The Debt-Growth Nexus in Keynesian and Classical Economics

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Beyond the scope of RR, public debt- economic growth nexus has historically been a contentious strand of economic analysis, involving many notable economists from various economic camps. There are two distinct schools of economics regarding the debt-growth nexus: Keynesian and Classical (Ricardian). Most economists involved identify as Keynesian, whose macroeconomic analysis asserts that debt has a negative effect on economic growth. According to the doctrine of Ricardian equivalence, in the long flow of debt (deficit) does not affect the aggregate demand in the economy. They attribute this to the fact that a temporary increase in the flow of debt directly raises burden on the stock of debt. This idea is associated with classical economists, such as David Hume, Adam Smith and David Ricardo.

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Adam Smith (1776) asserted that the state is ineffective in being creator of wealth and guarantor of individual freedoms. Smith’s negative attitude to debt also stems from anti-mercantilist philosophy and a comparative assessment of the effectiveness of public and private spending. National income is converted from investment to consumption. If the state can cover its budget deficit with loans from industrialists and traders, then a society that is poor in the capital will lose the income that would otherwise turn into productive investments. Smith’s rejection of debt led him to demand a balanced budget.

Ricardo (1821) shared Smith’s antipathy for debt but shared pro-mercantilist ideas. He believed that only by saving income and refraining from spending national capital can be increased and that interest expenses, being only domestic transfers, do not burden future generations. Similarly, Smith, Hume (1742) and Ricardo believed that due to unproductive spending of the state, the problem is not the debt itself, but the destruction of the capital that the debt contributes to. Thomas Robert Malthus (1826) observed the effect of population growth on the debt-growth nexus. He found that economic growth induces population growth which subsequently increases strain on public debt.

Conversely, Keynes (1936) believed that public debt tames fiscal restraint, as it can be argued that a temporary increase in the flow of debt (Deficit) can act as a catalyst for economic development, through loans and government spending. As public debt levels rise so do the costs associated with servicing: consequently, there will be an inevitable increase in the tax burden. Policymakers have an option to use refinancing methods and partially shift the real economic burden of its debt onto the shoulders of the next generation. In this case, there will be a significant ‘crowding-out effect’, namely that the state’s entry into the loan capital market as a large borrower will cause an increase in interest rates: this increase in rates will reduce investment potential since it will reduce the ability of private firms and the public to use borrowed capital. Many authors continue to develop Keynesian views of Neo-Keynesian economics (Samuelson, 1948; Hanson, 1997; Lerner, 1943, 1948, 1961).

This topic remains contentious among economists, with many pointing to various other faults in Reinhart and Rogoff’s methodology and conclusions, beyond those identified by HAP. Criticisms include that the relationship observed may be invalid, the study failed to account for individual country risk, also the restrictive, uncomprehensive data employed, subsequently giving rise to questionable robustness of the model. Economists seek to address these issues by applying RR model to a wider framework, as will be discussed later.

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