Stochastic debt sustainability analysis using time-varying fiscal reaction functions - an agnostic approach to fiscal forecasting

This paper presents a model-based approach for stochastic primary balance and public debt simulations to assess fiscal sustainability in selected OECD countries. Fiscal behaviour is modelled by means of a fiscal reaction function with time-varying coefficients, which is then, together with a time-varying coefficient vector autoregression, embedded in a stochastic debt sustainability analysis framework. In a pseudo-out-of-sample forecasting exercise using vintage datasets, the model is evaluated against its frequently used fixed coefficient pendant and the European Commission’s Economic Forecasts at different horizons. The results indicate that stochastic debt sustainability analyses based on time-varying fiscal reaction functions and vector autoregressions perform competitively in terms of mean squared error and forecast bias at different horizons, especially with respect to public debt as well as short-term primary balance forecasts. Thus, models of this sort should be considered for complementary use at policy institutions, using them jointly with more ‘discretionary’ approaches to fiscal sustainability analysis.