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Fiscal consolidation: Dr Pangloss meets Mr Keynes. Marcus Miller and Lei Zhang 19 th June 2013. Debt unsustainability and measure to correct this. Variables used may be defined as follows:. b. B. Debt sustainability and government expenditure. Tax take. Bond Accumulation . A 2.

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Fiscal consolidation dr pangloss meets mr keynes

Fiscal consolidation: Dr Pangloss meets Mr Keynes

Marcus Miller and Lei Zhang

19thJune 2013


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

Variables used may be defined as follows:


Fiscal consolidation dr pangloss meets mr keynes

b

B

Debt sustainability and government expenditure

Tax take

Bond Accumulation

A2

A0

A1

A

b0

E

b*

r-γ

B

g*

g

θ


Fiscal consolidation dr pangloss meets mr keynes

  • From a point such as A1, where the sum of expenditure and growth-adjusted interest charges exceeding 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.


Fiscal consolidation dr pangloss meets mr keynes

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 = b*.

The baseline model can then be summarised in two equations:

FC

B

where .

Or in matrix form:


Fiscal consolidation dr pangloss meets mr keynes

b structural deficit, S, so as to hit a target of

B

Fiscal consolidation with capacity output: the baseline model

F

r

Tax take

A

A'

E

b*

r-γ

F

B

g*

g

θ'

θ

δ*


Fiscal consolidation dr pangloss meets mr keynes

Different speeds of structural deficit, S, so as to hit a target of consolidation


Fiscal consolidation dr pangloss meets mr keynes

b structural deficit, S, so as to hit a target of

Fiscal fatigue defines an upper debt limit

B

“Fiscal fatigue” of Barr et al.

Tax take

F

r

A'

A

E

b*

r-γ

F

B

g*

θ

θ'

g

δ*


Fiscal consolidation dr pangloss meets mr keynes

b structural deficit, S, so as to hit a target of

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

M

F

B

θ′

g*

θ

g

δ*


Fiscal consolidation dr pangloss meets mr keynes

Simulation results which converge to full employment in the structural deficit, S, so as to hit a target of long-run

With endogenous

taxes

Non-cyclically adjusted

Baseline case


Fiscal consolidation dr pangloss meets mr keynes
Fiscal consolidation with endogenous structural deficit, S, so as to hit a target of income and taxation: flattens BB to left of MM so equilibrium shifts up FF.


Fiscal consolidation dr pangloss meets mr keynes

b structural deficit, S, so as to hit a target of

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

B

F

g*

g

θ'

θ

δ*


Fiscal consolidation dr pangloss meets mr keynes

With endogenous taxes structural deficit, S, so as to hit a target of

Simulations during the period of waiting and hoping

Non-cyclically adjusted

Baseline case


Fiscal consolidation dr pangloss meets mr keynes

b structural deficit, S, so as to hit a target of

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*


Fiscal consolidation dr pangloss meets mr keynes

Non-cyclically adjusted structural deficit, S, so as to hit a target of

Simulations showing the effect of the tightening of structural deficits

With endogenous taxes

Baseline case


Fiscal consolidation dr pangloss meets mr keynes

Fiscal consolidation structural deficit, S, so as to hit a target of 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*


Fiscal consolidation dr pangloss meets mr keynes

b structural deficit, S, so as to hit a target of

F

Failed attempts to stabilise

M

Z

B′

A

S

Z

b*

E

S

M

F

g*

θ

θ′

g

δ*


Fiscal consolidation dr pangloss meets mr keynes

b structural deficit, S, so as to hit a target of

B

DeLong and Summers: stabilisation delays fiscal consolidation

M

D

C

F

r

A

E´

F

b**

b*

E

r-γ

M

B

F

θ

g*

g

θ′

θ′′

δ*


Fiscal consolidation dr pangloss meets mr keynes

Different types of stability structural deficit, S, so as to hit a target of bonds


Fiscal consolidation dr pangloss meets mr keynes

Private structural deficit, S, so as to hit a target of Investors

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

LuckySovereigns

“Flight to safety”

UnluckySovereigns

Unlucky sovereigns face high spreads


Fiscal consolidation dr pangloss meets mr keynes

Lucky structural deficit, S, so as to hit a target of Sovereigns

UnluckySovereigns

Private Investors

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

 Stability and Growth Fund

Stability bonds

Growth bonds


Fiscal consolidation dr pangloss meets mr keynes

Balance sheet of SPV structural deficit, S, so as to hit a target of