Is fiscal consolidation self-defeating? A Panel-VAR analysis for the Euro area countries

Is fiscal consolidation self-defeating? A Panel-VAR analysis for the Euro area countries

Abstract

This paper studies the effects of fiscal consolidation on the debt-to-GDP ratio of
11 Euro area countries. Using a quarterly fiscal Panel VAR allows us to trace out
the dynamics of the debt-to-GDP ratio following a fiscal shock and to disentangle the
main channels through which fiscal consolidation affects the debt ratio. We define a
fiscal consolidation episode as self-defeating if the debt-to-GDP ratio does not decrease
compared to the pre-shock level. Our main finding is that when consolidation is implemented
via a cut in government primary spending, the debt ratio, after an initial
increase, falls to below its pre-shock level. When instead the consolidation is implemented
via an increase in government revenues, the initial increase in the debt ratio is
stronger and, eventually, the debt ratio reverts to its pre-shock level, resulting in what
we call self-defeating austerity.