Public debt and economic growth – economic systems matter

Abstract

Most studies on the relationship between public debt and economic growth implicitly assume homogeneous debt effects across their samples. We –in accordance with recent literature– challenge this view and state that there likely is a great deal of cross-country heterogeneity in that relationship. However, other than scholars assuming that all countries are different, we expect that clusters of countries differ. We identify three country clusters with distinct economic systems: Liberal (Anglo Saxon), Continental (Core EU members) and Nordic (Scandinavian). We argue that different degrees of fiscal uncertainty at comparable levels of public debt between those economic systems constitute a major source of heterogeneity in the debt-growth relationship. Our empirical evidence supports this assumption. Continental countries face more growth reducing public debt effects than especially Liberal countries. There, public debt apparently exerts neutral or even positive growth effects, while for Nordic countries a non-linear relationship is discovered, with negative debt effects kicking in at public debt values of around 60% of GDP.

Appendices

Appendix 1

Table 4 Robustness check – rotating continental group composition

Appendix 2: Theoretical Foundation of Group Assignment: VoC, WWS and Economic Systems

In order to identify different economic systems, i.e. types of institutional frameworks that might shape expectations of market participants and by this the debt-growth relationship, we employ a joint VoC and WWS framework and compare the growth effects of public debt in different economic systems. The VoC approach, as one strand of literature on economic systems, focusses on the consistency of alternative types of institutional frameworks. Its core message (see e.g. Hall and Soskice 2001) is that different types of institutional matrices in the economy shape different market regimes or capitalist variations. These microeconomic institutional frameworks determine incentives for firms, households and policymakers and thereby influence the overall performance of the economy with respect to the societal preferences within the economic system. The VoC literature identifies two polar cases of capitalist varieties. Liberal Market Economies (LMEs, mainly Anglo-Saxon countries) rely primarily on markets to achieve coordination among economic actors with price signals and formal contracting as its main mechanisms. Opposite to these market-driven LMEs, Coordinated Market Economies (CMEs, mainly Scandinavian and Continental European countries) are identified by the VoC approach, where non-market institutions play critical roles and influence processes of strategic interaction. Countries cluster along the line of this bipolar continuum according to their institutional characteristics. As mentioned, when it comes to economic performance, consistency of the respective economic system matters. Meaning that none of the two polar cases performs better or worse by itself but that it is crucial for economic performance of a country to feature a consistent economic system where the institutions within all microeconomic spheres are complementary, i.e. produce matching incentive structures.

While the focus of VoC approach largely lies on microeconomic features of the production system with government activity playing no or only a secondary role, the literature on WWS, inspired by the seminal work of Esping-Andersen (1990) focusses on different shapes of welfare states in developed countries. The WWS literature distinguishes three different welfare state regimes: a Liberal (Anglo-Saxons), a Conservative (Continental Europe) and a Social Democratic (Nordic States) model. Each of these models possesses its own particular patterns of welfare state provision. The Liberal welfare state focusses on poverty alleviation and the provision of basic needs and otherwise relies on markets and private provision of social security. In the Conservative and Social Democratic welfare regimes on the other hand, the state plays a much more active role in providing social securities. The latter focusses on social services, i.e. subsidies for work (e.g. child care), while the emphasis of spending in a Conservative framework is on transfer payment like unemployment benefits and pensions, i.e. subsidies for leisure (Esping-Andersen and Myles 2011; Rogerson 2007). Following Schröder (2013) an integration of the two strands of literature is possible and useful for our investigation of economic systems. He argues that the similarity in country groupings that arises through various comparative analyses of economic systems cannot be due to coincidence but must be the result of underlying causal factors that link a Liberal welfare state to a Liberal Market Economy and Conservative or Social Democratic welfare states to a coordinated variety of capitalism. This link is again provided by institutional complementarities. In the same manner as institutions are complementary to each other within the production system (as postulated by the VoC approach), certain welfare state characteristics enhance the efficiency of institutions in other spheres and vice versa. A strong Conservative or Social Democratic welfare state with its strong unemployment protection e.g. encourages the appropriation of sector/firm-specific skills, a feature of a CME that is crucial for its firms to generate incremental innovation. A Liberal welfare state on the other hand reinforces labour market flexibility, which is crucial for LME firms to successfully engage in sectors where radical innovation is prevalent. Apart from this link between welfare states schemes and skill creation, Schröder (2013) identifies further complementarities between the three Worlds of Welfares States and the two Varieties of Capitalism, which leads him to the identification of three economic systems, namely: Liberal capitalism, Conservatively, and Social Democratically Coordinated Capitalism.

In our group assignment, we basically follow Schröder’s (2013) classifications by differentiating between Liberal, Continental (Conservatively Coordinated Capitalism) and Nordic (Social Democratically Coordinated Capitalism) economic systems. Several ambiguities had to be considered nonetheless. Switzerland is according to Schröder (2013) and other scholars a borderline case, since it mixes liberal and coordinated aspects in its economic system. Opposite to Schröder (2013) we assign it to the Liberal cluster, since our focus is on state activity and welfare state provision, a field where the Swiss characteristics (and descriptive statistics) clearly point in the direction of a Liberal configuration of state activity. This view is very much supported by our cluster analysis in Ahlborn et al. (2016). Japan, another borderline case is left out of this analysis, since it does not match well enough one of our three models. Due to the ambiguity of group assignment of Mediterranean countries, the later developing economies Spain, Portugal and Greece are excluded from our group assignment as well, while EU founding member Italy (as supported by Schröder 2013) can justifiably be identified as a Continental economic system.

In addition to this classification of production systems and welfare states within economic systems, further characteristics of countries play a role in our investigation. One such factor are the underlying preferences within a society concerning different aspects of economic performance. Iversen and Wren (1998) e.g. state that there is a trilemma of the societal objectives employment creation (i.e. economic growth), equality of income distribution and fiscal stability. Following their line of thought, any economic system can only achieve two goals at the same time, while the other one has to be neglected. Liberal countries are then favouring employment creation and fiscal stability over equality while the coordinated countries favour equality of income distribution and either neglect fiscal stability (Nordics) or employment creation (Continentals). The analysis of economic systems in Ahlborn et al. (2016), however, suggests, that the Nordic countries presumably escaped this assumed trade-off, since a low level of regulation combined with an active state and high state employment allows these states to achieve good outcomes in all three aspects of economic performance.