5 Fiscal consolidation - a simple illustration
The examples of Spain and Greece from the app of the previous section show that budget consolidation in the sense of reducing the debt ratio is a very difficult policy area. It is not that easy to simply cut the budget and the debt ratio will fall. First, unforeseen economic shocks can dramatically change the course of a consolidation path or plan. Second, the feedback effects of austerity measures on economic activity can undermine the planned consolidation efforts.
The next app uses a simple simulation to illustrate the first problem in a stylised form. In the app, you can set a specific path for fiscal consolidation or expansion and activate temporary disruptions (so-called “shocks”) to the level of GDP and/or permanent changes in the growth rate of GDP to see how this affects the evolution of the debt ratio. An important simplifying assumption in this exercise is that the change in fiscal policy, in terms of the path of the deficit, has no feedback effects on GDP. This is of course unrealistic, but it helps to understand how exogenous shocks to GDP can already become a challenge to the goal of fiscal consolidation. We also ignore for the moment that government revenue and expenditure can also be affected by changes in GDP. So in this exercise we are merely illustrating the simple fact that the denominator of the debt-to-GDP ratio, the level of GDP, does not necessarily develop as originally planned or assumed by the government. This alone can undermine the planned consolidation plan.
A simple illustration of fiscal consolidation: In this app, you get a first impression of the impact that sudden and unanticipated changes in GDP and its growth rate could have on a given path of fiscal consolidation (or expansion).
Important assumptions and limitations: The simulation makes the important simplifying assumptions that shocks to GDP are fully exogenous and that there are no feedback effects on GDP from changes in the government deficit ratio. There are also no cyclical feedback effects on government revenue and expenditure.
The scenario in the app provides a basic illustration of the way in which exogenous shocks to economic activity can affect the public debt ratio. Of course, the scenario presented in the app completely neglects the fact that changes in fiscal policy usually also affect the level and growth rate of GDP and that economic fluctuations also affect government revenues and expenditures. Such macroeconomic feedback effects can, however, have serious consequences, as we have previously noted with regard to the damaging effects of austerity policies in Greece, Spain and other southern European countries in the wake of the euro crisis. Austerity policies, especially when applied during a crisis, are likely to undermine consolidation efforts, at least in the short term. But even without such feedback effects, the App scenario shows that unforeseen economic shocks, such as a crisis or a permanent decline in the growth rate, can have serious consequences for any consolidation path. Of course, the reverse is also true: an unforeseen economic boom can make consolidation much easier for the government.
In the next app, you can repeat the exercise described above with actual data.
A simple illustration of fiscal consolidation with actual data: In the following app, you can repeat the previous exercise but with a connection to actual data.
Important assumptions and limitations: The simulation makes the important simplifying assumptions that shocks to GDP are fully exogenous and that there are no feedback effects on GDP from changes in the government deficit ratio. There are also no cyclical feedback effects on government revenue and expenditure. Scenarios created in this app are for illustrative purposes only. They should not be confused with actual projections, as they contain many strong simplifications and assume away a few important factors that can be strong drivers of debt dynamics.6