The impact of fiscal consolidation on debt to GDP ratios: Self-defeating austerity?

Following the global financial crisis many countries introduced austerity policies aimed at reducing soaring government debts. The purpose was to increase taxes and decrease spending in order to accumulate primary surpluses and reduce debt to GDP ratios. This strategy can work if the value of fiscal multipliers is below one. On the contrary, when fiscal consolidation has strong contractionary effects on output due to high fiscal multipliers, debt to GDP ratios increase rather than decrease, resulting in self-defeating austerity. This paper investigates the impact of austerity episodes on debt ratios over a sample of 15 countries between 1978 and 2014 using both fixed effect and system GMM methods to estimate a dynamic panel regression equation. The main result shows a contemporaneous increase of GDP ratios following fiscal retrenchment, with the effect of spending consolidation being stronger than that of revenue consolidation. In addition, spending consolidation is found to increase contemporaneously the debt ratios more in countries that belong to the Euro Area, in countries of the periphery of the Euro Area and in times of crisis. Investigation of the effect of lags of austerity episodes on debt ratios show that the effect of revenue consolidation takes more time to peter out adverse effects on the debt ratio than spending consolidation does. Overall, fiscal retrenchment is always found to increase debt ratios. The results point out to self-defeating austerity policies and thus hint to values of fiscal multipliers that are greater than one.