The spending multiplier in a time of massive public debt: The Euro-area case

Abstract

This article argues that in Euro-area economies, where the European Central Bank (ECB) cannot bail out financially distressed governments, the spending multiplier is adversely affected by the amount of public debt. A regression model on a panel of 26 EU countries over the last 16 years shows that a 10 percentage point increase in the debt-to-GDP ratio is connected to a slowdown in annual growth rates of 0.28 percentage point. Furthermore, the effectiveness of fiscal spending is adversely affected by the amount of public debt; in particular, when the public debt exceeds 150% of GDP, the growth impact of the deficit might turn negative.

Keywords:

• spending multiplier
• Euro-area
• public debt
• illiquidity
• the Great Recession

JEL Classification:

• E62
• G01
• C23

Notes

¹ In practice, on 28 and 29 June 2012, the European Council approved the Compact for Growth and Jobs expected to boost the financing of the EU economy by additional 120 billion euros.

² The no-bail out orthodoxy of the ECB was somehow relaxed in September 2012 with the introduction of the Outright Monetary Transactions programme.

³ See Besancenot et al. (2004) for a dynamic model where a small and remote risk of unsustainability can trigger immediate illiquidity default on public debt

⁴ We checked that the correlation between the daily Credit Default Swaps (CDSs) spreads on 10-year Treasury bonds and the five biggest industrial corporations in Spain (a ‘high-risk’ country), in the period July 2007 to July 2012 is 0.80. If the two main banks are included, the correlation rises to 0.96.

⁵ Including Luxemburg does not change the results.

⁶ The Breusch and Pagan LM test indicates that the RE effect model is better than the pooled OLS estimator.