Much discussion has focused on the size of government budget deficits and whether it is PA desirable to harmonize EC member countries' medium-term fiscal policies to ensure that they are both sustainable and consistent with medium-term noninflationary growth in a monetary union. In Discussion Paper No. 607, Fernando Ballabriga and Research Fellows Juan Dolado and Jos6 Viñals apply co-integration techniques to data from ten Eccountries for the last three decades to assess the consistency of public and private sector savings/investment behaviour with the long-term solvency of their respective sectors and of the nation as a whole. They focus on whether 'excessive' government budget deficits have undermined long-term external solvency. In their open economy model any failure to satisfy the national intertemporal budget constraint can be traced to a failure of the corresponding public or private constraint (or both); but the national constraint can hold even when neither of its 'components' is satisfied. Solvency requires that the savings-investment gaps of each domestic sector and the current account are equal to the expected declines in the present discounted values of the sectoral primary surpluses.

Ballabriga, Dolado and Viñals then examine the effects of interest rate expectations. They find that the stationarity of deficits (inclusive of interest) is both necessary and suff icient for solvency when expected interest rates are constant and positive, but it is only sufficient when they are variable and positive (as the data suggest). They find that many countries violate the public and private sector budget constraints, but not the national constraint; while external solvency is usually maintained either through changes in private savings and investment to offset changes to government deficits or by imposing capital controls when the current account exceeds a 'target' level.

The authors caution, however, that these results assume that current fiscal policies and the Community's macroeconomic structure will remain unchanged. In fact, some countries will probably soon take fiscal actions to correct excessive budget deficits and abandon capital controls. As European financial integration increases, excessive national budget deficits may no longer be financed principally by domestic savers, and even countries with no history of public debt undermining their external solvency may find it compromised, which would lead to a negative externality for the Community as a whole.

Investigating Private and Public Saving- Investment Gaps in EC Countries
Fernando C Ballabriga, Juan J Dolado and José Viñals

Discussion Paper No. 607, December 1991 (IM)