Assessing New Approaches to Fiscal Sustainability Analysis∗

The term fiscal sustainability has many definitions, though it almost always refers to the fiscal policies of a government or the public sector. One concept of sustainability relates to solvency, the ability of the government to service its debt obligations in perpetuity without explicit default. Rarely does fiscal sustainability analysis reach the conclusion that a government is insolvent unless it is already obvious to all concerned that it is insolvent. Another concept of fiscal sustainability relates to the government's ability to maintain its current policies while remaining solvent. With this concept, fiscal sustainability analysis has broader scope. It can discuss the types and consequences of fiscal and monetary policy adjustments needed in order to avoid insolvency in the future. Even more broadly, fiscal sustainability analysis has, at times, encompassed discussions centered on the optimality of policy rather than its mere feasibility. One of the shortcomings of fiscal sustainability analysis is that it often does not take into account the effects of uncertainty. As we will see below, most of the simple analytical tools for assessing sustainability uses the modeling framework of perfect foresight. This can lead to misleading conclusions about the sustainability of policy that are of the yes or no variety. Either policy is deemed sustainable or it is not. But little is said about the probability with which a government might become insolvent, or the risks to fiscal sustainability. Recently the literature on fiscal sustainability has expanded in a number of interesting ways. Several methods for bringing uncertainty into the analysis have been proposed, with and Mendoza and Oviedo (2004a) being prominent among them. America and Caribbean region commissioned several case studies of fiscal sustainability that apply these new methods: da Costa, Silva and Baghdassarian (2004), Mora (2004) and Mendoza and Oviedo (2004b). My purpose is to explain and assess these new approaches to fiscal sustainability analysis. Part of this assessment involves examining the fruitfulness of their application in the case studies. In order to complete my assessment, I keep in mind the following tasks for which an analyst might use fiscal sustainability analysis: 1. Estimation of the government's ability to borrow. 2. Prediction of the onset of fiscal crises. 3. Assessment of the fiscal risks associated with contingent liabilities. 4. Assessment of the prior fiscal policy record, and discussion of future policy choices. I show that each new approach to fiscal sustainability analysis, by bringing uncertainty into …