PowerPoint Presentation

Fiscal consolidation: Dr Pangloss meets Mr KeynesbyMarcus Miller and Lei Zhang

1Debt unsustainability and measure to correct thisParameterDefinitionbLevel of debt/capacity output - endogenousgGovernment expenditure/capacity output - endogenousTax revenue as a fraction of capacity outputrCost of debt service as a fraction of capacity outputRate of capacity growth,Rate of inflationVariables used are defined as follows:22bgg*Er--Bb*Tax takeBb0A1A2AA03Debt sustainability and government expenditureFrom a point such as A1, where the sum of expenditure and interest charges (adjusted for growth and inflation) exceeds 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.4455rbgg*EAr--A'FB*b*Tax take'BF

Fiscal consolidation with capacity output: the baseline model6Different speeds of consolidation7

= 0.4 = 1 = 0.57A'*bgg*Fiscal fatigue of Barr et al.rEAr--FBb*Tax take'BF

Fiscal fatigue defines an upper debt limit8Fiscal consolidation with endogenous income and taxation: BB flatter to left of MM; equil shifts up FF.9

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M*bgg*Higher debt with lower tax takerEAr--FBb*Tax take at capacity outputBFMRecessionNo RecessionCBFiscal stabilisation works, but with temporary recession10Simulation results which converge to full employment in the long-run11

Not cyclically adjustedWith endogenous taxesBaseline case11Fiscal consolidation waiting and hoping12gg**'rbEAr--A'FBb*Tax take at capacity outputBFRegime switchesE'XCMMDDTemporary recessionNo recession13Simulations during the period of waiting and hoping

With endogenous taxesBaseline caseNot-cyclically adjusted 1314g*'ErbFBb*Tax take at capacity outputMFB'B'F'F'EDE'MBg*gDRecessionNo RecessionTightening fiscal policy to hit the debt target, b*

15Simulations showing the effect of the tightening of structural deficits

With endogenous taxesBaseline caseNot cyclically adjusted *bgExplosive path of debt rAFEFUUSSBB

Fiscal consolidation defeated by high interest rates16

17Failed attempts to stabilise*bgFEFSSBg*b*AMMZZDeLong and Summers: stabilisation delays fiscal consolidation, with higher taxes to cover debt interest18

*bgg*rEr--FBb*ACDb**EFBFMMNameConceptEuro-bondsIssue of common bonds to replace all debt Blue bondsIssue of common bonds up to 60% of GDP Elite bondsCommon bonds only for AAA rated countriesDebt retirement fundNew entity that pools all debts above 60% of GDP, issues its own common bonds. Countries have a credible commitment to amortise the debt in a certain time frameDifferent types of stability bonds1919Private Investors Flight to safetyLuckySovereignsUnluckySovereignsUnlucky sovereigns face high spreadsBEFORE: Investors holds sovereign bonds - but are prone to switch20Growth bondsStability bondsLuckySovereignsUnluckySovereignsPrivate InvestorsStability and Growth FundAFTER: Stability and growth fund pools sovereign debt - and diversifies types of bond21AssetsLiabilitiesSovereign bonds: Plain vanilla

(b) Growth and GDP-linked Euro stability bonds

Equity baseBalance sheet of SPV2222ConclusionHave used simple multiplier to capture private sector reaction to public sector consolidation.Far preferable explicitly to model private and public sector behaviour as they engage in a dance of deleveraging, butKoo warns of balance sheet recession that will result. Is it true that credibility rules out state contingent policy?2323

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