If a nation's current expenditure persistently exceeds its income, net foreign indebtedness may rise to a level at which it cannot service its debt and becomes insolvent. Both borrower and lender therefore need to assess whether current policies will cause eventual insolvency. Some argue that while the rest of the world is willing to finance a country's current- account deficit, insolvency cannot be a problem and the deficit can continue unchecked. Others have proposed measures of impending insolvency using the techniques developed for the analysis of a government's intertemporal budget constraint, but these are ad hoc, not sufficient, or sufficient but not necessary.

In Discussion Paper No. 437, Research Fellow Michael Wickens and Merih Uctum develop a more formal model of the nation's intertemporal budget constraint to determine whether a country's initial net national assets are sufficient to offset future expected current account deficit. The reverse problem may also occur, if a country with persistent current account surpluses is accumulating more net foreign assets than it requires to sustain future consumption and hence suffers from
`dynamic inefficiency'.

Wickens and Uctum show that a negative feedback on the current account or a negative real rate of return on net national indebtedness (adjusted for the rate of output growth) is sufficient to establish the failure to meet the national intertemporal budget constraint. If the primary deficit is a stationary process, so must be net national debt; and if the primary deficit is non- stationary, but stationary in its rate of growth, then the rate of growth of the net national debt must also be stationary. While the cointegration of the primary deficit and the net national debt is necessary but not sufficient, the stationarity of the current account is both necessary and sufficient.

Wickens and Uctum use quarterly data for 1970-88 to show that the US was not satisfying its intertemporal budget constraint, since its current account was non-stationary, and they show that it is the persistent current account deficit of the government sector in the 1980s it was principally to blame. They also consider the argument that a high correlation between national savings and national investment indicates a lack of integration with world capital markets, domestic investment is financed largely from domestic savings rather than by foreign capital. They note that if savings and investment, expressed as proportions of GNP, have unit roots, then their correlation is virtually guaranteed, so the cointegration of savings and investment may provide a better indication. If they are, then in the long run they move together; and if not, they will move apart, reflecting the influence of other factors. In the former case the difference between them the current account is stationary and in the latter it is non-stationary, so the failure of the US to satisfy its intertemporal budget constraint also indicates a lack of integration of the US capital market with the rest of the world.

National Insolvency: A Test of the US Intertemporal Budget Constraint
M R Wickens and Merih Uctum

Discussion Paper No. 437, August 1990 (IM)