In the last few years, Germany has been continuously violating the 3% deficit criterion of the Maastricht treaty, leading to a debt-GDP ratio of more than 65% in 2005. Italy could considerably reduce its deficits in the mid and late 1990s leading to a decline in its debt ratio. Nevertheless, the debt ratio still clearly exceeds 100% due to the excessive deficits in previous periods making it the largest debt ratio of the Euro-area countries. Further, most recently Italy again shows deficits exceeding 3% of GDP.
In the debate about deficit and debt ratios in countries of the Euro-area it has been argued that fiscal policy has been threatened to become unsustainable. Thus, a crucial issue about debt and deficits is the sustainability of public debt policy. Empirical studies which help to clarify whether governments pursue sustainable debt policies are indeed desirable and help to answer the question of whether policy makers adequately react to rising debt ratios.
For the United States a great many empirical studies exist beginning with the contribution by Hamilton and Flavin (1986). In their analysis they propose a framework for studying whether governments fulfill the intertemporal budget constraint and apply the tests to the United States for the time period from 1960-1984. Other papers followed which also investigated this issue for the United States, some of them confirming Hamilton and Flavin’s result while others reached different conclusions (see e.g. Kremers, 1988, Wilcox, 1989, or Trehan and Walsh, 1991). For European countries, Afonso (2005) gives a good survey of the studies about sustainability using time series methods.
However, these tests have been criticized by Bohn (1995, 1998) because they make assumptions about future states of nature that are difficult to estimate from a single set of observed time series data. In a recent paper Bohn (1998) proposes a new test where he suggests to empirically test whether the primary surplus to GDP ratio rises at least linearly with increases in the debt ratio. If the latter holds the intertemporal budget constraint of the government is fulfilled and public debt is sustainable.
In this paper we apply the test proposed by Bohn to Germany and Italy, the largest and third largest country in the Euro-area, which have recently been characterized by large deficit and debt ratios as outlined above. Greiner et al. (2004) and Ballabriga and Marinez-Mongay (2005) have performed OLS estimations which study how the primary surplus to GDP ratio reacts to the debt ratio in some countries of the Euro-area. In Greiner et al. (2004a) evidence was found suggesting that the reaction of the primary surplus to variations in the debt ratio in Germany has not been constant over time. In this contribution, we extend these papers both from a theoretical as well as empirical point of view. So, we first derive necessary and sufficient conditions for a sustainable debt path assuming that the debt accumulation process is described by a stochastic differential equation. In a next step, we empirically test whether those conditions are satisfied for Germany and Italy by applying more sophisticated statistical methods.
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Debt policy in Euro-area countries: Evidence for Germany and Italy using penalized spline smoothing
