Of debt and hot air

It is clear that the management of the public debt by the Government has been sound.

If there is a study that has had an enormous impact on the lives of millions, this is Growth in a time of debt, published by Carmen Reinhart and Kenneth Rogoff in 2010.  The two professors’ economic paper drew on historical data series on government debt and economic growth to conclude that a ratio of public debt to GDP of more than 90% was associated with significantly reduced growth rates.  It was not long before this had a political impact, especially in Europe where influential policymakers then adopted a causal interpretation   ̶   high public debt/GDP ratios are bad for growth   ̶   to argue for strict austerity.

Olli Rehn, then European Commissioner for the Economy, and the influential US congressman Paul Ryan trumpeted what they described as the “common-sense conclusion” that public debt acts as a permanent drag on growth.  We all know the results of that conclusion in the wake of the 2008-2012 financial crises.  A decade of austerity ravaged economies, provoked high unemployment, and destroyed the lives of millions of people.  

Little did it matter that Reinhart and Rogoff quickly came under criticism by none other than a postgraduate student, Thomas Herndon, who showed that their results were biased by selective choice of data, coding errors in the Excel file, and unconventional decisions in weighting the summary statistics.  After making corrections, Hendon and two co-authors found that Reinhart and Rogoff’s data no longer associated debt/GDP ratios of more than 90% consistently with lower GDP growth   ̶   there was no ’magic threshold’ beyond which growth fell sharply.

Thank God, European and US governments and central banks did not follow this prescription when the Covid pandemic broke out and economies were on the brink of a huge recession.  Debt levels, both private and public, were already at record highs before the pandemic, but public debt and easy credit rose sharply to counter the severe shock induced by the pandemic, and then continued in its aftermath when supply chains were severely disrupted and the Ukraine war broke out.

The increases in debt reflected both the rise in deficits due to the automatic stabilisers as economic growth collapsed, as well as the discretionary policy measures undertaken by governments to respond to the health crisis. Corporate debt also rose significantly, partly thanks to governments support, as corporates tried to manage the large economic shock and lockdowns.

The additional debt helped fund policy actions that reduced the negative effects of the crisis, including on potential growth, and allowed for a faster economic recovery. In addition, the case for increasing debt to promote economic growth was greater in 2019 given low interest rates.

However, the issue has not died down by any stretch of the imagination.  Any number of economists are arguing that high debt levels could constrain economic activity over the next years. Even if governments and private sector avoid bankruptcies, the effects of a private and public debt overhang could undermine economic prospects. Other economists reply that the rise in debt as a response to the economic crisis allowed the funding of programmes to save lives and businesses and could reduce scarring permitting a stronger economic recovery thereafter.

This should sound familiar to people in Malta.  In 2012 Joseph Muscat declared that, if elected prime minister, he would consign austerity to the dustbin, to which the faltering PN government of the day replied with its famous “red bulbs are flashing” slogan.  His dash-for-growth worked brilliantly, even allowing him to reduce the deficit and public debt. 

When Covid struck, Opposition leader Bernard Grech immediately criticised the government for acting slowly and too late.  When the Government did, and its huge support programme yielded the desired result, he soon reverted to the charge that the government was spending too much and imperilling the economy with high fiscal deficits and public debt.

So, who is right and who is wrong? 

I strongly believe that most of the political talk is just hot air intended for the theatre.  I always ask, what does the evidence show?  Well, it suggests that the relation between debt surges and future economic prospects are complex and that it is not clear the impact of high public debt will be necessarily negative.  It does seem that output is persistently lower after a total debt surge; however, the growth pattern depends on different factors including type of debt surge and initial macro-fiscal conditions.

Although private debt surges tend to be associated with lower potential GDP, the worse growth performance is especially pronounced among public debt surges.  But the effects depend to some degree on the initial economic conditions. The negative impact of public debt surges on future growth seems to be more pronounced when the economy starts from a stronger cyclical position (large positive output gap).  The evidence also suggests that debt surges accompanied by procyclical fiscal policy will be more disruptive. Private debt surges, on the other hand, are associated with temporarily higher GDP if the economy is experiencing a large positive output gap.

Looking at how the output gap has evolved over the last twelve years one finds that in 2012 the output gap was -2.6.  Between 2013 and 2019 it averaged +2.9, from which it fell to -6.5 in 2020.  Since then, it has risen but still remains a negative -1.8.   The latest projections show it to remain negative throughout the forecast horizon to 2025 but converge progressively towards potential growth.

Putting this in the context of the evidence adduced for the relation between debt and GDP, it is clear that the management of the public debt by the Government has been sound.  The debt/GDP ratio decreased when the output gap turned from negative to positive, even though the economy was still operating below its potential, albeit less so.  The ratio increased sharply, in contra-cyclical fashion, during Covid and its immediate aftermath and the onset of the Ukraine war and the cost-of-living crisis.  The government’s fiscal plan anticipates that the ratio will go down slowly over the forecast horizon, even though the output gap is still in negative territory.

Earlier I mentioned that whether higher debt has a negative impact for future economic growth depends on the initial conditions.  Here I would like to mention research conducted by João Tovar Jalles and Paulo Medas of the International Monetary Fund.  They found that, if total debt leverage (including private and corporate debt) is high, eventual GDP growth is on average 4 percent lower relative to the case of no debt surge. However, if leverage is low, debt surges may be associated with higher real growth for a few years.

Somewhat surprisingly, these effects are mainly driven by private sector debt surges. The initial level of total leverage is not as relevant for public debt. This suggests that excess private sector leveraging is more detrimental for future growth prospects than the size of public debt.  Wait a minute, if there was such a surge, it was surely between 2007 and 2011 under the PN government when the debt of non-financial corporations rose from 56.4% of GDP to 59.7%.  Since then, the ratio has gone down and has averaged 30.5% over the last decade.

Meanwhile, the Public Debt, which rose 6 p.p. between 2006 and 2011 to a peak of 64.8% in 2011, then declined year by year to 37.3% of GDP by 2019, and increased after Covid to 52.9% in 2021, to decline again to 51.3% in 2022.  So, again, arguably if the increase in the ratio had a negative impact on GDP with a lag, it was because of the increase under the PN government.

Looking at the total debt/GDP, the surge was between 2003 and 2011 when the ratio rose from 163.1% to 181.6%.  Since then, the ratio had been going down, declining to a low of 107.3% in 2019, except for a spike between 2020-2022 when it went up to 126.3% on average.    

Obviously, whether there was any negative impact on GDP growth can only be established with certainty by an econometric analysis.  But personally, I doubt that there was a significant effect of this kind, except possibly for a brief period because of the increase in the debt of Non-Financial Corporations.

In any case, it is important to establish some clues for why debt surges can be detrimental for economic growth. Both corporate and public debt surges are followed by significantly lower public and private investment. It suggests that firms and governments cut investment when under financial distress. Surges in public debt also have a negative impact in private and public consumption. It could be because governments undertake spending cuts and increases in taxes after the debt surge or because households constrain their spending concerned with future tax increases.

Overall, the results further strengthen the call for prudent policies and building buffers to manage large shocks, like the Covid-19 pandemic. Countries with initial lower debt levels are in better shape to increase borrowing in a crisis without jeopardising future growth.  For this, we must thank the sound public debt policy of the Labour Government, contrary to what the Opposition would have us believe.

Most studies of advanced countries over the period 1970–2002 did not find any significant relation between government debt and economic growth.  For example, Piotr Misztal’s analysis for a sample of EU Member States over the period 2000–2010, concluded that an increase in public debt by 1% in these countries led, on average, to a reduction in GDP by 0.3%, while a GDP growth by 1% resulted in a reduction of public debt, on average, by 0.4%.  Other studies confirmed that the turning point beyond which growth gradually decreases is around 100% of GDP. 

There’s no doubt that more work is needed to better understand the impact of large debt surges, including in response to large crises. The problem is that debt surges are often accompanied by other fiscal and monetary measures that generate inherent uncertainty and cross-country heterogeneity regarding key variables (for example, fiscal multipliers, government funding costs) and possible unique effects associated with pandemics.

In conclusion, all this shows, in my opinion, that many statements made by poorly-informed people, including in key stakeholder associations, the Opposition, opinion writers, and the general public are way off the mark.  As I said, it is mostly hot air which leaves us none the wiser.

Photo: sweet_tomato/Shutterstock

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