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Fiscal consolidation: Dr Pangloss meets Mr Keynes. by Marcus Miller and Lei Zhang. Debt unsustainability and measure to correct this. Variables used are defined as follows:. b. B. Debt sustainability and government expenditure. Tax take. Bond Accumulation. A 2. A 0. A 1. A. b 0.

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debt unsustainability and measure to correct this
Debt unsustainability and measure to correct this

Variables used are defined as follows:

slide3

b

B

Debt sustainability and government expenditure

Tax take

Bond Accumulation

A2

A0

A1

A

b0

E

b*

r-γ-π

B

g*

g

θ

slide4

From a point such as A1, where the sum of expenditure and interest charges (adjusted for growth and inflation) exceeds the tax base, debt will grow unsustainably unless some action is taken. Such action may include:

  • reducing expenditure or raising tax rates;
  • debt reduction via inflation or explicit repudiation;
  • financial repression, i.e. lowering the rate of interest paid;
  • increasing the growth rate
  • a debt equity swap
  • or some combination of the above.
slide5

Let the plan for fiscal consolidation be to adjust the structural deficit, S, so as to hit a target of δ*, where S is defined as .

b*; so

The baseline model can then be summarised in two equations:

FC

B

where .

Or in matrix form:

slide6

b

B

Fiscal consolidation with capacity output: the baseline model

F

r

Tax take

A

A\'

E

b*

r-γ-π

F

B

g*

g

θ\'

θ

δ*

slide7

α = 0.4

α = 1

α = 0.5

Different speeds of consolidation

slide8

b

Fiscal fatigue defines an upper debt limit

B

“Fiscal fatigue” of Barr et al.

Tax take

F

r

A\'

A

E

b*

r-γ-π

F

B

g*

θ

θ\'

g

δ*

slide9
Fiscal consolidation with endogenous income and taxation: BB flatter to left of MM; equil shifts up FF.
slide10

b

Fiscal stabilisation works, but with temporary recession

B

M

Recession

No Recession

B′

Higher debt with lower tax take

F

r

C

A

Tax take at capacity output

E

b*

r-γ-π

M

F

B

θ′

g*

θ

g

δ*

slide11

Simulation results which converge to full employment in the long-run

With endogenous

taxes

Not cyclically adjusted

Baseline case

slide12

b

Fiscal consolidation – waiting and hoping

Regime switches

B

M

D

Temporary recession

No recession

F

r

Tax take at capacity output

C

A\'

E\'

A

E

b*

X

D

M

r-γ-π

B

F

g*

g

θ\'

θ

δ*

slide13

With endogenous taxes

Simulations during the period of waiting and hoping

Not-cyclically adjusted

Baseline case

slide14

b

Tightening fiscal policy to hit the debt target, b*

B

M

Recession

No Recession

B\'

F\'

F

r

Tax take at capacity output

E\'

ED

E

b*

B\'

B

F\'

g*

gD

M

F

g

θ\'

θ

δ*

slide15

Simulations showing the effect of the tightening of structural deficits

With endogenous taxes

Not cyclically adjusted

Baseline case

slide16

Fiscal consolidation defeated by high interest rates

b

U

Explosive path of debt

F

r

B′

S

A

E

S

B′

F

U

g

θ′

θ

δ*

slide17

b

F

Failed attempts to stabilise

M

Z

B′

A

S

Z

b*

E

S

M

F

g*

θ

θ′

g

δ*

slide18

b

B

DeLong and Summers: stabilisation delays fiscal consolidation, with higher taxes to cover debt interest

M

D

C

F

r

A

E´

F

b**

b*

E

r-γ-π

M

B

F

θ

g*

g

θ′

θ′′

δ*

slide20

Private Investors

BEFORE: Investors holds sovereign bonds - but are prone to switch

LuckySovereigns

“Flight to safety”

UnluckySovereigns

Unlucky sovereigns face high spreads

slide21

LuckySovereigns

UnluckySovereigns

Private Investors

AFTER: Stability and growth fund pools sovereign debt - and diversifies types of bond

 Stability and Growth Fund

Stability bonds

Growth bonds

conclusion
Conclusion
  • Have used simple multiplier to capture private sector reaction to public sector consolidation.
  • Far preferable explicitly to model private and public sector behaviour as they engage in a dance of deleveraging, but…
  • Koo warns of balance sheet recession that will result.
  • Is it true that credibility rules out state contingent policy?
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