On theory grounds, Ballabriga and Martinez-Mongay (2005) have been criticized for
seemingly discarding the distinction between ad hoc sustainability and model-based
sustainability as discussed in Bohn (2005a). On empirical grounds, the availability of
additional sample evidence allows to confront the existence of the sustainability-
enhancing impulse associated to the run-up to the euro with a potential post-EMU
fatigue, which would have shown up after 1999. Furthermore, the ad hoc dummy-
modelling approach for the ‘euro impulse’ can be complemented with an endogenous
mechanism for structural shift detection.
Within this framework, the objective of this chapter is to develop further the assessment
of the sustainability of EU public finances. Alternative theoretical and empirical
approaches in the literature to assess the sustainability of public finances are discussed in
section 2.2. Section 2.3 takes a first descriptive look at the evolution of gross debt series
in 14 Member States (EU 15 except Luxembourg), the US and Japan over the period
1977-2005. Section 2.4 presents alternative estimates of the reaction of the primary
surplus to debt levels and concludes that a positive reaction of the former to the latter is
rather ubiquitous both across countries and over time. This section also presents evidence
of a series of structural breaks in such a response, which can be associated to the adoption
of the Maastricht Treaty and the convergence criteria after 1992, to the launching of the
euro after 1995, and to the adoption of the euro after 1999. Moreover, a positive response
of the primary surplus to debt levels is robust with respect to alternative specifications
and estimation methods. Comparing the posterior distributions generated by the pre-
Maastricht, Maastricht and EMU sub-sample periods, Section 2.5 considers Bayesian-
modelling as a systematic endogenous mechanism to explore potential structural breaks
in the response of the primary surplus to debt levels. Section 2.6 concludes the chapter.
2.2 How to Assess the Sustainability of Fiscal Policy
Definition of Sustainability
In line with standard practice in dynamic optimization models, we term fiscal policy as
sustainable when government debt issuing policy does not use Ponzi financing schemes,
i.e. financing strategies consisting in rolling over a given initial level of debt that would
never be repaid. The absence of Ponzi schemes in debt policy is a general equilibrium
condition required by rational private sector agents in order to be willing to lend to the
government. A no-Ponzi scheme condition guarantees that the government intertemporal
budget constraint (IBC) is satisfied, so that its outstanding debt is backed by future
primary surpluses.
Formally, a no-Ponzi scheme condition takes the form of a transversality condition (TC)
whereby the discounted value of debt issued infinitely far in the future is zero. In
stochastic economies, IBCs and TCs take the algebraic form of expectations of products
of the discount factor and the components of the government budget equation. As we
discuss below, this fact turns out to be relevant to distinguish between existing
approaches in the literature to assess the sustainability of fiscal policy.
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