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Adhere to the rules or be discretionary? Empirical evidence from the euro area

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Abstract

This paper constructs a framework for modelling the interaction between monetary and fiscal policies before and after the formation of the euro area with a view to determining how and why member states’ fiscal policies become more discretionary after the adoption of the euro. Two hypotheses are theoretically derived and empirically tested, developing results with predictions in a robust manner based on various checks. The paper concludes that prior to joining the euro area, the fiscal policies of the member states only respond to demand shocks. However, after joining the euro area, states follow a more discretionary approach that suits both demand and supply shocks, whether domestically or abroad and regardless of the strict rules of the Stability and Growth Pact and other treaties, particularly in response to adverse shocks. This change in fiscal policies in response to economic shocks originates from the asymmetric policy structure: a common monetary policy outlined by the European Central Bank in the euro area, which contrasts with the fiscal policies determined individually by national governments. Although the European Union has been consolidating its governance structure since the recent global financial crisis and the ensuing European sovereign-debt crisis, substantial efforts continue to be required to transform the euro area into a thorough and genuine economic and monetary union.

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Notes

  1. Although member states could implement individual monetary policies prior to joining the euro area, they are not independent in their monetary policies as a result of the spillover effects from other countries’ policy decisions. For example, as Eichengreen (2008) points out, other countries had to adapt to the monetary policy decisions of Germany in Europe as a result of the leading role of the Deutsche Mark.

  2. It should be mentioned here that experience has shown that countries can “get away with” violating the SGP (at least in the past), as the experiences of big countries such as Germany and France in the early 2000s showed (De Haan et al. 2004).

  3. The EU has been collecting data on discretionary current expenditure since 2010, providing insufficient observations to study fiscal policy changes. Therefore, to capture the discretionary orientation of fiscal policy, this paper uses the ratio of the cyclical component of expenditure of the general government to the potential GDP (GEXP) as the dependent variable.

  4. Reed (2015) argues that the common practice of using lagged variables—a widespread practice in the economics and finance literature that even appears in leading journals, including but not limited to the American Economic Review and the Journal of Finance—does not solve the problem of simultaneity bias. An alternative solution is to use lagged values of the endogenous variable as instruments for estimation. Reed warns that “this is only an effective estimation strategy if the lagged values do not themselves belong in the respective estimating equation, and if they are sufficiently correlated with the simultaneously-determined explanatory variable”. However, Bellemare et al. (2017) emphasise that “this argument does not imply that lagged explanatory variables are always and everywhere inappropriate”, and “there are several kinds of data generating processes (DGPs) in which lagged explanatory variables are appropriate in the context of no unobserved confounding, in which case one of the following DGPs must be assumed”:

    (a) There is no reverse causality, and the causal effect operates with a one-period lag only.

    (b) There is reverse causality, but reverse causality is contemporaneous only, and the causal effect of X on Y operates with a one-period lag only.

    (c) There is reverse causality, and the causal effect of X on Y is contemporaneous; there are no dynamics in Y, but there are dynamics in X.

    Bellemare et al. (2017) observe that “Scenarios (a), (b), and (c) are valid justification for lagging explanatory variables”. In specification (11), the dependent variable—GEXP, the ratio of the cyclical component of expenditure of the general government to the potential GDP of the member states—primarily responds to economic shocks, as economic theory and policy practice suggest. It is also constrained by the debt level and the annual budgetary balance. Therefore, there is supposed to be no unobserved confounding in (11). Further, the core variables—SS, DS, SSF, and DSF—are obtained as, or calculated from, structural residues of PVAR models. Therefore, the reverse causality of GEXP on economic shocks is very weak. Even if there is a degree of reverse causality, specification (11) still satisfies scenario (b). Therefore, specification (11) operating with a one-period lag only is appropriate for estimation.

  5. Germany, France, Italy, Spain, Portugal, Finland, Holland, Austria, Belgium, Cyprus, Greece, Estonia, Ireland, Luxemburg, Malta, Slovenia and Slovakia. Since Latvia and Lithuania joined the euro area after 2014, we excluded these two countries from our study.

  6. The Stata command of the GLS regression for panel data with correlated disturbances is “XTGLS”.

  7. Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxemburg, Holland, Portugal, and Spain.

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Acknowledgements

We thank the two referees for their very helpful and constructive comments.

Funding

This work was funded by the National Social Science Fund of China (Grant Number 16BJL087).

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Authors and Affiliations

  1. School of Business, Qingdao University of Technology, 2 Changjiang Middle Road, Qingdao Economic and Technological Development Zone, Qingdao, 266520, Shandong, The People’s Republic of China

    Zongsen Zou, Xiuling Wang & Dengtian Feng

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  1. Zongsen Zou
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  2. Xiuling Wang
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Correspondence to Zongsen Zou.

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Zou, Z., Wang, X. & Feng, D. Adhere to the rules or be discretionary? Empirical evidence from the euro area. J Econ Interact Coord 15, 501–525 (2020). https://doi.org/10.1007/s11403-019-00239-4

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