Working Paper: NBER ID: w17571
Authors: Roberto Perotti
Abstract: As governments around the world contemplate slashing budget deficits, the "expansionary fiscal consolidation hypothesis" is back in vogue. I argue that, as a statement about the short run, it should be taken with caution. I present four detailed case studies, two - Denmark and Ireland - undertaken under fixed exchange rates (the most relevant case for many Eurozone countries today) and two - Finland and Sweden - after floating the currency.\t\n\nAll four episodes were associated with an expansion; but only in Denmark the driver of growth was internal demand. However, after three years a long slump set in as the economy lost competitiveness. In all the others for a long time the main driver of growth was exports. In Ireland this occurred because the sterling coincidentally appreciated. In Finland and Sweden the currency experienced an extremely large depreciation after floating. \n\nIn all consolidations interest rate fell fast, and wage moderation played a key role in generating a gain competitiveness and a decline in interest rates. These results cast doubt on at least some versions of the "expansionary fiscal consolidations" hypothesis.
Keywords: Fiscal Policy; Expansionary Consolidation; Budget Deficits
JEL Codes: E62; E65; F32
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| discretionary fiscal consolidations (E62) | smaller estimated effects (C92) |
| spending cuts (H56) | less significant than believed (Y50) |
| spending cuts in Ireland (H69) | larger than revenue increases (H29) |
| spending cuts in Finland (H69) | negligible (F11) |
| stabilizations (E63) | associated with GDP expansions (E20) |
| Denmark growth driven by domestic demand (O52) | long slump due to competitiveness loss (F66) |
| second exchange rate-based stabilization in Ireland (F33) | currency depreciation before consolidation (F31) |
| currency depreciation (F31) | boosted Irish exports (F10) |
| budget consolidations (H61) | significant declines in nominal interest rates (E43) |
| wage moderation (J38) | maintaining competitiveness (F23) |
| conditions for past consolidations (N20) | may not apply in current low inflation environment (E31) |