Expansionary Fiscal Consolidation Revisited: Evidence from the Over-Indebted Europe

• Thesis title in Czech: Prorůstová fiskální konsolidace znovu na scéně: analýza předlužené Evropy
• Thesis title in English: Expansionary Fiscal Consolidation Revisited: Evidence from the Over-Indebted Europe
• Key words: Fiskalní konsolidace, Evropská unie, lokální projekce, narativní přístup, nekeynesiánské vlivy
• English key words: Fiscal consolidation, European Union, Local projections, Narrative approach, Non-Keynesian effects
• Academic year of topic announcement: 2022/2023
• Thesis type: diploma thesis
• Thesis language: angličtina
• Department: Institute of Economic Studies (23-IES)
• Supervisor: PhDr. Jaromír Baxa, Ph.D.
• Author: hidden - assigned by the advisor
• Date of registration: 27.06.2023
• Date of assignment: 27.06.2023
• Date of electronic submission: 29.04.2024

Guidelines

Motivation:
Public sector traditionally plays an important role in Europe. Moreover, in reaction to the wave of unexpected shocks such as COVID-19 pandemic and Russian invasion of Ukraine with related energy crisis, virtually all governments boosted their economies taking advantage of the suspended Stability and Growth Pact until 2024. While it remains questionable how much governments spending aimed at offsetting “black swans” and to what extent the underlying motivation was purely political, there is no doubt it leads to hardly sustainable debt levels for multiple countries in the European Union (The Economist, 2023a). Indeed, Italy and Spain among others reported debt-to-GDP ratio exceeding 100%! Moreover, the situation is complicated as ECB and other monetary authorities must raise interest rates to combat inflation “monster” which makes debt service burden strikingly expensive (Arnold, 2023).

As a consequence, recent developments resemble the set up in the 2010s when European sovereign debt crisis took place threatening pure existence of second-largest reserve currency. “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough,” declared Mario Draghi, then ECB President, to calm down financial markets and return trust in the euro area (European Central Bank, 2012). Nowadays, widening government bond yield spreads are once again calling for fiscal consolidation (Vladkov and Arnold, 2023).

Alesina and Perotti (1995) point out that austerity measures do not have to automatically cause a decline of output or a prolonged recession with huge unemployment. In fact, in case of heavily indebted countries, it is assumed the so-called non-Keynesian effects are more likely to occur. The principle is as follows: households and firms are aware of debt burden, including possible risk of bankruptcy, and thus sophistically hold extra savings to be prepared for bad times. Under these circumstances, if governments go for austerity in a credible way, economic agents may feel free to consume and invest more given lowered risk premium (Giavazzi and Pagano, 1995). Therefore, fiscal consolidation can turn out to be expansionary in the end.

Hypotheses:
To ground a fiscal fantasyland (The Economist, 2023b), following hypotheses will be tested:
#1 There are signs of expansionary fiscal consolidation (incl. post-European sovereign debt crisis era)
#2 The composition of fiscal consolidation plays a significant role
#3 The exchange rate regime significantly impacts fiscal consolidation

Expected Contribution:
The expansionary fiscal consolidation firstly attracted attention when Ireland and Denmark have undergone austerity in the 1980s. Giavazzi and Pagano (1990) find that GDP growth can be maintained despite budget cuts/tax increases as in case of Denmark/Ireland, respectively. The topic then became well established in the literature within the framework of the political economy as Alesina takes a lead and revises it on a regular basis, rather confirming that expansionary fiscal consolidation can hold (e.g., Alesina and Perotti, 1995; Alesina and Perotti, 1996; Alesina and Ardagna, 2010; Alesina et al., 2015; Alesina et al., 2017).
However, several recently published papers have delivered contrasting results indicating that debate is not yet over, and that further evidence is needed (e.g., Guajardo et al., 2014; Attinasi and Metelli, 2017; Georgantas et al., 2023). In other words, we are interested in whether expansionary fiscal consolidation identified in papers by Alesina et al. is robust to a variety of approaches, or whether the results are mainly driven by the choice of empirical methodology.
As it is already a couple of years since the last comprehensive studies were published, it is essential to provide additional evidence on how the results have shaken out in light of the European sovereign debt crisis or the recent excessive fiscal stimulus. Moreover, we would like to document whether composition matters as suggested by Alesina and Perotti (1996).
Furthermore, researchers usually focus on OECD countries though history of sovereign debt crises in Europe can be traced back to the early 19th century (Reinhart et al., 2012). Indeed, Europe is significantly more egalitarian compared to other OECD countries, not to talk about the rest of the world. Therefore, this thesis makes a great deal by enriching much smaller literature on expansionary fiscal consolidation in the Old Continent.
Last but not least, we offer a fine alternative to the latest papers such as the one by Georgantas et al. (2023) sticking primarily to the narrative approach which is considered state-of-the-art methodology free of potential endogeneity. The same applies to focus on EU and time range as already mentioned.

References

Core Bibliography:
[01] Alesina, A. et al. (2017) “The Effects of Fiscal Consolidations: Theory and Evidence.”
[02] Alesina, A. and Ardagna, S. (1998) “Tales of fiscal adjustment,” Economic Policy, 13(27), pp. 487–545.
[03] Alesina, A. and Ardagna, S. (2010): “Large Changes in Fiscal Policy: Taxes versus Spending,” Tax Policy and the Economy, 24(1), pp. 35–68.
[04] Alesina, A., Favero, C.A. and Giavazzi, F. (2015) “The output effect of fiscal consolidation plans,” Journal of International Economics, 96, pp. S19–S42.
[05] Alesina, A. and Perotti, R. (1995) “The Political Economy of Budget Deficits,” IMF Staff Papers, 42(1), p. 1.
[06] Alesina, A. and Perotti, R. (1996) “Fiscal Adjustments in OECD Countries: Composition and Macroeconomic Effects,” IMF Working Paper, 96(70), p. 1.
[07] Arnold, M. (2023) “ECB must do more to tackle inflation ‘monster’, says Christine Lagarde,” Financial Times.
[08] Attinasi, M.G. and Metelli, L. (2017) “Is fiscal consolidation self-defeating? A panel-VAR analysis for the Euro area countries,” Journal of International Money and Finance, 74, pp. 147–164.
[09] Beetsma, R. et al. (2021) “Revenue- versus spending-based fiscal consolidation announcements: Multipliers and follow-up,” Journal of International Economics, 131, p. 103455.
[10] European Central Bank (2012) “Verbatim of the remarks made by Mario Draghi.”
[11] Georgantas, G., Kasselaki, M. and Tagkalakis, A.O. (2023) “Τhe effects of fiscal consolidation in OECD countries,” Economic Modelling, 118, p. 106099.
[12] Giavazzi, F. and Pagano, M. (1990) “Can Severe Fiscal Contractions Be Expansionary? Tales of Two Small European Countries,” Nber Macroeconomics Annual, 5, pp. 75–111.
[13] Giavazzi, F. and Pagano, M. (1995) “Non-Keynesian Effects of Fiscal Policy Changes: International Evidence and the Swedish Experience.”
[14] Guajardo, J., Leigh, D. and Pescatori, A. (2014) “EXPANSIONARY AUSTERITY? INTERNATIONAL EVIDENCE,” Journal of the European Economic Association, 12(4), pp. 949–968.
[15] Reinhart, C., Reinhart, V. and Rogoff, K. (2012) “Public Debt Overhangs: Advanced-Economy Episodes Since 1800,” Journal of Economic Perspectives, 26(3), pp. 69–86.
[16] Romer, C.D. and Romer, D.H. (2010) “The Macroeconomic Effects of Tax Changes: Estimates Based on a New Measure of Fiscal Shocks,” The American Economic Review, 100(3), pp. 763–801.
[17] The Economist (2023a) “Europe will need to fundamentally reset its fiscal policies,” The Economist.
[18] The Economist (2023b) “Governments are living in a fiscal fantasyland,” The Economist.
[19] Vladkov, A. and Arnold, M. (2023) “ECB rate rises expose fears for Italy as eurozone’s weakest link,” Financial Times.

Preliminary scope of work

Methodology:
As our baseline empirical methodology, we stick to the narrative approach first proposed by Romer and Romer (2010). Under this framework, fiscal announcements and measures are collected by a researcher who organizes them into the so-called fiscal “plans” which can be regarded as typically multi-year austerity measures. As governments do not always fully announce them in advance, thus they carry both expected and unexpected parts (Alesina et al., 2017). The main advantage of this method is that it is assumed to contain no potential endogeneity. Nonetheless, we certainly consider alternative approaches, particularly the one based on cyclically-adjusted primary balance presented mostly in pioneering studies, to assess the robustness of our results (Giavazzi and Pagano, 1995; Alesina and Ardagna, 1998; Georgantas et al., 2023). After setting fiscal episodes, impulse response functions are estimated using vector autoregressive models or other methods with regards to literature review (Alesina et al., 2017; Beetsma et al., 2021).
Our sample consists of the current EU-27 member states and the United Kingdom, a former EU member state until 2020. Following Alesina et al. (2017), our baseline time span starts in 1981 and ends in 2019. This gives us a representative dataset with a sufficient number of countries known for fiscal consolidation in recent years and sufficient diversity in terms of exchange rate regimes (hard peg vs. free float).
Regarding “exogenous” fiscal adjustment plans, we benefit from data sources publicly available on the Bocconi IGIER website. Additionally, macroeconomic variables will be taken mainly from Eurostat Database and Refinitiv Datastream.

Outline:
The master’s thesis would be divided into following parts:
Introduction
Literature Review
Methodology
Data
Results and Discussion
Further Issues
Conclusion
References
Appendix