Abstract
The success of a consolidation in reducing the debt ratio depends crucially on the value of the multiplier, which measures the impact of consolidation on growth, and on the reaction of sovereign yields to such a consolidation. We present a theoretical framework that formalizes the response of the public debt ratio to fiscal consolidations in relation to the value of fiscal multipliers, the starting debt level and the cyclical elasticity of the budget balance. We also assess the role of markets confidence to fiscal consolidations under alternative scenarios. We find that with high levels of public debt and sizeable fiscal multipliers, debt ratios are likely to increase in the short term in response to fiscal consolidations. Hence, the typical horizon for a consolidation during crises episodes to reduce the debt ratio is 2–3 years, although this horizon depends critically on the size and persistence of fiscal multipliers and the reaction of financial markets. Anyway, such undesired debt responses are mainly short-lived. This effect is very unlikely in non-crisis times, as it requires a number of conditions difficult to observe at the same time, especially high fiscal multipliers.
JEL codes: E62; H63.
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Notes
- 1.
This range can be compared to values for government investment multipliers presented in Coenen et al. (2012) which proposes a range of 0.9–1.3 or 1.1–2.2 depending on the model discussed.
- 2.
This is the case for most DSGE models see for example Clinton et al. (2010).
- 3.
The cumulative multiplier at a given period is obtained as the ratio of the cumulative response of GDP and the cumulative response of government expenditure.
- 4.
Technically, while Ramey (2011) provides evidence that SVAR-based innovations in the US as identified in Blanchard and Perotti (2002) can be anticipated and Granger-caused by Ramey and Shapiro (1998) war episodes. However, Perotti (2004) finds little evidence that SVAR-based innovations are predictable. In turn, Bouakez et al. (2010) show that, the fiscal foresight problem is not severe enough to preclude the use of SVAR innovations as correct measures of unanticipated fiscal shocks as Ramey’s results are driven by the Korean War episode.
- 5.
True fiscal policy data at quarterly frequency are computed in France only for recent years. Data used in Bouthevillain and Dufrenot are based on yearly time series interpolation by the OECD.
- 6.
The stock-flow adjustment is the difference between the change in government debt and the government deficit/surplus for a given period. The main categories of stock-flow adjustments are net acquisitions of financial assets, items that do not directly affect the Maastricht definition of debt and effects of face valuation, comprising also effects of exchange rate variation. See http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/STOCK_FLOW_2011/EN/STOCK_FLOW_2011-EN.PDF
- 7.
This formula is derived from the identity \( B_{t} \, = \, B_{t - 1} \left( {1\, + \,r_{t - 1} } \right)\, - \,PBal_{t} \), where B represents government debt in cash terms, PBal primary government balance and stock-flow adjustments are assumed to equal zero. The formula in the text is derived by expressing all variables as a ratio to GDP (Y) \( \frac{{B_{t} }}{{Y_{t} }}\, = \,\frac{{B_{t - 1} }}{{Y_{t - 1} }}(1\, + \,r_{t - 1} )\frac{{Y_{t - 1} }}{{Y_{t} }}\, - \,\frac{{Bal_{t} }}{{Y_{t} }} \) and simply rewriting \( b_{t} = \frac{{b_{t - 1} (1 + r_{t - 1} )}}{{1 + g_{t} }} - bal_{t} \) and approximating \( \frac{{(1 + r_{t - 1} )}}{{1 + g_{t} }} \) with \( \left( {1 + r_{t - 1} - g_{t} } \right) \) gives the formula in the text.
- 8.
It is to be remarked the assumption that financial markets are assumed not to take into account the consequences of their own behaviour on debt evolution. This seems coherent with the assumption of myopic behaviour.
- 9.
Notice that n* represents the number of years starting from the year of consolidation. If consolidation is implemented in year 1, n* represents the critical year. Therefore n* = 1 means that there is no debt increase at all, while n* = 2 indicates that the debt increase lasts one year and so on.
- 10.
See Eq. (13). The persistence parameter is the ratio between the responses of two consecutive years if the long-run impact of fiscal consolidation is null.
- 11.
A more immediate impact can be seen on the yield of government debt, which may react more abruptly as borrowing goes up or down. The more muted effect on the interest rate is partly driven by the fact that only a share of overall debt needs to be reissued in any one year and so the effect on the average (or apparent) interest rate is more modest. An increase in interest rate of 50 basis points has a modest impact in the first year if 20 % of the debt is rolled over every year: for example with debt ratio at 100 % and a 20 % rollover, 50 basis points increase means an additional 0.1 % increase in deficit/debt. Nevertheless, in difficult times, there have been sizeable increases in the apparent interest rate that can be observed in the data. For example, between 1974 and 1975 the apparent interest rate increased from 15.7 to 22.2 in Denmark, while it increased from 8.3 to 15.2 in Portugal between 1980 and 1981. Conversely to these large sharp increases, decreases are often more gradual even when sustained, as was the case for the countries with higher yields at the entry in the EMU.
- 12.
Of course, other variables such as the conduct of monetary policy also affect this term.
- 13.
It is to be remarked the assumption that financial markets are assumed not to take into account the consequences of their own behaviour on debt evolution. This is a simplifying assumption which has very reduced practical impact if myopia is interpreted as backward-looking behaviour or if the horizon in question is as short as one or two years. Notice that the formula could apply to new emissions as well, without substantive.
- 14.
Notice that if interest rates decrease with consolidation, the formula for the change in r reinforces the possibility of undesired effects. In DSGE models multipliers decrease with interest rates.
- 15.
Given these result in what follows it is assumed to set real growth, apparent rate, primary balance, output gap and long-term multiplier at zero and the budgetary semi-elasticity at 0.5. Multiplier persistence is fixed at 0.7.
- 16.
0.6/0.7 is the ratio of second to first year GDP responses in the case of composition-balanced permanent consolidation in European Commission (2010). This is the basis for the choice of 0.5 as low persistence and 0.8 as high persistence parameters. Note that the persistence in the following years is however, smaller. Values of the GDP responses broadly constant for the first three years are very commonly found in VAR estimates. This wold make raise an hump-shaped GDP response with the consequence that the debt increases following a consolidation would be reversed only after three years for values of the impact multiplier of 1.5. This being the only difference, the case is not developed here.
- 17.
It should be noted that h = 2 already would reduce sensibly n*.
- 18.
“Inf” stays for infinity, i.e., the country’s debt is diverging. one means that the country’s debt is converging.
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Boussard, J., de Castro, F., Salto, M. (2013). Fiscal Multipliers and Public Debt Dynamics in Consolidations. In: Paganetto, L. (eds) Public Debt, Global Governance and Economic Dynamism. Springer, Milano. https://doi.org/10.1007/978-88-470-5331-1_12
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