PUBLIC DEBT AND ECONOMIC GROWTH IN EUROPEAN UNION COUNTRIES Vendula Kramolišová 1, Lenka Spáčilová 2 1 Vysoká škola báňská Technická univerzita Ostrava, Ekonomická fakulta, Sokolská 33, 702 00 Ostrava Email:Vendula.Kr@seznam.cz 2 Vysoká škola báňská Technická univerzita Ostrava, Ekonomická fakulta, Sokolská 33, 702 00 Ostrava Email:Lenka.Spacilova@vsb.cz Abstract: In recent years, public debts in the European Union due to the economic crisis have increased, while the rate of growth of real output was not very favourable. Existing empirical literature found the negative correlation between debt and growth in advanced and emerging economies, especially at the rate of public debt higher than 90 % of GDP. In this study we focused on the relationship between public debt-to-gdp ratio and real GDP growth rate on the sample of European Union countries in the pre-crisis period. Our empirical evidence points to a relatively strong negative linear relationship between the public debt and economic growth in European Union countries. Keywords: economic growth, public debt, debt-to-gdp ratio, negative correlation, European Union. JEL classification: E 62, H63, O40 1. Introduction Due to the development in recent years, the interest of economists and politicians in the issue of public debt 1 has increased. At a low level and in the short term the public debt seems to be beneficial for economic growth and prosperity, but in the long term a high level of debt can be threatening economic growth. While in the 1980s there was a major international debt crisis because several less developed countries in Latin America and Africa defaulted on their debt repayments (see e.g., Sládečková and Kulhánek, 1986), in 1990s debt as a percent of GDP exceeded the 100 % threshold in Japan, the financial crisis that has begun in late 2007 led to a dramatic increase in the public debt for most advanced economies. The financial crisis transformed into sovereign debt crises in several European countries. Despite the fact that the debt has grown only in a few euro area countries, it is beginning to be perceived as a problem for the European Union as a whole. In this connection, there is an important economic policy issue: Whether high public debt does not cause a slowdown in economic growth. The aim of this paper is to explore the relationship between public debt and real GDP growth rate in European Union. The rest of the paper is organized as follows. Section 2 describes the evolution of public debt in the European Union in the period 2002-2014. Section 3 presents the results of some empirical studies on relationship between public debt and economic growth. In the Section 4 we investigate the relationship between the public debt-to-gdp ratio and real GDP growth rate of European Union countries in the pre-crisis period. Conclusions follow in the Section 5. 2. Development of Public Debt-to-GDP Ratio in European Union Public debt in the euro area reached on average 68.5 % of GDP in 2007. When the crisis started to impact the euro area, its Member States reacted with important stimulus packages and injections of public money into their banking systems, which in many countries increased public debt and deficit well beyond the Maastricht reference values. Public deficits in the euro area peaked at 6.2 % of GDP 1 In this paper we use general government gross debt (henceforth public debt ). -304-
in 2010, in 2014 they were reduced to 2.4 % of GDP. While public debt continues to increase as a result of the measures taken during the crisis, in 2014, it stood at 91.9 % of GDP on average in the euro area, way above pre-crisis levels (see Figure 1). Figure 1. Public Debt in Euro Area and European Union, 2002 2014 (% of GDP) 100 90 80 70 60 50 68,2 69,3 69,8 70,8 70,2 61,9 62,2 62,70 60,3 58,9 78,4 74,5 68,5 68,2 62,2 85,8 83,7 80,2 80,9 72,1 89 83,7 90,9 91,9 85,5 86,8 Euro area EU-28 40 30 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Source: European Commission, 2015, own proposition The situation in the European Union as a whole has evolved in a similar way. As can be seen in Figure 1, the average public debt ratio in the EU has increased approximately by 25 % from 2007 to 2014. Keeping in mind that each country is different, we move on to more detailed analysis. In order to understand the European deficit bias, it is helpful to look at the pre-crisis situation. Figure 2 below shows the evolution of debt in 15 countries, so-called Old Member States of EU, at three points in time: 2005, 2009 and 2013. Among the EU-15 Members, nearly half had a debt ratio in excess of 60 % in 2005. This was true for only three (Cyprus, Hungary and Malta) of the New EU Member countries (see Figure 3). Three Eurozone countries, Greece, Italy and Belgium, had debt ratios in excess of 90 % (none of the New Members). Some countries, later highly indebted, had low debt in 2005. Irish government debt was very low at around 27% of GDP, Spanish was around 37 % of GDP, UK debt was just over 40 % of GDP. -305-
Figure 2. Public Debt in Old Member States, 2005 2013 (% of GDP) 200 180 160 140 120 100 80 2005 2009 2013 60 40 20 0 AT BE DE DK EL ES FI FR IE IT LU NL PT SE UK Source: European Commission, 2015, own proposition Figure 3. Public Debt in New Member States, 2005 2013 (% of GDP) 120 100 80 60 40 2005 2009 2013 20 0 BG CY CZ EE HR HU LT LV MT PL RO SK SI Source: European Commission, 2015, own proposition -306-
The financial crisis has radically changed the debt situation in Europe. In fact, it has prompted an unprecedented and possibly contagious public debt crisis, which is still unfolding. Many euro area and EU countries are still at high risk with regard to fiscal sustainability. The four countries with the largest increases of debt was Spain, Portugal, Ireland and Greece. Public debt in Greece has almost doubled, from 103.4 % of GDP in 2005 to 177.1 % of GDP in 2014 the highest value of public debt in EU. 2 Similarly, Portugal s debt was going from 67 % of GDP in 2005 to 134.6% in 2014 and Spain s from 42% ten years ago to 92 % last year. Among the countries currently experiencing sovereign debt crises, Ireland s case is perhaps the most dramatic. By the mid-1980s, Ireland had a debt-to-gdp ratio over 110 percent and was paying out almost 10 percent of GDP per year in interest payments. Change for the Irish economy came to an end 1980s, when the government decided to reform the Irish economy. Ireland had combined a long period of high economic growth and low unemployment with budget surpluses. Factors as population growing, incomes expanding rapidly and historically low interest rates, increased demand for housing. The acceleration in housing activity after 2002 was largely financed by the Irish banks. As house prices fell in 2007, the collapse in housing construction occurred and unemployment jumped, resulting in a large loss in income tax revenues. Irish real GDP declined by 3.5 percent in 2008 and by 7.6 percent in 2009. (Whelan, 2011) The bursting of the bubble in the real estate market turned to a banking crisis and in 2009, the government began using state funds to recapitalise the guaranteed banks. This trend was reflected in a substantial increase in government deficit (32 % of GDP in 2010) and public debt (from 62 % of GDP in 2009 to 123 % in 2013). Spain, like Ireland, faced a housing-market burst that left its banking sector highly exposed. By 2012, it was forced to request a bailout, and EU leaders agreed to use Eurozone funds for recapitalizing of Spanish banks. In the Portugal, financial crisis worsened the current crisis of Portuguese economy. Portuguese stagnation of output started in 2002. This problem was mostly due to the lack of structural reforms, namely in the labour market, low levels of human capital of the Portuguese labour force, low productivity in large segments of the economy and low competitiveness. With decreasing of interest rates, the degree of public and private indebtedness reached very high levels. Portuguese government bond yields raised to unsustainable levels as Fitch and Standard & Poor s cut their ratings of Portuguese sovereign debt in March 2011. In April 2011, Portugal became the third European Union country to apply for EU and IMF financial assistance in the amount of 78 billion euro to help it cope with its budget deficit. In November 2013, the Portuguese government approved more spending cuts, mainly affecting public-sector employees' wages, conditions and pensions, in order to avoid a second international bailout. (Andrade and Duarte, 2011) The initial worries lay with four peripheral countries of the European Union but soon extended to Italy - the Eurozone s third largest economy - in the summer of 2011 and later to Cyprus, Slovenia and even France. In Italy, indebtedness has not risen as fast but it is on a clear uphill slope, going from 102 % in 2005 to 132 % of GDP in 2014. Before the financial crisis, several governments of the euro area, most notably those of Portugal, Italy, Ireland, Greece, and Spain, had been able to finance their deficits at artificially low interest rates. Some had accumulated unsustainable levels of public debts. Since the start of the global financial crisis, a number of European countries have experienced severe difficulties refinancing their debts in the financial markets and have requested financial support from European Union and the International Monetary Fund (IMF) to help them overcome their fiscal and external imbalances. Four 2 At the time of writing, the situation about Greece was still ambiguous and so-called Grexit (exit of Greece from euro area) was discussed. -307-
members of the euro area Greece, Portugal, Ireland, and Cyprus also accessed IMF resources. 3 Access to IMF resources for Europe is being provided through Stand-By Arrangements (SBA), the Flexible Credit Line (FCL), the Precautionary and Liquidity Line (PLL), and the Extended Fund Facility (EFF). Ireland s and Portugal s EFFs concluded in December 2013 and June 2014, respectively, and they then entered into Post-Program Monitoring (PPM). (IMF, 2015b) Figure 4. Development of Public Debt in Four EU Members with the Highest Public Debt in 2014, 1980 2014, (% of GDP) 200 180 160 140 120 100 80 60 40 20 0 Ireland Portugal Greece Italy Source: IMF, World Economic Outlook, 2015, own proposition In 2014 public debt of EU members remained at very high levels, above 90 % of GDP, in Belgium (107 %), Ireland (110 %), Greece (177 %), Spain (98 %), France (95 %), Italy (132 %), Cyprus (108 %) and Portugal (130 %), or at levels that are well above their pre-crisis levels. Between 2009 and 2013, from the 28 EU member states only Hungary and Sweden succeeded in reducing their public debt to GDP ratio. Between 2013 and 2014 there were seven countries with reducing of public debt or at least its stagnation, four of them decreased their public debt-to-gdp ratio more than by 2 percent Ireland, Poland, Czech Republic and Germany. While the public debt of European Union grew in past decade, the rate of economic growth was weak. Trend of GDP growth was already relatively slow before the crisis (see Figure 5) and the global financial crisis plunged Europe into recession. After a moderate growth in last year, EU economy began to slow and the growth rate of GDP is projected to be very modest in the near future. The impact of the crisis has not only been cyclical, as highlighted by the weakness in aggregate demand, but also has a significant structural component which has lowered the potential growth of EU economies. 3 In December 2011, euro area countries committed to providing additional resources to the IMF of up to 150 billion euro. (IMF, 2015) -308-
Figure 5. Real GDP Growth Rate in European Union, 2003 2014 (%) 4 3 2 1 0-1 3,4 3,1 2,5 2 2,1 1,5 1,7 1,3 0,5 0,1-0,5 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014-2 -3-4 -5-4,4 Source: European Commission, 2015, own proposition 3. Literature Review With the growing indebtedness of developing and developed economies, the number of empirical studies dealing with the issue of the impact of debt on economic growth is also growing. Schclarek (2004) investigated the long-run relationship between total external debt and economic growth for developing and industrial countries. He examined a panel of 59 developing countries over non-overlapping five-year period from 1970 to 2002 and found a linear negative impact of external debt on per-capita growth. Schclarek (2004) also investigates the relationship between gross government debt and per-capita GDP growth in 24 developed countries. For industrial countries, he does not find any significant relationship between gross government debt and economic growth. Study by Reinhart and Rogoff (2010), which examines economic growth and inflation at different levels of government debt in 20 advanced and 24 emerging market economies based on long historical data series (1790 2009), found the difference in median growth rates of GDP between low debt (below 30 percent of GDP) and high debt (above 90 percent of GDP) groups is 2 percentage points in advanced economies over the period. By contrast, the differential in median growth between low and high debt groups in emerging economies is smaller (1.6 percentage points). Conclusions of Reinhart and Rogoff (2010) suggest that there is a debt turning point, beyond which debt starts having a negative impact on growth. Caner et al. (2010) solve these questions with the help of threshold estimations based on a yearly dataset of 101 developing and developed economies spanning a time period from 1980 to 2008. Their estimations establish a threshold of 77 percent public debt-to-gdp ratio. According to them, if debt is above this threshold, each additional percentage point of debt costs 0.017 percentage points of annual real growth. They found the effect is even more pronounced in emerging markets where the threshold is 64 percent debt-to-gdp ratio. In these countries, the loss in annual real growth with each additional percentage point in public debt amounts to 0.02 percentage points. Similar results have also achieved by Afonso and Jalles (2013) via panel 155 countries. Kumar and Woo (2010) estimated inverse relationship between initial debt and subsequent growth of real per capita GDP for a panel of advanced and emerging market economies in the period 1970 2007. They suggest, on average, a 10 percentage point increase in the initial debt-to-gdp ratio is associated with a slowdown in annual real per capita GDP growth of around 0.2 percentage points per year, with the impact being smaller (around 0.15) in advanced economies. According to them, -309-
there is some evidence of nonlinearity, with only high (above 90 percent of GDP) levels of debt having a significant negative effect on growth. This adverse effect largely reflects a slowdown in labour productivity growth, mainly due to reduced investment and slower growth of the capital stock per worker. Cecchetti et al. (2011) use a sample of 18 OECD countries for the period 1980 2010 and obtain a threshold for government debt at 85 % of GDP, for corporate debt at 90 % of GDP and for household debt around 85 % of GDP. The threshold over which additional debt has a negative impact on economic growth was estimated also by Checherita and Rother (2010) or Baum et al. (2013). Checherita and Rother (2010) investigate the relationship between government debt-to-gdp ratio and per-capita GDP growth rate in a sample of 12 euro area countries over a period of about 40 years starting in 1970, with using the empirical growth model based on a conditional convergence equation that relates the GDP per capita growth rate to the initial level of income per capita, the investment/saving-to-gdp rate and the population growth rate. They found a non-linear impact of debt on growth with a turning point - beyond which the government debt-to-gdp ratio has a deleterious impact on long-term growth - at about 90-100 % of GDP. According to them, the channels through which government debt affects the economic growth rate are private savings, public investments, total factor productivity, and sovereign long-term nominal and real interest rates. Baum et al. (2013) focused on 12 euro area countries for the period 1990 2010. Their empirical results suggest that the short-run impact of debt on GDP growth is positive and highly statistically significant, but decreases to around zero and loses significance beyond public debt-to-gdp ratios of around 67%. For high debt-to-gdp ratios (above 95%), additional debt has a negative impact on economic activity. A sample of 25 EU countries have used too Mencinger et al. (2014). They analysed the subgroup of so-called Old Member States over the period 1980-2010 and subgroup of New Member States over the period 1995-2010 with using a panel estimation. Their results indicate a statistically significant non-linear impact of public debt ratios on annual GDP per capita growth rates with threshold between 80 % and 94 % for the Old Member States and about 53 % for New Member States. Tipping point may be much lower, as also found Égert (2012), who determined the range between 20 % and 60 % of GDP. Many papers show that public debt is negatively correlated with economic growth at higher rates of public debt to GDP. However Panizza and Presbitero (2012) could not find a negative correlation between debt and growth in high-debt OECD countries. They confirmed negative correlation for low-debt countries. 4. Relationship between Public Debt and Growth In the following section we will examine the relationship between public debt-to-gdp ratio and real GDP growth rate in a sample of 28 European Union countries. To exclude the impact of the economic crisis on these variables, 4 we opted the pre-crisis period 2001-2007 for the analysis, since data for variables are not available before then for some EU countries. Data are drawn from the IMF s World Economic Outlook Database. In the first step, we analysed the relationship between average debt-to-gdp ratio and average growth rate of real GDP graphically by scatter plot. Each point in the Figure 6 shows the average debt ratio and average growth rate of real GDP for a specific European Union country in period 2001-2007. The visual evidence in the Figure 6 indicates that the points cluster around negative linear line. 4 Crisis is likely to contribute to the growth of debt and decline in product. -310-
Growth (%) 13 th International Scientific Conference Figure 6. Debt-to-GDP Ratio/Real GDP Growth Rate Position of EU Countries, 2001 2007 12 10 8 6 4 2 0 0 20 40 60 80 100 120 Debt/GDP (%) Source: IMF, World Economic Outlook, 2015, own calculations Scatter diagram suggests a negative relationship between public debt-to-gdp ratio and real GDP growth rate, so we also calculated the correlation coefficient (see Table 1). The correlation coefficient shows that there is a relatively strong negative correlation between public debt and economic growth in European Union countries in the pre-crisis period 2001 2007. Table 1. Correlation coefficient for Debt-to-GDP Ratio and Real GDP growth, EU-28 Correlations Debt Growth Debt Pearson Correlation 1 -,681 ** Sig. (2-tailed),000 N 28 28 Growth Pearson Correlation -,681 ** 1 Sig. (2-tailed),000 N 28 28 **. Correlation is significant at the 0.01 level (2-tailed). Source: IBM SPSS Statistics Correlation, however, does not imply causation. Based on these results we cannot say that high debt is dangerous for economic growth, because there may be a reverse causality. Maybe it is low economic growth that leads to high levels of debt. When we express the debt ratio to GDP, then the relationship between these variables is always linear - a decline in the economic growth rate is, ceteris paribus, associated with an increase in the public debt-to-gdp ratio, since GDP is the denominator of this ratio. Alternatively, the observed correlation between debt and growth could be due to a third factor that has a joint effect on these two variables. -311-
In the next step, we used a simple regression in SPSS programme, in which growth rate of GDP is a function of debt. The comparison of the data of 28 member states based on linear regression indicates relation, where a one percentage point increase of the debt ratio results in a 0.058 percentage point 5 decrease of the annual rate of GDP growth. However, we must take into account the limitations of our research and therefore, it would be bold to say that we have demonstrated negative relationship between debt and growth of GDP in EU countries. Further research is certainly needed to fully understand the link between public debt and economic growth. 5. Conclusions The sharp increase in sovereign debts, especially in the euro area, as a result of the global economic crisis has led to serious concerns about fiscal sustainability, and their broader economic and financial market impacts. According to Navrátil (2014), the financial and debt crisis have led to reforms of the EU's economic governance rules, introducing new surveillance systems for economic and in particular fiscal policies of EU Member countries including timelines (called European Semester). In the future, public finances of European Union members are likely to come under pressure primarily as the result of an ageing population. For this reason, economists and politicians have already focused on the potential impacts of increased public debt. The economic theories assume, that the impact of public debt on economic growth can be positive (Keynesian approach), negative (Neoclassical theory) or neutral (Ricardian equivalence). In this paper we focused on the relationship between public debt-to-gdp ratio and real GDP growth rate on the sample of 28 European Union countries in pre-crisis period from 2001 to 2007. We found the relatively strong negative relation. Our findings are consistent with other studies. In the future, our research could be extended with using of panel regression. It would be also interesting to look for the channels through which the impact of public debt is indirectly transmitted to growth. Several empirical studies have shown that a rise in public indebtedness causes a reduction in growth when the public debt-to-gdp ratio is above a specific threshold. Caner et al. (2010), Kumar and Woo (2010), Cecchetti et al. (2011), Checherita-Westphal and Rother (2012) and Baum et al. (2013) found that public debt starts having a negative effect on growth when debt reaches 90 % of GDP. These conclusions are associated with the debt-overhang hypothesis defined by Krugman (1988), whereby after exceeding a certain level of a threshold value of debt, there are adverse effects on growth due to growing uncertainty to meet country s debt servicing obligations. The channels through which public debt can potentially affect economic growth are different. Long-term interest rates can be an important channel. Higher long-term interest rates, resulting from more debt-financed government budget deficits, can crowd-out private investment, thus dampening potential output growth. In more extreme cases of a debt crisis, these effects can be magnified. High debt is also likely to constrain the scope for countercyclical fiscal policies. EU fiscal imbalances increase the risk of bankruptcy of some member countries and the collapse of the euro area and European Union as a whole. Like for individual households and firms, overborrowing leads to bankruptcy and financial ruin. For a country, too much of debt impairs the government s ability to deliver essential services to its citizens. 5 The coefficient of public debt is statistically significant at the 5 % confidence level. The value of R-squared is 0.463 for the linear trendline. -312-
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