Determinants of fiscal sustainability : establishing the role of economic fundamentals through a neo-classical growth modelling approach

Abstract

Fiscal rules aimed at instilling discipline to remove policy bias have in many cases failed at engendering fiscal sustainability. This is evident from the experiences of a number of countries within the European Union and elsewhere, over the past decade, culminating in what has been termed as the sovereign debt crisis. This policy failure coincides with notable lacunae in economic literature in providing an objective definition of ‘fiscal sustainability’ and a clear understanding of its determinants, particularly within the context of the functions of fiscal policy and the role played by economic fundamentals. This lack of conceptual framework results in assessments of fiscal sustainability which are often unduly biased towards the aggregate demand management perspective and reliant on targets and benchmarks with an insufficient basis for justification. To address these gaps, this thesis develops a model which embeds the net worth approach towards assessing fiscal financial performance within a Neo-Classical economic growth model. This enables an assessment of fiscal policy sustainability and optimality from the longer-term perspective of the allocative function of government intervention. The net worth component in the model provides the accounting relationships for the determination of fiscal sustainability through budget constraints. The economic growth model element enables the modelling of the allocation function of government within the context of an economic optimisation framework. Fiscal sustainability is on this basis defined in terms of the existence of a steady state equilibrium and of the growth dynamics enabling convergence towards it. The steady state dynamics of the model are studied through the use of phase diagrams, where the distinctions between ‘high and low productivity’ economies as well as economies featuring ‘structural surpluses or deficits’ are key factors for the assessment of fiscal sustainability. The dynamics of the economic model are presented for selected European economies, showing that results for sustainability are strongly determined by economic fundamentals. This leads to differences in the steady state values for assets, debt and consumption across countries, with consequent variations in the existence and values associated with sustainable positions. A key message derived from this work is that a sustainable debt-to-GDP ratio depends on a number of variables including ingrained government expenditure elements, productivity of assets, interest rates, depreciation of productive assets as well as the rate of time preference. This implies that a narrow focus on the deficit and debt ratios can provide a misguided assessment of fiscal sustainability. Furthermore, the sustainable debt ratio, if it exists, is not a static parameter but varies between countries and over time. Given the difference in the values of the exogenous parameters used in the model, it is also evident that there is no reason to assume that the application of any one target value which is independent of economic fundamentals can be justifiable, sustainable or optimal. The thesis also argues that the current fiscal governance structure adopted by the EU needs to be considered in light of the two extreme forms of superior fiscal governance, namely complete harmonisation and country-level optimisation. Through an extension of the conclusions derived from the economic model, a conceptual cost-benefit approach is presented, pitting the benefits obtained from lower interest rates against the cost of debt and asset reduction for a country forfeiting individual optimisation to participate in policy harmonisation. The analysis is extended through a case study approach, chiefly to assess points of convergence and differences in individual country assessments undertaken in the thesis as compared with Debt Sustainability Analyses carried out by the International Monetary Fund and the European Commission, and to identify the added value in the nature of results derived through the model as developed in this thesis. The conclusions confirm the importance of focusing on economic fundamentals, the relationship between medium term growth and the fiscal balance, and the level of productive assets needed to achieve steady state debt in order to derive rational conclusions regarding the sustainability of a country’s fiscal position. This indicates a potential need for reconsideration of the methodological approach used in mainstream Debt Sustainability Analyses. In conclusion, this thesis highlights the need for a subject as important as fiscal sustainability and the related policy implications to be firmly grounded in a rational, consistent and comprehensive theoretical framework rather than viewed through subjective and limited approaches. It is furthermore argued that the integration of a stock-flow accounting model within an economic growth modelling context founded on optimisation is a conceptual approach that can be usefully applied to other strands of economic research which focus on sustainability in general and on issues concerning the allocation function of fiscal policy in particular.