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Address by Governor Carlos da Silva Costa at 18th Conference of Montreal

I. Introductory remarks

Good morning ladies and gentlemen. It is a pleasure and an honour to be here.

My mandate today is to speak to you about “Budget constraints and economic growth: Striking a balance”. This is a timely and provocative subject.

It is timely because both fiscal imbalances and weak growth prospects are currently major concerns on both sides of the Atlantic; and because it is widely acknowledged that fiscal policy matters for sustainable growth.

It is provocative because the idea of striking a balance suggests that there is – or there might be under certain circumstances – a trade-off between fiscal consolidation and growth prospects. This possible trade-off has been very much at the heart of recent policy debates, with significant differences of views emerging across the Atlantic.

I will deal with each of these points in turn.

Let me start with the easy bit: the idea that fiscal policy matters for growth.

II. Fiscal policy matters for sustainable growth

The view that high debt levels are harmful to growth finds strong theoretical and empirical support in the economic literature.

A large number of studies, performed using different methodologies and for different country sets and time periods, point to important non-linearities in the relationship between public debt and growth, and suggest that high public debt ratios, typically somewhere around 90% of GDP, are associated with lower growth outcomes.

While the actual threshold and negative effects of debt on growth vary among the studies (e.g. the threshold tends to be lower for emerging economies), the estimated impacts are quite impressive. Indeed, a 10 p.p. increase in the public debt ratio of highly indebted countries could have an impact on growth that varies between -0.1 and -0.6 p.p.

From a conceptual viewpoint, fiscal policy may impair growth through at least three channels.
First, high public debt levels increase uncertainty.

The concerns about fiscal sustainability and the restrictive policies (in particular distortionary taxes, including the inflation tax) that will have to be implemented in order to meet the debt service obligations have adverse effects on investment, and thus on growth.

In the face of increased uncertainty, potential investors (domestic and foreign) will prefer to defer their investments, or simply to divert them to other economies. Moreover, the reduced investment that still takes place is likely to be concentrated in activities with quick returns rather than on projects enhancing long-term potential growth. Finally, rapid accumulation of public debt may be accompanied by capital flight due to fear of imminent devaluations and/or tax hikes resulting in sudden slumps of activity, and further depressed investment. In some extreme cases, the public debt crisis can trigger a banking crisis, magnifying even more the adverse effects on real activity.

Second, unsustainable public debt levels impair the use of fiscal policy as a counter-cyclical tool.

As public debt levels increase relative to GDP, the government’s ability to service debt becomes progressively more sensitive to drops in growth and to hikes in interest rates.

Highly indebted governments are perceived as having a higher probability of default. They therefore face higher interest rates and, in more extreme cases, the ability to issue new debt may be constrained or ended. This perception of creditworthiness of a given highly indebted economic agent is critically dependent on the fluctuations in overall risk aversion in the financial markets. This means that highly indebted agents become very vulnerable to negative shocks associated with events with apparent little direct relevance for the determination of their creditworthiness. In such circumstances, a diminished flow of credit to the public sector can limit essential government functions and severely constrain the scope for counter-cyclical fiscal policy, thereby increasing income volatility and depressing growth.

Downturns tend to be associated with lower potential output, not only because of lower investment, but also because of labour-market and capital hysteresis effects. By raising short-term growth, a counter-cyclical fiscal policy limits the hysteresis, and therefore the negative impact of the downturn on long-run growth. Conversely, the lack of a counter-cyclical fiscal policy implies a deeper recession and a negative impact on long-run growth.

Third, the increase in the public sector risk premia tends to be transmitted to the private sector, impairing the effectiveness of the monetary policy, on top of the zero interest rate lower bound.

There is ample evidence that sovereign fund strains often spill over into private credit markets. Contagion from the sovereign to the private sector may occur through two channels:

  • Through an increase in the private sector risk premium (private debtors should be more risky because they do not have the ability to raise funds through taxation);
  • And through a funding constraint resulting from reduced access to external savings, whenever there is a deficit of internal savings (and therefore a need for external funding).

If monetary policy is constrained by the zero lower bound on interest rates, it is unable to offset the increase in private funding costs, and therefore to mitigate a negative impact on domestic demand and growth. In a worst-case scenario, the domestic agents may experience a shutdown of market access and a severe debt crisis.

III. Fiscal consolidation and economic growth: Is there a trade-off?

Having mentioned the main channels through which large fiscal imbalances impair growth, let me now turn to the policy lessons, and particularly to the question of whether there is a trade-off between fiscal consolidation and growth.

The first point to make is a normative one, and again this point should meet with a high degree of consensus: There is a need to preserve fiscal policy’s room for manoeuvre during the cycle, so as to allow the automatic stabilizers to play their role of smoothing cyclical downturns. Given political cycles and short-sightedness, this can only be achieved by appropriate rules and institutions.

Setting fiscal policy within a long-term fiscal sustainability framework is the only way to avoid temporary measures or a counter-cyclical fiscal stance continuing, and eventually becoming a procyclical policy. In other words, for fiscal policy to be available as a stabilization tool, budget constraints need to be managed before unsustainability is reached.

The second point I would like to make is a positive one: The right fiscal policy in a cyclical downturn is debt-path dependent.

The impact of a counter-cyclical fiscal policy on growth depends on the perception of the country’s public debt sustainability. Fiscal sustainability is a dynamic forward-looking concept - it depends on the initial debt level, on current and expected policies and on the economy’s trend growth. Beyond a certain ‘trigger’, a government’s debt level starts being regarded as unsustainable. This ‘unsustainability trigger’ is neither a precise nor a constant figure. It depends on a country’s track record and fundamentals, as well as on the global economic environment.

Fiscal consolidation always means austerity. However, while the impact of a fiscal contraction on activity is negative (versus a non-policy change and ceteris paribus scenario), this does not necessarily imply that the economy will fall into recession. Nor does it imply that the short-term growth performance of the economy will be worse than in the absence of consolidation. In other words, the relevant counterfactual needs to be kept in mind when assessing the impact of a fiscal consolidation programme.

The debt-path dependency of optimal fiscal policy suggests that the answer to the question posed by this debate - Where to strike the balance between austerity and growth - is essentially a matter of practical judgment. Being a matter of judgment, very reasonable and competent people will actively disagree on where we should ‘draw the line’, or under what circumstances one should postpone fiscal adjustment.

The key word is ‘credibility’ – credibility in a dynamic sense, i.e. at the point of departure and at the point of arrival. The right prescription will depend on the answer to questions such as: Is the postponement of fiscal consolidation likely to affect the government borrowing costs? What is the likely impact on the private sector financing conditions?

For the US economy, a very large and relatively closed economy, postponing fiscal consolidation may be appropriate if we believe that the borrowing capacity of the public sector is not constrained and that the American government will be able to credibly commit to future consolidation. Some will argue that the current low yields of US Treasury bonds indicate that for the time being this is the case. Others might argue that current yield levels are distorted by excess liquidity and do not accurately reflect the risk assessment of US sovereign debt, and that the US lacks the institutions that will allow credible commitment to medium-term adjustment.

For other countries, a pro-cyclical fiscal consolidation is either the best alternative, or the only option available. Indeed, where and when the contagion from the sovereign to the private sector affects the private sector funding costs, or worse, when it stops access to external funding (to refinance the debt stock and the new deficits), a frontloading of fiscal consolidation becomes either strongly advisable (to minimize the negative impact on growth of the increase in interest rates) or unavoidable (to ensure access to external funding conditional on an appropriate adjustment programme).

For highly indebted small open economies, the idea of piling more public debt on top of the existing debt may be either unfeasible if the borrowing capacity of the public sector is already constrained; or very risky, because it may trigger a confidence problem and aggravate the debt problem, by making apparent the borrowing limits. If these economies have their own currency and are dependent on external financing, opting for a fiscal expansion is likely to increase pressures on the exchange rate, and any devaluation will cause the domestic-currency value of external debt to increase substantially (reducing the ability to serve the debt, which in turn will contribute to a further depreciation and so on).

Policy implications in the case of monetary union

In the case of the European monetary union, where there is a prohibition of monetary financing of the public sector, and where the stability of the financial sector depends on the capacity of the local sovereign to rescue the local financial institutions, there is a two-way risk of contagion between the financial institutions and sovereigns:

  • From highly indebted sovereigns to the financial institutions, through the sovereign risk channel;
  • And from financial institutions to the sovereigns, through the need to rescue/capitalize institutions in order to safeguard financial stability (which may lead to significant public debt increases).

The outcome of this two-way interdependence is a fragmentation of the monetary union, with no transmission of the monetary policy at a time when there is reduced or no room for a counter-cyclical fiscal policy.

This has two far-reaching implications for the EMU institutional and governance model.

First, we need to prevent sovereign risk from affecting the transmission of monetary policy across the euro area. This can only be achieved if we de-link the fate of local banks from that of their sovereigns, so as to break the negative feedback loops that are at the heart of the current crisis. For this, we need to complement the monetary union with a banking union.
I see this banking union as comprising the following key elements: (i) a supranational supervision framework with centralised decision-making and decentralised implementation (as is the case for the single monetary policy) and extending to all banking institutions (not only the cross-border ones); (ii) a single deposit guarantee scheme; (iii) an EU bank resolution and capitalisation fund (a backstop facility).

For countries, like my own and others, that have suffered from negative spillovers from the deterioration of the public sector financing conditions, breaking down the obstacles to the transmission of monetary policy will have a positive impact on the credit conditions of the non-public sector with meaningful effects on demand and supply and, as a result, on growth.

Second, we need common fiscal policy rules to preserve the sustainability of public debt over the long term and adequate institutional arrangements to ensure the right enforcement.

In this context, the merits of the adoption of a fiscal compact need to be seen from two complementary angles:

  • From the perspective of ensuring public debt sustainability and the improvement of the policy mix in each country;
  • From the systemic viewpoint, which is that of safeguarding the stability of the economic and monetary union: by limiting national fiscal sovereignty, the fiscal compact is trying to address the ‘inconsistent quartet’ of (i) national fiscal sovereignty; (ii) no default; (iii) no bail-out; and (iv) no-exit.

[On European fiscal rules and institutions, a couple of complementary comments are in order.

  • First, it is interesting to note that the limits on public debt and deficit enshrined in the European Union Treaty and the provisions of the Stability and Growth Pact were, from a conceptual viewpoint, fully consistent with the normative principles on the importance of fiscal soundness for sustainable growth. However, Europe failed to put in place the rules and institutions that would ensure compliance with the underlying conceptual framework. This is precisely what the fiscal compact and other governance enhancing mechanisms are trying to fix.
  • Second, when the European Union decided for a fiscal expansion in 2009, the relative position of the Member States’ public finances were not taken into account. Portugal is a case in point: a huge fiscal expansion was decided in spite of an already high public debt level and poor trend growth. This decision eventually took the country beyond the ‘unsustainability trigger’, shutting it out of the markets and pushing it towards international financial assistance.]

IV. Concluding remarks

Let me conclude.

We are now in the fifth year since the beginning of the global crisis. The causes of the crisis are well understood. On the contrary, its full consequences are far-reaching and still unclear and huge challenges remain.

The decline of potential output growth in advanced economies can certainly not be attributed to low levels of public spending, or public debt. Beyond demographic trends, low potential growth is largely related to institutional characteristics of product and labour markets and policy frameworks, as well as poor private and public sector balance sheets.

The direct implication of the conceptual framework and empirical evidence reviewed here is that highly indebted governments should deleverage, and that more cautious governments not yet highly indebted should take action to avoid becoming so in the future, by committing to fiscal consolidation. Otherwise, governments may seriously compromise economic growth, both current and potential.

In view of current debt levels, bringing down public debt ratios even to pre-crisis levels appears a Herculean task. This task will be greatly facilitated:

  • If countries implement a clever type of austerity;
  • If austerity policies are combined with reforms to boost long-term growth;
  • And, last but not least, if the interdependence between the sovereign and banking sectors’ fates is significantly reduced through appropriate regulatory and supervisory reform of the financial sector. For euro area countries, this is absolutely critical.

According to IMF calculations, an increase in annual long-term economic growth of just a quarter of a percentage point could set in place a virtuous circle that would lead, after ten years, to a decline in the public debt to GDP ratio by 6 p.p. If this virtuous circle between growth and lower public debt is engineered, lowering public debt to where it was before the beginning of the crisis will be considerably easier. In this regard, the fact that the current crisis seems to have acted as a catalyst for reforms – and particularly so in the countries under an EU/IMF adjustment programme or countries experiencing tensions in sovereign debt markets – is certainly good news.

In Europe, we need to go further and develop an institutional framework to ensure that not only monetary policy, but also financial sector and fiscal policies are appropriate for the euro area as a whole. We need a banking union as an intermediate and necessary step to overcome the fragmentation of the monetary union and the impairment of monetary policy transmission. We also need a common set of fiscal rules and institutions to safeguard the stability of monetary union. The fiscal compact should be seen as a first step on the longer path that will eventually lead to the establishment of a fiscal union.

After a late and hesitant response to the crisis, the EU has taken important decisions to strengthen the euro area governance framework. Also, the initiatives by the EBA and the ECB, aimed at strengthening the banking system’s capital and improving liquidity in the banking system should contribute to limiting the transmission of sovereign risk into private sector borrowing conditions.

Naturally, the task of reforming European institutions and governance is just beginning. Over the past few weeks we have witnessed a promising evolution in the policy and political debate. I am sure that this conference will offer many important insights and meaningful contributions to further enlighten our policy options.

Thank you.

Montreal, 11 June 2012  


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