LAUSR

The European debt crisis has emphasized the importance of a reliable assessment of the sustainability of fiscal balances. The literature on policy reaction functions interprets debt as sustainable if a rising debt-to-GDP ratio invokes a positive reaction in the primary surplus. In this study, I show in a panel framework that the persistence of debt-to-GDP ratios and the correlation of respective innovations with primary surpluses generate size distortions of t -tests for common policy reaction coefficients. An analysis of European data prior to 2009 reveals that these size distortions can potentially cause conventional inference techniques to spuriously signal sustainability of fiscal balances. In contrast, size-corrected bootstrap-based critical values allow for a timely detection of increased solvency risk.