Why Fiscal Regimes Matter for Fiscal Sustainability

Abstract

This paper introduces a Regime-Switching Model-Based Sustainability test allowing for periodic (or local) violations of Bohn (1998, QJE)’s sustainability condition. We assume a Markov-switching fiscal policy rule whose parameters stochastically switch between sustainable and unsustainable regimes. We demonstrate that long-run (or global) fiscal sustainability not only depends on regime-specific feedback coefficients of the fiscal policy rule but also on the average durations of fiscal regimes. Evidence on French data suggests that both the No-Ponzi Game condition and the Debt-stabilizing condition hold in the long run, when accounting for fiscal regimes, contrary to standard MBS tests. Drawing on former evidence about the characteristics of monetary policy in France, we discuss about the proper specification of the monetary-fiscal policy mix since 1965.