Fiscal policy in Europe: The importance of making it predictable

- The paper provides novel evidence on the effectiveness of fiscal policy in Europe.
- Based on two-country VAR models, it identifies surprise and foresight shocks.
- A surprise stimulus triggers expectations of deficit reversals in all samples.
- Expected reversals crowd out private expenditure and depress activity in France and Italy.
- An anticipated stimulus, instead, boosts economic activity at home and abroad.
- This evidence has important consequences for discretionary policy.

This paper provides evidence in support of the hypothesis that fiscal policy is largely anticipated and its effects depend on the extent to which policy is able to affect expectations. Based on a set of 2-country Bayesian VAR models between major European economies, we find that a surprise stimulus triggers expectations of deficit reversals that may crowd out private expenditure. An anticipated stimulus, on the contrary, is found to boost domestic activity in all samples. Moreover, it has positive cross-border effects in 50 percent of the cases. Overall, our findings suggest that fiscal policy is effective when it is not “crowded out” by expectations of reversals. We document such crowding out effects in Italy and France. Finally, we argue that predictability has important consequences for the design of discretionary policy.