Bob Murphy has a very good discussion on Econlib about “What Economic Research Says About Fiscal Austerity and Higher Tax Rates”.
Bob has a very good discussion about why the traditional keynesian thinking on monetary policy is wrong and has a good discussion about what Bob terms “Expansionary Austerity”, but what also have been termed expansionary fiscal contractions.
Bob among other points to Giavazz and Pagano’s pathbreaking 1990 study “Can Severe Fiscal Contractions Be Expansionary? Tales of Two Small European Countries.” Giavazz and Pagano in their paper highlight two cases of expansionary fiscal contractions. That is Denmark 1982-1985 and Ireland 1987-89. In both cases fiscal policy was tightened and the public deficit reduced dramatically and in both cases – contrary to what (paleo?) Keynesian theory would predicted – the economy expanded.
The Danish and Irish cases are hence often highlighted when the case is made that fiscal policy can be tightened without leading to a recession. I fully share this view. However, where a lot of the literature on expansionary fiscal contractions – including Bob’s mini survey of the literature – fails is that the role of monetary policy is not discussed. In fact I would argue that Denmark was a case of an expansionary monetary contraction – a the introduction of new strict pegged exchange rate regime strongly reduced inflation expectations (I might return to that issue in a later post…).
In all the cases I know of where there has been expansionary fiscal contractions monetary policy has been kept accommodative in the since that nominal GDP – which of course is determined by the central bank – is kept “on track”. This was also the case in the Danish and Irish cases where NGDP grew strong through the fiscal consolidation period.
My view is therefore that that fiscal austerity certainly will not have to lead to a recession IF monetary policy ensures a stable growth rate of nominal GDP. This in my view mean that we will have to be a lot more skeptical about austerity for example in Spain or Greece being successful. Spain and Greece do not have their own monetary policy and therefore the countries cannot counteract possible contractionary effects of fiscal austerity with monetary policy. That of course does not mean that these countries should not tighten fiscal policy – in my view there is no other option – but it mean that austerity in these countries are not likely to have the same positive growth effects as in Denmark and Ireland in the 1980s.
Therefore, in my view the future research on expansionary fiscal contractions should focus on the policy mix - what happened to monetary policy during the periods of fiscal consolidation? -instead of just focusing on the fiscal part of the story.
All the cases of expansionary fiscal consolidations I have studied has been accompanied by a period of fairly high and stable NGDP growth and the unsuccessful periods have been accompanied by monetary contractions. My challenge to Bob would therefore be that he should find just one case of a expansionary fiscal contraction where NGDP growth was weak…
PS the discussion above it about the business cycle perspective. Obviously if we take a longer term perspective then supply side factors dominate demand side factors. In these cases I think is it fairly easy to demonstrate that cuts in public spending will increase potential or long-term real GDP growth. I am pretty sure that Bob and I fully agree on this issue – others might not…