PowerPoint Presentation

Fiscal consolidation: Dr Pangloss meets Mr KeynesMarcus Miller and Lei Zhang19th June 2013

1Debt unsustainability and measure to correct thisParameterDefinitionbLevel of debt/capacity outputgGovernment expenditure/capacity outputTax revenue as a fraction of capacity outputrReal rate of interest, taken as exogenousRate of capacity growth, taken as exogenousVariables used may be defined as follows:22bgg*Er-Bb*Tax takeBb0A1A2AA03Debt sustainability and government expenditureFrom a point such as A1, where the sum of expenditure and growth-adjusted interest charges exceeding 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 model6

Different speeds of consolidation77A'*bgg*Fiscal fatigue of Barr et al.rEAr-FBb*Tax take'BF

Fiscal fatigue defines an upper debt limit8

M*bgg*Higher debt with lower tax takerEAr-FBb*Tax take at capacity outputBFMRecessionNo RecessionCBFiscal stabilisation works, but with temporary recession9Simulation results which converge to full employment in the long-run10

Non-cyclically adjustedWith endogenous taxesBaseline case10Fiscal consolidation with endogenous income and taxation: flattens BB to left of MM so equilibrium shifts up FF.11

11Fiscal 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 caseNon-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 caseNon-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 consolidation18

*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 SPV2222