Abstract
Rather than stabilising aggregate demand, discretionary fiscal policy tends to amplify cyclical fluctuations of output. The commonly accepted reasons are political economy and uncertainty. In the EU, the pro-cyclical nature of discretionary fiscal policy has also been associated with the commonly agreed fiscal rules, which, for some observers, unduly limit the scope for stabilising output. Using panel data covering close to 40 EU and non-EU countries, we provide evidence that the volatility of output gap estimates is not a convincing explanation for pro-cyclical policies. With the exception of very large shocks, discretionary measures remain ill-timed from a stabilisation perspective even when observable and politically more meaningful indicators of the cycle are used. We also show that deviations from fiscal rules and the accumulation of government debt foster pro-cyclical fiscal policy. Lawmakers can run discretionary fiscal policy measures based on political economy considerations up to a point. Once debt grows too high, the leeway to stabilise output with discretionary fiscal policy measures fades. Complying with fiscal rules that limit the increase in government debt or keep a steady course in the face of cyclical fluctuation is conducive to counter-cyclical fiscal policy making.
Highlights
The EU fiscal framework is an institutional safeguard against cross-border spillovers of national fis c al policies in the economic and monetary union
In light of the results derived from the extended fiscal reaction function we looked at an alternative and more direct way to assess the drivers of pro-cyclical fiscal policy, notably logit models
In line with existing studies, we find that discretionary fiscal policies tend to be pro-cyclical, but we add several findings to the literature
Summary
The EU fiscal framework is an institutional safeguard against cross-border spillovers of national fis c al policies in the economic and monetary union. In spite of the increased flexibility of the Pact, many observers still consider the framework as too tight and biased towards sustainability, imposing clear limits to an effective stabilisation of output in the short term. This conclusion is generally substantiated by the well-known graphical juxtaposition of cyclical conditions on the one hand and the orientation of discretionary fiscal policy on the other ; s ee Figure 1. This addition allows us to discriminate between two competing views whereby pro-cyclicality either results from the constraints imposed by fiscal rules or from deviating from the rules
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