ABSTRACT
We examine how exchange rate regimes affect fiscal discipline by investigating European countries as they transitioned from flexible to fully fixed exchange rates under the Euro. We apply the synthetic control method to estimate, for each Eurozone country, its counterfactual budget stance under flexible rates. Our evidence strongly suggests that fixing exchange rates negatively impacted negatively fiscal discipline. However, effects were not homogeneous, as they were mediated by political factors. For example, countries where policymakers faced a longer political horizon and operated within a more cohesive political environment, managed to perform better in terms of fiscal discipline.
Acknowledgements
We are grateful to Vitor Gaspar, Sanjeev Gupta and Ben Clements for useful comments and suggestions. Participants of the FAD Seminar Series also contributed with valuable discussions. We thank Jaime Marques Pereira and Michela Schena for excellent research assistance. The opinions expressed herein are those of the authors and do not necessarily reflect those of the authors’ employers.
Disclosure statement
No potential conflict of interest was reported by the authors.
Notes
1 See Bordo (Citation2003) for a review on exchange rate regime adoption.
2 See Tornell and Velasco (Citation1995; Citation1998) and Sun (Citation2003).
3 In 1999, 11 EU member states (Euro 11) joined the final stage of monetary union and fixed their bilateral exchange rates. The Euro was introduced then as a virtual currency, while national currencies remained in circulation for 3 more years. In 2002, the Euro substituted national currencies in circulation. Euro-11 countries are Austria, Belgium, Finland, France, Germany, Luxembourg, Ireland, Italy, Netherlands, Portugal, and Spain.
4 The source for all variables considered is the Database on Political Institutions (Cruz, Keefer and Scartascini, Citation2016).
5 Some comparator countries may be assigned a negative weight when creating the synthetic comparator.
6 Our results are robust to alternative measures of the budget balance.