Fiscal consolidation: Dr Pangloss meets Mr Keynes

1. Fiscal consolidation: Dr Pangloss meets Mr Keynes Marcus Miller and Lei Zhang 19thJune 2013

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

3. b B Debt sustainability and government expenditure Tax take Bond Accumulation A2 A0 A1 A b0 E b* r-γ B g* g θ

4. 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.

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 = b*. 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 F B g* g θ' θ δ*

7. 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 F B g* θ θ' g δ*

9. 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 M F B θ′ g* θ g δ*

10. Simulation results which converge to full employment in the long-run With endogenous taxes Non-cyclically adjusted Baseline case

11. Fiscal consolidation with endogenous income and taxation: flattens BB to left of MM so equilibrium shifts up FF.

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 B F g* g θ' θ δ*

13. With endogenous taxes Simulations during the period of waiting and hoping Non-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. Non-cyclically adjusted Simulations showing the effect of the tightening of structural deficits With endogenous taxes 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 M D C F r A E´ F b** b* E r-γ 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