13/10/2012: ECB study on fiscal (non)sustainability in OECD 1970-2010

An interesting study (ECB Working paper NO 1465 / AUGUST 2012) titled "REVISITING FISCAL SUSTAINABILITY: PANEL COINTEGRATION AND STRUCTURAL BREAKS IN OECD COUNTRIES" by António Afonso and João Tovar Jalles (link http://ssrn.com/abstract_id=2128484 ) attempts to identify if "fiscal imbalances in a number of OECD countries need to be curtailed before they become economically unsustainable, leading to insolvency situations". The study covered 18 OECD countries over the 1970-2010 period. Italics are mine, throughout.

Per authors: "In our empirical approach we perform a systematic analysis of the stationarity properties of the first-differenced stock of government debt as well as, on the one hand, the relation between government revenues and expenditures and, on the other hand, the relation between primary balances and debt. These approaches provide us with an indirect test on the solvency of public finances in these countries. We conduct this analysis on a country-by-country basis, …as well as for the country panel as a whole."

The study results show that "the first-differenced debt series for most countries is non-stationarity suggesting that the solvency condition would not be satisfied".

In addition, the authors find "the existence of one cointegrating relationship in only 6 countries between revenues and expenditures. However, the overall test results allow the rejection of the cointegration hypothesis in both relationships under scrutiny. In other words, government expenditures, in half of the countries, exhibited a higher growth rate than government revenues, challenging therefore the hypothesis of fiscal sustainability."

"... the cointegrating coefficients for the revenues-expenditures relationship are positive (but less than one) and statistically significant, meaning that for each percentage point of GDP increase in public expenditures, revenues increase by less than one percentage point of GDP."

In terms of causality, the study finds "...stronger effects running from revenues to expenditures and most countries are not able to generate the revenues required to finance the planned expenditures. We find Granger-causality from government debt to the primary balance, which can be seen as evidence of the existence of a Ricardian regime."

Finally, "panel data results corroborate time-series findings, and even though we find that long-run causality seems to run from lagged debt to the primary balance, on average the marginal long-run impact is zero."

Core conclusion: "All in all, we cannot say that fiscal policy has been sustainable for most countries in our sample."

In effect, there has been systemic, long term overspending by the states incapable of backing expenditure hikes with revenues. Living beyond their means is a long-term thing in the sample and is a prevalent modus operandi for the majority of the states over the period of 40 years.