A Comparative Analysis of the Effects of Public and Private Debt in the Euro Area

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Department of Economics and Management Master of Science in Economics

A Comparative Analysis of the Effects of

Public and Private Debt in the Euro Area

Supervisor:

Prof. Andrea Roventini

Candidate:

Giulio Ciacchini

Winter Session

Academic Year 2017-2018

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Introduction

The objective of this Thesis is to investigate the effects of public and private debt in the Euro Area. This work stems from the recent 2007-2008 Financial Crisis and the consequent European Sovereign Debt Crisis. These events have stimulated an intense debate about the effectiveness of fiscal policy and the consequences of rising government debt. The European response to the Sovereign Debt Crisis, in line with the IMF recommendations, has exposed and worsened the huge economic differences between Northern and Southern Europe. The European Monetary Union policy answer to the crisis was univocal and mandatory: Fiscal Austerity. Austerity is the deliberate deflation of domestic wages and prices through cuts in public spending, designed to reduce a state’s debts and deficits which (supposedly) increase its economic competitiveness and revive economic growth (Blyth, 2013).

One of the most influential paper on this topic, which gave evidence in support to the aus-terity measures (Reinhart and Rogoff, 2010), identified a precise threshold of public debt over GDP (90%) beyond which increasing public debt is associated with slower real GDP growth. This article, written in the middle of the crisis, sparked an international debate from the US to Europe. The whole Euro Area, and in particular PIIGS (Portugal, Italy, Ireland, Greece, Spain), were treated with this medicine to heal high public debt-to-GDP ratios, given that public debt was supposed to be the only problem. Indeed, after the financial crisis, public debts increased exponentially throughout the region, with some countries reaching more than the 20% growth of public debt-to-GDP ratios (section 3.5). The schol-ars that endure the notion of “expansionary fiscal contraction” (Giavazzi and Pagano, 1990, 1995; Alesina and Perotti, 1997; Alesina and Ardagna, 1998) advocate the fact that fiscal tightening produces non-Keynesian expansionary effects, “if they are sufficiently large and protracted” (Giavazzi and Pagano, 1995).

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However, recent experience and blossoming empirical evidence have proven that Fiscal Austerity is self-defeating: it has a strong and negative effect on the performance of the economy both in the short and in the long-run leading to a stagnation equilibrium and anaemic output growth (Auerbach and Gorodnichenko, 2012; DeLong et al., 2012; Blan-chard and Leigh, 2013; De Grauwe and Ji, 2013; Guajardo et al., 2014; Ostry et al., 2015; Dosi et al., 2016). Panizza and Presbitero (2013) argue that “these policies (austerity measures), in turn, may reduce growth, especially if implemented during a recession. In this case it would be true that debt reduces growth, but only because high levels of debt lead to con-tractionary policies. While such an interpretation would justify long-term policies aimed at reducing debt levels, it also implies that countries should not implement restrictive policies in the middle of a crisis (pro-cyclical measures)”. On the same vein, DeLong et al. (2012) stressed the fact that “in a depressed economy, with short-term nominal interest rates at their zero lower bound, ample cyclical unemployment, and excess capacity, increased gov-ernment purchases would be neither offset by the monetary authority raising interest rates nor neutralized by supply-side bottlenecks. Then even a small amount of hysteresis, even a small shadow cast on future potential output by the cyclical downturn means, by simple arithmetic, that expansionary fiscal policy is likely to be self-financing […]. Policies of aus-terity may well be even by the yard stick of reducing the burden of financing the national debt in the future. Austerity in a depressed economy can erode the long-run fiscal balance”. In addition, the austerity agenda forgets to deal with private debt levels, which have been increasing exponentially in the last two decades (Jordà et al., 2017). Indeed, excessive bor-rowing combined with risky investments and lack of transparency by financial institutions have been identified as the main causes for the 2007-2008 financial crisis and the consequent Great Recession (Acharya and Richardson, 2009; Crotty, 2009; Commission et al., 2011). “While there is awareness that public debt instability may need more careful scrutiny, in the 2007 crisis the problems of many other countries largely stemmed from private debt fiascos, often connected in large part to housing booms and bust” (Jordà et al., 2011). In-deed, public debt is not the disease, but rather it has been the cure of financial crises (Batini et al., 2018; Jordà et al., 2016b; Mian et al., 2017). The financial crisis, which started in the United States, infected Europe in the form of failures of some the biggest financial

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agglom-erates. The subsequent bailouts transformed what started as a banking crisis into the so called “Sovereign Debt Crisis”. Ultimately, “private debts become public debts after the cri-sis” (Reinhart and Rogoff, 2011).

Moreover, recent studies have pointed out that financial deepening could be in itself detri-mental to future economic growth when its level surpasses a certain threshold (Cecchetti et al., 2011; Law and Singh, 2014; Arcand et al., 2015; Fagiolo et al., 2017). Their findings imply that private debt is bell-shaped: when private debt is low it could be growth enhanc-ing whereas when its level becomes excessive it could stifle economic growth. Indeed, the financial and economic crisis of 2008-2013, initiated by a credit boom gone bust, defines a turning point in the history of Europe’s development and particularly with respect to its cross-country integration experience and policies. Over the years 2010 and 2011 it looked as if the European Union as a whole was recovering from the deep recession it experienced in 2009. However, what emerged was a recovery only for Germany and a few other North-ern Economies (such as Austria, Finland and Sweden), while the South was still struggling (Landesmann, 2015). Guerini et al. (2018) argue that the crisis has created a fracture in the Euro Area, that is not yet healed, on the contrary the asymmetries and the divergences within the Euro Area are still increasing.

This Thesis lies within the lively debate around the differences in the economic effects of public and private debt. We started from the recent work of Batini et al. (2018) and fur-ther extend their analysis in different directions. They focus on the Euro Area countries and show empirically that higher private debt leads deeper recessions, while higher pub-lic debt does not, unless the level of pubpub-lic debt is especially high. On the same vein of Mian et al. (2017), Batini et al. (2018) show that exists a negative correlation between in-creases in private debt and future levels of output, and a lack of correlation between a rise in public debt and the severity of future recessions. They also find a non-linear relationship between public debt and economic growth: when public debt is low it is growth enhanc-ing whereas when its level is high its impact on future economic growth turns negative. Furthermore, they build a dynamic stochastic general equilibrium (DSGE) which “suggests that, running into a financial shock with high private debt is potentially more hazardous for output than confronting such a shock with high public debt […]. Government loans to

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borrowing-constrained agents during deleveraging phases mitigates the adverse recession-ary effects of financial shocks on output” (Batini et al., 2018). It follows that one of the key benefits of having fiscal buffers is the greater macroeconomic resilience to financial shocks. In this work we focus on the Euro Area to investigate on how the dynamics of public and private debt affect the economic performances within European countries. We move for-ward from Batini et al. (2018) in different directions. First, we use the same methodology, Fixed Effects estimation, but we exploit different data transformations to investigate these issues. In particular, we use variables in levels, Hp filtered and their average growth rates. We do search for a non-monotonic relationship between public debt and econmic growth, but in addition we search for non-linear behaviours of private debt over future growth. In line with Mian et al. (2017), we deepen the analysis of private debt components, household and corporations debt. Moreover, we study the impact of public and private debt over dif-ferent groups of countries and search for optimal time lags and leads of our main variables. At last, we extend the time horizon, by employing the latest data available.

In particular, we will exploit a Fixed Effects estimation to investigate a long-run run dataset, which stretches from 1960 to 2017 and encompasses eleven countries. This approach en-ables to address two main research questions. First, whether public and private debt affect income and economic growth in the long run in the Euro Area and in which way. Second, whether there exist non-monotonic behaviours in the effects of public and private debt over future output growth. In addition we will analyse more in detail private debt dynamics, by studying its components household and corporations debt. We then search for differences in the effects of these shocks between different regions of the Euro Area, such as between Northern and Southern European countries and between PIIGS and the “Others” countries. On the one side, our main results suggest that Private debt is always dangerous and detri-mental for future economic growth, in each and every specification, regardless of its level and of the sub-sample that we consider. Private debt harmfulness for the economy is a result in line with the most recent scientific literature on the topic, which suggests more caution and attention in controlling and monitoring its dynamics (Adrian and Boyarchenko, 2012; Jord`a et al., 2015, 2016a; Mian et al., 2017; Batini et al., 2018). Moreover we do find, in line with Mian and Sufi (2015); Guerini et al. (2017), that the “bad” component of private debt is

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represented by the household debt whereas corporate debt could actually be beneficial for economic growth.

On the other side, public debt results are more fragmented. While several studies indicate that high levels of sovereign debt hamper the growth prospects of a country, our results question this. It is mostly beneficial to economic growth when its level is low. However, when its level surpasses a certain threshold its contribution to economic growth becomes statistically insignificant and when we extend the time window it actually has a negative impact on growth, so that at least its effect is ambiguous. Therefore, we do not find consis-tent evidence in support of the negative non-monotonic relationship between Public debt and economic growth put forward by a scientific strand led by Reinhart and Rogoff (Rein-hart and Rogoff, 2010; Cecchetti et al., 2011; Woo and Kumar, 2015; Checherita-Westphal and Rother, 2012; Baum et al., 2013). On the contrary, the non-monotonic behaviour of pub-lic debt and economic growth that we find goes in the opposite direction: from positive, when public debt is low, to non-significant, when the latter is high. The Thesis is organized as follows.

In Part I we try to answer the research questions using the existing scientific literature. In particular, chapter 1 analyses the relation between private debt and financial crises whereas chapter 2 focuses on the relation between public debt and Economic growth. Part II presents the Data at our disposal. chapter 3 presents the Long-term Annual dataset and its sources. We then deepen the dynamics of economic growth and of the indebtedness of the Euro Area to have a better understanding of how the situation evolved through time. Part III analyses the Research Methodology. Specifically, chapter 4 explains the reason why we used Fixed Effects estimations and presents the different specifications that we exploited. Part IV, is the core of our work. It presents the Results of the Empirical Analysis. chapter 5 summarizes the results of our investigation on economic growth and indebtedness. chapter 6 presents the results of our baseline regressions. In chapter 7 we search for non-linear behaviours in the effects of public and private debt over economic growth. Moreover, in chapter 8 we will run several robustness checks to see whether when we change a bit the analysis our results hold. Finally, chapter 8.3 presents the conclusive remarks, policy recommendation and future research. Further graphs and tables are appended to the Thesis.

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Part I

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In this part, we will try to answer the research questions by using the existing litera-ture. In particular, we will deepen the scientific literature regarding Private and Public debt impact on economic growth.

On the one side, in chapter 1 we will investigate the relationship, if any, between private debt dynamics and financial crises. In section 1.1 we will underline the dangerousness of sudden booms of private debt whereas in section 1.2 and section 1.3 we will present the empirical evidence regarding the financialization process, and the economic consequences of this dynamic. We will show that an increase of private debt is actually growth enhancing when its level is moderate, but finance starts to have a negative effect on output growth when credit to the private sector reaches a certain threshold.

On the other side, in chapter 2 we will deepen the economic effects of Public debt, pre-senting the different views on the topic: in section 2.1 we will question the validity of the negative non-linear relationship between public debt and economic growth whereas in sec-tion 2.2 we will try to understand whether there exists a causal relasec-tionship between public debt and economic growth and whether public debt is the cause or the consequence of fi-nancial crises. Regarding the economic impact of public debt there is a lively debate: a strand of literature argues that public debt stifles economic growth whereas other scholars support the idea that the enemy is low economic growth and not Public debt, since the latter is also the consequence of the former. At last, in section 2.3 we will argue that private and public debt are two sides of the same coin, they are interconnected and should be analysed together.

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Chapter 1 Private Debt and Financial Crises

1.1 Private Debt Dangerousness

The 2007-2008 financial crisis, which exploded in the US and later spread also to the rest of the world, has brought the attention mainly on the dynamics of public debt. Indeed, in the last decades the scientific literature has focused extensively on studying the impact of public debt on the economy and has given less importance to the behaviour of private debt. Especially right after the European Sovereign Debt crisis the international economic and political debate was dominated by the dangerousness and the (supposed) negative effects of public debt, and little attention was given to investigate the effects of ever increasing private debt ratios, as we shall see actually the financial crisis resulted in bail-outs so that the governments had to intervene via increasing public debts. Only recently, this trend has stopped and now there is much more awareness about the importance of deepening private debt dynamics and understanding its impact on the economy.

In the last few years many studies have underlined the potential negative effects of booms in private debt, especially when they are fuelled by credit to household, as rapid increase of its size makes financial crises more likely (Adrian and Boyarchenko, 2012; Jord`a et al., 2015, 2016a; Mian et al., 2017; Batini et al., 2018). Surges of Private Debt are potentially more damaging for the economy than hikes in public debt. This is because conditional on having a recession, stronger credit growth predicts deeper recessions whereas public debt does not generally exacerbate recessions, its impact on recessions mainly depends on its level

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(Ba-tini et al., 2018). (Ba(Ba-tini et al., 2018) built a general equilibrium model which predicts that economies with a larger stock of private debt tend to face more severe recessions following financial shocks. When public debt is high, the negative effects of excessive private debt on growth are harshened, because of the lack of fiscal space to stabilize the economy, that would be necessary to solve the crisis caused by excessive private debt in the first place. Therefore, Batini et al. (2018) conclude that “hefty levels of private debt are as, or possi-bly more worrisome than hefty stocks of public debt for macroeconomic stability at times of heightened financial volatility”. ? describe three main characteristics of the aftermath of financial crises: asset market collapses are deep and prolonged and there is a profound decline in output and employment. The real value of government debt tends to explode, ris-ing an average of 86 percent in the major post-World War II episodes, due to large bail-outs and the inevitable collapse in tax revenues that governments suffer in the wake of deep and prolonged output contractions, as well as often ambitious countercyclical fiscal policies in advanced economies aimed at mitigating the downturn.

On the same vein, Jord`a et al. (2011) by exploiting a long-run dataset, which stretches from 1870 to 2008, containing over 200 recession episodes in 14 advanced countries, show that “stronger increase in financial leverage, measured by the rate of change of bank credit relative to GDP, tends to correlate with a deeper subsequent downturn”. Credit plays an important role in shaping the business cycle and in particular the intensity of the reces-sion as well as the likelihood of the financial crisis. Within the 223 recesreces-sions episodes, 173 are normal recessions and the 50 others are financial crisis recessions (the definition of financial crisis is borrowed from Schularick and Taylor (2012)). They built an excess credit variable that measures the excess rate of change per year in the aggregate bank loan to GDP ratio in the expansion i.e. how fast the economy was increasing leverage according to the loan-to-GDP ratio metric. By taking a 5 year horizon, financial crisis recessions are shown to be more costly than normal recessions: on average output relative to peak is more depressed in financial recessions than in normal ones and a higher excess of credit in the previous expansion creates an even more painful post-peak trajectory. A recession and recovery path associated with financial crisis peak is liable to be much prolonged and more painful than that found in normal peak. That is why they define excess credit as the

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Achilles heel of capitalism. Moreover, the economic costs of the crises vary considerably depending on the run-up in leverage during the preceding boom: “the more excess of credit formation in the preceding expansion, the worse the recession and the slower the subse-quent recovery” (Jord`a et al., 2011). In sum, financial recessions are associated with lower GDP per capita, lower real investment per capita, higher chances of a lasting deflationary trap, credit crunches and unusually low interest rate environments (Jord`a et al., 2011). In these situations it is likely that the financial accelerator, theorized by Bernanke et al. (1999), comes to action amplifying and worsening credit-market conditions especially when bal-ance sheets are larger and thus more vulnerable to weakening.

After an initial negative shock to the economy, that lowers the value of existing collateral hence decreasing the borrower’s net worth, borrowers facing relatively high agency costs in credit market will bear the brunt of economic downturns. Lenders will reallocate credit from low-networth to high-networth borrowers by tightening borrowing constraints, the so called flight-to-quality phenomenon. As explained by Brunnermeier et al. (2012), the amplification effects can lead to rich volatility dynamics and explain the inherent insta-bility of the financial system. Even when the exogenous risk is small, endogenous risk resulting from interactions in the system can be sizeable. This will result in a raise of the premium on external finance, which varies inversely with the borrower’s net worth, that forces low-networth borrowers to reduce spending, production and investment exacerbat-ing the effects of recessionary shocks: the initial negative shock is propagated through time. Indeed, the financial accelerator is the result of endogenous changes over the business cycle in the agency cost of lending at the onset of a recession. This mechanism emphasizes the importance of monitoring credit dynamics for the sake of economic well-being and stabil-ity. The key mechanisms at the root of the financial-accelerator dynamics are the external finance premium paid by firms and the evolution of their net worth. Moreover, as pointed out by Ferraresi et al. (2015), the certified presence of these dynamics should support the case for regime-dependent fiscal policies. In periods when firms face increasing difficulties in borrowing funds to finance their production and investment activities, policy makers should consider to carry out expansionary fiscal policies, which would be highly effective in boosting aggregate demand, output and thus relaxing firms financial constraints. The

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policy makers should carefully plan fiscal policy measures according to the state of credit markets, so to adjusts their policies to the credit market conditions. Indeed, Jaccard and Smets (2017) have recently shown that “differences in financial structures are an important cause of asymmetry in the Eurozone and that this specific source of cross-country hetero-geneity has a critical impact on financial imbalances not only at business cycle frequencies, but also in the long-run”. Ultimately, the well documented association between Private debt booms and harsh financial crises is not an exceptional peculiarity of the 2007-2008 finan-cial crisis (Acharya and Richardson, 2009; Crotty, 2009; Commission et al., 2011), but it is actually a common feature of modern economies, that should be monitored more carefully. In particular, Ng and Wright (2013) in line with Jord`a et al. (2011), investigate the features of business cycles before and after the Great Recession. Ng and Wright (2013) show that “while there are broad similarities, recessions that originate with financial market disloca-tions are distinctively different from those in which financial markets play a passive role. Recoveries are slow when the recessions have financial origins, especially in resuming the flow of private credit and moving the unemployed back to work”. They argue that “the de-cline in volatility, known as the Great Moderation, was ended or at least interrupted by the Great Recession. All the recessions since the mid 1980s have had financial origins, although the 1990-1991 and 2001 recessions were mild and brief. The last three recessions have been characterized by slow and jobless recoveries, unlike the rapid bounce backs from earlier downturns”. They conclude that in the US the Great Recession was unlike most other post-war recessions in being driven by deleveraging and financial market factors, questioning the idea that all business cycles are all alike, in the sense of having many common fea-tures. Gourinchas and Obstfeld (2012) analyse both emerging and advanced economies. In both groups they find that the two most robust predictors of crises in general “are domestic credit growth and real currency appreciation. Thus, financial vulnerabilities, in the form of excessive leverage, and real vulnerabilities, in the form of low international competi-tiveness, both seem to play important roles. Credit booms typically promote real currency appreciation, and countries that experience both simultaneously are likely to be especially susceptible to financial crisis”.

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this line of reasoning further. In particular Crotty, an American Post-Keynesian Macroe-conomist, in his article published on the “Cambridge Journal of Economics” right after the financial crisis (Crotty, 2009), argued that the financial crisis was by no means an acci-dent, but rather “the latest phase of the evolution of financial markets under the radical financial deregulation process that began in the late 1970s. This evolution has taken the form of cycles in which deregulation accompanied by rapid financial innovation stimulates powerful financial booms that end in crises. Governments respond to crises with bailouts that allow new expansions to begin. As a result, financial markets have become ever larger and financial crises have become more threatening to society, which forces governments to enact ever larger bailouts. This process culminated in the current global financial crisis, which is so deeply rooted that even unprecedented interventions by affected governments have, thus far, failed to contain it” Crotty (2009). In fact, as claimed by Crotty, a major role was played by the economic theory that policy makers had in mind: after the crisis of 1929, it was believed that unregulated financial markets are inherently unstable, subject to fraud and manipulation by insiders, and capable of triggering deep economic crises and political and social unrest, hence the US government created a strict financial regulation system that worked effectively through the 1960s, which was founded around the Glass-Steagall Act of 1933. These economic and political events found reflection in the financial market theories of endogenous financial instability created by John Maynard Keynes and Hyman Minsky. However, the efficient financial market theory and new classical macro theory replaced the theoretical visions of Keynes and Minsky, and the existing system of tight financial regulation was deconstructed through radical deregulation pushed by finan-cial institutions and justified by efficient finanfinan-cial market theory: “relatively free finanfinan-cial markets minimise the possibility of financial crises and the need for government bailouts” (Crotty, 2009). However, the recent history has shown that this view is rather optimistic as financial crises have not stopped to occur. Crotty’s radical view, was implicitly supported by the “Financial Crisis Inquiry Commission”, which in 2011 came to conclusion on what happened during the financial crisis (Commission et al., 2011). In the “Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States” they argued that the financial crisis was avoidable and that widespread failures in

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financial regulation and supervision proved devastating to the stability of the nation”s fi-nancial markets. “The sentries were not at their posts, in no small part due to the widely accepted faith in the self-correcting nature of the markets and the ability of financial insti-tutions to effectively police themselves. More than 30 years of deregulation and reliance on self-regulation by financial institutions, championed by former Federal Reserve chairman Alan Greenspan and others, supported by successive administrations and Congresses, and actively pushed by the powerful financial industry at every turn, had stripped away key safeguards, which could have helped avoid catastrophe. This approach had opened up gaps in oversight of critical areas with trillions of dollars at risk, such as the shadow banking system and over-the-counter derivatives markets. In addition, the government permitted financial firms to pick their preferred regulators in what became a race to the weakest supervisor” (Commission et al., 2011). They ultimately conclude that a combination of ex-cessive borrowing, risky investments, and lack of transparency put the financial system on a collision course with crisis. According to Jordà et al. (2011), rises in public debt have no bearing on the probability of a financial crisis, which are more costly than normal reces-sions in terms of lost output. “While there is awareness that public debt instability may need more careful scrutiny, in the 2007 crisis the problems of many other countries largely stemmed from private debt fiascos, often connected in large part to housing booms and bust” (Jordà et al., 2011). These facts indicate that credit is not an epiphenomenon, as many famous scholars from the past century believed, but it has now a crucial role in shaping the business cycle and in determining the intensity and the likelihood of financial crises (Jordà et al., 2011, 2016a; Gourinchas and Obstfeld, 2012).

1.2 The Age of Credit

Contrary to several famous scholars’ opinion of the XX century (Friedman and Schwartz, 1963; Modigliani and Miller, 1958), in the modern era credit is not an epiphenomenon, it has a crucial role in shaping the business cycle and in determining the intensity and the like-lihood of financial crises (Jord`a et al., 2011, 2016a). On the one side, Modigliani and Miller (Modigliani and Miller, 1958) put forward the “irrelevance view” of credit. They theorized

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that the market value of a firm is determined by its earning power and by the risk of its underlying assets, and that its value is independent of the way it chooses to finance its investments or distribute dividends. On the other side, Monetarism, embodied by Milton Friedman, theorized the so called “money view”. This school of thought argued that the objectives of monetary policy, and in particular the stability of the economy, are best met by targeting the growth rate of the money supply since increasing its size provides only a temporary boost to economic growth and job creation, but over the long run, it will increase inflation. However, no particular attention was posed on credit dynamic and its implication for policy maker decisions. In their seminal study Schularick and Taylor (2012), by using a long-run dataset, stretching from 1870 to 2008, established a number of important stylized facts about “two eras of finance capitalism” to investigate the relationship between money, credit and financial crises. They identified the first era as running from 1870 to 1939 called the “Age of Money”. In this era money and credit were volatile, but over the long run they maintained a roughly stable relationship to each other and to the size of the economy, mea-sured by GDP. In the Age of Money the “money view” of the economy, associated with the fundamental contribution of Friedman and Schwartz (1963), looks entirely possible. Money growth and credit growth were essentially two sides of the same coin as the ratio of credit to money remained broadly stable between 1870 to 1939 and formal analysis could use the latter as a proxy for the former. However, monetarism principles start to totter against the empirical evidence of the second financial era, which questions the validity of the money viewand irrelevance view in favour of the credit view, that shifts the attention to credit ag-gregates as they provide valuable information for policy makers aiming for financial and economic stability. According to Schularick and Taylor (2012) findings the second finan-cial era, starting in 1945, looks very different. In this period, called the “Age of Credit”, financial innovation and regulatory ease broke the link between money and credit, set-ting in motion an unprecedented expansion role of credit in macroeconomy. First, money and credit began a long postwar recovery, trending up rapidly and then surpassing their pre-1940 levels compared to GDP by about 1970. Then, credit itself started to decouple from broad money and grew rapidly. With the banking sector progressively more lever-aged the divergence between credit supply and money supply offers a prima facie support

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to the credit view as against a pure money view: credit grew strongly relative to GDP and broad money, via a combination of higher leverage (after the 1970s) and through the use of new sources of funding, mainly debt securities, creating more and more non-monetary bank liabilities. After the 1945, financial crises were fought with more aggressive mone-tary policy responses, banking system imploded neither so frequently nor as dramatically, and the Fisherian debt-deflation mechanism, that tended to operate in pre WW2-crises, was avoided, although crises still had real costs. However, despite the stronger policy responses by central banks to financial crises, through a supported money base growth, the cumula-tive real effects have been stronger in postwar period: in the aftermath of postwar financial crises, the cumulative real output and investment declines are substantially larger than in the pre-war financial crises. This result is explained by the fact that before 1939, even if the authorities put less efforts in dealing with financial crises, the financial sector played a less central role in the economy and financial crises were hence less costly. In the Age of Creditthe financial sector has grown and increased leverage, expanding the size of the threat even as the policy defences have been strengthened. As a result, the shock hitting the financial sector might now have a potentially larger impact on the real economy, absent the policy response. Ultimately, in the Age of Credit, financial crises can be seen as credit booms gone wrong: “reckless lending” and financial speculation are closely linked to credit creation as the monetary complement of innovation over the business cycle (Schumpeter et al., 1939). Stock market booms become more problematic with larger financial sectors since they are more crisis-prone. Indeed, Schularick and Taylor (2012) finds that “lagged credit growth turns out to be highly significant as a predictor of financial crises and that financial stability risks increase with the size of the financial sector and that boom-and-bust episodes in stock markets become more problematic in more financialized economies”. The frequency of the crises in the period 1945-1971 was virtually zero, when liquidity hoards were ample and leverage was low; but since 1971, as these hoards evaporated and banks levered up, crises became more frequent, occurring with a four percent annual probability. Before the 2007 financial crisis, the New Keynesian consensus held that money and credit have essentially no constructive role to play in monetary policy, actually embracing the Monetarism thesis. Therefore, central bankers were to set interest rates in response to

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in-flation and output gap, with no meaningful additional information coming from credit or monetary aggregates (King, 2016). However, before the crisis a number of dissenters argued that credit deserved to be watched carefully and incorporated into a broader central bank policy framework in order to reach for financial and economic stability: “the old view that a single-minded focus on credible inflation targeting alone would be necessary and suffi-cient to deliver macroeconomic stability has been discredited” (Jord`a et al., 2011). In the final part of their work (Schularick and Taylor, 2012) shows that “monetary aggregates are not useful as predictive tools in forecasting crises, in contrast to the correct measure, total credit. Credit is a superior predictor, because it better captures important, time-varying features of bank balance sheets such as leverage and non-monetary liabilities: credit mat-ters, not money”. In addition the authors venture the possibility that credit system may not be merely an amplifier of economic shocks, as in the financial accelerator model of (Bernanke et al., 1999), but the financial sector could be capable of creating its own shocks, acting more and beyond its role of propagator of shocks hitting the economy. This view reflects the ideas of scholars such as Minsky (1977) and Kindleberger and Aliber (1978), who have argued that the financial system itself is prone to generate economic instability through endogenous credit booms. In particular, Minsky et al. (1986) claimed that “a totally free modern capitalist economy is economically and politically impossible, for in such an economy financial disaster and economic depressions will frequently occur”. The financial system is becoming more explosive as its size grows.

1.3 Too Much Finance?

It is a fact that in the last three decades advanced economies have experienced what Jord`a et al. (2016a) call a financialization process, borrowing the term from Epstein (2005). This term refers to the rising in income share of finance, the ascent household debt and the growth of the volume of financial claims on the balance sheet of financial intermediaries (Jord`a et al., 2016a; Mian and Sufi, 2015). Even though the scientific literature suggests prudence also when dealing with private debt, “the ratio of aggregate private credit to in-come in advanced economies has surged to unprecedented levels over the second half of the

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twentieth century” (Jord`a et al., 2017). This phenomenon is a key stylized fact of modern macroeconomic history called by the authors the “financial hockey stick” and captures the fact that the volume of private credit has grown dramatically relative to both output and monetary aggregates. However, financialization is not a good or bad phenomenon per se, it depends on its intensity and on the environment in which it takes place.

Credit is not bad a priori, on the contrary it could be beneficial for the entire economy. “Banking crisis are typically credit booms gone bust. But not all credit booms end in crisis: some credit booms are equilibrium responses to improved fundamentals. Such booms, that can represent financial deepening or be the reaction to positive productivity shocks, are likely to be beneficial and short-cutting them may come at a considerable long-run cost for the economy” (Richter et al., 2017).

At the time of this writing, there is lively debate regarding the economic effects of financial deepening. The oldest strand of the scientific literature, which started from the seminal con-tributions of Bagehot (1873) and Schumpeter (2017), argues that there is a positive long-run association between indicators of financial development and economic growth. In general, this line of thought suggests that a well-developed financial market is growth-enhancing, and therefore consistent with the proposition of “more finance, more growth”, countries with deeper financial markets or higher credit to GDP ratio experience more rapid economic growth (King and Levine, 1993; Rajan and Zingales, 1996; Ranciere et al., 2008). In particular, King and Levine (1993) present cross-country evidence consistent with Schumpeters’ view that the financial system can promote economic growth, using data on 80 countries over the 1960-1989 period. They find that various measures of the level of financial development are strongly associated with real per capita GDP growth, the rate of physical capital accumu-lation, and improvements in the efficiency with which economies employ physical capital (King and Levine, 1993). They support the idea of Joseph Schumpeter, which argued that the services provided by financial intermediaries-mobilizing savings, evaluating projects, managing risk, monitoring managers, and facilitating transactions are essential for tech-nological innovation and economic development. At the same time, (Ranciere et al., 2008) show that countries that have experienced occasional financial crises have, on average, grown faster than countries with stable financial condition which suggests a positive effect

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of systemic risk on growth. In sum, this line of thought suggests that a well-developed fi-nancial market is growth-enhancing: “more finance, more growth” (King and Levine, 1993; Beck and Levine, 2004).

More recently, another strand of scientific literature, suggests that exists a complex, non-linear relationship between finance and growth. In particular, excessive level of finanzial-ization could hamper economic growth. As pointed out by Rousseau and Yilmazkuday (2009), these positive growth effects of financial deepening might be weakening as more countries have well developed financial markets. Moreover, since much of the literature used post World War II panel datasets1_{, they were not able to capture financial dynamics}

after the mid-1980 which coincides with a marked increase in the incidence of financial crises.

Ultimately, financial deepening may be beneficial in early stages of financial development and credit booms can be growth enhancing, but can be a precursor to banking distress and crisis too, as we have extensively reported in this chapter. This finding would suggest that there exists an inverted U-shaped relationship between financial deepening and economic growth: low levels of financial deepening are growth enhancing whereas high levels of the former could be detrimental to future economic growth. In their original study Richter et al. (2017) present a method through which policy-makers could distinguish, in real time, be-tween good and bad credit booms with high accuracy. They investigate which features of a credit boom determine whether it turns into a banking crisis and find that credit booms that are accompanied by house price booms and a rising loan-to-deposit-ratio, which measures the banking sector liquidity, are much more likely to end in a systematic banking crisis. In addition, among the economic variables most of them are insignificant or they do not add any predictive power to the analysis, instead a deteriorating current account balance plays a role in increasing the odds of a bad boom since it implies increasing financial flows from abroad that rise financial fragility because of possible capital flow reversal.

In more recent studies, the authors have wondered whether “too much finance harm eco-nomic growth” which would imply that private debt effects on ecoeco-nomic growth could be non-monotone (Rousseau and Wachtel, 2011; Cecchetti et al., 2011; Law and Singh, 2014;

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Arcand et al., 2015; Fagiolo et al., 2017).

In particular, Rousseau and Wachtel (2011) examine the robustness of some now-classic findings on the cross-country relationship between financial development and economic growth. The finance-growth relationship that was estimated with data from the 1960s to the 1980s simply disappears in the past fifteen years, the so called vanishing effect. Financial deepening has a strong impact on growth throughout the sample period as long as a country can avoid a financial crisis. In crisis episodes, which are more often than not due to exces-sive deepening, the benefits of financial deepening, not surprisingly, disappear. They put forward two related explanations. First, excessive financial deepening or too rapid growth of credit may have led to both inflation and weakened banking systems which in turn gave rise to growth-inhibiting financial crises. Second, excessive financial deepening may be a result of widespread financial liberalizations in the late 1980s and early 1990s in countries that lacked the legal or regulatory infrastructure to exploit financial development success-fully. More importantly they find that the increased incidence of financial crises since the 1990s is primarily responsible for the recent weakening of the finance-growth link. Law and Singh (2014) took a step forward and indicate that there exists a threshold effect in the finance-growth relationship. In particular, they find that the level of financial development is beneficial to growth only up to a certain threshold; beyond the threshold level further development of finance tends to adversely affect growth. These findings reveal that more finance is not necessarily good for economic growth and highlight that an optimal level of financial development is more crucial in facilitating growth. On the same vein, Arcand et al. (2015) and Cecchetti et al. (2011) examine whether there exist a threshold above which financial development no longer has a positive effect on economic growth. Arcand et al. (2015) showed that “too much finance”, when credit to the private sector reaches 100% of GDP, could actually have a negative effect on output growth. This threshold is quite impres-sive, if we think that in the Euro Area, at the time of this writing2_{, there is no country below}

such threshold, therefore implying that there is indeed too much finance in the Euro Area. In line with the general consensus, Arcand et al. (2015) argue that at intermediate levels of financial depth, there is a positive relationship between the size of the financial system

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and economic growth, but it also shows that, at high levels of financial depth, more finance is associated with less growth. At the same time, Cecchetti and Kharroubi (2015) establish a strong negative relationship between the rate of growth of the financial sector and the rate of growth of total factor productivity: “the level of financial development is good only up to a point, after which, by draining resources from the real economy, it becomes a drag on growth and that a fast-growing financial sector is detrimental to aggregate productiv-ity growth”. The financial sector has an inverted U-shaped effect on productivproductiv-ity growth. This result is stronger in industries that either have significant external financing needs or are R&D-intensive. This is because the financial sector growth disproportionately benefits to high collateral/low productivity sectors (such as construction) and because there is an that creates a possible misallocation of skilled labour. Their message could be synthesized by the words of James Tobin, who when speaking about the development of the finan-cial system wrote: “we are throwing more and more of our resources, including the cream of our youth, into financial activities remote from the production of goods and services, into activities that generate high private rewards disproportionate to their social produc-tivity” (Tobin, 1984). More recently, Fagiolo et al. (2017) through an agent-based approach, show that the introduction of a banking sector allows for higher growth (and lower output volatility) in the long-run. However, they find that “the relation between financial depth and growth is non-linear and bell shaped. This implies that, for low financialization levels, increasing financialization has a positive marginal effect on growth, while the sign is re-versed for larger financial-depth values (Fagiolo et al., 2017).

All in all, the scientific literature indicates that Private debt is the main cause of financial crises and economic stagnation, and that financial deepening has at least a controversial impact on the economy when its level increases exponentially, which has actually been the case in the last decades (Jord`a et al., 2017). Therefore we wonder why Public debt dynamics has brought so much attention in the last years and so little focused was posed on investi-gating Private debt.

In the next chapter we will try to understand the rationale behind this attention by deep-ening the relationship between public debt and economic growth.

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Chapter 2 Public Debt and Economic Growth

2.1 Does Public Debt Stifle Economic Growth?

Regarding the economic effects of public debt, the scientific literature is less univocal and far from conclusive, there is still a lively debate on the matter. On the one side, after the financial crisis many scholars have tried to find empirical evidence that support the auster-ity agenda, advocating the fact that higher public debts stifle GDP growth. One of the most influential paper on this topic, Reinhart and Rogoff (2010) identified a precise threshold of public debt over GDP (90%) beyond which increasing public debt is associated with slower real GDP growth. At that time the article, which suggested that austerity measures were the right way to precede in order to restore economic growth, sparked an international debate on the topic, from the US to Europe. However, the findings of the study have been heavily criticized by several economists (Irons and Bivens, 2010; Herndon et al., 2014; Minea and Parent, 2012), because of flaws both from a theoretical and a computational standpoint. In particular, although an observed negative correlation between debt and growth remains, Herndon et al. (2014) challenge the robustness of a 90 percent threshold. In addition, it is not clear that the correlation implies causation. One of the key assumptions implied in these studies is that lower economic growth is spurred by high debt. Increase in a budget spending leads to a crowding out effect, or even debt overhang. But in theory, causality can go both ways: in recessions, debt raises because of automatic stabilizers. Countercyclical fiscal policy decreases taxes and increases spending in order to increase GDP growth.

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Be-sides, debt is usually measured as a debt to GDP ratio. In that case, when GDP falls, there is a mechanical increase in debt ratio. One should be aware that both debt and growth could be influenced by a third factor. For example, wars or economic crises both lower GDP growth, and increase debt. This is an important endogeneity issue. Does high debt lead to low growth, or does low growth lead to high debt? The 90% threshold rests on simple correlation of high debt levels with slower growth, but no evidence on causality is given. Nevertheless, other authors have shown that public debt can be a drag on the economy, especially when its level goes out of control (Cecchetti et al., 2011; Reinhart et al., 2012; Woo and Kumar, 2015; Checherita-Westphal and Rother, 2012; Baum et al., 2013).

One of the most convincing paper on the subject (Cecchetti et al., 2011), do find some thresh-olds beyond which government debt and corporate and household debts become a drag for the economy. In particular, for government debt the threshold is around 85% of GDP whereas for corporate and household debts they are, respectively, 90% and 85%. The funda-mental idea of the authors is that “debt is a two edge-sword, used wisely and in moderation it clearly improves welfare, but when it is used imprudently and in excess the results can be disaster” (Cecchetti et al., 2011). Looking at the debt-growth nexus literature, only few studies focus on Euro Area countries. In particular, Checherita-Westphal and Rother (2012) in a working paper of the ECB, analyse the impact of high and growing government debt on economic growth in the Euro Area. They find that the short-run impact of debt on GDP growth is positive and highly statistically significant, but decreases to close to zero and loses significance beyond public debt-to-GDP ratios of around 67% (i.e. up to this threshold, ad-ditional debt has a stimulating impact on growth). This result is robust throughout most of their specifications, in the dynamic and non-dynamic threshold model alike. For really high debt ratios (above 95%), additional debt has a negative impact on economic activity. Some scholars took this line of reasoning to the extreme, advocating that cutting public expen-diture enhances economic growth, the “expansionary fiscal contraction” theory (Giavazzi and Pagano, 1990, 1995; Alesina and Perotti, 1997; Alesina and Ardagna, 1998).

Ultimately, this strand of literature suggests that high levels of public debt stifle economic growth, but the results are not rock-solid. In particular it is not clear if the causal effect runs from public debt to economic growth or the other way round. In 2012, even the

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Inter-national Monetary Fund admitted that “there is no simple relationship between debt and growth […]. There are many factors that matter for a country’s growth and debt perfor-mance. Moreover, there is no single threshold for debt ratios that can delineate the “bad” from the “good” (International Monetary Fund, 2012, p. 9). Indeed, in the next section, we will show that these results are strongly challenged by other scholars who shifted the focus from public debt to economic growth.

2.2 Is There a Causal Relationship between Public Debt

and Economic Growth?

We have documented that several studies indicate that high levels of sovereign debt hamper the growth prospects of a country, but other articles question this. When more sophisti-cated models are used, they yield uncertain results on the relationship between debt and growth. Indeed, many scholars, using multiple techniques have come to different conclu-sions. Panizza and Presbitero (2014) results are consistent with the existing literature that has found a negative correlation between debt and growth. However, the link between debt and growth disappears once they instrument debt with a variable that captures valuation effects brought about by the interaction between foreign currency debt and exchange rate volatility. That is, they could not find evidence supporting the negative relationship be-tween public debt and growth, using an instrumental variable approach.

Other scholars suggest that the dynamic is more likely to run in the opposite direction: from slow growth to high debt levels (Irons and Bivens, 2010; Lof and Malinen, 2014; Fer-reira, 2014). For instance, Lof and Malinen (2014) through a Panel VAR analysis, find that the negative correlation between the variables is primarily driven by the impact of growth on debt rather than vice versa: “an increase in growth has a negative effect on debt, which makes sense given that government expenditure is in general counter-cyclical, while gov-ernment revenue is pro-cyclical” (Lof and Malinen, 2014). In addition, even when they con-trol for this negative effect, they find no evidence for a significant long-run reverse impact of debt on growth. Ferreira (2014) investigate the causal relationship between public debt

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and economic growth in Europe. They find non-statistically significant causality between foreign debt and economic growth and the limited importance of the causality between private debt and real GDP growth. “On the contrary, the results obtained show statistically relevant bidirectional causality relations between public debt and economic growth, and this is true before and after the outbreak of the recent financial crisis. Moreover, there is clear evidence of economic growth’s contribution to the decrease in public debt” (Ferreira, 2014). On the same vein, Guerini et al. (2017) through a Cointegrated Structural Vector Au-toregressive approach (SVAR) show that “public debt shocks have positive and persistent influence on economic activity. In contrast, rising private debt has a milder positive impact on GDP, but it fades out over time”. Moreover, several studies have questioned the idea of a crowding-out effect of public debt over the private sector. On the contrary, in some cir-cumstances public debt could actually have a crowding-in effect, which would imply that it has a beneficial impact on the economy. Indeed, in presence of firms constrained in their borrowing by the value of their collateral, expansionary fiscal policies could relax the con-straint itself, thus crowding-in private investment (Ferraresi et al., 2015). In the words of Turrini et al. (2011) “the effectiveness of the fiscal stimulus adopted by many governments after the acute phase of the crisis is likely to be effective exactly because of the key ele-ments of the financial crisis itself, namely the tightening of lending conditions by banks”. Panizza and Presbitero (2013) perfectly summarized where the literature stands regarding this matter: “there is no paper that can make a strong case for a causal relationship go-ing from public debt to economic growth”. Panizza and Presbitero (2013) survey the recent literature on the links between public debt and economic growth in advanced economies. They conclude that “apart from causality issues, we also show that the evidence of a com-mon debt threshold above which growth collapses is far from being robust […]. We suggest that a fully solvent government with a high level of debt may decide to put in place restric-tive fiscal policies to reduce the probability that a sudden change in investors sentiments would push the country towards a bad equilibrium. These policies, in turn, may reduce growth, especially if implemented during a recession1_{”. Indeed, in this case it would be true}

1_{Notice that this has been exactly what happened during the European Sovereign Debt Crisis: austerity}

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that debt reduces growth, but only because high levels of debt lead to contractionary policies. While such an interpretation would justify long-term policies aimed at reducing debt levels, it also implies that countries should not implement restrictive policies in the middle of a crisis. On the same vein DeLong et al. (2012) stressed the fact that “in a depressed economy, with short-term nominal interest rates at their zero lower bound, ample cyclical unemployment, and excess capacity, increased government purchases would be neither offset by the mone-tary authority raising interest rates nor neutralized by supply-side bottlenecks. Then even a small amount of hysteresis, even a small shadow cast on future potential output by the cyclical downturn means, by simple arithmetic, that expansionary fiscal policy is likely to be self-financing […]. Thus, at the zero bound, where the central bank cannot or will not but in any event does not perform its full role in stabilization policy, fiscal policy has the stabilization policy mission that others have convincingly argued it lacks in normal times”

2_{. In the next section, we will argue that public and private debt are two sides of the same}

coin, therefore they should be analysed together.

2.3 Public and Private Debt: Two Sides of the Same Coin

A recent scientific paper tries to connect up all the dots regarding the effects of Public and Private debt. Mbaye et al. (2018) argue that Public and Private debt are indeed two sides of the same coin, they are strongly connected and by trying to analyse one at a time, will result in partial and incomplete analysis. Their main thesis is that excess private debt tends to spill over into the public-sector balance sheet regardless of whether the leverage cycle resulted in a crisis or a more orderly deleveraging process. In particular, they claim that besides the more evident form of the typical bank bailout, there has been a more silent form of bailout that works automatically and mostly goes unnoticed. Mbaye et al. (2018) by exploiting a newly-created Global debt Database, show that “excess private debt systematically turns into higher public debt, regardless of whether the credit boom resulted in a crisis or a more orderly deleveraging process. This debt migration operates mainly through growth rather

2_{Notice that the economic situation described by DeLong et al. (2012), was actually the situation of many}

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than explicit bailouts: private deleveraging weighs on activity, prompting a countercycli-cal government response to support economic activity”. Moreover, the adverse impact on GDP more than offsets the deleveraging efforts of the private sector, thus contributing to pushing the debt ratio up. Ultimately, whether this debt substitution results in a net in-crease or a net decline of overall indebtedness in the economy depends on the extent of the growth slowdown during the deleveraging spell. These findings suggest that markets and policy-makers should move away from looking at private and sovereign debt in silos and pay closer attention to the total stock of debt in the economy, as the line between the two tends to become blurry. They show that whenever the private sector is caught in a debt overhang and needs to deleverage, governments systematically come to the rescue through a countercyclical rise in government deficits and debt. Thus, excess private debt invariably leads to higher public debt once the private sector is forced to deleverage. This finding could explain why households and firms in advanced economies have been going through a painfully slow deleveraging process since the onset of the global financial crisis of 2007-2008 and in contrast, government borrowing shot up as early as 2007 and continued rising through 2014 before levelling off. Most surprisingly, the total stock of debt in advanced economies markedly increased as a share of GDP over the period. “In other words, while the private sector was trying to pare its debt burden, governments were taking on new debt, and on balance, countries were left with higher total debt than when the private deleverag-ing started off” (Mbaye et al., 2018). The mechanism that they describe is identical to the one that we witnessed in the Euro Area: after the financial crisis, private debt increased rather than decreasing, public debt grew drastically and total debt increased. Public debt, on the other hand, tends to increase faster than normal during private deleveraging episodes. The surge in public debt is front-loaded, starting one year before the beginning of the deleverag-ing episode, before subsequently taperdeleverag-ing off as growth bounces back and the deleveragdeleverag-ing process takes root. Finally, total debt goes up in the run up to the deleveraging episode, before stabilising early in the deleveraging process, and eventually declining”3_.

Another article seems to shed some light on the relationship between public debt, private debt and financial crisis. First, Jord`a et al. (2016b) show that total economy debt levels have

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risen strongly over time, but the bulk of the increase has come from the private sector. History shows that high levels of public debt tend to exacerbate the effects of private sector deleveraging after financial crisis, but in advanced economies financial crisis are not preceded by public debt build-ups nor are they more likely when public debt is high. Indeed, the eco-nomic costs of financial crises rise substantially if large private sector credit booms are unwound at times when the public sector has little capacity to pursue macroeconomic and financial stabilization: “entering a financial crisis recession with an elevated level of public debt seems to exacerbate the effects of private sector deleveraging and it is typically ac-companied by a prolonged period of sub-par economic performances” (Jord`a et al., 2016a). This concept is expressed also by Batini et al. (2018): “countries with larger fiscal buffers are better positioned to weather a financial crisis, both because they have the room needed to allow automatic stabilizers to work fully and because they can offer stabilizing fiscal sup-port to credit-constrained agents”. However, private credit booms, not public borrowing or the level of public debt, tend to be the main precursor of financial instability in industrial countries. What happens is that credit booms cause the problem. Then the government must intervene, if it has enough fiscal space, via an increase of public debt in order to sta-bilize the economy and weather the financial crisis. What started as a private debt crisis becomes a sovereign debt crisis, “private debts become public debts after the crisis” (Rein-hart and Rogoff, 2011). Based on these evidence we can conclude that also the Sovereign debt crisis was not originally fiscal in nature, but rather a private debt crisis that afterwards became a public debt crisis. Therefore, more emphasis should be placed in monitoring pri-vate debt levels (Adrian and Boyarchenko, 2012) as in the words of Irving Fisher back in 1933 “over-investment and over-speculation are often important, but they would have far less serious results were they not conducted with borrowed money” and easy money is the great cause of over-borrowing (Fisher, 1933). Ultimately, the scientific literature seems to converge to the idea that “in medio stat virtus”: at moderate levels Public and Private debt improve welfare and enhance growth whereas their excesses brings bad outcomes.

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Part II

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In this part we will present the dataset that we exploited for our analysis. In particular, in chapter 3, and its sections, section 3.1, section 3.2 and section 3.3 we will deepen the components of the Long term Annual Dataset, Real GDP, Public debt-to-GDP and Private debt-to-GDP ratios. We show the data sources and the main summary statistics.

Moreover, we will describe the economic evolution of the Euro Area, from the beginning of our observations in 1960 to 2017. In section 3.4 we will focus on economic growth, how it has changed during the last decades and more importantly what has happened after the financial crisis. We will show that the financial crisis has caused a fracture in the region and has increased the divergence between countries. At last, we will investigate the dynamics of Public, Private and Total debt to discover if there are any differences in the behaviour of these variables across the Euro Area. Indeed, we will find that there has been different dynamics of Public and Private debt between different groups of countries of the region. In particular, before the financial crisis Private debt has increased throughout the period under observation whereas Public debt remained almost constant for three decades. After the financial crisis this dynamic reversed, Public debt increased exponentially in response to the downturn while Private debt growth was near the 0%. At last, we highlight that when we consider Total debt, the differences between high and low public debt countries becomes smaller. Indeed, high public debt countries tend to have lower private debts whereas in the low public debt group there are countries with very high private debts. What emerges is some kind of substitution between public and private debt.

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Chapter 3 Long-Term Annual Dataset

The Long-Term Annual dataset is an unbalanced annual panel dataset encompassing eleven countries over the period 1960-2017.

The countries of our interest are: Austria, Belgium, Finland, France, Germany, Greece, Ire-land, Italy, Netherlands, Portugal and Spain.

The main variables of our analysis are: • Real Gross Domestic Product1

• Public debt-to-GDP ratios2

• Private debt-to-GDP and its components3

– Credit to non-financial corporations

– Credit to household and non-profit institutions serving households

We exploited two data sources. In particular Private debt and its components are taken from the Bank of International Settlements (BIS) dataset “Long series on total credit to the private non-financial sector”; Public debt and Real GDP come from the IMF World Economic Outlook dataset.

Figure 3.1 synthesises the main data sources of each variable. In the next sections we will present each variable in detail.

1_{https://www.imf.org/external/pubs/ft/weo/2018/02/weodata/index.aspx} 2_{https://www.imf.org/external/pubs/ft/weo/2018/02/weodata/index.aspx}

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Figure 3.1: Baseline variables and their sources

Source:Authors elaboration

3.1 Real Gross Domestic Product

Real output is taken from IMF World Economic Outlook dataset4_{. Table 3.1 shows the data}

length and summary statistics for Real GDP growth rates. In our dataset Real output indi-cates Gross domestic product, at constant prices expressed in billions of national currency units; the base year is country-specific. Expenditure-based GDP is total final expenditures at purchasers’ prices (including the f.o.b. value of exports of goods and services), less the f.o.b. (free on board) value of imports of goods and services.

We also downloaded from the same source, GDP per capita, unemployment and inflation rates. We will exploit these variables to present a more comprehensive picture of the eco-nomic situation in the Euro Area.

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Table 3.1: Real GDP Growth, Summary Statistics

Country Years Average Std. Dev Median Max value Min value N of obs

Austria 1980-2017 1.50% 1.95% 2.09% 4.35% -3.76% 37 Belgium 1980-2017 1.44% 1.81% 1.80% 4.72% -2.25% 37 Finland 1980-2017 3.11% 2.11% 2.80% 6.25% -8.27% 37 France 1980-2017 1.39% 1.82% 1.95% 4.74% -2.87% 37 Germany 1980-2017 1.98% 1.76% 1.83% 5.72% -5.56% 37 Greece 1980-2017 3.53% 0.86% 1.35% 5.79% -9.13% 37 Ireland 1980-2017 5.05% 4.88% 4.91% 25.01% -5.05% 37 Italy 1980-2017 1.82% 1.11% 1.47% 4.03% -5.48% 37 Netherlands 1980-2017 1.88% 2.15% 2.19% 5.03% -3.67% 37 Portugal 1980-2017 2.63% 2.04% 1.90% 7.86% -4.03% 37 Spain 1980-2017 2.31% 2.35% 2.98% 5.71% -3.57% 37 Euro Area 1980-2017 2.42% / / 25.01% -9.13% 407

Source:Authors elaboration with data from IMF World Economic Outlook dataset

3.2 Public Debt

Regarding the Public debt we employ data from the IMF World Economic Outlook dataset. Table 3.2 shows the data length and summary statistics for Public debt changes. Specifi-cally, Public debt is defined as “General government gross debt (Percent of GDP)”. Gross debt consists of all liabilities that require payment or payments of interest and/or principal by the debtor to the creditor at a date or dates in the future. This includes debt liabilities in the form of SDRs (special drawing rights), currency and deposits, debt securities, loans, in-surance, pensions and standardized guarantee schemes, and other accounts payable. Thus, all liabilities in the Government Finance Statistics Manual (GFSM) 2001 system are debt, except for equity and investment fund shares and financial derivatives and employee stock options.

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Table 3.2: Public debt-to-GDP Change, Summary Statistics

Austria 1988-2017 5.44% 1.23% -0.07% 16.32% -11.21% 29 Belgium 1980-2017 4.92% 0.94% 0.18% 16.78% -4.94% 37 Finland 1980-2017 18.45% 6.04% 0.31% 79.43% -13.70% 37 France 1980-2017 5.28% 4.36% 3.02% 20.73% -4.11% 37 Germany 1991-2017 5.55% 2.04% 1.69% 15.28% -5.96% 26 Greece 1980-2017 8.78% 6.15% 2.61% 25.41% -11.62% 37 Ireland 1995-2017 24.69% 1.73% -7.19% 77.36% -26.22% 22 Italy 1988-2017 4.01% 1.29% 0.60% 9.90% -8.00% 29 Netherlands 1980-2017 7.24% 0.93% 0.81% 28.15% -11.52% 37 Portugal 1990-2017 7.01% 3.23% 2.65% 23.05% -9.11% 27 Spain 1980-2017 11.41% 5.51% 3.55% 33.77% -8.73% 37 Euro Area 1980-2017 9.34% / / 79.43% -26.22% 355

Source:Authors elaboration with data IMF World Economic Outlook dataset

3.3 Private Debt

Data on private debt is taken from the Bank of International Settlements (BIS) dataset “Long series on total credit to the private non-financial sector”5_{. Table 3.3 shows the data length}

and summary statistics for Private debt change. The BIS has constructed long series on credit to private non-financial sector for 44 economies, both advanced and emerging. Credit is provided by domestic banks, all other sector of the economy and non-residents. The “private non-financial sector” includes non-financial corporations (both private-owned and public owned), households and non-profit institutions serving households as defined in the System of National Accounts 2008. In terms of financial instruments, credit covers loans and debt securities. The series have quarterly frequency and capture the outstanding amount of credit at the end of the reference quarter. Therefore, in order to have observation with annual frequency, we just computed the average of private debt-to-GDP ratio every four

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quarters.

The data for each country include:

• Credit to private non-financial sectors by domestic banks • Total credit to private non-financial sectors, decomposed in

– Credit to non-financial corporations

– Credit to household and non-profit institutions serving households

Table 3.3: Private debt-to-GDP Change, Summary Statistics

Austria 1960-2017 2.78% 2.79% 2.58% 8.74% -2.55% 57 Belgium 1970-2017 2.35% 3.97% 2.85% 10.37% -8.92% 47 Finland 1970-2017 1.65% 4.74% 2.12% 14.48% -10.65% 47 France 1969-2017 1.59% 2.04% 1.78% 6.12% -2.28% 48 Germany 1960-2017 1.10% 2.32% 0.96% 5.66% -6.11% 57 Greece 1970-2017 2.84% 5.65% 1.02% 16.11% -8.04% 47 Ireland 1971-2017 2.95% 8.24% 1.67% 21.51% -14.59% 46 Italy 1960-2017 1.41% 4.33% 2.49% 9.11% -9.47% 57 Netherlands 1961-2017 3.21% 3.47% 3.00% 13.10% -3.21% 56 Portugal 1960-2017 2.02% 5.96% 2.59% 13.51% -16.91% 57 Spain 1970-2017 2.01% 5.45% 2.15% 14.50% -6.63% 47 Euro Area 1960-2017 2.17% / / 21.51% -16.91% 566

Source:Authors elaboration with data from from BIS “Long series on total credit to the private non-financial sector” and IMF World Economic Outlook dataset

In particular Total Private debt is defined as “Credit to Private non-financial sector from all sectors, at market value - percentage of GDP - adjusted for breaks, per cent units”; Total credit to household is “Credit to Households and NPISHs (Non-profit institutions serving households), from all sectors at market value - percentage of GDP - adjusted for breaks,

A Comparative Analysis of the Effects of Public and Private Debt in the Euro Area