The 'German View', Fiscal Consolidation and Consumption Booms: Empirical Evidence from Denmark

We develop an alternative test of the 'German View' that fiscal contractions may lead to immediate consumption booms derived from a form of an open-economy permanent income model where we add uncertainty over whether shocks are permanent or transitory. Using a time-series statistical methodology, we distinguish between three shifts to "permanent" income - those arising from permanent shifts in government expenditure, terms-of-trade and "other" factors including cost and productivity shocks. We are also able to identify a composite transitory disturbance on consumption, which incorporates short-run aggregate demand considerations and business cycle effects. In our empirical study we find, in accordance with the 'German View', that an anticipated permanent reduction of government expenditure is associated with a strong short-run (and permanent) increase in private consumption. However, the Danish experience following the fiscal contraction in 1982 suggest that this was not a dominant factor behind the consumption boom. Our evidence shows instead that other factors increasing permanent income, including a substantial terms-of-trade improvement, were much more important.