Fiscal Policy, Consumption and Current Account in the European Countries

This paper explores the relationship between fiscal deficit, trade deficit and private consumption in European countries in the years 1970-2010 period. The aim of the paper is to test empirically the validity and rationale of the Keynesian proposition (conventional view or Twin Deficits hypothesis) and the Ricardian Equivalence hypothesis, as well as to analyze the relationship between fiscal policy and private consumption. The empirical findings of our study show mixed results. In fact, static panel data estimates suggest that a one percent increase in the fiscal deficit/GDP ratio tends to deteriorate the current account/GDP ratio of 0.21 percent, although it increases the private consumption of 0.21 percent. Furthermore, the dynamic estimates largely depend on the estimator chosen, since the GMM-Dif estimates show a significant effect of fiscal deficit both on trade balance and on private consumption, in line with TD hypothesis; on the contrary, the GMM-Sys method suggests that these effects are irrelevant, supporting RE hypothesis. With regard to the former estimates, we observed that each euro rise in the fiscal deficit is associated, on average, with a 22 cents decline in the current account, while the estimated rise in private consumption is smaller (11 cents). Finally, Granger-causality tests show mixed results.