crisis. There are some papers that investigate the origins of this crisis. The
theoretical drivers and consequences of excessive debt are sometimes found in this crisis.
3.2.1 Laffer Curve
In the United States the Laffer curve has been the reason for some tax cuts in the 1980’s. It is
often claimed that through these tax cuts the tax revenues increased. In fact, in the United States
during the time of president Reagan, tax cuts lead indeed to higher declared income of the richer
people in the country, which meant that tax revenues where rising. This is often used as an
empirical argument of the existence of the Laffer curve. An empirical paper I will discuss now is
a paper by Martin Feldstein (1986), who investigates the effect of the tax cuts in the United
States during 1981.
After the United States government implemented a flat tax rate of 25 percent, the economy grew
fast and tax revenues grew with the economy. The question is whether this economic growth is
caused by the effect of the Laffer curve. The author points out the fact that initial growth
expectations were much higher than the actual growth rates in the period after the tax reform.
Although Feldstein claims that the relatively big increase in tax revenue is not only the work of
the reduction of the tax rates, there is a paper that investigates the behavioral effect of the tax
rate reduction in the United States. This paper by Lindsey (1985) looks at the declared taxable
income for tax payers in different segments before the introduction of this flat tax rate. The
findings of the paper that especially the tax payers with higher income have higher declared
taxable income than before. Feldstein recognizes this, but still concludes that the effects of the
policy are overstated (Feldstein, 1986).
Another paper I will discuss is a paper by Trabandt & Uhlig (2009) on the existence of a Laffer
curve in the United States and Europe. The main focus of this paper is to calculate the revenue
maximizing tax rate in fourteen countries in Europe and in the United States. The distinction is
made between taxation on income and taxation on capital revenues. A neoclassical growth
model is applied on the statistics of the United States and on the fourteen European countries
and the results can be summarized as follows: Both the United States and the countries from
Europe can raise their taxes without losing revenue. This holds for both taxes on capital as well
as for taxes on income. The Laffer curve has no maximum level and the revenues appear to be
increasing in the tax rate. Although taxes are still distortionary and transitions between different
tax rates have an influence as well (Trabandt & Uhlig, 2009). This view is based on a neoclassical
growth model, which begs the question whether this is perfectly compatible with the real world.
It is also not likely that there is no maximum tax revenue that is possible. This paper is included
in this research to show that although there are differences in opinion about the Laffer curve,
there is always a maximum in tax revenues that a government should take into account. Even
though this maximum tax revenue is there, it is not likely that it will be implied, because of the
fact that a government deals with real citizens, which would not accept their government
extorting them. Despite the different views on the existence of a Laffer curve, the idea that the
government faces a budget constraint in which the tax revenue cannot be infinite is not refuted.
3.2.2 Excessive Debt
In the theoretical part of this research I have stated some accounting identities that show the
budget constraint that a government faces. When the government has a debt that is excessive,
financial markets might react by increasing the interest rates on government bonds. This makes
it harder to repay the debt in the future and the probability of a default is very likely to rise. To
see whether the mechanisms that are discussed in the theory hold in practice, I will look at the
case of the European sovereign debt crisis. It is an example of how debt can turn into excessive
debt in some countries. I will try to examine the driving forces of this crisis. The first paper that
gives good insight in this crisis is a paper by Philip Lane (2012) which explains the possible
causes and effects of the Euro sovereign debt crisis.
The paper starts by stating that at first glance, sovereign debt itself did not appear to be a threat
to Euro area countries. In figure 5 the sovereign debt levels of some Euro area countries are
represented.
Figure 5 – The development of sovereign debt leading up to the Euro crisis
By simply looking at these different slopes, one cannot conclude that a certain pattern of
sovereign debt is considered as risky. Especially Spain is an example of a country that is hit
severely during the Euro crisis, but the sovereign debt level is one of the lowest of all the
countries that are represented in the graph. Lane names other possible pre-crisis factors that
have played a role in the buildup to the Euro sovereign debt crisis. One of the factors that is
mentioned is domestic credit. These domestic credit figures of the countries that are
represented in figure 5 appear to be a predictor of vulnerability of a country during the financial
crisis of 2008. Before this financial crisis, the Euro area faced a boom in the economy, which led
to relatively high domestic credit in ratio to GDP. Ireland is a good example of this. Because of
the economic boom, the domestic credit in Ireland rose immensely, which implies extra
vulnerability (Lane, 2012).
When the financial crisis hit Europe, countries with high domestic credit where hit the hardest,
because of the fact that companies and people were less likely to repay their debt, which has an
effect on the economy in a country. This was the trigger for financial assets to be revaluated. It
appeared that sovereign bonds from certain countries like Greece, Spain, Portugal and Italy were
more risky than initially thought. The result of this is that interest rates of government bonds,
especially Greek bonds, increased immensely, leading to a vicious cycle, which made default
almost inevitable (Lane, 2012).
What can be learned from this is that there is not a general level of sovereign debt that is
applicable to all countries. However, even though financial markets had to revalue sovereign
bonds due to the impact of the financial crisis, there are certain levels of debt where financial
markets tend to react by increasing the interest rates on sovereign bonds in such a way that the
debt becomes almost impossible to repay. In other words: debt has become excessive. In the
theoretical part that was discussing the paper of Buiter (2012), there were named several
factors that lead to the leveraging of the past decades. These factors contributed to the fact that
financial markets did not react immediately when a government has a debt that is excessive. The
existence of excessive debt is backed by research of Calvo (1988) and Corsetti & Debola (2011)
which both made models where the interest on public debt appeared to be caused by
expectations about the repayment of the debt. These models where theoretical, but nevertheless
they appear to be applicable when we look at the Euro sovereign debt crisis.
3.2.3 Ability & Willingness To Pay
In the theoretical section there was made a short remark about the willingness of a government
to repay its debt. When it comes to excessive debt of governments as discussed before, the
ability to repay the debt becomes a crucial part, whereas the willingness of a government to
repay its debt is also an important factor on the origins of a governments’ debt. Reinhart &
Rogoff (2009) argue that governments do not need real leverage to borrow money and the
penalties on not repaying government debt are quite low, because of the reputation of
repayment of a government. There are two main articles mentioned in their book which test this
hypothesis empirically.
In the papers of Bulow & Rogoff (1989) and Eaton & Gersovitz (1981) this issue is addressed
theoretically as well as empirically. Both papers recognize that especially small governments do
not face sufficient penalties for not repaying their debt. In the paper by Eaton & Gersovitz it is
found that governments are not very likely to repay their debt, because of the non-sufficient
penalty. Lenders tend to set a certain ceiling of debt, where they will not lend to a government
when it has reached the ceiling. When a government has reached its ceiling it is rationed.
However, when a government does not meet this ceiling that is established contractually, it will
remain at a certain debt level and has no incentive to repay (Eaton & Gersovitz, 1981). This is
quite an important finding, because this existence of a lack of penalty for non-repayment can
lead to excessive debt or to a certain tipping point when the debt ceiling that is introduced by
the lender is lower than the demand for loans by a government.
3.2.4 Reinhart & Rogoff
In the introduction of this paper, the research of Reinhart & Rogoff (2010) was mentioned. This
paper was essentially about the relationship between government debt and economic growth
and also about the non-linearity in this relationship. The 90% threshold that Reinhart & Rogoff
calculated has had an impact on the discussion about austerity in Europe and the United States.
First the outline of the paper of Reinhart & Rogoff will be discussed and after that a paper that
discussed the paper of Reinhart & Rogoff will be summarized. The research of Reinhart & Rogoff
was on a historical basis. They looked at a large database of many countries during a long period
of time. The 44 countries that were analyzed had data available in a time span of 200 years. The
analysis was pretty straightforward. They categorized their data in periods where the
government debt to GDP ratio was 0-30%, 30-60%, 60-90%, and 90% or higher. These
categories were divided into developed and developing countries. The economic growth rates of
all the categories were compared and it appeared that the observations above the 90% ratio in
developed and developing countries had a significantly smaller economic growth than all the
other categories. Leading to the conclusion that the relationship between government debt and
economic growth is non-linear and knows a threshold of 90% (Reinhart & Rogoff, 2012).
However, Herndon, Ash, and Pollin (2013) found some coding errors in the analysis of Reinhart
& Rogoff, which is quite problematic regarding the outcomes of the research. Also, some data
was left out in the original research of Reinhart & Rogoff. The paper of Herndon et al. replicates
the research of Reinhart & Rogoff, leading to completely different results. They find that the 90%
threshold is not a hard rule of thumb. Which begs the question whether this threshold exists.
However, on the question whether a country faces a threshold where government debt becomes
harmful for the economy more research is needed (Herndon, Ash, & Pollin, 2013).
3.3 The Role of Banks
The role of banks in the relationship between government debt and economic growth has been
discussed in two parts in the theoretical part: The relationship between banks and economic
growth and the relationship between banks and government debt. I will discuss two papers that
empirically assess the relationship between the banking sector and economic growth. The two
papers are by Levine & Zervos (1998) and Naceur & Ghazouani (2007). Both papers have shown
different results and these results are conducted by using different methods. I will briefly
discuss the differences between both papers.
The first paper that I will discuss is the paper by Levine & Zervos (1998). There is a quite a lot of
research done by economists to determine the relationship between banks and economic
growth. This paper investigates empirically whether banks and stock markets are linked to
economic growth, capital accumulation, and productivity improvements during a period of 1976
and 1993 in 47 countries. The focus of the research is on stock markets and the banking sector. I
will mostly focus on their results on the banking sector, although I will briefly look into the
results of the stock markets section of the paper. The variables that are chosen for both parts
are: Capitalization, value traded, turnover, volatility, bank credit, APT integration, and CAPM
integration and the dependent variables are: Output growth, capital growth, productivity
growth, and savings (Levine & Zervos, 1998). The results are summarized in regressions on the
four dependent variables and can be summarized as follows: The initial level of stock market
liquidity and the initial level of banking development has an effect on future economic growth,
even after controlling for a set of other variables. The results are significant with a confidence
interval of 5% and the results are significantly high (Levine & Zervos, 1998). This means that
according to this study the mechanism that is described in the theoretical part has some backup
according to this paper.
The other paper that I will discuss briefly is a different study by Naceur & Ghazouani (2007) and
the outcomes of that paper are different than the outcomes of the paper that is described before.
The structure of the paper is slightly different as well. Like Levine & Zervos, the authors use a
regression to estimate the effects of stock market development and banking development.
However, the data that is used is from MENA (Middle-Eastern and Northern African) countries
that vary in state of economic growth and development in financial system. That being said, the
only dependent variable is economic growth, but the distinction is made between banking
development and stock market development. The outcomes of this research are that the
development of the banking sector has a negative correlation with economic growth, but the
coefficients that are related to the development of the stock market show no significant
relationship (Naceur & Ghazouani, 2007).
These papers have different outcomes, obviously. The authors of the second paper state that the
positive outcomes of the paper of Levine & Zervos suffer from econometric problems. These
econometric problems are not explained. Although the results of their paper is different, the
authors of the second paper make an important remark at the end of their paper, stating that the
difference in results may be obtained by the weakness of the NEMA countries’ financial sector.
Also political and economic turmoil in the countries in the Middle East and Northern Africa may
also have caused the fluctuations in economic growth. This being said, it might not be correct to
state that the development of the financial sector leads to less economic growth. Looking at both
papers and other literature regarding this topic, it seems that a healthy financial system
stimulates economic growth.
In the theoretical part is discussed that slow economic growth can have an effect on banks in a
way that the lending by banks declines. When the lending of banks appears to be connected to
economic growth, banks drying up their lending during an economic crisis have an amplifying
effect on economic growth. I will discuss a paper by Ivashina & Scharfstein (2008) which
investigates the empirical relationship between an economic crisis and the lending behavior of
banks. Theory predicts that banks will dry up their lending during an economic crisis. The
authors of this paper divided the paper in two empirical parts, where the first part focusses on
basic numbers and figures and describing the effects of the financial crisis on different types of
lending. The summary of the findings is that during the financial crisis new lending dropped by
37% in dollars and by 22% in issued loans (Ivashina & Scharfstein, 2008). Loans of all sorts
dropped significantly and there is a distinction made between a demand and a supply effect. In
this case the supply effect seems to be relevant. During the financial crisis banks were exposed
to more risk and this might have caused a part of the decline in lending (Ivashina & Scharfstein,
2008).
3.3.1 Summary
The research on the effect of banks on economic growth in combination with the research on the
effect of an economic crisis on the lending of banks shows that the theoretical relationship
seems to be somewhat present. Also the effect of bank bailouts on government debt seem
evident. When a bank needs support of the government, it will result in extra government debt.
4. ConclusionThe central question that this paper is building up to is the question what the relationship is
between government debt and economic growth. Also the question whether there is a tipping
point in this relationship is examined. I will conclude by summarizing both the theoretical and
the empirical part. After that I will answer the two research questions that where proposed at
the beginning. Finally there will be some concluding remarks.
4.1 Summary
The relationship between government debt and economic growth was divided in a theoretical
and an empirical part. The theoretical literature that was discussed was divided into several
parts. The main idea behind the theoretical part is that government debt in the present results in
a higher taxation in the future. The first part was dedicated to the theoretical approach to the
government spending multiplier. The distinction was made between the Ricardian equivalence
proposition and the neoclassical model on the one hand and on the other hand the (new)
Keynesian approach, which lead both to somewhat different outcomes: The well-known debate
in economics whether government stimulus has a neutral or negative effect or a positive effect.
Also the distortionarity and the timing of taxes play an important part in the theoretical
relationship between government debt and economic growth.
The next part was about the existence of a tipping point in the relationship between government
debt and economic growth. The focus in this part was mainly on the budget restriction of a
government regarding the evolution of government debt. The first theory that was discussed is
the so called Laffer curve. The idea behind this was to show that, when government debt in the
present means a raise in taxes in the future, that the government faces a maximum in tax
revenues, which makes debt at a certain point impossible to repay. The higher taxation in the
future might in this case lead to a decline in economic growth. This means that there is a certain
point of government debt where this debt harms the economic growth. The other half of the part
was dedicated to the phenomenon of excessive debt. Debt has grown in the past decades and
several driving forces behind this leveraging were discussed. The effect of this debt
accumulation can be that debt becomes excessive and that financial markets react by increasing
interest rates on government bonds. This can lead to a vicious cycle where the government will
be unable to repay its debt or even its interest payments of its debt, which can lead to default.
However, not only the ability of a government to repay its debt is important in the theoretical
part. The willingness of a government to repay is also worth investigating, because when a
government is not willing to repay its debt, debt can reach quite high levels, which makes the
chance of default higher. Also this mechanism shows that the existence of a tipping point can be
explained in a theoretical way.
An extra aspect of the relationship between government debt and economic growth is the
banking sector. In this part the linkages between banks and government debt on the one hand
and banks and economic growth on the other hand were theoretically explained. Banks may
have an amplifying effect on both, which has an amplifying effect on the relationship between
debt and growth in general.
4.2 Empirical Part
In the empirical part the different theoretical mechanisms were somewhat tested by discussing
some empirical literature on the matters. The first part of this section consisted of studies on the
multiplier on government spending. It appears that different methods lead to different
outcomes. On average and also according to other papers that summarized the available
empirical evidence, the government spending multiplier is somewhat above the value of one.
Another insight was also discussed, namely the value of the multiplier in times where the
interest rate does not respond to an increase in government spending. This is an interesting
case, especially when the current economic crisis is concerned.
The other part consisted focused on the existence of a tipping point. The empirical evidence on
the Laffer curve also shows two sides, but the existence of a maximum tax revenue of the
government seemed likely, which aligns with the theoretical idea. The other part was mainly
about the influence of government debt on the current sovereign debt crisis in Europe. What can
be found is that debt can indeed be excessive, although financial markets will not react instantly.
In the Euro sovereign debt crisis the financial crisis was the trigger to revalue government
bonds. These results align with the paper of Buiter on leveraging and excessive debt. Another
issue when it comes to debt levels of governments is that a government is not always willing to
repay its debt. Mainly because of the fact that there are no real penalties for not repaying the
debt, because of a certain reputation of repayment that a government seems to have.
The third and final part of the empirical literature overview was dedicated on the role of banks
in the relationship between government debt and economic growth. The first thing that is
established is the idea that a growing banking sector stimulates economic growth by issuing
loans to productive uses. Another finding was that during the financial crisis the lending of
banks dried up, also lending to productive uses and corporate activity. This aligns with the
theoretical part, although a broader view on the empirical literature is necessary to make strong
statements.
4.3 Conclusion
I will now conclude on the research questions I stated in the introduction. The paper of Reinhart
& Rogoff rose the question whether government debt has a negative influence on economic
growth, especially after the 90% threshold that is explained in the introduction. The research
question is the following:
What is the relationship between Government Debt and Economic Growth?
I have looked at several theoretical aspects to determine the relationship between government
debt and economic growth. Government debt was defined as extra government spending in the
present financed by an increase in taxes in the future. Government spending appears to have a
slight positive or neutral effect on economic growth. In times where the interest rate does not
respond on government spending, the positive effect is likely to be stronger. However, the timing
and distortionarity of taxes determines the net effect of government debt. I also showed that
banks can have an amplifying effect on the relationship between both variables. Reinhart &
Rogoff state that the relationship between government debt and economic growth is non-linear,
but the research in the literature suggests that the level of debt is not determining the effect of
an increase in government expenditures. This is mainly determined by the factors that are
described above.
Another aspect of the relationship between government debt and economic growth was
formulated in the following question that was stated at the beginning:
Does a tipping point exist in the relationship between Government Debt and Economic Growth?
Theoretically there can be argued that such a relationship exists. Due to an existing budget
constraint of a government. There are several factors that might influence leveraging even when
this could lead to excessive debt. In the case of excessive debt governments face high interest
rates on their bonds, which can lead to serious solvency problems. But not only the ability of a
government to repay its debt matters in this case. Also the willingness to repay is an important
factor. Governments do not have real good reason to repay their debt, because of the lack of
penalties. The theoretical and empirical analysis points in the direction of the existence of a
tipping point. Whether that tipping point is at a certain value for all governments is not clear.
This means that the idea that there is a 90% threshold in the relationship between government
debt and economic growth is not likely to hold in reality. The tipping point might exist, but the
absolute value of 90% for every country is not in line with the findings of this paper.
The relationship between government debt and economic growth is dependent on several
factors and it appears that the existence of a tipping point is likely. More thorough research on
the effects that are discussed in this paper is necessary to get a deeper understanding in the
underlying mechanisms.
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