Abstract
This paper analyses the characteristics of episodes of fiscal consolidation in the EU exhibiting non-Keynesian features, i.e., followed by an improved growth performance. Roughly half of the episodes of fiscal consolidations that have been undertaken in the EU in the last 30 years have been followed by higher growth. Probit regressions indicate that the consolidations that turned out to be expansionary were more likely started in periods with output below potential and based on expenditure cuts rather than on tax increases. These results appear quite robust with respect to the criteria used to identify the consolidation episodes and to classify such episodes as expansionary.
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Notes
In Blanchard (1990) this is due to the fact that agents’ have short-term horizons associated with the “perpetual youth” assumptions, i.e., each agent faces a constant positive probability of death. Hence, Ricardian equivalence does not hold in this model even in absence of tax distortions.
The credibility of the fiscal adjustment, and therefore the likelihood of the emergence of non-Keynesian effects, can also be increased by the introduction of fiscal rules for the maintenance of budgetary discipline (Cotis et al. (1998)).
Fiscal consolidations exhibiting expansionary effects also appears to be more frequent among consolidations classified as “successful,” i.e, that reduce persistently the debt/GDP ratio (McDermott and Wescott (1996)).
Two issue are particularly relevant. First, relying on deficit-based measures tends to exclude fiscal reforms with a limited impact on current budget balances but potentially large effects on long-term public finances and on permanent income, such as pension reforms. Second, cyclically-adjusted primary balances are not always providing the full information about the effective fiscal position, as such variable does not capture the effect of one-off policy measures (e.g., tax amnesties, sales of real assets,....) or temporary changes in budget balances unrelated with the economic cycle (e.g., revenues on property income).
In Von Hagen et al. (2001) there is an attempt to take into account the links between fiscal and monetary policies by estimating, together with output equations, fiscal and monetary policy reaction functions. In Giudice et al. (2004), in order to control for the impact of monetary policy or other macroeconomic policies, the analysis of possibile non-Keynesian effects of fiscal consolidations is carried out via simulations with the QUEST macro model of the European Commission.
The output expansion following fiscal consolidations may be due to independent cyclical developments rather than to the factors outlined in the previous section, especially when fiscal consolidations are undertaken in weak phases of the cycle, as they are naturally followed by a recovery. Moreover, the relation between fiscal consolidations and short run growth may go the other way round: the expectation of a recovery (stronger during the trough of the cycle) may increase the likelihood of public finance consolidation. Some studies (Giavazzi and Pagano (1996), Giavazzi et al. (2000)) account for possible simultaneity problems by using two SLS estimation techniques.
Luxembourg, as well as the ten Member States which joined the EU in 2004 are excluded due to missing data. The set includes therefore 14 EU countries with observations for 33 years. The last years of the sample are dropped when identifying expansionary consolidations since it is not possible to evaluate countries growth performances after those years.
The use of trend output growth should help to isolate those expansionary episodes where the acceleration in growth is not purely cyclical. The criterion based on the difference between the growth rate in countries’ GDP and the EU average GDP aims to identify those expansionary episodes where the growth acceleration is not attributable to the EU-wide economic cycle.
The correlation index between ‘size’ and ‘persistence’ consolidation indicators (taking the value 1 for country/year combinations in which consolidations occur and zero otherwise.) is positive but quite low (0.33).
Correlation indexes among expansionary consolidation indicators based on different definitions of expansion help to understand the extent to which alternative criteria tend to yield overlapping results. The correlation coefficient between the benchmark criterion based on the acceleration of real GDP growth and the trend growth criterion is 0.63, while the correlation with the measure based on actual minus EU growth is 0.76. The trend growth criterion has a relatively low correlation with the criterion based on actual minus EU growth (0.51).
With ‘pure’ expansionary fiscal consolidations we indicate those consolidations where short run real interest rates do not fall. Under likely assumptions, non-decreasing real interest rates tend to exclude both monetary expansions under floating exchange rates and devaluation policies under fixed exchange rates regimes. This is the case for instance in a Mundell–Fleming open economy setting with uncovered interest rate parity.
The ECU was the European Currency Unit, representing a basket of EU currencies until it has been replaced by the euro in 1999. The exchange rate developments of national currencies with respect to the ECU are used given the very high weight of trade with the rest of the EU for the countries under consideration.
Anecdotal evidence suggests that a number of fiscal consolidations experiences that turned out to be expansionary were preceded (rather than accompanied) by a depreciation of the currency associated with unilateral devaluations or ERM realignments. This was for instance clearly the case for the Danish consolidation started in 1983 and the consolidation of Italy in 1993.
The size variable refers to an average change in the cyclically-adjusted primary balance over a 3-year period to dispose of a variable that captures also those cases of strong fiscal adjustment that are spread over several years.
The output gap variable is aimed at representing the cyclical conditions immediately preceding the consolidation. It is therefore constructed as the simple average of the output gap at year t and t − 1. The exchange rate variable is instead aimed at capturing developments both immediately preceding and following the consolidation, so it is built as the average (percentage) change between t+1 and t − 1 (according the our definitions of expansionary consolidations, exchange rate appreciations/depreciations could relate to the expansionary status of consolidations when taking place both before and after the fiscal adjustment). A similar reasoning applies to the interest rate variable, which is constructed as the average change in real short-term interest rates between t+1 and t − 1. Real interest rate are chosen (as opposed to nominal) to dispose of a variable which is more closely related to output.
The sample size is kept the same in the two specifications to permit comparison of the results.
The finding that the output gap is not significant in explaining expansionary consolidations defined in terms of the difference between domestic and EU growth does not help in the interpretation of the coefficient of the output gap variable. On the one hand, the lack of significance may be due to the fact that expansionary consolidations in this case are defined in a way that reduces the likelihood of a spurious relation with the output gap (what matters is not the acceleration in growth per se but an acceleration with respect to EU growth). On the other hand, the output gap coefficient could be non-significant due to correlation of the cycle across EU countries: if cyclical developments are common to the rest of the EU, a low initial value of the output gap in one country may not be associated with a subsequent acceleration of growth with respect to other EU countries.
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Acknowledgments
The authors thank Servaas Deroose, Elena Flores, Roberto Perotti and Werner Röger, for helpful discussions and useful comments on previous versions of the paper. The usual disclaimer applies. The views expressed here are those of the authors and should not be attributed to the European Commission.
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Giudice, G., Turrini, A. & in’t Veld, J. Non-Keynesian Fiscal Adjustments? A Close Look at Expansionary Fiscal Consolidations in the EU. Open Econ Rev 18, 613–630 (2007). https://doi.org/10.1007/s11079-007-9026-8
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DOI: https://doi.org/10.1007/s11079-007-9026-8