Fiscal Consolidation and Employment Loss

The recent sovereign debt crisis has renewed the interest in fiscal consolidation policies and the associated output losses they entail. However, countries that adopted such policies are also plagued by persistent unemployment, and debt reduction ought to magnify the problem. This paper extends the standard neoclassical growth model to (i) the presence of public debt and (ii) the search and matching frictions in the labor market and quantifies the output and employment losses associated with fiscal consolidation episodes. The main results indicate that these losses can be substantially high. For instance, a 25% debt reduction yields a 50% increase in unemployment along the adjustment path. The paper also shows that policymakers need to carefully consider the intertemporal trade-off between short-run losses and long-run gains from the lower debt in their design of fiscal consolidation plans. Its timing, its size, the choice of fiscal instruments used to achieve it, and the role of monetary policy, also matter.