Avoiding the debt trap
citizens will be less productive and have smaller real incomes. This effect is only partly reflected by the macroeconomic concept of ‘crowding out’ private investment as a consequence of public borrowing. In a narrow sense, crowding out does not refer to taxation or regulation (both of which may discourage private consumption and investment), but to competition on credit markets. When governments increase their demand for credit, the interest rate is likely to be higher than it would be without increased public demand for credit. As a consequence, private investment becomes more expensive and less of it is undertaken. The sheer amount of crowding out (both in a narrow and a broader definition) is difficult to measure and heavily disputed amongst economists. In a recent study, Ardagna, Caselli and Lane (2007) collected cross-country evidence from 16 OECD countries covering a maximum time span from 1960 to 2002. They found that a one percentage point increase in the primary2 deficit-to-GDP ratio is associated with a 10 basis point rise in the nominal interest rate on 10year government bonds. In short, public deficits do increase interest rates. The authors also found that the effect of public debt on interest rates is ‘non-linear’: only for countries with above-average levels of debt (as is the case with most EU countries) does more public debt also increase interest rates (with above-average increases). On globalised financial markets, crowding out becomes even more messy and more multi-dimensional. Higher 2 The authors use the primary rather than the total budget, which means that interest payments are taken off the public balance sheet. The rationale is that autonomous changes in fiscal policy are better captured if the direct effect of interest rate changes on the budget itself is not part of the correlation.
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