Thus, at low levels of indebtedness, an increase in the proportion of external public debt to GDP could promote economic growth; however, at high levels of indebtedness, an increase in this proportion could hurt economic growth.
This article studies the non-monotonic relationship between external public debt and economic growth via a model of endogenous growth. The theory of economic growth examines the relationship between external debt and growth using some contributions from international finance.
Thus, Krugman shows the debt relief Laffer curve with the shape of an inverted U , where the nominal value of debt of a country and its actual expected payment are related. On the upward segment of the curve, debt and expected payments increase because the risk of default is low; in the descending segment, the level of debt increases but expected payments begin to descend because the risk of default is very high.
He concludes that when a country is on the descending segment of the curve, the country suffers from debtoverhang. Using the above concepts, researchers have studied the effects of external over-indebtedness. Thus, Cohen extends the model of endogenous growth of Cohen and Sachs to formalize the relationship between external-indebtedness and investment.
In the first one, there is free access to the global financial market, and the rate of investment and production is greater than with financial autarky. In the second scenario, there is a credit restriction with soft repayment, and the investment rate is lower than the free access case but higher than the financial autarky case.
In the third one, there is a credit restriction with forced repayment, and the investment rate is lower than with financial autarky.
Therefore, the investment rate rises in the first scenario, before falling in the second and third scenarios. Thus, the relationship between external debt and investment and growth is non-linear. In addition, Cohen concludes that the third scenario would correspond to the concept of debt overhang, where external debt acts as a tax on investment, hurting economic growth. Moreover, Saint-Paul shows an endogenous growth model with overlapping generations, where an increase in public debt reduces the growth rate of the economy.
Adam and Bevan develop a model of endogenous growth with individuals who live two periods. They study various ways to finance public deficits.
An increase in domestic public debt slows growth, while an increase in external public debt, financed in concessional terms, but rationed, helps growth. Aizenman, Kletzer and Pinto show a model of endogenous growth with restrictions in tax revenues and public debt. In general, they find that the higher the public debt the lower the growth.
Finally, Checherita-Westphal, Hallett and Rother present a growth model with public capital and debt, where the public deficit is equal to public investment. In their model, the relationship between debt and growth is nonlinear. So, in the steady state, the optimal debt to GDP ratio can be determined where growth is maximized.
In order to study the relationship between external public debt and economic growth, this article presents an endogenous growth model for a small open economy. The economy produces two goods, tradable manufacturing and non-tradable non-manufacturing. The tradable sector produces domestic technological knowledge through learning by doing Romer, This knowledge is used in the non-tradable good sector.
Therefore, in this model there are two learning externalities. The foreign lenders perceive a country risk that depends positively on the level of external public debt. More-over, the government collects taxes through another lump-sum tax on households to finance the purchase of non-tradable goods. Households consume a constant fraction of their disposable income, and own the two types of capital. They can borrow abroad, subject to a foreign credit constraint.
In this article, country risk is fully transferred to the private sector. I study how the economy responds, in the steady state, to an increase in the proportion of external public debt to GDP and I obtain a nonlinear relationship between the ratio of external public debt to GDP and the growth rate.
That is, my results show an inverted U-shaped curve connecting external public debt and economic growth. This nonlinearity is the result of two opposite effects on the growth rate of the economy when the proportion of external public debt to GDP increases. The positive effect is as follows: when the proportion of external public debt to GDP increases, the relative price of the non-tradable good decreases the real exchange rate depreciates and the tradable sector, leader in technological terms, attracts resources.
Therefore, the proportion of labor employed in the manufacturing sector increases and the ratio of non-tradable to tradable capital diminishes, increasing the growth rate of the economy. The negative effect is as follows: when the proportion of external public debt to GDP increases, the country risk premium increases and interest payments on total external debt increases.
Therefore, household disposable income falls, the proportion of savings to GDP declines and resources for capital accumulation decrease, thus the growth rate of the economy decreases. At a high external public debt to GDP ratio, the economic growth that is stimulated by the depreciation of the real exchange rate and the attraction of resources towards the tradable sector, is offset by the exit of resources to the exterior due to the burden of external debt , and the consequent decrease in the savings to GDP ratio.
The results of this paper are related to Cohen and Checherita-Westphal, Hallett and Rother , where nonlinear relationships between debt and growth are also presented, although in their models, the external debt affects economic growth through different channels than those presented here. The result that public spending on tradable goods leads to a depreciation of the real exchange rate, stimulating the tradable sector, is related, inversely, with Korinek and Serven They affirm that the accumulation of international reserves the extension of credit to foreigners for the purchase of domestic tradable goods leads to a depreciation of the real exchange rate, stimulating the tradable sector and triggering the desired learning effects.
The results I obtained for an economy with endogenous growth, with two goods, two learning externalities, where the external public debt acts positively and negatively on economic growth, are not present in the literature and contribute to a better understanding of the relationship between external public debt and economic growth.
Moreover, the existence of a maximum level of external public debt means that those responsible for public finances should be prudent in handling external public debt, to avoid high debt levels and prevent the kind of situations that occurred in Latin America in the s and in the European periphery in recent years. In the empirical literature, there is evidence showing the existence of this non-linearity between public debt and growth, for both developing and developed countries.
Thus, Pattillo, Poirson and Ricci , study the contribution of the proportion of external debt to GDP to the growth of per capita GDP for 93 developing countries between the years They find that the contribution of external debt current net value on growth is nonlinear, in the form of an inverted U. The negative impact of the high level of external debt on growth operates through adverse effects on the formation of physical capital and total factor productivity see Pattillo, Poirson and Ricci Analyzing 55 low-income countries between the years to , Clements, Bhattacharya and Nguyen argue that the servicing of external debt negatively affects public investment and, indirectly, growth.
Similarly, Caner, Grennes and Koehler-Geib determine the critical level, where an increase in average public debt ratio to GDP decreases the average annual growth for developed and developing countries between the years They conclude that for the total sample of countries, the threshold stands at Also, Checherita-Westphal and Rother show that the relation between public debt to GDP ratio and growth in per capita income has an inverted U shape, for a sample of 12 countries in the euro area, with data since The main channels through which public debt affects the rate of growth are private saving, public investment and total factor productivity.
It is important to mention that in the empirical literature there is also evidence of a relationship which is always negative between debt and growth; for example, Kumar and Woo show an inverse relationship between initial public debt and growth of per capita GDP for advanced and developing economies for the period The paper is organized as follows.
In section 2, I develop an endogenous growth model of a small open economy. In section 3, I redefine the model in stationary variables. In section 4, I demonstrate the existence and stability of the steady state, as well as the nonlinear relationship between external public debt and growth. I present my conclusions in section 5.
In this model, the economy is small, so the world market determines the price of the tradable good and the world interest rate.
This represents a very serious challenge to models of debt sustainability; if true it means that debt limits are not finite. Advanced country governments can borrow as much as they like. We have all been tightening our belts for no reason whatsoever. This is going to go down well, politically.
For countries with long, unbroken datasets and few extreme events UK, USA, France we can be more precise: both VAR-based and spectral estimates agree that the largest plausible value for the interest-growth differential over the long run is somewhere between 0 and 2 percent per year.
It is of course prudent to manage public debt on a worst-case scenario, so as there is an outside chance that the interest-growth differential could be positive, governments might still want to run small primary surpluses.
Barrett observes that this was in fact the case in the U. Barrett finds that the term structure of government debt matters considerably. Governments that have large amounts of short-term debt have greater financing needs, and this reduces their debt capacity.
It also increases their default risk, since there is always a small risk that debt cannot be refinanced at rollover, and they roll debt over more frequently than countries with higher amounts of long-dated debt. The U. Barrett concludes that in practice, governments probably do have limits on debt issuance, but those limits are unlikely to stem from affordability constraints. They are more likely to arise from rollover risk. This implies that governments would be wise to lengthen the maturity profiles of their debt portfolios.
Of course, this paper only looks at six advanced countries with long and stable histories. But for the large sovereign countries examined in this paper, there is no reason to impose any more austerity on your populations. Throw off your hair shirts and invest in your economies. Most countries — from those developing their economies to the world's richest nations — issue debt in order to finance their growth. This is similar to how a business will take out a loan to finance a new project, or how a family might take out a loan to buy a home.
The big difference is size; sovereign debt loans will likely cover billions of dollars while personal or business loans can at time be fairly small. Sovereign Debt Sovereign debt is a promise by a government to pay those who lend it money. It is the value of bonds issued by that country's government. The big difference between government debt and sovereign debt is that government debt is issued in the domestic currency, while sovereign debt is issued in a foreign currency.
The loan is guaranteed by the country of issue. Before buying a government's sovereign debt, investors determine the risk of the investment. The debt of some countries, such as the United States, is generally considered risk free, while the debt of emerging or developing countries carries greater risk.
Investors have to consider the government's stability, how the government plans to repay the debt, and the possibility of the country going into default. In some ways, this risk analysis is similar to that performed with corporate debt, though with sovereign debt investors can sometimes be left significantly more exposed. Because the economic and political risks for sovereign debt outweigh debt from developed countries, the debt is often be given a rating below the safe AAA and AA status, and may be considered below investment grade.
Debt Issued in Foreign Currencies Investors prefer investments in currencies they know and trust, such as the U. This is why the governments of developed economies are able to issue bonds denominated in their own currencies. The currencies of developing countries tend to have a shorter track record and might not be as stable, meaning that there will be far less demand for debt denominated in their currencies.
Risk and Reputation Developing countries can be at a disadvantage when it comes to borrowing funds. Like investors with poor credit, developing countries must pay higher interest rates and issue debt in foreign stronger currencies to offset the additional risk assumed by the investor. Most countries, however, don't run into repayment problems. Problems can arise when inexperienced governments overvalue the projects to be funded by the debt, overestimate the revenue that will be generated by economic growth , structure their debt in such a way as to make payment only feasible in the best of economic circumstances, or if exchange rates make payment in the denominated currency too difficult.
What makes a country issuing sovereign debt want to pay back its loans in the first place? I have my own name for it. They plunder the commonwealth. There's no political strength to stop or restrain them. National Debt 3 or percent of GDP.
Who holds that debt. They hold it and don't spend it. Let me venture a guess In this case whole countries. It comes from predatory impulses to subordinate and subjugate. Because if domestic income inequalities were to be reduced first without any concomitant action on external imbalances, the resulting consumption increase would simply increase US trade deficit and US debt further?
Thank you. The conclusion again seems to be that the external imbalances must be corrected first. Trump is the first US president in a long time to focus on reducing the US trade deficit. However, the initial focus of the Trump administration has been on trade tariffs while the monetary aspects of trade exchange rate, capital flows, international role of the US dollar have been completely ignored, thus reducing the chance of a satisfactory resolution of trade imbalances. Do you now see a better appreciation of the role of monetary factors in the diagnosis of the US administration about the causes of the persistent US trade deficit?
The IMF treaty allows a country to prevent another country from buying the former's government debt. This provides a country with the capacity to prevent another country from manipulating the value of the former country's currency value.
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You are leaving the website for the Carnegie-Tsinghua Center for Global Policy and entering a website for another of Carnegie's global centers. Carnegie Endowment for International Peace. Kerr Carnegie Middle East Center. Programs Projects Regions Blogs Podcasts. China Financial Markets. Issues Balance sheet fragility. Credit expansion. Emerging markets. Global trade. Income inequality.
Market structure. Politics of rebalancing. Why U. Debt Must Continue to Rise. Michael Pettis. Debt is rising more quickly in the United States than most people would prefer. This is happening in part because the U. February 07, To begin with, broadly speaking, debt can be divided into two types: Self-liquidating debt is used to fund investment projects that increase economic productivity enough after including all associated positive and negative externalities to service the debt fully.
Is Excessive Debt Bad for the Economy? What are the Actual Costs of Excessive Debt? However, while such debt does not generate real wealth creation or productive capacity or debt-servicing capacity, which ultimately amount to the same thing , it does generate economic activity and the illusion of wealth creation. Second, and more importantly, an excessively indebted economy creates uncertainty about how debt-servicing costs are to be allocated in the future.
As a consequence, all economic agents must change their behavior in ways that undermine economic activity and increase balance sheet fragility see endnote 2. This process, which is analogous to financial distress costs in corporate finance theory, is heavily self-reinforcing. Some countries—China is probably the leading example—have a high debt burden that is the result of the systematic misallocation of investment into nonproductive projects.
In these countries, it is rare for these investment misallocations or the associated debt to be correctly written down. If such a country did correctly write down bad debt, it would not be able to report the high GDP growth numbers that it typically does.
As a result, there is a systematic overstatement of GDP growth and of reported assets: wealth is overstated by the failure to write down bad debt. Once debt can no longer rise quickly enough to roll over existing bad debt, the debt is directly or indirectly amortized, and the overstatement of wealth is explicitly assigned or implicitly allocated to a specific economic sector. This causes the growth of GDP and economic activity to understate the real growth in wealth creation by the same amount by which it was previously overstated.
Insofar as the excess debt is owed to foreigners, its servicing costs represent a real transfer of resources outside the economy. To the extent that the excess debt is domestic, its servicing costs usually represent a real transfer of resources from economic sectors that are more likely to use these resources for consumption or investment to sectors that are much less likely to use these resources for consumption or investment.
In such cases, the intra-country transfer of resources represented by debt-servicing will reduce aggregate demand in the economy and consequently slow economic activity. Does Debt Affect Demand?
Debt I have no way of calculating the extent to which recent increases in U. Why Trade Deficits Actually Matter I have explained many times before including here and here that the United States runs trade deficits mainly because the rest of the world exports its excess savings there. Why Income Inequality Matters It may seem surprising at first that income inequality has the same economic impact as forced imports of foreign capital. What Drives Down Savings?
Net capital inflows may strengthen the dollar to a level far higher than it would otherwise be. Unemployed workers have a negative savings rate as they consume out of their savings, so rising unemployment would drive down the savings rate.
If that happens, unemployment would require more government borrowing to fund larger fiscal transfers, most of which would cause consumption to rise and savings to decline. To reduce unemployment, the U. Federal Reserve might expand credit and the money supply, encouraging additional borrowing. The capital inflows, or looser monetary policy, may inflate the prices of real estate, stocks, and other American assets, even setting off asset bubbles, a recurring response historically speaking to substantial capital inflows.
Higher asset prices can make Americans feel richer, creating a wealth effect that drives up consumption. The consequent boost in real estate prices could set off additional real estate development, some of which might be economically justified and some that might not be. Technically, this would not be a reduction in savings but rather an increase in investment, but it would have the same net impact on the capital account.
To the extent that some real estate development turns out to be economically unjustified, in future periods it may be written down, with the losses representing a reduction in the total stock of savings. As long as there is a normal distribution of risk-taking and optimism among American households—and this is the case in every country—whenever banks lower their consumer lending standards, there are households who take out loans and spend the proceeds on additional consumption, driving down savings.
Credit card companies and consumer finance companies with abundant liquidity may make consumer credit more widely available and at cheaper rates than they otherwise would. Constraining consumption, however, reduces investments that are sensitive to marginal changes in demand by lowering the demand that drives the profitability of such investments.
As an article this week in Reuters reminds us: The White House had predicted that the massive fiscal stimulus package, marked by the reduction in the corporate tax rate to 21 percent from 35 percent, would boost business spending and job growth.
What Can Be Done? Limit foreign capital inflows. The United States must reduce its trade deficit with the world, but not by addressing the trade deficit directly through import tariffs or quotas. Remember that because the U. Import tariffs or quotas will only reduce the U. And it is not at all clear that they will do so—in fact, they are at least as likely to increase inflows.
Instead, the United States must address foreign capital inflows directly, perhaps by taxing them. Reverse income inequality. There are many ways in which the United States can reverse income inequality. If the US decides that it cannot choose but to tolerate high levels of income inequality and run large capital account surpluses, it can at least decide to match the resulting increase in savings availability with higher investment, especially by boosting funding for infrastructure.
Otherwise, debt must continue to rise to prevent savings to adjust in the form of high unemployment. Notes 1 Because this may seem surprising to many, it is probably worth specifying how the wealth-redistribution impact of debt can leave an economy better off, even when the debt is nonproductive. More on: Americas United States Income inequality. Post your comments character limit. No links or markup permitted. Comments are moderated and may not appear immediately. Screen names appear with your comment.
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