Academic journal article Contemporary Economic Policy

The Behavior of U.S. Public Debt and Deficits during the Global Financial Crisis

Academic journal article Contemporary Economic Policy

The Behavior of U.S. Public Debt and Deficits during the Global Financial Crisis

Article excerpt

I. INTRODUCTION

Macroeconomists and policy makers have traditionally been concerned with the issue of the sustainability of public debt in developing and emerging market countries. However, since the global financial crisis, the attention has shifted to developed economies that suffer from rising debt/gross domestic product (GDP) ratios in the face of stagnant or contracting output, aging population. and liabilities from financial sectors. Of significant interest in the debate on fiscal sustainability is the U.S. economy, in which the problem of a ballooning public debt has attracted significant media attention in recent years. This paper seeks to address the question of sustainability of the U.S. fiscal debt using a novel approach. Specifically, we seek to answer the questions: Has U.S. fiscal policy become unsustainable in the light of the global financial crisis? And if so. when did it become unsustainable?

The literature on testing the sustainability of U.S. fiscal policy is extensive. Using long time-series data spanning the period 1916-1995, Bohn (1998) shows that the condition for the sustainability of fiscal policy is supported by the data and that the level of primary surpluses responds positively to marginal changes in the debt/GDP ratio. Despite the United States having suffered from extended periods of primary deficits. Bohn (1998) shows that the U.S. fiscal policy has been historically sustainable. Bohn (2008) uses an even longer dataset spanning more than two centuries (1792-2003) and finds substantial evidence in favor of a sustainable fiscal policy. Be that as it may, there are studies to the contrary that question the sustainability of U.S. fiscal policy (e.g.. see Hamilton and Flavin 1986).

In this paper, we examine this issue of fiscal sustainability using the model-based specification of Bohn (1998. 2008). Bohn's (1998) model is widely regarded as a robust test for the sustainability of public debt over a given time path. However, this model assumes that the relationship between the primary surplus to GDP ratio and the debt/GDP ratio is time-invariant. Bohn (2008) alludes to permitting the policy rule (or reaction function) for the primary surplus to GDP ratio to be time-varying. Fincke and Greiner (2010) use the penalized spline estimation method to estimate a time-varying reaction function and examine the debt policies of a few African and Latin American countries. Our approach differs from those of both Bohn (1998. 2008) and Fincke and Greiner (2010) in that we modify Bohn's (1998) original parametric specification by casting it in a state-space framework to accommodate a possible time-varying relationship between the primary surplus/GDP ratio and the debt/GDP ratio. We do this because we take into account the fact that the reaction of the primary surplus to variations in debt need not be constant but may be time-varying. Our prediction of a time-varying reaction function is in fact well supported by the data. The time-varying parameter model is estimated on a longer sample of the U.S. data (1916-2012) to determine whether the condition for fiscal sustainability is satisfied in recent years amidst growing concern and debate over the U.S. (un)sustainable debt policies. Paniagua et al. (2015) also apply a time-varying parameter model to study the sustainability of peripheral Euro countries' fiscal policy. Their model allows the fiscal reaction function to follow an autoregressive process. In contrast, we estimate a random coefficient model in which the transition equation of the fiscal reaction coefficient follows a random walk process.

In addition, we provide prima facie evidence by applying an alternative test that analyzes the stationarity property of the stock of debt as a proportion of GDP. The earlier literature focusing on evaluating the sustainability of a government's fiscal financial strategy utilized the government's intertemporal budget constraint to derive sufficient conditions for sustainability. …

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