Pushing the Limit? Fiscal Policy in the European Monetary Union

Governments are facing increasing scrutiny over debt and deficits following the worldwide recession and financial crisis which began in 2007. Additionally, policy makers are confronted with the growing realization that they face fiscal limits on the size of debt and deficits relative to GDP. These fiscal limits invalidate Bohn's criterion for fiscal sustainability since it allows explosive debt relative to GDP, eventually violating any fiscal limit. The purpose of this paper is to derive restrictions on a fiscal rule, necessary for the government to eliminate explosive behavior. We show that the restrictions require that the response of the primary surplus to debt be relatively strong. Additionally, since fiscal limits rule out explosive behavior, they imply cointegration between debt and the primary surplus, and between the primary surplus and output. We test these two empirical implications for a panel of eleven EMU countries, and find that fiscal policy is responsible, in the sense that governments rule out explosive behavior.