IMF: Better late than never but never late is better

The Challenge of Debt Reduction during Fiscal Consolidation
by Luc Eyraud and Anke Weber


This paper examines the effect of fiscal consolidation on the debt ratio. It first assesses the importance of the fiscal multiplier assumption in the nexus between fiscal consolidation, growth, and debt reduction. With multipliers close to 1 in the current environment, fiscal consolidation is likely to raise the debt ratio in the short-run in most advanced countries. We provide empirical evidence supporting this hypothesis. The slow response of the debt ratio to fiscal adjustment could be an issue if financial markets focus on its short-term behavior.
Our analysis suggests three main operational conclusions, which are particularly relevant for Europe today. First, underestimating fiscal multipliers may cause unpleasant surprises. As fiscal consolidations generally take place in a depressed economic environment with relatively high multipliers, fiscal tightening may initially raise the debt ratio. Not explicitly taking into account multipliers or underestimating their value could lead authorities to set unachievable debt (and deficit) targets and miscalculate the amount of adjustment necessary to curb the debt ratio. Missing announced targets could impact the credibility of adjustment programs and increase uncertainty about the future path of fiscal policy.

Second, using the debt ratio as an operational fiscal target presents risks. If country authorities focus on the short-term behavior of the debt ratio, they may engage in repeated rounds of tightening in an effort to get the debt ratio to converge to the official target, undermining confidence, and setting off a vicious circle of slow growth, deflation, and further tightening. A possible solution could be to monitor debt ratios and set debt targets in cyclically-adjusted terms, though, as explained in Section V, using the CADR for this purpose can entail certain difficulties as well.

Third, an appropriate design of consolidation packages can minimize adverse loops involving fiscal tightening and short-term debt dynamics. As Cottarelli and Jaramillo (2012) highlight, in many countries, the composition of fiscal adjustment can be rebalanced to make it more “growth friendly.” Setting the right pace of consolidation is also important: if financing allows, a more gradual approach is preferable, since  djustment measures can be taken when the economy recovers and multipliers are lower. For example, Bagaria and others (2012) simulate scenarios with alternative timings for the UK government’s fiscal consolidation plans. The results indicate that delaying the consolidation effort until more normal economic conditions prevail would substantially lessen the size and duration of the fiscal adjustment’s impact on growth. Finally, structural reforms can also contribute to breaking adverse loops. While their benefits usually take time to materialize, there is evidence that some structural reforms deliver gains already in the short run, and can boost growth relatively quickly (OECD, 2012).

Our results should be interpreted with caution. In particular, they do not imply that fiscal consolidation is undesirable or could place public debt on an unsustainable path. Almost all advanced economies face the challenge of fiscal adjustment in response to elevated government debt levels and future pressures on public finances from demographic change. The short-term effects of fiscal policy on economic activity are only one of the many factors that need to be considered in determining the appropriate pace of fiscal consolidation. In addition, multipliers differ across countries and time. In some cases, confidence effects may partly offset the negative impact of fiscal tightening on growth.

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