The Dynamics of Government Debt and Economic Growth

The dynamics of government debt and economic growth, once a subject of interest mostly to very few macroeconomists is suddenly of immense attention for many researchers in the backdrop of Euro zone sovereign debt crisis and Reinhart & Rogoff’s related research. This study investigates the government debt – growth relationship and contributes to literature in the following ways: First, we extend the horizon of analysis to several country groupings and make the study inclusive of economic, political and regional diversities based on a sizeable dataset. Second, we provide evidence for the presence of a causal link going from debt to growth with the use of ‘instrumental variables approach’ unlike the RR approach. Third, we overcome the issues related to data adequacy, coverage of countries, heterogeneity, endogeneity, and non-linearities by conducting a battery of robustness tests. We find that a 10-percentage point increase in the debt-to-GDP ratio is associated with 2 to 23 basis point reduction in average growth. Our results establish the nonlinear relationship between debt and growth.