The Global Dimension to Fiscal Sustainability

The results from Table 8 reveal important similarities and differences between
emerging market and industrial countries. Models overall seem well specified since
we have no evidence of second order autocorrelation and the Sargan Test statistic for
the appropriateness of the instruments is passed. There is an important role for debt in
both industrial countries since they are both significant. We also identify an important
role for interest expenditure in both countries, with again both significant. This
suggests that both groups of countries respond to debt sustainablity issues. However,
there are important differences in terms of responses to temporary fluctuations in
output and primary government spending. Industrial countries can combine a concern
with debt sustainability with being able to smooth the business cycle¹⁶ (i.e. the
estimated coefficient on government spending is positive indicating industrial
countries ability to go into debt when there is a downturn in output) and they also
respond optimally to temporary increase in government spending by not adjusting tax
rates but by running fiscal deficits. On the other hand emerging market economies do
not appear to be able to run deficits when there are downturns in the economy, nor are
they able to run deficits when there are temporary increases in government spending,
consistent with neoclassical tax smoothing since both these variables are insignificant
and have a smaller estimated coefficient.¹⁷ Our contention is that this is consistent
with the difficulties that emerging market economies have in issuing debt. These
countries pursue fiscal policies focused on debt sustainability which leaves them little
opportunity to pursue the welfare enhancing fiscal policies adopted in industrial
countries. The significance of the interest expenditure variables is also consistent with

¹⁶ See also Méltiz (2000) for evidence that industrial countries pursue countercyclical fiscal policy.

¹⁷ It is interesting to note that Mendoza and Ostry (2007) find little difference between industrial
countries and emerging markets in terms of the statistical significance of temporary output and
government spending, although the size of the effect is greatly reduced for emerging market
economies. Our GMM estimator which is robust to potential endogeneity in this case may explain the
difference in results.

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