Assessing Fiscal-Policy Sustainability: On the Different States of the Debt-to-GDP Process

This paper assesses fiscal-policy sustainability. A sufficient condition for this is that public debt is on a stationary trajectory. This is tested by means of a very general Markov-switching augmented Dickey-Fuller (MS-ADF) model, which expands and improves simpler existing models of this type, and produces more reliable results than conventional state-invariant unit-root tests. Long data series (in some cases with more than 200 observations) on the debt-to-GDP ratio are analyzed for 16 countries. Empirical results indicate that Finland, Norway, Sweden, Switzerland, and the UK have sustainable fiscal policies. Greece and Japan have unsustainable fiscal policies, which could lead to debt default unless appropriate measures are taken. The remaining countries are characterized as having uncertain debt policies, which governments could take as a warning to try to better balance their budgets. The results are found to be robust to variations in the specific time period investigated and the number of states used.