Debt reduction and fiscal multipliers

The deterioration of public finances in the first years of the crisis has led most Member States to adopt sizeable consolidation packages. However, in view of the persistence of the crisis and the signs of weakening economic activity a vast public debate has arisen on the effectiveness of fiscal consolidation in the current situation, centred on the question of whether "austerity can be self-defeating". In this context, "self-defeating" would mean that "a reduction in government expenditure leads to such a strong fall in activity that fiscal performance indicators actually get worse" (Gros (2011)). (29) Fiscal multipliers are key to assess the response of the public debt ratio to a fiscal consolidation. This section analyses the effects of fiscal consolidations on the public debt ratio in alternative scenarios for the key parameters affecting debt dynamics. The main factors affecting the debt response are the fiscal multipliers and the financial markets' horizon. The work presented here summarizes the more detailed analysis presented in Part III of the European Commission 2012 Public Finance Report. (30) The section begins with a presentation of the analytical framework that formalizes the debt dynamics following a consolidation shock and its relationship with fiscal multipliers. It proceeds with an analysis of the conditions influencing the number of years that, in case of a short-term consolidation-induced debt-increase, are needed for a consolidation to show its effects on the debt ratio. It concludes with a discussion of some policy implications.