22 November 2013

IMF Working Paper: Debt Reduction, Fiscal Adjustment, and Growth in Credit-Constrained Economies

This paper shows that gradual and adequately balanced fiscal adjustments may be more appropriate to spur medium-term economic growth than deficit reductions driven by spending cuts in the context of financial constraints.

Authors: Emanuele Baldacci, Sanjeev Gupta, and Carlos Mulas-Granados

If credit is not available to consumers and investors, private demand cannot compensate for cutbacks in public demand and strong fiscal adjustments can have a negative effect on growth. Crowding-in of the private sector when the public sector adjusts is also difficult in the presence of credit constraints.

Post-crisis uncertainty about financial sector health could affect the degree to which fiscal policy can raise medium-term growth through public debt consolidation. The combination of bank deleveraging and public debt consolidation could change the way economic agents assess the effects of government policies. In particular, the fiscal mix that under normal circumstances would have delivered growth-boosting public debt consolidations may not be successful under an environment of credit restrictions.

These findings are consistent with those of Eggertsson and Krugman (2010), who illustrate the growth consequences of deleveraging when the effectiveness of monetary policy is constrained by a liquidity trap. They are also consistent with the findings in the expansionary fiscal contraction literature (Alesina and Ardagna, 2010) in cases where credit supply to the private sector is not affected by financial sector weaknesses.

The results presented in this paper show that both the size and pace of fiscal adjustment are relevant for medium-term output growth. When private debt remains high and lending to the private sector subdued, the fiscal mix is critical for post-episode output expansion:

• Spending cuts may reduce aggregate demand and exacerbate real debt pressures by causing price deflation, while protecting public investment during deficit-reduction spells can support medium-term output growth.
• Revenue increases may be less damaging for economic growth to the extent that they have a less adverse effect on consumption in the medium term. Deficit-reduction measures that succeed in raising direct tax revenues by broadening the tax base can be beneficial for medium-term growth.

The policy implications of these results are significant: when bank deleveraging is high and credit is not flowing to the private sector, public debt consolidations should be gradual and based on an appropriate combination of revenue and expenditure measures rather than spending cuts alone (IMF, 2012b). The fiscal policy mix should rely on cutting non-priority spending and protecting pro-growth public investment, especially when there is high structural unemployment. Revenue raising measures should aim at reducing inefficiencies and encouraging labour market participation and consumption. This calls for removing tax exemptions, lowering incentives for tax avoidance and evasion, and shifting tax pressure away from labour to property and low-elasticity consumer goods and services.

Reforms to enhance competitiveness in product and labour markets and strengthen fiscal institutions (Schaechter and others, 2012) can also help support debt consolidation strategies over time sustaining the needed fiscal reforms while limiting the risk of “adjustment fatigue” (IMF, 2012a).

Full paper

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