Academic journal article Economic Inquiry

Multicointegration and Sustainability of Fiscal Practices

Academic journal article Economic Inquiry

Multicointegration and Sustainability of Fiscal Practices

Article excerpt


Governments are charged with the responsibility of crafting national budgets. Over time budgets tend to move between balance, surplus, and deficit. These fluctuations result from the fact that all too often a government makes financial decisions in one year that have implications for spending commitments and revenue streams a number of years down the road. Thus, responsible government budgeting involves examining the budget position over time, that is, engaging in intertemporal budgeting. Economists generally utilize two criteria to assess the intertemporal budget's sustainablity: does the government run persistent deficits? If so, what is the resulting level of debt?

Are these two criteria sufficient to make predictions regarding budget sustainability? Recent work by Bohn (1995, 1998) and Ball et al. (1998) suggests that budgets are far too complicated to be evaluated with respect to deficits and debt alone. These authors have shown that persistent deficits and accumulation of debt does not necessarily imply that the debt is unmanageable and, hence, fiscal processes unsustainable. The implication of their work is that the standard approach to testing whether government adheres to its intertemporal budget constraint, cointegration analysis, does not provide sufficient criteria for determining whether the fiscal process is truly sustainable.

Consequently, in this article we develop a more encompassing set of criteria under more realistic assumptions for determining whether a country exhibits a sustainable budgeting process. Our criteria for sustainability are based the multicointegration approach first presented by Granger and Lee (1989, 1990) and further developed in Engsted, Gonzalo and Haldrup (1997) and Haldrup (1998). The budgeting practices of 15 industrialized countries (Belgium, Canada, Denmark, Finland, France, Great Britain, Greece, Italy, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland and the United States) are evaluated in terms of the criteria. Our sample spans the modern era, 1960-98.

We extend the intertemporal budgeting literature by employing the multicointegration framework to develop the appropriate policy responses to deficits and debt accumulation and to test for their presence. The methodology assesses both the stock and flow relationships that should characterize sustainable fiscal processes when the data are nonstationary. Cointegration between the spending-revenue flow relationship is the first component of our criteria. Cointegration between the flow of revenue (spending) and the stock of debt is the second. Jointly these conditions characterize multicointegration between government spending and revenue. In the multicointegration case, the system is characterized by a complex stock-flow equilibrium relationship that is not uncommon in intertemporal models of economic behavior. Such a relationship is typically associated with issues of optimal control where the levels and rates of change of the variables making up the system are determinants of the policy response. Multicointegration can ensure that a country's budgeting strategy is sustainable in "bad" states of nature, that is, when the rate of economic growth falls short of the real interest rate on sovereign debt. (1)

Bohn (1995) and Ball et al. (1998) point out that existing theoretical models that underpin traditional sustainability tests are too simple. Specifically, Bohn (1995) shows that the sustainability of imbalances in a stochastic setting involves satisfying an intertemporal budget constraint and a transversality condition that differs from that implicit in simple (deterministic) models. The transversality condition requires that the limit of the debt discounted at a rate that is a function of the probability distribution of future debt and the marginal rate of substitution between present and future consumption be zero. This correct discounting is critical in economies where the rate of growth has been higher than the real interest rate. …

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