Fiscal consolidation versus inflation in reducing public debt in OECD countries (1985-2023)

Abstract

Theoretical background: The problem of excessive public debt, which arose in the wake of the global financial crisis and intensified as a consequence of the COVID-19 pandemic, is currently one of the most important challenges for fiscal authorities. Theoretical considerations and practical experience indicate that reducing public debt is possible through appropriate actions under fiscal and monetary policies. Fiscal actions may consist of fiscal consolidation (increased taxation, spending cuts), and monetary actions may relate to inflationary policy.

Purpose of the paper: The aim of this paper is to analyse debt consolidation episodes in OECD countries in 1985–2023 in order to identify which approach – fiscal austerity or inflation – was the key factor in reducing (stabilising) public debt.

Research methods: The empirical analyses in the paper were conducted with the use of the following research methods: chi-square test, Cramer’s V coefficient and odds ratio. Mosaic plots were used to capture and visualise the relationships between variables. The research used annual data for OECD countries for 1985–2023.

Main findings: The research hypotheses were supported by the research findings: a) in OECD countries, fiscal consolidation is more effective in reducing public debt than inflationary policy. This effect strengthens in the long term, which means that fiscal consolidation results in a lasting debt reduction; b) in the short term, higher inflation leads to a decrease in the public debt-to-GDP ratio. However, this effect is time-limited and does not translate into a permanent debt reduction; c) fiscal consolidation based on austerity policy brings a more lasting effect than reducing public debt through inflation. Countries that pursued austerity policies were more likely to achieve long-term success in reducing debt, which highlights the advantages of this approach over inflationary policies. Sustainable consolidation of public debt is possible thanks to the implementation of responsible fiscal policy (tax and expenditure), and simultaneous support for economic growth (GDP growth). The use of inflation should be seen as a method to reduce the debt-to-GDP ratio under debt pressure, bearing in mind, however, that this reduction will have a short-term effect and carries a significant risk.