1. Introduction The recent global financial crisis triggered a series of orthodox, unconventional monetary and fiscal policies that led to a sharp increase in the sovereign debt of advanced countries. The massive debt build-up reignited the debate about fiscal sustainability and the impact of the accumulation of government liabilities on financial markets and on real economic performance. Poor economic performance, referring to low growth and low productivity, reduces a country’s capacity to pay and aggravates the fiscal sustainability problem, raising the expectation of a severe fiscal adjustment. It has been argued that public debt can stimulate aggregate demand and have a positive growth effect in the short run. Public debt, however, crowds out private investment and deteriorates economic performance in the long run (Elmendorf and Mankiw, 1999). By raising long-term interest rates, higher public debt can crowd out investment (Modigliani, 1961, Gale and Orszag, 2003; Baldacci and Kumar, 2010). This is not the only channel through which a fiscal debt burden may affect long-run growth. Deterioration of the fiscal balance in the presence of high public debt stocks is detrimental for growth, even though a deficit helps to finance public capital (Adam and Bevan, 2005, Saint-Paul, 1992 and Aizenman, Kletzer, and Pinto, 2007). Generally, it is argued that a higher stock of public debt will induce future distortionary taxation, or higher inflation, to pay the debt, which reduces future potential growth. Thus, high public debt reduces the ability to implement countercyclical fiscal policies, resulting in higher volatility and lower growth (Aghion and Kharroubi, 2007; Woo, 2009). A sovereign debt crisis can affect growth to the extent that it triggers banking or currency crises (Burnside, Eichenbaum, and Rebelo, 2001; Hemming, Kell, and Schimmelpfennig, 2003). This paper’s goal is to empirically investigate the relationship between public debt and growth, and to explore alternative channels to those proposed in the existing literature. First, the paper examines the direct effect of public debt on growth through its impact on the steady state of output per capita. Next, the study considers a more promising channel: the ability of good policy environments to cushion the adverse growth effects of public debt accumulation.
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