Spain, Japan, and the Dangers of Early Fiscal Tightening

Javier Díaz-Giménez and R. AntonBraun

No 2010-14, Working Papers from FEDEA

Abstract: Spain's current recession was preceded by an extended period of rapid growth in real estate and equity prices. The recent sudden and sharp decline in these asset prices has been followed by a deep economic contraction. Is this recession a large but transient phenomenon? Or is it perhaps instead the harbinger of a protracted period of depressed asset prices and economic stagnation? Japan experienced a similar pattern of growth in land and equity prices in the late 1980s. The collapse of the Japanese bubble economy was followed by a protracted period of declines in asset prices and depressed economic activity. We compare Japan's experience in the 1980s and 1990s with current developments in Spain. One message that emerges from this narrative is that a fiscal tightening in Japan in 1997 may have been premature. We develop a prototypical New Keynesian model, calibrate it to replicate the Japan's experience in the 1980s and 1990s, and use it to evaluate the risks of tightening fiscal policy too early when the nominal interest rate is low. We find that a premature fiscal tightening can have large and negative effects on the real economy.

Date: 2010-03
New Economics Papers: this item is included in nep-cba and nep-mic
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