The Effects of Public Debt on Economic Growth in the EU, Empirical Analysis in different EU subgroups

Abstract

In its recent history the EU and its economic growth prospects have been tested by numerous challenges be it economic or societal. One of the more persistent effects of these pressures comes in the form of the accumulation of public debt, shaping the EU’s economic outlook and potential. Public debt’ effects on economic growth has been a central part of debates, as it can simultaneously be a powerful tool for public investments and crisis management, while also threatening their economies when accumulated. To contribute to this ongoing discussion, this thesis aims to empirically examine the effects of public debt on economic growth in the short (immediate) term in the EU and different subgroups within it. Specifically, the paper investigates whether public debt is stimulating or hindering economic growth in the region, accounting for possible nonlinear effects between the two. All the while the paper is also reviewing the existing literature on the subject. There are several ways in the literature in which public debt could affect growth. These include: higher taxes to pay for future liabilities and rising debt repayments, the crowding out of private investment; a higher degree of long-term interest rates, the reduction of total factor productivity. Its positive effects include: borrowed funds used on productive public investments and helping in the reduction of the effects of negative external shocks. To examine the direct effects of public debt the paper examines 24 EU countries (with the exclusion of Greece, Cyprus and Malta), through a period of 11 years, from 2013 to 2023. The empirical investigation is done through a Dynamic Panel Data model using the System Generalized Method of Moments as the estimation method. The thesis uses GDP growth as the proxy for economic growth, in order to capture the broad extent of effects that can affect GDP the study also uses additional variables in its panel data analysis. The study also employs a lagged dependent variable to account for the effects past growth has on current growth, also it employes a squared debt variable in order to account for the nonlinear effects debt can have on growth. The study finds that public debt affects GDP growth in a nonlinear manner. This means that around lower debt to GDP ratios debt can have a positive effect on the short run, while beyond this threshold debt will affect growth negatively. Amongst the three subgroups examined (EU, Western EU and CEE EU) the subgroup with the lower institutional quality and economic performance has this threshold level the lowest (54.78%), while the EU (74.18%) and Western EU (90.37%) have it higher. This confirms the notion that, at least in the EU, lower institutional quality and economic performance makes countries more vulnerable to the effects of debt. This is due to their public investments being less effective, all the while the negative effects are more pronounced due to more financial constraints in debt repayment. The limitation of the thesis include the fact that the study was carried out with a limited observation period of 11 years, it also included a shock in the form of the COVID-19 pandemic. The decision behind the observed time period was impacted by the availability of data on the required variables. Additionally the study is looking at the immediate impact of debt on growth. Measuring long term impacts was out of the scope of this study as the shorter observed period prevented the employment of time lags within the regressors.