Fiscal Fatigue, Fiscal Space and Debt Sustainability in Advanced Economies

Abstract

How high can public debt rise without compromising fiscal solvency? We answer this question using a stochastic model of sovereign default in which risk-neutral investors lend to a government that displays 'fiscal fatigue', whereby its ability to increase primary balances cannot keep pace with rising debt. As a result, the government faces an endogenous debt limit beyond which debt cannot be rolled over. Using data for 23 advanced economies over the period 1970-2007, we find evidence of a fiscal reaction function with these features, and use it to compute 'fiscal space', defined as the difference between current debt ratios and the estimated debt limits.

Fiscal Policy Reaction Function and Sustainability of Fiscal Policy in Ukraine

“…Unlike Abiad and Ostry (2005), but in-line with Bohn (2005), our findings suggest fiscal policy strengthens in response to debt. The identified nonlinear effects are consistent with the so-called "fiscal fatigue" described by Ghosh et al (2013). This implies that fiscal policy switches to an unsustainable regime at low and high levels of public debt, when the government becomes incapable of reducing the budget deficit and does not respond to growing debt after a certain threshold.…”

“…In addition, if the economic growth is accompanied by a decrease in debt levels, the debt becomes problematic for a government that pays little attention to it. Switching over fiscal policy in an active regime with a high debt ratio corresponds to the "fiscal fatigue" phenomenon described in Ghosh et al (2013). It can be explained by the fact that after a certain threshold, the government is no longer able to reduce the budget deficit and no longer responds to high debt levels.…”

“…The work of Ghosh et al (2013) serves as evidence for the possibility of the existence of this type of nonlinearity in fiscal policy. The authors, while using a cubic regression empirically, show that fiscal policy becomes less responsive to debt at extremely low and high debt levels, but reacts to increasing debt at moderate debt levels.…”

“…In contrast to existing literature, they did not find that the responsiveness to debt increases when debt exceeds threshold levels in panel regressions for advanced countries, but it does diminish for emerging market countries. Ghosh et al (2013) examined the phenomenon of "fiscal fatigue", referring to the switching of fiscal policy in an unsustainable regime in response to a high debt ratio. In the sample of developed countries, the authors empirically proved the existence of "fiscal fatigue" by constructing a cubic FRFP.…”

Is There a Debt-threshold Effect on Output Growth?

“…They …nd that these di¤erentials peak when debt-to-GDP ratio is around 90-100%. Krugman (1988) and Ghosh et al (2013) also consider possible threshold e¤ects in the relationship between external debt and output growth, which is known as debt overhang. However, these results are based on strong homogeneity restrictions, zero feedback e¤ects from GDP growth to debt, no dynamics, and independence of cross-country errors terms.…”