01 January 2013

2012/13 Rybczynski Prize Essay

Navigating the New Era of Public Debt Build‑ups

José Ursúa, Goldman Sachs

The enormous public debt build-ups that developed markets (DMs) have accumulated over the past few years‒from around 75% in 2007 to almost 110% of GDP in 2012‒will likely rank among the longest-lasting legacies of the Great Recession. They are unprecedented in an environment with no major global wars and stand in contrast with the moderate debt increases seen in emerging markets (EMs) during the crisis. To complicate matters further, IMF projections for the next few years suggest that debt levels are unlikely to decline any time soon.

It is easy to see how these trends have brought attention to the potentially negative impact of public debt on growth‒a focus that has been heightened by the debt crisis in the Euro Area periphery and the electoral debate in the United States. Concerns extend to whether there is a certain threshold of public debt after which risks to growth increase rapidly, what is the magnitude of those negative effects, and how the paths out of similar debt build-ups might look. In this piece we exploit large-sets data to find answers to those questions. Our goal is to provide a better understanding of the balance of risks so that policy makers and market participants can successfully navigate the new era of public debt build-ups around the world.

Public debt may hurt growth for several reasons

Debt is not intrinsically bad for growth, but it may become problematic at very high levels relative to a country’s GDP. There are several reasons why this may be the case. The first is simply that at some point debt needs to be repaid. After periods of significant debt accumulation, fiscal consolidation will usually be needed to ensure sustainability. At the same time, fiscal consolidation tends, on average, to be a drag on growth.

High levels of debt may be particularly dangerous because they have the potential to create additional problems. Worries about sustainability could lead borrowers to demand a more abrupt adjustment or lead to a full-blown debt or currency crisis. High tax burdens, weak budgetary discipline or ongoing fiscal deficits could crowd out private spending or create distortions. Excessively loose monetary policy or increased inflation used as part of the solution to debt build-ups may hurt growth by damaging confidence. Lastly, an association between high debt and lower growth may arise if both were influenced by common events. After banking crises, for instance, public debt may be higher (as systemic losses are assumed by governments) and growth may be weak (as deleveraging pressures weigh). But that association would not necessarily mean that high public debt was responsible for the weakness in growth.

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