Considering the major impact of the global economic and financial crisis on the fiscal accounts of the main advanced economies, and their widely differing policy responses, how confident should we be that each of these countries remains fiscally prudent? And, more generally, should we think of a country's degree of fiscal prudence as constant throughout its history, or are there identifiable times of fiscal profligacy even for countries that eventually rectified their behaviour and never defaulted?
The terms ‘fiscal prudence’ and ‘fiscal profligacy’ are often used, somewhat loosely, to denote whether fiscal policies tend to lead to a sustainable or unsustainable fiscal position. In more academic terms, this relates to whether the government’s intertemporal budget constraint is met – that is, whether the expected present discounted value of all future fiscal surpluses matches the existing stock of public debt.
Keeping an eye on prudence
Although a precise definition of prudence or profligacy has not been established, policymakers, investors, and voters need to take a view all the time, in real time, on whether a country’s fiscal policies are appropriate to support economic growth and achieve other social objectives without causing a fiscal crisis. The focus is on the fiscal stance within the control of the government – usually proxied by the primary fiscal balance (i.e. the fiscal balance net of interest payments). Policymakers often rely on comparisons of the actual primary fiscal balance with the primary surplus that would be needed to stabilise the government debt-to-GDP ratio by a certain date, under assumptions about the differential between the cost of borrowing and the rate of economic growth. But the horizon over which the comparison should be made remains vague.
In practice, prudence and profligacy are probably medium-term concepts. Neither prudence nor profligacy is built up overnight: one or even a few years of expansionary fiscal policies do not necessarily cause a fiscal crisis, if a government’s initial position is sufficiently strong. Conversely, one cannot expect that, in real life, people will wait until infinity to check whether the intertemporal budget constraint is met: a few years of sustained deficits could well suggest that the intertemporal budget constraint is at risk. Thus, judgements regarding whether prudence or profligacy prevails are necessarily made over the course of a few years.
In the academic literature, the ‘state of the art’ is probably the work by Henning Bohn (1998, 2008), whose sustainability criterion is based upon a time-series regression of the primary fiscal surplus on the public debt and other controls. The intuition is simple: for debt to be sustainable, the primary fiscal balance must improve sufficiently in response to increases in the debt-to-GDP ratio.
Thus far, empirical application of Bohn's test has been constrained by data limitations. Bohn’s own work analysed long-run historical time-series data for the US. Mendoza and Ostry (2008) analysed panel data for a sample of emerging markets and advanced economies over the period 1990-2005, but the relatively short time period for which data were available required constraining the estimated fiscal-policy response coefficient to be the same across the advanced economies and across the emerging markets.
In recent work (Mauro et al. 2013), we collected a new historical dataset of fiscal variables for a large panel of countries – to our knowledge, the most comprehensive database currently available – to gauge the degree of fiscal prudence or profligacy for each country over the past several decades. Specifically, our dataset consists of fiscal revenues, primary expenditures, the interest bill (and thus both the primary and the overall fiscal deficit), the government debt, and gross domestic product, for 55 countries for up to 200 years. For the first time, a large cross-country historical data set covers both fiscal stocks and flows.
Our data collection effort makes it possible to run simple tests, such as the "policymakers' criterion" comparing the actual with the needed primary balance, or more sophisticated ones, such as Bohn's test, for a large number of individual countries over long periods. In fact, the richness of our data set makes it possible to relax Bohn’s assumption of a constant long term fiscal policy response. Specifically, for each country, we employ three variations of the standard Bohn regression, including structural break tests, recursive searches for particularly influential observations, and iterations of the standard regression over rolling subsamples. By algorithmically combining these criteria, we provide a gauge of the degree of fiscal prudence or profligacy for each country at various points in time.
- For most advanced countries, particularly prior to the global economic and financial crisis that began in 2008, we find evidence that the response of the primary fiscal surplus to variation in government debt is consistent with meeting the intertemporal budget constraint, as well as stationarity of the debt;
- Nevertheless, the evidence suggests that a given country’s fiscal policy response to changes in debt is by no means constant throughout its history (a working assumption that previous studies had made owing to data limitations); on the contrary, we document significant variation in such response, not only across countries, but also over time within a given country;
Periods of a few or more years are distinguishable as clearly ‘prudent’ or ‘profligate’, often with all techniques giving consistent messages. Indeed, one of the paper’s contributions is to document how individual countries fare with respect to fiscal prudence and profligacy, using each of the methods outlined above. Individual country results are reported in detail in the working paper’s tables and charts, with further information in the accompanying ‘Chartbook’.
- The results suggest widespread fiscal prudence in most advanced economies during the first era of global finance (pre-WWI), and the mid-1990s until at least the mid-2000s. Conversely, departures from prudence were frequent among the advanced economies in the mid-1970s. For the emerging economies, prudence becomes more widespread after the year 2000, after adjustment that followed the wave of defaults of the 1980s.
- Strong prudence is evident in the US in the late 1990s (recalling contemporary discussion of a possible disappearance of the public debt); in Canada since the mid-1990s (beginning with an ambitious and successful fiscal adjustment plan); in several Eurozone countries during the mid-1990s (coinciding with the Maastricht euro-entry process); in Ireland in the late 1980s and early 1990s (a well known fiscal-adjustment episode); in Japan in the mid-1980s to early 1990s (as it sought to stabilise the debt); and in Turkey in the mid-1990s and at several points in the 2000s (as it improved its primary balance significantly).
Notable episodes of fiscal stimulus are also evident, including the US in 2009-11 and Spain in 2010. And Japan is found not to sufficiently improve its primary balance despite rising debts for several years starting in the late 1990s.
- Finally, we began the search for the root causes of changes in prudence and profligacy; we found that a stronger response of the primary fiscal balance to changes in government debt is significantly associated with changes in long-run real-GDP growth rates and long-term sovereign borrowing costs (measured by secondary market-interest rates on long-term government debt).
Declines in ‘potential’ (or long-run) economic growth may not be fully apparent in real time to contemporary policymakers, who therefore often fail to respond to such declines through sufficient improvements in the primary balance. Conversely, increases in the cost of sovereign borrowing prompt policymakers to tighten fiscal policy in response.
Putting all this together for how we view countries' present fiscal policies in a historical context, we conclude that:
- The global financial crisis that began in the late 2000s posed challenges of a scale that was unprecedented in peace times;
- Policy responses in some cases signaled increased prudence, in others profligacy;
- These differing responses were likely shaped by differences in market conditions and sovereign borrowing costs;
- How these responses are eventually assessed will largely depend on whether the slowdown in economic growth proves long-lasting or long-run economic growth returns to pre-crisis levels.
Bohn, Henning (1998), “The Behavior of US Public Debt and Deficits”, Quarterly Journal of Economics, August, 113(3), 949–963.
Bohn, Henning (2008), “The Sustainability of Fiscal Policy in the US”, in Reinhard Neck and Jan-Egbert Sturm (eds.), Sustainability of Public Debt, MIT Press, Cambridge MA, 15–49.
Mauro, Paolo, Rafael Romeu, Ari Binder, Asad Zaman (2013), “A Modern History of Fiscal Prudence and Profligacy”, IMF Working Paper No. 13/5; video summary available at http://www.youtube.com/watch?v=fNcUMo8GsRE.
Mendoza, Enrique G and Jonathan D Ostry (2008), “International evidence on fiscal solvency: Is fiscal policy ‘responsible’?”, Journal of Monetary Economics, 55(6), September, 1081–1093.