When is fiscal adjustment an illusion?

Abstract

Fiscal adjustment is an illusion when it lowers the budget deficit or public debt but leaves government net worth unchanged. Conventional measures of the budget deficit largely show the change in public sector debt. Ideally, the measured deficit would reflect the change in Public sector net worth. Many people consider it impractical to try to measure public sector assets. My paper does not discuss what the deficit should measure, but instead proposes a positive and testable theory of how governments actually behave. When an outside agent forces a reduction in a government's conventional deficit and debt accumulation, the government responds by lowering asset accumulation or increasing hidden liabilities. Since government net worth is unchanged, such fiscal adjustment is an illusion. Using data from countries with World Bank and IMF fiscal adjustment programmes, and case studies of EMU countries' compliance with the Maastricht criteria, I confirm my theoretical predictions: fiscal adjustment in these countries was at least partly an illusion.