Is fiscal austerity really self‐defeating?

This paper analyzes local and global equilibrium dynamics in an optimizing endogenous growth model under expenditure‐based fiscal austerity feedback policies expressed relative to the private capital stock—prescribing spending cuts in reaction to public debt accumulation. Because the present value of equilibrium primary surpluses turns to be a nonlinear function of debt, two steady state equilibria are shown to emerge, one exhibiting low debt and high growth, one exhibiting high debt and low growth. Local analysis reveals that the low‐debt/high‐growth steady state is saddle‐path stable while the high‐debt/low‐growth steady state is unstable—the latter thus indicating the possibility of self‐defeating austerity, characterized by off‐equilibrium upward spirals in debt because of persistent policy‐induced adverse effects on growth dividends and fiscal revenues. However, when global nonlinear dynamics are taken into account, it is demonstrated that the two steady states are endogenously connected. In particular, global analysis reveals that even if the high‐debt/low‐growth steady state is locally unstable, there exists a unique and possibly nonmonotonic saddle connection making the economy converge to the low‐debt/high‐growth steady state. The existence of the saddle connection guarantees global determinacy of perfect foresight equilibrium should the high‐debt/low‐growth steady state be a node, ruling out multiple explosive paths incompatible with the government's intertemporal budget constraint and the private agents' transversality condition. The foregoing results are robust with respect to the adoption of an output‐based—rather than a capital‐based—policy function as long as the rule is nonlinear and sufficiently reactive to debt changes.