Olivier Blanchard and Daniel Leigh provide a good account of the trade-off facing policy makers in identifying the optimal speed of fiscal adjustment. See also Chapter 2 of the IMF’s recent Fiscal Monitor. Reasons for slower adjustment include time-varying multipliers, the danger of “stall speed” where adverse feedback loops kick in at low or negative growth rates, and hysteresis effects from fiscal contractions that are worse when the economy is already in recession. The main reason for faster adjustment is the danger of falling into a bad equilibrium with high interest rates and high expectations of default, especially where it is difficult to credibly commit to future adjustments.
The debate focuses mainly on the trade-off for a country such as the UK that retains its own independent monetary policy. In contrast to the uncertainty that surrounds such empirical questions as the size of fiscal multipliers or the causal link from debt to growth, recent experience in Ireland and elsewhere shows that the risk of falling into a “bad equilibrium” is not hypothetical for a high-debt country within EMU. For fragile EMU members, an additional factor is the existence of a conditional lender of last resort, where one of the conditions for support could be a forced restructuring of privately held debt (PSI). (I make an initial stab at integrating a conditional LOLR into a model with possible multiple equilibria here)