This paper discusses the complex relationships between fiscal policy and growth, both in the short and in the long run.
Implementation of fiscal consolidation by advanced economies in coming years needs to take into account the short and long-run interactions between economic growth and fiscal policy. Many countries must reduce high public debt to GDP ratios that penalise long-term growth. However, fiscal adjustment is likely to hurt growth in the short run, delaying improvements in fiscal indicators, including deficits, debt and financing costs. Revenue and expenditure policies are also critical in affecting productivity and employment growth.
The cross section estimates point to the current short-term vision of markets, with special concern for near-term growth prospects. This could possibly reflect strong risk aversion after four years of market turmoil. These results imply that tighter fiscal policy could actually lead to wider, rather than narrower, spreads in the short term. It is important to note, however, that the euro area crisis is still not fully resolved and financial markets remain unsettled, therefore these results may reflect the particular state of markets in 2011 rather than more permanent features, something that a cross section cannot shed light on. Moreover, it would be important to assess the direct effect on spreads of other variables beyond fiscal fundamentals, such as exposure to contingent liabilities from the banking sector. Potential simultaneity issues (e.g. between spreads and growth) also deserve additional attention.
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