A new framework for detecting the short term fiscal vulnerability for the European Union countries

Stoian, Andreea and Obreja Brasoveanu, Laura and Dumitrescu, Bogdan and Brasoveanu, Iulian (2015): A new framework for detecting the short term fiscal vulnerability for the European Union countries.

Abstract

The aim of this study is to develop a new framework (V-L-D) for detecting the short term vulnerabilities in fiscal policy for the European Union countries. The methodology relies ontwo distinct indicators: one showing the vulnerabilities signalled by the size of the cyclically adjusted budget and public debtand one indicatingthe vulnerabilities through their annual changes.V-L-D is able to categorize fiscal vulnerability into five distinct classes having scores from 0 (no fiscal vulnerability) to 4 (extreme fiscal vulnerability). From 1990-2013, we found310 episodes of fiscal vulnerability for the 28 European Union countries out of which 128 episodes of low vulnerability, 94 of moderate, 62 of strong and 26 of extreme fiscal vulnerability. We also explored the correlation between financial market sentiment and fiscal vulnerability. We used V-L-D as a predictor and Credit Default Swaps (CDS)as dependent and proxy for the market sentiment in a balanced panel model consisting in 17 European countries with random effects over the period 2008-2013. The results indicatethat CDS are higher and significant for strong and extreme vulnerability periodscompared with times having zero vulnerability. The CDS for low and moderate fiscal vulnerabilityare also higher but they are not significant, suggesting that investorsoverprice the risk randomly during low and moderate vulnerability.Employing a logit model for a panel consisting of 12 European countries over 2008-2013, we also found that governments are less likely to adjust fiscal policy when it is strong or extremely vulnerable and that the probability of fiscal consolidation increaseswhen market sentiment is negative and CDS are higher.

• Item Type: MPRA Paper
• Language: English
• Keywords: fiscal policy, budgetary deficit, fiscal sustainability, primary balance, debt dynamics, European Union
• Subjects: E - Macroeconomics and Monetary Economics > E6 - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook > E62 - Fiscal Policy; H - Public Economics > H1 - Structure and Scope of Government > H12 - Crisis Management; H - Public Economics > H6 - National Budget, Deficit, and Debt

References

Adema, W.; Fron, P.; Ladaique, M. (2011), ‘Is the European Welfare State Really More Expensive?: Indicators on Social Spending, 1980-2012; and a Manual to the OECD Social Expenditure Database (SOCX)’, OECD Social, Employment and Migration Working Papers, No.124, OECD Publication.

Afonso, A.; Agnello, L.; Furceri, D.; Sousa, R. (2009), ‘Assessing Long Term Fiscal Developments: A New Approach’, European Central Bank, Working Paper Series No.1032/March 2009.

Afonso, R; Rault, C. (2007), ‘What Do We Really Know About Fiscal Sustainability in the EU? A Panel Diagnostic’, European Central Bank, Working Paper Series No.820/October 2007.

Afonso, A. (2000), ‘Fiscal Policy Sustainability: Some Unpleasant European Evidence’, ISEG Working Paper No.12/2000/DE/CISEP, August 2000.

Aizenman, J.; Pasricha, G. (2010), ‘Fiscal fragility: what the past say about the future’, NBER Working Paper No.16478, October 2010.

Alesina, A.; Ardagna, S.; Trebbi, F. (2006), ‘Who Adjusts and When? The Political Economy of Reforms’, IMF Staff Papers, Vol. 53, Special Issue.

Alesina, A.; Ardagna, S. (1998), ‘Tales of Fiscal Adjustment’, Economic Policy 13(27), pp.489-585.

Allen, M.; Rosenberg, C.; Keller, C.; Setser, B.; Roubini, N. (2002), ‘A Balance Sheet Approach to Financial Crisis’, IMF Working Paper WP/02/210.

Baldacci, E.; McHugh, J; Petrova, I. (2011), ‘Measuring Fiscal Vulnerability and Fiscal Stress: A Proposed Set of Indicators’, IMF Working Paper WP/11/94.

Baldacci, E.; Petrova, I.; Belhocine, N.; Dobrescu, G.; Maazrani, S. (2011), ‚Assessing Fiscal Stress’, IMF Working Paper WP/11/100.

Berti, K.; Salto, M.; Lequien, M. (2012), ‘An early-detection index of fiscal stress for EU countries’, European Commission, Economic Papers 475/December 2012.

BlackRock Investment Institute (2011), ‘Introducing the BlackRock Sovereign Risk Index. A More Comprehensive View of Credit Quality’, BlackRock Investment Institute, June 2011.

Bouthevillain, C.; Quinet, A. (1999), ‘The Relevance of Cyclically - Adjusted Public Balance Indicators – The French Case in Indicators of Structural Balance, Bancad’Italia.

Brixi, P.; Shatalov, S.; Zlaoui, L. (2000), ‘Managing Fiscal Risk in Bulgaria’, Policy Research Working Paper 2282, January 2000, The World Bank.

Bruglio, L.; Cordina, G.; Farrugia, N.; Vella, S. (2008), ‘Economic Vulnerability and Resilience. Concepts and Measurements’, UNU-WIDER Research Paper No. 2008/55, May 2008.

Buiter WH (2004 revised), ‘Fiscal Sustainability’, paper presented at The Egyptian Center for Economic Studies, October 2003

Claeys, P. (2007). ‘Sustainability of EU fiscal policies: A panel test’, Institut de Recerca en EconomiaAplicada2007, Documents de Treball 2007/02.

Corsetti, G.; Roubini, N. (1996), ‘European versus American Perspectives on Balanced Budget-Rules’, The American Economic Review, 2 pp. 408-413.

Corsetti, G., Roubini, N. (1991), ‘Fiscal Deficits, Public Debt, and Government Solvency: Evidence from OECD Countries’, NBER Working Paper No.3658.

Cottarelli, C. (2011), ‘The Risk Octogon: A Comprehensive Framework for Assessing Sovereign Risks’, paper presented at seminar held at the Sapienza University (Rome, January 25, 2011) and Politeia (London, January 26, 2011)

Daniel, J.; Davis, J.; Fouad, M.; Van Rijckeghem, C. (2006), ‘Fiscal Adjustments for Stability and Growth’, International Monetary Fund Pamphlet series no.55.

De Grauwe, P; Ji, Y. (2012), ‘Mispricing of Sovereign Risk and Macroeconomic Stability in the Eurozone’, Journal of Common Market Studies, Volume 50, Number 6, pp.866-880.

Detragiache, E.; Spilimbergo, A. (2001), ‘Crises and Liquidity: Evidence and Interpretation’, IMF Working Paper WP/01/2.

Fatas, A.; Mihov, I. (2009),‘The Euro and Fiscal Policy’,NBER Working Paper No.14722, February 2009.

Frankel, J.; Saravelos, G. (2010), ‘Are Leading Indicators of Financial Crisis Useful for Assessing Country Vulnerability? Evidence from 2008-09 Global Crisis’, NBER Working Paper No.16047, June 2010, pp2.

Furman, J.; Stiglitz, J. (1999), ‘Economic Crisis: Evidence and Insights from East Asia’, in Brookings Papers on Economic Activity, eds: Brainard, William and Perry Goerge, The Brookings Institution, 1999, pp.5-6.

Ghezzi, P., Keller, C., Wynne, J. (2010), ‘Our measure of fiscal vulnerability: a systematic global approach’, Barclays Capital Economic Research, September 10.

Greene, J.E. (2011), ‘Public Finance: An International Perspective’, World Scientific Publishing Company.

Greiner, A., Semmler, W. (1999), ‘An Inquiry into the Sustainability of German Fiscal Policy: Some Time-Series Tests’, Public Finance Review, Vol. 27 No. 2 (March 1999), p. 220-236.

Hayes, S. (2011), ‘Fiscal vulnerability: a stocktake’, The IFS Green Budget, February 2011.

Hemming, R.; Kell, M; Schimmelpfennig, A. (2003), ‚Fiscal Vulnerability and Financial Crisis in Emerging Market Economies’, Ocasional Paper 218, IMF, 2003.

Hemming, R.; Petrie, M. (2000), ‚A Framework for Assessing Fiscal Vulnerability’, IMF Working Paper WP/00/52.

Jedrzejowicz, T.; Kozinski, W. (2012), ‘A framework for fiscal vulnerability assessment and its application to Poland’, Bank for International Settlements, vol.67 (2012), pp.285-294.

Ghosh, A.; Kim, J.; Mendoza, E.; Ostry, J.; Qureshi, M. (2011), ‘Fiscal Fatigue, Fiscal Space and Debt Sustainability in Advanced Economies’, NBER Working Paper No.16782, February 2011.

Kotlikoff, L.; Hagist,C. (2005), ‘Who’s Going Broke? Comparing Growth in Healthcare Costs in Ten OECD Countries’, NBER Working Paper Series.

Leiner-Killinger, N. (2011), ‘Fiscal Vulnerabilities in the CESEE Countries: the Role of Fiscal Policy Structures and Budgetary Discipline’, Proceedings of OeNB Workshops No.17, pp.61-77.

Missale, A. (2012), ‚Sovereign debt management and fiscal vulnerabilities’, Bank for International Settlements, vol.65 (2012), pp.157-176.

Pisani-Ferry, J. (2012), ‘Should Europe Emulate the US?’,Project Syndicate, http://www.project-syndicate.org/commentary/why-america-s-economy-is-recovering-faster-than-europe-s-by-jean-pisani-ferry.

Reinhart, C.; Rogoff, K. (2011), ‘A Decade of Debt’, NBER Working Paper No.16827, February 2011.

Schaechter, A. et al (2012), ‘A Toolkit to Assessing the Fiscal Vulnerabilities and Risks in the Advanced Economies’, IMF Working Paper WP/12/11.

Stiglitz, J. E. (2012). Monetary Mystification, Project Syndicate, http://www.project-syndicate.org/commentary/quantitative-easing-3--qe3--and-the-problems-of-the-fed-and-ecb-s-expansionary-monetary-policy-by-joseph-e--stiglitz.

Stoian, A., Iorgulescu, F. (2014), ‘Some Stylized Facts on Public Debt Dynamics in the Advanced and Emerging Economies of the European Union’, paper presented at 16th INFER Annual Conference, May 29th-31st May 2014, Pescara, Italy.

Wilcox, D. W. (1989), ‘The Sustainability of Government Deficits: Implications of the Present-Value Borrowing Constraints’, Journal of Money, Credit, and Banking, Vol.21,No.3 (Aug., 1989), pp.291-305.