A simple dynamic framework is used to show how consolidation plans that are robust
and effective at capacity output can be undermined by demand failure. If the market
panics and interest rates rise, the process can indeed become dynamically unstable.
Tightening fiscal policy to reassure financial markets can lead to a low level
“consolidation trap”, however. Better that the Central Bank acts to keep interest rates
low; and that fiscal consolidation efforts be state contingent – allowing room for
economic stabilisation. The pro-cyclicality of fiscal policy could also be reduced if, as
Shiller has argued, debt amortization were state contingent, being indexed to GD