Determinants of public investments in the European Union: Is there a debt overhang effect?

The combination of the sovereign debt crisis that started in 2009 in the European Union (EU) and the fiscal consolidation policies that were implemented as a result, has significantly hampered economic growth and inflated debt levels; since 2007, the average public debt-to-gross domestic product (GDP) level has increased by 66.66% in the European Union and by 70.23% in the Eurozone. This paper exploits a panel dataset for 28 EU countries between 1995 and 2015 to examine the extent to which increased levels of public debt have led to reduced public investments, the so called 'debt overhang' hypothesis. Data is gathered from Eurostat’s National Accounts database or Government Statistics database and from the International Monetary Fund's (IMF) World Economic Outlook database. We contribute to the existing literature by incorporating a broader set of explanatory variables to explain public investment. More specifically, our explanatory variables include short-term and long-term interest rates, public and private debt, the government deficit, public expenditure, property income, the current account, trade openness, private investment, foreign direct investment, gross national disposable income per capita, the population growth rate and finally inflation, as measured by the harmonized consumer price index. Moreover, we focus on all EU countries rather than a limited subset of European countries. Finally, to address endogeneity concerns, we start our analysis from basic probit ordinary least square (POLS) models and expand it gradually to fixed effects (FE) estimation models as well as a Generalized Method of Moments (GMM) model, based on the linear GMM estimator of Arellano and Bond (1991).

Our results validate the debt overhang hypothesis and remain robust across various model specifications. Interestingly, we find evidence that the impact of this causal relationship is five times stronger for high debt countries compared to low debt countries. In addition, we find that the debt overhang effect is stronger in EZ countries than in non-EZ countries, which might suggest that the institutional framework of the Eurozone acted as a ‘straightjacket’ for countries that experience high debt levels. Moreover, we find that it is mainly the stock of debt which contributes to lower investment, rather than the flow of public debt.