Interpretation and limits of sustainability tests in public finance

Abstract

Public debt is considered sustainable if discounted net repayments are expected to cover the initial debt issuance, i.e. if the government's inter-temporal budget constraint is expected to hold. With risk-averse lenders and an uncertain economic environment, Bohn (1995) stresses that this constraint relies on a stochastic discount factor which depends on lenders' preferences. To get round the difficulty related to the specification of private agents' preferences in empirical analysis, Bohn (1998) suggests to estimate fiscal reaction functions describing how primary surplus reacts to indebtedness. After having solved the econometric issues arising when primary surplus and`debt have a very different persistence (with a nonparametric approach) or are both integrated (with parametric tests), we estimate fiscal reaction functions for France and Greece. There remain important limitations and interpretation difficulties that are common to all econometric sustainability tests.

Fiscal reaction to interest payments: The case of Serbia

“…5 We build on theoretical models of Barro (1979) and Debrun and Kinda (2013) in our choice of fiscal policy stance indicator. This choice is also consistent with the model-based sustainability analysis developed in Bohn (1998), and later on outlined in Mendoza and Ostry (2008) and Lamé et al (2014). The use of overall primary fiscal balance enables us to assess the overall response of fiscal policy stance to changes in public debt, interest payments and borrowing costs.…”

“…Since our FRF specification controls for public debt and interest payments variations, we have, therefore, indirectly controlled for the great majority of variations in privatization proceeds as well. Lamé et al (2014) argue how estimates of FRFs are difficult to interpret when the primary fiscal balance to GDP ratio is stationary, while public debt and interest payments are (near) unit root processes. 16 The error term is most likely correlated with the evolution of public debt and interest payments.…”

“…Primary fiscal balance, on the other hand, is trend stationary, so we do not test for the cointegration between the two series. 17 Lamé et al (2014) also propose a nonparametric correction to the heterogeneous persistence between primary fiscal balance on one hand, and public debt and interest payments on the other. The nonparametric approach is, however, only valid under the assumption of uncorrelated primary fiscal balance, a condition not satisfied throughout our sample span.…”

“…The finite sample bias is present even when the regressors are instrumented with their lagged values. Lamé et al (2014) propose a parametric correction for the elimination of this potential finite sample bias by adding additional lags of public debt and interest payments in FRF. 17 They estimate the FRF specification of the following general type:…”

“…We follow the advice of Lamé et al (2014) and augment equation (9) with lagged first differences of public debt and interest payments. The primary 16 First lag autocorrelation coefficient for both public debt and interest payments equals 0.91.…”