Public debt sustainability and fiscal reaction functions in Europe.

Summary This dissertation is devoted to the analysis of public debt sustainability using an ad hoc fiscal reaction function, proposed by Stefan Collignon (Collignon, 2012) to describe the Stability and Growth Pact framework. This reaction function relates, in the form of an error correction model (ECM), the variation in the primary public balance to deviations of the total deficit and public debt from respective deficit and public debt targets. In this framework, public debt sustainability is analyzed as the stability and convergence conditions of a system of differential equations comprising an accounting equation representing the government's budget constraint and a behavioral equation describing the budgetary response to a deviation from the deficit and public debt targets. The debt is said to be "sustainable" if there are conditions on the parameters of this reaction function such that the system is stable and if these conditions are satisfied. We propose to take this simple two-equation model, to re-estimate the fiscal reaction function for a sample of EU and Eurozone countries, and then to substitute the long-term interest rate, which has been considered exogenous until now, with a function modeling the risk premium associated with public debt, to take into account its effect on stability conditions. We then estimate this risk premium relationship in order to produce alternative tests to those initially proposed by Collignon. The results obtained are inconclusive, but we nevertheless propose to derive sustainability tests, for methodological and indicative purposes. Finally, in a last theoretical part, an extension of this three-equation model is also presented, where this time the long-term real interest rate is directly endogenized, by introducing a third reaction function supposed to represent the reaction of financial markets to public debt.