Ricardian equivalence and twin deficits hypotheses in the euro area

Abstract

This paper analyzes two fundamental hypotheses of fiscal policy literature: the well-known Keynesian Twin Deficits and the Ricardian Equivalence. Using yearly data for the 1970–2010 years, we studied the Euro Area countries. A key requirement of sustained economic growth states that the current account deficit and the budget deficit should be under control. During the last decades a major controversy has emerged on the sign of fiscal multiplier, that is, positive (Keynesian or conventional view), zero (Ricardian view), or negative (expectational view). The empirical findings of our study show mixed results. In fact, for the static panel data, fixed effects and random effects estimates are in line with the Ricardian approach; while Pooled OLS and Prais–Winsten (GLS) reach the opposite conclusion, since the government budget/GDP ratio coefficient is positive and statistically significant (somewhere in the range of 0.14–0.18 %). Moreover, the estimates of two sub-groups constructed with the Index of Globalization confirm the Ricardian hypothesis. In regard to the dynamic panel data, the Anderson–Hsiao IV estimators indicate that only the first lag of government budget has a positive and significant effect on trade deficit, while the more reliable GMM methods seem to be consistent with the Ricardian view. The Common Correlated Effects Mean Group estimates show that RE holds for 1970–1991 years, while in the second sub-period results are in line with the Keynesian view. Finally, FMM estimates produce three homogeneous groups, confirming previous results. Yet, mixture models provide empirical support to TD hypothesis, with effects differentiated among clusters.