Fiscal consolidation: Dr Pangloss meets Mr Keynes

1. Fiscal consolidation: Dr Pangloss meets Mr Keynes by Marcus Miller and Lei Zhang

2. Debt unsustainability and measure to correct this Variables used are defined as follows:

3. 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

4. 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.

5. 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:

6. 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*

7. α = 0.4 α = 1 α = 0.5 Different speeds of consolidation

8. 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*

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

10. 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*

11. Simulation results which converge to full employment in the long-run With endogenous taxes Not cyclically adjusted Baseline case

12. 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*

13. With endogenous taxes Simulations during the period of waiting and hoping Not-cyclically adjusted Baseline case

14. 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*

15. Simulations showing the effect of the tightening of structural deficits With endogenous taxes Not cyclically adjusted Baseline case

16. 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*

17. b F Failed attempts to stabilise M Z B′ A S Z b* E S M F g* θ θ′ g δ*

18. 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*

19. Different types of stability bonds

20. Private Investors BEFORE: Investors holds sovereign bonds - but are prone to switch LuckySovereigns “Flight to safety” UnluckySovereigns Unlucky sovereigns face high spreads

21. 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

22. Balance sheet of SPV

23. 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?