Essays on the impact of debt and saving on economic performance in the EU

Abstract

The Global Financial Crisis (GFC) of 2007-2009 highlighted the devastating impact both public and private debt can have on an economy. This doctoral dissertation is situated in the broad research agenda of analyzing how debt, and in particular excessive levels of debt, negatively affects economic performance. Although the research on the potential harmful effect of debt has vastly expanded over the past ten years, there is by no means a consensus in the literature on what type of debt (e.g. public or private) is more damaging, at which level it becomes a drag on growth and/or investment and through which channels. In our research, we try to advance the literature by conducting a cross-country empirical analysis on the impact of debt on economic performance in the European Union (EU). It appears intuitive that excessive debt levels can hurt economic growth. However, scholars have struggled to specify at what point public debt becomes detrimental for growth. Following the highly influential 2010 paper by Reinhart & Rogoff, the assertion that debt levels in excess of 90% of GDP bring about economic mayhem and hence need to be avoided by all means, was treated as received wisdom and this threshold swiftly became ammunition in political debates on austerity, on both sides of the Atlantic. We first study whether there indeed is a tipping point for public indebtedness, beyond which economic growth is dramatically compromised. We find little evidence to support the hypothesis that a critical debt threshold exists after which economic output is substantially reduced. Instead, our research shows growth performance deteriorates progressively as the level of total debt-to-GDP increases. Moreover, this relationship is stronger for short-term growth than for medium- to long-term growth, which suggests the causality most likely runs from low growth to high debt, rather than vice versa. If such a threshold does exist, it presumably varies from country to country, fluctuates over time and depends on a plethora of different factors (e.g. a country’s potential growth rate, debt servicing costs, institutional capabilities and the willingness and ability of the private sector to save). Even if there is no ‘magical’ debt threshold after which economic output collapses, excessive debt levels might still have a negative impact on a broad array of macroeconomic indicators. For example, as public debt levels soared after the GFC, public investment plummeted. Therefore, we examine to what extent higher public debt results in lower public investment. Our results indicate a significant negative impact of sovereign debt on public investment: if public debt levels in the EU would be 10 percentage points lower, public investment would be around €18.5 billion higher. Moreover, we find that this debt overhang effect is only prevalent in high debt countries. This suggests that, when sovereign debt rises, public investment is crowded out by the increase in debt servicing costs. When faced with the need to curtail spending, governments have a bias for reducing investment spending rather than current spending, as the political cost of deferring investment projects is generally lower than the political cost of trimming current expenditure since the latter often benefits politically influential interest groups (e.g. civil servants). As a result, highly indebted governments spend less on public capital. Hence, from an economic policy perspective, fiscal consolidation measures might be justified, if the aim is to boost public investment. The decline in public investment in the EU since the GFC has generally been acknowledged by policymakers and is starting to draw attention of the academic community. However, private investment collapsed even more than public investment did, most notably in Europe’s Southern periphery. Coinciding with this reduction in private investment, public and private debt levels soared. Hence, we examine to what extent higher debt results in lower private investment. We find scant evidence to support the hypothesis that high private debt leads to low private investment. However, we do find that inflated levels of public debt result in diminished private investment: should public debt levels in the EU decrease by 10 percentage points, investment would increase by €65 billion. In addition, this debt overhang effect is again stronger in countries characterized by high levels of public debt. We identify three potential channels through which higher public debt can result in lower private investment. Firstly, as government debt rises, companies and households expect future taxes to increase as well and decide to reduce investment spending now. Secondly, the private sector considers public debt to be an indicator of economic uncertainty: if sovereign debt goes up, economic prospects are dismal. In a future mired in economic uncertainty, the incentive to invest will be lower. Thirdly, higher levels of public debt will, ceteris paribus, bring about higher borrowing costs for the sovereign, as this implies a higher risk of default. This increase in borrowing costs feeds through to the private sector and crowds out private investment. Our research shows that debt per se is not a good predictor of future GDP growth, but that it does have a negative impact on a variety of macroeconomic indicators, such as public and private investment. Hence, we advocate a more comprehensive view of fiscal sustainability and public wealth, which goes beyond debt and deficits and takes into account the entire public sector balance sheet. Shifting the attention from one component of a public sector’s balance sheet, i.e. debt, to the entirety of government assets and liabilities will yield a more accurate account of the health and sustainability of public finances, is likely to lead to better management of state assets and will draw attention to nondebt liabilities (e.g. unfunded pension obligations) that are often neglected in standard fiscal analyses. Moreover, we show that countries characterized by high levels of public debt tend to devote less resources to public investment. Decreased public investment, for example in education and roads, hurts the long-term productive potential of a country and has obvious negative implications for the private sector. Thus, countries, especially highly indebted ones, should be incentivized to allocate sufficient resources towards public investments. Therefore, we propose to rewrite the Stability and Growth Pact (SGP) by exempting spending on public investment from the deficit rule. More specifically, we advocate the introduction of a ‘golden rule’ at the European level, which would allow a government to borrow with the purpose of financing public investment but would require current spending to be covered by current revenues. As noted, the GFC wreaked havoc on the European economy and led to a deterioration in the public finances of nearly every EU country. The marked increase in sovereign debt forced most governments to push through stringent austerity measures, including cuts in social security spending and laying off civil servants. Moreover, monetary policy reacted by implementing a host of conventional and unconventional policy measures to contain the fall-out of the crisis. These events also brought about an unprecedented increase in uncertainty for households and severely dented consumer confidence: in the spring of 2009, at the height of the crisis, overall consumer confidence reached a three-decade low. People are less sure whether they will be able to keep their job, what return they can expect on their savings and to which extent they will have to provide for their own health insurance and pension plans. Therefore, we study the effect the Global Financial Crisis has had on consumer confidence and in turn how this evolution in consumer sentiment influenced household saving behavior. We find that confidence in the financial situation of households has a substantially larger effect on household saving than confidence in the general economic situation. More specifically, if the indicator measuring the confidence in households’ current financial situation decreases by 1 standard deviation, household saving increases by 12.43 percentage points. This compares to a 2.82-3.81 percentage points increase in the saving rate of households if the indicator measuring the general economic situation decreases by 1 standard deviation. As the household saving rate averages 10.72% in our sample, this effect is quite substantial. Households are hence more concerned with how their personal financial situation develops than with the state of the general economy. Indeed, it is the evolution of a household’s finances over the past year, and their outlook for the coming year, which ultimately drives their spending decisions. If they experience a deterioration in their financial situation, and/or expect it to deter further, they will postpone the consumption of durable consumer goods (e.g. a car) to a time when their finances, or at least the perception thereof, have improved. Moreover, our results suggest the impact of consumer confidence on household saving has increased after the Global Financial Crisis: a broader array of sub-indicators of consumer sentiment impact household saving and their impact is stronger post 2008. More research is needed to establish the mechanisms behind this. We posit that a threshold effect might be in place: after the GFC, consumer confidence dropped to such a low level, that it altered how households incorporate consumer sentiment in their saving decisions: consumer confidence plays a more important role and households incorporate a larger set of confidence indicators to determine their economic or financial situation. When consumer confidence is low, for example during or shortly after a recession, policymakers should be very careful not to implement measures intended to counteract this fall in consumer sentiment but in reality prove to aggravate a dire economic situation. With regards to fiscal policy, governments need to show a clear commitment to long-run debt sustainability. If governments proceed with a budgetary stimulus to counter a recession that is regarded by citizens as being excessive and jeopardizing the long-term health of public finances, households might respond more sluggishly to this demand stimulus. With regards to monetary policy, central banks need to tread carefully as to not worsen consumer sentiment. Highly accommodative monetary policy, especially unconventional policy measures, might be viewed by the public as an indicator that the economic future looks very bleak, in the process negatively affecting household expectations about the economic outlook. In the final part of this doctoral dissertation, we explore what has driven the increase in public debt and what policy lessons can be drawn from studying the evolution of public debt. In order to do so, we carry out a case study on one of the most highly indebted countries when the Maastricht Treaty was signed by European leaders in 1992: Belgium. More specifically, we assess the main drivers of Belgium’s debt dynamics between 1995 and 2014. As a result of its historically high debt burden, Belgium had ample experience in running primary surpluses. Already during the 1980s, the Belgium government had to realize substantial primary surpluses, as to avoid debt snowballing out of control. When Belgium decided to enter the EMU, the risk premium on Belgian bonds decreased and interest rates on government bonds started to fall substantially. Both elements combined with an uptick in international growth and the ‘stars aligned’ for an impressive debt reduction episode: the ratio of public debt-to-GDP declined from a peak of 138% in 1993 to 87% in 2007. We do not claim the Belgium government refrained from implementing important reforms to establish these relatively high primary surpluses. However, the latter were not significantly larger than the surpluses it had historically realized. Of course, maintaining a primary surplus also requires taking difficult, and often unpopular, measures, but Belgium had extensive experience in doing so. Then, the GFC caused the worst economic disaster since the Great Depression and forced governments across the globe to bail out large parts of the financial sector. Also in Belgium, the federal government had to inject capital in several large, failing banks, causing a sizeable increase in the public debt-to-GDP ratio. Moreover, anemic growth combined with the cost of servicing a large stock of legacy debt, resulted in public debt to rise even further. Subsequently, we take a brief look at what, if any, lessons can be learned from the Belgium experience and applied to Greece, a country which would certainly benefit from a comparable, or preferably even larger, reduction in sovereign debt. Whether Greece can achieve a similar reduction in its public debt ratio is not clear-cut. Certain factors speak in favor of Greece emanating the Belgium experience. For example, even at the heights of the GFC, the Greek people showed an unequivocal desire to remain part of the common currency block, even if this meant stringent austerity measures. As staying part of the Eurozone seems as important to the Greek people as entering it was for the Belgian people, they are likely willing to make considerable sacrifices to this end. Other aspects are less favorable. Whereas only around a quarter of Belgium’s stock of sovereign debt was held by non-residents when it entered the Eurozone, approximately 83% of Greece’s debt was owed to official, foreign creditors at the end of 2014. Running continued primary surpluses to pay down debt constitutes a massive transfer of Greek wealth to other counties. If Greek citizens take the view that these transfers are unfair, as future generations will have to continue to “pay for mistakes made by previous governments”, this will significantly hamper their willingness to tolerate painful austerity measures. In the current economic environment, where the nominal growth rate exceeds the yield on government bonds, the intertemporal budget constraint facing the government no longer binds, absent primary deficits. Hence, public debt has limited to no fiscal costs. However, excessive levels of sovereign debt still have welfare costs because they reduce capital accumulation, as our research has shown. Moreover, although at present interest rates are at subdued levels, they can, and most likely will, rise in the future, for example due to a positive shock to productivity resulting from advances in artificial intelligence and robotics, or because of a reassessment of risk premia on government bonds caused by the global rise in populism. Furthermore, unless substantial policy changes are implemented, a rapidly ageing population will put sovereign debt on an upward trajectory in most advanced economies as spending on pensions and healthcare is forecasted to grow considerably. Thus, sound debt management and prudent fiscal policy is still warranted. Nevertheless, further research is required to assess the cost of public debt in the current environment of low interest rates, as well as the implications for fiscal rules that guide governments’ tax and spending decisions.