Prior to the Great Depression of the 1930s, governments accepted large fluctuations in the growth of

output and income as inevitable. Rather than requiring policy actions to stabilize the economy,
fluctuations in economic activity were seen as natural and self-correcting. In his seminal work "The
Means to Prosperity" published in 1933, economist John Maynard Keynes challenged classical
economic thinking by outlining his belief that problems of mass unemployment and idle capital were
not always best left to market forces. Instead, Keynes proposed direct government intervention to
stimulate aggregate demand and thereby restore full employment and economic growth.

After World War II, governments around the world began to use Keynesian economic management
to shape economic cycles. For the first time, deficit spending was considered a valid tool to combat
economic downturns. In the United States, President John F. Kennedy cited demand-side economic
theory to argue for a substantial tax cut that was eventually passed in 1964. Although the cut was
projected to lead to a fiscal deficit, national income indeed rose and an economic boom ensued. His
economic advisers enthusiastically concluded that "economics has come of age in the 1960s."

Enthusiasm for Keynes' economic theory soured, however, with its perceived failure to combat
worldwide recession following the abolishment of the Bretton Woods system of fixed exchange rates
in 1971 and the oil crisis of 1973. Governments sought a new strategy for economic stabilization.
Many settled on "Chicago-school" free-market economist Milton Friedman's prescription to focus on
eliminating inflation through control of the money supply while empowering markets and minimizing
state planning. Monetarists, led by Friedman, firmly rejected fiscal policy based on deficit spending
to counteract recessions because they believed it led to "crowding out" of the private sector.

By 2000, most economists agreed that Keynesianism could not be used to fine tune the economy.
However, in the face of a worldwide slowdown in economic growth, many countries-including the
United States through President George W. Bush's tax cuts in 2001 and 2003-continued to try to use
fiscal policy to orchestrate increased aggregate demand and, thereby, economic recovery.

Fiscal Policy

Toward the common goal of economic stabilization, the monetarist approach stressed monetary
policy whereas the Keynesian approach stressed fiscal policy.

Monetary policy is directed at controlling the money supply, often through the mechanism of
influencing interest rates. In most countries, monetary policy is delegated to a partially or fully
independent central bank that often relies on inflation as an indicator of economic stability. In an
overheated economy with signs of rising inflation, a central bank might choose to dampen economic
activity by decreasing the money supply through the sale of government bonds to the public in open-
market operations. The central bank encourages the sale of bonds by lowering their price, equivalent
to increasing their yield. Increasing interest rates also dampens investment directly by raising the
cost of capital.
Fiscal policy centers on government decisions about taxation and spending. In Keynes' view,
expansionary fiscal policy-increasing government purchases, increasing transfer payments, or
decreasing taxes could be used to increase aggregate demand, thereby stimulating GDP growth in a
recessionary economy. Similarly, contractionary fiscal policy-decreasing government purchases,
decreasing transfer payments, or increasing taxes-could be used to cool down an overheated
economy through decreasing aggregate demand and national income. Some of these adjustments in
government spending occur automatically. For example, government transfer payments such as
unemployment insurance increase automatically during a recession, which helps to stimulate
national income. Likewise, tax collection automatically increases during a boom, which reduces
aggregate demand.

An important component of expansionary fiscal policy is the hypothesis of a multiplier effect, which
predicts that an increase in government spending or an increase in income due to lower taxes will
increase national income and GDP by an even greater amount. This happens because the initial
additional income will lead to successive rounds of additional consumption and income. As a very
simple example, suppose a tax cut leaves someone with $100 in extra income. Suppose everybody
has a marginal propensity to consume (MPC) 40% of each additional dollar they receive on domestic
products. The recipient of the initial $100 will then consume $40 on domestic products, such that
national income is increased by $140 in total. The recipient of the secondary $40 will then consume
40% of that, or $16, on domestic products such that national income is increased by $156 in total.
The effect continues indefinitely. In total, national income increases by $167, equivalent to the initial
$100 times the income multiplier of 1/(1-MPC), or 1/(1-4), which equals 1.67.1 The portion of the
increase in income that is not consumed on domestic products goes to taxes, imports, and savings.
Several studies have pointed to a multiplier of approximately 1.5 for the United States.

While Keynes focused on the demand-side effects of a tax cut, other economists focus on the supply
side. Supply-side economists, whose thinking became popular in the 1980s, argue that cutting tax
rates serves to encourage more work and production, leading to increased tax revenues and a
growing GDP.

Either from a demand- or supply-side perspective, fiscal policy suffers from a number of
disadvantages, Economists point out that it lacks flexibility and is subject to political manipulation.
They also point out that the long time lag between proposal of a tax cut or an additional government
spending program and implementation means that policies may be implemented counter-cyclically.

While Keynes focused on the demand-side effects of a tax cut, other economists focus on the supply
side. Supply-side economists, whose thinking became popular in the 1980s, argue that cutting tax
rates serves to encourage more work and production, leading to increased tax revenues and a
growing GDP.

Either from a demand- or supply-side perspective, fiscal policy suffers from a number of
disadvantages, Economists point out that it lacks flexibility and is subject to political manipulation.
They also point out that the long time lag between proposal of a tax cut or an additional government
spending program and implementation means that policies may be implemented counter-cyclically.

While monetarists argue that expansionary fiscal policy crowds out private investment, classical
economists believe that government intervention is unnecessary since prices and wages adjust
quickly and automatically to restore general equilibrium in the economy, Other models of the
economy assume that intelligent consumers recognize that any government spending increase or tax
cut will be followed in the future by reduced spending or tax increases, so adjust their spending
accordingly. Therefore, any attempt at expansionary or contractionary fiscal policy results in no
change in national income.

The Case of Expansionary Fiscal Contraction in Ireland in the 1980s

While conventional economic theory suggests that fiscal contractions-higher taxes, reduced
government spending, and lower public deficits will lead to slower economic growth, in several
cases, fiscal contraction may have actually boosted growth. For example, the Keynesian model of
economic management appeared to be reversed in the case of Ireland in the 1980s. The key
mechanism which reverses the view expressed by traditional Keynesian logic is the longer-term
sustainability of the public finances. When this is in question, fiscal stimulus is likely to undermine
private confidence and create expectations of higher future taxes, thereby reducing current
consumption as expected lifetime income declines.

Expansionary Fiscal Contraction

Ireland experienced significant growth from 1987 to 1990 (see Exhibit 1). An "expansionary fiscal
contraction" (EFC) has been suggested by several economists as the underlying cause of this
performance.

In the standard Keynesian analysis, increases in government expenditure are passed on through a
fiscal multiplier to increases in aggregate demand. The opposite also holds true: A decrease in
government expenditure should lead to a decrease in aggregate demand and to fiscal contraction.
However, this may not be true for countries that have very large budgetary deficits in addition to high
debt ratios. In this case, fiscal contraction may actually lead to increased economic activity. This is
because the role of "expectations" needs to be taken into account.

Suppose a government with a high debt ratio and budget deficit makes a firm and credible
commitment to reduce its budget deficit extensively. If financial market players perceive this policy to
be credible and to signal a commitment to price stability and financial integrity, the risk premium on
long-term interest rates will decline. This decrease in long-term interest rates will have expansionary
effects on both demand and supply as consumption and investment are stimulated. A wealth effect is
created as a result of the lower cost of capital and lower debt servicing of households, firms, and the
public sector.
Furthermore, higher taxes associated with tackling the current budget deficit lead to an expectation
that future tax liabilities will be lower than the private sector had previously assumed. This increase
in expected future wealth can further stimulate consumer spending. Investment can rise due to the
expectation of a more vibrant private sector in the future and by an anticipation of lower interest
rates. Business will respond positively to the increased stimulus on domestic demand. In this
example, EFC implies more than 100% crowding out. In other words, private sector spending due to
the more optimistic assessment of the future is actually greater than the contraction in government
spending. This results in an increase in aggregate demand, employment, and output.

It is important that governments exploit these market sentiments correctly. The credibility of a fiscal
adjustment would be enhanced by up front action to achieve the medium-term desired fiscal results.
Furthermore, fiscal contraction through a decrease in spending seems to be more effective than
through an increase in taxation, which raises an economy's cost structure and can worsen its
competitiveness.

Ireland's experience in the late 1980s

In the mid-1980s, Ireland was plagued by persistent inflation, high costs of depressed industry. and
long-term unemployment. A decade of severe budget deficits, financed largely by borrowing from
abroad (see Exhibit 2), combined with a lack of concrete proposals for future surpluses raised doubts
about the ability of any fiscal plan to address the country's deepening recession successfully.

A new government elected in 1987 aimed to turn Ireland's economic situation around (see Exhibit 3).
The Fianna Fail party succeeded in ousting a fractious coalition led by the Fine Gael party from
power, following the Irish pound's devaluation in August 1986 against the German Deutsch Mark in
the European Exchange Rate Mechanism. Ireland had been forced to devalue in order to restore
competitiveness against its major trading partner, the United Kingdom, whose pound had
depreciated markedly in the first half of 1986 (see Exhibit 4).

Because it did not obtain an absolute majority in the election, Fianna Fail was forced to rely on the
support of independents. The new government's first task was producing the 1987 budget. The tone
of the budget was harsh as it attempted to tackle Ireland's public spending and borrowing problems.
Much of the plan was based on the earlier failed proposals of the Fine Gael government. Fine Gael's
conciliatory endorsement of the Fianna Fail party's new budget allowed it to proceed.

The three fundamental principles of the budget were.

 Public finance targets had to be consistent with good management of the economy.
  Borrowing and the servicing of national debt were to be significantly reduced.
 Particular focus was to be placed on productive economic activity and employment growth.

Ultimately, the budget was driven by the first two of these principles. The 1987 Exchequer (finance
ministry) borrowing requirement was targeted at 1.85 billion Irish pounds (IEP), or 10.7% of GNP. This
was a significant reduction from the 1986 borrowing requirement target of IEP 2.15 billion, or 13% of
GNP. The current budget deficit target was reduced from 8.5% of GNP to 6.9% of GNP, representing
IEP 1.2 billion.

The actual outcome was better than targeted. The current budget deficit came in IEP 20 million
below target due to increased savings on expenditure. The borrowing requirement came in IEP 72
million below target due to lower than expected spending. This trend was continued in the following
two years with the borrowing requirement decreasing to 2% of GNP by 1989. The current budget
deficit achieved similar positive results over the same period (see Exhibit 2).

Wage growth was another key issue the government planned to tackle (see Exhibits 5 and 6). The
Programme for National Recovery initiated in 1988 indexed social welfare and public sector pay to
inflation. In the manufacturing sector, increases in weekly earnings fell from 4.9% in 1987 to 4.3% in
1988. Even more importantly, wages in Ireland's main trading partners were rising much more
steeply. Moderate wage growth combined with Ireland's favorable exchange rate was estimated to
have translated into a cost competitiveness gain of 3% against the United Kingdom.

Monetary policy targeted preserving the strength of the Irish pound as well as maintaining its
stability. Following the stringent 1987 budget, markets began to trust that the Fianna Fail
govemment did not intend to release an expansionary inflationary episode in the future. This
expectation led to increased confidence and a 5 percentage point drop in interest rates between
March and December 1957. Consumer price inflation dropped to 3.2%, the lowest rate since the
1960s. In 1988, even in the face of a less favorable international climate, interest rates dropped
another percentage point. By the second half of 1985, Irish retail rates, a full 6 percentage points
lower than in the United Kingdom, were at their lowest level for over a decade. In 1989, the
weakness of the UK pound and net capital outflows from portfolio adjustments linked to a relaxation
of exchange controls led to a slight increase in interest rates. However, by the end of 1989, the prime
commercial rate was still 4 percentage points lower than in the United Kingdom (see Exhibit 7).
Inflation on various measures remained low into 1990 (see Exhibit 8)

Economic effects

The policies followed by the government in the late 1980s had several noticeable effects on the Irish
economy. Through a combination of price competitiveness and increased confidence, there was
strong impetus for growth. In 1987, growth was focused outward. Both industrial production and
export earnings enjoyed double-digit expansion From 1988 onwards, growth was linked more closely
to domestic demand.
Liquidity in the domestic banking system improved greatly as a result of a significant increase in
official external reserves during 1987 and 1988 (see Exhibit 9). Private-sector credit growth increased
from 4.7% in 1987 to 13.5% in 1988.

The stabilization and accompanying sharp fall in real interest rates subjected households to two
policy shocks:

1) Income effect-a cut in current disposable income due to fiscal contraction

2) Wealth effect-due to the unanticipated fall in nominal and real interest rates

Nonetheless, private consumption increased by more than 3% in 1988 as households decreased their
savings ratio. Similarly, investment began to pick up during the second half of 1988 and grew 10% in
1989. Growth was fuelled in particular by a boom in the property sector, with planning permission
for development projects increasing by 20% in 1989. In contrast, public consumption dropped
cumulatively by 10% between 1986 and 1989 (see Exhibit 10). The drop in public consumption and
investment was more than compensated for by domestic demand and investment that increased the
need for private sector employment (see Exhibit 11). In other words, the traditional Keynesian effects
were more than offset by a combination of two factors: (a) the impact of other policies (eg.
devaluation); and (b) non-conventional effects of fiscal policy (e.g. improved confidence and lower
expected future taxes).

This optimistic economic climate not only had a positive effect on GDP, but also facilitated the
government's success in hitting its aggressive national debt and public finance targets: From the cost
side, debt servicing was reduced due to the decrease in the interest rate. Similarly, social welfare
payments were reduced as the private sector demanded more labor to deal with higher domestic
demand and investment. From the revenue side, indirect taxes also benefited from the stronger
economy. For example, VAT (value-added tax) was boosted by a widening of the tax base and growth
in high-priced items. Tax revenues increased by 8% in 1988 over the previous year, spurred by a 9%
increase in the value of consumer spending over the same period, as well as by a 25% increase in
new car sales. Therefore, the fiscal consolidation started by the initial spending cuts were quickly
augmented by higher tax revenue.