In the 1980s, most European countries tightened their fiscal policies, although both the size of the turnaround and the relative contributions of taxes and spending to the outcome have varied considerably. Keynesians have warned that this fiscal contraction would have strong contractionary effects on output and employment, while others have argued that its effects would be expansionary, owing to the benign impact on expectations of cuts in public spending. This latter interpretation, widely labelled the `German view', emphasizes that fiscal policy actions have not only direct effects on the current level and composition of demand, but also indirect effects via expectations, in so far as they signal the future course of fiscal policy.

Few studies have tried to assess the practical importance of such expectational effects for the conduct of policy, perhaps because of the lack of empirical evidence. In Discussion Paper No. 417, Programme Director Francesco Giavazzi and Research Fellow Marco Pagano draw on data generated by the most extreme cases of this European exercise in fiscal rectitude Denmark and Ireland.

A brief examination of the macroeconomic data for a number of European countries suggests that the `German view' of negative fiscal multipliers cannot be dismissed easily, at least for the countries where spending cuts were sharpest and most expected to persist. In Denmark, the fiscal turnaround of 1983 was accompanied by an unusually strong expansion in the subsequent four years, and in Ireland the 1987-9 stabilization had a similar outcome.

Giavazzi and Pagano review the key facts of the Danish and Irish experiments, highlighting the importance of the monetary and exchange rate policies that accompanied fiscal stabilization. In both cases, budget cuts coincided with the announcement that the domestic currency would be durably pegged to the Deutschmark, which led to a sharp fall in domestic interest rates and a corresponding increase in asset prices.

They then discuss how much of the rise in private consumption may be explained by the direct effects of the policy package, acting via changes in current taxes, spending and asset prices, as a result of the fall in disposable income due to the increase in current taxes, the wealth effect due to the fall in interest rates, and the reduction in the provision of public services to consumers. They then assess whether the portion of the surge in consumption left unexplained by the change in current variables can be attributed to changes in expectations about future fiscal policy, before finally assessing the extent to which the extraordinary performance of private investment during the Danish stabilization can be related to the shift in fiscal policy.

They conclude that the `German view' is empirically relevant in certain cases. In Denmark, cuts in government spending were associated with increases in consumption even after controlling for wealth and income and with a substantial increase in taxes. The Irish case highlights rather the potential importance of liquidity constraints for the operation of this mechanism.

Can Severe Fiscal Contractions be Expansionary? Tales of Two Small European Countries
Francesco Giavazzi and Marco Pagano

Discussion Paper No. 417, May 1990 (IM)