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Unit 4 Macro: New research on fiscal austerity and the sovereign debt crisis

Friday, March 01, 2013
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The latest edition of the Economics Journal publishes some new macroeconomic research on the vexed issue of fiscal austerity. Below are some of the summaries of these research papers.


Current efforts at fiscal consolidation are unlikely to raise economic growth, according to research by Huixin Bi, Eric Leeper and Campbell Leith, published in the latest issue of the Economic Journal. Their study shows that an expansionary fiscal consolidation is conceivable in a very particular set of conditions – but these conditions are unlikely to be fulfilled in the foreseeable future.

What’s more, the researchers conclude, even if it were possible to engineer the conditions for an expansionary fiscal consolidation, it is unlikely to be a good thing. The policy relies on depressing the economy by leading households and firms to believe that one debt reduction strategy will be followed, only to induce a boom by implementing a different, less costly, policy. In other words, it works by fooling people, which is rarely desirable. Debt reduction is, inevitably, a long and painful process.


Greece, Iceland, Italy, Japan and Portugal all have limited or no available room for fiscal manoeuvre before markets force them to tighten policies sharply, raising taxes and/or cutting government spending in order to restore or maintain the sustainability of public debt.

That is one of the findings of research by Atish Rex Ghosh and colleagues, which develops a measure of ‘fiscal space’ – the distance between the current level of public debt and the maximum level that is compatible with fiscal solvency – and applies the methodology to a sample of advanced economies.

Their study, which is published in the latest issue of the Economic Journal, finds ample fiscal space for Australia, Korea and the Nordic countries. For the UK and the United States, the study finds around 50-75% of GDP of remaining fiscal space.


When the economy is flat-lining or in recession, fiscal stimulus will only be effective when concerns about sovereign risk (the possibility that the government will default on its debt) are contained. That is the central conclusion of research by Giancarlo Corsetti, Keith Kuester, André Meier and Gernot Müller, published in the latest issue of the Economic Journal.

Their study explores how policy-makers can preserve macroeconomic stability in a situation where fears about sovereign default drive up risk premia for banks, firms and the wider economy. The threat to stability becomes acute when public debt is high and monetary policy is at the zero lower bound. Once the central bank has exhausted the room for further monetary easing, government spending cuts can become a critical tool to avert self-fulfilling crisis dynamics.

What’s more, government spending cuts are less harmful to growth in the presence of the ‘sovereign risk channel’ through which high public indebtedness raises funding costs in the private sector and dampens overall economic activity. The researchers conclude:

‘Our results underscore the importance of keeping the public finances under control during good times.

‘Only when concerns about sovereign risk are contained, do fiscal policy-makers retain the capacity to enact effective fiscal stimulus during bad times.’


A ‘Robin Hood’-style redistribution policy, which takes money from the rich and gives it to the poor, can boost consumption and output, although at the cost of higher inflation. So too can an increase in public debt that is used to transfer resources to everyone.

These are among the conclusions of research by Florin Bilbiie, Tommaso Monacelli and Roberto Perotti, published in the latest issue of the Economic Journal. One of the key insights of their study is that public debt is equivalent to redistribution.

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