This research project reviews the economic literature which has investigated empirically the conditions under which a fiscal contraction, of the kind currently in process in the UK, may be expansionary. Five factors are identified as being likely to be of significance: the size of the consolidation; the composition of the consolidation between spending cuts and tax increases; the initial level of public debt; whether interest rates are at a lower bound; and whether there is a devaluation of the exchange rate. Of these, there is more empirical support for the importance of the first two. Both of these factors are positive for the UK. Of the others, only the low interest rates points in the opposite direction. However, this optimistic position should be treated with caution for two reasons. First, there are number of weaknesses in the empirical literature. Second, the favourable probability of the consolidation being expansionary is only relative to other consolidations. Despite the relatively good position of the UK, there must still be considerable doubt as to the eventual outcome.
Katarzyna Bilicka, Michael Devereux and Clemens Fuest