According to the traditional Keynesian approach to fiscal policy, reviewed in the last chapter, expansionary fiscal policy will tend to raise GDP when there are unemployed resources. At worst it will have no effect at all. Under certain circumstances the effect can be large. Under no circumstances whatsoever can the effect be negative. Although this may have been a fairly conventional view at the outset of the GFC, it was also thought that, for stabilization purposes, fiscal policy was not a very good tool. Even if expansionary fiscal policy did have favourable effects on output and employment, it was inferior to monetary policy for stabilization purposes, and it was better for fiscal policy to be conducted so as to create a fairly stable and predictable framework within which economic agents could make their decisions. (It might be thought desirable for this reason for there to be no unexpected changes in government spending or tax rates.) After the GFC, views of fiscal policy changed. In part, this was because if the interest rate is at its lower bound, it is not possible to use conventional monetary policy for stabilization purposes in an expansionary direction. Also there has been some work, both empirical and that based on simulation of DSGE models, which suggests that fiscal policy is more powerful in the conventional direction than previously thought, especially in times of underutilized resources.

It came as a considerable surprise to many economists when claims were made that fiscal consolidation could be expansionary.

Giavazzi and Pagano (1990) were the first economists to argue seriously that severe fiscal contraction might be expansionary. Their paper consisted of a detailed discussion of the experiences of Denmark and Ireland in the 1980s. In Denmark, a severe fiscal retrenchment started in late 1982/early 1983; this resulted in a reduction in the primary budget deficit of 15.4 per cent of GDP. The result was not a recession but real GDP growth at an annual rate of 3.6 per cent between 1983 and 1986, with rapid growth of private consumption and a boom in investment. In Ireland, starting in early 1987, the newly elected government of Charles Haughey reduced the full employment primary deficit by 7 per cent of GDP within two years.