Fiscal Policy and Sovereign Debt Dynamics: (Re-)Assessing the Intertemporal Viability of the Government Budget Using a Model-Based and Consistently Measured Sustainability Indicator

Fiscal deficits and public debt have risen sharply in response to the global financial crisis, the pandemic shock, and the Russia–Ukraine war, bringing up the issue of fiscal consolidation. There is, however, considerable uncertainty about the policy mix and timing of such budgetary adjustment, and this can have a harmful impact on economic activity. Reducing this source of uncertainty calls for a reliable indicator—theoretically grounded and internally consistent—measuring the fiscal adjustment needed to warrant the long-run sustainability of the government budget. In this chapter, we show, in the context of an endogenous growth model, that forward-looking agents’ optimizing behavior typically gives rise to a wealth-based and not to an output-based sustainability index of government policy. Calibrating the new index from 2001 to 2018 for 15 European countries along with the U.S. and Japan as reference countries gives results that are very different from common wisdom and makes explicit that tests of debt sustainability based on the debt-to-GDP ratio are strongly biased and misleading and may conduct to wrong and perverse policy strategies. This may contribute to explain the recent pickup in policy-induced uncertainty and the observed adverse effects on economic activity and growth perspective.