The steepness of the crisis, its origin in the banking sector, and its medium-term consequences will make the consolidation of public finances particularly delicate. It will not make it less necessary. Although there have been signs of a turnaround for several months (business cycle indicators, rebound in industrial activity), the recovery is still fragile. The expected resumption of growth in Q3 GDP by no means signals a return to the strong GDP growth that prevailed before the crisis. As budget stimulus measures wear off next year, and the private sector still has no appetite for debt, growth is bound to be disappointing in the coming years falling short of its long-term potential. This will lead to a prolonged under-utilisation of resources (unemployment and output gap). Clearly we should fear deflationary pressures more than the risk of inflation. Looking beyond the cyclical horizon, the big risk is for the potential growth. Recent research shows that when recessions are accompanied by banking crises, they tend not only to be longer and more severe(1), but also to be followed by feeble recoveries(2). A combination of factors explains this trend, some of which are classical and well established. In the short term, factor productivity erodes with the decline in economic activity. For the most part, this is only a temporary decline since the ensuing recovery is accompanied by a rebound in production factor utilisation rates, which explains the cyclical nature of productivity gains. Yet the impact on the factors of production themselves is more lasting. This is the case with employment, for example. Under-employment tends to become partially structural as the duration of unemployment gets longer and skills become obsolete, which lowers the participation rate (active population/working age population) as job seekers get discouraged or take early retirement. The reallocation of labour resources between sectors is also hampered by the rigidities of job market institutions. Uncertainty and the output gap discourage investment. The same can be said for the malfunctioning of the financial system: some projects have a hard time finding financing due to high risk premiums, the credit squeeze or cutbacks in R&D spending, etc. Of course, sluggish growth does not make it any easier to consolidate public finances. Yet there is no need to rush, and it is certainly not worth endangering a particularly fragile recovery(3) (as was the case of Japan in the mid 1990s). For the moment, public spending has only offset the depressive impact arising from the current correction in private debt, notably at the household level. Although it is debatable whether budget policies are an effective means of stimulating economic growth during normal cyclical periods, the same cannot be said for recessions that are coupled with a banking crisis, especially at the beginning of the recovery phase. Nonetheless, it is important to have a strategy for consolidating public finances. If rising public debt ratios were to unhinge inflationary expectations, money market rates would soar, straining growth (and thus the tax base) as well as the cost of debt, making the correction even more painful. Markets can play a vigorous disciplinary role once the impact of “flight to quality” behaviour has dissipated(4). Similarly, if the surge in debt were to fuel expectations of higher taxes, private savings would increase even further, with a negative impact on both growth and public finances (the famous Barro-Ricardian equivalence theorem). Successful budget cleanups in the 1990s show that the greatest efforts should be made to reduce spending, particularly current spending. This brings to mind the lessons of the Alesina and Perotti study(5), which sought to identify the characteristics of successful budget consolidations. The authors defined successful budget stabilisation as one resulting in a 5-point decline in the debt rate over three years based on a sample of 38 stabilisation plans. The study points out that the 14 successful cases were associated with more ambitious initial objectives (3.6 points of GDP vs 1.7 points in the other cases) and placed priority on lowering spending (-2.19 points of GDP on average vs –0.44), notably current spending (cutbacks in public investment accounted for only 18% of the decline in spending vs 60% for the experiences that failed), rather than on raising taxes (0.4 points vs 1.28). A credible budget consolidation policy results in a decrease in private savings (good examples are Sweden and Canada in the 1990s) and encourages central banks to adopt or conserve accommodating policies, which reduce the cost of the adjustment in terms of growth. Seen in this light, it is unfortunate that past budget policies have often been too pro-cyclical. The task is not easy of course, and as OECD surveys on structural reforms have shown, it is only when “there are no other options” that these tough decisions are finally made(6).   (1) C. REINHART, K. ROGOFF :  “The aftermath of financial crisis“,  CEPR Discussion paper 7209, mars 2009, “the forgotten history of domestic debt” NBER working paper 13946, April 2008. (2) D. HAUGH, P. OLLIVAUD, D. TURNER: “The macroeconomic consequences of banking crises in OECD countries”, OECD working paper 683, March 2009. (3) V. CERRA, U. PANIZZA, S. SAXENA:”International evidence on recovery from recessions”, IMF working paper 183, August 2009. (4) IMF, Global stability report, chap 1, p 34-35, Oct 2009, D. HAUGH, P. OLLIVAUD, D. TURNER: “What drives sovereign risk premium? An analysis of recent evidence from the euro area”, OECD working paper 718, July 2009. (5) “Financial expansions and adjustments in OECD countries”, Economic Policy 1995, S.GUICHARD, M.KENNEDY, E.WURZEL, C.ANDRE: “What promotes fiscal consolidation: OECD countries experience”, OECD working paper 553, May 2007. (6) J. Hoj, V. Galaxo, G. Nicoletti, T. Tranh Dang: “The political economy of structural reform: evidence from OECD countries”, OECD working paper 501, 2006, A. Alesina, R. Perotti, J. Tavares: “The political economy of fiscal adjustments”, Brookings papers On Economic Activity, 1998.