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The Stability and Growth Pact: A European Answer to the Political Budget Cycle?

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Comparative European Politics Aims and scope

Abstract

The existing literature on political budget cycles (PBCs) looks at the temptation for incumbent governments to run a greater deficit before an election by considering the characteristics of the incumbent. We propose here to look at the signals the incumbent receives from the voters. For this purpose, we consider the votes from the previous national elections and see whether they may influence the incumbent government to run a sound fiscal policy or an expansionary fiscal policy. Since Europe has been equipped with two fiscal rules under the Stability and Growth Pact: a deficit and debt ceiling, the possibility of PBCs is particularly relevant. Can we find evidence of a ‘political budget cycle’ before 1993, and did the fiscal rules prevent the existence of a ‘political budget cycle’ afterwards? To address these questions, we use a cross-sectional time-series analysis of European countries from 1979 to 2005.

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Notes

  1. The authors would like to thank Todd Allee, Bill Bernhard, and two anonymous referees for their comments and particularly for their suggestions with respect to coding Europe's political parties. The usual caveats apply.

  2. Competence is defined as the ability to transform tax revenues into public goods.

  3. In our model, we just focus on public deficits.

  4. As in Shi and Svensson (2002), we use fiscal balance as a percentage of GDP, government revenue as a percentage of GDP, and government expenditure as a percentage of GDP.

  5. In order to identify whether a random effects vs fixed effects specification was appropriate, a Hausman test was run for the entire data set, and the fixed effects model was more appropriate. This does not come as a surprise since there are likely country effects throughout the panel.

  6. However, even if there is no autocorrelation in the error term in levels, the error term in first differences is correlated with the first differences of the lagged dependent variable (Shi and Svensson, 2002).

  7. By definition this estimator generates a large number of instruments. To test the validity of over-identifying restrictions, a Sargan test or Hansen test can be applied. The key idea is to find instrumental variables that correlate with the explanatory variables, but not with the error term.

  8. See Appendix 1 for further econometric details.

  9. For checking the validity of the Arellano–Bond method, we consider two tests. The first is a Sargan test of over-identification, where the null hypothesis is that the instruments are uncorrelated with the residuals. Due to the numerous lagged party variables, the GMM model is always over-identified. This is less of an issue here since the GMM-in-difference method is used as a complement. The second one, the Arellano–Bond test, is a test of the assumption of no serial correlation (in levels), on which the moment conditions rely. This test is implemented as a test of second-order serial correlation in the difference equation (3), and the null assumption is always rejected, confirming the absence of auto-correlation.

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Appendix

Appendix

Arellano and Bond (1991) note that under the assumption that the error term ɛi, t is not serially correlated, values of def lagged two periods or more are valid instruments for the transformed lagged dependent variables Δdefi, t−1. For the control variables, we assume that wi, t is weakly exogenous; that is, wi, t is uncorrelated with future realizations of the error term. Thus the GMM dynamic first-difference estimator uses the following linear moment conditions:

The election indicator ELEi, t is assumed to be strictly exogenous, and we therefore use ΔELEi, t as its own instrument in Equation (3).

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Donahue, K., Warin, T. The Stability and Growth Pact: A European Answer to the Political Budget Cycle?. Comp Eur Polit 5, 423–440 (2007). https://doi.org/10.1057/palgrave.cep.6110117

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