**Summary:**
This paper examines whether severe fiscal contractions can be expansionary, using the cases of Denmark and Ireland as examples. In the early 1980s, many European countries faced severe debt problems due to high interest rates and large public debt. Governments implemented contractionary fiscal policies, but there was disagreement on their effects. In Denmark, the Ministry of Finance anticipated that fiscal contraction would dampen private consumption, while the German Council of Economic Experts argued that fiscal retrenchment could lead to expansion. The paper analyzes the effects of fiscal consolidation on private consumption and investment, using data from the 1980s.
The study finds that in Denmark, despite the fiscal contraction, real GDP grew by 3.6% from 1983 to 1986, driven by domestic demand and investment. This was attributed to a combination of factors, including a fall in disposable income due to higher taxes, a wealth effect from lower interest rates, and reduced public services. In Ireland, the first stabilization led to a decline in private consumption, but the second stabilization in 1987-89 resulted in a consumption boom, driven by lower taxes and improved disposable income.
The paper also discusses the role of monetary and exchange rate policies in these stabilizations. In Denmark, the pegging of the currency to the German mark and a sharp monetary disinflation helped reduce public debt and improve economic conditions. In Ireland, a devaluation and a sharp disinflation led to a reduction in interest rates, which stimulated domestic demand.
The study concludes that the experiences of Denmark and Ireland highlight the importance of expectations about future fiscal policy. The "German view" that fiscal consolidation can be expansionary if it is perceived as permanent is supported by the data. The paper also notes the role of liquidity constraints and the importance of credit markets in explaining consumption behavior. The findings suggest that severe fiscal contractions can be expansionary if they are perceived as permanent and if they are accompanied by appropriate monetary and exchange rate policies.**Summary:**
This paper examines whether severe fiscal contractions can be expansionary, using the cases of Denmark and Ireland as examples. In the early 1980s, many European countries faced severe debt problems due to high interest rates and large public debt. Governments implemented contractionary fiscal policies, but there was disagreement on their effects. In Denmark, the Ministry of Finance anticipated that fiscal contraction would dampen private consumption, while the German Council of Economic Experts argued that fiscal retrenchment could lead to expansion. The paper analyzes the effects of fiscal consolidation on private consumption and investment, using data from the 1980s.
The study finds that in Denmark, despite the fiscal contraction, real GDP grew by 3.6% from 1983 to 1986, driven by domestic demand and investment. This was attributed to a combination of factors, including a fall in disposable income due to higher taxes, a wealth effect from lower interest rates, and reduced public services. In Ireland, the first stabilization led to a decline in private consumption, but the second stabilization in 1987-89 resulted in a consumption boom, driven by lower taxes and improved disposable income.
The paper also discusses the role of monetary and exchange rate policies in these stabilizations. In Denmark, the pegging of the currency to the German mark and a sharp monetary disinflation helped reduce public debt and improve economic conditions. In Ireland, a devaluation and a sharp disinflation led to a reduction in interest rates, which stimulated domestic demand.
The study concludes that the experiences of Denmark and Ireland highlight the importance of expectations about future fiscal policy. The "German view" that fiscal consolidation can be expansionary if it is perceived as permanent is supported by the data. The paper also notes the role of liquidity constraints and the importance of credit markets in explaining consumption behavior. The findings suggest that severe fiscal contractions can be expansionary if they are perceived as permanent and if they are accompanied by appropriate monetary and exchange rate policies.