"the relationship between government debt and real GDP growth is weak for debt/GDP ratios below a threshold of 90% of GDP. Above 90%, median growth rates fall by 1%, and average growth falls considerably more.” Reinhart and Rogoff (2010a)
Revisiting Figure 1 is useful for illustrating the importance of nonlinearities in the debt-growth link. Simply put, for 92% of the observations in our sample there is no systematic link between debt and growth (Bruno and Easterly 1998 find similar results). Thus, if we did a simple scatter plot of all the observations on debt/GDP and on growth we might expect to find a “clouded mess.” We can highlight this general point with the US case. As noted in the working paper version of Reinhart and Rogoff (2010a), for the period 1790-2009, there are a total of 216 observations of which 211 (or 98%) are below the 90% debt to GDP cutoff.7 It should be quite obvious that a scatter plot of the US data would not be capable of revealing a systematic pattern (as demonstrated in the work Iron and Bivens 2010). Indeed, this example illustrates one of our main results, that there is no systematic relationship between debt and growth below a threshold of 90% of GDP.
Debt and growth causality
As discussed, we examine average and median growth and inflation rates contemporaneously with debt. Temporal causality tests are not part of the analysis. The application of many of the standard methods for establishing temporal precedence is complicated by the nonlinear relationship between growth and debt (more of this to follow) that we have alluded to.
But where do we place the evidence on causality? For low-to-moderate levels of debt there may or may not be one; the issue is an empirical one, which merits study. For high levels of debt the evidence points to bi-directional causality.
Growth-to-debt: Our analysis of the aftermath of financial crisis Reinhart and Rogoff (2008) presents compelling evidence for both advanced and emerging markets over 1800-2008 on the fiscal impacts (revenue, deficits, debts, and sovereign credit ratings) of the recessions associated with banking crises; see Figure 3.
As we sum up,
“Banking crises weaken fiscal positions, with government revenues invariably contracting. Three years after a crisis central government debt increases by about 86%. The fiscal burden of banking crisis extends beyond the cost of the bailouts.” Reinhart and Rogoff (2008).8
There is little room to doubt that severe economic downturns, irrespective whether their origins was a financial crisis or not, will, in most instances, lead to higher debt/GDP levels contemporaneously and or with a lag. There is, of course, a vast literature on cyclically-adjusted fiscal deficits making exactly this point.
