Discussion
Fabrizio Balassone
Chapter 2 estimates fiscal reaction functions for EU member countries over 1977-2005 to
assess the sustainability of fiscal policy. Specifically, the chapter tests the consistency of
fiscal policy with solvency as defined by the “no-Ponzi game” condition. The authors find
that a necessary condition for solvency — i.e. that the primary balance improve in
response to an increase in the debt-to-GDP ratio — is met in most countries (the more so
after Maastricht). From this they derive strong policy implications. They argue that “if the
concern is government solvency [debt ceilings] impose unnecessary constraint on fiscal
policy” and “if sustainability is the issue, there is no clear reason for concern [in the
EU]”.
The chapter clearly defines the analytical issues. The econometric analysis is accurate.
The results appear to be robust. However, some caution is warranted in deriving the
policy implications.
The no-Ponzi game condition is a weak requirement. It requires that the debt-to-GDP
ratio grows at a rate lower than the difference between the interest rate and the growth
rate (McCallum, 1984). It is consistent with an ever growing debt ratio, a situation that
most analysts would not regard as sustainable.
Moreover, while the chapter finds that the response of the primary balance to the debt
ratio was positive in most EU countries over 1977-2005, this does not allow a
straightforward extrapolation of this behaviour in the future. A growing debt ratio calls
for a growing primary surplus, but what is the maximum sustainable primary surplus?
Whether a given fiscal policy is or is not sustainable ultimately depends on its effects on
macro parameters such as the rate of interest and the rate of growth. “[T]he issue [...] is
how interest service will affect the economy” (Musgrave and Musgrave, 1984, p. 689),
and “the problem of the debt burden is a problem of an expanding national income...”
(Domar, 1944, p. 166).
Policy implications aside, the reading of econometric results in the chapter would benefit
from further discussion of some issues. For instance, those concerning the “power” of the
tests conducted in the chapter, and the role of the cyclicality of fiscal policy in
determining debt dynamics.
The solvency test conducted in the chapter cannot identify policies that are inconsistent
with solvency. A positive response of the primary balance to the debt ratio is a sufficient
condition for solvency, but it is not necessary. A policy characterised by a negligible or
even negative response of the primary balance to the debt ratio could still be consistent
with solvency (and sustainability). This may explain, for instance, why a country like
Finland, whose debt-to-GDP ratio has never exceeded 57 percent over the sample period
fails to pass the solvency test in Section 2.4.
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