When can fiscal consolidation be expansionary? Evidence from a small open economy

Abstract

The paper focuses on the implications of stabilisation policies in a small open economy that were introduced to reverse burgeoning public sector deficit. In particular, I examine the hypothesis that such stabilisation policies can actually have expansionary effects on business investment. While this goes against the standard Keynesian view that the institution of more conservative fiscal and monetary programmes will, at least initially, lead to deflationary outcomes, there are important reasons for believing that such policies will in fact be expansionary. Such predictions are made in a dynamic setting, which weighs the short-term consequences of curtailed government expenditures against their long run implications for future increases in government spending, a reduction in debt burdens and greater stability. With the introduction of expectations, the positive implications of such policies can be immediate. This paper tries to clarify the ‘expectational crowding-in’ process and investigates whether the effects of stabilisation on business investment were due to that process or to other features of the stabilisation programmes. The policy message from my analysis is that budget consolidations producing expansionary effects are more than a theoretical construction. The experience of small open economies mentioned above should be taken into account also in policy making. Empirical findings indicate that EMU countries may need to carry out budgetary consolidations to dispose of room for manoeuvre against first the fiscal constraints in smoothing the business cycle imposed by the Stability Pact, and second, the looming budgetary implications of ageing populations.