PUBLIC DEBT AND ECONOMIC GROWTH IN THE EUROPEAN UNION

PUBLIC DEBT AND ECONOMIC GROWTH IN THE EUROPEAN UNION Piotr MISZTAL Technical University in Radom, Poland Economics Department misztal@tkdami.net Abstract The main aim of the article is to present the relationships between public debt and economic growth in the European Union in the period 2000 2010. The article consists of two parts. The first part deals with theoretical analysis of the relationships between public debt and economic growth, including reasons and factors determining these relationships. In the next part of article, there are examined the relationships between public debt and gross domestic product in the EU by using the Vector Autoregression Model (VAR). There are estimated elasticity coefficients of public debt to GDP and elasticity coefficients of GDP to public debt on the base of impulse response function. Then, there is made variance decomposition of the public debt and GDP in order to assess the impact of these factors on the variability of GDP and public debt respectively. Keywords: public debt, budget deficit, economic growth, crowd in effect JEL Classification: H6 1. Introduction The issue concerning the impact of public debt on the economic growth was and still is one of the subjects of the debate among theorists and practitioners of economics. Basically, in the economics literature on this subject, theoretical and empirical considerations can be divided into three main groups. The first group of analyses constitutes works of Keynesians, the second, research of the Neo classical School representatives and the third, studies of proponents of the Ricardian Equivalence hypothesis. These three contrasting approaches to budget deficit and public debt contribute to many discussions in the country and abroad on the role of budget deficit and public debt in the process of economic growth. 2. Model of budget deficit, public debt and economic growth Budget deficit is typically defined as the difference between government expenditure (including interest on debt) and government income. However, in accordance with the more complex definition, budget deficit is the difference between the size of public debt at the end of the year and the size of public debt at the end of the previous year. These two definitions are equivalent if the public debt is defined as the value of issued bonds. Budget deficit in country implies that public debt increases. But because GDP also increases, the ratio of government debt to GDP may change or remain stable. Therefore, whether the ratio of government debt to GDP varies or remains unchanged that depends on the growth rate of the national debt is greater or less than the GDP growth rate. Systematically increasing the ratio of domestic debt to GDP is a threat for the country, the public debt will enter the unsustainable growth path, leading to the insolvency of the country. Even if the ratio of public debt to GDP does not increase rapidly, high debt to GDP ratio is serious and unfavorable consequences for the country associated the growing cost of public debt service. Therefore it is important to understand the causes of the increase the ratio of public debt to GDP and to find the optimal size of this ratio in the country. For this purpose it is necessary to distinguish the standard budget deficit from the primary budget deficit. Basic (primary) budget deficit is equal to the standard budget deficit corrected by the cost of public debt service (Feldstein 2004). Therefore, standard budget deficit and the primary budget deficit can be presented in the form of the following expressions, as: SB= G+ PB= G T ( i PD) T (1) (2) 292

Volume V/ Issue 3(13)/ Fall 2010 where: SB standard budget deficit; PB basic budget deficit; PD public debt; G government expenditure; i interest of public debt; T government incomes (tax and non tax). Hence, on the basis of the above mentioned expressions we can present the ratio of public debt to GDP in the following form: PD GDP G T GDP = + i GDP GDP PD GDP (3) where: GDP gross domestic product. In accordance with Equation 3, the ratio of public debt to GDP is the sum of the ratio of primary budget deficit to GDP and the difference between the interest rate and the growth rate of GDP multiplied by the ratio of government debt to GDP. Therefore, in accordance with the above mentioned equation the ratio of government debt to GDP rises when in the situation of the primary budget deficit, interest of public debt is greater than the growth rate of GDP. In order to reduce the ratio of public debt to GDP it must be the surplus in the primary government balance (greater government income than public expenditure) or GDP must grow faster than the cost of public debt service. 3. Literature review on the public debt and economic growth According to Keynesian opinions, budget deficit and the public debt have a positive impact on economic activity in the country, in particular through the mechanism of public expenditure multiplayer. Moreover, they provide arguments indicating the prevalence of crowd in effect in public expenditure as a result of deficits and debt induced by expansionary fiscal policy. They also argue that budget deficit and government debt increase national production, what makes that private investors perceive the future economic situation more optimistic and increase their investments. On the other hand, representatives of the Neo classical School state that the budget deficit and public debt can make harmful effects for economic growth. They analyze consumption expenditure of households during their entire life cycle and consider that the government with budget deficit moves the tax burden on future generations, what leads to increase of current consumption. On the assumption of full employment, representatives of the Neo classical School argue that increasing consumption means decreasing savings. Therefore interest rates must increase in order to restore equilibrium on the capital market what leads to decrease the size of private investment (Keho 2010). However, advocates of the Ricardian Equivalence conception argue that government deficit and public debt are neutral for economic growth. According to this hypothesis the current budget deficit, resulting for example from tax decreasing must be repaid in the future, for example by tax increasing, thus leaving private investments and interest rates unchanged (Saleh 2003). Some economists, such as Modigliani (1961), Diamond (1965), and Saint Paul (1992) indicate that increasing public debt always contributes to economic growth. In turn, Patillo, Poirson, and Ricci (2004) concluded that the low level of public debt affects positively economic growth but high public debt affects negatively the growth rate of GDP. Furthermore, the results of empirical studies carried out by Kumar, and Woo (2010) on a group of countries including both developed economies, as well as developing countries indicate the presence of negative relationship between initial public debt and economic growth in the period 1970 2007. The results of their analyses confirmed that the increase in the ratio of public debt to GDP by 10 p.p. accompanied the decline in real GDP per capita by 0.2 p.p. within one year. Schclarek (2005) analyzing 59 developing countries and 24 developed economies stated that in the case of developing countries it is always negative and substantial relationship between the total indebtedness of the country and economic growth. On the other hand, in relation to high developed 293

countries Schclarek (2004) did not find a significant relationship between the public debt and economic growth. Ferreira (2009) analyzed the relationship between economic growth and public debt using vector autoregression model and Granger causality test confirmed the existence of the relationship between economic growth per capita and the ratio of public debt to GDP in OECD member countries over the period 1988 2001. Furthermore, he confirmed that this relationship is always bidirectional. Keho (2010) examined the relation between budget deficit and economic growth in seven West African countries in the period 1980 2005 using VAR model and Granger causality test. He obtained inconclusive results. In the case of the three countries he did not find a causal relationship between budget deficit and economic growth. But in the case of three other countries he found two way, negative relationship between fiscal balance and economic growth. Simultaneously, it should be emphasized that many empirical studies conducted over the past several years suggests a non linear relationship between the public debt and economic growth (Moore, Chrystol 2008). Namely, the results of these studies indicate that public debt positively affect economic growth, but only to a certain level of the debt in relation to GDP. To similar conclusions came Elbadaw Ndulu, and Ndung u (1997) analyzing the relationship between public debt and GDP in 26 sub Saharan African countries in the period 1980 1994. They have demonstrated that public debt positively affected economic growth in these countries, but only up to 97% of GDP. Similarly, Pattillo, Poirson, Ricci (2002) examined 93 developing countries in the period 1972 1998 and they found positive impact of public debt on GDP growth rate, but only up to 35 40% of GDP. Similar studies conducted Smyth, and Hsing (1995), who analyzed the impact of public debt on economic growth in the USA in the 80s and 90s of the 20th century. However, these authors assessed an optimal level of public debt (the level of public debt, which maximizes economic growth) for the U.S. economy. Their results indicated that an optimal level of public debt to GDP for American economy amounted to 38.4% in the analyzed period. Reinhart, and Rogoff (2010) examining 44 developed and developing countries over the last hundred years concluded that the high level of public debt in relation to GDP (over 90%) is accompanied by a lower level of economic growth in developed countries as well as in developing countries. Furthermore, in the case of developing countries, the relatively high level of external debt in relation to GDP (over 60%) negatively affected economic growth. 4. Public debt and economic growth in the EU in the period 2000 2010 Relatively high size of public debt in many EU member countries contributed to numerous discussions on the impact of public debt on economic growth (Biondo 2010). In order to analyze the causal relationship between changes of public debt and GDP in the EU member countries in the period 2000 2010 there was used vector autoregression model (VAR) proposed by Ferreira (2009) and presented by the following expressions: GDP PD t t = = k= 1 p p α GDP k χ PD t k + + k t k k= 1 k= 1 p p k= 1 k β PD k δ GDP t k t k + µ + υ t t (4) (5) where: PD public debt expressed in national currency; GDP gross domestic product expressed in national currency;, residuals; t given period; k lag length. All the above mentioned time series had quarterly frequency and cover the period from the first quarter of 2000 to the first quarter of 2010. These data came from the base of the European Union Statistical Office (Eurostat). Before the model structural parameters were estimated, it was necessary to isolate a seasonal factor from the time series. The existence of a seasonal factor in the time series 294

Volume V/ Issue 3(13)/ Fall 2010 could lead to difficulties in interpreting changes in a given phenomenon in the analyzed period. To eliminate the time series from seasonal fluctuations, the X12 ARIMA method was applied. Moreover, it was necessary to specify the stationarity of the analyzed time series. For this purpose the Augmented Dickey Fuller Test (ADF) was used. Among analyzed variables there were time series of the integration degree 0 and 1. The lack of stationarity of time series forced the modification of function model, in order to bring the variables to stationarity. This modification was to replace the size of variables by their first differences. It should be also pointed out that in the absence of cointegration between variables there was no possible to expand and transform structural VAR model into the Error Correction Model (ECM). In the analysis one lag period (one quarter) between explanatory variables was adopted. The choice of lag lengths was in line with the results of the information criteria of the Akaike, Schwartz Bayesian and the Hannan Quinn models. According to these criteria, a model with one lag length was characterized by the biggest information capacity. Analyzing ratios of public debt to GDP in the EU it can be noted that these indicators increased significantly over the past ten years. The average share of public debt in GDP in the 27 EU member states was 65% at the beginning of 2000 and at the beginning of 2010 this ratio was about 75%. The highest ratios of public debt to GDP were found in Greece, Italy and Belgium but the lowest in Estonia, Luxembourg and Bulgaria. 120.0 100.0 80.0 60.0 40.0 20.0 0.0 EU Belgium Bulgaria Czech Rep. Denmark Germany Estonia Ireland Greece Spain France Italy Cyprus Latvia Lithuania Luxembourg Hungary Malta Netherlands Austria Poland Portugal Romania Slovenia Slovakia Finland Sweden UK 2010 2000 Figure 1. The ratios of public debt to GDP in the EU member countries in years 2000 and 2010 [in %] Source: Own calculations on the basis of Eurostat (2010). Moreover, the size of GDP per capita in the EU increased substantially over the past few years. The average level of GDP per capita in the 27 EU member countries was 19 thousand euro at the beginning of 2000 and 24 thousand euro at the beginning of 2010. The highest sizes of GDP per capita in 2010 were in Luxembourg, Denmark and Ireland, but the lowest in Romania, Bulgaria, Lithuania and Latvia. 295

80000 70000 60000 50000 40000 30000 20000 10000 0 EU Belgium Bulgaria Czech Rep. Denmark Germany Estonia Ireland Greece Spain France Italy Cyprus Latvia Lithuania Luxembourg Hungary Malta Netherlands Austria Poland Portugal Romania Slovenia Slovakia Finland Sweden UK 2010 2000 Figure 2. Size of GDP per capita in the EU member countries in years 2000 and 2010 [in euro] Source: Own calculations on the basis of Eurostat (2010). From a theoretical point of view, less economically developed countries should have generally higher level of public debt in relation to GDP than highly developed countries due to financial constraints and economic needs in poorer countries. However, analyzing data concerning the share of public debt in GDP in the EU member countries we may notice higher ratios of public debt to GDP in relatively high developed EU member countries. This may indicate a positive impact of public debt on the level of economic development of these countries or the positive impact of the economic growth on the size of public debt. However, the experience of many countries, both developed, as well as developing shows that too high share of public debt in GDP may increase the risk of investment in the country, the outflow of foreign capital and consequently the depreciation of the national currency. Of course, this situation negatively affects the rate growth of GDP in the country. In order to find a causal relationship between the average level of public debt and GDP in the EU in the period 2000 2010 it was necessary to estimate structural parameters of VAR model. Results of parameters estimation of the model were shown in the following table. Table 1. The results of structural parameters estimation of VAR model VAR system, lag order 1 OLS estimates, observations 2000:2 2010:1 (T = 40) Log likelihood = 258,18577 Determinant of covariance matrix = 8,4843479e 009 AIC = 12,7093 BIC = 12,5404 HQC = 12,6482 Portmanteau test: LB(10) = 67,6214, df = 36 [0,0011] Equation 1: GDP Coefficient Std. Error t ratio p value GDP_1 1,32922 0,167257 7,9472 <0,00001 *** PD_1 0,334161 0,169398 1,9726 0,05585 * GDP_1 0.861849 0.0250165 34.4513 <0.00001 *** PD_1 0.145892 0.0265551 5.4939 <0.00001 *** 296

Volume V/ Issue 3(13)/ Fall 2010 Mean dependent var 15,71887 S.D. dependent var 0,121356 Sum squared resid 0,006189 S.E. of regression 0,012762 R squared 0,999999 Adjusted R squared 0,999999 F(2, 38) 30343398 P value(f) 1,4e 118 rho 0,199296 Durbin Watson 1,504455 F tests of zero restrictions: All lags of GDP F(1, 38) = 63,158 [0,0000] All lags of PD F(1, 38) = 3,8913 [0,0558] Equation 2: PD Coefficient Std. Error t ratio p value GDP_1 0,430476 0,168944 2,5480 0,01500 ** PD_1 0,563264 0,171107 3,2919 0,00216 *** Mean dependent var 15,51963 S.D. dependent var 0,123634 Sum squared resid 0,006314 S.E. of regression 0,012891 R squared 0,999999 Adjusted R squared 0,999999 F(2, 38) 28991312 P value(f) 3,3e 118 rho 0,049724 Durbin Watson 1,828029 F tests of zero restrictions: All lags of GDP F(1, 38) = 6,4925 [0,0150] All lags of PD F(1, 38) = 10,837 [0,0022] On the basis of the estimation results of the Equation 4 (GDP), we can see that one of the factors that determined GDP growth in the EU in the period 2000 2010 was public debt. Namely, the increase in public debt by 1% led to decline the value of GDP on average by 0.3%. On the other hand, on the basis of the estimation results of the Equation 5 (PD) it was affirmed that one of the most important factors which determined the size of public debt in the EU in the period 2000 2010 were just GDP changes. In this case, GDP growth by 1% led to increase public debt on average by about 0.4%. However, comparing the elasticity coefficients in these two equations it was proved that GDP changes affected the size of public debt in much more degree, than public debt influenced on GDP growth in the EU in the examined period. The next step of analysis was the measurement of the impact strength of public debt changes on GDP and GDP changes on the size of public debt in the EU. It was made using the so called impulse response function, i.e., function of a GDP and public debt response to an impulse resulting from one unit changes of public debt and GDP respectively. 297

GDP -> GDP GDP -> PD 0.019 0.018 0.018 0.017 0.017 0.016 0.015 0.014 0.016 0.015 0.014 0.013 0.012 0.013 0.011 0.012 0 2 4 6 8 10 12 14 16 18 20 0.01 0 2 4 6 8 10 12 14 16 18 20 quarters quarters PD -> GDP PD -> PD 0 0.01-0.005 0.005-0.01-0.015 0-0.005-0.01-0.02-0.015-0.025 0 2 4 6 8 10 12 14 16 18 20-0.02 0 2 4 6 8 10 12 14 16 18 20 quarters quarters Figure 3. Impulse response function of gross domestic product (GDP) and public debt (PD) to a one shock in public debt and gross domestic product On the basis of above figure, it was noted one shock change in GDP led to the gradual growth of GDP over the next twenty quarters from the time of shock, and subsequently to stabilization. What is more, the increase of GDP led to increase in the size of public debt over next 20 quarters, and then to gradual stabilization. The situation seemed differently in the case of GDP reaction to changes in the size of public debt. The increase of public debt led to the gradual decrease of GDP over the next twenty quarters, and subsequently to gradual stabilization. However, one shock change in size of public debt led to an immediate increase in public debt and then to gradual decline during the next twenty quarters. The last step of the analysis was the residual component variance decomposition of public debt and GDP, in order to estimate the impact of these factors on the variability of GDP and public debt respectively in the EU. Table 2. The error variance decomposition for public debt and gross domestic product in the EU in the period 2000 2010 The number of quarter The error variance decomposition for variable PD The error variance decomposition for variable GDP after shock PD GDP PD GDP 1 34,7 65,3 0,0 100,0 2 24,3 75,7 1,8 98,2 3 16,8 83,2 5,1 94,9 4 12,5 87,5 9,1 90,9 5 11,2 88,8 13,2 86,8 6 11,9 88,1 17,1 82,9 7 13,8 86,2 20,8 79,2 8 16,4 83,6 24,1 75,9 9 19,3 80,7 27,0 73,0 10 22,1 77,9 29,7 70,3 11 24,9 75,1 32,1 67,9 12 27,5 72,5 34,2 65,8 13 29,9 70,1 36,1 63,9 298

Volume V/ Issue 3(13)/ Fall 2010 The number of quarter The error variance decomposition for variable PD The error variance decomposition for variable GDP after shock PD GDP PD GDP 14 32,1 67,9 37,7 62,3 15 34,0 66,0 39,2 60,8 16 35,8 64,2 40,6 59,4 17 37,4 62,6 41,8 58,2 18 38,9 61,1 42,9 57,1 19 40,2 59,8 43,9 56,1 20 41,4 58,6 44,8 55,2 In accordance with data in above table it can be noted that GDP changes accounted for 87% of the public debt variance in the EU after fourth quarter and nearly 59% after twentieth quarter. For comparison, changes in the size of the public debt in the EU explained about 9% changes of GDP at the end of the fourth quarter and close to 45% after twentieth quarter. The impact of public debt on economic growth and the impact of economic growth on public debt significantly varied in size among the individual EU member countries. Namely, the highest absolute values of impact coefficients of public debt to GDP were affirmed in Spain and Ireland, and the lowest value in Latvia. On the other hand, the highest absolute values of impact coefficients of GDP to public debt were found in Finland and the smallest in Spain, Ireland, Slovenia, Sweden, Denmark, Netherlands and Cyprus. Table 3. Elasticity coefficients of public debt to GDP and elasticity coefficients of GDP to public debt in the EU member countries in the period 2000 2010 Country GDP PD PD GDP Belgium 0,01 0,02 Bulgaria 0,04 0,01 Czech Rep. 0,02 0,07 Denmark 0,06 0,00 Germany 0,02 0,05 Estonia 0,08 0,05 Ireland 0,29 0,00 Greece 0,07 0,06 Spain 0,32 0,00 France 0,03 0,06 Italy 0,05 0,06 Cyprus 0,04 0,00 Latvia 0,00 0,11 Lithuania 0,05 0,09 Luxembourg 0,02 0,07 Hungary 0,09 0,01 Malta 0,01 0,32 Netherlands 0,01 0,00 Austria 0,01 0,15 Poland 0,01 0,06 Portugal 0,03 0,03 Romania 0,02 0,09 Slovenia 0,24 0,00 Slovakia 0,03 0,17 Finland 0,03 0,49 Sweden 0,12 0,00 UK 0,02 0,10 299

Analyzing values of elasticity coefficients of GDP to public debt and public debt to GDP in each of the EU member countries it was identified certain regularities. Generally speaking, it was found the highest, positive impact of public debt on GDP in these EU member states, in which the share of public debt in GDP was close to 65%. Therefore, such a share of public debt in GDP was an optimum from the impact of public debt on economic growth point of view. 0,4 0,3 0,2 Elasticity of GDP to public debt 0,1 0,0-0,1-0,2-0,3-0,4-0,5-0,6 0 20 40 60 80 100 120 Public debt in relation to GDP [in %] Figure 4. Elasticity of GDP to public debt and the ratio of public debt to GDP in the EU member countries in the period 2000 2010 Taking into account the values of elasticity coefficients of public debt to GDP and public debt to GDP in the EU member countries it was not identified a significant relationship between these variables. However, it should be noticed that the negative values of elasticity coefficients of public to GDP were confirmed in these countries where the share of public debt in GDP was between 20% and 60%. 0,15 0,10 0,05 Elasticity of public debt to GDP 0,00-0,05-0,10-0,15-0,20-0,25-0,30-0,35 0 20 40 60 80 100 120 Public debt in relation to GDP [in %] Figure 5. Elasticity of public debt to GDP and the ratio of public debt to GDP in the EU member countries in the period 2000 2010 300

Volume V/ Issue 3(13)/ Fall 2010 To sum up, an optimal share of public debt to GDP, expressing the highest, positive impact on economic growth in the EU member countries was close to 65%. While the negative impact of economic growth on the size of public debt was found in these EU member countries, whose public debt was from 20% to 40% of GDP. Taking into account public debt forecasts to 2020 in selected developed countries and emerging markets made by Deutsche Bank, it should be noted that among examined EU member countries, we should expect a positive impact of public debt on economic growth in Poland, Czech Republic, Hungary and Romania, in which public debt will be closest to the optimum level in 2020. Table 4. Matrix of public debt projections by 2020 in selected EU member countries Developed countries The share of public Medium (73.7<debt High (debt Low (debt ratio<73.7) debt in GDP/Tendency ratio<131.4) ratio>131.4) Falling Denmark, Sweden Belgium Italy Stable Germany, Ireland, Spain Increasing France, Slovakia, UK Greece, Portugal Emerging markets The share of public Medium (20<debt Low (debt ratio<20) debt in GDP/Tendency ratio<52.2) High (debt ratio>52.2) Falling Stable Poland Increasing Czech Rep., Hungary, Romania Source: Deutsche Bank Research (2010). However, according to data reported in the above table, the most of developed EU member countries will perceive a negative impact of public debt on economic growth in 2020, because the level of public debt in these countries will significantly exceed its optimal size, 5. Conclusions On the basis of the results of investigation concerning the relationship between public debt and economic growth in the EU during the first quarter of 2000 to the first quarter of 2010 we can point at several key conclusions. Firstly, it was found that one of the factors that determined GDP growth in the EU in the period 2000 2010 were changes in public debt. Namely, average elasticity coefficient of public debt to economic growth amounted to 0.3. On the other hand, one of the factors which determined the size of public debt in the EU in the period 2000 2010 was changes in GDP. In this case, average elasticity coefficient of GDP to public debt in the EU amounted to 0.4. Moreover, it was estimated that changes in GDP accounted for public debt variability in much more degree than the scale in which public debt changes accounted for GDP variability in the EU. Secondly, it was found that elasticity coefficients of public debt to economic growth and economic growth to public debt significantly differed in the individual EU member countries. The highest absolute values of impact coefficients of public debt to GDP were reported in Spain and Ireland, but the lowest value in Latvia. However, the highest absolute values of impact coefficients of GDP to public debt were found in Finland and the smallest in Spain, Ireland, Slovenia, Sweden, Denmark, Netherlands and Cyprus. Thirdly, it was affirmed that the highest, positive impact of public debt on GDP took place in the EU member countries, where the share of public debt in GDP was close to 65%. What is more, there was not found a significant relationship between the values of elasticity coefficients of GDP to public debt and the share of public debt in the GDP in individual EU member countries, but it was noted the existence of negative values of elasticity coefficients of public debt to GDP in these countries where the share of public debt in GDP was from 20% to 60%. 301

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