Is There a Debt-threshold Effect on Output Growth?

IMF Working Papers, September 8, 2015

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This paper studies the long-run impact of public debt expansion on economic growth and investigates whether the debt-growth relation varies with the level of indebtedness.
Contribution is both theoretical and empirical.
Using data on a sample of 40 countries (grouped into advanced and developing) over the 1965- 2010 period, the authors find:
- No evidence for a universally applicable threshold effect in the relationship between public debt and economic growth once the impact of global factors and their spillover effects are accounted for.
- Regardless of the threshold, significant negative long-run effects of public debt build-up on output growth.
- Provided that public debt is on a downward trajectory, a country with a high level of debt can grow just as fast as its peers in the long run.

Develop tests for threshold effects in the context of dynamic heterogeneous panel data models with cross-sectionally dependent errors.
Illustrate via Monte Carlo experiments that the proposed tests perform well in small samples.

Sample: 40 countries (grouped into advanced and developing).
Time coverage: 1965- 2010 period.
Key empirical results:
- No universally applicable debt threshold affecting output growth after controlling for global factors and spillovers.
- Significant negative long-run effects of public debt accumulation on output growth irrespective of threshold specification.
- Evidence that a downward trajectory of public debt allows high-debt countries to achieve long-run growth comparable to peers.

Public debt build-up has materially negative long-run effects on output growth.
Debt trajectory matters: reducing public debt can enable convergence in long-run growth rates with lower-debt peers.
Accounting for global factors and spillover effects is crucial when assessing debt-growth relationships and searching for threshold effects.