Alesina, A., R. Perotti, J. Tavares, M. Obstfeld, and B. Eichengreen, 1998, “The Political Economy of Fiscal Adjustments,” Brookings Papers on Economic Activity, vol 1998, No 1 (1998), pp 197–266.
Chalk, N.A., 2002, “Structural Balances and All That: Which Indicators to Use in Assessing Fiscal Policy,” International Monetary Fund, Working Paper No. WP/02/101.
Christiano, L., M. Eichenbaum, and S. Rebelo, 2010, “When is the Government Spending Multiplier Large?” unpublished paper, Northwestern University.
Coenen, C., M. Mohr, and R. Straub, 2008, “Fiscal Consolidation in the Euro Area: Long-Run Benefits and Short-Run Costs,” European Central Bank, Working Paper Series, No 902, May 2008.
Cournede, B., 2007, “The Political Economy of Delaying Fiscal Consolidation,” OECD Economics Department Working Papers, No 548, OECD Publishing.
van Ewjik, C., N. Draper, H. ter Rele, and E. Westerhout, 2006, “Ageing and the Sustainability of Dutch Public Finances,” CPB Netherlands Bureau for Economic Analysis, The Hague.
European Commission, 2009, “The 2009 Ageing Report: Economic and Budgetary Projections for the EU-27 member States (2008-2060),” European Commission, Directorate General for Economic and Financial Affairs, European Economy No. 2/2009.
European Commission, 2009, “Sustainability Report 2009,” European Commission, Directorate General for Economic and Financial Affairs, European Economy No. 9/2009.
International Monetary Fund, 2010, “Will it Hurt? The Macroeconomic Effects of Fiscal Consolidation,” Chapter 3 of World Economic Outlook: Recovery, Risk, and Rebalancing, October 2010, International Monetary Fund, Washington DC.
Guichard, S., M. Kennedy, E. Wurzel, and C. Andre, 2007, “What Promotes Fiscal Consolidation: OECD Country Experiences,” OECD Economics Department Working Papers, No 533, OECD Publishing.
The author would like to extend his sincere thanks to Lorenzo Figliuoli, who provided the original motivation and redirected him away from some dead-ends during the preparation of this paper.
It should be noted that significant reforms to pension systems are being envisaged in some European countries, which will reduce sustainability gaps once implemented.
The estimated sustainability gap for Netherlands is significantly higher than that found in its 2011 IMF Article IV staff report, because the staff report calculates the gap as of 2012, giving full “credit” for the significant fiscal adjustment planned for 2011, and, also, this paper uses EC demographic projections which are less favorable than those from Statistics Netherlands which underpin the estimates in the staff report.
For simplicity, we abstract from consideration of structural reforms (such as increasing the retirement age or measures to raise potential growth) which can improve fiscal sustainability with little effect on the output gap.
In principle, monetary authorities could apply sufficient stimulus to close output gaps very quickly. However, most monetary authorities have inflation control as the primary objective, which constrains their ability to aggressively apply stimulus under most scenarios because such stimulus often raises inflationary pressures.
This approximation of the coefficients of equation (14) is accurate to one decimal place, and the simplification enables us to derive analytical solutions for the optimal fiscal path below. As a check, equation (14) was also used directly in the optimization problem, and the coefficients obtained in the policy functions for the different countries from a numerical solution method closely matched those obtained algebraically using equation (15) even for values of ∂ as high as 1.
Strictly speaking, there are three solutions found, but only one where both A and B are positive.
For Germany, one issue that arises is that estimating the structural primary balance using the output gap (as in equation (6)) may bias downward our estimates of the annual structural fiscal adjustment, because labor market indicators showed significantly smaller economic slack than indicated by the size of the output gap. In that case, the value of alpha for Germany could be significantly smaller than estimated here. And for Ireland the 2011 budget also reflects discussions related to the Fund-supported program, which may affect the value of alpha.
IMF staff projections are used for ease of comparability across countries. This could however introduce some bias to the results, as the projections are not exactly the same as the macro outlooks used by country authorities in arriving at their consolidation plans.