Discussion

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 sufficient 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 characterized 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 per cent over the sample period, fails to pass the solvency test in Section 2.4.