The “shock therapy” of front-loaded, “ambitious” fiscal consolidation plans, also known in Europe as “austerity”, hinges on the credibility approach. In this approach, governments are urged to announce and implement large fiscal adjustments that are rewarded with lower interest rate (e.g. Corsetti et al. (2010)). This is crucial. Even though austerity may have short-run negative effects on aggregate demand, these may be compensated by a permanent cut of the risk premium that prompts long-term private expenditure.
This view has now become highly controversial well beyond the circles of traditional opponents (see among others the Forum organized by the website Vox (www.voxeu.org) and Corsetti (ed., 2012)). The punishment, or lack of reward, in terms of spreads of hard austerity plans implemented by countries like Italy and Spain, or the self-defeating effect of conditionality plans in Greece and Portugal (and partly in Ireland), raise the thorny issue of whether such plans were too small (non credible) or too large (non sustainable). Sustainability is indeed another approach which is partly analogous to, but partly different from, the celebrated one of credibility.
In simple words, sustainability is the chance that at any point in time the government is willing or able to sustain the level of fiscal effort (say the primary surplus/GDP ratio) required by the solvency condition of its outstanding debt. Hence sustainability is a key variable in the investors’ assement of default risk, and in the determination of sovereign risk premia. The essential difficulty in assessing sustainability lies in its political dimension, which is a source of peculiar, extra-economic, uncertainty not amenable to “objective” analysis of the so-called “fundamentals”. The current generation of sovereign debt models is in fact concerned with institutional setups where the government’s ability to tax or monetize is constrained (for instance, euro-governments have no access to monetization) and therefore the government can in fact opt for default as a result of a cost-benefit analysis (e.g. Cooper (2012), Corsetti and Dedola (2011), Gros (2012), De Grauwe (2011)).
Against this background, I have shown in a recent study (Tamborini (2012)) that, contrary to the credibility apporoach, sustainability indeed predicts that governments engaged in larger and larger fiscal efforts will pay a higher interest rate. This happens because, as the fiscal effort increases, a larger share of investors believe that the government will opt for default, and the risk premium increases. As a consequence, one possible equilibrium is typically a “self-fulfilling default prophecy” due to the positive feedback mechanism among market beliefs of default, higher spread, higher fiscal effort, reinforcement of market beliefs.
Here I present some data of EMU12 countries  that show the evolution of spreads of their sovereign debts vis-à-vis their fiscal effort. I identify fiscal consolidation with a positive change in the primary-surplus/GDP ratio over the previous year. The data cover the three years 2010-2012 in which almost all countries engaged in fiscal consolidation. In the first place, figure 1 plots fiscal consolidation against spreads. The non-linear fit of the second order suggests that spreads in the EMU as a whole are poorly, and wrongly, related with fiscal consolidation. Larger fiscal efforts have not been rewarded with smaller spreads, and /or higher spreads require larger fiscal efforts in a vicious circle.
Figure 1. Fiscal consolidation spreads. EMU12 countries 2010-12
(1) Year average of monthly spreads over ten-year German bonds (ECB definition). Source: Eurostat, AMECO database; ECB, Interest-rate statistics.
A more precise interpretation of sustainability is that investors asses not so much actual primary balances as the gap with the target primary balance that would be necessary for the government to stay solvent (see figure 2).
Figure 2. Gap between realized and target primary-surplus GDP/ratio. EMU12 countries, 2010-12
Source: Eurostat, AMECO database, and personal calculations
The latter is by itself a difficult and controversial measurement (e.g. IMF (2012)). As a point of reference, for each country and each year I have computed the primary-surplus/GDP ratio necessary to keep the debt/GDP ratio constant. This is somewhat arbitrary, because each country might have a specific target either self-imposed or imposed by external agencies. However, my measure of the target represents a minimal requirement, whereas some countries under debt distress may have even “more ambitious” programmes of debt reduction implying higher targets. Indeed, as shown by figure 2, all countries, except Germany-2012, have systematically failed to achieve their targets, though improving over time.
Combining the previous evidence, figure 3 suggests a better explanatory variable for spreads, namely the deviations from target. In fact, the evolution of spreads seems to track such deviations rather closely. On the one hand, it may be argued that investors have not rewarded fiscal adjustments mostly because the latter were too small. On the other hand, along with more formal tests such as those of De Grauwe and Ji (2012), these data denote a scenario of “consolidation fatigue” which is consistent with the sustainability view in that the required adjustments were deemed excessive by the investors. Setting ambitious fiscal targets is likely to produce deviations from target; the market does not look at the realized part of consolidation but at the missing part, and it responds with higher interest rates, which require even more ambitious targets and so on with the positive feedback mechanism described above.
Figure 3. Gaps from target and average monthly spreads. EMU12 countries 2010-12
Source: Eurostat, AMECO database; ECB, Interest-rate statistics.
The shift from a credibility to a sustainability pradigm by investors is probably playing a role in making the euro-sovereign debt crisis so difficult to manage. This shift of paradigm may have caught policy makers brought up in the credibility doctrine by surprise. The latter, in the different market context focused on sustainability, may in fact provide misleading policy prescriptions. The point of the sustainability approach is that when a government is caught in the self-fulfilling prophecy trap, announcing and implementing harder fiscal plans is not the right move because, as explained above, it will boost the risk premium even though the plans are initially sustainable. Consequently, EMU reforms that hinge exclusively on the hardening of the Maastricht doctrine of “rules + punishment”, like the Fiscal Compact, are also disputable on the same grounds (e.g. De Grauwe (2011), Wyplosz (2011), Roubini (2012)).
Cooper R. (2012), “Fragile Debt and the Credible Sharing of Strategic Uncertainty”, NBER Working Paper, n. 18377.
Corsetti G. (ed., 2012), Two Much of a Good Thing?, London, Centre for Economic Policy Research.
Corsetti G., Dedola L. (2011), “Fiscal Crises, Confidence and Default. A Bare-bones Model with Lessons for the Euro Area”, mimeo.
Corsetti G., Kuester K., Meier A., Mueller G. (2010), “Debt Consolidation and Fiscal Stabilization in Deep Recessions”, American Economic Review, 100, pp.41-45.
De Grauwe P. (2011), “The Governance of a Fragile Eurozone”, CEPS Working Document, n.346.
De Grauwe P., Ji Y. (2012), “Mispricing of Sovereign Risk and Multiple Equilibria in Sovereign Risk”, CEPS Working Document, n. 361.
Gros D. (2012), “A Simple Model of Multiple Equilibria and Default”, CEPS Working Document, n. 366.
IMF (2012), “A Toolkit to Assessing Fiscal Vulnerabilities and Risjs in Advanced Economies”, Working Paper, n.11.
Roubini N. (2012), “A Balance-Sheet Recession Calls for Monetized Fiscal Deficits, Not Fiscal Austerity”, Roubini Global Economics, April, www.rge.com.
Tamborini (2012), “Market opinions, fundamentals, and euro-sovereign debt crisis”, Discussion Paper, Dipartimento di Economia, Università di Trento, n.9, Available at SSRN: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2172474.
Wyplosz C. (2011), “A Failsafe Way to End the Eurozone Crisis”, Vox, September, www.voxeu.info.
 Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal, Spain.