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I would like to thank Ali Al-Eyd, Celine Allard, Carlo Cottarelli, Edward Gardner, Martine Guerguil, Abdelhak Senhadji, and Edda Zoli for useful comments and suggestions. The paper also benefitted from discussions with Elif Arbatli, Lorenzo Forni, and Laura Jaramillo. Raquel Gomez Sirera provided excellent research assistance. The usual disclaimer applies.
The only paper we are aware of that uses a similar methodology is Conway and Orr (2002). However, their sample includes only a limited number of advanced economies (seven in total) and does not cover the global financial crisis period.
The fixed effects methodology employed in previous studies imposes the relationship between sovereign bond yields and their fundamentals (the slope coefficients) to be the same across countries, without testing the validity of this assumption.
To illustrate this point, consider the standard intertemporal maximization condition (Euler’s equation) from the household’s utility maximization problem:
It is important to note that while the potential output growth is expected to have a positive impact on real bond yields in the long-run, a short-run positive deviation of output growth from its potential level could reduce borrowing costs as the temporary increase in taxing capacity of the country lowers the sovereign risk.
There is also a large group of studies analyzing determinants of government bond yield spreads. We do not review these papers given that this topic, despite of being closely related, is beyond the scope of our study.
The short time series dimension of the data is particularly acute in studies using macroeconomic (especially fiscal) determinants of bond yields, which are typically available only in low frequencies (annual or quarterly).
The fixed effects specification only partially relaxes this assumption by introducing country-specific intercepts, while maintaining the homogeneity of slope coefficients.
As discussed in Baldacci and Kumar (2010), the coefficients of deficit and debt variables are closely related in the presence of permanent shocks to deficits. More specifically, the impact on the debt ratio of a permanent 1 percentage point increase in the deficit ratio is (1+g)/g, where g is the nominal GDP growth rate (in percent).
Interestingly, Knot and De Haan (1995) arrive to a similar conclusion using a sample of five European countries.
A separate stream of literature, not reviewed here due to space constraints, provides strong evidence that the response of sovereign bond spreads to changes in macroeconomic and fiscal determinants has substantially weakened in advanced euro area countries following the introduction of the euro in 1999 (see, e.g., Attinasi et al, 2009; Schuknecht et al., 2010; Bernoth et al., 2012; De Grauwe and Ji, 2012).
The PMG specification fully conforms to the empirical implications of the simple theoretical framework based on the Cobb-Douglas production function outlined in Engen and Hubbard (2004). According to this framework, the level of the interest rate is determined by the level of government debt, while the change in the interest rate is affected by the change in government debt (pp. 84-85).
To illustrate the intuition behind this test, recall that the PMG estimator constrains the long-run slope coefficients to be the equal across all panels. This is in contrast to the MG estimator, which does not impose the poolability constraints on the slopes. The pooling across countries yields efficient and consistent estimates when the restrictions are true. However, if the slope homogeneity assumption is rejected by the data, the PMG estimates become inconsistent, while the MG estimates are consistent in either case. The Hausman test provides the statistical evaluation of the difference across these two models under the null hypothesis that the poolability restrictions imposed by the PMG are valid.