Do Spanish fiscal regimes follow the euro-area trends? Evidence from Markov-Switching fiscal rules

Do Spanish fiscal regimes follow the euro-area trends? Evidence from Markov-Switching fiscal rules

Economic Modelling 59 (2016) 484–494 Contents lists available at ScienceDirect Economic Modelling journal homepage: www.elsevier.com/locate/ecmod D...

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Economic Modelling 59 (2016) 484–494

Contents lists available at ScienceDirect

Economic Modelling journal homepage: www.elsevier.com/locate/ecmod

Do Spanish fiscal regimes follow the euro-area trends? Evidence from Markov-Switching fiscal rules Alejandro Ricci-Risquete a,⁎, Julián Ramajo a, Francisco de Castro b a b

Department of Economics, University of Extremadura, Avenida de Elvas s/n, E-06006 Badajoz, Spain DG ECFIN — Directorate-General for Economic and Financial Affairs, European Commission, Rue de la Loi 170, B-1049 Brussels, Belgium

a r t i c l e

i n f o

Article history: Received 25 February 2016 Received in revised form 22 July 2016 Accepted 13 August 2016 Available online xxxx Keywords: Fiscal regimes Fiscal rules Markov-Switching Spain Euro area

a b s t r a c t As has been the case for Spain, the Great Recession has exposed the destabilizing potential of national fiscal decisions which do not adhere to the European rules for the euro area. In this context, we characterize the discretionary behavior of Spanish fiscal policymakers in comparison with the euro-area one. For this purpose, we estimate cyclically-adjusted fiscal policy rules for the period 1986–2012 within a Markov-Switching framework. Our results show that the discretionary fiscal behavior of Spanish and euro-area governments has manifested switching properties throughout the last thirty years, uncovering the existence of two fiscal regimes which shift in accordance with the extent of deficit persistence and the intensity of debt-stabilizing and outputcountercyclical measures. Irrespective of fiscal regime, the Spanish authorities have committed to meeting the Maastricht criteria and the SGP rules by centering on the public deficit-debt association, whereas the euro-area administrations have engaged in stimulating the economic activity by focusing on the deficit-output gap relation. Our conclusions are robust to the impact of house price changes on fiscal policy variables for the Spanish case. © 2016 Elsevier B.V. All rights reserved.

1. Introduction: fiscal stance in context The Great Recession has shaken the foundations of the global economy and has generated serious doubts about the decisions of fiscal policymakers. Contrary to what it might seem, the fiscal performance of the euro area has been slightly better than that of some advanced economies as the United States (USA) or Japan since the beginning of the current international financial and economic crisis. According to the IMF (2016), the euro area experienced lower annual deficit-toGDP ratios and annual debt-to-GDP ratios than the USA and Japan on a year-by-year basis and also lower debt-to-GDP ratio growth rates than the USA between 2008 and 2014 (see Table 1). Whereas the USA and Japan are sovereign individual countries that have a single fiscal policy, the euro area is an ad-hoc group of 19 Member States of the European Union (EU), including Spain, which have adopted the euro as their single currency and share a single monetary policy, but preserve fiscal sovereignty. Euro-area countries have agreed on introducing some kind of fiscal policy coordination for achieving the common objectives of stability, growth and jobs. Coordination of fiscal policies has adopted several forms at the euroarea level, but one of the most important is fiscal rules.

⁎ Corresponding author. E-mail addresses: [email protected] (A. Ricci-Risquete), [email protected] (J. Ramajo), [email protected] (F. de Castro).

http://dx.doi.org/10.1016/j.econmod.2016.08.017 0264-9993/© 2016 Elsevier B.V. All rights reserved.

In general terms, a fiscal rule is a tool that matches an objective with some instruments in order to guide the action of fiscal policymakers. In the economic literature, fiscal rules are powerful instruments to disentangle the factors determining fiscal policymaking. In the real world, fiscal rules are nevertheless neither a necessary nor a sufficient condition for fiscal policy to pursue both the sustainability of public finances and macroeconomic stability in the medium to long term simultaneously (Castañeda, 2009), as the recent euro-area fiscal developments have proven. The most widely-known euro-area fiscal rules are enshrined in the Stability and Growth Pact (SGP), approved in 1997 and revised later. The SGP is applied not only to euro-area countries, but to all EU Member States, even though the former are subject to sanctions in case of noncompliance. Under the provisions of the SGP, Member States must respect two basic criteria: a deficit-to-GDP ratio should be lower than 3% and a debt-to-GDP ratio should not exceed 60%. Moreover, Member States must register structural budgetary improvements that ensure a steady and lasting convergence towards their medium-term budgetary objectives (MTOs).1 Although all EU Member States have to comply with those regulations, the fiscal performance of the aggregate outlined above can hide the different behaviors of its parts as the European integration process is far from concluded. Moreover, no sanctions have been adopted so 1 Šehović (2015) offers a recent analysis of fiscal rules in the Economic and Monetary Union (EMU).

A. Ricci-Risquete et al. / Economic Modelling 59 (2016) 484–494 Table 1 Fiscal performance in the euro area, Japan and the United States. Source: International Monetary Fund, World Economic Outlook Database, April 2016. Country

2013

2014

General government structural balance (Percent of potential GDP) Euro area −3.3 −4.6 −4.5 −3.7 −2.0 Japan −3.6 −7.5 −7.9 −8.5 −7.9 United States −5.9 −7.6 −9.4 −8.1 −6.1

2008

2009

2010

2011

2012

−1.2 −8.2 −4.0

−1.0 −5.8 −3.5

General government gross debt (Percent of GDP) Euro area 68.5 78.3 84.0 86.6 Japan 191.8 210.2 215.8 231.6 United States 72.8 86.0 94.7 99.0

93.4 244.5 104.8

94.5 249.1 105.0

91.3 238.0 102.5

far, despite the excessive deficits registered by a number of euro-area countries. Accordingly, in the height of the current financial and economic crisis, fears about the fiscal weaknesses of the euro area were revealed to governments and investors alike and markets brought back the spotlight to the PIIGS (i.e. Portugal, Ireland, Italy, Greece and Spain), a group of euro-area's peripheral economies which have faced deficit and debt issues and have experienced slow growth. Since the PIIGS account for almost 30% of euro-area GDP (IMF, 2016), concerns on the sustainability of their public finances can spread across Member States and can undermine the whole euro area. For restoring credibility in the European project, several extraordinary policy responses have been implemented, e.g. numerous austerity measures, which help to contain the deficit as data presented in Fig. 1 corroborate, have been enforced. Alesina et al. (2015) describe in detail the size and composition of the fiscal plans executed by a selection of EU countries over 2009–13 and their effects on output growth, whereas Baldwin et al. (2015) formulate a consensus narrative on the causes of the euro-area crisis. As opposed to Portugal, Ireland and Greece, smaller economies which have been bailed out, the case for Spain should be highlighted, because of two converging reasons: the larger size of the Spanish economy and the need for European financial assistance have inflamed the controversy about the convenience of euro-area fiscal rules. Spain's significant fiscal efforts made so far following the European guidelines have been recognized by both investors and economists and have also begun to bear fruit (see Martí and Pérez, 2015, for a discussion on the evolution of Spanish public finances through the financial and economic crisis). Under these circumstances, it would be particularly interesting to examine whether those factors that characterize the behavior of Spanish fiscal policymakers are similar to or different from the euro-area ones. In this paper, first we analyze the discretionary fiscal behavior of the Spanish economy by estimating cyclically-adjusted fiscal policy rules in which the government reacts to public debt and business cycles, and

Fig. 1. Change in general government structural deficit (fiscal stance) for Portugal, Ireland, Italy, Greece and Spain, 2008–2014. Note: The actual balance is adjusted for the cyclical component and one-time and other factors. Source: Own calculations based on IMF (2016) database.

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then we compare the results obtained for Spain with those for the euro area as a whole. We apply Markov-Switching techniques to allow for a shift in the parameters of the fiscal policy rules in order to account for the non-linearity of fiscal policy and its relation to different political preferences. For this purpose, we use two new quarterly fiscal databases fit for economic analysis (see De Castro et al., 2014, for Spain; and Paredes et al., 2014, for the euro area) compiled by means of similar statistical techniques to guarantee the comparability of our results. The rest of the paper is structured as follows. In Section 2, we briefly review the recent literature on fiscal rules that focuses on European countries. Section 3 explains the methodology used in this paper, concentrating on the specification of our fiscal rules. In Section 4, we describe the main characteristics of the two new quarterly fiscal datasets employed in our paper. In Section 5, we present the results for the different Spanish and euro-area fiscal regimes and discuss the economic policy implications of our results. Finally, Section 6 summarizes our findings and concludes. 2. A brief literature review about fiscal policy rules Since the publication of the famous article “Discretionary versus Policy Rules in Practice” by Taylor (1993), where he proposed a simple monetary policy rule according to which interest rates are set as a function of inflation and output deviations, much has been said about the use of rules in policymaking, especially on the monetary side. Among the advantages of policy rules are their simple specification, their potential to differentiate between discretionary and rule-based policy behavior and their use as a benchmark for policy evaluation (Thams, 2007). Nevertheless, their main disadvantage follows from one of their benefits: their simplicity may not be adequate to deal with complex situations like the current international economic crisis. All in all, policy rules are tools that can guide the action of economic policymakers, as they explicitly link the instruments to the objectives. However, the instruments, the objectives and the links between them can change over time. On the fiscal side, many advanced countries introduced fiscal rules over the last 25 years, in the form of golden rules, balanced budget rules or deficit and debts targets; the EU's Maastricht criteria and the SGP are usually put as examples. Following Badinger (2009), two basic reasons support the introduction of fiscal rules: the need to ensure sustainability of fiscal policy by avoiding excessive deficits and unsound policies and the need to achieve macroeconomic stability by limiting the room for discretionary fiscal policy. Both academics and policymakers acknowledge that the Maastricht criteria together with the SGP led to fiscal consolidations in many EU countries in the nineties, and thus served as a discipline device for fiscal authorities. This move towards “rules rather than authorities” (in the terminology of Friedman, 1948) reflects a fundamental shift in the paradigm of fiscal policy. According to the behavior of fiscal authorities, we can distinguish between “active” (non-Ricardian) fiscal policies and “passive” (Ricardian) fiscal policies (Leeper, 1991). Fiscal policy is said to be “active” when is does not stabilize public debt, and “passive” when it does stabilize government debt. In this latter case, primary budget balances react to changes in public debt to safeguard fiscal solvency in a way that future fiscal receipts cover the cost of current outstanding government liabilities. Following the seminal papers of Bohn (1998, 2005), in which he examines the behavior of US public debt and deficits, and Favero and Monacelli (2005) and Davig and Leeper (2007, 2011), in which they estimate Markov-Switching policy rules for the USA, the applied study of fiscal rules for European countries has been methodologically developed from two different perspectives: panel analysis and MarkovSwitching regressions. Those papers present and test some kind of fiscal policy reaction functions where the primary budget balance reacts not only to the public debt, in order to ensure fiscal sustainability, but also to the output gap, in order to smooth business cycle fluctuations.

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Within the first group of studies, Ballabriga and Martinez-Mongay (2005) test the response of primary surpluses to accumulated debt over the period 1977–2002 and find that sustainability was prevalent in many EU-15 countries before Maastricht, but also that the Maastricht criteria induced a shift towards sustainability in some of them. Afonso (2008) provides evidence of Ricardian behavior for the EU-15 governments between 1970 and 2003, as primary budget surpluses react to counter increases in the debt-to-GDP ratio. Marneffe et al. (2011) conclude that debt increases lead to lower total and primary balances in a panel with 16 euro area countries for the period 1995–2008. Recently, Maltritz and Wüste (2015) analyze the determinants of the primary budget balance of 27 EU countries from 1991 to 2011 with a panel approach and demonstrate a significant positive influence of fiscal rules and stock-flow-adjustments on the fiscal budget during the sample period, and a positive effect of fiscal councils at least in times of financial distress. In turn, Fincke and Wolski (2016) compare the consequences of the 2004 EU enlargement on the structural (primary) budget balance between Old Member States and New Member States over the years 2000–2011 and show that the latter switched towards more countercyclical fiscal policies after their EU entry, whereas the former ran erratic fiscal policies for the whole period. An interesting survey on 26 empirical papers that analyze the fiscal behavior of EMU countries is provided by Golinelli and Momigliano (2009). The authors discover that differences in the results are driven partly by the choices made in modelling fiscal behavior and in the related notions of fiscal policy cyclicality, but are also affected by data source and vintage. The second group of studies allows for endogenous changes in fiscal policy regimes by means of Markov-Switching regressions. Several types of fiscal rules have been estimated: first, a fiscal rule whereby the primary deficit-to-GDP ratio adjusts to stabilize the debt-to-GDP ratio; second, a fiscal rule whereby one fiscal instrument (public expenditure-to-GDP ratio or public receipts-to-GDP ratio) reacts to the other, the government debt-to-GDP ratio and the output gap, and; third, a fiscal rule which combines the two last approaches, i.e. the primary deficit-to-GDP ratio responds to changes in the public debtto-GDP ratio, the output gap and other variables. Claeys (2006) tests fiscal sustainability in Germany, France, Italy, Great Britain, Spain, the Netherlands and Austria, as well as the United States and Japan, with annual data from the 60s or 70s to 2003. He detects a significant stabilizing reaction to debt, although the model is not able to reject insolvency for Germany, France and Japan. Moreover, he observes that fiscal policy shifts are mainly related to debt. Thams (2007) finds that both Germany and Spain generally exhibit a positive relationship between government revenues and debt, and that both countries changed their policy behavior at the end of the nineties as a result of the increase in public debt ratios. However, this change in policy behavior seems to be non-permanent in the case of Germany. Afonso and Toffano (2013) assess the existence of fiscal regime shifts in the UK, Germany and Italy, using a new quarterly fiscal data set for the periods 1970Q4–2010Q4, 1979Q4–2010Q3 and 1983Q3–2010Q4, respectively. They prove that fiscal policy in the UK tended to be more active for the periods 1992–1996 and as of 2007. By contrast, in Germany fiscal regimes have been overly passive, supporting more fiscal sustainability throughout the sample period, whereas in Italy a more passive fiscal behavior is unveiled in the run-up to EMU. Cevik et al. (2014) determine the fiscal policy regimes for some former transition, emerging European economies, estimating the fiscal rule suggested by Davig and Leeper (2007) across the period 1995Q1– 2010Q4. Their results suggest that the Czech Republic, Estonia, Hungary, and Slovenia alternated between active and passive fiscal regimes before the global financial crisis, but adopted an active regime after that point. In contrast, the Slovak Republic and Poland followed a single (active) fiscal regime throughout the analyzed years. Among the studies for individual countries, Claeys (2008) concludes that the introduction of procedural and numerical rules in Sweden in

response to the severe 1991 fiscal crisis and the subsequent fiscal consolidation did not prevent destabilizing policies over the period 2000–2002. Finally, Afonso et al. (2011) estimate both primary budget deficit and public expenditure and public receipts rules for Portugal with a new dataset of quarterly fiscal series that ranges from the first quarter of 1978 to the fourth quarter of 2007. They obtain some evidence for the existence of two fiscal regimes: a pre-1988 period, when fiscal policy was active, and a post-1988 period, when fiscal policy becomes only slightly more passive and procyclical, although fiscal policy continued to be unsustainable. Opposite to the previous literature on the subject, the European Commission (2015b, Part IV) estimates the EU's fiscal reaction function to excessive deficits in the Member States between 2003 and 2014, by considering both fiscal and economic factors. Its analysis indicates that the Council of the EU recommends a higher fiscal effort but a longer deadline when the initial fiscal position is worse, and a lower fiscal effort and a longer deadline when the cyclical economic conditions are worse. Surprisingly, the debt-to-GDP ratio does not seem play any role in determining the recommended fiscal effort. 3. The empirical framework A fiscal rule is a reaction function that links a fiscal instrument to some macroeconomic and other fiscal variables in order to evaluate and recommend some sort of policy behavior. On this point, we should bear in mind that many economic time series are not linear (Hamilton, 1989). Essentially, non-linearity is especially pronounced in the asymmetric business cycle, which can be described by a sequence of long but gradual expansions and short but sudden recessions.2 According to the approach proposed by Bohn (1998, 2005), parameters in fiscal policy rules can change endogenously as fiscal policy is highly influenced by the current phase of the economic cycle and the political sign of the government among others. In detail, our MarkovSwitching fiscal policy rule can be specified as3:           pdt ¼ γ0 StF þ γ1 StF pdt−1 þ γ 2 StF bt−1 þ γ 3 StF yt þ σ StF ε t ð1Þ where pdt is the cyclically-adjusted primary deficit-to-GDP ratio, bt the nominal debt-to-GDP ratio, yt the output gap, and εt a normal mean zero-constant variance error term. SFt ∈ {1, … , M} denotes the state of fiscal policy at time t, which follows a first order Markov chain with transition matrix P F = (pij) with elements pij = Pr [st = i, st − 1 = j], for all i ,j ∈ {1, … , M}, and the parameters γi, for i = 0 , … , 3, can take different values depending on the prevailing fiscal regime. The variance of the error term is state dependent. The output gap yt is gauged with the Hodrick-Prescott (HP) filter with a smoothing parameter of λ= 1600.4 Since there is no unanimous opinion about the specification of fiscal policy rules in the literature, the selection of the variables is not trivial. 2 The way to estimate Markov-Switching models and its several applications are thoroughly described in Krolzig (1997) and Kim and Nelson (1999). 3 As noted by an anonymous referee, endogeneity problems could arise in the proposed equation. This potential shortcoming may be solved by using multivariate versions of the fiscal rule. Future research will address this extension. 4 As indicated by an anonymous referee, there is a high degree of uncertainty surrounding the estimates of the output gap, since potential GDP cannot be observed directly and actual GDP is often revised at a future time. We acknowledge the availability of several procedures to approximate the output gap, including simple statistical techniques and more complex econometric models. Among the former ones, the HP filter is widely used by economists and some government and international organization practitioners, and among the later ones, the production function approach is preferred by the European Commission, the OECD and the IMF. In consideration of the lack of agreement about the most suitable method to compute the output gap, as proven in the recent analyses of Marcellino and Musso (2011), Deutsche Bundesbank (2014), and European Commission (2015a, Chapter II), we have favored the employment of the simple and useful HP filter for that purpose. The selection of the smoothing parameter of λ=1600 has been made following the conventional setting for quarterly data suggested by Hodrick and Prescott (1997).

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As opposed to Bohn (1998), we allow the smoothed adjustment of the primary deficit by including the AR(1) term. According to Thams (2007), the addition of the lagged debt-to-GDP ratio is compulsory for econometric and economic reasons: on the one hand, there would be an endogeneity problem if the current debt-to-GDP ratio were considered and, on the other hand, it would be difficult to empirically detect a contemporaneous reaction of fiscal policy to changes in public debt because of implementation lags. As we mentioned earlier, fiscal policy is “active” in the sense on Leeper (1991) when the behavior of the fiscal authority targets several objectives other than debt stabilization (γ2 N 0), and it is “passive” when the fiscal authority aims to stabilize public debt and therefore decreases the primary deficit in response to public debt increases (γ2 b 0). In turn, the inclusion of the output gap aims to capture how fiscal policy reacts to the economic cycle. In this regard, fiscal policy would be deemed as countercyclical if γ3 b 0, and procyclical in the opposite case. Following Gali and Perotti (2003), it would however be interesting to disentangle those changes in fiscal policy that are related to the “automatic” influence of business cycle fluctuations (for example, output rises and falls cause changes in public expenditures connected to variations in unemployment benefits and changes in public receipts linked to modifications in tax revenues) from those associated to “discretionary” measures intentionally implemented by policymakers (for example, “systematic” increases in public consumption or reductions in tax rates when the economy is in a recession, and the opposite in an expansion, and “non-systematic” efforts in exceptional circumstances). Thus, in order to assess the discretionary comportment of fiscal policymakers only, we specify our fiscal rule denoted in Eq. (1) in terms of cyclically-adjusted fiscal variables. 4. The database In this section we briefly explain the database employed in the estimation of the fiscal rules. Contrary to previous studies, we use two new quarterly datasets of public finance variables fit for economic analysis, one for Spain (see De Castro et al., 2014) and the other one for the euro area (see Paredes et al., 2014), compiled by means of similar statistical techniques. The sample period covers from the first quarter of 1986 to the fourth quarter of 2012 and so includes some facts that are noteworthy for analyzing the behavior of fiscal policy in our zone of interest: (a) the accession of Spain into the European Economic Community in 1986, (b) the construction of its welfare state in the second half of the eighties, (c) the entry into force of the Treaty on European Union (the “Maastricht Treaty”) in November 1993, which created the Economic and Monetary Union (EMU) and forced Member States to respect financial and budgetary discipline, (d) the Spanish economic

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crisis of 1993–1994, (e) the adoption of the Stability and Growth Pact (SGP) in 1997, which constrains Member States to apply sound budgetary policies (basically, a deficit-to-GDP ratio below 3% and a debt-toGDP ratio below 60%) from the time they enter the third stage of EMU (1 January 1999 for Spain), (f) the international financial and economic crisis, whose beginning dated back to the bankruptcy of one of the largest global financial services firms Lehman Brothers in September 2008, and the burst of the housing bubble in Spain, whose climax was marked by the collapse of the country's leading real estate company MartinsaFadesa in July 2008, and (g) the intensification of the sovereign debt crisis in the euro area since May 2010. Fig. 2 depicts the Spanish and the euro-area output gap and the yearon-year inflation rate for the analyzed period, respectively. Note that the estimation of the output gap offers information about the evolution of the economic activity that can be different from the analysis of the economic cycles. Roughly speaking, the Spanish and the euro-area output gap series share a common path. Regarding inflation, both series shows a downward trend thorough the sample period, although Spanish inflation was usually higher than the euro area one, except from 2009 onwards. In Fig. 3 we present the Spanish and the euro-area (unadjusted and cyclically-adjusted) primary balance-to-GDP ratio and the public debt-to-GDP ratio for the period under scrutiny, respectively. Spain registered a primary surplus in three periods only: first, from the third quarter of 1987 to the second quarter of 1988; second, in the third and fourth quarters of 1989; and, third, from the fourth quarter of 1996 to the first quarter of 2008. A somewhat similar picture emerges for the euro area as a whole. Primary surpluses are registered between 1988 and 1993 and from 1995 till the outbreak of the Great Recession in 2008. That third phase of primary surplus-to-GDP ratio was accompanied by a reduction of the debt-to-GDP ratio in Spain, as we can see from the graph. Contrary to what was observed in Spain, only limited reductions in the public debt ratio were observed in the euro area between 2001 and 2008. In this regard, while the Maastricht criteria might have been instrumental to promote greater fiscal discipline, it also seems that positive fiscal outcomes are mainly the result of good economic times, rather than structural improvements in fiscal discipline. Focusing on Spain, both facts, i.e. the accomplishment of primary surpluses and the reduction of the debt-to-GDP ratio, are related to the commitment of the Spanish government to meet the convergence criteria set out in the Maastricht Treaty to regulate access to the Third Stage of EMU. However, proper fiscal consolidation does not apply to the whole 1996–2007 period. While expenditure retrenchment took place in the second half of the nineties, the reduction in the public deficit achieved thereafter was mainly due to buoyant government receipts linked to a large extent to the housing boom. Annual inflation rate

Output gap 4

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Fig. 2. Output gap and inflation rate for Spain and the euro area, 1986Q1–2012Q4. Notes: All variables are expressed in percentage terms. The output gap is denoted as the percentage deviation of actual from potential GDP based on the HP filter method. Source: Own calculations based on De Castro et al. (2014) and Paredes et al. (2014) databases.

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A. Ricci-Risquete et al. / Economic Modelling 59 (2016) 484–494 Spain's primary balance-to-GDP ratio and its components

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Fig. 3. Primary fiscal balance-to-GDP ratios and their components, and debt-to-GDP ratios for Spain and the euro area, 1986Q1–2012Q4. Note: All variables are expressed in percentage terms. The cyclically-adjusted balance is calculated in percent of potential GDP, the unadjusted balance is in percent of GDP. Source: Own calculations based on De Castro et al. (2014) and Paredes et al. (2014) databases.

5. Results In the first part of this section, we determine and explain the characteristics which define the fiscal regimes for Spain and the euro area according to our fiscal rule specified above. In the second part of this section, we consider the influence of Spanish house price cycles on the evolution of its public finances, and thus we re-specify and reestimate our fiscal rule for Spain and examine the subsequent results on a comparative basis. 5.1. Spanish and euro-area fiscal behaviors In this subsection we display the outcomes related to the estimation of the “cyclically-adjusted” fiscal rules based on Eq. (1) for Spain and the euro area.5 We should highlight again that these specifications are intended to assess the discretionary behavior of fiscal policymakers only. The left side of Table 2 presents the Maximum Likelihood (ML) estimation results of the fiscal rule described in Eq. (1) for the Spanish cyclically-adjusted primary deficit-to-GDP ratio.6 We depict the filtered 5 In order to check the robustness of our results, we have also estimated three modified fiscal rule specifications of that denoted in Eq. (1) by adding, first, the primary expenditure-to-GDP ratio gap, second, the year-on-year inflation, and finally both variables, as suggested by Barro (1984) and Claeys (2006). The obtained results (not shown in the paper) present some minor differences to those reported here, in particular, regarding the statistical significance of certain variables. 6 Preliminary analysis indicates that a fiscal rule with three regimes was difficult to estimate with a number of local roots exhibiting coefficient singularity. Also, following the suggestion of Diebold et al. (1994), and Filardo (1994), who argue that the probability of switching from one regime to the other cannot depend on the behavior of underlying economic fundamentals, but the transition probabilities can and should vary with fundamentals, we estimate the Markov-Switching two-regime fiscal policy rule denoted in Eq. (1), using variable-dependent transition probabilities for the case of Spain. The results are very close to those reported in the main text for constant transition probabilities.

probabilities of each regime and the residual, actual and fitted cyclicallyadjusted primary deficit-to-GDP ratio for Spain in Fig. 4. We can distinguish the existence of two regimes: regime 1, which basically prevails from the beginnings of 1987 to the middle of 1990, from the second half of 2002 to the first half of 2003, from the middle of 2005 to the second quarter of 2010 and from 2012 onwards, and regime 2, which predominates in the first quarter of 1987 and also spans between the middle of 1990 and the second quarter of 2002, between the second half of 2003 and the first half of 2005, and between the middle of 2010 and the end of 2011. Both regimes are very persistent as indicated by the transition probabilities presented at the bottom left of Table 2. The probability that regime 1 is followed by regime 1 is 0.9244, and the probability that regime 2 is followed by regime 2 is 0.9372, so regime 2 is slightly more persistent than regime 1. In addition, the expected duration of regime 1 is shorter than that of regime 2; in particular, regime 1 would last for around 13.2 quarters, while regime 2 would go on for about 15.9 quarters. Almost all of the relevant coefficients are statistically significant, with the exception of the parameter related to the output gap in regime 1. Regarding the short-run behavior of the Spanish government, fiscal policy seems to be “passive” in both regimes, as the cyclically-adjusted primary deficit decreases in response to higher debt; however, such passive behavior is stronger in regime 1 than in regime 2. Furthermore, the coefficient on the output gap is negative in both regimes, but is not statistically significant in regime 1, implying that fiscal policy can be regarded as “erratic”,7 while it is “countercyclical” in regime 2. In both regimes, the coefficient estimate of the lagged primary deficit-to-GDP ratio is positive and significant, revealing to 7 Argimón et al. (1999) find that fiscal policy in Spain tended to be procyclical, especially before the Maastricht Treaty.

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Table 2 Markov-Switching cyclically-adjusted fiscal policy rules for Spain and the euro area. Source: Own calculations based on De Castro et al. (2014) and Paredes et al. (2014) databases. Spain

Constant Lagged cyclically-adj. (deficit/GDP) Lagged (debt/GDP) GDP gap Log (sigma) Transition probabilities Exp. duration (Q) Log likelihood AIC SC HQC

Euro area

Regime 1

Regime 2

Regime 1

Regime 2

2.0707⁎ (1.1873) 0.8821⁎⁎⁎ (0.1201) −0.0459⁎ (0.0248)

0.7289⁎ (0.4025) 0.5812⁎⁎⁎ (0.0738) −0.0120⁎ (0.0070) −0.1546⁎⁎⁎ (0.0575) −0.9130⁎⁎⁎ (0.1068)

1.7446 (2.1556) 0.5717⁎⁎⁎ (0.0736) −0.0188 (0.0311) −0.3854⁎⁎⁎ (0.0943) −1.3271⁎⁎⁎ (0.1764) P(1 | 1) = 0.8293 P(2 | 1) = 0.1707 5.8587

0.3232 (0.2598) 0.6995⁎⁎⁎ (0.1123) −0.0071⁎ (0.0036) −0.2358⁎⁎⁎ (0.0782) −1.4183⁎⁎⁎ (0.1111) P(1 | 2) = 0.0655 P(2 | 2) = 0.9345 15.2565

−0.1608 (0.2596) 0.2336⁎ (0.1228) P(1 | 1) = 0.9244 P(2 | 1) = 0.0756 13.2301

P(1 | 2) = 0.0628 P(2 | 2) = 0.9372 15.9347 −114.2543 2.4280 2.7331 2.5516

−23.6901 0.6609 0.9589 0.7818

Notes: The dependent variable is the cyclically-adjusted primary deficit-to-GDP ratio. Standard errors in brackets. Q – Quarters. AIC – Akaike information criterion. SC – Schwarz criterion. HQC – Hannan-Quinn criterion. ⁎ Indicates statistical significance at a 10% level. ⁎⁎⁎ Indicates statistical significance at a 1% level.

some extent the persistence of this variable, especially in regime 1. There is also some volatility of policy shocks in both regimes, which is particularly intense in regime 1. The long-run responses of Spanish fiscal policymakers, however, reveal other implications for the evolution of public finances. As shown in the left side of Table 3, the long-run influence of the output gap on the primary deficit in regime 1 is almost four times more than one in regime 2, even though the difference between the short-run point estimates of the output gap is minor. Bearing in mind that the euro area is a heterogeneous ad-hoc group of countries, it is straightforward to analyze how the Spanish fiscal behavior adjusts to the euro-area counterpart, since Spain belongs to the euro area from its founding days. Therefore, in the right side of Table 2 we present the estimation results of the Markov-Switching cyclicallyadjusted fiscal policy rules for the euro area. We can also differentiate two regimes for this aggregate: regime 1, which covers from the second quarter of 1990 to the middle of 1992, the second half of 1994, from the fourth quarter of 2000 to the end of 2002, and from the first quarter of 2008 to the end of 2010, and regime 2, which extends from the beginning of 1986 to the start of 1990, from the middle of 1992 to the first half of 1994, from the beginning of 1995 to the third quarter of 2000, from the start of 2003 to the end of 2007, and from the first quarter of 2011 onwards. Concerning the short-run behavior of the euro area fiscal policymakers, the coefficient on the lagged debt-to-GDP ratio is negative in both regimes, but is not statistically significant in regime 1, suggesting that fiscal policy appears to be neither active nor passive in regime 1, whereas it is “passive” in regime 2. Besides, both regimes can be described by a countercyclical fiscal policy, as increases in the output gap are followed by a fall in the cyclically-adjusted primary deficit; however, the countercyclical behavior is stronger in regime 1 than in regime 2. Nevertheless, the long-run fiscal effects for the euro area provide other flavor of discretionary policy behavior. As displayed in the right side of Table 3, the euro area governments in regime 1 react to the lagged debt-to-GDP ratio a little stronger than one in regime 2, although the estimated impacts of the lagged debt and the output gap on the primary deficit between the regimes are almost the same. From the results summarized in Fig. 5, we can compare the fiscal regimes and the business cycles for Spain and the euro area. The discretionary behavior of Spanish and euro-area fiscal policymakers has exhibited switching properties over the last three decades, revealing the existence of two fiscal regimes. The main differences between both fiscal regimes concern the degree of deficit persistence and the level of

debt passiveness and output countercyclicality; in other words, fiscal regimes have not followed either an active or a procyclical pattern in Spain and the euro area. Throughout the second half of the 80s, the early-2000s downturn, the housing bubble and the sovereign-debt crisis (in regime 1), the Spanish government reduced the cyclically-adjusted primary deficit in response to an increase in the public debt-to-GDP ratio (passive behavior). By contrast, over the 90s, the period 2003–2005 and the financial crisis (in regime 2), the Spanish fiscal authorities kept on applying policies to control deficit and debt, but in a less passive manner, and implemented discretionary countercyclical fiscal measures as well. The euro area governments decreased the cyclically-adjusted primary deficit in response to an upsurge in the output gap (countercyclical behavior) during the early-90s crisis, the early-2000s downturn and the Great Recession (in regime 1). On the other hand, euro-area fiscal administrations executed discretionary passive fiscal policies and also carried on enforcing measures to stimulate the economic activity, but in a less countercyclical fashion, throughout the second half of the 80s, most of the 90s, the period 2003–2007 and the sovereign-debt crisis (in regime 2). The comparison between regimes in the euro area and Spain unveils some common features. Specifically, regimes 2 in both Spain and the euro area are deemed as “passive” and countercyclical. These regimes usually coincide in time and prevailed over most of the nineties, between 2003 and 2005 and in 2011 (see Fig. 5). In turn, time synchronization between regimes 1 in Spain and in the euro area is less salient, only between 2008 and 2010 and in 2012. However, regimes 1 do not share any characteristic as in Spain is “passive”, whereas in the euro area is “countercyclical”, at least in the short run. Spanish and euro-area governments do not only adjust fiscal policies to business cycles, but often adapt them to other factors in order to pursue diverse objectives, such as tax collection, income redistribution, macroeconomic stabilization, deficit reduction and debt sustainability. Fiscal regimes in Spain have been more stable, whereas shifts between regimes in the euro area have occurred far more frequently. Short-run and long-run fiscal effects derived from policy responses of Spain and the euro area are dissimilar and to some extent erratic, particularly in one of the two fiscal regimes. During certain periods, Spanish and euro-area fiscal policymakers were inclined to concentrate on the association between the primary deficit and one explanatory variable in the very short run, disregarding the relations between the primary deficit and the other factors until the long run.

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Fig. 4. Fiscal regimes (constant transition probabilities) for Spain and the euro area, 1986Q1–2012Q4. Source: Own calculations based on Table 2.

Table 3 Short-run vs. long-run effects derived from Markov-Switching cyclically-adjusted fiscal policy rules for Spain and the euro area. Source: Own calculations based on Table 2. Spain

Euro area

Regime 1

Regime 2

Regime 1

Regime 2

Short run Lagged cyclically-adj. (deficit/GDP) Lagged (debt/GDP) GDP gap

0.8821 −0.0459 −0.1608

0.5812 −0.0120 −0.1546

0.5717 −0.0188 −0.3854

0.6995 −0.0071 −0.2358

Long run Lagged (debt/GDP) GDP gap

−0.3898 −1.3644

−0.0286 −0.3691

−0.0440 −0.8997

−0.0236 −0.7847

Notes: The dependent variable is the cyclically-adjusted primary deficit-to-GDP ratio. Long-run lagged (debt/GDP) parameter is calculated as γ2(SFt )/[1 − γ1(SFt )]. Long-run GDP gap parameter is computed as γ3(SFt )/[1−γ1(SFt )].

Even though the Spanish authorities focused on controlling the public deficit-debt link in the second half of the 80s, the early-2000s downturn, the housing bubble and the sovereign-debt crisis (in Spain's regime 1), such discretionary passive fiscal policies also had countercyclical effects in the long run. Instead, the euro-area governments centered on stimulating the deficit-output gap nexus in the early-90s crisis, the early-2000s downturn and the Great Recession (in euro area's regime 1), but such discretionary countercyclical fiscal responses also had passive effects in the long run. Whatever fiscal regime, cyclically-adjusted primary deficits exhibit a high degree of persistence in Spain and the euro area, partly because the connection between government expenditure with the structure of public administrations and services, partly due to the dependence of government revenue on the structure of economic activity. Once public deficit increases, mainly attributable to an unexpected fall in government revenue especially visible in economic downturns, the control of that variable can last for some quarters.

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Fig. 5. Fiscal policymakers' behaviors vs. business cycles for Spain and the euro area, 1986Q1–2012Q4. Notes: In left-side graphs, grey-shaded areas indicate quarters of fiscal regime 1, and white-shaded areas designate quarters of fiscal regime 2. In right-side graphs, grey-shaded areas indicate quarters of recession, and white-shaded areas designate quarters of expansion. Sources: Own calculations based on Table 2; AEE (2015); CEPR (2015).

The persistence of Spanish and euro-area public deficits is significant in both regimes but higher in Spanish regime 1 and euro-area regime 2 (although the differences between regimes are more pronounced in Spain). In turn, the volatility of policy shocks is lower in the euro area (and similar in both regimes) than in Spain in regime 1 (almost five times as large as the euro-area average). 5.2. Robustness checks: Spanish house price effects8 Admitted by economists as a practical rule, the output gap as a proxy for business cycles usually captures the state of the economy relatively well, so fiscal indicators corrected for macroeconomic fluctuations could be obtained by applying the conventional cyclical adjustment techniques. Nevertheless, macroeconomic shifts might be originated not only from business cycles but also from house (asset) price cycles, among other sources. In fact, house prices affect fiscal balances directly through public revenues and indirectly through wealth effects (Price and Dang, 2011; Liu et al., 2015; Jaeger and Schuknecht, 2007; Morris and Schuknecht, 2007; Tagkalakis, 2011a, 2011b, 2011c; Tujula and Wolswijk, 2007). As we actually acknowledged in Section 4, the buoyancy of Spanish government receipts in the period 2000–2007 was linked to the country's housing boom. If significant house price 8 This subsection was not included in the original version of the paper. We are very grateful to an anonymous referee for suggesting us the introduction of this subsection.

boom-and-bust cycles are detected for the Spanish case, adjustments beyond the output gap may be needed. In order to control for the impact of Spanish house prices on the fiscal variables, our empirical approach can be described as follows. Firstly, we select the seasonally-adjusted real house price index issued by the OECD (2016) as an appropriate measure for identifying the house price cycles. Secondly, we examine to what extent the output gap as a proxy for business cycles, and the house price gap as a proxy for house price cycles are synchronized (the house price gap is estimated using the HP filter with the standard smoothing parameter of λ = 1600). A close inspection of both Spanish variables depicted in the left-hand side of Fig. 6 suggests a notable degree of similarity in certain periods only, and thus the usual adjustment for business cycles could not be sufficient. In those circumstances, the third step entails the calculation of the primary deficit-to-GDP ratio adjusted for the output and house price gaps. For that purpose, we follow the methodology and employ the MS Excel® template provided by Bornhorst et al. (2011). The comparison of Spain's unadjusted primary balance with the ones adjusted for both business and house price cycles traced in the right-hand side of Fig. 6 reveals the impact of the house prices in the Spanish fiscal position. The fourth and final step involves the consideration of the effects not only of the business cycles but also of the house price cycles on the Spanish fiscal stance in the fiscal rule specification. Accordingly, our

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Primary balance Primary balance adjusted for the output gap Primary balance adjusted for the output and house price gaps

Fig. 6. Output and house price gaps, and primary fiscal balance-to-GDP ratios for Spain, 1986Q1–2012Q4. Notes: All variables are expressed in percentage terms. The output and house price gaps are denoted as the percentage deviation of actual from potential values based on the HP filter method. The adjusted balances are calculated in percent of potential GDP, the unadjusted balance is in percent of GDP. Source: Own calculations based on De Castro et al. (2014) and OECD (2016) databases.

Markov-Switching fiscal policy rule denoted in Eq. (1) is transformed into Eq. (2):           pdt ¼ γ0 StF þ γ1 StF pdt−1 þ γ 2 StF bt−1 þ γ 3 StF yt þ σ StF ε t ð2Þ where pdt is the primary deficit-to-GDP ratio adjusted for the output and house price gaps, and the remaining terms are defined as in Section 3. The ML estimation results of our fiscal rule specified in Eq. (2) for the Spanish primary deficit-to-GDP ratio adjusted for the output and house price gaps are displayed in the right-hand side of Table 4. As gathered from the transition probabilities displayed at the bottom right of that table, the two regimes which can be identified are fairly persistent. In detail, the probability that regime 1 is followed by regime 1 is 0.7585, and the probability that regime 2 is followed by regime 2 is 0.9010, hence regime 2 is more persistent than regime 1. Moreover, since regime 1 would go on for roughly 4.1 quarters and regime 2 would last for approximately 10.1 quarters, the expected duration of regime 1 is less than half the time of regime 2. In regime 1, all but the coefficient associated to the output gap are statistically significant; on the contrary, only the parameters related to the lagged deficit-to-GDP ratio and the error term are statistically significant in regime 2. With respect to the short-run behavior of Spanish

fiscal authorities, fiscal policy can be labelled as “passive” at least in regime 1, because the primary deficit adjusted for the output and house price gaps responds negatively to debt rises. The last-mentioned findings are rather similar to those outcomes of the fiscal rule for the primary deficit adjusted for the output gap reported in the antecedent subsection, particularly for regime 1. Besides that passive fiscal behavior on impact, Spanish fiscal policy seems to be “erratic” in both regimes, as the effect of the output gap on the primary deficit adjusted for the output and house price gaps is negative but not significant. As probed by the comparison of both sides of Table 4, there are some variations in the degree of countercyclicality between the Eq. (1) results and the just-described ones, especially for regime 2. The two regimes, but especially regime 2, exhibit a marked deficit persistence and some policy shock volatility too. The short-run behavior of Spanish fiscal policymakers shows some minor dissimilarities depending on how fiscal balances are adjusted. The long-run responses of Spanish fiscal authorities, by contrast, remain unchanged in qualitative terms irrespective of our fiscal rule specification. As displayed in Table 5, even if the Spanish government directs its efforts to a single clear objective in the short run, such discretionary fiscal policies have passive and countercyclical effects in the long run regardless of fiscal regime. The long-run outcomes of those fiscal actions, however, are more pronounced in regime 1 than in regime 2.

Table 4 Comparison of Markov-Switching cyclically-adjusted fiscal policy rules for Spain. Source: Own calculations based on De Castro et al. (2014) and OECD (2016) databases. Spain's Eq. (1)

Constant Lagged cyclically-adj. (deficit/GDP) Lagged (debt/GDP) GDP gap Log(sigma) Transition probabilities Exp. duration (Q) Log likelihood AIC SC HQC

Spain's Eq. (2)

Regime 1

Regime 2

Regime 1

Regime 2

2.0707⁎ (1.1873) 0.8821⁎⁎⁎ (0.1201) −0.0459⁎ (0.0248) −0.1608 (0.2596) 0.2336⁎ (0.1228) P(1 | 1) = 0.9244 P(2 | 1) = 0.0756 13.2301

0.7289⁎ (0.4025) 0.5812⁎⁎⁎ (0.0738) −0.0120⁎ (0.0070) −0.1546⁎⁎⁎ (0.0575) −0.9130⁎⁎⁎ (0.1068) P(1 | 2) = 0.0628 P(2 | 2) = 0.9372 15.9347

5.3171⁎⁎⁎ (0.4336) 0.8687⁎⁎⁎ (0.0313) −0.0844⁎⁎⁎ (0.0072) −0.1315 (0.0822) −1.1289⁎⁎⁎ (0.1711) P(1 | 1) = 0.7585 P(2 | 1) = 0.2415 4.1407

−0.0052 (0.7549) 0.9477⁎⁎⁎ (0.0311)

−114.2543 2.4280 2.7331 2.5516

−0.0036(0.0146) −0.0103 (0.0958) −0.2595⁎⁎ (0.1054) P(1 | 2) = 0.0990 P(2 | 2) = 0.9010 10.1015 −118.4235 2.5081 2.8133 2.6318

Notes: The dependent variable of Eq. (1) is the primary deficit-to-GDP ratio adjusted for the output gap, whereas the dependent variable of Eq. (2) is the primary deficit-to-GDP ratio adjusted for the output and house price gaps. Standard errors in brackets. Q – Quarters. AIC – Akaike information criterion. SC – Schwarz criterion. HQC – Hannan-Quinn criterion. ⁎ Indicates statistical significance at a 10% level. ⁎⁎ Indicates statistical significance at a 5% level. ⁎⁎⁎ Indicates statistical significance at a 1% level.

A. Ricci-Risquete et al. / Economic Modelling 59 (2016) 484–494 Table 5 Comparison of short-run vs. long-run effects derived from Markov-Switching cyclicallyadjusted fiscal policy rules for Spain. Source: Own calculations based on Tables 2 and 4. Spain's Eq. (1)

Spain's Eq. (2)

Regime 1

Regime 2

Regime 1

Regime 2

Short run Lagged cyclically-adj. (deficit/GDP) Lagged (debt/GDP) GDP gap

0.8821 −0.0459 −0.1608

0.5812 −0.0120 −0.1546

0.8687 −0.0844 −0.1315

0.9477 −0.0036 −0.0103

Long run Lagged (debt/GDP) GDP gap

−0.3898 −1.3644

−0.0286 −0.3691

−0.6427 −1.0012

−0.0684 −0.1961

Notes: The dependent variable of Eq. (1) is the primary deficit-to-GDP ratio adjusted for the output gap, whereas the dependent variable of Eq. (2) is the primary deficit-to-GDP ratio adjusted for the output and house price gaps. Long-run lagged (debt/GDP) parameter is calculated as γ2(SFt )/[1− γ1(SFt )]. Long-run GDP gap parameter is computed as γ3(SFt )/ [1−γ1(SFt )].

The preceding robustness checks reveal that only a few negligible differences in the short-run discretionary behavior of Spanish fiscal policymakers, especially in regime 2, can emerge when the effects of not only the business cycles but also the house price cycles on fiscal balances are accounted. For that reason, we can affirm that the analysis is robust to our several fiscal rule specifications, and that the discussion and subsequent results presented in the foregoing subsection remain valid. 6. Summary and conclusions In this paper we study fiscal regime shifts for the economy of Spain in comparison with the euro area as an aggregate. We characterize the discretionary behavior of Spanish and euro-area fiscal policymakers by means of cyclically-adjusted fiscal policy rules (i.e. we exclude the automatic stabilizers' components) according to which the government reacts to public debt and business cycles. We apply Markov-Switching techniques to allow for a shift in the parameters of the fiscal policy rules and to account for the non-linearity of fiscal policy and its relation to different political preferences. Our results show that the discretionary fiscal behavior of Spanish and euro-area governments has manifested switching properties throughout the last thirty years, uncovering the existence of two fiscal regimes which shift in accordance with the extent of deficit persistence and the intensity of debt-stabilizing and output-countercyclical measures. Irrespective of fiscal regime, the Spanish authorities have committed to meeting the Maastricht criteria and the SGP rules by centering on the public deficit-debt association (passive behavior), whereas the euro-area administrations have engaged in stimulating the economic activity by focusing on the deficit-output gap relation (countercyclical behavior). In regime 1, those discretionary fiscal actions described above have also unintentionally had long-run countercyclical results for Spain and long-run passive effects for the euro area. In regime 2, however, Spanish and euro-area governments have combined the application of the discretionary fiscal measures noted in the preceding paragraph with the implementation of countercyclical and passive fiscal policies, respectively. Whatever fiscal regime, the persistence of structural public deficit has been significant in both Spanish and euro-area cases. Contrary to previous studies, it is interesting that fiscal regimes have not followed either an active or a procyclical pattern in Spain and the euro area. Furthermore, our conclusions are robust to the impact of house price changes on fiscal policy variables for the Spanish case. From a deficit perspective, Spanish public finances have commonly experienced a fiscal deficit position for the last three decades, in the sense that government receipts have not been enough to cover public expenditure. From a debt perspective, passive fiscal rules imply that

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when policymakers detect deterioration in the fiscal stance, such as debt increases, the primary balance reacts to correct it. Accordingly, as a policy conclusion, it seems important that Spain reduces its currently high public deficit and debt in a durable manner. High public deficits and debt hampers the ability of the government to adopt countercyclical measures in downturns when public finances deteriorate and public debt is likely to rise. Sounder public finances enhance the macroeconomic stabilization capacity of the governments in severe recessions when the need for such tools can be highest.

Acknowledgements The authors acknowledge the constructive comments on an earlier version of this manuscript from the Editor and two anonymous referees. The authors are also grateful to Francisco de Castro, Francisco Martí, Antonio Montesinos, Javier J. Pérez and A. Jesús Sánchez-Fuentes, and to Joan Paredes, Diego J. Pedregal and Javier J. Pérez for the permission to use their Spanish and euro-area quarterly fiscal databases, and the session participants at the INFER Workshop on Applied Macroeconomics and Labour Economics at Seville, 2015, and at the 5th UECE Conference on Economic and Financial Adjustments in Europe at Lisbon, 2016, for their helpful comments. Any remaining errors are the responsibility of the authors.

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