Fiscal Austerity in Ambiguous Times

Axelle Ferrière and Anastasios G. Karantounias

Working Paper 2016-6
March 2016

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How should public debt be managed when uncertainty about the business cycle is widespread and debt levels are high, as in the aftermath of the last financial crisis? This paper analyzes optimal fiscal policy with ambiguity aversion and endogenous government spending. We show that, without ambiguity, optimal surplus-to-output ratios are acyclical and that there is no rationale for either reduction or further accumulation of public debt. In contrast, ambiguity about the cycle can generate optimal policies that resemble "austerity" measures. Optimal policy prescribes front-loaded fiscal consolidations and convergence to a balanced primary budget in the long run. This is the case when interest rates are sufficiently responsive to cyclical shocks; that is, when the intertemporal elasticity of substitution is sufficiently low.

JEL classification: D80; E62; H21; H63

Key words: endogenous government expenditures, distortionary taxes, balanced budget, austerity, fiscal consolidation, martingale, ambiguity aversion, multiplier preferences

The authors are grateful to David Backus, Richard Rogerson, Thomas J. Sargent, Stanley E. Zin, and especially to Mikhail Golosov for their comments. They also thank Anmol Bhandari, Murat Tasci, conference participants at the Society for Economic Dynamics meetings in Toronto, the European Economic Association meetings in Toulouse, the Computing in Economics and Finance meetings in Oslo, the Ambiguity and Robustness workshops at the Becker Friedman Institute and at New York University, and seminar participants at the Federal Reserve Banks of Atlanta and Cleveland. The views expressed here are the authors' and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the authors' responsibility.
Please address questions regarding content to Axelle Ferrière, Department of Economics, European University Institute, 43 via della Piazzuola, 50133, Firenze, Italy,, or Anastasios G. Karantounias (corresponding author), Research Department, Federal Reserve Bank of Atlanta, 1000 Peachtree Street NE, Atlanta, GA 30309,
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