# I

### POLICY **RESEARCH WORKING PAPER** 1354

## Summary findings

Despite the current recession in many parts of the OECD, fiscal consolidation is likely in many OECD economies in _the 1_ 990s. McKibbin asks: Is fiscal consolidation in the OECD in a period of low growrh a recipe for global stagnation? In particular, what effects are likely in developing countries?

McKibbin starts with an overview of cuts in the U.S. fiscal deficit proposed by the Clinton administration and the extent to which European governments must cut fiscal deficits between now and 1997 to satisfy deficit targets in the Maastricht Treaty.

How changes in fiscal policy are transmitted within an economy and between that economy and thz rest of the world depends on whether those changes lead to permanent or temporary changes in government saving; whether they are implemented through government spending or taxes; and whether the taxes fall on households or firms. The main channels of transmission are through changes in

* Agents' expectations about futuire taxes

* Interest rates

- Exchange rarcs

a Economic activity.

McKibbin uses the MSG2 multicountry models to quantify the ramifications of those changes.

He concludes, among other things, that fiscal contraction in the OECD will probably lcad to slower growth over the _next several_ years. But the current and likely paths of fiscal policy are such that deficit reduction programs may have a stimulating effect in the short run, as long as future fiscal contraction is credible. And fiscal deficit reduction will probably increase long-run output in the OECD through its effects on savings and investment.

Finally, growth in the dcveloping countries (at least total growth) may not be impaircd ar all by fiscal consolidation in the OECD. The negative effects of fiscal contraction will occur through lower net exports of nonOECD economies. For developing countrie.; with open capital markets, _tlhc_ initial reduction in demand rhrough lower exports can be offset by the rcduction in interest rates following an inflow of capital from the countries with contracting fiscal policy.

A significant decline in real global interest rates is likely to increase growrh in developing countries thar are debt-constrained, either directly (through private capital inflows) or indirectly (by relaxing the balance of payments constraint, allowing more resources to be channeled to domestic investment needs).

TEhispaper is one in a series of background documents commissioned by the International EconomicsDepartment to support analyses and scenarios in _Global Economic Prospects_ 1994. Copies of this paper are available free from rhe World Bank, 1818 H Street NW, Washingron, DC 20433. Please contact Jackie Queen, room S8-216, extension 33740 (30 pages). September 1994.

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