Debt And Growth: Is There a Magic Threshold for Advanced Economies?

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Hassan Mohammadi

Mentor Department



Is there a threshold in the level of government debt above which higher debt would exert a detrimental effect on growth? The answer to this question is of critical importance given the historically high levels of debt in advanced economies. The literature on the interaction between growth and debt has been divided into two categories. First, one group of studies focus on the problem of endogeneity which is important due to the fact that the correlation between the debt and growth might be driven by low economic growth that leads to high level of debt (Reinhart et al.2012). Second, the vast majority of papers concentrated on finding a specific threshold in the level of government debt above which more debt would have a detrimental effect on growth. Reinhart & Rogoff (2010) suggest a debt to GDP ratio of 90 percent. However, their analysis is not based on formal estimation. After 2010, several papers have focused on estimating the value of threshold using formal econometric methods and economic theories. In this paper I utilize the threshold least squares regression procedure of Hansen (2010) to estimate the relationship between debt and growth for G7 countries during 1981-2016. This Procedure (1) determines the threshold value endogenously through a grid search, and (2) tests different models sequentially against one another using bootstrapping methods. The linear specification is tested against a two-regime model. If the null hypothesis of the linear model can be rejected against alternative hypothesis of the two-regime model, then the estimation can be carried out using the predetermined threshold variable. Control variables considered for this paper are inflation, trade openness, population growth and previous year's GDP which is consistent with majority of papers in the literature. The main finding of the paper is that the threshold level of the long-run debt-to-GDP ratio is about 78 percent among advanced economies. Each percentage point surpassing this threshold will cost the respective economy a 0.00015 percentage point decline in economic growth. Although, this value is not economically large, it can be substantial when we consider that as a cumulative amount over time.



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