Does public debt produce a crowding out effect for public investment in the EU?

Abstract

The combination of the sovereign debt crisis that started in 2009 in the EU and the fiscal consolidation policies that were implemented as a result, has significantly hampered economic growth and inflated debt levels. This paper exploits a panel dataset for 26 EU countries between 1995 and 2015 to examine the extent to which increased levels of public debt have led to reduced public investments, the so-called 'debt overhang' hypothesis. To address endogeneity concerns, we use an instrumental variable approach based on a GMM estimation. Our results validate the debt overhang hypothesis and remain robust across various estimation techniques; the GMM estimation with year dummies, for example, indicates that a 1 percentage point increase in public debt in the EU brings about a reduction in public investment of around 0.30 percentage points. Given the level of public investment prevalent in 2015, this is equivalent to a €1.85 billion euro drop. Interestingly, we find evidence that the impact of this causal relationship exists only for high debt countries. In addition, our results suggest that the negative impact of debt on investment is slightly smaller in the Eurozone than in the entire EU, which might suggest that the institutional framework of the Eurozone does not act as a ‘straightjacket’ for countries that experience high debt levels. Moreover, we find that both the stock and flow of debt have played a role in reducing public investment, and that the latter’s impact was more profound.