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# **5. Summary and conclusion**

Fiscal consolidation by advanced economies (in proportion to the size of their debt problem) has the temporary effect of lowering economic activity in those economies, but has a positive effect on emerging countries and a few advanced economies not undertaking fiscal consolidation.

The reason is that the negative flow-on effects from trade linkages by advanced economies reducing imports and stimulating exports with the emerging world are offset by favourable financial flow-on effects, which provides capital for emerging countries to increase GDP.

As prospects temporarily weaken in advanced economies as spending contracts with fiscal consolidation and governments borrow less, real long bond rates eventually fall. However, short real interest rates temporarily rise as future spending is brought into the present and central banks tighten monetary policy in response to higher inflation. Lower real long bond rates boost investment prospects in the emerging world and this positive effect outweighs the negative direct trade effects. Consequently, there is a capital outflow from advanced economies to the emerging world.

Emerging countries receiving a capital inflow experience a decline in their trade balance, with the effect that global trade imbalances become smaller.

It makes some difference for emerging countries whether the fiscal consolidation by high-income economies is fast (over four years) or slow (ten years). The benefits are a quicker recovery period after four years, but the cost is a sharper decline in economic activity in the short run. What matters for investment in emerging countries is the long term real rate of interest and this is affected by expectations over future debt/GDP ratios. Implicit in this conclusion is that the credibility of both the slow and fast consolidations is the same. There are competing forces here: a slow consolidation involves lower annual adjustment costs (more credible), but runs the greater risk of being derailed by a public tiring of austerity (less credible).

The important story from fiscal consolidation as modelled in this paper is the large scale and asymmetry in the required adjustment and the large impacts this has, not only within adjusting economies, but between the economies that are adjusting (mostly advanced economies) and emerging economies. The linkages through trade balance and exchange rate adjustment are large. The management of this will be a key problem for policymakers over the coming decade, including the need for them to resist the likely calls for trade protection as imbalances widen again — a point made by Knight and Wang (2011) in their examination of China’s macroeconomic imbalances.

This paper also demonstrates that, if the empirical results of Calderón et al (2009) is reasonable and if there was a program of substantial investment in infrastructure investment in emerging economies, there can be a large impact on the trade imbalance in the global economy in the short run and a net benefit to all countries in the world in the long run. This requires that the investment in infrastructure is as productive as it has been historically. Note that the results of Calderon et al (2009) are based on the actual data on productivity returns to public infrastructure, not an optimistic assumption about theoretical returns given productivity gaps.