Similar to financial crises, some of the sharpest deteriorations in fiscal positions have been among energy exporters. Energy-exporting EMDEs rely heavily on fiscal revenues from the resource sector, and the subsequent plunge in oil prices has forced some of them into severe fiscal adjustment and reserve losses (Danforth, Medas, and Salins 2016). Fiscal positions deteriorate sharply during oil price plunges in energy-exporting EMDEs but are subsequently rebounded as a result of a pro-cyclical fiscal tightening. Within two years after the oil price plunge, fiscal positions and debt dynamics are restored close to their pre-plunge levels (World Bank 2017a).

# 4.3. Constraining government action during downturns

High debt constrains governments’ ability to respond to downturns with countercyclical fiscal policy (Obstfeld 2013; Reinhart and Rogoff 2010; Romer and Romer 2018). This was the case during the global financial crisis: fiscal stimulus during 2008-09 was considerably smaller in countries with high debt than in those with low government debt (Figure 6.A; World Bank 2015). Moreover, weak fiscal positions tend to be associated with deeper and longer recessions, a situation that can be worsened if the private sector also falls into distress and its debt migrates to government balance sheets.

Not only the size but the effectiveness of fiscal policy could be constrained when governments face high debt levels. High government debt tends to render expansionary fiscal policy less effective (Adam and Bevan 2005). In theory, high government debt can reduce the size of fiscal multipliers through two channels.

First, there is a Ricardian channel. When a government with a weak fiscal position implements fiscal stimulus, households expect tax increases sooner than in an economy with a strong fiscal position (Blanchard 1990a,b; Sutherland 1997). The perceived negative wealth effect leads households to cut consumption and save more, thereby weakening the impact of the stimulus on output. Thus, the net effect of fiscal policy on output—the size of the fiscal multiplier—may be smaller in an economy with a weaker fiscal position. Some studies discuss the Ricardian channel and show that the effect of government spending shocks on private consumption depends on government debt (Perotti 1999; Giavazzi and Pagano 1990, 1995).

The second channel is an investor sentiment channel. Countries with high sovereign debt are more likely to have to pay a risk premium to borrow (Alcidi and Gros 2019). When debt is higher, fiscal stimulus can increase creditors’ concerns about sovereign credit risk, raising sovereign bond yields and, hence, borrowing costs across the whole economy (Corsetti et al. 2013). Higher risk premia, especially during times of sovereign financial stress, have been shown to feed into lower corporate borrowing (Bocola 2016). This, in turn, will crowd out private investment and consumption, reducing the fiscal multiplier.

Empirical evidence suggests that high government debt tends to render fiscal policy less effective and, therefore, fiscal multipliers are smaller when government debt is higher (Figure 6.B). Auerbach and Gorodnichenko (2012, 2013), Ilzetzki, Mendoza, and Vegh (2013), and Nickel and Tudyka (2014) estimate multipliers that depend on the fiscal position and find that weaker fiscal positions are associated with smaller fiscal multipliers.

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