Since the financial crisis, government debt ratios have increased in many countries. Most studies indicate that there is a negative association between high medium- and long-term debt ratios and growth, although the exact magnitude of the relationship is being discussed. Since high debt ratios impede growth, it is important to study the determinants of debt ratios.
While previous research has identified various economic and political factors as important for indebtedness, this article suggests that regulation of the economy is an important explanatory factor as well. To our knowledge, this paper is the first to investigate this indicator of economic freedom as a potential explanation for government fiscal behavior. There are at least three mechanisms that can explain why regulation affects government debt ratios.
The first mechanism assumes that beliefs about how well markets and government function affect policy. If one holds pro-market and government-skeptical attitudes, one is likely to advocate regulatory freedom and fiscal restraint. This establishes a negative link between regulatory restraint and debt ratios, not because the former causes the latter but because the underlying beliefs affect both in this way.
The second mechanism is based on the assumption that once regulation is in place, it can have direct effects on debt ratios by affecting various economic outcomes. For example, regulation could affect GDP and its development, and a regulated labor market could entail higher debt ratios (due to higher expenditures for the unemployed).
The third mechanism sees regulation as a signal of economic problems. If lenders interpret regulation as a result of various such problems, they may increase interest rates, which tends to increase debt ratios by making debt more costly to roll over and by increasing servicing costs.
For our empirical study, we use regulatory freedom, which measures how lightly an economy is regulated in the areas of labor, credit and business. We employ panel data from 67 countries with Western-style political institutions for which we have data on government debt ratios as well as a set of policy indicators. We observe these countries in up to seven five-year periods in which we are able to follow the development of their debt ratios and policy changes.
Our main result is that regulatory freedom is negatively related to the debt/GDP ratio: an increase in the former of one unit (on a 10-unit scale) is on average associated with a six percentage-point reduction in the debt ratio. Moving from the regulatory freedom of Greece to that of Denmark would, all other things being equal, entail a reduction in the debt ratio of ten percentage points within a five-year period.
We furthermore find that the stronger the veto players (i.e., upper legislative chambers, de facto influential opposition parties and courts with the power to review legislation), the stronger is the negative association between regulatory freedom and debt ratios; and that the higher the degree of legislative fractionalization, the more regulatory freedom is able to restrain debt ratios.
In all, our findings suggest that regulation of an economy, and the underlying beliefs about markets and government, is a relevant factor to consider when analyzing debt development.