but also to almost fully disregard debt developments, and so to an inadequate handling of
long-term sustainability issues.
Disregard of the issue of public debt was considered as a clear limitation of the original
SGP (Buti et al., 2005). Consequently, taking more into consideration public debt and
long-term sustainability when assessing budgetary positions was broadly shared by policy
makers as one of the lines along which the Pact should be reformed. The agreement
reached at the ECOFIN Council in March 2005 gave a more prominent role to debt in the
preventive arm by differentiating medium-term budgetary objectives across Member
States on the basis of their potential growth and debt levels. Also, structural reforms with
positive effects on long-term fiscal sustainability have to be taken into consideration
when assessing the adjustment path toward the medium-term objective, when considering
deviations from the target, and when evaluating the deficits exceeding the 3% of GDP
limit.
The Council also called for giving a stronger weight to public debt in the implementation
of the Pact, but was not able to agree on, for instance, a minimum debt reduction for
countries with very high debt ratios (Buti et al., 2005). In terms of the role of debt and
sustainability, the reform of the Pact also appears limited when compared with some
proposals made during the long debate on the Pact, such as the permanent balance rule by
Buiter and Grafe (2003) and the debt sustainability pact by Coeuré and Pisani-Ferry
(2003). The permanent budget balance is given by the difference between the constant
long-run average future values of tax revenue and government spending. The rule
proposed by Buiter and Grafe (2003) was to keep the permanent budget adjusted for
inflation and real growth in balance or surplus. For countries with debt levels below 50%
of GDP, Coeuré and Pisani-Ferry (2003) proposed to give them the choice of opting out
the corrective arm (the excessive deficit procedure) and adopt a so-called debt
sustainability pact, according to which countries should submit a five-year budgetary
program with a debt ratio target for the period.
However, if the concern is government solvency such debt criteria impose unnecessary
constraints on fiscal policy on the basis of debt ceilings (as the Pact also does) or
relationships between the components of the budget and ad hoc discount factors. Where
government solvency is concerned, this paper emphasizes that sufficient conditions for
solvency are rather weak, while, as general rule, it does not appear that sustainability has
been in danger during the last 30 years in Europe.
Specifically, this paper analyzes sustainability within the framework of the recent
literature on fiscal reaction functions, which provides a convenient framework to assess
fiscal sustainability. This literature investigates the type of fiscal flow reaction (viz. the
primary surplus) to public debt accumulation that would guarantee fiscal sustainability.
Bohn (1998) and Canzoneri et al. (2001) have developed and applied this approach for
the US case. Ballabriga and Martinez-Mongay (2003, 2005) have estimated the reaction
of the primary surplus to debt levels for the EU Member States. In the line of Canzoneri
et al. (2001), Ballabriga and Martinez-Mongay (2003) focused on the fiscal dominance
versus monetary dominance debate. They estimated fiscal and monetary policy reaction
functions and found supportive evidence of a monetary dominance regime in the EU
Member States. Our paper of 2005 put the emphasis on fiscal sustainability and, in this
sense, is closer to Bohn (1998). By fine-tuning the estimation of the fiscal reaction
functions reported in 2003, the paper provided evidence of the existence of a structural
policy shift in the run-up to the euro (after 1995), which enhanced sustainability.
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