An empirical IMF paper suggests that public debt reduction can support medium-term growth, if it is focused on cuts in non-investment spending. Such benign fiscal consolidation is less likely, however, when the private sector is credit constrained and fails to benefit from lower public borrowing, as has been the case after the 2008 financial crisis. In this case more balanced and gradual fiscal adjustment may be required to mitigate the negative growth effect.


Debt Reduction, Fiscal Adjustment, and Growth in Credit-Constrained Economies
Emanuele Baldacci, Sanjeev Gupta, and Carlos Mulas-Granados
IMF Working Paper 13/238

 http://www.imf.org/external/pubs/ft/wp/2013/wp13238.pdf

The below are excerpts from the paper. Cursive lines and emphasis has been added

The post-crisis fiscal consolidation challenge

“[Since the 2008 financial crisis] fiscal consolidations have not succeeded in lowering public debt in relation to GDP. Fiscal deficit-reducing measures in the presence of credit restrictions have worsened budget positions without being compensated by a substantial increase in private sector’s activity…The beneficial effect of fiscal adjustment on interest rates (and thus private credit growth) has been limited because of the perceived link between sovereign and financial sector credit risks. Furthermore, monetary policy effectiveness has been limited by impaired financial sector transmission channels.”

Empirical analysis of public debt reductions since 1980

“The starting sample used in this paper comprises 160 episodes of public debt reduction in 107 advanced and emerging economies during 1980–2012. The episodes are defined as at least two consecutive years of reduction in the ratio of public debt to GDP…In principle, the reduction in the debt-to-GDP ratio could stem from a decline in cyclically-adjusted primary balances (CAPB), a reduction in interest rates, output growth, and other adjustments to the stock of debt, such as privatizations and exchange rate movements. In our subsample, the key factor behind the reduction in the debt ratio was the improvement in CAPB.”

“The average distance of initial public debt from a reference (sustainable) target was 28.6 percentage points of GDP. The average debt reduction during the episodes amounted to 30 percentage points of GDP. In 45 percent of the episodes, the debt ratio was reduced to levels below the sustainable threshold. During the debt reduction episodes, the average increase in CAPB was 3.9 percent of GDP, mostly owing to spending cuts (53 percent of deficit reduction was achieved through cuts in non-productive spending).”

Fiscal adjustments relying on focused public expenditure cuts that preserve public investment contribute positively to medium-term output growth…During debt reduction episodes, gradually paced fiscal adjustments are positive for output expansion, but large deficit cuts have a contractionary effect. A 1 percent-of-GDP reduction in the cyclically-adjusted fiscal deficit reduces average medium-term growth by 0.27 percentage points. However, one more year in the length of the debt consolidation episode raises average economic growth by 0.22 percentage points in the subsequent five-year period. Initial public debt is not a significant impediment for future growth. The fiscal adjustment mix can have an impact on growth: a 1 percent increase in contribution of cuts to fiscal adjustment increases medium-term growth by 0.32 percentage points.”

“This relationship between the fiscal adjustment mix and growth is, however, affected by financial conditions. The results show that spending-based adjustments support output growth after the debt consolidation episode, except in cases where there is sustained bank deleveraging and tight private sector credit conditions…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.”

“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.”