Cross‐country spillovers of fiscal consolidations in the euro area

• Author: Tigran Poghosyan
• Published date: 01 March 2020
• Date: 01 March 2020
• DOI: http://doi.org/10.1111/infi.12349

International Finance. 2020;23:18–46.wileyonlinelibrary.com/journal/infi18

|

© 2019 John Wiley & Sons Ltd

DOI: 10.1111/infi.12349

ORIGINAL ARTICLE

Cross‐country spillovers of fiscal

consolidations in the euro area

Tigran Poghosyan

Fiscal Affairs Department, International

Monetary Fund, Washington, District of

Columbia

Correspondence

Tigran Poghosyan, Economist, Fiscal

Affairs Department, International

Monetary Fund, 700 19th Street, N.W.

Washington, D.C. 20431, USA.

Email: tpoghosyan@imf.org

Abstract

This paper revisits the issue of cross‐country spillovers

from fiscal consolidations using an innovative empirical

methodology. We find evidence in support of fiscal

spillovers in ten euro area countries. Fiscal consolidation

in one country not only reduces domestic output (direct

effect) but also reduces the output of other member

countries (indirect/spillover effect). Fiscal spillovers are

larger for (a) more closely located and economically

integrated countries, and (b) fiscal shocks originating from

relatively larger countries. On average, 1% of gross

domestic product fiscal consolidation in ten euro area

countries reduces the combined output by 0.6% on impact,

out of which half is driven by indirect effects from fiscal

spillovers. The impact peters out and becomes insignificant

over the medium term. It is largely driven by tax measures,

which have a relatively strongereffectonoutputcompared

to expenditure measures. The results are robust to

alternative measures of bilateral links across countries.

KEYWORDS

fiscal spillovers, local projection method, spatial econometrics

JEL CLASSIFICATION

E1; E6; F4; H5

1

|

INTRODUCTION

The European integration process over the last several decades has resulted in a greater

interdependence between euro area countries. There is a broad consensus among economists

that this has increased the likelihood that fiscal policies in one member state will spill over to

the rest of the euro area. Recognizing spillovers from fiscal policy actions in individual member

states to others, the European Commission has underscored the importance of taking an

appropriate fiscal stance in the euro area as a whole in a recent communication (see EC, 2016;

EPSC, 2016).

In a number of euro area countries, the debate has centred on fiscal consolidation, given

elevated debt levels. Fiscal consolidation in one country can reduce domestic demand for imports,

leading to lower output in its trading partners. Thus, trade linkages can play an important role in

propagating fiscal shocks across countries, with more synchronized fiscal consolidations leading to

significant cross‐country spillover effects. These effects can potentially be larger for members of a

currency union as the adjustment takes place through price compression and internal devaluation

over the medium term, even though the theoretical literature does not provide a clear‐cut answer

(Beetsma & Debrun, 2004; Beetsma, Debrun, & Klaassen, 2001).

This paper revisits the issue of fiscal spillovers from fiscal consolidations using an innovative

empirical methodology. The objective is to assess empirically the size of fiscal spillovers by taking

into account spatial output links across ten euro area countries covering more than 95% of euro‐area

gross domestic product (GDP). Specifically, we quantify the domestic impact of fiscal consolidation

measures by an individual euro area country, as well as bilateral spillovers to other euro area

countries. We also assess spillovers from revenue and expenditure measures separately.

Our results suggest that fiscal consolidation in one country reduces not only the domestic

output (direct effect), but also the output of other countries (indirect/spillover effects). Fiscal

spillovers are larger for (a) more closely located and economically integrated countries, and (b)

fiscal shocks originating from relatively larger countries. On average, 1% of GDP fiscal

consolidation in ten euro area countries reduces total output by 0.6% on impact, half of which is

explained by indirect effects from fiscal spillovers. The impact is largely driven by tax measures,

which have a relatively stronger effect on output compared with expenditure measures. The

results are robust to alternative measures of bilateral links across countries.

This analysis has important policy implications and suggests large welfare gains from policy

coordination at the euro area level. Country‐specific estimates of fiscal spillovers can be used to

run policy experiments to assess the effect of fiscal consolidations across countries and how it

can impact the output gap of the euro area as a whole. One caveat is that the analysis does not

assess the impact of fiscal expansions, which may not be symmetric.

The remainder of the paper is structured as follows: Section 2 reviews the related literature. Section

3 describes the data and presents descriptive statistics. Section 4 outlines the empirical methodology

used for estimating fiscal spillovers. Section 5 presents the estimation results. Section 6 concludes.

2

|

FISCAL SPILLOVERS: LITERATURE REVIEW

This section reviews the literature on fiscal spillovers. Although there is a vast empirical literature

on domestic fiscal multipliers (for a review, see Mineshima, Poplawski‐Ribeiro, & Weber, 2014),

empirical evidence on cross‐country spillovers from fiscal policy measures is relatively scarce.

The literature describes several channels for cross‐country transmission of fiscal shocks,

including trade, price, interest rate, and exchange rate channels (In't Veld, 2013; Weyerstrass

et al., 2006). In a monetary union, where member countries have a common currency and

interest rate, trade links between countries tend to play an important role in the cross‐country

transmission of fiscal shocks. Fiscal consolidation in one member country affects others via

reduced domestic activity and demand, some of which translates into reduced demand for

POGHOSYAN

|

19