Bubble finance and debt sustainability: a test of the government's intertemporal budget constraint

Abstract

This paper tests whether the government's budget is intertemporally balanced in a number of EC countries by applying a method first developed to detect speculative bubbles in financial markets. The test aims to establish whether the government can engage in buble finance, and is based on a comparison between two sets of estimates. The first is obtained directly by regressing the stock of outstanding debt on a distributed lag of the primary surplus. The second is obtained indirectly from a pair of equations, one relating the current debt stock to next period's primary surplus and debt stock, the other specifying an AR process for the primary surplus. In the presence of a bubble, only the first set of estimates is inconsistent, and hence the two sets differ. It is found that the null of no bubble can be rejected in the cases of Italy, Germany, Denmark and Greece implying that the government is not intertemporally solvent in these countries. The other EC member states appear to be on a sustainable path.