I am very happy to read this interesting post on the relationship between debt and growth. However, I would like to add some comments on the so-called Debt Laffer curve.

In a couple of papers (available on http://papers.ssrn.com/sol3/cf_dev/AbsByAuth.cfm?per_id=415104) I have investigated the debt-growth nexus, finding evidence in support of a linear relationship. In fact, controlling for the role of institutions and using past values of the debt ratios make the quadratic specification no more significant.

In the most recent paper (The Debt-Growth Nexus in Poor Countries: a Reassessment, the most recent version is available on request) I investigate the relationship between external indebtedness and economic growth, with a particular attention to LICs, for which I guess that the theoretical arguments of debt overhang and liquidity constraint should be reconsidered. The estimation of a growth model, with a panel of 121 developing countries, supports a negative and linear relationship between past values of the NPV of external public debt and current economic growth. This is due to the “extended debt overhang”, according to which a large indebtedness leads to misallocation of capital and discourage long-term investment and structural reforms.

The first contribution of this work is that there is no evidence of an inverse U-shaped curve representing the debt-growth relation. External public debt in the previous period is negatively associated with current economic growth, even controlling for policies and institutions. However, we recognize that this link could become less strong or even not significant when debt is too large, so that there might be a debt irrelevance zone. The upward sloping part of the Debt Laffer curve, instead, is not validated by the data, coherently with the reasonable assumption that rich and industrialized countries are the ones which occupy that portion of the bell curve.

A previous reduction in the discounted debt ratio from 50 to 30, similar to what happened in Bolivia in the last decade, is associated with an increase of almost half percentage point in current GDP growth.

A further step aims to disentangle the negative debt effect in Low and Middle Income countries, on the ground that debt overhang could be reduced or avoided in LICs thanks to the continuous external borrowing. Results are not conclusive, but they suggest the possibility that the negative effect of debt on growth is lower in the poorest countries.

The second contribution of the paper concerns the discussion on the channels through which external debt affects economic growth. The estimation of a total investment and a public investment equations does not find any relationship between external debt and investment rate, providing additional support to the extensive interpretation of debt overhang.

With respect to the crowding out effect, it is limited to total investment in LICs (on average, a one percent increase in the debt service to GDP ratio reduces the total investment rate by almost 0.4 percentage points), where, even considering the concessionality of external lending, interest payments on external debt are a constraint in the poorest because of their weak fiscal system.

Eventually, the paper underlines the great relevance of macroeconomic management and market oriented policies to trigger economic growth. Therefore, in order to reap of the benefit from a reduction in external debt, it is necessary that governments have the incentives to keep on pursuing structural adjustments and reforms. On the contrary, without conditionality, moral hazard issues could prevent these improvements and hinder economic growth.