Euro area time‐varying fiscal sustainability

• Author: João Tovar Jalles,António Afonso
• Published date: 01 July 2017
• Date: 01 July 2017
• DOI: http://doi.org/10.1002/ijfe.1582

RESEARCH ARTICLE

Euro area time‐varying fiscal sustainability*

António Afonso

1

| João Tovar Jalles

1,2

1

UECE—Research Unit on Complexity and

Economics. UECE is supported by FCT

(Fundação para a Ciência e a Tecnologia,

Portugal), ISEG/UL—University of Lisbon,

Lisbon, Portugal

2

Center for Globalization and Governance,

Nova School of Business and Economics,

Campus de Campolide, 1099‐032 Lisbon,

Portugal

Correspondence

João Tovar Jalles, UECE—Research Unit on

Complexity and Economics. UECE is

supported by FCT (Fundação para a Ciência

e a Tecnologia, Portugal), Center for

Globalization and Governance, Nova School

of Business and Economics Campus de

Campolide, 1099‐032, Lisbon, Portugal.

Email: joaojalles@gmail.com

JEL Classification: E62; H62; O52

Abstract

We assess the time‐varying features of fiscal sustainability in the euro area via

revisiting the empirical relationship between the primary budget sur plus and the

debt‐to‐GDP ratio. Focusing on a sample of 11 Euro‐area countries between

1999Q1 and 2013Q4 and by means of time series analyses, we find that (a) fiscal

policy seems to have been sustainable in Belgium, France, Germany, and the

Netherlands and a Ricardian (monetary dominant) regime might have been present;

(b) debt exhibited a negative response following an innovation in the budget surplus

in half of the sample; (c) the time‐varying coefficient model shows that the 2008–

2009 global economic and financial crisis exerted a sizeable negative impact on

fiscal sustainability; and (d) expenditure‐based fiscal rules are strong determinants

of fiscal sustainability. All in all, we found some evidence against the Fiscal Theory

of the Price Level.

KEYWORDS

causality,fiscal rules, fiscal sustainability, impulse responsefunctions, logistic model, time‐varying

coefficients

1|INTRODUCTION

The relevance of fiscal developments for price behaviour and

inflation can be traced back to some rather recent work

linked to the so‐called Fiscal Theory of the Price Level

(FTPL), initially made popular by Leeper (1991), Sims

(1994), and Woodford (1994, 1995). On the other hand, this

discussion links further back to Sargent and Wallace (1975)

and to the controversy of using rules to control the nominal

interest rate, which may lead to price level indeterminacy. In

a nutshell, the main idea is that fiscal policy may have a

relevant role, at least as important as monetary policy, in

determining the price level.

Nevertheless, several authors argued against such theo-

retical possibility, notably McCallum (2001) and Buiter

(2002). In addition, most available empirical assessments,

provided by, for instance, Canzoneri, Cumby, and Diba

(2001), Cochrane (1998) and Woodford (1995), and

Afonso (2008), point to the lack of adherence to the idea

that price level may be determined via the intertemporal

government budget constraint, given that governments are

in fact quite Ricardian. Ghosh, Kim, Mendoza, Ostry,

and Qureshi (2013) use annual data for the period

1970–2007 to assess the impact of primar y surpluses on

debt ratios, reporting the existence of non‐linear behaviour.

Weichenrieder and Zimmer (2014) also assess the euro

area responsiveness of the primary balance to government

indebtedness. Therefore, the primary budget balance reacts

to government debt to ensure fiscal solvency, implying the

existence of an active monetary policy and a passive fiscal

policy.

In this paper, we perform a systematic analysis of the rela-

tionship between the primary surplus and the debt‐to‐GDP

ratio for a sample of 11 Euro area countries using quarterly

data between 1999Q1 and 2013Q4. The fact that a part of

*

We thank twoanonymous referees and participants at the 5th UECE Confer-

ence on Economic and Financial Adjustments, 2016, for very useful com-

ments. The opinions expressed herein are those of the authors and do not

necessarily reflect those of the authors' employers.

Received: 18 November 2015 Revised: 31 March 2017 Accepted: 20 June 2017

DOI: 10.1002/ijfe.1582

244 Copyright © 2017 John Wiley & Sons, Ltd. Int J Fin Econ. 2017;22:244–254.wileyonlinelibrary.com/journal/ijfe