Platon Monokroussos
While a vast volume of theoretical and empirical work exists on the effects of fiscal policy on economic activity, the feedback effect from growth to fiscal aggregates, and in particular to government debt, has received less attention.
This issue is becoming increasingly important in this juncture, as debt reduction has become a key policy target in a number of advanced economies. In the case of Greece, an aggressive fiscal consolidation effort has been undertaken since the outbreak of the sovereign debt crisis and the subsequent signing of the first and the second (present) economic adjustment program. This effort has led to a cumulative adjustment of 19.4ppts of GDP in the cyclically adjusted primary fiscal balance, to a surplus of 5.8%-of-GDP in 2013, from a deficit of 13.6%-of-GDP in 2009. Despite this unprecedented improvement, the country’s general government debt ratio has actually increased by 45.3ppts since 2009, reaching 175%-of-GDP at the end of 2013.
This development naturally raises the question of whether Greece’s fiscal adjustment is actually a “self-defeating” proposition, in the sense that the implementation of aggressive fiscal consolidation may prove counterproductive as austerity in a depressed economy could arguably erode the fiscal balance and worsen debt dynamics on a sustained basis. This study presents a simulation exercise for Greece to highlight the effects of the applied fiscal austerity program on the debt ratio and other important fiscal metrics. The paper employs the stock-flow accounting identity, known as the intertemporal budget constraint, to study the evolution of the Greek public debt ratio under different assumptions regarding the size and the degree of persistence of fiscal multiplies, the size (and the implementation profile) of the applied fiscal adjustment, and the response of financial markets to fiscal consolidation (myopic vs. forward-looking markets).
Among others, the main results of our simulation exercise can be summarized as follows: a) in view of Greece’s present elevated debt ratio, a fiscal adjustment can lead to an initial (contemporaneous) rise in the debt ratio if the fiscal multiplier is higher than around 0.5; b) despite the unprecedented improvement in Greece’s underlying fiscal position since 2010, the concomitant increase in the country’s public debt ratio can be mainly attributed to the ratio’s elevated initial level, a very wide initial structural deficit as well as the ensuing economic recession; c) notwithstanding its negative initial effects on domestic economic activity, the enormous fiscal effort undertaken in the last 4-5 years leaves the country’s debt ratio in a more sustainable path relative to a range of alternative scenarios assuming no adjustment or a more gradual implementation profile of fiscal consolidation relative to that implemented thus far.
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