Doctoral Thesis University of Trento School of Social Sciences Doctoral School in Economics and Management Economic Growth and Public Debt: Beyond Debt-Thresholds. Theoretical and Empirical Issues. a dissertation submitted to the doctoral school of economics and management in partial fulfilment of the requirements for the Doctoral degree (Ph.D.) in Economics and Management Matteo Tomaselli 2017 / 2018 Academic Year Advisors Principal Advisor: Prof. Roberto Tamborini University of Trento, Trento Co-Advisor: Prof. Giuliana Passamani University of Trento, Trento Doctoral Committee Prof. Giovanni Di Bartolomeo Sapienza University of Rome, Rome Prof. Tullio Gregori University of Trieste, Trieste Prof. Alessandro Missale University of Milan, Milan Declaration This thesis is a presentation of my original research work. Wherever contributions of others are involved, every effort is made to indicate this clearly, with due reference to the literature. The work was done with collaborative discussions and under the guidance of Professors Roberto Tamborini and Giuliana Passamani at the University of Trento, Italy. Chapter 4 was primarily done under the guidance of Professor Luigi Mittone (University of Trento). Matteo Tomaselli Contents Introduction and overview 111 Chapter 1. Public debt and economic growth: a literature 111 review in search of theory 117 1. Introduction 18 2. Neoclassical views 111 2.1. Deficit spending and crowding out 111 2.2. Ricardian equivalence 114 2.3. Expansionary fiscal consolidations 117 2.4. The endogenous growth approach 119 3. Keynesian and new-Keynesian views 120 3.1. Fiscal multipliers 121 3.2. Sovereign risk and confidence 123 4. Public finance 125 4.1. Sustainability 125 4.2. Efficiency 127 5. Unsustainable debt and solvency defaults 129 6. Four scenarios for the study of the debt-growth relationship 134 6.1. A fiscal model of endogenous growth with efficient 1111111 and sustainable public debt 134 6.2. Sustainable but inefficient debt 139 6.3. Efficient but unsustainable debt: fiscal consolidation 139 6.4. Inefficient and unsustainable debt 141 7. Conclusions 142 Chapter 2. Analysing Economic Growth and Debt Relationship 111 in a Panel of European Countries 145 1. Introduction 146 1.1. The pursuit of the debt-threshold 146 1.2. Beyond thresholds: is there a general causal 111 relationship involving debt and growth? 150 2. Dataset description 154 3. A general specification for the empirical analysis 158 3.1. Within-country time series analysis 160 3.1.1. Methodology 160 3.1.2. Estimation results 162 3.2. Pooled dynamic panel data analysis 170 3.2.1. Methodology 170 3.2.2. Estimation results 171 3.2.3. Model validity: robustness and goodness of fit 173 3.3. Financial crisis and austerity: development of 111 the basic specification 176 3.4. Group 5, accounting for countries’ heterogeneity 180 3.5. Heterogeneity, cross-sectional dependence, and 111 small-samples correction 182 4. Conclusions 184 Appendix 186 Data Appendix 186 Cointegration Appendix 188 Chapter 3. Analysis of the Determinants of Austerity in a 111 Panel of European Countries 191 1. Introduction 192 2. A measure of austerity 193 2.1. Ex ante and ex post austerity 183 2.2. Timing and intensity 195 3. In search of explanatory variables 198 4. Step 1, correlation analysis. What explains differences 111 in austerity? 102 4.1. Fiscal consolidation: public deficits and debts 102 4.2. Market discipline: government bonds, ratings 111 and spreads 108 4.3. Fiscal discipline 111 4.4. Macroeconomic stabilisation 114 5. Dynamic panel data analysis 120 5.1. Methodology 120 5.2. Estimation results 122 6. Conclusions 127 Appendix 129 Data Appendix 129 PCFA Appendix 130 Chapter 4. An experimental approach in search of a 111 confidence channel 133 1. Introduction 134 1.1. Expectations within standard economic theories 136 1.2. Further theories 138 1.3. Expectations and fiscal policies in experimental 111 economics 138 2. Research questions and behavioural hypotheses 140 3. Experimental design 142 3.1. Design without tax controls 143 3.2. Forecasts and the final questionnaire 146 3.3. Laboratory implementation, calibration, and 111 subject pool 147 3.4. Strategic analysis 149 3.5. Design with tax controls 154 3.6. Treatments 155 4. Data analysis and discussion 156 4.1. Qualitative analysis, no tax controls 157 4.1.1. Treatment 1, results 157 4.1.2. Treatment 2, results 163 4.1.3. Forecasts, results 166 4.2. Research question 1 168 4.3. Research question 2 171 4.4. Analysis of residuals 174 4.5. Qualitative analysis, tax controls 175 4.6. Research question 3 180 4.7. Questionnaire and risk aversion, results 182 5. Conclusions 184 Appendix 186 Screenshots 186 Laboratory instructions 188 Strategic analysis 194 Acknowledgements 195 References 197 List of Figures Figure 1.1. The optimal level of * and the corresponding 훾∗ 138 Figure 2.1. Debt and GDP growth rates for each country 156 Figure 2.2. Debt and GDP quarterly growth rates, scatter-plot with 111 111linear regression line 111157 Figure 2.3. Debt and GDP quarterly growth rates, scatter-plot with 111 regression lines for each country 158 Figure 2.4. Quarterly debt-to-GDP ratio, boxplots by country 158 Figure 2.5. Cointegration analysis, groups of countries 167 Figure 2.6. Distribution of the time breaks 168 Figure 2.7. The logarithm of the VIX Index and its mean 172 Figure 2.8. Short-term temporal dynamics of gD(-1) for the five basic 111 specifications with gY as dependent variable 179 Figure 3.1. Average Ait dynamics by group of countries, 2011-16 195 Figure 3.2. CAit indicators by country over the period 2011-16 197 Figure 3.3. Deficit-to-GDP ratios, groups of countries, 2010-16 102 Figure 3.4. Correlation between Ait and deficit-to-GDP ratios. 111 EZ (panel a) and NoEZ (panel b) groups, 2011-16 104 Figure 3.5. NFA indicator over the period 2008-2014, groups of countries 105 Figure 3.6. Correlation between CFA08-09 and CFA10-14, all countries 106 Figure 3.7. Debt-to-GDP ratios, groups of countries, 2010-16 106 Figure 3.8. Correlation between Ait and the growth rate of the debt-to-GDP ratio. 111 EZ (panel a) and NoEZ (panel b) groups, 2011-16 107 Figure 3.9. Year average of monthly spreads of yields of government 111 long-term bonds, groups of countries 108 Figure 3.10. Correlation between Ait and spreads, 2011-16 109 Figure 3.11. Correlation between Ait and S&P ratings 2011-16, EZ countries 110 Figure 3.12. Distributions for Ait over the period 2011-2016. 111 EPD=0 (panel a) and EDP=1 (panel b) 112 Figure 3.13. Correlation between Ait and FFit|t-1 113 Figure 3.14. Year rate of change of GDP (panel a) and official 111 output gap (panel b), 2011-16, groups of countries 115 Figure 3.15. Correlation graphs between Ait and gYit and OGit, 111 2011-16. EZ (panel a) and NoEZ (panel b) groups 116 Figure 3.16. Correlation graphs between Ait and dURit, EZ (panel a) 111 and NoEZ (panel b) groups 118 Figure 3.17. Average standardised austerity and its predicted value, 111 all countries, 2012-16 127 Figure 4.1. Experimental steps 147 Figure 4.2. Expected value of Wit+1 for three values of savings, 111 S1, S2, and S3 (example) 154 Figure 4.3. Public debt, experimental dynamics 157 Figure 4.4. Average consumption, savings, and tax compliance dynamics with 111 boxplots without outliers. Treatment 1 without tax controls, Session 1 159 Figure 4.5. Average consumption, savings, and tax compliance dynamics with 111 boxplots without outliers. Treatment 1 without tax controls, Session 2 160 Figure 4.6. Aggregate consumptions-to-endowment (CtE) and 111 savings-to-endowment (StE) ratios. Treatment 1 without tax controls, Session 1 162 Figure 4.7. Aggregate consumptions-to-endowment (CtE) and 111 savings-to-endowment (StE) ratios. Treatment 1 without tax controls, Session 2 162 Figure 4.8. Average consumption, savings, and tax compliance dynamics with 111 boxplots without outliers. Treatment 2 without tax controls, Session 1 163 Figure 4.9. Average consumption, savings, and tax compliance dynamics with 111 boxplots without outliers. Treatment 2 without tax controls, Session 2 164 Figure 4.10. Aggregate consumptions-to-endowment (CtE) and 111 savings-to-endowment (StE) ratios. Treatment 2 without tax controls, Session 1 165 Figure 4.11. Aggregate consumptions-to-endowment (CtE) and 111 savings-to-endowment (StE) ratios. Treatment 2 without tax controls, Session 2 166 Figure 4.12. Aggregate expectations, fraction of "Debt will be reduced in the 111 next round" (Forecast1), and average sustainability perception (Forecast2). 111 Treatment 1 without tax controls, Session 1 167 Figure 4.13. Aggregate expectations, fraction of "Debt will be reduced in the next 111 round" (Forecast1), and average sustainability perception (Forecast2). 111 Treatment 2 without tax controls, Session 1 167 Figure 4.14. Aggregate expectations, fraction of "Debt will be reduced in the next 111 round" (Forecast1), and average sustainability perception (Forecast2). 111 Treatment 1 without tax controls, Session 2 167 Figure 4.15. Aggregate expectations, fraction of "Debt will be reduced in the next 111 round" (Forecast1), and average sustainability perception (Forecast2). 111 Treatment 2 without tax controls, Session 2 168 Figure 4.16. Average consumption, savings, and tax compliance dynamics 111 with boxplots without outliers. Treatment 1 with tax controls, Session 1 177 Figure 4.17. Aggregate consumptions-to-endowment (CtE) and 111 savings-to-endowment (StE) ratios. Treatment 1 with tax controls, Session 1 178 Figure 4.18. Aggregate expectations, fraction of "Debt will be reduced in the next 111 round" (Forecast1), and average sustainability perception (Forecast2). 111 Treatment 1 with tax controls, Session 1 178 Figure 4.19.