2.Literature Presbitero, 2013, 2014) this impact is rather

2.Literature Review

The existing literature focused on the topic of the relationship between
sovereign debt and economic growth can be divided into two types of research.
The first type focuses on model development based on economic theory and the
second type is empirical research studies. The Literature Review of my study begins
with the theoretical research, followed by the empirical one. Finally, it ends
with the contribution of my thesis to the existing research.

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2.1 Theory

There are three
different major school of thoughts of economic literature studying the effect
of public debt to growth and argue whether the rising public debt slows down
the pace of economic growth or not.

According to the
Keynesian theory a suitably structured fiscal stimulus which will lead to
higher budget deficit and public debt not only increases the consumption via
the budgetary multiplier mechanism (Baumol-Maurice, 1955) but also leads to
higher investment that may increase supply and hence lead to higher growth
rate. Moreover, Delong and Summers (2012) argue that budget deficits could have
a positive effect on economic growth during recessions if they are a product of
expansionary fiscal policies which under the circumstances could be self-financing
in a depressed economy. According to Krugman (1998) where the term “debt
overhang” is introduced, the expected debt service may have a positive impact
on country’s economic growth if the public debt level of a country is expected
to exceed the country’s repayment ability.

Opposing the
Keynesian approach, the neoclassical view argues that the public debt has a
negative impact to economic growth. Several studies, (Modigliani 1961, Diamond
1965, Saint Paul, 1992) claim that an expansionary fiscal policy boosts current
consumption which leads to a decline of saving rates. As a consequence, the
interest needs to rise which will result to a decrease of investment and
economic growth. However, according to other research papers (Elmendorf and
Gregory Mankiw (1999), Panizza and Presbitero, 2013, 2014) this impact is rather
small. Additionally, according to Teles et al. (2014), the impact of fiscal
policy on economic growth is limited by the public debt since it affects the potency
of public expenditures.

Differentiating
from the above two economic school of thoughts the Recardian Equivalence theory
supports that the influence of debt to growth is neutral or irrelevant (Barro,
1989). According to the Ricardian view, when the expansionary fiscal policy,
which lead to higher government deficit and public debt, is implemented, the
market players, expecting future austerity measures, shift from investments and
consumptions to growing savings. This change neutralizes the effect of the
fiscal stimulus.

2.2 Empirical Literature

There is a fairly
extensive body of economic literature about the importance of the sovereign
debt and its effect on economic growth. During the past decades, the empirical
studies had focused on emerging economies with a primary focal point the impact
of external debt and debt restructuring on growth in developing countries. It
was only after 2008 when the economic debt crisis triggered a series of
unconventional monetary and fiscal policies and many Eurozone members were
unable to repay or refinance their government
debt, that the economic literature examining the relationship of
public debt to growth in developed countries gained a new momentum.

From an empirical
standpoint, the research studies that have been conducted can be split into two
main different groups.

The first group
consists of studies which are focused on examining a linear relationship
between public debt and economic growth. Among those studies, Schclarek (2004)
after examining a panel of 59 developing countries and 24 industrial ones, found
a negative relationship between external debt levels and economic growth for
the developing countries. However, he did not find a systematic relationship
between sovereign debt and economic growth for the developed ones, suggesting
that for these developed countries, higher public debt levels are not
necessarily associated with lower GDP growth rates. Furthermore, Kumar and Woo
(2010) after examining a panel of advanced and developing countries found that
a 10 percentage point increase in the initial debt-to-GDP ratio results to a
0.2 percentage points per year slowdown in growth. The estimates of Panizza and
Presbitero (2012), after using a panel of 17 OECD countries, show that there is
no evidence that public debt has a causal effect on economic growth. Similarly,
Cohen (1993) after examining a dataset of developing countries did not find any
evidence of negative relationship between public debt and output growth.

The second group
consists of empirical studies that examine non-linear relationship between
public debt and GDP growth and address whether there are specific levels that
sovereign debt has negative impact on economic growth. The paper of Reinhart
and Roggof (2010) where the authors studied the economic growth at different
levels of sovereign debt, is considered a milestone. It is considered to be
among the first studies to discover the existence of threshold effects of
public debt to GDP growth. After using data from forty four countries (20
advanced and 24 emerging markets) in a period of about two centuries
(1790-2009) the authors found that:

·      
The impact of government debt to
real GDP growth is weak below the critical point of 90 percent debt/GDP ratio.

·      
Above the 90 percent threshold the
growth outcomes are notably lower.

The critical point
of public debt is the same for both the advanced and the emerging economies.

However, the paper
of Reinhart and Roggof (2010) was challenged by Herndon et al. (2013) who after
replicating the former paper discovered that a series of exclusion of data, a
number of coding errors and lastly an inappropriate weighting of summary statistics
lead to wrong results about the relationship between the public debt and the
economic growth. After correcting the above errors, Herndon et al. (2013) found
that the impact of the 90 percent debt threshold to the economic growth seems
to disappear.

Following the
study of Reinhart and Roggof (2010) several studies focused on investigating a
specific debt to GDP ratio above seen as a turning point in the effect of debt
to economic growth. Among them, Checherita and Rother (2012) after examining twelve
countries over the period from 1970 to 2011, found the threshold to be between
95-100 percent. Similarly, Baum, A., Checherita-Westphal, C., & Rother, P.
(2013) found that for high debt-to-GDP ratios (above 95 percent), additional
debt has a negative impact on economic growth. Misztal (2010) for the EU-27,
found that that the highest, positive impact of public debt on GDP took place
when the ratio of public debt to GDP was close to 65 percent. Cechetti et al.
(2011) after investigating 18 OECD countries from 1980 to 2010 found that
beyond the level of around 85 percent of GDP, public debt impacts negatively
the economic growth.  Additionally, Caner
et al. (2010) after an investigation of 101 developing and developed
economies spanning a period from 1980 to 2008 support the existence of a
threshold of 77 percent public debt-to-GDP ratio. Greenidge et al. (2012) using
data from Caribbean countries supports the view that there is a critical point
of 55-56 percent above which the impact of debt to economic growth switches
from positive to negative. Furthermore, Padoan et al. (2012) after examining an
unbalanced panel of 28 OECD countries over the period 1960 to 2011 reports a 90
percent debt threshold above which the public debt impacts negatively the GDP
growth. Égert (2013) using the same database with Reinhart and Roggof (2010), finds
also evidence in favor of a negative nonlinear relationship between public debt
and economic growth. More precisely, Égert (2013) finds that the
negative impact of public debt to growth starts at much lower debt ratio levels,
between 20 percent and 60
percent. On the other hand, Chang and Chiang (2009), for a sample of 15 OECD economies during
the years from 1990 to 2004, ?nds two public debt ratio thresholds, 32.3
percent and 66.2 percent; however, according to the findings of the study, the effect
of debt on economic growth is notably positive in all three groups, more
precisely higher in the middle regime and lower in the two other regimes. However,
Pescatori et al. (2014) using a dataset of 34 advanced
countries report no evidence of a specific debt threshold above which public debt affects negatively the economic growth. Similarly, Proaño et al. (2014) after investigating
16 OECD economies over the period 1981 to 2013, contrary to the research
studies that find particular debt thresholds above which the debt impacts
negatively the GDP growth, report no such critical point. Moreover, they argue
that a crucial source of the non-linear relationship between debt and growth is
the financial stress, high levels of which can impact negatively the economic
activity regardless of the debt levels.  Reinhart,
Reinhart and Rogoff (2012) focused on periods with debt to GDP ratios over 90
percent, i.e debt overhangs. According to their study these periods have an
average duration of 23 years. This characteristic implies that the aggregate
loss in output from debt overhang can be massive. Lastly, Bökemeier and
Clemens (2016) after examining data from 1970 to 2014 for 18 European countries tried to answer whether the participation in the European
monetary union and the commitment to fulfill the Maastricht Criteria might
imply an additional risk. By dividing the countries into two different groups,
members of the Euro area and counties that do not use the Euro as common
currency, found that debt ratios below the Maastricht benchmark (60 percent of
GDP) impact the economic growth positively for both groups. However, the negative
relationship between public debt and economic growth is more distinct and
significant for the Euro countries compared to the non Euro ones, implying that
participating in the common monetary union and following the Maastricht
criteria does pay off and prudent fiscal decisions are especially important on
the Euro set.   

In contrast to the
above two main groups of empirical research studies, another group of papers examines
the impact of the debt sustainability to the economic growth by distinguishing
between sustainable and non-sustainable debt periods, referring to the
relationship among the primary surplus, the debt ratio to GDP and the economic
growth. According to these papers, the findings of the empirical research can
be biased if they do not take into account the macroeconomic conditions
embedded in the above mentioned macroeconomic indicators. Moreover, according
to the results of these studies, the debt sustainability should be considered
as an additional important predictor of economic growth, contrary to the idea
that the debt thresholds alone are an adequate predicator of the growth.

The main paper
focused on investigating the effects of the non-sustainable debt on economic
growth is the paper of Dreger and Reimers (2013). After examining annual data
from 16 European countries from 1991 to 2011, they found that non-sustainable
debt periods affect negatively the economic growth of the European countries
that participate in the Euro Area, while no significant effect can be observed
for those European countries that are not members of the Euro Area. As a
result, the study concludes that being a member of the Euro area involves an
additional risk. Another study that examines the effect of the non-sustainable
debt on economic growth is the study of Antonakakis, Nikolaos (2014). By examining
the data from the 12 Euro area countries from the period of 1970 to 2013, he
tried to unify the studies of Baum, A., Checherita-Westphal, C., & Rother,
P. (2013) and Dreger and Reimers (2013) and examine the role of debt
sustainability in combination with debt thresholds and their effect on the
economic growth. According to the findings of the paper, on the short run, the
non –sustainable debt ratios both above and below the 60 percent critical
point, affect negatively the economic growth. On the contrary, sustainable debt
ratios impact positively the short-run economic growth. In the long run, the
non-sustainable debt ratios below the 60 percent critical point, as well as the
debt ratios above the 90 percent threshold (sustainable and non-sustainable
ones) have a negative effect on the economic growth. Regarding policy
implications, the results show the importance of responsible fiscal decisions for
countries with non-sustainable debt levels in order to ensure economic growth.

2.3 Contribution

On the previous
section I have listed few of the empirical studies which have been conducted
about the direct effect of public debt to economic growth based on data from
different countries from all over the world. As it can be noticed, there is a
lack of consensus in the economic literature about the effects of debt on the
economic growth since there have been mixed results about whether the growing
public debt decreases the pace of economic growth or not and whether a certain
threshold has to be reached in order to observe a negative relationship. My
intention is to be part of this academic research and further extend it by
examining the relationship between debt and growth in the European setting from
the year of 1991, the day that the Maastricht treaty was agreed, till the 2016.

Furthermore, contrary
to the empirical studies that focus exclusively on the relationship of the debt
levels with the economic growth, my paper examines additionally the
relationship of the debt sustainability to the growth by distinguishing between
sustainable and non-sustainable debt periods. Moreover, following previously
mentioned studies, my study tries to participate in the debate whether the participation
on the European Monetary union plays a role in the impact of the public debt to
the economic growth and whether the membership on the Euro Area entails an
additional risk for its members. The findings of a study with this subject could
we important implications for the design of the fiscal policies of counties
that face high level of debt and for the design of economic adjustment programs
for countries experiencing financial difficulties. Finally, I will try to
investigate whether the relationship of debt to GDP growth has been altered
after the financial crisis of 2008.