Academic journal article Federal Reserve Bank of St. Louis Review

Common Fluctuations in OECD Budget Balances

Academic journal article Federal Reserve Bank of St. Louis Review

Common Fluctuations in OECD Budget Balances

Article excerpt

Recent huge U.S. budget deficits--12.8 percent and 12.3 percent of gross domestic product (GDP) in 2009 and 2010, respectively--have returned fiscal issues to the front burner (Calmes, 2009). Analysts typically credit or blame the government for a country's fiscal situation. Leonhardt (2009), for example, apportions blame for prospective U.S. deficits to current and past presidents. Although Leonhardt (2009) more or less ignores the legislative branch, such assignments are appropriate in some sense: Governments decide how much to tax and spend and therefore are ultimately responsible for fiscal outcomes.

When analyzing fiscal balances, however, it is important to consider economic circumstances, because such circumstances determine the welfare implications and sustainability of fiscal policy. In this article, we analyze the effects of international circumstances on fiscal balances. Two observations motivate our analysis. First, the growth in economic and financial interdependence over the postwar era increases the potential for international circumstances to influence national fiscal policies. Second, Neely's (2003) casual examination of international comovements in fiscal balances illustrates the relevance of international influences in such matters.

We begin our analysis by estimating a dynamic factor model to identify the latent world factor underlying fiscal surpluses in 18 industrialized countries for 1980-2013. A latent factor model is a method to summarize common movements in related variables. For example, economists often use latent factor models to characterize the movement of interest rates on bonds of different maturities. (1) The determinants or factors are called latent (hidden) because economists cannot directly observe them. But one can infer the behavior of these unobserved factors from the common movement across variables in the data. Factor analysis estimates these hidden factors to explain as much of the variance of the dependent variables as possible; this effectively condenses the information from many related variables into one or a few underlying influences. When the factors are allowed to be autocorrelated over time, then they are called "dynamic" factors. For interest rates, the first three factors can be readily interpreted as the level, slope, and curvature of the yield curve.

In this article, we use factor analysis to summarize and analyze the comovements of national fiscal balances and investigate the determinants of those balances. Why do we study such comovements? We start by observing that net lending is strongly positively correlated across countries. One might think that some international factor or factors drive this comovement, but their identity and quantitative importance are not clear. Potentially, international budget measures might be related for many reasons. For example, net lending tends to be correlated internationally because trade and capital flows link business conditions between countries. Asset market conditions, such as equity valuations and interest rates, are also linked internationally and can affect fiscal measures through capital gains tax revenues and interest payments on debt. Noneconomic factors, such as common trends in age demographics (e.g., the baby boom) or military expenditures (the peace dividend in the 1990s) can also affect fiscal balances.

A factor method captures covariation among many variables in a unified framework and has major advantages over alternative procedures for measuring comovements in national budget surpluses. For example, the performance of a few large countries will dominate a GDP-weighted average of national surpluses. Similarly, pairwise correlations or related statistics are unwieldy, difficult to summarize, and fail to provide a unified framework. (2)

Our estimated world budget surplus factor explains a substantial portion of the variability in individual budget surpluses in member countries of the Organisation for Economic Co-operation and Development (OECD). …

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