Good and bad equilibria

Abstract

Fiscal consolidation will go too far if it pushes the economy towards a bad equilibrium with high and growing fiscal deficits and debt, high risk premia on sovereign debt, slumping economic activity and plummeting confidence. In this paper we examine the possible conditions under which fiscal consolidation would backfire in this sense. For this purpose we develop a stylised stock-flow model of public debt and growth, which we subsequently calibrate empirically on a sample of OECD countries. We find that, if the sovereign risk premium is initially high, fiscal consolidation will help a country to escape from a bad equilibrium, not push it toward it, even if the direct negative demand impact of fiscal consolidation is large. In that case the stabilising impact of structural reform and financial backstops will also be larger than under normal market conditions.