Can Severe Fiscal Contractions Be Expansionary? Tales of Two Small European Countries

According to conventional wisdom, a fiscal consolidation is likely to contract real aggregate demand. It has often been argued, however, that this conclusion is misleading as it neglects the role of expectations of future policy; if the fiscal consolidation is read by the private sector as a signal that the share of government spending in GDP is being permanently reduced, households will revise upward the estimate of their permanent income, and will raise current and planned consumption.
Only the empirical evidence can sort out which of these two contending views about fiscal policy is more appropriate—i.e., how often the contractionary effect of a fiscal consolidation prevails on its expansionary expectational effect. This paper brings new evidence to bear on this issue drawing on the European exercise in fiscal rectitude of the 1980s, and focusing, in particular, on its two most extreme cases—Denmark and Ireland.
We find that at least in the experience of these two countries the expectations view has a serious claim to empirical relevance.