The Relationship between Debt Level and Fiscal Sustainability in Organization for Economic Cooperation and Development Countries

By Camarero, Mariam; Carrion-I-Silvestre, Josep Lluis et al. | Economic Inquiry, January 2015 | Go to article overview

The Relationship between Debt Level and Fiscal Sustainability in Organization for Economic Cooperation and Development Countries


Camarero, Mariam, Carrion-I-Silvestre, Josep Lluis, Tamarit, Cecilio, Economic Inquiry


I. INTRODUCTION

The recent financial and economic crisis of 2008-2009 has raised serious concerns about the long-term fiscal sustainability of those countries within the Eurozone. Although economic analysis agrees on the need to maintain sustainability of debt/GDP (gross domestic product) levels, the policy debate still devotes most of the attention to deficit/GDP ratios, until very recently the main focus of the stability and growth pact (SGP). (1) Therefore, the practical implementation of the SGP has to some extent neglected the importance of the debt stock level and its behavioral relations with the deficit focusing instead on the fulfillment of the deficit bounds established by the agreement. (2) This fact led to a failure to adopt sufficiently prudent spending policies in good times and has resulted in one of the major sources of fiscal vulnerabilities in euro area countries. Only after the launching of the new Treaty on Stability, Coordination and Governance in the Economic and Monetary Union and the legislative packages that enhance the economic governance framework (the so-called "Fiscal Compact," "Six Pack," and "Two Pack") has the surveillance of fiscal policy been extended and reinforced through an early warning system. As a result both deficit and debt criteria are on an equal footing in the Treaty. Moreover, a quantitative benchmark for debt reduction has been established stressing the importance of a joint assessment for both fiscal variables.

Fiscal sustainability requires a government to be solvent, which means that at some point in the future it has to be able to repay its debt. The primary budget balance (budget balance net of interest payments) is a key determinant of government debt dynamics, but there are several other factors that have been neglected or, at least, underestimated so far by mainstream economic analysis. In fact, gross debt accumulation is driven by three main factors: first, the abovementioned government primary balance; second, the so-called "snowball effect," which captures the joint impact of interest payments on the outstanding stock of debt and of real GDP growth and inflation rates over the debt-to-GDP ratio; and third, the deficit-debt relationship, also called "the stock-flow adjustment," which relates to all other factors that affect the outstanding stock of debt but are not recorded as part of the primary balance (see European Central Bank 2011). (3) In this article, we focus on this last relationship.

Despite its importance, the empirical literature has rarely tackled the problem of the relationship between debt and deficit until very recently. The no-Ponzi scheme restriction, which is regarded as synonymous with the fulfillment of the intertemporal budget constraint (IBC), imposes testable restrictions on the time series 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 the last two decades, fiscal sustainability has been tested through the use of nonstationary time series analysis. Two different approximations can be found in the literature: first, a univariate time series approach that focuses on the stochastic properties of the deficit inclusive of interest payments--Hamilton and Flavin (1986)--or the stock of debt--Wilcox (1989)--and second, a multivariate perspective which examines the long-run properties of the flows of expenditures and revenues--Trehan and Walsh (1988), Hakkio and Rush (1991), Haug (1991) or Quintos (1995), among others.

Trehan and Walsh (1991) derived that the existence of a cointegration relationship between primary deficit and debt, as well as the I(0) stationarity of the quasi-difference of the primary deficit are sufficient and necessary conditions for the IBC to be satisfied. This approach encompasses the two above-mentioned approximations: the univariate analysis (in terms of the I(0) stationarity of the primary deficit) as well as the multivariate one, through the definition of the IBC conditions in terms of cointegration. …

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