Chapter 7. Fiscal Consolidation under the Stability and Growth Pact: Some Illustrative Simulations

Petya Koeva Brooks, and Mahmood Pradhan
Published Date:
October 2015
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Derek Anderson, Marialuz Moreno Badia, Esther Perez Ruiz, Stephen Snudden and Francis Vitek 

The Stability and Growth Pact (SGP) continues to be at the core of European Union (EU) fiscal governance (Figure 7.1). The SGP was put in place to avoid excessive deficits and debt levels. However, fiscal slippages during the first decade of the Economic and Monetary Union (EMU) led to high vulnerabilities during the global economic and financial crisis (Pérez Ruiz 2011). To remedy past flaws, EU fiscal governance is being upgraded around a number of reforms focusing on intertwined objectives. These reforms include tighter national enforcement of EU fiscal rules (implementation of the Directive on National Fiscal Frameworks under the Six-Pack and automatic correction mechanisms under the Fiscal Compact); expanded surveillance over internal and external imbalances (through the Excessive Imbalances Procedure introduced under the Six-Pack); and enhanced EU oversight of national budgetary processes (under the Two-Pack). Underpinned by these complementary processes, the SGP occupies a central role in the EU fiscal framework.

Figure 7.1Recent European Union Fiscal Governance Reforms

Note: EU = European Union; SGP = Stability and Growth Pact.

Both the scale and speed of consolidation in EMU countries are influenced by SGP rules. Bringing debt ratios down to safer levels will require a sustained period of adjustment. The key question is whether the pace of consolidation driven by the SGP is appropriate in the face of a weak outlook.

This chapter quantifies the output effects from fiscal consolidation as required by the SGP. To this aim, it proposes a conceptual framework in three steps. First, the analysis takes the April 2012 World Economic Outlook (WEO) as the baseline for fiscal consolidation.1 Second, the gap between fiscal plans under this baseline and the SGP targets (in structural terms) is quantified, keeping GDP at WEO levels (that is, no multiplier effects are at play). Third, using the IMF’s dynamic stochastic general equilibrium model—the Global Integrated Monetary and Fiscal model (GIMF)—the output effects of that fiscal shock are simulated. In short,

  • Step 1: The April 2012 WEO is used as the baseline scenario.
  • Step 2: The fiscal shock is quantified as
    in which, αt represents the change in the structural-balance (Sb)-to-GDP ratio relative to the fiscal consolidation path projected in the WEO, for a given GDP (at WEO values).
  • Step 3:The model economy is shocked with αt and the output decline GDPt,SGPGDPt,WEO is quantified when multiplier effects are at work.

The rest of this chapter is organized as follows: Building on EU legislation and discussions with the European Commission during the 2012 Article IV Consultation, the second section outlines the order of prevalence between the various SGP benchmarks and quantifies fiscal consolidation needs relative to the April 2012 WEO. The third section presents the associated output loss under different sets of assumptions. The different scenarios demonstrate that the effects of fiscal consolidation depend largely on the composition and credibility of fiscal packages, as well as on the ability of monetary policy to cushion the fiscal tightening. The chapter concludes with a number of policy recommendations.

A Characterization of SGP Regimes

Since its introduction, the SGP system has become increasingly complex (Table 7.1). Countries are required to converge to the 60 percent of GDP debt benchmark; prohibited from breaching the 3 percent of GDP deficit threshold; and mandated to improve the structural-deficit-to-GDP ratio at an average rate of 0.5 percent per year. In addition, government spending is constrained to grow in line with trend GDP. These requirements raise the question of the order of prevalence between the existing rules, complicating the task of quantifying the fiscal shock implied by the SGP.

Table 7.1EU Fiscal Rules from Maastricht to the Fiscal Compact
TypeMaastricht (SGP.1)2005 Reform (SGP.2)2011 “Six-Pack” Reform (SGP.3)Fiscal Compact
Debt ruleDebt/GDP is reduced to below 60 percentYearly reduction in Debt/GDP equal to 1/20th of distance between current level and target
Deficit ruleDeficit/GDP below 3 percent at any time
Structural balanced budget ruleMedium-term budget positions of “close to balance or in surplus”Structural deficit/ GDP to remain below 1 percent…below 0.5 percent
Expenditure rulePrimary expenditure (excluding unemployment benefits and tax discretionary increases) grows less than medium-term GDP growth
Sources: IMF staff, based on the European Union treaty, Stability and Growth Pact secondary legislation, and the Fiscal Compact intergovernmental treaty.
Sources: IMF staff, based on the European Union treaty, Stability and Growth Pact secondary legislation, and the Fiscal Compact intergovernmental treaty.

To disentangle the order of prevalence between rules, this analysis assumes the strictest criteria apply. EU regulations and discussions with the Commission suggest that where rules overlap, countries would be subject to the strictest benchmark. This direction rules out the possibility of overdetermination and makes it possible to calculate SGP consolidation paths in an unambiguous manner.

For the WEO horizon, this exercise assumes that compliance with the rules follows a three-stage process. All fiscal commitments are translated into deviations from the WEO for the structural-deficit-to-GDP ratio.2 Two regime switches operate during the WEO projection period: first, from the overall to the structural deficit benchmark; and second, from the structural deficit benchmark to the debt-reduction criterion. The relevant fiscal regimes can be summarized as follows:

  • Excessive Deficit Procedure (EDP) phase—Countries under the EDP by April 2012 are expected to deliver structural adjustments needed to meet the 3 percent of GDP deficit target by the requested deadlines (between 2012 and 2015; see Table 7.2).
  • Grace period—An exemption from the one-twentieth debt reduction rule will apply during the three-year period following the closure of the EDP for each country. During this period, each country is expected to improve its structural balance by at least 0.5 percent of GDP each year until it reaches its medium-term objective (MTO).3
  • One-twentieth debt benchmark—Beginning three years after exiting the EDP, structural balances will improve by 0.5 percent of GDP per year or more, if required by the one-twentieth debt benchmark. This benchmark ensures an annual pace of debt reduction of no less than 5 percent of the gap between the observed debt level and the 60 percent of GDP target. EU authorities will first verify compliance with the debt rule in a backward-looking manner and then in a forward-looking manner for countries breaching the first criterion (Figure 7.2).
Table 7.2Excessive Deficit Procedure Deadlines
2012Belgium, Cyprus, Italy
2013Austria, France, Germany, Netherlands, Portugal, Spain
Source: European Commission.Note: Excessive Deficit Procedure deadlines by April 2012.
Source: European Commission.Note: Excessive Deficit Procedure deadlines by April 2012.

Figure 7.2Translating Stability and Growth Pact into a Fiscal Shock

Sources: IMF, World Economic Outlook April 2012; Stability and Growth Pact regulations; and IMF staff calculations.

Note: EDP = Excessive Deficit Procedure; MTO = medium-term objective; SGP = Stability and Growth Pact; WEO = World Economic Outlook. Data labels in the figure use International Organization for Standardization (ISO) country codes.

1 The benchmark is given by Bt/Yt, = 60+(0.95/3)×(Bt-1/Yt-1−60)+((0.952)/3)×(Bt-2/Yt-2-60)+((0.953)/3)×(Bt-3/Yt-3-60).

2 The formula specified in footnote 1 is applied to projected debt-to-GDP ratio up to t + i + 3 + 2.

3 The “adjusted debt measure” is given by Bt/Yt=Bt+Σ02Ctj/Yt3Π02(1+Ytj*), with C the cyclical budget and Y* the growth rate of nominal potential GDP.

4To place a country under EDP, the report assesses risk factors such as the structure of debt, implicit liabilities related to aging, or private indebtedness.

5The High Debt group comprises Belgium, Greece, Ireland, Italy, Portugal, and Spain. The Low Debt group includes the rest of euro area countries.

Overall, planned fiscal efforts in the euro area fall significantly short of SGP requirements. For the euro area as a whole, the additional consolidation amounts to 1 percent of GDP during 2012–17, nearly half of which would be front-loaded during 2012–13 (Figure 7.2). For the analysis in this chapter, the euro area countries are split into two blocs: those countries with acute fiscal sustainability issues (high-debt4 or HD), comprising Belgium, Greece, Ireland, Italy, Portugal, and Spain, and those countries with less acute fiscal sustainability issues (low-debt or LD), comprising the rest of the euro area. Additional consolidation needs in the HD bloc (at about 2.2 percent of GDP for the WEO horizon) are five times as large as in the LD bloc (at 0.4 percent of GDP for 2012–17). Across countries, the additional fiscal effort is highest in Spain, mainly as a result of requirements under the EDP. In contrast, Belgium, Cyprus, Estonia, and Germany have no additional adjustment because the WEO path is consistently more demanding than requirements under the SGP. Among the larger euro area countries, additional consolidation is particularly front-loaded in the Netherlands and Spain.

The Output Effects from Fiscal Consolidation Underthesgp

The output effects from fiscal consolidation requirements under the SGP vary depending on key assumptions such as the composition of the fiscal adjustment, the monetary policy stance, and the credibility of fiscal policy. To illustrate this, a number of scenarios are conducted and simulation results are inspected based on the GIMF model (country groupings) and the G35 model (country specific results).


The impact of fiscal tightening on economic activity will depend on the underlying simulation assumptions. First, the composition of the fiscal adjustment makes a big difference, with multipliers typically being larger for spending-based consolidations. Second, the monetary policy reaction function is an important factor because multipliers are higher when interest rates are constrained by the zero lower bound. Finally, the credibility of fiscal packages also affects multipliers through anticipation of the future benefits of consolidation. This last effect may be substantial in some cases.

In practice, however, considerable uncertainty surrounds these assumptions. Information on the composition of the adjustment on a country basis is not readily available, and predicting the time horizon over which monetary policy in the euro area will be constrained by the zero lower bound is difficult. Also, governments’ credibility in delivering fiscal commitments is at stake, and risk-premium effects are inherently difficult to quantify when spreads are volatile and an increasing number of countries face punitive yields.

In the face of these uncertainties, a number of illustrative simulations are carried out. These alternatives are intended to illustrate the possible response of the economy under three different scenarios rather than aiming to accurately represent the economic reality (Table 7.3):

  • Scenario 1: Myopia and growth-friendly consolidation—Under this scenario, the consolidation package is tilted toward measures that have strong effects on households’ current disposable income, but little negative impact on factor supply and potential output. It is further assumed that fiscal plans are not credible per se, but rather that credibility needs to be established by action. In particular, agents do not perceive the government’s commitment to consolidation to be permanent but rather expect measures to revert back to baseline levels in each period. However, they change their beliefs once they verify past fiscal measures remain in place. This version is meant to portray an economy in which, because of a general lack of confidence in the future, agents base their decisions on short-term considerations. With regard to monetary policy, the zero interest floor is assumed to bind during the 2012–17 period. To gauge the magnitude of spillovers, two variants of this scenario are run featuring joint and stand-alone consolidation (that is, undertaken separately by the HD and LD groups).
  • Scenario 2: Credibility and growth-friendly consolidation—The assumptions mimic scenario 1 except that agents are not myopic, that is, changes in the structural balance are perceived to be permanent as of the year of implementation. As a result, agents incorporate the long-term benefits of the consolidation already undertaken (lower real interest rates and future debt-service costs) into their expectations. However, fiscal changes are not anticipated and do not affect behavior until they actually occur (absence of full Ricardian equivalence).
  • Scenario 3: Credibility and growth-unfriendly consolidation—A variant of scenario 2, this scenario is intended to illustrate the sensitivity of the results to the composition of the fiscal consolidation, with a package biased toward high-multiplier measures. In particular, fiscal efforts are switched (1) from consumption to corporate taxes, (2) from government consumption to public investment, and (3) from general transfers to transfers targeted to households with high marginal propensities to consume. As empirical evidence shows (for example, OECD 2010 and the references therein), corporate taxes have the highest distortionary effects among revenue measures. Government investment shrinks potential output, and cuts in targeted transfers reduce the income of households whose marginal propensity to consume is equal to one.
Table 7.3Assumptions Underlying Stability and Growth Pact Simulations
AssumptionsExplanationScenario 1: Myopia and Growth-Friendly ConsolidationScenario 1A: Scenario 1 plus ZIFScenario 1B: Scenario 1 plus Joint ConsolidationScenario 2: Credibility and Growth-Friendly ConsolidationScenario 3: Credibility and Growth-Unfriendly Consolidation
Composition of adjustment
1. Growth-friendly consolidation1/4 transfers, 1/3 government consumption, 1/4 labor income tax, 1/6 consumption taxXXXX
2. Growth-unfriendly consolidation1/4 targeted transfers, 1/3 government investment, 1/4 labor income, 1/6 corporate taxX
3. Joint consolidation

4. Individual consolidation
High Debt and Low Debt groups jointly consolidate Only one of the blocs consolidates (euro area calculated by simple addition disregarding spillovers)XXXXX
Monetary policy reaction
5. Interest rates unconstrained by zero interest floor (ZIF)Unconstrained reaction of nominal interest ratesXXXX
6. Interest rates constrained by ZIFNominal interest rates unchanged over first 5 yearsX
Credibility of fiscal plans
7. MyopiaAgents do not perceive as permanent the government’s commitment toward consolidation; they only change their beliefs ex post, once they verify past fiscal measures remain in placeXXX
8. Partial Ricardian behaviorChanges in the structural balance are perceived as permanent as of the year of implementationXX
Source: IMF staff.Note: ZIF = zero interest rate floor.
Source: IMF staff.Note: ZIF = zero interest rate floor.

Simulation Tools and Output Effects from Additional Fiscal Consolidation

The simulations are conducted for the two euro area country groupings using the GIMF model.5 The analysis uses a general equilibrium framework applying a six-region version of the GIMF, with the euro area split into the HD and LD blocs, the United States, Japan, emerging Asia, and a bloc encompassing the rest of the world. The GIMF models both liquidity-constrained and finite-planning-horizon households. This setup provides nonneutrality in both spending- and revenue-based measures, which makes the model particularly appropriate for analyzing the stabilization role of fiscal policy in the short term.

Country-specific effects are examined using the G35 model.6 The G35 model is an estimated structural macroeconometric model of the world economy, disaggregated into 35 national economies, including 11 euro area countries.7 Within this framework, each economy is represented by interconnected real, external, monetary, fiscal, and financial sectors. Spillovers are transmitted across economies via trade, financial, and commodity price linkages.

Even with a growth-friendly consolidation package, the output effects are sizable (Figure 7.3). Under scenario 1, output in the euro area is 1 percent lower than baseline by 2017 (Figure 7.3, panel 1). This result implies a cumulative output loss of 3½ percent between 2012 and 2017. The fairly large multiplier stems from negative spillovers (about 40 percent of the loss) and the inability of monetary authorities to ease the policy rate (20 percent of the loss). As expected, the HD bloc experiences the largest losses (Figure 7.3, panel 2)—1.4 percent of GDP by 2017 (cumulatively 5 percent during 2012–17)—mainly reflecting the scale of the additional fiscal adjustment required. Losses among the LD bloc of 0.8 percent by 2017 (cumulatively 3 percent during 2012–17) are largely caused by spillovers from the HD bloc (given their relatively high propensity to import from the LD countries) (Figure 7.3, panel 3). The aggregate results conceal considerable cross-country heterogeneity (Figure 7.3, panel 4). Because of contractions in domestic demand, cumulative output losses are highest in Spain (at about 10 percent), closely followed by Portugal (at almost 8 percent), largely caused by substantial spillovers from fiscal tightening in its neighboring country. Negative spillovers are also sizable in small open economies like Belgium, Finland, and Ireland. Somewhat surprisingly, Greece experiences positive spillovers from fiscal adjustment in other euro area countries. This occurs because a joint consolidation in the euro area reduces world demand for commodities and improves Greece’s terms of trade. Because Greece is a relatively closed economy, this improvement in the terms of trade outweighs the reduction in its external demand, yielding a positive net spillover.

Figure 7.3Output Effects from SGP Rules: Myopia and Growth-Friendly Consolidation

Sources: IMF, April 2012 World Economic Outlook; and IMF staff simulations carried out using the Global Integrated Monetary and Fiscal model (panels 1–3) and the G35 model (panel 4).

Note: SGP = Stability and Growth Pact; WEO = World Economic Outlook; ZIF = Zero interest floor. Data labels in the figure use International Organization for Standardization (ISO) country codes.

1The High Debt bloc comprises Belgium, Greece, Ireland, Italy, Portugal, and Spain. The Low Debt bloc includes the rest of euro area countries.

Multiplier effects dramatically change with credibility and fiscal composition assumptions (Figure 7.4). With myopia (scenario 1), private households and firms are so concerned with the short-term impact of fiscal retrenchment that they neglect the positive income effects arising from future lower tax liabilities when making their consumption, employment, and investment choices. For a given composition of adjustment and the zero lower bound constraint, the 2017 GDP loss in the euro area is considerably reduced if fiscal plans are credible (scenario 2), falling from 1 percent to 0.3 percent of GDP. However, the multiplier effect is more than doubled when consolidation remains credible but becomes growth unfriendly (scenario 3). In this case, the 2017 GDP loss in the euro area relative to the WEO amounts to 0.8 percent, compared with 0.3 under credible but growth-friendly consolidation. Cumulative losses in the euro area throughout 2012–17 amount to 1.5 percent under scenario 2 and 3.1 percent under scenario 3.

Figure 7.4Comparing Output Losses across Scenarios

(Percent deviations from WEO, 2017)

Sources: IMF, April 2012 World Economic Outlook (WEO); and IMF staff simulations carried out using the Global Integrated Monetary and Fiscal model.

Note: High debt comprises Belgium, Greece, Ireland, Italy, Portugal, and Spain. Low debt comprises the remainder of the euro area.

The output decline might be higher than implied by these simulations because of the state of the economy during the crisis. Empirical work suggests that fiscal multipliers are larger when there is excess capacity (for example, Batini, Callegari, and Melina 2012; and Baum, Poplawski-Ribeiro, and Weber 2012). This situation could arise from tighter credit constraints, the need to repair balance sheets, and higher precautionary savings.

Policy Perspectives: How Can the Output Loss from Additional Fiscal Consolidation be Mitigated?

The SGP rules should be applied flexibly to accommodate unexpected events. The appropriate pace of consolidation should depend on the state of public finances and growth, and the monetary policy stance. Given uncertainties surrounding these developments, consolidation strategies that adjust for new information can be welfare improving. Thus, the shift of focus toward structural targets under the SGP during the crisis is appropriate.

Where financing conditions permit, the pace of fiscal consolidation should take into account adverse economic conditions. With limited scope for monetary policy to mitigate output losses from fiscal tightening, negative output gaps, and joint consolidation efforts, multipliers are likely to be larger than normal. Furthermore, multipliers might increase with the size of consolidation (Stehn and others 2011; Erceg and Lindé 2010). Therefore, to the extent that market financing remains available at reasonable rates, adjustment should occur at a steady pace defined in cyclically adjusted terms and should avoid heavy front-loading.

The composition of fiscal adjustment should be tilted toward growth-friendly measures. Where adjustment needs are very large, countries will have to act on both the revenue and the spending sides. However, given the high spending levels prevailing in many European countries, consolidation should focus on the spending side, targeting in particular those areas in which multipliers are low or spending is most inefficient.

Reforms that underpin credibility are essential to limiting output losses from fiscal tightening. The findings in this chapter suggest that by raising agents’ expectations about the positive future income effects of consolidation, credible policies can reduce multipliers in the short term and act as a substitute for heavy front-loading. Anchoring adjustment in well-specified medium-term plans is crucial. Responsible implementation of automatic correction mechanisms under the Fiscal Compact will be important to safeguarding durable fiscal efforts.

Finally, monetary policy should accommodate the consolidation. The simulations suggest significant output losses if monetary policy does not provide support. When the zero bound is binding or if conventional interest rate cuts are less effective than normal, unconventional monetary policy stimulus may be needed.


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This chapter is based on Euro Area Policies 2012 Article IV Consultation—Selected Issues, IMF Country Report 12/182, 2012.

The authors are grateful for comments from the Directorate-General for Economic and Financial Affairs staff during the seminar held in Brussels, June 4, 2012.


The shock and simulation results presented in this chapter take into account the fiscal plans adopted or specified in sufficient detail at the time of the elaboration of the April 2012 WEO forecasts. Since then, some countries have announced additional measures.


GDP is kept at WEO levels and Organisation for Economic Co-operation and Development budgetary semi-elasticities are used to break down the overall deficit into its structural and cyclical components.


MTOs are country specific and updated every three to four years. MTOs applying to the 2012 EDP are 0.5 of debt for Belgium, Finland, and Luxembourg; 0 for Austria, Cyprus, Estonia, Greece, France, Italy, Malta, and Spain; –0.5 for Germany, Ireland, Netherlands, Portugal, and Slovak Republic; and—1 for Slovenia.


For the purposes of the simulation, the HD group includes countries with debt projected to be greater than 85 percent of GDP by 2017.


For further details on this model, see Kumhof and others (2010).


For further details, see Vitek (2012).


Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Netherlands, Portugal, and Spain.

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