Budget deficits and the feasibility of credit market reform

We ask the question: Why is it proposed that successful structural economic reforms (such as deregulation) require accompanying fiscal policy actions? And under what conditions can gradual reforms succeed? We use a dynamic general equilibrium model. We show that financial repression increases budget deficits. We characterize precisely the extent of deficit reductions required when financial markets are deregulated rapidly. In particular; we show the conditions under which budget deficits must be reduced in the short run below the level of maximum sustainable deficits in the long-run deregulated equilibrium. Finally, we show that the deregulation of financial markets may not uniformly improve welfare. This focus on the interaction between structural reforms and fiscal policies distinguishes our work from the literature on stabilization programs. Our study of interactions between stabilization and structural policies is equally important for both developed and developing countries.