Fiscal adjustment and the costs of public debt service: evidence from OECD countries

We use a panel of 21 OECD countries from 1970 to 2009 to investigate the effects of different fiscal adjustment strategies on long-term interest rates - a key fiscal indicator reflecting the costs of government debt service. As Europe's sovereign debt crisis has shown, governments confronted with high deficits and rising debt may be forced to enact fiscal adjustments in order to avoid increasing market pressure and solvency problems. Over the last four decades, such measures taken by governments in OECD countries have varied in duration, size, composition and in their success to re-establish fiscal sustainability. We find that large and expenditure-based adjustments lead to substantially lower long-term interest rates. Small and revenue-based measures do not have an effect on interest rates. Financial markets thus only seem to value strict and decisive measures - a clear sign that the government's pledge to cut the deficit is credible.