Timing Fiscal Retrenchment in the Wake of Deep Recessions

Government debt levels in industrialized economies are rising rapidly at a time when monetary policy remains constrained by the zero lower bound (ZLB) on policy rates. This confronts policymakers with a formidable challenge. On the one hand, reducing government spending under these circumstances directly curtails demand, potentially undermining economic recovery. On the other hand, delaying consolidation may lead to rising sovereign risk premia that spill over to private sector funding conditions and cannot be offset by monetary policy. In this paper, we use a new Keynesian model to study how the timing of fiscal retrenchment affects economic outcomes at the ZLB. The model incorporates a risk premium that rises endogenously with the deterioration of the fiscal outlook. We find that if public debt is low, delaying government spending cuts leads to output gains relative to earlier fiscal retrenchment. However, if public debt is already high, there is a strong case for immediate policy action, because high debt levels—via their impact on the risk premium—enlarge the region of parameters for which the equilibrium is indeterminate and thus magnify the risk that expectations become unanchored.