Unpleasant debt dynamics: Can fiscal consolidations raise debt ratios?

Using PESSOA, a medium-scale DSGE model for a small euro-area economy, we evaluate how fiscal adjustments impact short- and medium-term debt dynamics and output for alternative policy options, and budgetary and economic conditions. Fiscal adjustments may increase the public debt-to-GDP ratio in the short run, even for consolidations carried out in normal times in economies characterized by moderate indebtedness levels. Financial turmoils and hikes in the nationwide risk premia, coupled with high indebtedness levels and stiff fiscal measures, boost the output costs of fiscal consolidations and severely affect their effectiveness in bringing the public debt-to-GDP ratio down in the short term. In the medium run credible fiscal adjustments entail a decline in the public debt ratio, though at potentially very large output losses when carried out under unfavorable budgetary and economic conditions. (C) 2015 Elsevier Inc. All rights reserved.