The Relationship between Debt and Deficit: Empirical Evidence of Creative Accounting in EU25

1. The Academy of Economic Studies Doctoral School of Finance and Banking The Relationship between Debt and Deficit: Empirical Evidence of Creative Accounting in EU25 MSc student: Marius Marsanu Coordinator: Professor Moisă Altăr Bucharest, July 2007

2. Contents • Objectives • Introduction to the problem • Preliminary analysis • The model • Empirical specifications • Results • Conclusions Bucharest, July 2007

3. Objectives • Analyzing the fiscal aggregates in EU25 and their compliance with the limits imposed by the Stability and Growth Pact (SGP) • Comparing between the two groups of countries: EU15 and new member states (NMS10) • Providing empirical evidence for the use of creative accounting in EU25 in order to circumvent fiscal rules • Analyzing the behavior of EU15 and new member states (NMS10) comparatively, with respect to the introduction of the SGP Bucharest, July 2007

4. Introducing the problem • Purpose of the fiscal rules; Beetsma and Uhlig (1999) • In the run up to the euro; Dafflon and Rossi (1999) • Non-partisan application of the rules and improved transparency for the Stability an Growth Pact; Buti, Eijffinger and Franco (2002) • Restricted vs. unrestricted fiscal positions; Milesi-Ferretti and Moriyama (2004) • Creative accounting in EU15; von Hagen and Wolff (2006) Bucharest, July 2007

5. The Stability and Growth Pact and EU25 • The rationale behind SGP • SGP and the new member states, table A.1 • Inflexibility related to the business cycle • Efficiency of the SGP, Table A.3 (page 21ev / 29rv) • Perfectibility • Equivalence of the analyzed periods: • EU15:1992 – 2001; • NMS10:1998 – 2007; Bucharest, July 2007

6. Table A.1: Average economic growth in NMS10 Source: European Commission, AMECO, own calculations Bucharest, July 2007

7. Table A.3: Stability and Growth Pact criteria breach for EU27 Bucharest, July 2007

8. Table A.3: Stability and Growth Pact criteria breach for EU27 Bucharest, July 2007

9. Preliminary analysis • Accounting identity: • In practice (Table 1): • Central pillar: stock flow adjustments (SFA) • SFA rationale: financial operations (example 1) • SFA abuse (example 2) • Other elements: revaluation of debt denominated in foreign currency, time of recording deficits, transactions in financial assets Bucharest, July 2007

10. Stock flow adjustments • Example 1: ZCB issue • Issue value: 90 • Face value: 110 • Example 2: capital injections into public companies • Example 3: acquisitions of financial assets Bucharest, July 2007

11. Persistent SFA • Observing the persistence of positive SFA: • Results in Table 2 • Positive SFA in most EU15 countries • Budgetary surpluses for Finland and Greece • Various results across NMS10 • Positive SFA in Estonia, Lithuania and Cyprus Bucharest, July 2007

12. Table 2: Preliminary evidence of systematic positive SFA Bucharest, July 2007

13. Table 2: Preliminary evidence of systematic positive SFA Bucharest, July 2007

14. The model • Based on von Hagen and Harden (1995, 1996) and developed by Milesi-Ferretti(2003) • Government allocates its taxes and expenditures optimally over time • denotes the optimal change of public debt • If actual change deviates from optimal change, a cost incurs • represents the cost of deviating from optimal fiscal policy at different points of the business cycle • If no constraint is imposed on the deficit, then: where denotes an exogenous random variable, SFA, and deficits and SFA are assumed to be uncorrelated Bucharest, July 2007

15. The model (2) • DL is a limit imposed on the budget deficit • When the government breaks the limit ( ) a cost incurs: where is assumed to be positive • As it is assumed the government may use SFA strategically, we let denote the strategic component of stock flow adjustments • If the strategic use of SFA becomes known to the public, the government incurs a reputational cost: Bucharest, July 2007

16. The model (3) • The government disposes of two instruments to optimally derive debt change: DtandSt • It needs to solve the following optimization problem: min( ) taking into account the restrictions: and • The Lagrange multiplier method is employed to derive the optimal DtandSt : Bucharest, July 2007

17. Pearson coefficients • No systematic relationship is expected between SFA and deficits before 1998 and 2004, respectively • A negative correlation between SFA and deficit is expected afterwards • Pearson coefficients, as a preliminary test: Bucharest, July 2007

18. Variables used • Variables are taken from AMECO database and transformed • All variables are expressed in percentage of the GDP of the year they refer to • The methodology employed was Excessive Deficit Procedure (EDP) Bucharest, July 2007

19. Arellano Bond dynamic GMM panel estimator • Few time periods, many cross sections • The process can by dynamic and autoregressive • Independent variables do not have to be strictly exogenous • Heteroskedasticity and autocorrelation between idiosyncratic errors are allowed • Poor estimator for small samples Bucharest, July 2007

20. Arellano Bond dynamic GMM panel estimator • Testing with instrumental variables • The adequacy of instrumental variables • Sargan test of overidentifying restrictions • Efficiency of Sargan test • Testing for autocorrelation of the errors • Instrumental variables used: the lags of order one for all regressors, and the lags of order one and two for the dependent variable • Two steps difference GMM Bucharest, July 2007

21. The impact of the introduction of the fiscal rule • is a dummy variable that takes the value 1 after the introduction of the fiscal rule and 0 before. can be rewritten as follows: • To test for significant differences for the new member states, the following equation is employed: • Ci is a dummy variable taking the value 0 for EU15 member states and 1 otherwise Bucharest, July 2007

22. The impact of the introduction of the fiscal rule • Creative accounting is obvious in EU25, though not very obvious in NMS10 • An increase of SFA by one percentage points leads to a decrease in deficit by 0.17 percentage points • SFA became a policy variable to control to control deficits when the fiscal rule is in place Bucharest, July 2007

23. The impact of binding fiscal rule • Augmented approach empirically separates the effect of the introduction of the rule on governments whose policy objective is to spend more than 3% of GDP in excess of their revenues • is a dummy variable taking the value 1 if the expected change in debt is larger than 3% of GDP and 0 otherwise • Correlation between SFA and deficits should be negative when fiscal rules are in place and zero when expected debt change is below 3% of GDP • Governments will engage in creative accounting when the expected debt change is larger than 3% of GDP. A negative is expected. Bucharest, July 2007

24. The impact of binding fiscal rule • is not significant because the rule is not binding when deficits are below 3% of GDP • SFA contributes to the increase in debt change with a roughly 1:1 ratio • discussion: countries with a lower change in debt show a negative covariance between deficits and SFA , while for debt level changes above 3% of GDP the coefficient is close to 1, implying no correlation • discussion: negative covariance between deficits and SFA when countries intend to breach the limit (creative accounting) Bucharest, July 2007

25. The impact of business cycle can be rewritten as follows: • should be of the same sign as and of similar size since most part of the deficit is structural Bucharest, July 2007

26. The impact of business cycle • and relatively close to 1 • Creative accounting is not used very much with structural deficits • is strongly negative: an increase in cyclical deficit is almost completely offset by reductions in stock flow adjustment; creative accounting is used with the business cycle Bucharest, July 2007

27. Conclusions • After the introduction of the fiscal rules , stock flow adjustment became a policy variable to control the evolution of the deficit • Stock flow adjustment are mostly used with the business cycle in order to reduce its impact on the deficit • Creative accounting seems to prevail in EU15 countries, for which the rules of the Stability and Growth Pact were designed • Behavioral equivalence between EU15 and NMS10 Bucharest, July 2007

28. The Academy of Economic Studies Doctoral School of Finance and Banking The Relationship between Debt and Deficit: Empirical Evidence of Creative Accounting in EU25 MSc student: Marius Marsanu Coordinator: Professor Moisă Altăr Bucharest, July 2007