Fiscal outcomes, current account imbalances, and institutions in Europe: Exploring nonlinearities

Abstract

We analyze the fiscal outcomes associated to the current account imbalances within Europe. We hypothesize that the effects of current account imbalances on fiscal variables within the European Union are nonlinear and that the nonlinearity is modulated by the quality of governance. We use data on 28 European Union countries from 2000 to 2019, apply a Panel Smooth Transition Regression (PSTR) approach and proxy governance by measures of corruption. We find evidence of a nonlinear relationship: the fiscal effects related to current account imbalances are differentiated among European countries. On the one hand, we find a positive elasticity of fiscal balance to current account balance when the quality of institutions is low. This suggests that in countries with high corruption, a deterioration of the current account results in a degradation of fiscal balance and an increase of debt. On the other hand, we find a negative elasticity of fiscal balance to current account balance when the quality of institutions is high. This implies that in countries with low corruption, larger current account imbalances can be related to an improved fiscal balance and a lower debt. Robustness checks comfort our findings.