Estimating the effects of coordinated fiscal actions in the euro area
Highlights
► We estimate spillover effects of fiscal shocks in the euro area using GVAR techniques. ► We compute an area-wide shock as a weighted average of the shocks across all members. ► An area-wide fiscal shock is more effective than a similar size domestic shock. ► Our finding indicates the importance of coordinated fiscal actions in the euro area.
Introduction
In a speech in June 2011, Jean–Claude Trichet, the former president of the ECB, has provoked envisaging a ministry of finance at the euro area level to exert inter alia “direct surveillance of both fiscal and competitiveness policies”. In a similar vein, the IMF has emphasised the need for a “collective” fiscal response to the global economic crisis stormed in late 2008 through 2009.1 In addition to the discussion in the policy arena, economic theory posits that in a highly integrated world, domestic fiscal actions can affect foreign economies. Domestic effects of a fiscal shift and the associated cross-border externalities are particularly pronounced in the context of a currency union where the exchange rate between member countries is fixed.
In this study, we estimate the effects of coordinated fiscal stimuli in the euro area. Specifically, we build upon the multi-country global vector autoregression (GVAR) approach developed by Pesaran et al. (2004) and Pesaran and Smith (2006) as follows:
- •
Estimate an augmented country-specific VAR model for every economy in the euro 12 area. Country-specific VAR models are augmented with foreign variables.
- •
Estimate the spillover effects of a domestic budget balance shock on the members of the euro area by consistently combining all country-specific VAR models in one multi-country model and treating all variables as endogenous.
- •
Compare domestic effects with spillover effects of the area-wide fiscal shock. Following Dees et al. (2007), the area-wide fiscal shock is expressed as a weighted average of the budget deficit shocks across the euro area countries, allowing for inter-linkages between these economies.
In essence, in terms of magnitude, the area-wide shock is not larger than the domestic shock. One may think of the euro-wide shock as a shock that has the magnitude of a domestic shock, but to which each country contributes only a fraction depending on the size of the country. According to our results, the impacts on output of most members following the area-wide shock are larger than those resulting from a domestic shock. Noting that the cost of participating in the area-wide shock is lower than the cost of a similar size domestic shock, our findings indicate the importance of coordinated fiscal stimuli.
Perotti, 2007, Perotti, 2005 reappraises in detail arguments against the empirical results from VAR estimates of the effects of fiscal shocks. There is an ongoing debate on the identification of a structural fiscal shock that captures only discretionary fiscal actions.2 However, in the context of cross-border externalities, fiscal spillovers resulting from a (large) budget deficit in one country would occur whether the cause is only discretion or a combination of discretion, automatic responses, and other effects. Therefore, we primarily rely on identifying generalised impulse response functions. These impulse responses, although broadly interpretable, are informative and capture overall spillover effects.
This study proceeds as follows. Section 2 provides a brief theoretical background of fiscal spillover effects. Section 3 presents our empirical methodology of modelling fiscal policy externalities in the GVAR framework and interprets the fiscal shocks. Section 4 describes the data and our empirical specifications. Section 5 displays our main findings and the robustness analysis based on various identification strategies and specifications. Finally, Section 6 concludes.
Section snippets
Theoretical background
There are three main spillover channels of an expansionary fiscal policy in one member country into the rest of the currency union, as can be demonstrated in a multi-country Mundell–Fleming model with a fixed exchange rate peg between members and perfect capital mobility. (1) Positive spillover effects through trade: a fiscal expansion stimulates domestic activities, pressuring the exchange rate to appreciate and the domestic interest rate to increase. In a currency union, however, the exchange
The GVAR approach
The GVAR provides an unprecedented coherent approach to estimate spillover effects of a domestic fiscal shock on foreign variables by treating all domestic and foreign variables as endogenous. Strictly, while the terminology “global” VAR is due to the fact that Pesaran et al. (2004) include 25 countries from the world economy, our GVAR is indeed a “euro area” VAR that models interdependences across the euro area members.5
Data and empirical specification
Our benchmark specification is a VAR(1) model with a seven-dimensional , where x is real output per capita, bb is the ratio of primary budget balance to GDP or the ratio of cyclically adjusted government primary balance to potential GDP or real government investment spending per capita, c is real consumption per capita, r is the real interest rate, reer is the real effective exchange rate (an increase in reer indicates an appreciation), nx is the
Benchmark results
We study the effects of three distinct shocks. First, we compute the impulse response functions of output of a member country in the euro area to a domestic fiscal shock. Second, we compute the impulse response functions of overall, domestic and spillover, effects of an area-wide fiscal shock. Third, for the area-wide fiscal shock, we disentangle the spillover effects from the domestic effect on output. For this purpose, we exclude one member country, and derive pure spillover effects of an
Conclusion
This study contributes to the literature on the effects of fiscal shocks on the economy by (1) estimating the domestic and spillover effects of a domestic fiscal shock on outputs of the euro area members and (2) estimating the effects of a euro area-wide fiscal shock by applying a multi-country VAR framework, the GVAR, to the analysis of fiscal policy.
Our focus has been on the area-wide (global) dynamics. According to our results, an area-wide fiscal shock has higher impacts on output than a
Acknowledgments
We thank Alberto Alesina, Alan Auerbach, Alfons Weichenrieder, seminar participants at the Deutsche Bundesbank in Frankfurt, the annual congress of the International Institute of Public Finance in Uppsala, conference on post-crisis fiscal consolidation in Freiburg, and two anonymous referees for helpful comments and suggestions. The usual disclaimer applies. A previous version of the paper has been circulated under the title “budget deficit spillover effects in the euro area”.
References (41)
Fiscal and monetary rules for a currency union
Journal of International Economics
(2009)- et al.
Optimal monetary and fiscal policy in a currency union
Journal of International Economics
(2008) - et al.
The effects of fiscal policy in Italyestimates from a VAR model
European Journal of Political Economy
(2007) - et al.
Generalised impulse response analysis in linear multivariate models
Economics Letters
(1998) - et al.
Beggar thy neighbour? The transmission of fiscal shocks from the US to Canada
Open Economies Review
(2009) - et al.
Measuring output responses to fiscal policy
American Economic JournalEconomic Policy
(2012) - Ball, L., Leigh, D., Loungani, P., 2011. Painful Medicine. Finance and Development, September, 2011, IMF, Washington,...
- Bayoumi, T., Eichengreen, B., 1992. Shocking Aspects of European Monetary Union. NBER Working Paper No....
- et al.
An empirical characterization of the dynamic effects of changes in government spending and taxes on output
Quarterly Journal of Economics
(2002) - et al.
The effects of public spending shocks on trade balances and budget deficits in the European Union
Journal of the European Economic Association
(2008)