Abstract
This paper investigates two overarching questions: how high can public debt rise before it becomes unsustainable; and, how do sustainable changes in public debt impact growth? We review fiscal performance using annual data from a panel of 23 advanced economies, over the period 1970-2007.
Firstly, as in Ghosh et al. (2013), we estimate both a static and dynamic fiscal reaction function by regressing primary balance on debt, debt squared, and debt cubed (among others). This shows that the primary balance exhibits ‘fiscal fatigue’. Fiscal fatigue is where it gradually becomes harder and harder for a country to pay down rising debt, leading to an effective ‘debt limit’, beyond which a country cannot borrow because debt dynamics become unsustainable.
Using the fiscal reaction function results, we empirically determine debt limits for our 23 advanced economies, defined as the maximum sustainable debt level a country attain. Next, using these debt limits, we create a fiscal space data series for each country. Fiscal space is simply the difference between a country’s historical debt limit and its actual debt in any period.
Finally, we investigate the relationship between fiscal space and growth. Using modern empirical methods, we find evidence of an inverse quadratic relationship between fiscal space and growth. This implies fiscal space fits into conventional debt-growth theory, whereby an economy with high fiscal space (low debt) can increase growth by sustainably going into debt and increasing government spending. Alternatively, a country with limited fiscal space (high debt), would be better off reducing debt and increasing their fiscal space. Fiscal space provides an alternative angle to assess debt and growth dynamics, by introducing the concept of sustainability. Our results hold policy implications for government decision-makers.