Public debt, sovereign spreads and the unpleasant arithmetic of fiscal consolidations

Marco Di Pietro (), Luigi Marattin and Raoul Minetti

International Finance, 2021, vol. 24, issue 2, 155-178

Abstract: In response to severe fiscal consolidation policies implemented after the Great Recession and the euro area sovereign debt crisis, many have questioned the effectiveness of fiscal consolidations in reducing the burden of public debt. This paper revisits this fundamental policy debate qualitatively and quantitatively, studying conditions under which primary budget balance changes can successfully reduce government debt‐to‐GDP ratios. We first illustrate these conditions through a partial equilibrium setting. We then investigate the conditions quantitatively using a medium‐scale New Keynesian DSGE model calibrated on periphery countries of the euro area. The analysis highlights the critical role of sovereign spreads in driving the debt‐to‐GDP dynamics following a restrictive primary balance shock. Fiscal consolidations turn out to successfully reduce the debt‐to‐GDP even for fairly low elasticities of spreads to fiscal variables. However, their effectiveness is quantitatively moderate and varies crucially with the initial spread level, with the degree of monetary policy accommodation, and with the responsiveness of market investors to economic fundamentals.

Date: 2021
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Persistent link: https://EconPapers.repec.org/RePEc:bla:intfin:v:24:y:2021:i:2:p:155-178

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