Fiscal imbalances and output crises in Europe: will the fiscal compact help or hinder?

Abstract

The eurozone crisis has involved sharp output declines and has generated much discussion about the appropriate design of macroeconomic policy both in terms of dealing with the contemporary situation and minimising the risks of future crises. Much of the debate surrounding the crisis has focused on fiscal policy. All but two member states of the European Union have signed a draft treaty, the ‘fiscal compact’, that seeks to eliminate structural fiscal deficits. This paper examines the relationship between fiscal balances and output shortfalls amongst the eurozone countries allowing for other factors. In the light of the findings it critically assesses the fiscal compact.

Keywords:

• fiscal policy
• economic crises
• eurozone

Acknowledgements

The authors would like to thank the anonymous referees for extensive and valuable comments.

Notes

1. All data used in the analysis, with the exception of the banking crises variable, are from Eurostat.

2. Our sample consists of the 27 European Union members, as of 2011.

3. The private balance is the difference between private saving and investment. The former is calculated as national saving minus the government balance (including interest), whereas the former is captured by gross capital formation.

4. The reason why we do not employ a panel estimator is that likelihood-ratio tests, which we run for the baseline as well as for additional model specifications, cannot reject the hypothesis that panel-level variances are insignificant. It follows that the use of panel-level effects is unnecessary.

5. Lagging the variables does not necessarily alleviate potential endogeneity issues. It does, however, allow us to examine the sequence of events and compare the results to those from a contemporaneous estimation.

6. Data are from Reinhart and Rogoff (2008).

7. All results are available from the authors upon request.

8. Note that whereas in Table 2 the binary dependent variable captures a substantial shortfall in real output, in Table 3 the continuous dependent variable measures deviations from trend output (the business cycle), which can be positive or negative. Hence, we expect the signs of the estimates to be the opposite. For example, an increase in the value of the budget balance is expected to be positively correlated to an improvement in the business cycle – irrespective of the direction of causality.