Are Greek budget deficits 'too large'?

Abstract

We use a residual-based cointegration test suggested by Gregory and Hansen (1992) that allows for the determination of a structural break in the cointegrating vector to test for the sustainability of Greek fiscal deficits over the 1958-1992 period. This relatively recent test leads to a different result from that derived from standard Engle-Granger cointegration tests. The use of the conventional Engle-Granger test implies no cointegration between tax revenues and interestinclusive government expenditures. On the contrary, using the Gregory-Hansen test we conclude that tax revenues and interest-inclusive government expenditures are reintegrated and a structural break in the cointegrating vector took place in either 1981 or 1983. Our result of cointegration with a structural break is consistent with a strict interpretation of the government's intertemporal budget constraint since it implies a zero discounted value of the public debt. However, since the cointegration-regression slope parameter is significantly less than one (when tax revenues are regressed on expenditure), the undiscounted value of the public debt is different from zero. This means that the government has incentives to default on its debt and, therefore, Greek budget deficit policy is not sustainable.