Indebtedness and growth in the EMU before the Covid-19 pandemic shock.

• Date: 01 June 2023
• Author: Morganti, Patrizio

1. Introduction

   Since its creation in 1999, the euro area had to cope with challenges posed by the financial crisis, the new great recession, the sovereign-debt crisis, and finally the pandemic crisis. Accommodative monetary policy and financial conditions over the past few years have contributed to the buildup of high public and corporate debt in the eurozone countries. Overall private non-financial debt has increased from 160% of GDP in 2000 to almost 206% in 2019, mostly driven by the debt of the non-financial corporations (NFCs), while public debt rose from 70% to almost 86% with a peak of 95% in 2014. Private and public debt is high in a substantial number of European countries, with the majority of eurozone countries that have already breached the EU criterion that public debt should not exceed 60% of GDP. These hyper-debt signals cannot be neglected by regulatory authorities since they could materialize into serious threats to macroeconomic, financial, and fiscal stability of the euro area. Such vulnerabilities could be amplified by the different structural features that characterize the economies of each member state in a context of political and social instability. While leverage may support the economic recovery on the one side, it also increases the vulnerability of the non-financial sector and the cost of debt servicing on the other side.

   The relationship between economic growth and debt has been extensively explored in the academia, leading to the main outcome that high debt, mostly government debt, has a negative impact on the growth rate of a country, and in many cases that impact gets more pronounced as debt increases. Our key contribution is to analyze the potential link between economic growth and debt not at the global level, rather at a limited sample of countries, such as those of the European Monetary Union (EMU).

   The purpose of this paper is to analyze the relationship between debt and economic growth for the EMU countries following a two-steps approach. We first provide a breakdown of private (household and NFCs sectors) and public debt-to-GDP ratios and their changes over time, either at the eurozone-level and at country-level. Then we carry out an econometric exercise aimed to investigate the potential link between debt and economic growth for the 19 EMU countries over the 2000-2019 period. We point out that we intentionally decided to stop our analysis at the pre-pandemic period in order not to alter the results by excessive macroeconomic fluctuations caused by the pandemic shock after 2020. (1) In this regard, we believe that future research efforts intended to consider the structural break due to the pandemic crisis will have to focus on a broader time frame.

   We employ two different panel datasets, non-overlapping 5-year averages and overlapping 5-year averages, to consider variations across countries and over time of the variables of our interest, while controlling for both country and time fixed effects. (2) Macroeconomic data have been collected from The World Bank's World Development Indicators (WDI) while debt-to-GDP ratios from the IMF's Global Debt Database. We also investigate the potential impact of each sector-indebtedness on real economy growth volatility, as measured by the standard deviation of the real GDP per capita growth rates. We expect to find some empirical evidence showing a negative link between growth and indebtedness of the non-financial sector of the economy on the one hand, and a positive link between growth volatility and debt on the other hand, implying higher risk connected to macroeconomic and financial stability. (3)

   We also address two additional issues. The first one is whether private and public debt are complementary to economic growth, and the second one is to investigate which channels could be responsible for the effects of debt on economic growth. This could have relevant policy implications since the existence of complementarities between private and public debt as well as the understanding of the channels between debt and growth would suggest policy makers to be adopt policies mainly aimed to stabilize debt and rely on robust growth to ensure sustainability. The paper addresses three main questions: (i) does exist a statistically significant relationship between economic growth and debt for the EMU area? (ii) what about the relationship between debt and the volatility of GDP growth rates? (iii) what are the main channels through which the different sources of debt can influence economic growth?

   The paper is organized as follows. After a brief review of the literature in Section 2, Section 3 provides a breakdown of private and public debt in the EMU by analyzing debt-to-GDP ratios and their changes over time, both at the aggregate- and at the country-level. Section 4 is devoted to data description and methodology, and Section 5 to results. Section 6 concludes. A description of variables and data sources is available in the Appendix at the end of the paper.

2. Related literature

   Our paper is mostly related to the strand of the literature which focuses on the investigation of the debt and growth nexus.

   Indebtedness among economic agents should be aimed to improve their welfare by allowing them to enjoy better and larger opportunities in terms of investments or consumption, while always being able to afford future debt service. However, the real world teaches us that over-borrowing may end up in bankruptcy, financial turmoil, liquidity dry-ups, and, in the worst cases, severe financial or sovereign-debt crisis. At this regard, Cecchetti et al. (2011) point out the importance of looking carefully at the sources of non-financial debt, i.e. household, corporate, and public sector. The authors empirically examine the impact of debt on economic growth using a dataset on debt levels of 18 OECD countries from 1980 to 2010 (based primarily on flow of funds data). The results support the view that, beyond a certain threshold (85%, 90%, and 85% of GDP for government, corporate, and household debt, respectively), debt harms growth, even if they do not estimate the magnitude of the impact. They find out that debt is good at low levels, since it is a source of economic growth and stability; at high levels, private and public debt are bad, since they tend to increase volatility and retarding growth. In general, higher nominal debt raises real volatility, increases financial fragility and reduces average growth. In addition, Cecchetti et al. (2011) also investigate the link between debt and growth volatility, showing that high indebtedness amplifies the standard deviation of GDP growth rates.

   The negative relationship between debt and future GDP growth has been explored also by Jorda et al (2016), Mian et al. (2017), Alter et al. (2018). In particular, Alter et al. (2018) document a negative relationship between household debt and future GDP for a set of 80 countries over the period 1950-2016. This relationship is explained by three mutually reinforcing mechanisms: i) debt overhang impairs household consumption when negative shocks hit, ii) an increase in household debt heighten the probability of future banking crises, which significantly disrupts financial intermediation, iii) crash risk may be systematically neglected due to investors' overoptimistic expectations associated with household debt booms. Drehmann et al. (2018) study the transmission mechanism from financial markets to real economic activity. They analyze the effects of household debt on the economy by developing a transmission mechanism focused on the flows of resources between borrowers and lenders, i.e. new borrowing and debt service. They construct a panel dataset of household debt in 16 countries showing that new borrowing increases economic activity but generates a pre-specified path of debt service that reduces future economic activity. In particular, when new borrowing is auto-correlated and debt is long term, two systematic lead-lag relationships emerge. First, debt service peaks at a well-specified interval after the peak in new borrowing, since debt service is a function of the stock of debt outstanding, which continues to grow even after the peak in new borrowing. Second, net cash flows from lenders to borrowers reach their maximum before the peak in new borrowing and turn negative before the end of the credit boom. Jorda et al. (2013) use local projection methods to condition on a broad set of macroeconomic controls to study how past credit accumulation impacts key macroeconomic variables such as output, investment, lending, interest rates, and inflation. The authors use a dataset of 14 advanced countries between 1870 and 2008 and provide evidence that relatively to typical recessions, financial crisis recessions are costlier, and more credit-intensive expansions tend to be followed by deeper recessions (in financial crises or otherwise) and slower recoveries.

   Eggertsson and Krugman (2012) suggest that, in order to avoid high unemployment and deflation, the public sector should borrow to fill the spending gap left by private sector borrowers as the latter repair their balance sheets. However, the capacity of the public sector to borrow is not unlimited. When a crisis strikes, the ability of the government to intervene depends on the amount of debt that it has already accumulated as well as what its creditors perceive to be its fiscal capacity--that is, the capacity to raise tax revenues to service and repay the debt. At this regard Mbaye et al. (2018) document another form of private sector "bailout" that they consider as much more common and universal than the typical bank bailout, which is a sort of debt "mutualization" not involving financial institutions, rather households and firms. The authors show that whenever the private sector is caught in a debt overhang and needs to deleverage, governments systematically come to the rescue through a counter-cyclical rise...