High sovereign debt levels reduce long-term economic growth through crowding out and increased default risk
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Peer-reviewed economic literature and macroeconomic modeling studies indicate that high sovereign debt levels have a negative impact on long-term economic growth, operating through mechanisms such as the crowding out of private investment and increased financial risk premiums.
The paper reviews the economic risks associated with regimes of high public debt through DSGE model simulations. The large public debt build-up following the 2009 global financial and economic crisis acted as a shock absorber for output, while in the recent and more severe COVID19-crisis, an increase in public debt is even more justified given the nature of the crisis. Yet, once the crisis is over and the recovery firmly sets in, keeping debt at high levels over the medium term is a source of vulnerability in itself. Moreover, in the euro area, where monetary policy focuses on the area-wide aggregate, countries with high levels of indebtedness are poorly equipped to withstand future asymmetric shocks. Using three large scale DSGE models, the simulation results suggest that high-debt economies (1) can lose more output in a crisis, (2) may spend more time at the zero-lower bound, (3) are more heavily affected by spillover effects, (4) face a crowding out of private debt in the short and long run, (5) have less scope for counter-cyclical fiscal policy and (6) are adversely affected in terms of potential (long-term) output, with a significant impairment in case of large sovereign risk premia reaction and use of most distortionary type of taxation to finance the additional debt burden in the future. Going forward, reforms at national level, together with currently planned reforms at the EU level, need to be timely implemented to ensure both risk reduction and risk sharing and to enable high debt economies address their vulnerabilities. JEL Classification: E62, H63, O40, E43
The role of external debt in economic growth of developing countries has been questioned since there has been a high incidence of default, low economic growth and high levels of poverty, all of which are associated with high stocks of external debt. Also, the uncertainties about country external debt sustainability position as well as whether countries are already trapped in the debt-overhang situation have underlined point of debate among scholars. This study investigates the dynamic relationship between external debt and economic growth of Nigeria for period of 1985 to 2017 using Johansen approach to cointegration, vector error correction model (VECM) and granger causality test. Data for the study was collected from the CBN statistical bulletin. The findings revealed that debt service payment has negative and insignificant impact on Nigeria’s economic growth while external debt stock has negative and significant effect on economic growth. The causality test indicates no-directional causality between external debt and GDP. From the findings, the study recommends that policy-makers should reformulate the external debt management strategy to minimize sovereign risk through diversification of the external borrowing. This could potentially be achieved by reducing the dependency on one specific debt instrument or currency. Hence, the strategy will be effective if it is carried out in parallel with a comprehensive surveillance and debt-monitoring system.
This study attempts to investigate the mediating role of institutional quality on the relationship between public debt and economic growth in Pakistan spanning 1996-2020. Time series data on all six World Bank World Governance indicators of institutional quality is used in the empirical analysis. Findings of the autoregressive distributed lag (ARDL) bounds testing technique and error correction method (ECM) confirmed the existence of cointegration among variables of interest. The short-run results indicate that public debt has a favorable association with economic growth, while the relationship is found to be detrimental in the long run. Furthermore, the combined effect of public debt and institutional quality indicators revealed the significant positive association with economic growth, suggesting that better institutional quality can contribute to mitigate the negative impact of public debt on economic growth in Pakistan.
Historically high debt-to-GDP levels in the U.S. have raised concerns about future financial market stability and fiscal sustainability. We use high-frequency data and consider Treasury futures price changes within narrow windows around auction announcements in order to identify two distinct Treasury supply shocks: debt volume shocks that capture changes in the level of public debt, and maturity adjustment shocks that reflect changes in the maturity structure. We find that debt expansion shocks raise yields across the curve by increasing term premia, leading to tighter financial conditions. These shocks crowd out private sector activity by reducing investment and production, particularly during periods of rapid debt growth. In contrast, maturity extension shocks steepen the yield curve while lowering credit risk premia and fiscal uncertainty. By reducing risk premia, these shocks stimulate near-term investment and production, even as higher long-term borrowing costs weigh on longer-horizon investment. We also show that the Treasury debt management policy can meaningfully interact with the Federal Reserve's asset purchase programs.
Concerns about the economic effect of high sovereign debt levels have motivated policy makers to constrain or reduce the growth of fiscal deficits, a practice commonly known now as “fiscal austerity.” However, what do we know about the economic impacts of sovereign debt? This article provides an overview of some recent empirical economic research into this question. The article first discusses data and estimation challenges confronted by empirical research into the impact of sovereign debt on economic growth. The article then reviews several studies, which vary by country sample, time period studied, and estimation technique employed. The article also reviews recent empirical studies of the economic consequences of sovereign default. The results of this article’s survey suggest that while the bulk of the evidence shows a negative relationship between sovereign debt levels and economic growth, the evidence to date is mixed on whether higher debt burdens cause or are merely correlated with lower economic growth, and on whether there exists a certain ‘threshold’ beyond which this negative relationship arises. Only a few studies have provided evidence on the economic mechanism through which higher debt burdens impact economic growth. This review of the research does, however, reveal stronger evidence that sovereign default episodes have negative impacts on an economy’s growth. The article concludes by raising some important questions to be addressed if we are to better understand
After the economic downturn of 2008, youth unemployment rose rapidly in the EU. Simultaneously, many countries were also facing increasing public deficits. In this context, the EU developed a set of policies to tackle youth unemployment and public debt. While policies to fight unemployment were underpinned by the concept of social investment, austerity was seen as the best way to reduce public debt. These different approaches to the crisis led to a growing tension between the two policy areas. This problem was particularly visible in the countries most affected by the sovereign debt crisis where youth unemployment remained very high for a long period of time. Not only were countries with high public debt and low growth unable to invest sufficiently in active labour market policies (ALMPs), but also, at the same time, austerity policies depressed the economic activity. This study uses the fsQCA methodology. Our results point to the existence of one necessary condition for high youth unemployment—low expenditure on ALMPs. The analysis of sufficient conditions points to the existence of one configuration: the countries most affected by the sovereign debt crisis and characterized by having a demand-led growth model, combined a low GDP growth with a low expenditure on ALMPs. Together, this led to high levels of youth unemployment.
The issue of implementation of the areas of fiscal consolidation is particularly relevant in terms of the accumulation of public deficits and public debt in such amounts when the country is on the verge of insolvency. A clear policy to gradually reduce these deficits is necessary, since the budget deficit and quasi-fiscal deficits are rapidly increasing. This will help stabilizing public debt dynamics, and facilitating resolving the shortterm financial difficulties. The situation in Ukraine is complicated by the very low possibility to eliminate external shocks, since foreign exchange reserves and financial reserves are at their minimum, and continuing to show a downward trend. In addition, Ukraine’s economy is experiencing a phase of economic recession. Although the causes of these adverse events are complex and represent a number of external and internal factors, a path to immediate macroeconomic stabilization in Ukraine is possible. Reducing these macroeconomic imbalances should be the main task for the government in the near future, because otherwise there is no real opportunity to achieve sustainable economic growth. Further structural fiscal reforms in public spending are mandatory to maintain macroeconomic stability and economic development in the medium term. Fiscal consolidation will reduce external imbalances, help restoring fiscal space lost due to the crisis, and reduce the financial needs of the state budget and premium for sovereign risk. There are good reasons
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