There are some commentators who advocate a large reduction in the deficit and who argue that this reduction will actually lead to an immediate expansion in the economy. This “Expansionary Fiscal Contraction” view has been advocated by German officials recently. It is obviously at odds with the orthodox view described above. The way the the EFC is supposed to work is via private sectors expectations. The idea is that in a time of crisis with large deficits etc, the private sector cuts expenditure because people are scared and are hoarding their resources. If you take extreme measures to solve the budgetary problem, then the private will relax and start spending again.
There is obviously something to this — if your crisis is severe enough. On the other hand its sounds far too good to be true. It’s like having you economic cake and eating it. Is there any evidence that EFC occurs? Ironically, the budgetary crisis in Ireland in the 1980s is often cited as an example of an EFC. For those too young to remember, the story goes like this: In the 1980s the Irish economy went from bad to worse. Unemployment was huge, wages low, emigration unprecedented, huge deficits and explosive national debt. In 1987 the new government, cut expenditure dramatically. From that year the economy began to grow and Celtic tiger was born. On a superficial level this provides support for the EFC hypothesis. However a closer look shows that it was largely a coincidence. The Irish economy grew rapidly after 1987 because of a huge boom in exports that were, in turn, caused by a falling labour costs and a depreciating exchange rate.
More formal research has suggested that EFC effects can occur, but the evidence for them is weak. I certainly don’t advocated testing to see if we can get one now by engaging in huge cuts in the deficit.
