The Cyclical Reaction of Fiscal Policies in the Euro Area: The Role of Modelling Choices and Data Vintages

We survey the recent empirical literature concerning the cyclical response of fiscal policies in the euro area, finding large differences in results. We show that these differences are heavily influenced by the choices made in modelling fiscal behaviour. In particular, models where the overall reaction to the cycle – which includes the effects of both the discretionary actions and automatic stabilizers – is directly estimated, tend to suggest either strong pro-cyclical or counter-cyclical discretionary reactions, depending on how this component is identified. We make a case for the use, in assessing policies and in the EMU context, of the standard modelling choice where the discretionary reaction of fiscal policy is directly estimated. Within this model and for the years 1994-2008, we show that results are significantly affected by the data vintage (ex post or real-time). With ex post data we find an unambiguous indication of a-cyclicality. Using real-time data, we find that the output gap matters. However, depending on whether we assess policy intentions or actual policies, euro area governments’ behaviour radically changes. A plausible interpretation is that in the implementation phase governments loosen their fiscal stance, giving in to political pressures that are proportional to the scale of the economic difficulties in bad times and the size of the “growth dividend” in good times