Fiscal stimulus in times of high public debt reconsidering multipliers and twin deficits vox, cepr

Fiscal multipliers and twin deficits: How everything fits together

The national income accounting identities reveal that current account equals the gap between total domestic saving and investment. The public-sector deficit measures public dis-saving. The result of the ‘twin deficits’ (government and current account) to a fiscal shock is thus associated with how private saving and investment choice respond to the shock.

Specifically, private agents’ behaviour depend, inter alia, on what fiscal shocks are perceived. These perceptions will normally rely upon the economic environment – especially debt sustainability.

  • If expansion of the budget deficit strongly stimulates private consumption but does little to discourage private investment, the existing account will swing towards negative – producing a twin deficit situation.

This can be the traditional Keynesian paradigm (see Corsetti and Müller 2006).

However, the current-account deficit can move around in a divergent direction.

  • If the fiscal situation can be regarded as unsustainable, a bigger fiscal deficit may dampen private consumption by boosting precautionary savings. If the shock also dampens private investment sufficiently, the existing account deficit will swing towards positive just as the general public deficit is swinging towards negative (i.e. gets bigger).

In such situations, the external balance and the general public balance may diverge (see Kim and Roubini 2008, Nickel and Vansteenkiste 2008).

That is one clear illustration of the way the impact of fiscal shocks could be non-monotonic and the way the sign of the reaction depends upon measures of a nation’s debt sustainability. A fiscal shock’s effect on external balance and GDP (i.e. the fiscal multiplier) can transform in non-linear ways. It could shift from being ‘Keynesian’ or expansionary at low debt-to-GDP ratios to contractionary as government indebtedness rises.

This shift you can do continuously without any type of threshold. For example, in a model with credit-constrained consumers, Perotti (1999) demonstrates the result of government expenditure shocks on aggregate consumption may depend on initial conditions such as for example public indebtedness. The non-linearity arises since credit-constrained and unconstrained individuals perceive wealth effects differently. The ones that are credit-constrained only go through the positive income effect; the ones that are unconstrained experience also experience an abundance effect from future anticipated changes in fiscal policy. As debt levels rise, the latter will dominate the entire effect, so additional government spending is commonly contractionary.

Measuring the consequences of fiscal stimuli with varying debt-to-GDP ratios

In recent research, we empirically investigate the consequences of fiscal stimuli on macroeconomic variables such as for example real GDP, private investment and the trade balance (Nickel and Tudyka 2013). Specifically, we explicitly permit the behaviour of most variables contained in our specification to alter with the amount of indebtedness in response to a fiscal impulse. That is important because it allows government debt to have direct effects in addition to indirect effects through the other variables inside our specification.

To the end, we use an interacted panel vector autoregression as in Towbin and Weber (2011) which is estimated in Bayesian fashion for 17 Europe. The baseline specification includes government consumption, real GDP, real private investment, the debt-to-GDP ratio and the trade balance as endogenous variables (see Nickel and Tudyka 2013 for additional information).

Figure 1 reports cumulative impulse responses to a fiscal shock, concentrating on the flow variables for government consumption, real GDP, private investment and the trade balance. The shock is a growth in government consumption add up to one percentage point of GDP.

  • The columns represent our assumption regarding the initial public debt-to-GDP ratio (we show results for the ratio add up to 0.4, 0.67 and 1.09).
  • The rows show the variables of interest, namely government consumption (‘G’) in the first row, real GDP (‘Y’) in the next, private investment (‘I’) in the 3rd and the trade balance (‘TB’) in the ultimate row.
  • The solid line corresponds to the median (50th percentile) impulse response and the dotted lines will be the 16th and 84th percentiles of the respective posterior distribution as (one standard deviation) probability bands.
  • In every plots, horizontal axes indicate periods following the shock and vertical axes are in percentage shares of GDP.

Figure 1 . Cumulative impulse responses to a one percentage point of GDP shock to government consumption at various interaction levels

To summarise our findings, we concentrate on three points:

  • First, the impact of government consumption is highly reliant on the original debt ratio.
  • Second, it becomes a lot more self-reversing pattern at higher debt ratios (beyond approximately 60%).

This could be observed in the increasingly hump-shaped cumulative impulse responses (Chung and Leeper 2007, Corsetti et al. 2012). The hump indicates that the shock initially provides stimulus but this may become a contractionary force after a while.

  • Third, as the overall influence on real GDP is expansive even at lengthy horizons, the higher your debt ratio, the less it is the case.

Eventually, at debt ratios beyond 90%, the entire influence on real GDP becomes significantly negative (see Ilzetzki et al. 2010).

The cumulative response of private investment turns increasingly negative as government indebtedness increases. Specifically, the cumulative influence on private investment turns negative for the very first time at debt ratios of around 57%. Moreover, at low debt-to-GDP (significantly less than 40%) ratios the entire influence on the trade balance is negative (see Corsetti and Müller 2006). However, at high debt-to-GDP ratios (a lot more than 85%) the cumulative influence on the trade balance becomes significantly positive at longer horizons following the shock (see Kim and Roubini 2008).

Concluding remarks: Mind your debt!

Our results indicate that the private sector increasingly internalises the federal government budget constraint as the amount of indebtedness rises. This qualifies debt as a significant variable to view when taking into consideration the impact of fiscal stimulus.

  • Specifically, while fiscal stimuli exert expansionary effects on macroeconomic activity at low debt-to-GDP ratios, the entire influence on real GDP becomes less positive and even negative points at higher debt-to-GDP ratios.
  • Based on which debt scenario we examine, our results accommodate the inconclusive results of previous studies, which either document positively correlated or divergent behaviour of government activity and the trade balance or the existing account.

In sum, our findings lead us to summarize that the contradictory findings of previous studies could be the consequence of estimation within a static debt regime when indeed your debt regime is dynamic.

A rsulting consequence this may be, for example, that whenever estimating responses over the complete selection of debt ratios, the result on the existing account may well arrive as insignificant because negative and positive effects block out. Consequently, the potency of fiscal stimuli to improve economic activity or resolve external imbalances may fade with increasing debt-ratios. 1 Actually they could even be counterproductive. From an insurance plan perspective, these results therefore lend additional support to increased prudence at high public-debt ratios.

Editor’s note: The views expressed will be the authors’ and don’t necessarily reflect those of the ECB.


Chung, H and E M Leeper (2007), “What has financed government debt?”, Working Paper 13425, National Bureau of Economic Research.

Corsetti, G, A Meier, and G Müller (2012), “Fiscal stimulus with spending reversals”, The Overview of Economics and Statistics 94(4), 878-895.

Corsetti, G and G J Müller (2006), “Twin deficits: Squaring theory, evidence and good sense”, Economic Policy 21(48), 597-638.

Giavazzi, F and M Pagano (1990), “Can severe fiscal contractions be expansionary? Tales of two small Europe”, NBER Macroeconomics Annual 5, 75-111.

Ilzetzki, E, E G Mendoza, and C A Végh (2013), “What size (small?) are fiscal multipliers?”, Journal of Monetary Economics 60(2), March, 239-254.

Kim, S and N Roubini (2008), “Twin deficit or twin divergence? Fiscal policy, current account, and real exchange rate in america”, Journal of International Economics 74(2), 362-383.

Nickel, C and A Tudyka (2013), “Fiscal stimulus in times of high debt: Reconsidering multipliers and twin deficits”, Working Paper Series 1513, European Central Bank.

Nickel, C and I Vansteenkiste (2008), “Fiscal policies, the existing account and Ricardian equivalence”, Working Paper Series 935, European Central Bank.

Perotti, R (1999), “Fiscal policy in memories and bad”, The Quarterly Journal of Economics 114(4), 1399-1436.

Towbin, P and S Weber (2011), “Limits of floating exchange rates: The role of forex debt and import structure”, IMF Working Papers 11/42, International Monetary Fund.

1 Because of symmetry of the results, good literature on expansionary fiscal consolidations, contractionary policy measures may exert expansionary effects on medium-run economic activity when debt-to-GDP ratios are high (Giavazzi and Pagano 1990).

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