Output volatility is also known to exert a causally negative effect on long-run growth, an empirical result that is the basis of the volatility literature and its fundamental claim that business cycle volatility and the trend growth rate are not separate phenomena but causally linked. How is public debt linked to output volatility? One can think of two channels: macroeconomic uncertainty and its effect on investment; and the greater vulnerability to crises. A highly indebted country is more likely to experience a macroeconomic crisis in the face of a terms-of-trade shock or a reversal of capital flows, other things being equal. Such crises tend to be comprehensive, typically involving exchange rate collapses, runs on banks and sometimes, sovereign default. Deep recessions often follow. This is material because when output volatility is calculated over long periods, it averages over periods of normal cyclical fluctuation and periods of crisis. When Hnatkovska and Loayza (2004) decompose volatility into a crisis component that captures the effect of deep recessions and a component that captures normal cyclical fluctuations, crosscountry regressions over the period 1960-2000 show it is crisis volatility that truly harms long-run growth. These results place a premium on financial, fiscal, and institutional development and the avoidance of crisis as key factors in alleviating the negative impact of volatility on growth.

# **2.3 MAC Debt—Help or Hindrance?**

Expressions like “debt intolerance” and “original sin” may not have found their way into the titles of recent papers on sovereign debt if the reforms of the 1980s and the liberalization of capital markets in the 1990s had led to more positive outcomes.<sup>18</sup> The question therefore is why more positive results were not secured. The following reasons come to mind:

- Growth prospects of countries were overestimated, leading to excessive borrowing.

- Access to debt led to procrastination by governments on necessary but difficult reforms.

- Debt was misused, either facilitating capital flight or being invested in bad projects.

- Available market-based debt instruments create a predisposition to crisis.

In short, the literature tends to be negative on debt because MACs have appeared unable or unwilling to make good use of public debt, not because debt _per se_ is bad.<sup>19</sup> This section assesses three related questions: Whose fault is this? Will new instruments help? Are IFIs using a flawed framework for assessing how much countries should borrow?

_Debt Intolerance vs. Original Sin: Whose Fault is it?_ In examining the association of poor results with MAC debt, two polar views have emerged:

- “Debt intolerance” proponents argue that it is the fault of MACs themselves, especially those with a history of default and high inflation and weak fiscal and financial institutions.  These countries cannot handle debt without becoming vulnerable to a crisis once external (public plus private) debt crosses 15-25 percent of GDP—a threshold much lower than actual external debt levels for big MACs.  As similar arguments would apply to public debt, the policy prescription would be to lower indebtedness. Therefore, if debt is a binding constraint

> 18 Reinhart, Rogoff and Savastano (2003), and Eichengreen, Hausmann and Panizza (2002), respectively. IMF (2003a), chapter III, also asks whether public debt in MACs is too high.

> 19 An analogy many of us may be uncomfortably familiar with: the doctor says, “Lose weight if you want to live longer.”  This doesn’t mean food is bad for us, only that we need to eat less.

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