Monetary Developments and Expansionary Fiscal Consolidations: Evidence from the EMU

• Published date: 01 July 2016
• Date: 01 July 2016
• Author: Luís Martins,António Afonso
• DOI: http://doi.org/10.1002/ijfe.1544

MONETARY DEVELOPMENTS AND EXPANSIONARY FISCAL

CONSOLIDATIONS: EVIDENCE FROM THE EMU

†

ANTÓNIO AFONSO

a,

*and LUÍS MARTINS

b

a

Department of Economics; UECE –Research Unit on Complexity and Economics, ISEG/ULisboa –Universidade de Lisboa,

R. Miguel Lupi 20, 1249-078 Lisbon, Portugal

b

Banco de Portugal, Lisbon, Portugal

ABSTRACT

We provide new insights into the existence of expansionary fiscal consolidations in the Economic and Monetary Union, using

annual panel data from 14 European Union countries, over the period of 1970–2013. Different measures were calculated for

assessing fiscal consolidations, based on the changes in the cyclically adjusted primary balance. A similar ad hoc approach

was used to compute monetary episodes. Panel estimations for private consumption show that, in some cases, when fiscal con-

solidations are coupled with monetary expansions, the traditional Keynesian signals are reversed in the cases of general govern-

ment final consumption expenditure, social transfers and taxes. Keynesian effects prevail when fiscal consolidations are not

matched by monetary easing. Panel probit estimations suggest that longer consolidations contribute positively to its success,

whilst the opposite is the case for revenue-based ones. Copyright © 2015 John Wiley & Sons, Ltd.

Received 22 April 2015; Revised 06 November 2015; Accepted 16 November 2015

JEL CODE: C23; E21; E5; E62; H5; H62

KEY WORDS: fiscal consolidation; monetary expansion; non-Keynesian effects; panel data; probit

1. INTRODUCTION

Keynesian theory gives us some insights into the expected effect of government budgetary components’changes in

income. It postulates that an increase in government spending should stimulate the economy, via the multiplier

mechanism, thus increasing disposable income and private consumption. Following this reasoning, an increase

in taxation should lead to a decrease in private consumption.

Nevertheless, since the early 1990s, based on the case studies of Denmark and Ireland,

1

some literature dis-

cusses the possible non-Keynesian effects of fiscal policy, namely, during fiscal consolidation periods.

The theoretical underpinnings stemmed from the German Council of Economic Experts in their reports of 1981

and 1982, which referred to the ‘expectational view of fiscal policy’.

2

Arguably, the standard Keynesian relation-

ship between private consumption and government budgetary components may be reversed under certain circum-

stances. A deterioration of the fiscal position (resulting in a budget deficit) today may lead to an increase in taxation

in the future, in order to fulfil the government budget constraint, which would therefore reduce individuals’

*Correspondence to: António Afonso, Department of Economics, UECE –Research Unit on Complexity and Economics, ISEG/ULisboa –

Universidade de Lisboa, R. Miguel Lupi 20, 1249-078 Lisbon, Portugal.

Email: aafonso@iseg.utl.pt

†

We thank two anonymous referees, Christophe Blot, Christian Breuer, Jean-Bernard Chatelain and participants at seminars at the Free Univer-

sity of Berlin, at the Nova School of Business and Economics, at the UECE 3rd Conference on Economic and Financial Adjustments, at the 32nd

International Symposium on Money, Banking and Finance, at the 71st Annual Congress of the International Institute of Public Finance and at the

Macroeconomics Workshop, ‘The Euro crisis: where do we stand?’for useful comments and suggestions. The opinions expressed herein are

those of the authors and do not necessarily reflect those of the authors’employers. UECE is supported by the Fundação para a Ciência e a

Tecnologia (Portuguese Foundation for Science and Technology) through the PEst-OE/EGE/UI0436/2011 project.

Copyright © 2015 John Wiley & Sons, Ltd.

International Journal of Finance & Economics

Int. J. Fin. Econ. 21: 247–265 (2016)

Published online 17 December 2015 in Wiley Online Library

(wileyonlinelibrary.com). DOI: 10.1002/ijfe.1544

permanent income. If such expectations are taken into account by the agents, this could lead to a decrease in private

consumption today. The reverse reasoning holds for a fiscal consolidation, meaning that an improvement in the

fiscal position may lead to an increase in private consumption today. Some empirical research presents evidence

that supports this view.

3

In fact, the expectational view of fiscal policy relies on the assumption of Ricardian households, which smooth

consumption and have no liquidity constraints. This motivates a thorough assessment of the monetary develop-

ments when studying expansionary fiscal consolidations. Moreover, according to the Keynesian view, under the

IS-LM framework, a fiscal consolidation may lead to an increase in private consumption if it is accompanied by

a strong enough monetary expansion, which offsets the detrimental effects of fiscal policy developments on dispos-

able income and private consumption.

Arguably, whilst neglecting the monetary policy stance, one could find oneself in a situation described by

Ardagna (2004): ‘In this case, the coefficients of fiscal policy variables can be biased, capturing the effect of mon-

etary rather than fiscal policy’.

The importance of this issue within the Economic and Monetary Union (EMU) context is rather obvious,

because the expectational view of fiscal policy was to some extent reflected in the fiscal convergence criteria of

the Maastricht Treaty. Additionally, the monetary policy stance is outside national governments’influence.

This paper contributes to the existing literature by providing some new insights about the importance of the

monetary stance for the relationship between fiscal developments and private consumption during fiscal consolida-

tion periods. It does so by notably expanding Afonso’s (2010) and Afonso and Jalles’s (2014) core specification, in

order to accommodate monetary policy developments. We conduct an assessment of fiscal episodes, using the same

criteria. However, and in addition, we also identify monetary episodes for 14 European Union countries from 1970

to 2013 and study their relationship with fiscal developments. In fact, we want to assess if the existence of mone-

tary expansions plays a role in the identification of expansionary effects of the fiscal policy, during fiscal consol-

idation periods. Moreover, we investigate if different types of fiscal consolidations as well as monetary expansions

play a role in the success of the adjustments.

The paper is organized as follows. Section 2 reviews the related literature. Section 3 presents an identification of

the fiscal and monetary episodes and their respective relationship. In Section 4, we conduct the empirical analysis

of expansionary fiscal consolidations, resorting to panel estimations, which accommodate the developments of

monetary policy. We also assess the success of the fiscal consolidations in this section. Section 5 concludes the

paper.

2. LITERATURE SURVEY

Hellwig and Neumann (1987) were pioneers with regard to the assessment of the expansionary fiscal consolidation

hypothesis. They argue that fiscal consolidation in Germany in the 1980s, under Chancellor Kohl, had such a

positive impact on private sector confidence that demand actually increased. Supposedly, fiscal consolidation by

the Federal Government and monetary tightness by the Bundesbank led to continued growth of output and low

inflation. Furthermore, lower deficits stimulated private investment in the long run, owing to the reduced cost of

financing. Nevertheless, unemployment remained high, which authors attribute to labour market rigidity.

Giavazzi and Pagano (1990) test this hypothesis for Denmark and Ireland, for the mid and late 1980s, respec-

tively. In the case of Denmark, they report that the boom in consumption experienced in 1983–1986 cannot be

explained by the decline in interest rates alone, and that as such, it is related to fiscal consolidation through the

increase in revenue from income taxation and the decrease in public investment. Regarding the Irish case, the fast

consumption growth in the second stabilization was due to the government focus on decreasing spending, rather

than increasing taxation, and also due to the liberalization of the credit markets. In these cases, on the whole,

expansionary fiscal consolidation is linked to an adjustment on the public spending side, rather than of revenues,

although in Denmark, the adjustment occurred through investment spending, and in Ireland, it came about through

current spending.

Alesina and Ardagna (1998) investigate the expansionary fiscal consolidation possibility, recurring to an anal-

ysis of Organisation for Economic Co-operation and Development (OECD) countries from 1960 to 1994.

ANTÓNIO AFONSO AND LUÍS MARTINS248

Copyright © 2015 John Wiley & Sons, Ltd. Int. J. Fin. Econ. 21: 247–265 (2016)

DOI: 10.1002/ijfe