Evaluating The Self-Defeating Fiscal Austerity Hypothesis for a Dollarized Economy: The Peruvian Case

Abstract

This paper tests the hypothesis of self-defeating fiscal austerity (Attinasi and Metelli, 2017; Cherif and Hasanov, 2018), using a time-varying parameter vector autoregression with stochastic volatility (TVP-VAR-SV) model estimated on Peruvian data for 2000Q2–2024Q2. The central objective is to assess whether, following a transitory fiscal austerity shock, the debt-to-GDP ratio declines in the long run. If debt fails to decrease—or rises—over time, fiscal policy would be deemed self-defeating for the period under study, reflecting the contraction in economic activity that typically accompanies fiscal tightening. The paper also examines the role of exchange rate dynamics in fiscal consolidation—an aspect largely unexplored in the literature. A family of models with time-varying parameters and stochastic volatility is estimated to evaluate whether these features are essential for an adequate model fit. The results provide evidence against the self-defeating austerity hypothesis: the long-run cumulative response of the debt-to-GDP ratio stabilizes roughly 0.6 percentage points of GDP below its no-shock path. The findings underscore the importance of the exchange rate channel in enhancing the effectiveness of austerity shocks. However, fiscal stabilization becomes ineffective when achieved through expenditure cuts rather than revenue measures, as spending-based austerity dampens GDP growth and exhibits limited persistence, weakening its long-term effect.