Growth implosions and debt explosions

Do growth slowdowns cause public debt crises?

Published at www.bepress.com

By William Easterly, Center for Global Development and My Aunt Marilyn

Grow

th Implosion: The W

orld G

rowth Slow

down

0.01

0.02

0.03

0.04

0.05

0.061951

1954

1957

1960

1963

1966

1969

1972

19751978

1981

1984

1987

1990

1993

1996

1999

GDP Growth Rate (Unweighted world average)

Debt explosion: the rise in public debt to GDP ratios (world

average)

20%25%30%35%40%45%50%55%60%

1975

1977

1979

1981

1983

1985

1987

1989

1991

1993

Change in growth 60-75 to 75-94 and Log Change in public debt to GDP ratios 1975-94

0%

1%

2%

3%

4%

5%

6%

7%

-5% -4% -3% -2% -1% 0% 1%

Change in growth 60-75 to 75-94 (by quintiles from worst to best)

Log

annu

al c

hang

e in

deb

t rat

iofr

om 1

975

to 1

994

(ave

rage

for

quin

tile)

Growth rate of debt ratio and change in growth has negative association:

• Significant correlation of -.41• Regression of annual change in debt ratio on

change in growth: change in growth has coefficient not significantly different than -1 (and coefficient on growth in each period is unity of opposite sign when entered separately)

• Implies borrowing 1975-94 was calibrated to old growth rate 1960-75 rather than to new growth rate 1975-94

Don’t borrow a lot when your growth is going down!

Message of this paper

Never take a sleeping pill and a laxative on the same night.

My Aunt Marilyn puts it in more earthy language:

Outline• The growth slowdown as an explanation for

various debt crises: the HIPCs, middle income countries, and industrial countries

• The role of growth in the government’s intertemporal budget constraint

• Policy conclusions: increasing growth is a fiscal adjustment measure!

The birth of debt crises

t

t

t

tttt

YDgr

YASTG

YD *)()( −+++−=∆

First expression is the primary deficit as a ratio to GDP. Knowing data on Change in D/Y, r, g, and D/Y, we can back out primary deficit (later we’ll calculate it from primary data for a smaller sample)

Data sources

• Public Debt (for concessional debt, present value of debt service from World Bank, for non-concessional debt Loayza, Schmidt-Hebbel, and Serven 1998)

The evolution of public debt

1975 1994Highly indebted poor countries 48% 94% 1.8% * -0.44%Not highly indebted poor countries 28% 41% 4.4% 0.14%Highly indebted middle-income countries 27% 56% 3.4% 0.52%Not highly indebted middle income countries 9% 24% 3.4% 0.40%Industrial countries 29% 59% 2.4% ** 0.06%

Total net public debt

GDP Growth rate 75-

94

Implied primary deficit/

GDP, 1975-94

HIPCs became HIPCs not because of primary deficits (they actually had primary surpluses)

but because of low growth

Similarly industrial countries’ had high public debt ratios by 1994 because of slow growth

1975-94

Public debt to GDP ratios, actual and counterfactual at 1960-75

growth rate

0%10%20%30%40%50%60%70%80%90%

100%

HIPC Industrial

1975 actual1994 actual1994 counterfactual

Public debt to GDP ratios, actual and counterfactual at 1960-75

growth rate

0%

20%

40%

60%

80%

100%

120%

Cos

taR

ica

Cot

ed'

Ivoi

re

Gab

on

Ital

y

Tog

o

actual 1975actual 1994counterfactual1994

Policy variables explain low HIPC growth 1975-94 and thus

the HIPC debt crisis

Replication of Easterly and Rebelo 1993 Growth Regression for Fiscal Variables and Other

Controls

VariableCoef-

ficientt-Sta-tistic

Constant 0.04211 1.60Public Spending on Transport and Communication/GDP 0.00255 2.01Government Surplus/GDP 0.00139 3.41Initial Income -0.00850 -2.20Primary enrollment 0.00023 2.24Secondary Enrollment 0.00019 1.46M2/GDP 0.00026 2.38Real Overvaluation -0.01187 -2.55

Dependent Variable: Per Capita Growth Estimation Method: Seemingly Unrelated RegressionPooled sample of 70s, 80s, 90s

Differentials in policy variables HIPCs vs. non-HIPC low income countries 1990s (t-stats below)Public Spending on Transport and Communication/GDP -1.65 -0.4% -12%

-2.33Government Surplus/GDP -1.43 -0.2% -5%

-0.71Primary enrollment -19.27 -0.5% -12%

-2.50Secondary Enrollment -11.16 -0.2% -6%

-2.38M2/GDP -12.29 -0.3% -9%

-3.04Real Over-valuation 0.39 -0.5% -13%

1.94Total explained growth or net worth differential -1.8% -49%Actual growth or public debt differential -1.9% 57

Policy different

ials

Net worth effect

Growth effect

Policy implications

• World Bank and IMF should be begging countries to spend more on infrastructure and education (with suitable incentives for quality spending of course) to promote growth during fiscal adjustment programs.

• Avoid repeated myopic fiscal adjustments• Haiti has gotten 22 IMF stand-bys!

The Idiot’s Guide to Fiscal Policy (i.e. guide for politicians)

• There doesn’t exist a one-period “resource envelope” or “budget constraint” for the government

• There is only the intertemporal government budget constraint.

• Any public spending that carries an above-normal financial rate of return should be done, just like in the private sector – solve the problem of financing high return projects, don’t cut the projects!

The role of growth in the government’s intertemporal

budget constraint

The government’s intertemporalbudget constraint

( ) 0tttt0

rt DdtGASTe ≥−++∫∞

−

T taxes

S seignorage

A aid reciepts

G government spending

D Public net debt at time zero

Define government net worth as: present value of primary surplus (assuming fiscal ratios remain

constant) - debt

t

t

t

tttt

t

t

YDgr

YGAST

YW −−−++= )(

Solvency constraint is that W/Y≥0

Condition for intertemporalbudget constraint to be satisfied assuming constant fiscal ratios

0

0

YD

gr=

−σ

σ=T/Y+ A/Y + S/Y-G/Y

The effect of growth on net worth

Evaluate at point of zero net worth (just solvent)

( )2/

grgYW t

−=

∂∂ σ

( )grYD

gYW

−=

∂∂ /

60-75 75-94Highly indebted poor countries 3.6% 1.8% 46% -25%Not highly indebted poor countries 3.7% 4.4% 13% 10%Highly indebted middle-income countries 4.9% 3.4% 29% -21%Not highly indebted middle income countries 4.9% 3.4% 15% -7%Industrial countries 4.5% 2.4% 30% -23%

Effect of growth on net worth and change in debt, 1975 and 1994 Growth rate

Growth effect on

net worth to

GDP

Change in debt

ratio 75 to 94

More data sources

• Government expenditures, taxes (IMF Government Finance Statistics)

• Aid from World Bank project: Chang, Fernandez-Arias, and Serven 1999

• Seignorage I calculate from IMF as (g+π)/(1+g+π) *H/Y

Slow growth (suitably instrumented) interacted with

initial debt explains number of debt reschedulings in HIPCs and HIMCs compared to other LDCs.

Results on debt rescheduling and growth for developing countries

Dependent variableEstimation method TSLS GMM

Coef- ficient

T- statistic

Coef- ficient

T- statistic

Constant 2.1 1.87 2.8 3.08Primary fiscal surplus/GDP, 1980-94 2.7 0.08 -47.8 -2.02PV Debt/GDP,1980 10.4 3.97 12.1 6.04Growth8094* Debt/GDP -272.2 -3.6 -292 -6.39observations 49 49

# of debt reschedulings, 1980-94

Instruments for all equations: PV Debt/GDP 1980, Trading partner growth*PV Debt/GDP, Africa dummy*PV

Debt/GDP, Latin America dummy*PV Debt/GDP, Trading Partner Growth, Africa dummy, Latin America dummy

Define intertemporal fiscal imbalance as difference between actual (permanent component of) primary surplus and

required primary surplus for solvency

t

t

t

tttt

t

tttt

t

t

YDgr

YGAST

YGAST

YIFB )( −−−++=−−++= σ

Fiscal adjustment and intertemporal fiscal imbalance

1975 1994 1975 1994Highly indebted poor countries -0.5% 4.3% -1.6% 0.4%Not highly indebted poor countries -1.6% 4.1% -2.3% 3.4%Highly indebted middle-income countries -1.5% 5.6% -1.8% 4.1%Not highly indebted middle income countries 0.2% 3.8% 0.1% 3.2%Industrial countries -2.2% 0.2% -2.7% -2.0%

Primary surplus/ GDP,

(permanent

Inter-temporal fiscal

imbalance/ GDP

Developing countries had attained solvency by 1994, industrial countries had not.

Industrial countries failed to adjust to the fiscal consequences

of the growth slowdown.

The HIPCs were only solvent by 1994 because of increased aid flows and inflation tax, not because of domestic fiscal adjustment

Highly indebted poor countries

1975 1994 1975 1994Including aid and inflation tax -0.5% 4.3% -1.6% 0.4%Excluding aid -3.2% -2.2% -4.4% -6.2%Excluding aid, excluding inflation tax -4.1% -4.1% -5.3% -8.1%

Primary surplus/ GDP,

(permanent component)

Intertemporal fiscal imbalance/

GDP

HIPC debt relief program may reflect aid-weariness by donors, desire to substitute once for all

debt relief for continuing flow of aid

Richest countries have intertemporal fiscal balance of 5.5 percentage points of GDP if pension liabilities are included.

Auerbach and Gale 2000 estimate intertemporalfiscal imbalance of 1.4 - 2.9 percent in US (depending on whether a tax cut is implemented)

Perhaps we now need a program of debt relief for highly indebted

rich countries’ (HIRC).(Just kidding)

When trouble arises & things look bad, there is always oneindividual who perceives a solution & is willing to take

command.

--Aunt Marilyn

Very often, that person is crazy.

Growth implosions and debt explosions: conclusions

• Growth slowdowns were a major contributing factor to the HIPC debt crisis, the middle income debt crisis, industrial countries’ debt crisis, and maybe a tangential factor in the East Asian financial crisis.

• A negative growth shock is a fiscal shock to which governments must adjust like other fiscal shocks

• Fiscal adjustment programs are myopic if they reduce growth-enhancing public expenditures -- actions to increase growth should be part of fiscal adjustment.