How Do EU Members’ Fiscal Plans Affect Each Other?

Although Europe’s Stability and Growth Pact (SGP) requires countries to pay fines for repeated violations of the 3% deficit/GDP norm, so far no country has paid a fine and most experts doubt that this will ever happen. Indeed, they generally view the SGP as an instrument through which countries can impose peer pressure on each other, thereby stimulating each other to follow disciplined policies. Therefore, the interesting question is how effective such peer pressure mechanism will be in practice.

In a recent empirical contribution, we investigate to what extent planned fiscal policies in the European Union (EU) affect each other. We focus on planned fiscal policies rather than actual fiscal outcomes, because the former reveal more about the fiscal authorities’ true intentions, while the latter are “contaminated” by the reaction of fiscal policy to unexpected economic developments (for example, unforeseen changes in the business cycle). Of course, the fiscal plans presented by governments may not entirely reflect their true intentions. Therefore, we measure fiscal plans by using next-year fiscal forecasts published by the OECD. The OECD filters the data at least to some extent by basing its forecasts on existing legislation and legislation that has been approved but not yet implemented. In addition, our econometric approach filters out some of the potential systematic bias in the published plans.

Our dataset includes 14 EU countries (all those that were EU member in 2000, minus Luxemburg) over the period 1994-2005, which yields budgetery forecasts for the years 1995 – 2006. We regress the forecast for the cyclically-adjusted primary deficit (the “planned fiscal stance”) on the average planned fiscal stance of all other countries in our sample, controlling for other factors that potentially affect planned fiscal stances, such as forecasts for output gaps and the deviation of the current deficit from the 3% reference level of the SGP. Our baseline estimates suggest that an average relaxation by one pecentage point of the other countries’ planned fiscal stance induces an individual country to relax its own planned stance by 0.3 percentage points. This indicates a substantial spill-over of fiscal plans, and we conduct a large number of tests to confirm the robustness of the result. As a by-product of these regressions, we find in most of the cases an a-cyclical response of the planned fiscal stance to the projected output gap. Debt/GDP ratios also seem to have no role, while there is mild evidence that future elections induce a relaxation in fiscal plans. Finally, violations of the 3% deficit norm do seem to induce a fiscal tightening both before and after monetary unification Europe.

Next we move on to split the sample into a set of “large” countries (Germany, France, Italy, Spain and the U.K.) and the remaining “small” countries. This yields particularly interesting results. Repeating the standard regression for each group separately shows that large countries’ fiscal plans are unaffected by what the other large countries on average plan to do, while the small countries’ fiscal plans are strongly influenced by the plans of the other small countries. However, including the average fiscal plan of the large countries in our regressions for the small countries’ plans, reveals that the other small countries plans no longer matter. Only the average large country’s plan matters. This strongly suggests that large countries’ plans are a common driving force behind the small countries’ fiscal plans. Some further experimentation indicates that it is actually the one-period lag of the large countries’ plans that performs best in explaining the plans of the small countries. The figure below illustrates our finding very clearly.

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Notice that the planned cyclically adjusted primary deficits are negative and thus effectively correspond to surpluses. This is because they leave out the interest payments on the public debt. Remarkably, starting with the year 2000, large countries’ fiscal plans are progressively becoming more relaxed, which is in line with the widespread perception. In this trend the large countries are followed by the small countries, although with some lag.

What are the policy implications of this finding? Obviously, if peer pressure is supposed to work in disciplining fiscal policies in the EU, then it is important that the large Member States be provided with the right incentives to follow disciplined policies. The other countries would then be expected follow their example.

One Response to "How Do EU Members’ Fiscal Plans Affect Each Other?"

  1. Guest   May 21, 2008 at 9:21 am

    Peer pressure seems to work the wrong way; if a big country has a looser fiscal policy others will follow; rather than the reverse…so peer pressure seems to work in a vicious rather than virtuous way…it sounds like the Keynes beauty contest…or a form of herd behaviour.