Public Debt Overhang and Economic Growth

Reinhart, Reinhart and Rogoff (2012) call the deterioration of the economy due to an increase in public debts a public debt overhang. This paper provides an overview of empirical studies on public debt overhang using data concerning economic crises that have recently been accumulated. Moreover, it takes a look at related theoretical models and shows that it is difficult to explain public debt overhang based on existing theories. Under existing models, which assume that fiscal deterioration brings low growth, an interest rate rise arising from fiscal deterioration causes economic deterioration. Essentially, this phenomenon is similar to crowding-out. However, in many cases of public debt overhang, including the situation of Japan, low growth and low interest rates coexist, a phenomenon which cannot be explained by the crowding-out effect. The latter half of this paper examines a new theoretical model and provides a theoretical basis for a possible formation of public debt overhang that simultaneously brings low growth and low interest rates. Under this theoretical model, as public debts (government bonds) function as liquid assets, their increase itself has the effect of promoting economic growth (liquidity supply effect). Meanwhile, if productive economic entities are taxed and subsidies are paid to the labor sector as a result of fiscal policy, workers whose income has increased reduce the supply of labor (income effect). As a result, the wage rate rises, prompting highly productive companies to reduce production. When the income effect prevails over the liquidity supply effect, fiscal deterioration reduces production. In addition, market interest rates fall because highly productive companies f demand for borrowings declines. In this way, fiscal deterioration (increases in public debts and subsidies) leads to decreases in both productivity and interest rates. This theoretical model brings results consistent with the public debt overhang hypothesis. If there is a cause-and-effect relationship between fiscal deterioration and the deterioration of real economic conditions as indicated by Reinhart et al. and this paper, it will render useless the strategy that Japan has pursued for many years - stimulating the economy by continuing expansionary fiscal policy. That is because such fiscal policy works to restrain economic growth by aggravating the fiscal position. According to the theoretical model, in order to increase overall production, it will be necessary to reduce the fiscal burden on productive companies while increasing the fiscal burden on the labor sector. The labor sector in the model corresponds to the household sector in the real world. Therefore, the policy implication for the real world is that it will be desirable to increase the ratio of the fiscal burden on the household sector by further raising the consumption tax rate and reducing social security benefits.