Public debt dynamics: the interaction with national income and fiscal policy

AbstractThe 2008 financial crisis triggered the debt crisis in Europe. High debt-to-GDP ratios made it impossible for some countries to apply countercyclical policy in order to overcome the recession. As a result, highly indebted countries were forced to apply austerity measures to avoid sovereign default, which deepened even further the decline of their GDP. We examine the case of a highly indebted country, which is not cut off from the financial markets yet, using a bilinear difference equation system. We contemplate the dynamic equations of national income and sovereign debt together, as GDP fluctuations directly affect the debt evolution and we introduce the notion of the second relation, namely the deceleration of private investments due to sovereign debt. We build a new method for the implementation of fiscal policy, a feedback control of the economic system, and we stress its consequent policy implications. We contribute to the existing debt dynamics literature providing a new perspective for the interaction of public debt and GDP. The fiscal policy method we propose vanishes the dilemma between the front-loaded and back-loaded austerity, combines the fiscal recovery from a recession and the fiscal consolidation, as it immediately improves the debt-to-GDP ratio by increasing the national income and restraining the rise of public debt. Finally, we stress why the second relation is important for the implementation of fiscal policy, as its presence leads to a slower and more painful recovery.