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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