Convergence and public debt in the European Union: An overlooked trade-off?

ABSTRACT

The paper brings together two distinct strands of literature that discuss the process of convergence in the EU and the impact of public debt on growth. It makes a contribution to both literatures, by challenging the standard approach that relates public debt to growth, on two grounds. First, it shows that the process of convergence that took place among EU countries prior to the crisis was driven primarily by public policies that, however, increased public debt. Second, it provides evidence that the component of public debt that is related to infrastructure development, public goods provision and caching-up with the more advanced countries has a positive impact on growth and convergence. The findings of the paper call for a re-examination of the role of public policies in the processes of economic integration and development, leaving some room for a debt-led growth strategy.

KEYWORDS:

• Convergence
• public debt
• growth
• EU countries

Disclosure statement

No potential conflict of interest was reported by the author(s).

Notes

1 The discussion is about the so-called troika (i.e. the International Monetary Fund, the European Commission and the European Central) that provided bail-out programs in the debt-burdened Eurozone countries (i.e. Greece, Cyprus, Ireland and Portugal). The bail-out programs have been consolidated in corresponding Memoranda of Understanding on the condition of the implementation of far-reaching austerity measures.

2 See e.g. Allen (2010), Joyner (2010) and Koba (2011).

3 This, particularly, concerns the so-called ‘PIIGS’ (i.e. Portugal, Italy, Ireland, Greece and Spain). Of course, the crisis was severe in Eastern European countries as well.

4 This is so despite any reservations (European Commission 2008).

5 See e.g. the economic mismanagement of the German unification and the convergence process in (the former) Eastern Germany (Zimmermann 2002).

6 Croatia is not included in the analysis. The UK is included.

7 The discussion is about the EU countries that mostly specialize in labor- and resource-intensive industries, and thus develop inter-industry type of trade relations with the EU core countries (Petrakos, Kallioras, and Anagnostou 2011).

8 Noteworthy is the fact that the corresponding coefficient for the periods 1981–2008 and 1981–2007 was even higher, reaching the levels of -0.66 and -0.72, respectively. Data are available upon request.

9 Particularly, Reinhart and Rogoff (Ibid.) incorporate data on 20 advanced countries, over the period 1946-2009. Presenting four debt-to-GDP categories (i.e. ≤30%, 30–60%, 60–90%, and >90%), and comparing average real annual GDP growth rates across each category, they argue that: (a) the relationship between public debt and long-term growth is weak at ‘normal’ debt levels (i.e. for debt-to-GDP ratios below the threshold of 90%), and (b) above the threshold of 90%, the average real annual GDP growth rate is -0.1%. Yet, the study of Herndon, Ash, and Pollin (2013; 2014), observing that average real annual GDP growth rate at debt-to-GDP ratios over 90% was not dramatically different than at debt-to-GDP ratios ranging from 30% to 90%, highlighted that public debt might be mistakenly invoked as a reason to dismiss calls for expansionary fiscal policy, casting strong doubts, and thus animating the debate, on the effectiveness of austerity policies as a remedy to the economic crisis.

10 This is in line with Pescatori, Sandri, and Simon (2014), who argue that the level of debt alone is an inadequate predictor of future growth.

11 Particularly, to capture institutional environment, the ‘Rule of Law’ composite indicator is used. This indicator covers areas of property rights, government integrity and judicial effectiveness. Each component is weighted equally in determining country scores.

12 At this point, it needs to be mentioned that several studies focusing on public sector expenditures (Devarajan, Swaroop, and Zou 1996; Kneller, Bleaney, and Gemmell 1999; Nijkamp and Poot 2004) have distinguished between ‘productive’ and ‘unproductive’ public expenditures. Τhe common practice to distinguish between them is, grosso modo, to treat public consumption as ‘unproductive’ and public investment as ‘productive’. Despite any existing ambiguity (taking into consideration that public consumption includes public employment, which is necessary for public goods to be provided), this mirrors the fact that there is a commonly-held belief among scholars that public investment exerts a positive impact on long-run growth (Aschauer 1989; 2000; Barro 1990; Turnovsky and Fischer 1995; Heintz 2010). Yet, this might not be the case when, for example, public investment expenditures are used in an excessive way (Holtz-Eakin 1994; Romp and de Haan 2005).

13 Results are available upon request.

14 In addition, it should be kept in mind that an expansionary fiscal policy may, actually, lead to a decrease of the debt-to-GDP ratio (Aspromourgos 2007). This is, especially, so, when monetary policy loses all its traction at near zero interest rates (Eggertsson and Krugman 2012).

15 Of course, the sustainability of economic governance based on flexibility can be questioned as well.

16 This case reminds of the case of New York (Simon and Caher 2003, 151; Harvey 2005, 46). Particularly, regarding the economic problems in New York in year 1975, the (then) Secretary of the Treasury William Simon advised (the then) US President Gerald Ford that the terms of any bail-out should be ‘so punitive, the overall experience so painful, that no city, no political subdivision would ever be tempted to go down the same road’. As a result, much of the social infrastructure of the city was diminished and the physical infrastructure deteriorated markedly due to lack of investment or even maintenance. Daily life in New York ‘became grueling and the civic atmosphere turned mean’.

17 Moreover, such policies will restore the trust of international financial markets (Caner, Grennes, and Koehler-Geib 2011; Kourtellos, Stengos, and Chih 2013).