The Ratio of Uncertainty

There are two sides of the public debate on austerity after the 2008 crisis. One argues that pro-growth fiscal interventions should be adopted at the expense of the debt-to-output ratio reduction. The second one highlights the importance of debt stabilization, as established by the European Stability and Growth Pact. The debate does not take into account the long-term prospects of the economy, says Mariano Massimiliano Croce, Full Professor of Finance whose research focuses on general equilibrium models in which there is uncertainty about the long horizon perspectives of the economy.

"Fiscal interventions that are supposed to be pro-growth may come at the cost of dimmer long-term growth", he says. "Increasing the debt-to-output ratio to deal with transitory crises creates uncertainty about how the government will pay the debt and thus about the future fiscal burden. This uncertainty discourages investments in innovation that contribute to long-term growth".

Mariano Croce and his co-authors have empirically tested this model using data from fifteen developed Countries, including Italy. They have found that, when the government is slow in adjusting debt-to-GDP ratio, production and consumption worsen, while long-run uncertainty and long-run downside risk increase. "There is a trade-off between short-run stabilization and long-term growth. We must therefore be cautious in using fiscal interventions that are supposed to be pro-growth. A rapid reduction of the debt-to-GDP ratio, on the other hand, can enhance the values of innovation and aggregate wealth".

Read more about this topic:
Financial Crises: Who Can Predict Them and How. By Carlo Favero
The Lunar Algorithm That Predicts the Future
The Controllers That Report the Risk of a Crisis
How Companies Overcome a Crisis