A Retrospective Approach on Government Response to Increasing Public Debt: Empirical Evidence for European Countries

Many researchers have been focused for decades on the issue of public debt considering its effect on fiscal sustainability in the long run. There is a recent body of research showing that the current financial crises will lead to a considerable increase of public debt in a number of advanced economies. Many European countries have confronted with large and increasing public debt stocks that overrated GDP. Considering that, the question on how government should address this problem arises. Theoretically speaking, governments should increase/decrease primary surplus/deficit, and the response should be immediate. The aim of this paper is to investigate government’s reaction to increasing public debt for European Union countries. Fiscal reaction function is employed on annual data spanned mostly on 1980.2012. Empirical evidence shows various results. In the case of Germany fiscal policy is pro-cyclical, but the results reveal no significant reaction of government to changes in public debt. For Belgium and Denmark the test shows a long run relationship between cyclically adjusted primary balance and public debt and error correction term indicates the existence of adjustment mechanism in the short term for assessing primary surplus. In the cases of Spain and France the response is opposite as expected and parameters point out on difficulties in achieving a cointegrated relation. For Greece and Italy test rejects any cointegration relationship and the use of fiscal rule reveals that government has difficulties in generating primary surplus. This conclusion is also valid in the case of Portugal and the UK. In the cases of Sweden and Ireland government has the ability to generate primary surplus larger than the required one that stabilizes public debt.