When the economy is flat-lining or in recession, fiscal stimulus will only be effective when concerns about sovereign risk (the possibility that the government will default on its debt) are contained. That is the central conclusion of research by Giancarlo Corsetti, Keith Kuester, André Meier and Gernot Müller, published in the February 2013 issue of the Economic Journal.


Their study explores how policy-makers can preserve macroeconomic stability in a situation where fears about sovereign default drive up risk premia for banks, firms and the wider economy. The threat to stability becomes acute when public debt is high and monetary policy is at the zero lower bound. Once the central bank has exhausted the room for further monetary easing, government spending cuts can become a critical tool to avert self-fulfilling crisis dynamics.


What”s more, government spending cuts are less harmful to growth in the presence of the ”sovereign risk channel” through which high public indebtedness raises funding costs in the private sector and dampens overall economic activity. The researchers conclude:


”Our results underscore the importance of keeping the public finances under control during good times.


”Only when concerns about sovereign risk are contained, do fiscal policy-makers retain the capacity to enact effective fiscal stimulus during bad times.”


In the wake of the global financial crisis, sovereign risk premia have risen sharply in several countries, notably in the euro area periphery. The rise in sovereign spreads has been accompanied by a tightening of private credit markets in the relevant countries, as investor fears about sovereign risk have spilled over to banks and corporates.


The study analyses how this sovereign risk channel threatens macroeconomic stability – and what policy-makers can do to counter the threat. First and foremost, the researchers find that the sovereign risk channel may give rise to problems of beliefs-driven economic outcomes in highly indebted countries when monetary policy can no longer provide accommodation.


Consider a sudden pessimistic shift in expectations that implies weaker future growth and a higher government deficit. In this scenario, the risk premium on public debt rises and, through the sovereign risk channel, spills over to private borrowing costs. Higher interest rates for firms and households, in turn, slow down activity, validating the pessimistic shift in expectations.


By reducing sovereign risk, government spending cuts can help to rein in these beliefs. But austerity may be insufficient to do so under all circumstances, particularly for very high levels of sovereign risk. This suggests that there are potentially significant benefits of other policies aimed at countering a sharp rise in sovereign risk premia, for example, unconventional central bank measures.


Second, even in the absence of beliefs-driven outcomes, the sovereign risk channel alters the effects of government spending on economic activity in important ways. Government spending cuts have two direct effects: they reduce demand; and they reduce the deficit. In addition, they also affect demand and the deficit indirectly through the sovereign risk channel.


When sovereign debt is high, the initial fall in the deficit reduces risk premia, stimulating private sector demand. Therefore, output contractions following spending cuts are smaller than in the absence of the sovereign risk channel. Indeed, output may – in extreme cases – even rise.


In contrast, when sovereign risk is relatively low and the central bank is constrained for an extended period of time, fiscal austerity can become self-defeating: the initial reduction in economic activity (and the ensuing fall in tax revenues) is then so steep that the budgetary situation deteriorates despite the austerity measures.


”Sovereign Risk, Fiscal Policy and Macroeconomic Stability” by Giancarlo Corsetti, Keith Kuester, André Meier and Gernot Müller is published in the February 2013 issue of the Economic Journal. Giancarlo Corsetti is at the University of Cambridge. Keith Kuester and Gernot Müller are at the University of Bonn. André Meier is at the International Monetary Fund.

Gernot Müller