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Working papers from the Economics Department of the OECD that cover the full range of the Department’s work including the economic situation, policy analysis and projections; fiscal policy, public expenditure and taxation; and structural issues including ageing, growth and productivity, migration, environment, human capital, housing, trade and investment, labour markets, regulatory reform, competition, health, and other issues.
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Choosing the Pace of Fiscal Consolidation
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- Łukasz Rawdanowicz1
- Author Affiliations
- 1: OECD, France
- 24 Sep 2012
- Bibliographic information
In many OECD countries debt has soared to levels threatening fiscal sustainability, necessitating its reduction over the medium to longer term. This paper uses stylised simulations in a small, calibrated macroeconomic model which features endogenous interactions between fiscal policy, growth and financial markets. Simulations are done for a hypothetical economy, reflecting key characteristics of fiscally stressed OECD countries. Given the assumed objective to stabilise debt at a 60% of GDP target within 20 years, a consolidation path is chosen by maximising cumulative GDP growth and minimising cumulative squared output gaps. The simulations highlight four issues. First, lowering the debt-to-GDP ratio within a finite horizon requires big initial consolidation which can be largely unwound if debt is to be stabilised at a lower level. Second, some frontloading of the adjustment turns out to be optimal in case of an interest rate shock. Third, debt reduction with high fiscal multipliers, hysteresis effects and adverse market reactions involves protracted large negative output gaps and deflation. This stresses the importance of selecting reasonable fiscal targets consistent with market conditions. Fourth, delaying the attainment of the debt target by two years has generally little implications for initial consolidation, though under adverse conditions this would result in much higher debt and slower growth.
- fiscal rules, government budget balance, sovereign debt, fiscal consolidation
- JEL Classification:
- E61: Macroeconomics and Monetary Economics / Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook / Policy Objectives ; Policy Designs and Consistency ; Policy Coordination
- E62: Macroeconomics and Monetary Economics / Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook / Fiscal Policy
- H6: Public Economics / National Budget, Deficit, and Debt