Signalling Fiscal Austerity

Austerity measures may play a signalling role when sovereigns have private information about their ability to repay their debts. Reducing debt is less costly for more creditworthy countries, so by implementing a sucient degree of austerity they can avoid imitation by less creditworthy ones. In a separating equilibrium, more creditworthy countries suer from an ‘excessive’ debt reduction, but benet by being able to sell their debt at a higher price. The incentive to signal creditworthiness through austerity increases when sovereign credit ratings are less informative. Using a panel of 58 countries from 1980 to 2011, I nd that, consistent with the model, increased scal austerity is associated with episodes in which ratings are less informative.