When fiscal consolidation meets private deleveraging

Abstract

Inspired by the recent experience in some euro area countries, we analyze the interaction between fiscal consolidation and private deleveraging in a model of a small open economy in a monetary union. The coexistence of long-term private debt and collateral constraints on new loans implies that, following an adverse financial shock, the economy enters a slow private deleveraging process, the duration of which is endogenous to collateral and debt dynamics. In this context, large and/or front-loaded consolidations increase the length and depth of private deleveraging, causing higher relative output losses over the medium run. As a result, such aggressive consolidation strategies entail larger present-value multipliers. Our results thus speak in favor of ‘deleveraging-friendly’ (smaller/more gradual) consolidations.