What is the relationship between debt and growth?
stephen clarke, 30 January 2012
Last Friday the U.S. Commerce Department’s Bureau of Economic Analysis (BEA) announced that it had estimated the growth in American GDP in the fourth quarter of 2011. The BEA estimated that the American economy had grown at an annualised rate of 2.8 per cent. This shines a harsh light on the current economic growth, or economic contraction, of the British economy, which shrank by 0.2 per cent in the final quarter of 2011.
A further unflattering comparison between the two economies was also made last week by the economist Paul Krugman in the New York Times who drew attention to research by the National Institute of Economic and Social Research which showed that Britain’s current slump was worse than that experienced in the Great Depression.
The research by the NIESR came on the back of the latest study by the McKinsey Global Institute into debt and deleveraging in the world’s major developed economies. The study, and the others which preceded it, indicate that Britain’s gross debt (public and private) grew dramatically between 2000 and 2008 and continued to grow from 2008 to the second quarter of 2011 (when the latest data was available).
What is the link between debt and growth? The McKinsey report discusses how important it is for economies to deleverage before they grow and Britain’s Coalition Government has built its economic policy around the premise that significant spending cuts (and so reductions in public debt) are a prerequisite for economic expansion. Both of these views are not necessarily incorrect. Nevertheless, a brief look, albeit at a small sample of countries, suggests that the relationship between debt and growth is far from simple.
Figure one plots countries along two variables; total debt (public, private, corporate) and the change in GDP between 2008 and 2011. There is no discernible relationship between the two variables. It is of note that the five countries whose GDP has not yet returned to 2008 levels are all European countries, four of which are in the Eurozone. Figure one suggests that a large amount of debt does not necessarily restrict the ability of an economy to grow. South Korea’s total debt is equal to 314 per cent of GDP equivalent to that of Italy, however South Korea’s GDP has grown by 8.5 per cent since 2008 while Italy’s shrank by 10.9 per cent.
Figure two plots the same set of countries, excluding Switzerland for which data was not available, along two variables: the increase in debt between 2000 and 2008 and the change in GDP between 2008 and 2011. There is a relationship between these variables with a negative correlation of -0.47. The negative correlation could indicate a relationship between growth in debt and GDP, furthermore because the increase in debt occurred before the change in GDP the result cannot suggest that falling GDP caused the growth in debt. This result does seem to chime with the view that countries which take on debt quickly are more likely to take on unsustainable levels of debt which subsequently act as a drag upon GDP. However, if we take the UK out of this calculation the negative correlation falls to -0.2, suggesting that the UK’s experience may be dominating this result. It is also important not to overstate the significance of this result when one bears in mind the fact that Germany took on very little debt between 2000 and 2008 yet its GDP in 2011 had not yet recovered to its 2008 level. Clearly there are other factors at work in these results suggesting that examining debt levels in themselves may not be particularly useful in predicting future economic growth.
Finally, figure three examines the relationship between debt levels and growth between 2008 and 2011. Unlike the previous set of results one cannot be sure that in this case the two are not affecting one another: a fall in debt could spur growth but can growth also result in a fall in debt when the two are occurring simultaneously. As with figure one there is little discernible relationship between the change in debt and the change in GDP between 2008 and 2011. The US and South Korea deleveraged and grew, yet leverage increased in Japan and Canada and these two countries saw GDP levels rise above those of 2008. Once again the European and Eurozone countries recorded a fall in GDP and a growth in debt.
Debt is a concern for governments and individuals everywhere, however one should be cautious when attempting to come to general conclusions about how debt affects growth. Clearly the simplistic analysis above ignores, and fails to control for, a number of important factors and the sample size is too small to make generalisations. Nevertheless the results may tentatively illustrate that a growth in debt should be viewed with more concern than the total level of debt and that the key issue is how sustainable debt is. This conclusion is perhaps obvious but politicians across the world should bear it in mind as they embark on significant austerity measures.