Fiscal consolidation in times of financial stress: theory and evidence

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We investigate how fiscal consolidation affects economic activity in times of financial stress. Measures of fiscal consolidation include the reduction of government spending and transfer payments as well as tax increases. Such measures are currently enacted in many OECD countries and further measures are likely to be observed in coming years as governments attempt to reign in public debt. The notion of times of financial stress is meant to capture a situation where 1) borrowing costs of governments and/or private agents are high because of increased default risk and 2) the conduct of monetary policy is constrained by the zero lower bound on policy rates. While standard models and most empirical studies suggest that fiscal consolidation is detrimental to economic activity in normal times, i.e. in a situation where borrowing costs are low and monetary policy is unconstrained, the consequences of consolidation in times of financial stress are less well understood. We therefore assess, both theoretically and empirically, the hypothesis that the consequences of fiscal consolidation in times of financial stress differ from its consequences in normal times. In order to do so, we develop tools which allow us to account for state dependence of the effects of fiscal policy measures. In terms of specific objectives we aim at developing a model of the fiscal transmission mechanism which also features the possibility of sovereign default, establishing robust time-series evidence on the effects of consolidations measures in times of financial stress, and, eventually, exploring the role of credibility for the success of consolidations.