Debt Consolidation and Financial Stability

Transcription

1 Debt Consolidation and Financial Stability Ignazio Angeloni European Central Bank and BRUEGEL Ester Faia Goethe University Frankfurt, Kiel IfW and CEPREMAP Roland Winkler Goethe University Frankfurt November 21. Abstract We compare three alternative public debt consolidation policies (respectively based on expenditure cuts, labour tax or consumption tax increases) in their effects on key macro variables and on bank stability. Labor tax-based policies attain a rapid debt adjustment and low intertemporal debt costs, but at the expense of higher oscillations in bank leverage and risk. Expenditure based and consumption tax-based strategies perform rather similary from one another, though the second entails a somewhat higher output cost in the short to medium term. Keywords: debt consolidation, financial stability, bank runs. 1

2 1 Introduction The focus of this paper is the impact of public debt consolidation on financial stability. The analysis of the effects of fiscal policy, a constantly active area of research, has received new attention recently in the context of the financial crisis. Two different perspectives have been taken. On one side, a lively debate has developed on the size of fiscal multipliers. Some economists, including some close to the US administration, have argued that fiscal multipliers are large, hence suggesting an active use of fiscal policy to stimulate aggregate demand. Others have provided evidence suggesting much smaller or even negligible effects of fiscal policy 1. On the other side, concern in international policy circles have grown over the effects the crisis will have over the medium-long term on public debt accumulation in advanced economies. Discussions have focused mainly on the conditions for maintaining long term fiscal solvency, and on the timing, modalities and effects of debt consolidation programs 2. The very extensive theoretical and empirical literature on the effects of fiscal policy on the macroeconomy provides a natural background for all these discussions, but unfortunately the conclusions of this literature are very ambiguous 3. In this paper we look at debt consolidation from a different angle, that of its effects on the stability of the banking sector. Debt consolidation and financial stability are linked in a variety of mutually interacting ways. It is evident that risks to financial stability, to the extent that they require sizeable public financial resources to guarantee or recapitalize ailing banks, can have a powerful fiscal impact: many examples, most recently and dramatically that of Ireland, illustrate the point. But financial stability (or lack thereof) impacts on fiscal outcomes also indirectly, through its effect on credit flows, aggregate demand, and eventually public budgets. Conversely, debt consolidation strategies limit the resources available to support the banking sector, and, in a longer run, affect the environment in which banks operate through their effects on growth and inflation. Given the complexity of these links, we find it useful to approach the issue using a macro model enriched by explicit banking and fiscal sectors. Our model, described in some detail in the 1 See Romer and Bernstein [14]; Cogan et al. [4]; Cwik and Wieland [5], Uhlig [17]; and Christiano, Eichenbaum and Rebelo [3]. 2 See in particular a stream of papers produced by the IMF staff, including Freedman et al [9] and IMF [11]. 3 In his comprehensive 24 VAR study of the effects of expenditure and tax shocks on inflation and output in the main OECD countries, Perotti [13] notes at the outset that: While most economists would agree that a 1 percent increase in the money supply will lead to some increase in prices after a while, perfectly reasonable economists can and do disagree even on the basic qualitative effects of fiscal policy. 2

3 next section, is the one presented in Angeloni and Faia [1], which introduces a banking sector a la Diamond and Rajan ([7], [8]) into an otherwise standard DSGE model with nominal rigidities. We extend the model with calibrated rules for public expenditures and receipts, divided into labour and consumption taxes, and equations for interest payments and debt dynamics. The government uses tax receipts and debt to finance public expenditures and to recapitalize risky banks. With this model we conduct a thought experiment in two steps. First, we subject the model to a set of shocks that proxy the impact of the financial crisis on the euro area economy in 27-29, including the immediate policy responses in terms of monetary and fiscal accommodation as well as bank support. Second, we consider three alternative scenarios of fiscal consolidation: the first based on expenditures reduction, the second on higher labour taxes, the third on higher consumption taxes. In all three cases, we assume the objective is to return to the initial level of the debt to output ratio within 1 years. We then compare the effects of these alternatives on the main macro variables and two key fiscal variables and on the riskiness of the banking system. To compare alternative banking outcomes, we assume that the steady state level of risk is optimal, so that lower variability around, or faster convergence to, the steady state are desirable. Our main conclusion is that the adjustment strategy based on labour taxes is the one that destabilizes the financial sector the most. The labour tax increase opens a wedge between gross and net wages and alters, at the margin, the return from using labour vs capital in production. The marginal cost of a unit of output increases, and in presence of price stickiness so does inflation and, given our assumptions about monetary policy, the nominal rate of interest. Bank leverage and risk decline before gradually returning to the steady state. Given our parameter values the deviation from baseline values is quite large. The differences between the adjustment based on expenditure cuts or consumption taxes is more nuanced. The consumption tax is contractionary on output, but its effect on inflation is less pronounced. Inflation and interest rates oscillate moderately, and so does bank risk. Expenditure cuts have a moderate effect on output and inflation. All in all, bank risk remains closer to baseline in the case of expenditure cuts, though the difference here depends crucially on uncertain parameter values. After an overview of the model in section 2, section 3 describes our alternative debt consolidation policies and illustrates our results. Section 4 concludes. 3

4 2 The Baseline Model There are four type of agents in this economy: households, financial intermediaries, final good producers and capital producers. Households make consumption and working decisions and hold demand deposit and bank capital. Banks have special skills in redeploying projects in case of early liquidation. Uncertainty in projects outcomes injects risk in bank balance sheets. Banks are financed with deposits and capital; bank managers optimize the bank capital structure by maximizing the combined return of depositors and capitalists. Banks are exposed to runs, with a probability that increases with their deposit ratio or leverage. The desired capital ratio is determined by trading-off balance sheet risk with the ability to obtain higher returns for outside investors in good states (no run), which increase with the share of deposits in the bank s liability side. Finally, firms are monopolistic competitive producers who face quadratic adjustment costs of changing prices. The government finance government expenditure and bank recapitalization policy through a mix of debt, consumption and labour taxes. 2.1 Households There is a continuum of risk averse identical households who consume, save and work. Households save by lending funds to financial intermediaries, in the form of deposits and bank capital 4.Since household are risk averse in terms of their consumption and working decisions, they behave as standard consumption smoother, solving a dynamic optimization problem. We further assume that their utility features a certain degree of habit persistence in consumption; such an assumption serves the purpose of smoothing fluctuations in consumption in a way that is empirically more realistic. Households wealth is made up of their wage income and the returns from investment in deposits, net of consumption and labour taxes. Households maximization results in the following 4 To allow aggregation within a representative agent framework we follow Gertler and Karadi [1] and assume that in every period a fraction γ of household members are bank capitalists and a fraction (1 γ) are workers/depositors. Hence households also own financial intermediaries. Bank capitalists remain engaged in their business activity next period with a probability θ, which is independent of history. This finite survival scheme is needed to avoid that bankers accumulate enough wealth to remove the funding constraint. A fraction (1 θ) of bank capitalists exit in every period, and a corresponding fraction of workers become bank capitalists every period, so that the share of bank capitalists, γ, remains constant over time. Workers earn wages and return them to the household; similarly bank capitalists return their earnings to the households. 4

5 Euler condition: c t = c 1 c t 1 + c 2 E t c t+1 c 3 (r t E t π t+1 ) c 4 (τ c t E t τ c t+1) (1) where c t is the percentage deviation of consumption from the steady state, r t is the percentage deviation of the rate paid on deposits, π t+1 is the percentage deviation of inflation and τt c is the percentage deviation in consumption taxes. The parameters are c 1 = γ/(1 + γ), c 2 =1/(1 + γ), c 3 =(1 γ)/((1 + γ)σ), and c 4 = c 3 τ c /(1 + τ c ). The labour supply decision reads as follows: w t = w 1 n t + w 2 c t w 3 c t 1 + w 4 τ c t + w 5 τ n t (2) where w t is the percentage deviation of wages from the steady state, n t is the percentage deviation in employment, and τt n is the percentage deviation in labour taxes. The rest is as follows: w 1 = N/(1 N), w 2 = σ/(1 γ), w 3 = γw 2, w 4 = τ c /(1 + τ c ), and w 5 = τ n /(1 τ n ). 2.2 Banks There is in the economy a large number (L t ) of uncorrelated investment projects. The project lasts two periods and requires an initial investment. Each project s size is normalized to unity (think of one machine) and its price is Q t. The projects require funds, which are provided by the bank. Banks have no internal funds but receive finance from two classes of agents: holders of demand deposits and bank capitalists. Total bank loans (equal to the number of projects multiplied by their unit price) are equal to the sum of deposits (D t ) and bank capital, (BK t ). The aggregate bank balance sheet reads as Q t L t = D t + BK t. In the aggregate the demand for loans equates the aggregate capital invested in the economy: Q t L t = Q t K t. The capital structure (deposit share, equal to one minus the capital share) is determined by bank manager on behalf of the external financiers (depositors and bank capitalists). The manager s task is to find the capital structure that maximizes the combined expected return of depositors and capitalists, in exchange for a fee. Demand deposits have to be served first and sequentially 5, hence they are subject to runs, on the other side bank capitalists are rewarded pro-quota after all depositors are served. 5 This set of assets include asset backed securities and alike. 5

6 As in Angeloni and Faia [1], we assume that the return of each project for the bank is equal to an expected value, R A,t, plus a random shock, for simplicity assumed to have a uniform density with dispersion h t. We assume that the dispersion of project is return is time-varying: more specifically we assume that it follows an AR(1) process. Therefore, the outcome of project j is R A,t + x j,t, where x j,t spans across the interval [ h t ; h t ] with probability 1 2h t. Each project is financed by one bank, which act as a relationship lender. By running the project the bank acquires special skills by means of which it can extract some rent. Indeed if uninformed investors would finance directly investment projects, they would be able to redeploy only a fraction <λ t < 1 of the project returns. Such fraction, namely the liquidation value, is also subject to aggregate shocks and follows an AR(1) process. In equilibrium three situations might arise: 1. the realized return to the project is so low that a run occurs with certainty: 2. the realized return to the project is high enough to prevent a run only if the bank redeploys the funds invested in the project: 3. the realized return to the project is high enough to prevent runs even in absence of bank intervention. By considering those three events, the bank managers chooses the optimal debt to loan ration to maximize the expected return to outside investors: d t = r t + d 1 r A,t + d 2 h t + d 3 λ t (3) where d t is the percentage deviation from the steady state in demand deposits and r A,t is the percentage deviation in the return to investment. The parameters are determined as follows: d 1 = R A /(R A + h), d 2 = h/(r A + h), d 3 = λ/(2 λ). The optimal deposit ratio depends positively on h, λ and R A, and negatively on R. An increase of R reduces deposits because it increases the probability of run: this effect rationalize the so called risk taking channel (see Borio and Zhu [2], Lorenzoni [12]). Moreover, an increase in R A raises d as it raises the marginal return in the no-run case. Finally, an increase in h, which captures the riskiness of investment projects, raises d: higher dispersion of returns induces banks to take up more risk. The counterpart of the deposit ratio is represented by the optimal demand for capital, which in log-linear form reads as: bk t = d/(1 d)d t + q t + k t 1 + u bk t (4) where bk t is the percentage deviation from the steady state in bank capital, q t is the percentage 6

7 deviation in the price of capital and k t 1 is the percentage deviation in capital. The variable u bk t represents a random shock to bank capital. As can be seen from equation 4 an increase in the price of capital increases the value of bank capital: this effect captures the balance sheet channel in our model. In each period bank capitalists earn an expected return, which in log-linear form reads as follows: rtk t = r 1 r A,t + r 2 h t r 3 (r t + d t ) (5) where r 1 =2R A /(R A + h Rd), r 2 =(h R A + Rd)/(R A + h Rd), r 3 =2Rd/(R A + h Rd). In every period with a certain probability, (1 θ) bank capitalists exit the market. The capitalists who continue operating reinvest their returns in next period bank capital, whose dynamics is described by the following log-linear accumulation equation: bk t = θbk t 1 +(1 θ bk 1 )(rtk t + q t + k t )+bk 1 bkg t (6) where bkg t represents the bank recapitalization policy set by the government and bk 1 = BKG/BK. Since demand depositors can enact an early withdrawal, the likelihood of a run will give us a measure of bank riskiness: br t = br 1 h t br 2 r A,t + br 3 (r t + d t ) where br 1 =(R A Rd)/(h R A + Rd), br 2 = R A /(h R A + Rd), br 3 = Rd/(h R A + Rd). 2.3 Producers Producers are modeled, as it is standard in the literature, as monopolistic competitors who produce different varieties and face quadratic adjustment costs of changing prices. Their production function is a Cobb-Douglas, which in log-linear terms reads as: y t = a t + α(k t 1 + u t )+(1 α)n t (7) where y t is the percentage deviations of output from the steady state, a t represents the productivity shock, u t captures variable capital utilization (see next section), and α is the share of capital in the production function. Firms dynamic optimization decision leads to the following expectation augmented Phillips curve (in log-linear terms): π = βe t π t+1 + κmc t (8) 7

8 with κ =(ε 1)Y/ϑ, and to the following equations for labour and capital demand: w t = mc t + a t + α(u t + k t 1 ) αn t (9) z t = mc t + a t +(α 1)(u t + k t 1 )+(1 α)n t (1) where is the percentage deviation of the marginal cost from the steady state and z t is the percentage deviation of the rental rate of capital. 2.4 Capital Producers A competitive sector of capital producers combines investment (expressed in the same composite as the final good, hence with price P t ) and existing capital stock to produce new capital goods, according to the following law of motion (in log-linear terms): k t =(1 δ)k t 1 + δi t (11) where i t is the percentage deviation of investment from the steady state. We follow Smets and Wouters (23) in assuming variable utilization of capital and adjustment costs on investment. Under this assumption capital produces optimization leads to the following optimal investment schedule (in log-linear terms): i t = i 1 i t 1 + i 2 E t i t+1 + i 3 q t (12) where i 1 = R A /(1 + R A ), i 2 =1/(1 + R A ), and i 3 = φ I i 1, and to the following equation for the price of capital: q = q 1 E t q t+1 + q 2 E t z t+1 E t (r A,t+1 π t+1 ) (13) where q 1 =(1 δ)/(1 δ + z) andq 2 = z/(1 δ + z) andwherez t+1 is set according to the variable utilization equation u t = ψ u z t. 2.5 Goods Market Clearing, Monetary and Fiscal Policy Production in this economy is allocated to consumption, investment and government, g t : y t = y 1 c t + y 2 i t + y 3 g t + y 4 z t (14) where y 1 = C/Y, y 2 = I/Y, y 3 = G/Y, y 4 = ψ u zk/y. As in the aftermath of the crisis most central banks had driven their interest rate close to the zero lower bound, we assume that the 8

9 nominal interest rate is set to zero for a certain number of periods, T, while it follows a standard Taylor thereafter: r t = { for t T φ π π t + φ y y t for t>t (15) The fiscal sector is characterized by the following policy rules. The first determines the share of financing between taxes and debt, b t : τ n t + τ c t = ψ T (b t + τ n t + τ c t ) (16) The second determines the share of financing between consumption and labour taxes: τ n t = ψ τ (τ c t + τ n t ) (17) The third is the evolution of government spending, which follows an AR(1) process, but also responds to government debt as in Corsetti et al. (29): g t = ρ g g t 1 γ B b t + ε g t (18) The government budget constraint is given by: b t = b 1 b t 1 + b 2 (r t 1 π t )+b 3 g t + b 4 bkg t b 5 (c t + τ c t ) b 6 (τ n t + w t + n t )+b 7 τ t (19) where b 1 =1/β, b 2 = b 1 B/Y, b 3 = y 3, b 4 = BKG/Y, b 5 = τ c y 1, b 6 = τ n wn/y,andb 7 = τ/y. 3 Debt Consolidation Strategies Parameters values for our simulations are detailed in the table below. Most have been chosen following previous literature expect the values for the banking parameters which have been calibrated based on micro data. InsertTable1here We simulate the model assuming an initial crisis scenario, which is set up to mimic closely the actual situation experienced during the crisis. Starting from this scenario we evaluate 9

10 alternative strategies to return the debt to output ratio to its pre-crises level within 1 years 6.Our baseline simulation incorporates two elements: a set of shocks to the financial system, reproducing the initial factors that generated the crisis, and a number of policy interventions, representing the supporting measures (monetary, fiscal and financial) adopted as an immediate response to the financial turmoil. Our aim here is to model, in a stylized way and according with the model s specification, the main forces that drive the behavior of the macroeconomic variables after the crisis but before the fiscal consolidation is initiated. The set of shocks generating the crisis includes three components: a persistent increase in the riskiness of investment for banks; a persistent decrease in the early liquidation value of bank investment; a destruction of bank capital. 7 The immediate post-crisis stimulus policies include monetary expansion, fiscal expansion and bank support measures. First, we assume that the short term interest rate is brought down to zero for 12 quarters. The second policy assumption is that fiscal policy adopts a proactive output stabilization stance, with public expenditures responding to output and not to past debt, and taxes constituting only a small shares of expenditures financing. 8 Finally, the third policy is a bank capital support policy. We assume that the government intervenes to refinance the bank capital when their capital/asset ratio is below the steady state. 9 The recapitalization increases the budget deficit and is financed by taxes or debt, according to the above rules. Subject to these shocks and these policy rules, the model produces profiles for output, inflation, bank risk, the budget deficit and the debt to output ratio depicted in figure 1. Insert Figure 1 here Note, first, the strong contractionary effect on output which drops around 5 percent before recuperating. Inflation drops by about 5 percent relative to steady state, then quickly rises back. 6 The IMF staff has designed long term scenarios of fiscal consolidation for the advanced G2 countries (see [11]). The scenarios are based on a target of returning to a debt to output ratio below 6 percent by 23. They assume that the exit process starts in 211, when the debt ratio for the aggregate they consider, is projected to be above 8 percent. In their scenario, the debt level would return to this level around 221, i.e 1 years after the fiscal exit starts. Hence, our consolidation strategy is broadly consistent with these IMF normative scnarios. 7 Formally: h t =.85h t 1 + ε h t, ε h =.2222; λ t =.85λ t 1 + ε λ t, ε λ =.2222; u bk t =.95u bk t + ε bk t, ε bk =.2. 8 Formally, the tax and spending rules are set in a passive mode (γ B =,ψ T =.1), the tax split is calibrated to reproduce the euro area average (ψ τ =2/3) and government spending increases by 5 percent of GDP (ε g =.5Y ). 9 Formally: bkg t =.7d t. 1

11 The public debt ratio rises quickly in the first years, then rises more slowly; in the long run, it returns very slowly back to baseline given the very weak debt adjusting stance incorporated in the policy functions. The budget deficit, as a ratio to output, rises by more than 4 percent. In the financial sector, bank riskiness rise, mainly reflecting the impact effect of bank capital destruction. The same figure 1 shows the response profiles of the main macro variables under the following hypotheses concerning debt consolidation: consolidation based on spending cuts (left column), on increases in labour taxes (central column), or on increases in consumption taxes (right column). We posit that the debt consolidation takes place 12 quarters after the initial shock. This lag is based on the observation that, in most countries, a significant adjustment of public budget is not expected to take place before three years after the peak of the financial turmoil (211 vs. 28). All three strategies are calibrated so as to bring public debt back to baseline within 1 years. The three strategies are plotted against the no-consolidation case. To start with, consider a debt consolidation achieved through spending cuts. The decline in public spending leads to a contraction of output, despite some crowding in of private consumption. The fall of output and employment increases marginal product and, in equilibrium, real marginal costs. Hence inflation rises on impact 1. Responding to the higher inflation profile, monetary policy (which also exits the crisis mode at t = 13) increases real rates. The monetary restriction reduces bank risk, in presence of a risk-taking channel of monetary policy. The short-medium term outcome is (moderately) less output, a bit more inflation and higher nominal rates, a safer financial system and, of course, less public spending and lower budget deficit and debt accumulation. In the long term, the policy activism is rewarded by higher output beyond t = 3. If we compare the impulse responses of a labour tax-based and a spending-based strategy, we find that the tax-based strategy reduces output more strongly in the short run. Labour taxes produce a leftward shift in the labour supply curve that raises marginal costs sharply, hence inflation. Monetary policy reacts with a significant increase in interest rates leading to a sharp drop in bank risk which now undershoots its desired baseline value. Relative to the spending strategy, the labour tax-based one obtains a more front-loaded debt reduction at the cost of a larger output loss. There 1 The rise in inflation is mild, however, and highly dependent on preferences parameters. This uncertain effect matches the empirical evidence of Perotti [13], which is particularly ambiguous concerning the effect of public expenditure changes on inflation. 11

12 is also a significant loss in terms of inflation stabilization. If we compare a the labour tax-based to the consumption tax-based strategy, we see that the consumption tax allows to overcome some of the drawbacks of the labour tax. The overshooting of inflation is significantly reduced. The sharp monetary contraction is avoided, and thus also the sharp deviation of bank risk from the desired baseline value. Complementing the visual inspection, we calculate root sums of discounted squared deviations of output, inflation, bank risk and debt cost from the no-consolidation case, separately for the first 2 quarters (representing the performance of the three alternative policies in the short to medium run) and for the whole infinite time horizon (long run). These calculations are reported in table 2. InsertTable2here Note, first, that there are significant improvements in the output and debt cost columns in the section all quarters. This means that all consolidation strategies, regardless of their characteristics, improve markedly over the no-consolidation case in terms of long term output and costs of debt performance. In terms of bank riskiness and inflation, the advantage is more mixed but we see that the expenditure based and the consumption tax based strategies are beneficial or at last neutral in terms of all our criteria relative to the indefinite continuation of the post-crisis policy course. By comparing the performance of the different strategies in table 2, we see that the spendingbased strategy does not produce significant changes relative to no-consolidation in the short to medium run. In the long run, however, it improves the performance in terms of all criteria under consideration. By contrast, a labour tax-based strategy generates a significant loss in terms of bank risk and inflation at short horizons. The labour tax-based strategy actually leads to a loss of 12 and 32 percent for bank risk and inflation relative to the no-consolidation scenario. In the longer run such losses are mitigated, but there is still an under-performance in terms of inflation and bank risk. The consumption tax-based strategy outperforms the labour-tax based one in terms of bank risk and inflation but at the cost of a significant output loss in the short run. Notice that the tax-based strategies do better in terms of a reduction in the costs of debt, because they entail a more front-loaded consolidation of public debt. 12

13 4 Conclusions To our knowledge, there are no other papers so far that have attempted an evaluation of the effects of fiscal consolidation on bank and financial stability along lines similar to ours. Our attempt is in many respects a very preliminary one, and as such should be refined and extended in a number of ways. First, the alternative policy options we considered are rather sketchy and chosen mainly for expository purposes: more realistic policy strategies could easily be constructed. Second, as we have noted and as confirmed by the empirical evidence, certain key linkages (like for example the effect of public expenditures on inflation) are highly depended on arbitrary parameter assumptions, yet critical in shaping the effect of fiscal changes on the banking sector. The way forward here would probably be to characterize more carefully the mapping between parameter values and macroeconomic outcomes. Finally, and obviously, our results are model dependent; their robustness to alternative modelling choices should be ascertained before drawing any firm policy conclusions. References [1] Angeloni, Ignazio and Ester Faia, 29. Capital Regulation and Monetary Policy with Fragile Banks. Mimeo. [2] Borio, Claudio and Haibin Zhu, 28. Capital regulation, risk-taking and monetary policy: a missing link in the transmission mechanism?. BIS Working Papers No [3] Christiano, Lawrence, Eichenbaum, Martin and Sergio Rebelo, 29. When is the government spending multiplier large?. NBER Working Paper [4] Cogan, John F., Cwik, Tobias, Taylor, John B. and Volker Wieland, 21. New Keynesian versus Old Keynesian Government Spending Multipliers. Journal of Economic Dynamics and Control 34, [5] Cwik, Tobias and Volker Wieland, 29. Keynesian government spending multipliers and spillovers in the euro area. Mimeo. [6] Corsetti, Giancarlo, Andre Meier, and Gernot Müller, 29. Fiscal Stimulus with Spending Reversals. IMF Working Paper 9/16. 13

14 [7] Diamond, Douglas W. and Raghuram G. Rajan, 2. A Theory of Bank Capital. Journal of Finance 55, [8] Diamond, Douglas W. and Raghuram G. Rajan, 21. Liquidity Risk, Liquidity Creation and Financial Fragility: A Theory of Banking. Journal of Political Economy 19, [9] Freedman, Charles, Kunhof, Michael, Laxton, Douglas, Muir, Dirk, and Susanna Mursula (29). Fiscal Stimulus to the Rescue: Short Run Benefits and Potential Long Run Costs of Fiscal deficits, IMF Working paper 9/255 [1] Gertler, Mark and Peter Karadi, 29. A Model of Unconventional Monetary Policy. Mimeo, NYU. [11] International Monetary Fund, 21. Strategies for Fiscal Consolidation in the Post-Crisis World. Mimeo. [12] Lorenzoni, Guido, 28. Inefficient Credit Booms. Review of Economic Studies [13] Perotti, Roberto, 24. Estimating the Effects of Fiscal Policyin OECD Countries, IGIER Working paper 276. [14] Romer, Christina and Jared Bernstein, 29. The job impact of the American recovery and reinvestment plan. [15] Smets, Frank and Rafael Wouters, 23. An Estimated Dynamic Stochastic General Equilibrium Model of the Euro Area. Journal of the European Economic Association 1, [16] Trabandt, Mathias and Harald Uhlig, 29. How Far Are We from the Slippery Slope? The Laffer Curve Revisited. NBER Working Paper [17] Uhlig, Harald, 29. Some fiscal calculus. American Economic Review 1,

15 Table 1: Parameter values Parameter Description Value σ Elasticity of consumption 1.4 γ Degree of habit formation.5 N Steady state value of labour hours.3 β Discount factor.99 α Share of capital in production 1/3 δ Capital depreciation rate.25 ε/(ε 1) Price mark-up.2 φ I Capital adjustment cost 1/6 ψ u Capital utilization cost 1/.2 ϑ Price stickiness parameter 3 h Project return dispersion in steady state.45 λ Steady state liquidation value.45 θ Bank capitalist survival probability.97 φ p Weight on inflation stabilisation 1.5 φ y Weight on output stabilisation.5/4 G/Y Steady state share of government spending.23 τ c Steady state consumption tax.17 τ n Steady state labour tax.41 15

16 Table 2: Comparison of alternative debt consolidation strategies Horizon 2 quarters All quarters Criterion Output Bank risk Inflation Debt costs Output Bank risk Inflation Debt costs Consolidation: Gain/loss in percent Gain/loss in percent Spending Labour tax Consumption tax Notes: Gains (+) or losses (-), in percent, of the corresponding consolidation strategy in terms of the given criterion, relative to the no consolidation scenario. 16

17 2 SPENDING 2 LABOUR TAX 2 CONSUMPTION TAX OUTPUT INFLATION BANK RISKINESS BUDGET DEFICIT DEBT OUTPUT RATIO Figure 1: Debt consolidation strategies. Solid lines with x-marks are baseline crisis simulations without debt consolidation. Solid lines with circles are impulse responses under debt consolidation based on spending cuts (left column), on labour tax increases (central column), on consumption tax increases (right column). 17