Early warning indicators for debt sustainability
Early warning indicator to assess debt sustainability
Having insight into the sustainability of public finances is essential to European policymakers and financial markets alike. The merit of the indicator is that it assesses the uncertainties around the future development of public finances. In this respect, it can be regarded as a first step towards a more in-depth risk analysis of government finances.
Applied to the current crisis, the indicator would have been able to distinguish, in advance, countries that were going to have sustainability problems in the medium term (Italy, Spain and Portugal) from those without such problems (the United States, the United Kingdom, the Netherlands and Belgium). The findings by CPB researchers Casper van Ewijk, Jasper Lukkezen and Hugo Rojas-Romagosa are published in the CPB Policy Brief 2013/08 'Early-Warning Indicators for Debt Sustainability', presented today at the Brussels-based economic think tank Bruegel, a partner of the CPB.
Assessing public finances is no easy task. Recent experience in Europe underscores how difficult it is to anticipate public debt crises, with regard to both occurrence and depth. Simple parameters, such as the size of the budgetary deficit or the level of public debt, may be useful for monitoring the state of government finances in the present, but provide little insight into future sustainability. The level of stability of the economic environment and the quality of fiscal policymaking are at least as important.
The early warning indicator represents a new approach to help assess whether a country is 'in control' of its public finances. It cannot predict the actual occurrence of an urgent debt crisis, as the dynamics of such an event are far too erratic and unstable. Furthermore, the indicator should be regarded not as an alternative, but rather as a complement to other indicators, such as debt level and long-term sustainability of public finances.
This allows us to assess the degree to which governments are in control of their finances. Using stochastic simulations, we derive ‘early warning’ indicators for financial stability, looking at both the expected evolution of public debt and the degree of uncertainty around this path. This approach is then used to assess the position of nine OECD countries in 2007 (thus, prior to the debt crisis); our results show that these indicators clearly distinguish countries that have sustainability concerns (Italy, Spain and Portugal) from those that do not (the US, the UK, the Netherlands and Belgium).