The Fallacy of Fiscal Discipline

Abstract

Fiscal discipline is commonly evaluated on the basis of the debt-GDP ratio, which exhibits a stock variable measured relative to a flow variable. This way of monitoring debt solvency is arguably not consistent with transversality conditions obtained from optimizing macroeconomic frameworks. In this paper we consider a wealth-based sustainability index of government debt policy derived from a baseline endogenous growth model. We calculate the index from 1999 onwards for countries in which the after-growth real interest rate is positive, consistently with the theoretical setup. Results are radically different from common wisdom. We show that the fiscal position is sustainable for both Germany and Italy, and strongly unsustainable for both Japan and France. Policy implications of our findings are discussed.

A quest between fiscal and market discipline

“…However, when market signals are proxied by interest payments on debt (expressed as percentage of government expenditures) or by the 10-year government bond yield, the effects exerted by fiscal discipline on the cyclically-adjusted budget balance are either weakly significant or not significant. Therefore, fiscal discipline may be a "smokescreen" (Debrun and Kumar, 2007) or, as Canofari et al (2020) put forward, a "fallacy". For instance, as noted by the authors, the EU debt rules do not account for the dynamics of households' aggregate wealth; only for the path of the public debt-to-GDP ratio.…”

“…In the context of the European Union (EU), given that fiscal rules enshrined in the Fiscal Compact disregard the time path of households' aggregate wealth, they can mislead the assessment of the degree of debt sustainability. Thus, fiscal discipline appears to be a mere "fallacy" (Canofari et al, 2020) or "smokescreen" (Debrun and Kumar, 2007).…”

Is fiscal austerity really self‐defeating?

“… See Bruce and Turnovsky (1999) andCanofari et al (2020) for reasons for preferring the debt-to-capital ratio to the debt-to-output ratio in the context of endogenous growth models.…”