The economic aftermath of surges in public and private debt: Initial conditions and channels

Abstract

Debt levels, both private and public, were already at record highs before the Covid-19 pandemic and surged further in 2020. The high indebtedness raises concern that it will undermine future economic prospects. Contributing to the ongoing debate, we use the local projection method to dynamically study the behavior of economic activity and its main components after public and private debt surges. A new dataset on debt surges in 190 countries between 1970 and 2020 is used. Debt surges are followed by persistently weaker economic growth. However, this negative relationship does not always hold, as it depends on the type of debt surge: rapid increases in public debt have the most negative impact, particularly when an economy operates with a large positive output gap. Debt surges also tend to be followed by worse economic performance if the initial total debt levels are high. Public debt surges lead to weaker private and public investment. Surges in nonfinancial corporate debt are followed by lower private and public investment.