Does economic growth really depend on the magnitude of debt? A threshold model approach

In recent economic literature it has been emphasized that across both advanced countries and emerging markets, high levels of debt-to-gross domestic product (GDP) ratio (90% and above) are associated with notably lower growth outcomes. On the other hand, much lower levels of external debt-to-GDP ratio (60% and below) are associated with adverse outcomes for emerging market growth. These findings have been broadly cited and used in practice. On the other hand, there is an opposite evidence, such that the initial level of debt-to-GDP ratio has no impact on economic growth rate. Taking both viewpoints into account, we propose to employ a time series-based nonlinear mechanism in the threshold autoregression form in order to examine the possible relationship between economic growth rate and its potential determinants included the mentioned debt-to GDP indicator. The originality of the study is that it employs threshold variables instead of exogenous variables and time-series data instead of panel data to reveal the economic instruments that have determined the business cycle in European countries for the last 2 decades -starting from 1995. The purpose of the study is to check the mechanism of growth (measured in terms of GDP growth rate and industrial production growth rate) depending on several important macroeconomic variables, such as public debt, rate of inflation, interest rate, and rate of unemployment with the level of growth itself serving as the threshold variable. We propose an efficient methodology for seeking the best specification of threshold autoregression model in terms of both goodness of fit and parsimony of parametrization. The data (quarterly and monthly) applied in the research cover the time period from the beginning of 1995 to the end of 2013. Such a long period is interesting because it allows investigation of the mechanism of growth under two different economic policy models. We identify that the exogenous monetary mechanism played an important role in diagnosing the phases of business cycle in most European economies which is in line with liberal economic policy dominating in the observed period. The initial level of debt-to-GDP ratio as its increase within the recession period was of no value for the economic growth pattern.