Permanent and transitory effect of public debt on economic growth

Purpose: This study examines the effect of public debt on the economic growth of OECD countries by disentangling the effect into permanent and transitory components. The study covers 37 OECD countries. Design/methodology/approach: The Mundlak decomposition was employed to decompose the effect of public debt into its transitory and permanent effect on economic growth. To account for potential endogeneity problem, the Hausman and Taylor estimator was employed to estimate the decomposed model. Further, the study disaggregated the OECD model into country group models for further analysis of the dynamics of the relationship between the variables. Findings: The findings of the study reveal that in the full OECD model public debt exerts a significant negative permanent and positive transitory effect on economic growth. This was robust to alternative model specifications. The magnitude of the negative permanent effect of debt was found to be larger than the positive transitory effect. Further, the estimates of the disaggregated models reveal that though public debt has a negative permanent effect across all the country groups, it was not the case for the transitory effect of debt. Also, a net public debt model was estimated, and its effect on public debt was found to be largely insignificant, exhibiting a Ricardian-like behaviour. Originality/value: To the best of our knowledge, this is the first study, particularly in the OECD context that employed the Mundlak transformation to examine the permanent versus transitory effect of public debt on economic growth.