Budget Deficits and the Public Debt in Sweden: The Case for Fiscal Consolidation
  • 1 0000000404811396https://isni.org/isni/0000000404811396International Monetary Fund

Since the late 1980s, there has been an abrupt turnaround in Sweden’s public finances. The present paper makes the case for the very early adoption of a policy of medium-term fiscal consolidation in Sweden, notwith-standing the presently relatively depressed state of the Swedish economy. It does so by examining the reasons why large public deficits and the buildup of public debt might be detrimental to future economic performance; by reviewing how the maintenance of large deficits might undermine credibility in markets; and by looking at the experience of a number of countries that have undertaken successful programs of fiscal consolidation.


Since the late 1980s, there has been an abrupt turnaround in Sweden’s public finances. The present paper makes the case for the very early adoption of a policy of medium-term fiscal consolidation in Sweden, notwith-standing the presently relatively depressed state of the Swedish economy. It does so by examining the reasons why large public deficits and the buildup of public debt might be detrimental to future economic performance; by reviewing how the maintenance of large deficits might undermine credibility in markets; and by looking at the experience of a number of countries that have undertaken successful programs of fiscal consolidation.

A disturbing aspect of economic performance in the industrial countries over the past decade has been the persistence of large deficits in the public finances. Between 1982 and 1992, the general government financial deficit averaged over 3 percent of GDP in the OECD area as a whole and over 4 percent of GDP for the European countries. As a consequence, measured as a percentage of GDP, the total gross public debt of the OECD area rose from about 50 percent at the beginning of the 1980s to its present level of about 65 percent (Table 1). A notable feature of this steady rise in the public debt among most industrial countries is that, unlike previous historic episodes of sizable debt buildups, the current buildup has occurred in the absence of war or a major depression.

Table 1.

Budget Deficits and Public Debt Levels of Selected Industrial Countries

(In percent of GDP)

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Sources: IMF, World Economic Outlook, September 1993; and OECD, Economic Outlook, June 1993.

The persistence of fiscal imbalances within the industrial countries has spawned an active debate about the possible harmful effects that sustained budget deficits might have for economic performance.1 Against the background of that debate, policymakers in a large number of industrial countries have committed themselves to policies of medium-term fiscal consolidation. Perhaps the most explicit of these commitments was by the 12 EC countries in the context of the December 1991 Maastricht Treaty. Specifically, among the convergence criteria for monetary union established by the Maastricht Treaty were a target of no greater than 3 percent of GDP for the general government budget deficit and a target of no more than 60 percent for the gross public debt to GDP ratio.

More recently, despite the climate of recession or at best faltering recovery, medium-term budget consolidation programs have been announced by a number of major industrial countries. These include the recently approved Clinton deficit reduction package in the United States; the Solidarity Pact in Germany aimed at reducing the problems posed by the burden of transfers to the Eastern Länder; the expenditure reduction and tax increase programs announced in the April 1993 U.K. budget; and the ambitious deficit reduction programs in Canada and Italy.

Sweden has certainly not been immune from the general trend toward weaker budgetary performance. Indeed, the abrupt turnaround in Sweden’s public finances since the late 1980s has increased the overall public sector deficit to an estimated 14½ percent of GDP and the central government borrowing requirement to an even higher 18 percent of GDP in 1993, which would place Sweden among those countries with the highest deficits as a share of GDP among the OECD countries (see Table 1).2 Moreover, although Sweden’s gross public debt-to-GDP ratio, at some 75 percent, is only somewhat higher than the average in Europe, the prospect of public deficits being maintained at anywhere near their present levels would catapult Sweden to the ranks of those countries with the highest public debt-to-GDP ratios in the industrialized world. This point is illustrated by official projections presented in the April 1993 budget, which indicate that even if there were to be a progressive reduction in the budget deficit over the next four years, the gross public debt-to-GDP ratio would rise to about 110 percent of GDP by 1998.

To an outside observer, what is as striking as the recent abrupt deterioration in Sweden’s public finances is the nature of the current domestic debate on what should be done about the budget deficit. In particular, one is struck by the sense of complacency or resignation among Swedish economic commentators about large budget deficits.3 Given a public deficit in Sweden that currently dwarfs those elsewhere in the OECD, an outside observer is naturally taken aback by the pronouncements from prominent participants in the Swedish debate that far from needing a policy of medium-term fiscal consolidation, Sweden should embark on a policy of budgetary easing to provide support to the economy.

In the remainder of this paper, the case is made for a policy of medium-term fiscal consolidation for a country in Sweden’s present circumstances. This is done by examining the reasons why large budget deficits and the buildup of public debt might be detrimental to future economic performance; by reviewing how the maintenance of large deficits might undermine credibility in markets; and by looking at the experience of a number of countries that have undertaken large-scale and successful programs of fiscal consolidation.

I. The Problem with High Budget Deficits

In recent years, a rich economic literature has developed on the adverse effect that sustained and high public deficits might have on economic performance. Within this literature, two basic channels have been identified as to how deficits might impact future economic growth and prosperity. The first relates to “financial crowding out,” whereby unfinanced public spending precludes productive investment or necessitates foreign financing. The second relates to inflation, with all of its attendant distortionary effects. The severity of these adverse impacts would of course bear a direct relation to the relative size of the deficit. In the present Swedish context, “mainstream representations” of these effects and some of the qualifications that have been raised bear reviewing.

Financial Crowding Out

In the 1960s IS-LM curve variety of the crowding out argument, in a closed economy, increased budget deficits would, ceteris paribus, result in increased credit demands that would raise domestic interest rates. The rise in interest rates would in turn dampen the interest-sensitive components of demand and, in particular, productive investment would be lower than otherwise. This would lead to a lower path of capital accumulation than would be the case if there were a smaller budget deficit, unless of course the increase in the deficit was the result of a rise in public investment rather than public consumption. A cursory comparison of world real interest rates in the 1980s with those in the 1950s and 1960s would support this line of reasoning, as would the relatively dismal global investment and growth performance over the more recent period.

In the small open economy variant of the IS-LM paradigm, domestic interest rates would be linked to world interest rates, which would allow productive investment to be maintained despite a rising budget deficit, at least until such factors began to affect capital inflows. However, the pressure from government deficits in the domestic credit markets would induce an appreciation of the exchange rate and result in both a worsening in the external current account balance and a buildup in external debt. Thus, while the level of productive investment at home might be maintained, the country’s future prosperity would be diminished by its worsened net investment position and by the steadily mounting external debt-servicing requirements.

A more sophisticated version of the crowding out argument is the Neoclassical Paradigm. This argument is basically a response to the Ricardian equivalence objection that a rational consumer should regard budget deficits as merely a shift of taxes from the present to the future, which should not influence his consumption behavior.4 Under the Neoclassical Paradigm, in the absence of operative intergenerational transfers or where households might be liquidity constrained, budget deficits would be seen as raising total lifetime consumption at the expense of subsequent generations or as easing the household borrowing constraint.5 If economic resources were fully employed, increased consumption would necessarily imply decreased savings, with higher interest rates or a weakening in the external balance being the mechanism to bring capital markets back into equilibrium.

A valid reservation against the crowding out argument relates to a situation of underemployed resources.6 In such circumstances, it could be argued that far from crowding out private investment, a temporary increase in the budget deficit would crowd in such investment by stimulating demand and by reducing excess capacity. There will certainly be occasions where this would be the case. In particular, where the initial size of the budget deficit is small and the level of the public debt is relatively low, recourse can and should be made to an active fiscal policy to support growth without engendering fears about the government’s commitment to meet its intertemporal budget constraint. This will not, however, be the case where the past accumulation of debt and the already high budget deficit from which one would be starting out has exhausted the room for fiscal policy maneuver.

In the Swedish context of very high deficits and a rapidly rising public debt, two fundamental objections can be raised against using the budget deficit to increase domestic demand: (1) for reasons that will be elaborated below, the budget is not necessarily the appropriate policy instrument to increase effective demand. It could very well be that, with the public finances already highly compromised, an active fiscal policy will have at most only limited effects on the economy and that an easing of monetary policy, in the context of a credible budget consolidation program, would be better suited to increasing effective demand in a manner that facilitated a balanced economic recovery; and (2) the state of the public finances and the public debt at the end of the period of underemployed resources will be of paramount importance for future economic performance. In particular, if, as the economy approaches capacity, large budget deficits persist, either there will simply not be the room for private investment needed to sustain the recovery or, alternatively, such investment will have to be financed from abroad with the consequent increase in external debt-service obligations referred to above.

In gauging the likely degree of future long-run crowding out, conceptually one might wish to focus on the structural component of the budget deficit or that part of the deficit that would persist were the economy to return to its potential.7 In Sweden, it is precisely the large size of the deficit at present that, in the absence of policy action, would not be eliminated as the economy returns to a more normal state that gives cause for serious concern about future crowding out and hence about the country’s medium-term growth prospects.

A further aspect of crowding out is the management of future budgets. To the extent that large public deficits are tolerated and the public debt is allowed to rise, mounting commitments will be built up to service that debt in the future. This would necessarily imply that any given future budget target would subsequently have to be met by an increased level of taxes or by reduced noninterest expenditures. Either of these options can be expected to have significant implications for efficient resource allocation and for future public welfare.


In principle, countries with a very high public debt-to-GDP ratio can reduce this ratio in any one of four ways. They can repudiate the debt, introduce a “once and for all” capital levy, inflate the debt away, or adjust their fiscal policies in a manner that produces a sufficiently large primary budget surplus.8 While the options of debt repudiation or of a capital levy would have the advantage of allowing the government to start with a clean slate, the cost of such policies is a “loss of reputation” with adverse effects on expectations. Such a loss of reputation could preclude any future government borrowing and could precipitate external capital flight. Moreover, such policies would raise fundamental questions of equity and, in normal circumstances, could be politically divisive.

It has long been argued that rather than resorting to overt repudiation, governments are often tempted, consciously or otherwise, to reduce the burden of a high public debt level by engaging in inflationary policies. Thus, for instance, Keynes in his Monetary Tract of 1923 predicted that devaluation-induced inflation would be an inevitable consequence of the then large French public debt. He wrote that “the level of the franc is going to be settled in the long run not by speculation or the trade balance, or even the outcome of the Ruhr adventure, but by the proportion of his earned income which the French taxpayer will permit to be taken from him to pay the claim of the French rentier.”9

The basic line of reasoning underlying this view is that unanticipated inflation can succeed in reducing the public debt. If the debt were of a long maturity and denominated in nominal terms in the domestic currency, its real value as well as that of interest payments would be proportionally reduced by an unanticipated rise in inflation. In the present Swedish context, however, the scope for engaging in such policies is clearly limited. At about 2½ years, Sweden’s debt is not nearly mature enough for inflation, other than at extremely high levels, to have a material impact on the real burden of that debt; while that part of the public debt denominated in foreign currency, which currently constitutes about one third of Sweden’s public debt, would not be eroded by domestic inflation. Moreover, were bondholders to anticipate that inflation was the only way out for the government, they would require correspondingly higher rates of return now to compensate them for the probability of inflation later, thereby limiting the scope for an inflation-induced reduction of the debt burden.

While inflation might not be the most efficient way to reduce the public debt burden, rising debt levels may nonetheless result in an acceleration in inflation. One reason for expecting such an outcome is that the monetary authority is likely to be subjected to increased pressures to relax monetary policy as the interest burden on the public finances rises. A factor that might come into play in this regard is that rising inflation has in the past, at least temporarily, been associated with a lower level of long-run real interest rates.

A second and more telling reason why rising debt levels must at some point precipitate inflation is that put forward by Sargent and Wallace (1981). Stripped of its technicalities, their argument rests on the idea that there is a limit to the amount of government bonds that the public will be willing to hold. Once that limit is reached, the central bank is forced to finance the public deficit through money creation.10 Once again, bond-holders can be expected to anticipate such an outcome by demanding higher rates of return on their bond holdings now, thereby aggravating the government’s budgetary problems and bringing forward the date at which the government can no longer finance itself through noninflationary means.11 Typically, when a country is perceived to be on an unsustainable debt path, one would see the early manifestation of steadily increasing long-term interest rate spreads with respect to major trade partners, a continued depreciation of the currency, and an eventual downgrading of the country’s debt paper on international capital markets by rating agencies.

Access to international capital markets and the absence of exchange controls does increase a country’s possibility of borrowing abroad. However, it also heightens the vulnerability of the economy to changes in both domestic and foreign market perceptions of the sustainability of domestic financial policies. In an open economy without exchange controls, expectations of future inflation engendered by high public deficits are apt to be translated not simply into increased domestic bond yields but also into capital outflows and a marked depreciation of the currency. The resulting combination of high interest rates and a depreciated currency heightens the risk of creating a basic duality in the economy between the traded and nontraded goods sectors of the economy. Thus, the combination of a booming export sector encouraged by an attractive exchange rate, and a depressed domestic sector constrained by high domestic interest rates, would hardly be conducive to a balanced or sustainable noninflationary recovery in the economy. This would be particularly the case in an economy like that of Sweden, which is characterized by a high degree of openness and by a relatively high level of household and corporate indebtedness.

II. Sustainability of Fiscal Policy

In gauging the risk of default or of the resort to inflationary finance, markets will focus on the issue of fiscal policy sustainability.12 For many countries, the growth of the debt ratio in the past decade has raised concerns about a debt trap or the “snowball effect,” where ever-higher debt-servicing costs require ever-higher taxation levels or ever-deeper cuts in noninterest expenditures even to stabilize the debt ratio. What-ever the initial level of public sector indebtedness, any level of deficit on the government’s noninterest operations will lead to an ever-increasing level in the debt ratio as long as the real interest rate exceeds the real growth of GDP.13 This implies that if the government is to meet its intertemporal budget constraint, primary budget deficits now will need to be offset by primary budget surpluses later, if the government is not to resort to ever-increasing levels of borrowing to finance its overall operations. Delaying fiscal adjustment now not only shifts the problem to the future, but it also complicates the solution of the future budget problem by allowing public debt to be built up in the interim.

While, in principle, markets need not be concerned about the debt-to-GDP ratio so long as there is the reasonable prospect that the government will generate future primary surpluses sufficiently large to reduce it over time, there are at least three reasons why market expectations will be affected by the debt to GDP ratio. First, when the accumulation of the debt has not been the result of war or other natural disasters and when the debt has been allowed to rise long enough, a commitment to generating a primary surplus sometime in the future may lose credibility. In such circumstances, the public is bound to wonder whether the government is ever going to meet its intertemporal budget constraint and they may become suspicious that a Ponzi-type situation may be developing, where the government will finance its mounting obligations with ever-increasing borrowing from the public.

A second reason why the level of the public debt does matter relates to the problem of feasibility. The higher the level that the debt ratio is allowed to attain, the greater is the size of primary surplus that will eventually be required to meet the government’s intertemporal budget constraint. If there are perceived social and political limits to the government’s ability to reduce expenditures and to increase taxation net of transfers, or more generally, to enforce a growing redistribution of income from earnings and capital toward unearned income from interest on public debt, there are also limits to the level of the debt ratio that is compatible with a credible commitment on the part of the government to meet the intertemporal constraint and to ensure that the debt will not always be serviced by further borrowing.

A third reason why the level of the public debt matters relates to the problem of increased vulnerability to capital market developments. In particular, a high level of public debt would both complicate the management of monetary policy and make the public finances extremely vulnerable to a generalized increase in real interest rates. Thus, what might be a sustainable public debt position with real interest rates at 1–3 percent may no longer be a sustainable position with real interest rates in the range of 3–6 percent, as occurred during the early part of the 1980s.

III. Fiscal Consolidation and the Cycle

It is often argued that while medium-term fiscal consolidation is desirable to reduce crowding out and to minimize the risks of inflation, it is imprudent to begin such a process before there are clear signs that economic recovery has begun. The basic argument rests on the fear that fiscal withdrawal at a time of cyclical weakness will inhibit any economic recovery and that, through scaling back on transfer payments, incentives might be created to raise household saving at a time of weakness in consumer demand.

There can be no denying that the direct impact of fiscal withdrawal must be to lessen aggregate demand. Moreover, it is possible, though by no means necessary, that measures of fiscal consolidation might give rise to increased private savings. However, the above line of reasoning over-looks the indirect impact that fiscal policy might have on aggregate demand, which is likely to increase in significance the larger the budget disequilibrium. Also ignored is the role of the alternative instruments of macroeconomic policy, namely interest rates and exchange rate policy, which can have a substantial influence on the level of aggregate demand.

Indirect Impact of the Budget

The principal channel through which the indirect impact of increased future budget deficits can lead to a limited or even perverse response of the economy to a fiscal policy loosening is that of long-term interest rates. Thus, the prospect of future budget deficits could raise real long-term interest rates now, either in anticipation of future crowding out or of increased inflationary expectations.14 This rise in long-term interest rates would, in the near term, depress interest-sensitive and wealth-related components of demand, such as business and housing investment and consumption spending on durables. Since the budget deficits would only occur in the future, the net results of a budget loosening might actually be a decline of near-term GDP. By the same token, the credible commitment to a policy of medium-term fiscal consolidation could have a beneficial impact on interest rates that would provide support to the economy now that might limit the immediate contractionary impact of a medium-term program of fiscal consolidation.

A further possible constraint on the fiscal multiplier is that an increase in the budget deficit may undermine business confidence and thereby reduce the willingness of businesses to invest.15 In particular, business-men might fear that prolonged deficits could lead to a cycle of inflationary expectations followed by deflationary contraction or to subsequent increases in business taxes. Similarly, measures to reduce the budget deficit could stimulate confidence by showing that the government was prepared to take politically unpopular steps in order to improve future economic prospects.

Monetary Policy

However one gauges the combined direct and indirect impact of fiscal policy, it is important that fiscal policy is not viewed in isolation from the other instruments of macroeconomic policy. This would especially be the case under a floating exchange rate regime with free capital movements since, for the reasons already discussed, the relative potency of monetary policy with respect to fiscal policy on aggregate demand is likely to be enhanced.

In a small and open economy with a high level of household and corporate indebtedness, exchange rate and interest rate reductions can be expected to have a major impact on the level of aggregate demand. However, the full effect of such reductions will only be felt with a lag. In setting a medium-term course for fiscal policy, consideration has to be paid to any loosening in monetary policy conditions that might already have been undertaken. Moreover, attention would need to be paid to the future mix between monetary and fiscal policy that is most likely to produce a balanced and sustainable economic recovery. In Sweden’s present situation of a large public deficit and a highly indebted private sector, a fiscal policy loosening would be an inappropriate instrument to support the economy since it would likely further depress the currency and increase interest rates by raising questions about fiscal sustainability and increasing the prospect of future inflation.

IV. Experience with Major Fiscal Contractions

Whether the direct effects of a fiscal contraction can be offset by a combination of the indirect effects of such a contraction and a loosening of monetary and exchange rate policies is essentially an empirical question. Experience in a number of European countries during the 1980s suggests that major fiscal contractions can indeed be effected without putting at risk the prospects for economic recovery.

Perhaps the most celebrated of these cases was the 1981 U.K. budget, which at a time of recession proposed substantial fiscal withdrawal as part of a medium-term financial strategy aimed at restoring balance in the public accounts. To the surprise of 365 British economists, who wrote to the Times of London predicting that this budget would aggravate the domestic recession, the 1981 budget actually marked the beginning of a sustained economic recovery. In the event, the direct impact of fiscal withdrawal was more than offset by a loosening in monetary conditions in general and by a depreciation of the currency in particular.

The United Kingdom’s experience is far from unique. In an analysis of the 1983 Danish fiscal adjustment program and the 1987 Irish deficit reduction program, Giavazzi and Pagano (1990) found that both of these experiences fully supported the “expectations” or German view, which stresses the importance of the role of current changes in tax and government spending as signals of future policy intentions. In particular, they stressed that while the direct effect of slower public expenditure growth was clearly negative, important indirect effects occurred through an improvement in expectations, when the measures taken were understood to be part of a credible medium-term program of consolidation designed to reduce permanently the share of government in GDP and thus taxation in the future. These factors also appeared to be at play in the case of the 1985 Israeli stabilization program, where once again a major fiscal policy contraction accompanied by a sharp devaluation in the currency resulted in significant economic growth in 1986 and 1987.

Ample evidence of a different sort, which also emphasizes the role of expectations in economic performance, can be found in Latin America. That continent is replete with examples of fiscal policy indiscipline leading to highly adverse consequences in credit and foreign exchange markets, thereby resulting in higher inflation and declining output growth.16 A similar process appears to have been at play in France in the early 1980s. Sweden’s own experience over the past few years also suggests that fiscal expansion can hardly be viewed as a panacea. If fiscal expansion were the answer, over the past few years the Swedish economy’s performance should surely have been very different than that actually registered.

V. Implications for Sweden

Over the past three years, the Swedish budget deficit has risen to levels that must be considered high by any standards. The very size of these deficits poses significant risks to medium-term economic performance because of the prospects they raise for future crowding out and for future inflation. From a shorter-term perspective, the maintenance of these deficits could also be expected to generate uncertainties in both credit and exchange markets that could complicate the prospects for a balanced economic recovery.

Considerations of both a medium- and a short-term nature suggest the overriding need for a policy of medium-term fiscal consolidation. To be sure, in gauging the appropriate speed at which one might aim at fiscal policy consolidation, one needs to balance the respective risks that large deficits pose to medium-term growth with those that their rapid elimination might pose to economic recovery. However, the experience of the countries alluded to above suggests that a point might be reached where the size of the budget deficit is such that both medium- and short-term considerations argue in favor of an early and ambitious program of medium-term fiscal consolidation.


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Desmond Lachman is a Senior Advisor in the European I Department and holds a Ph.D. in Economics from Cambridge University. This paper was presented in Stockholm in November 1993 at a seminar on the Swedish Budget Deficit organized by the Expert Group on Public Finance (ESO), a permanent committee within the Swedish Ministry of Finance. The author would like to thank Charles Adams, Krister Andersson, Ted Beza, Michael Deppler, Klas Eklund, Vito Tanzi, and Teresa Ter-Minassian for helpful comments on an earlier draft.


In the Swedish context, where pensions are predominantly financed by the state and where the social security system is heavily underfunded on a present value basis, the central government borrowing requirement adjusted for cyclical influences might give a more accurate indication than the overall public sector deficit of the degree of fiscal imbalance. For a similar reason, in comparing the relative indebtedness of the Swedish public sector with that in other industrial countries, it is more relevant to focus on a gross concept of public debt that excludes the assets of the social security system than a net concept of public debt that includes such assets.


The recommendations of the recent Lindbeck Commission, which calls for a program of medium-term budget consolidation to stabilize the public debt ratio and for far-reaching institutional reforms to the budget process, are a notable exception to the apparent complacency in Sweden about the public deficit. For a summary of the Commission’s findings, see Lindbeck and others (1993).


See Barro (1974). In the Swedish context, it is worth recalling that under the Ricardian equivalence argument, while the method of financing of the deficit may not contribute to crowding out of the private sector, a higher level of government expenditure would.


The main assumptions underlying the Ricardian equivalence proposition that have been challenged in the literature include the following: (a) consumers are rational and have an infinite planning horizon, (b) capital markets are perfect and individuals are not liquidity constrained, (c) future income and tax shares are known with certainty, and (d) taxes are lump sum. A strong body of theoretical and econometric evidence suggests that neo-Ricardian responses by individual savers, which might otherwise offset the overall saving impact of an increase in the deficit, are limited. See, for example, Bernheim (1987).


A further valid reservation against the crowding out argument pertains to those cases where the counterpart of the budget deficit is matched by increased public investment. Since the recent rise in the Swedish budget deficit has not been matched by increased investment, this matter is not pursued in this paper.


In using the concept of a structural deficit, great care needs to be taken not to understate the structural deficit by overstating the extent to which the economy might be deviating from its long-run potential. This will be particularly the case where the economy might be undergoing structural transformation or where hysteresis-type phenomena might be at play. Moreover, one also needs to bear in mind that the financing of the cyclical component of the deficit will give rise to increased public borrowing. Such borrowing, which can be substantial where the economy is far from its potential and unlikely to return to its potential soon, will require future debt-service payments, which will then become permanently embedded in the structural deficit.


In an interesting paper by Alberto Alesina “The End of Large Public Debts” (in Giavazzi and Spaventa (1988)), it is argued that, historically, the alternative chosen by countries to solve their debt problem has depended on the relative political power of rentiers, the business sector, and the working classes.


Keynes (1923), pp. 72–73.


Debt monetization would be inconsistent with Sweden’s future participation in the European Community. The Maastricht Treaty not only prohibits direct central bank credit to the government, but it also constrains monetary policy, including voluntary purchases of government paper on the open market, to the achievement of price stability.


The persistence of large interest rate premiums in highly indebted countries such as Belgium, Ireland, and Italy illustrates the potential added budgetary cost of a high level of public indebtedness.


For an interesting discussion of how fiscal policy sustainability might be measured, see Blanchard and others (1990).


The path of a country’s debt-to-income ratio may be described by the following equation:

dxt = αxt1 - β

where: dxt = the change in the debt-to-income ratio,

α = the real interest rate less the real growth rate of output,

xt-1 = the debt-to-income ratio at the start of the period,

and β = the noninterest surplus, net of seigniorage, as a ratio of GNP.

The primary or noninterest component of the deficit is the measure of the budget deficit most relevant to a country’s debt dynamics and it is immaterial whether this primary deficit arises on account of structural or cyclical factors.


For a fuller discussion, see Blanchard (1984).


The relative potency of fiscal policy on the level of aggregate demand will also depend very much on the exchange rate regime in place. In the Fleming-Murdell world of a small open economy, fiscal policy is likely to have its greatest impact on aggregate demand under a fixed exchange rate regime. By contrast, under a floating exchange rate regime, provided the issue of nonsustainability does not arise, an easing of fiscal policy could induce an increase in interest rates and a corresponding appreciation of the currency. This latter appreciation would result in a reduction in exports and an increase in imports that would tend to neutralize the overall impact of the fiscal loosening on aggregate demand. Where the sustainability of the fiscal position is called into question, however, any further easing in the fiscal stance could be expected to be accompanied by a further depreciation in the currency, which would accentuate the tendency toward a two-speed economy and heighten inflationary pressures.


The more recent experience in Argentina, where a serious attempt at fiscal consolidation since early 1991 has been accompanied by a marked economic boom, would provide a further example of the favorable effects on even short-run economic performance that might flow from an enhancement of credibility in policies.