Public debt, sovereign spreads and the unpleasant arithmetic of fiscal consolidations

• Published date: 01 August 2021
• Author: Marco Di Pietro,Luigi Marattin,Raoul Minetti
• Date: 01 August 2021
• DOI: http://doi.org/10.1111/infi.12390

International Finance. 2021;24:155–178. wileyonlinelibrary.com/journal/infi © 2021 John Wiley & Sons Ltd.

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155

Received: 30 January 2020

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Revised: 8 January 2021

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Accepted: 17 March 2021

DOI: 10.1111/infi.12390

ORIGINAL ARTICLE

Public debt, sovereign spreads and the

unpleasant arithmetic of fiscal consolidations

Marco Di Pietro

1

|Luigi Marattin

2

|Raoul Minetti

3

1

Dipartimento di Economia e Diritto,

Sapienza University of Rome,

Rome, Italy

2

Dipartimento di Scienze Economiche,

University of Bologna, Bologna, Italy

3

Department of Economics, Michigan

State University, East Lansing,

Michigan, USA

Correspondence

Raoul Minetti, Department of

Economics, Michigan State University,

486 W. Circle Drive, 110 Marshall‐Adams

Hall, East Lansing, MI 48824‐1038, USA.

Email: minetti@msu.edu

Abstract

In response to severe fiscal consolidation policies im-

plemented after the Great Recession and the euro area

sovereign debt crisis, many have questioned the effective-

ness of fiscal consolidations in reducing the burden of

public debt. This paper revisits this fundamental policy

debate qualitatively and quantitatively, studying conditions

under which primary budget balance changes can suc-

cessfully reduce government debt‐to‐GDP ratios. We first

illustrate these conditions through a partial equilibrium

setting. We then investigate the conditions quantitatively

using a medium‐scale New Keynesian DSGE model cali-

brated on periphery countries of the euro area. The ana-

lysis highlights the critical role of sovereign spreads in

driving the debt‐to‐GDP dynamics following a restrictive

primary balance shock. Fiscal consolidations turn out to

successfully reduce the debt‐to‐GDP even for fairly low

elasticities of spreads to fiscal variables. However, their

effectiveness is quantitatively moderate and varies cru-

cially with the initial spread level, with the degree of

monetary policy accommodation, and with the respon-

siveness of market investors to economic fundamentals.

KEYWORDS

debt sustainability, debt‐to‐GDP, fiscal consolidations, sovereign

spreads

JEL CLASSIFICATION

E60; H63

1|INTRODUCTION

After the Great Recession and the euro area sovereign debt crisis, several countries have im-

plemented fiscal consolidation policies. For example, from 2009 to 2018 deficit‐to‐GDP ratios

were massively reduced both in the EU‐28 (from 6.6% to 0.7%) and in the United States (from

9.8% to 3.8%).

1

These fiscal consolidation processes have reignited the debate on the effectiveness

of economic austerity (Blanchard & Leigh, 2013; Gros & Maurer, 2012;Mauroetal.,2015). Critics

of austerity policies challenge the view that fiscal consolidations can achieve reductions in the

burden of public debt. Some point out that, by depressing the GDP, consolidation policies may

sometimes even result in increases in the debt‐to‐GDP ratio. A more established view is that fiscal

consolidations can reduce the burden of public debt, though at the costof a GDP fall. Even within

this view, however, opinions widely differ about the magnitude of the debt‐to‐GDP reductions

that can be attained.

Given the complex mechanisms through which primary balance changes can affect the

stock of government liabilities relative to the GDP, this heterogeneity of points of view is not

surprising. The goal of this paper is to revisit this fundamental debate to clarify and quantify the

conditions under which a change in the government primary balance produces a change of the

same sign in the debt over GDP ratio. The main message of the paper is that endogenous

sovereign spreads play a critical role in the impact of fiscal consolidations on the debt‐to‐GDP

ratio. The analysis reveals that, in designing fiscal consolidation policies, policy makers should

account for the forces that shape the response of sovereign spreads to fiscal consolidations,

including investors' responsiveness to economic fundamentals (state of public finances and

growth dynamics) and the degree of accommodation of monetary policy.

We first present a partial equilibrium example that illustrates the forces at work following

fiscal consolidations. Using the arithmetic of government budget constraints, we identify the

conditions under which a change in the primary balance budget produces a change of the same

sign in the government debt‐to‐GDP ratio. We then develop a quantitative analysis building a

dynamic, general equilibrium medium‐scale New Keynesian model à la Smets and Wouters

(2003) augmented with a public sector. We use the model to investigate the impact of fiscal

consolidations, implemented through public expenditure reductions or income tax increases. In

the model, to capture the role of sovereign debt spreads in the recent dynamics of public debts,

we allow for endogenous feedback mechanisms between risk premia on government bonds and

the debt‐to‐GDP ratio. In particular, the specification of the sovereign spread allows for its

endogenous response to the debt‐to‐GDP ratio, to fiscal deficits, and to the growth dynamics of

the economy. It also allows for the role of investors' sentiments in driving the responsiveness of

the spread to fundamentals. We calibrate the baseline model to data from Italy, a country with

a historically large debt over GDP ratio that has faced tensions in the government bond market

during the European sovereign debt crisis. We then perform a comparative analysis across four

economies of the euro area periphery (Italy, Spain, Portugal, and Greece) by adjusting the

calibration to country‐specific parameters.

As illustrated in the partial equilibrium example, three forces are at work following a fiscal

consolidation (Cottarelli & Jaramillo, 2012). One is direct: ceteris paribus, a public spending cut

(or an increase in taxes) causes a decrease of the stock of nominal debt. The other two are

indirect: a decrease in the primary deficit decreases nominal growth in the short run and

therefore increases the debt over GDP ratio. At the same time, by modifying risk premia on the

existing and new debt, it may decrease the average cost of government debt and, hence, the

debt‐to‐GDP ratio.

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