Fiscal convergence and sustainability in the European Union

Abstract

This paper analyzes fiscal convergence and sustainability in the European Union using data on government debt, revenues, and expenditures. Absolute fiscal divergence is present in the EU, especially after the sovereign debt crisis. However, we find evidence of fiscal club convergence when clubs are endogenously determined. Club convergence is important for the EU because there is no single fiscal policy and member states’ policies are heterogeneous. Endogenous clubs do not share the usual geographical, political, or development similarities. Fiscal policy in the EU is found to be unsustainable, but it is countercyclical. We use a policy response function where the primary surplus is a function of public debt and the output gap. The primary surplus does not respond to changes in public debt, and this is considered to be unsustainable. However, it increases in expansions and decreases in recessions thus being countercyclical. The countercyclical primary surplus is important for smoothing business cycles.