Effects of Fiscal Consolidation in the OECD

# _1. Introduction_

Despite the current OECD-wide recession, there is a likelihood of significant fiscal consolidation over the remainder of ti.o* decade in many of the OECD economies. In the United States, the Clinton Administration has proposed and Congress has passed, a credible fiscal deficit reduction package. In Europe, the Maastricht Treaty imposes a period of fiscal consolidation in most countries within the EMS, as these countries attempt to reach targets for government debt and fiscal deficits that are considered as preconditions for a move to a single currency. Other OECD countries such as Australia and Canada have also announced intentions to reduce fiscal deficits over the next few years.

Is fiscal consolidation within the OECD during a period of slow growth, a recipe for global stagnation for the remainder of the decade?A common argument is that the fall in government demand necessarily implies a fall in aggregate demand and therefore through conventional Keynesian mechanisms, a deficit reduction policy at this stage of the global business cycle would worsen the recession. An alternative argument is that because the fiscal consolidation will be undertaken gradually, long term interest rates will fall in the short run and this will help _short term_ growth within the OECD. By the time the fiscal cuts are actually implemented the world economy will already be growing strongly and the negative demand consequences of the consolidation will largely be diluted. Opponents of this view argue that either interest rates are largely independent of fiscal policy, or that interest rate changes have little effect on real activity and the dominant outcome of fiscal consolidation will be the negative impact on aggregate demand.

This paper focuses on this issue. In particular, it presents some evidence on the impact of a change in fiscal policy in major OECD economies. Section 2, gives an overview of the extent of cuts in the fiscal deficit proposed by the Clinton Administtion as weil the extent to which European governments will need to cut fiscal deficits between now and 1997 if they are to satisfy the deficit targets in the Maastricht Agreement. In Section 3 the MSG2 multi-country model is used to focus on the key channels through which fiscal policy influences the economy as well as suggesting quantitative magnitude of the impact of the cuts. A global model is essential for capturing the many channels through which a change in fiscal policy influences global economic activity- In that section it is shown that the transmission of changes in fiscal policy within an economy and between that economy and the rest of the world depends on a number of factors. Among the many factors are: whether the change in fiscal policies lead to pemaent or temporary changes in government saving; whether the change in fiscal policy occurs through changes in govermment spending or through change in taxes; if taxes are used it matters whether these taxes are levied on households or firms. The major channels of transmission are through changes in agents expectations of future taxes, changes in interest rates, changes in exchange rates, and changes in economic activity. In the MSG2 -model, a reduction in government demand reduces overall economic activity because the Keynesian style multiplier more than outweighs the stimulus caused by lower real interest rates and a weaker exchange rate. However, it is shown that if the path of fiscal reduction is pushed sufficiently into the future, the change in interest rate and exchange rates which occur in the present, then it is possible for a deficit reduction program to be stimulatory in the short term. When the cuts in spending finally occur there is still a fall in aggregate demand but it is offset to some extent by the stimulus from changes in asset prices.

In section 4. the empirical relevance of the various channels that are the basis for the simulation results are reviewed. The evidence from econometric studies as well as simulations from other multicountry models are summarized. The evidence from econometric studies of the link between budget deficits and interest rates and between interest rates and economic activity are less than robust.