Debt Sustainability in Selected Euro Area Countries: Empirical Evidence

The severe economic downturn and the recent crisis with large deficits and increasing public debt have revived discussions and research concerning international public finances both, from the economic and political point of view as they are important factors affecting the budget plan of a government. Especially for members of the European Monetary Union this represents a serious problem since these countries have to stick to the Convergence Criteria of the Maastricht Treaty of the European Union and to the Stability and Growth Pact that imposes limitations with respect to fiscal policies. An important aspect in this context is the question of whether governments are able to respond in a sustainable way to the above mentioned tendency of persistent budget deficits and growing levels of debt. Here, it is important to recall that the concept of sustainability is well compatible with indebtedness in the short run but it requires that the present value of debt converges to zero asymptotically. This raises the question of how governments react to higher debt levels, which options they have to respond and if these actions are still effective. In the economics literature several approaches can be found to test for sustainability of public debt. In this paper, we resort to the approach by Bohn (1998) that has received great attention in economics. There, it is tested how the primary surplus relative to GDP reacts to variations in public debt relative to GDP. If this response of the primary surplus to public debt is positive and statistically significant a given fiscal policy can be shown to satisfy the inter-temporal budget constraint of the government. This test has a nice economic intuition: If a government runs into debt today it has to run primary surpluses in the future so that its fiscal policy remains sustainable. In our empirical analysis we test the response of the primary surplus to changes in public debt. In contrast to other contributions, which oftentimes use OLS estimation technique as for example in Greiner et al. (2007), we use a time varying coefficient giving the reaction of the primary surplus to GDP ratio to variations in the debt ratio. This methodology not only enables a more flexible estimation but also allows for interpretation on the government’s emphasis in public debt policy and how this has (possibly) changed over time. The countries we consider in our study are France, Germany, Greece, Ireland, Italy, Portugal and Spain. France, Germany and Italy are included because they are the largest economies in the euro area. We also include Greece, Ireland, Portugal and Spain because they belong to the so-called PIIGS countries that have been characterized by large deficits and debt to GDP ratios recently which have raised questions about sustainability of their debt policies respectively. Greece had even to be backed by other euro area member countries and by the IMF in order to not go bankrupt in early 2010.