Monday, April 22, 2013

Public debt and growth

Many readers will be aware of the first class controversy that is raging in the economist fraternity over a paper written by Reinhart and Rogoff  (RR)on the relationship between public debt and growth. In a nutshell, the paper purported to show that growth falls off a cliff once the public debt to gdp ration crosses 90%. Three economists at Massachussets, Amherst have shown that the calculations underlying the paper were flawed: the impact on growth at that level of debt is far less lethal than RR made it out to be.

FT has several interesting posts on the subject. Here is a sample: One, two and three

Students of economists should know, from first principles, that there was more than an element of exaggeration in the RR thesis. Think of why higher debt should hurt growth. As governments raise borrowings, there is crowding out of private investment through higher interest rates. But in an open economy where savings from outside the economy can be tapped, this effect will be far less severe than in a closed economy.

Secondly, much depends on what your borrow for. If higher government borrowing goes into infrastructure or even human capital, it could "crowd in " private investment.

Lastly, when the economy is way below full employment, government borrowing helps move output towards the equilibrium level; it is when an economy close to full employment that the deleterious effects of government borrowing are felt. When governments cut back on borrowings by cutting government spending at a time when economies are mired in recession, you get what we are seeing in the Eurozone today.


Anonymous said...

Dear Sir,

Many thanks for the brilliant post

just one amendment The third link (FT) should most probably redirect here

i.e. article titled "Perils of placing faith in a thin theory"
by Wolfgang M√ľnchau

Thank You,

T T Ram Mohan said...

Thanks, JPM, I have provided the correct link.