II.1. Debt reduction and fiscal multipliers. dbt da dpbal da dg. bal

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1 Quarerly Repor on he Euro Area 3/202 II.. Deb reducion and fiscal mulipliers The deerioraion of public finances in he firs years of he crisis has led mos Member Saes o adop sizeable consolidaion packages. However, in view of he persisence of he crisis and he signs of weakening economic aciviy a vas public debae has arisen on he effeciveness of fiscal consolidaion in he curren siuaion, cenred on he quesion of wheher "auseriy can be self-defeaing". In his conex, "self-defeaing" would mean ha "a reducion in governmen expendiure leads o such a srong fall in aciviy ha fiscal performance indicaors acually ge worse" (Gros (20)). ( 29 ) Fiscal mulipliers are key o assess he response of he public deb raio o a fiscal consolidaion. This secion analyses he effecs of fiscal consolidaions on he public deb raio in alernaive scenarios for he key parameers affecing deb dynamics. The main facors affecing he deb response are he fiscal mulipliers and he financial markes' horizon. The work presened here summarizes he more deailed analysis presened in Par III of he European Commission 202 Public Finance Repor. ( 30 ) The secion begins wih a presenaion of he analyical framework ha formalizes he deb dynamics following a consolidaion shock and is relaionship wih fiscal mulipliers. I proceeds wih an analysis of he condiions influencing he number of years ha, in case of a shor-erm consolidaion-induced deb-increase, are needed for a consolidaion o show is effecs on he deb raio. I concludes wih a discussion of some policy implicaions. Deb dynamics and effecs from consolidaions In he absence of any sock-flow adjusmens, he governmen deb o GDP raio (b) evolves according o he following formula: ( 29 ) See also Bui, M. and L. Pench, (202) 'Fiscal auseriy and policy credibiliy', VoxEU.org, 20 April; Cafiso, G. and R. Cellini (20), 'Fiscal consolidaions for deb-o-gdp raio conainmen? Maybe bu wih much care', VoxEU.org, 20 March; Gros, D. (20), 'Can auseriy be self-defeaing?', VoxEU.org, 29 November; Corsei, G. and G. Müller, (202), 'Has auseriy gone oo far?', VoxEU.org, 20 February; Coarelli, C. (202), 'Fiscal Adjusmen: oo much of a good hing?' VoxEU.org, 8 February; Krugman, P. (202), 'Europe s Economic Suicide', New York Times, April 5. ( 30 ) European Economy. 4 July 202. b = b ( g ) bal = b ( + r g ) bal where bal represens he budge balance o GDP raio, pbal he primary budge balance, r he average effecive ineres rae on governmen deb and g nominal GDP growh. The evoluion of he deb raio can herefore be undersood as being driven by he primary balance and he snowball effec, which is he difference beween he average effecive ineres rae and he growh rae of he economy. Over he medium-erm, he snowball effec is of paricular imporance as i deermines he magniude of primary balances ha are necessary in order o ensure ha governmen deb remains susainable. Shor-run effecs of fiscal consolidaions The effec of a consolidaion ("a" in he following) is measured by is induced change on deb. A posiive consolidaion effec is found if he deb raio under consolidaion is smaller han he deb raio in he baseline. Arihmeically, he change induced on deb by consolidaion is: db db dpbal db = + da dpbal da dg dg da In he shor-erm, a consolidaion affecs he deb raio boh via is effec on he primary balance and via is effec on he rae of growh of GDP. In urn, he firs of hese wo effecs is he sum of wo componens reflecing he direc increase in he primary balance due o he consolidaion measures adoped, and he indirec impac on growh of he primary balance via he auomaic sabilizers (which leads o a parly offseing decrease of he primary balance). ( 3 ) The second effec reflecs he so-called "denominaor effec", i.e. he fac ha a lower level of GDP enails a higher deb raio for a given level of deb. Overall, he shor-erm effec of consolidaions on he deb level is a funcion of he exising deb level, he oupu muliplier of fiscal policy measures (i.e. he overall GDP response o he fiscal shock) and he cyclical budge semielasiciy, ε, which measures he response of he ( 3 ) If m is he one-year oupu muliplier and ε is he semielasiciy of budge balance o growh, he precise formula, where m and ε are posiive parameers, is dpbal pbal g pbal = + = ε m + da g a a

2 II. Special opics on he euro area economy general governmen balance-o-gdp raio o he GDP growh rae: ( 32 ) db da = ( b + ε ) m This equaion leads o he conclusions ha i) a high saring level of deb ends o dampen he deb-reducing impac of consolidaion all else equal, which operaes hrough he denominaor effec. If he iniial deb raio is large enough, consolidaions can even bring abou increases in he shor erm. The same holds for he elasiciy of he governmen balance o he cycle; and ii) he larger he shor-erm muliplier, he smaller he deb-reducing impac of consolidaions. This effec is acually independen of he economic growh rae and of he ineres rae prior o he fiscal consolidaion. four quarers (one year) are usually found o be above uniy. Tax-based consolidaions are usually found o enail somewha lower mulipliers han expendiure-based consolidaions, alhough here is much variaion across he differen sudies depending on he mehodology o idenify ax shocks and he counry concerned. Mulipliers derived from he European Commission's QUEST model amoun o around 0.4 o 0.7 for he euro area for a balanced consolidaion relying equally on expendiures and revenues in normal economic imes, depending on credibiliy and o 0.7 o around.2 in crisis siuaions. Table II..: Criical firs year mulipliers in he euro area a consan ineres raes (20) I is herefore possible o compue a criical value for he muliplier beyond which a consolidaion leads o a negaive raher han posiive impac. This criical value is compued as: m c = b + ε I diminishes wih he level of deb he higher he deb he larger he growh impac on he deb o GDP dynamic and wih he response of he governmen balance-o-gdp raio o GDP growh he effec of consolidaion measures on defici are smaller he more he auomaic sabilizers reac o diminished growh. For a deb raio equal o 00% of GDP, a ypical order of magniude on he value of he criical mulipliers can be compued o be 2/3 if i is assumed ha he semielasiciy of he budge balance o growh is /2. Table II.. shows he esimaed criical mulipliers for he euro-area Member Saes, for he 20 levels of Maasrich deb and he semielasiciies currenly employed o gauge he cyclical componen of he budge balance. A review of he empirical lieraure indicaes ha in many cases he empirical mulipliers are close o or even higher han he criical values presened in he able. In paricular, for European counries cumulaive mulipliers of public expendiure afer ( 32 ) All he previous compuaions are done wih respec of a baseline, i.e. hey show he comparison beween he deb raio a ime afer he consolidaion and he deb raio ha would have prevailed a ime in he absence of consolidaion. Source: Commission services' calculaion The comparison beween he criical mulipliers in Table II.. and he esimaes found in he lieraure would sugges ha Greece is he only counry where shor-run deb increases could be observed even in normal imes and if consolidaion is balanced. However, in he curren siuaion more han one hird of he euro area counries are likely o see heir deb raio increasing compared o he baseline in he firs year when a consolidaion process is implemened. This is due o several facors. Firs, he public deb has increased furher relaive o he 20 level shown in he able. Second, fiscal mulipliers are likely o be high a he curren juncure for a number of reasons: consolidaion is parly spending-based and some households and firms are credi consrains and he ransmission of moneary policy is parly broken. In addiion, in case of doubs abou he credibiliy of he consolidaion sraegy fiscal mulipliers could even be higher

3 Quarerly Repor on he Euro Area 3/202 Medium-run effecs of fiscal consolidaions The medium-erm evoluion of he deb raio, in he absence of any effec on governmen yields, is he sum of he same hree effecs indicaed in he previous subsecion: i) he cumulaive effec of growh on deb, which is larger he larger he iniial deb sock and he larger he medium-erm mulipliers; ii) The cumulaive effec of growh on governmen balance via he operaion of he auomaic sabilisers on he budge balance, which is greaer he larger he size of he mulipliers and he size of auomaic sabilisers and; iii) he cumulaive effec from he adjusmen of governmen balance, which increases wih he number of years and wih he size of he consolidaion implemened. The firs wo effecs increase he deb raio, while he hird lowers i. One way o look a he medium-erm effecs of a consolidaion is o consider he number of years n * (hereafer "he criical year") necessary for he consolidaion o lead o a decrease in deb wih respec o a baseline scenario ha keeps he primary balance-o-gdp raio consan (i.e. nonconsolidaion scenario). The criical period n* is differen from he number of years required for he deb o go below is level before saring o consolidae unless he baseline corresponds o a scenario wih a consan deb raio. However, when he baseline scenario is characerized by an increasing deb-o-gdp raio, he number of years needed o bring he raio below he preconsolidaion level exceeds n*. In his connecion, i is worhwhile noicing ha he size of he consolidaion does no affec n*, whereas i is key o deermine he number of years needed o reduce he deb raio below he exising level before he adopion of he consolidaion measures. low-persisence mulipliers pah under differen assumpions abou he impac muliplier. The baseline scenario is one of a consan deb raio of 00% of GDP and a cyclical budgeary semielasiciy of ε=0.55. When he firs-year muliplier lies below 0.7 corresponding o he value of he criical muliplier, he consolidaion lowers he deb raio from he firs year. I should be noed ha a firs year muliplier of.5 is on he high side of exising esimaes as i is he esimae of a emporary consolidaion based on governmen spending. Graph II..: Deb dynamics wih no effec on ineres raes, low persisence (% of GDP, ime horizon: 6 years) () () baseline seady sae, b0 = 00% Graph II..2: Deb dynamics wih no effec on ineres raes, high persisence (% of GDP, ime horizon: 6 years) () The higher he mulipliers in he firs year and he larger he change in GDP induced by he consolidaion, he larger he value of n* and he longer i will ake for a consolidaion o be effecive in reducing he public deb raio. The response of oupu o he fiscal consolidaion, i.e. he fiscal muliplier, can be very persisen or can decay rapidly in he firs years. ( 33 ) Graph II.. shows he deb-o-gdp raio dynamics for he ( 33 ) Medium erm mulipliers are obained by applying a decay funcion wih powers of 0.5 for he low persisence case and of 0.8 for he high persisence case. In he low persisence case around 47% of he iniial effec on oupu vanishes a he 2 nd year and around 90% hereof a he 6 h year. In he high persisence case only around 8% of he iniial effec on oupu disappears he following year afer he shock and a he 6 h year around 3.7% of he iniial effec sill remains. () baseline seady sae, b0 = 00% Graph II..2 shows he corresponding case for a high persisence of he muliplier. The higher persisence generaes longer-lasing negaive effecs from fiscal consolidaion. If he firs-year

4 II. Special opics on he euro area economy Graph II..3: Confidence effecs on deb dynamics, firs-year m=.5 (in % of GDP, ime horizon: 6 years) muliplier is.5 he consolidaion-based deb increase lass for one more year so ha hree years are needed before deb goes below baseline. Inroducing changes of governmen yields The analysis has so far been based on he assumpion of consan ineres rae. This is obviously a very srong assumpion as consolidaion affecs solvabiliy and hereby ineres raes which in urn affec fiscal balances and he dynamics of consolidaion. Over he medium-erm, changes o he average effecive ineres rae are as imporan a facor for he deb o GDP dynamics as he growh rae of GDP. The impac of consolidaion on average effecive ineres raes is more visible in he medium-erm han in he shor-erm, wih limied firs-year impac on he deb level. The sign of his effec however is no clear cu as i depends crucially on he way marke expecaions are generaed. In he simulaions presened hereafer i is assumed ha he change on average effecive ineres raes is driven by he risk premium so ha he change of he average effecive ineres rae ri due o a consolidaion a is expressed as: dri db = µ + γ da da i+ h dr=0 where µ can be inerpreed as he effec on he ineres rae (via he risk premium) linked o he credibiliy of he consolidaion measures adoped ( 34 ), while γ represens he yield sensiiviy o he deb level and h refers o he horizon considered by he financial markes. The normal case would be ha consolidaion improves marke confidence and reduces yields, leading o a lower average effecive ineres rae r. In his case, he effec of consolidaion on deb is reinforced and deb-o-gdp raios are likely o decrease a a higher speed (or increase less) han wih consan yields. This is he case illusraed by Graph II..3 under he condiion ha he firs-year muliplier is.5 and no reacion of ineres raes o public deb increases (γ=0) akes place. I can be seen ha he criical number of years before he deb is reduced o below is saring level declines somewha wih respec o he simulaion where hese confidence affecs are no accouned for. Myopic behaviour and deb raio However, under cerain condiions markes migh reac o consolidaions by increasing yields, especially when saring levels of deb are very high, he consolidaion sraegy lacks credibiliy, he expecaions abou fuure GDP growh are subdued or when he ime horizon considered by financial markes is very shor. In such a case, he increase in ineres raes would enail a rise in he deb raio, which would involve an increase in he number of years needed o resume o he saring ( 34 ) A consan coefficien associaed o he credibiliy of he adjusmen is arguably a srong assumpion, alhough helpful o illusrae is implicaions for deb dynamics. Anoher inconvenien of his linear specificaion is ha i does no ake ino accoun hresholds effecs, which can be poenially relevan in crisis periods

5 Quarerly Repor on he Euro Area 3/202 Graph II..4: Deb evoluion as a funcion of marke horizon, firs year m=.5 (in % of GDP, ime horizon: 6 years) level. Such an effec would be raher unusual, however. In paricular, where h= indicaes ha markes look a he deb in he year of he consolidaion, hereby indicaing a high degree of myopia of financial markes. In his case, if a consolidaion increases he deb raio due o he denominaor effec, a high sensiiviy of ineres raes o he deb raio could make consolidaions self-defeaing and ac as a driver for a divergen deb raio. The presence of myopia in financial markes can play a role in increasing he number of years afer which he deb raio remains above baseline. However, as simulaions in Graph II..4 shows, only in very exreme cases characerized by high and persisen mulipliers and elevaed deb raios, financial markes myopia would lead o a deb increase in he medium run. In hese simulaions a posiive reacion of ineres raes o deb increases (γ=0.3) has been assumed. Conclusions The reacion of deb raios o fiscal consolidaions is largely driven by he size of he GDP muliplier. In his regard, i is likely ha one-year mulipliers are larger in he curren crisis period han in normal imes. Accordingly, he currenly high deb levels and he presumably sizeable fiscal mulipliers due o he crisis, joinly wih normal values for cyclical elasiciies, are likely o lead o deb rises in response o consolidaions in he shor run in several Member Saes. consolidaions are generally successful in reducing he deb-o-gdp-raio as long as hey are based on measures wih permanen effecs on he budge. However, deb increases following fiscal consolidaions can be more proraced if mulipliers are high and very persisen or if ineres raes rise abnormally in response o a fiscal ighening accompanied by a shor-erm rise in deb. A credible consolidaion sraegy would significanly reduce such risks. A fully selfdefeaing dynamics would only be generaed under very unlikely configuraions for which, in addiion o very large mulipliers and brisk increases in sovereign ineres raes in response o he consolidaion, a high degree of financial marke myopia is required. The analysis presened in his secion implies ha, for a number of euro-area Member Saes, i will ake some ime before consolidaion brings deb raios back o curren levels. In he curren seing, involving high fiscal mulipliers, i is likely ha some consolidaion packages will lead o emporary shor-erm deb increases ha will lenghen he horizon over which public deb will sar o decrease. To speed up he process of deb reducion in he sense of bringing deb below is pre-consolidaion level, sizeable consolidaions are warraned. Moreover, given he currenly high deb levels in many of hese counries, consolidaing is of primary imporance, as delaying he adjusmen implies rising deb raios, which increases significanly he likelihood of fully self-defeaing dynamics in he fuure. However, for high bu plausible values of he mulipliers, such couner-inuiive effecs are shor-lived. Over he medium-erm,

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