The recent deterioration in U.S. budget deficit has raised serious concerns about the long-run sustainability of U.S. fiscal policy. In addressing this issue, many studies have examined whether U.S. fiscal policy respects the intertemporal government budget constraint. This constraint implies that Ponzi games in which the government rolls over its debt in full every period by borrowing to cover both principal and interest payments are ruled out as a viable option for government finances. The no-Ponzi game restriction, which is regarded as synonymous with sustainability, requires that today's government debt is matched by an excess of future primary surpluses over primary deficits in present value terms. This condition imposes testable restrictions on the time-series properties of key fiscal measures such as the stock of public debt, the budget deficit, and the long-run relationship between government expenditures and revenues.
In a seminal article, Hamilton and Flavin (1986) suggest that a sufficient condition for the intertemporal budget constraint to hold is for the deficit inclusive of interest payments to be stationary. Wilcox (1989) extends the work of Hamilton and Flavin by allowing stochastic interest rates and nonstationarity in the noninterest surplus. He shows that when the sustainability condition holds, the present value of the stock of public debt should be stationary and has an unconditional mean of zero. Trehan and Walsh (1988) generalize the Hamilton and Flavin result and show that if debt and deficits are integrated of order 1, and if interest rates are constant, then a necessary and sufficient condition for sustainability is that debt and primary balances (net-of-interest deficits) are cointegrated. Other studies examine the time-series properties of government spending and revenues. For instance, Hakkio and Rush (1991) show that a necessary condition for intertemporal budget constraint is the existence of cointegration between government expenditure (inclusive of interest payments) and government revenues. Quintos (1995) expands on Hakkio and Rush (1991) and introduces the concept of strong sustainability condition, which implies that the undiscounted public debt is finite in the long run.
More recent work has emphasized the importance of nonlinearity in the U.S. fiscal policy. This nonlinearity may arise if we expect fiscal authorities to react differently to whether the deficit has reached a certain threshold deemed to be unacceptable or unsustainable. Bertola and Drazen (1993) develop a framework that allows for trigger points in the process of fiscal adjustment such that significant adjustments in budget deficit may take place only when the ratio of deficit to output reaches a certain threshold. This may reflect the existence of political constraints that block deficit cuts, which are relaxed only when the deficit reaches a sufficiently high level deemed to be unsustainable (Alesina and Drazen 1991; Bertola and Drazen 1993).
Recent studies have found strong evidence of nonlinearity in U.S. fiscal policy. Using an exponential smooth transition autoregressive model and long-span data set starting from 1916, Sarno (2001) provides evidence of nonlinear mean reversion in the U.S. debt-to-gross domestic product (GDP) ratio. By using a threshold autoregressive model, Arestis, Cipollini, and Fattouh (2004) provide evidence of threshold effects such that policymakers will intervene to reduce per capita deficit only when it reaches a certain threshold.
In line with the above studies, we provide new evidence of strong nonlinearity in the U.S. fiscal policy. We contribute to the existing literature by extending the analysis of U.S. fiscal adjustment from a single-equation setting to a multivariate one using a nonlinear vector error correction model (VECM). This extension adds value both in terms of our economic understanding of the fiscal adjustment process in the United States and assessing the forecasting power of the model. …