We think that the reason for the large contribution of fiscal policy is to be found
elsewhere. To the extent that automatic stabilisers reduce the volatility of economic
fluctuations, the tendency of governments to reduce taxation and/or rise spending in a
procyclical way only adds to short-term output fluctuations and brings about aggregate
macroeconomic instability. This policy volatility can moreover have negative effects on
the long-term growth prospects of the economy.93 The unwinding of previous taxation
decisions goes against the principle of ‘tax smoothing’. The procyclicality of budgets
implies negative supply-side effects. This explains the surprisingly low contribution of
cyclical fluctuations.
Before going deeper into the past trends in fiscal policy, we want to check our model on
some other aspects too. We compute the output gap based on the historical decomposition
of the output series as actual minus potential output (y- y*). In Figure 5.5 (top left
panel),94 we have repeated for comparison the output gaps of the European Commission,
OECD and the one obtained by applying a Hodrick-Prescott filter. There is a rather close
correspondence between these measures and our supply shock based gap for France and
Germany. Given that we have used the OECD elasticities only for distinguishing shocks
with transitory effects on output, this is all the more remarkable. The smooth gap for
Portugal and Spain underlines the importance of supply relative to demand shocks in both
countries. This might indeed be expected given the strong economic catch-up that both
countries have experienced. We believe that potential output tracked much closer actual
output developments in these countries. The usual statistical filtering methods are not
adequate to capture this trend behaviour over small samples. Cyclical fluctuations are
therefore rather minor. We provide some further robustness checks in the Appendix
5.B.95
Overall, in all countries, there definitely was an improvement in economic conditions at
the start of EMU. We find that economic conditions have worsened in both France and
Germany in recent years. We nevertheless find the crisis in Germany to have set in
somewhat earlier and to be more prolonged. As cyclical fluctuations are not large, we do
not find much economic slack in recent years in Spain or Portugal.
93
94
95
We are certainly not the first study to document that European countries have not left automatic
stabilisers to work, but instead have overturned these in a procyclical way. We do show however the
macroeconomic instability that results as a consequence. With other models, Alesina and Bayoumi
(1996) showed how fiscal policy at the US state level rather contributes to macroeconomic
instability, and how fiscal rules have been useful in constraining discretion. Similar cross-country
evidence is provided by Fatas and Mihov (2003b).
We plot all series over the period 1980-2004 only.
A rough indication on the robustness of our output gap measure can also be given by the dates of
peak and troughs in the business cycle. We plot in Appendix 5.B the first difference of the output
gap against the chronology of peak to trough turning points of the growth cycle provided by the
Economic Cycle Research Institute (ECRI). These calculations are based on monthly industrial
production series. Our measure matches the changes in the output gap in all countries.
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