Economics in a picture
The effects of fiscal stimulus tend to be weaker in high-debt countries
The “great recession” left a legacy of historically high government debt levels in various euro area countries. The literature on the relationship between public debt and economic growth is not consensual. Such relationship is found to crucially depend on country-specific factors, including the quality of institutions, the size of the public sector, the debt accumulation mechanism, and its composition.
Model-based simulations suggest that, in case of negative shocks, high-debt economies can be more affected in terms of output loss (actual and long-term potential growth), may remain longer at the zero-lower bound, are more affected by spillovers, and face stronger crowding out of private debt.
Moreover, in high-debt economies the scope for counter-cyclical fiscal policies is restrained. These countries are thus less equipped to withstand adverse shocks, especially in a context where monetary policy is centrally decided and fiscal policy is determined at the national level. A simple regression on a panel of euro area countries spanning the period from 2003 to 2014 shows that periods of fiscal tightening (ie, increases in the structural primary balance) were concomitant with short-term declines in the output gap. Analogously, periods of fiscal loosening (ie, negative changes in the structural primary balance) were concomitant with short-term improvements in the output gap. This effect - which can be broadly interpreted as a proxy for a short-term multiplier - is found to be weaker in countries with higher public debt, in which cases potential short-term benefits of fiscal loosening should also be weighed against sustainability concerns.
For additional detail, refer to Checherita-Westphal et al. (2019): “Economic consequences of high public debt and challenges ahead for the euro area”, Banco de Portugal Occasional Paper, No. 4/2019.
Prepared by Maria Manuel Campos. The analyses, opinions and results expressed above are those of the author and do not necessarily coincide of those of Banco de Portugal or the Eurosystem.
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