The effects of debt on economic development: Debt, credit availability and optimal debt levels

Marcel Wächter

Student thesis: Master thesis


Despite their monetary nature, credit and debt significantly influence real economic development. The financial system’s role of transforming savings into credit is “one of the most critical mechanisms we have for allocating resources” (Cecchetti and Schoenholtz, 2011). Failures in this mechanism can cause severe economic problems whereof the current financial and economic crisis is an example. Its roots lie in the US mortgage debt market slowdown and its propagation started in late 2008 with Lehman Brothers’ bankruptcy filing. The growing mistrust among banks and insurances led to a credit crunch constituting a latent danger for economies around the globe. Many governments reacted by increasing expenses and debt to prevent their economies from a collapse. As a result, the financial crisis soon turned into a government debt crisis especially harming peripheral European countries. In spring 2010, Greece was unable to afford borrowing. To date, four countries of the European Union (Greece, Ireland, Portugal and Spain) have received help from a bailout package. Hence, high debt levels may harm welfare. However, at moderate levels debt supports economic development. This thesis empirically assesses a non-linear relationship between debt and economic development for 23 OECD countries between 2000 and 2009 and discusses the reasons for this pattern. Besides total indebtedness in a country, its individual components (household, non-financial corporate and government debt) are also examined. To allow for a non-monotonic but still smooth functional form, quadratic model specifications are used. Additionally, it is tested whether the effect occurs contemporaneously or with a time lag. The impact on real GDP levels and growth rates is in clear focus throughout the thesis but there is an attempt to shed some light on the mechanisms behind the link between debt and economic performance through consumption, investment, capital and total factor productivity. Moreover, the connection between credit availability and debt is discussed. The different estimations show some variation on what level of debt maximizes GDP per capita and/or GDP growth, making it difficult to determine the optimal debt-to-GDP ratio. Output maximizing total debt-to-GDP ratios range between 200% and 220% whereas short-term growth already begins to decline for levels above 150%. Estimations on government debt indicate a monotonic negative effect on both, GDP levels and growth. Assessing private debt yields in a higher threshold value of around 270% when considering GDP per capita levels and ca. 180% for growth maximization. The one year lagged specification seems to be the most reliable ones. This thesis’ results suggest that total debt of many countries, which has risen sharply over the last decade, clearly exceed optimal levels. The thesis’ theoretical discussion with a simple Overlapping Generations Model supports empirical results, by stating that the availability of credit can improve economic performance since investments can be conducted optimally in size and allocation. Moreover, it confirms a non-linear relationship.

EducationsMSc in Applied Economics and Finance, (Graduate Programme) Final Thesis
Publication date2012
Number of pages112