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Out of balance

The effects of current account and fiscal balances on growth and inflation in the Eurozone
Jennifer Evans Student number: 3409740 Applied Economics Research Course Supervisor: Dr. Kevin Nell Utrecht School of Economics June 27, 2011

ABSTRACT Macroeconomic imbalances between European member states have stirred up an intense political debate since the financial crisis began in late 2007. However, in order to discern the proper policy response, it is important to consider the source of these imbalances. To study the relationship between the current account balance, the fiscal balance, inflation and growth within economies of different sizes in the Eurozone, Granger causality tests are performed on Germany, the Netherlands, Spain and Portugal. The results suggest excess inflation in smaller Eurozone economies can be addressed by tighter fiscal policies. Furthermore, they indicate that countercyclical policies could be a better remedy for fiscal deficits than the procyclical recommendations proposed in recent Stability and Growth Pact reforms.

Table of Contents
1. Introduction ...............................................................................3 2. Literature review........................................................................5 The fiscal balance, the current account and inflation ..................5 Current account and fiscal balances in the Eurozone .................. 7 Inflation in the Eurozone ...........................................................11 The crisis................................................................................... 12 3. Empirical framework ............................................................... 13 4. Data and Methodology.............................................................. 15 5. Results...................................................................................... 17 (H1) .......................................................................................... 17 (H2) .......................................................................................... 18 (H3) ..........................................................................................20 (H4) ......................................................................................... 21 (H5) .......................................................................................... 25 6. Conclusion ...............................................................................26 7. References ................................................................................28 8. Appendix ..................................................................................30 Variable definitions ..................................................................30 Descriptive statistics .................................................................30 Sensitivity analysis.................................................................... 31 Summary of results ................................................................... 31

1. Introduction
Macroeconomic imbalances between European member states have stirred up an intense political debate since the financial crisis and subsequent recession began in late 2007. European Union (EU) leaders worry that these imbalances will harm the credible of the Euro and cause financial turmoil leading to additional crises (Baldwin, 2010). In 2010, the EU set up the Van Rompuy Commission to investigate and draft policy measures that would address the growing divergence. Less than a year later, amid the continuing European Sovereign Debt Crisis that began in 2009, the president of the European Central Bank (ECB) proposed that the Eurozone deepen its fiscal coordination by creating a European ministry of finance (Hewitt, 2011). However, when investigating solutions for these divergences, it is important to consider their source, and how these variables interact with one another. Eurozone members have different types of economies and levels of per capita GDP, which may be reflected in their current account and fiscal balances as well as inflation rates. For example, catch-up growth caused when poorer Southern countries joined the Eurozone may be the reason for their current account deficits as these countries build their capital stock via imports. If Eurozone policies inadvertently slow the growth of the catch-up countries, it also makes it harder for these governments to pay back the debt they accumulated in order to grow. On the other hand, if the smaller Eurozone economies are racking up fiscal and trade deficits only to fuel higher consumption in light of low borrowing costs, it is difficult to justify such behavior. The market may react negatively to high fiscal balances, leading to a situation like the Sovereign Debt Crisis, in which countries are unable to borrow on the market, or only able to borrow at unsustainable interest rates, to fund their spending. Furthermore, increasing fiscal deficits may be associated with increasing inflation, which drives up a countrys real exchange rate and decreases the competitiveness of its exports. This thesis will investigate the effect of current account and fiscal balances on growth and inflation through Granger causality tests. Throughout 3

the paper, the subquestions listed in Box 1 below will be answered. Two sets of Granger causality models will be run on two large Eurozone economies, Germany and the Netherlands, and two smaller Eurozone economies, Portugal and Spain. The variables under investigation were chosen because they reflect the main economic restrictions to Eurozone countries via the Stability and Growth Pact (SGP) framework1 and the common monetary policy. These variables also allow a potential cause of the twin deficit relationship to be tested. In the next section, the literature on the fiscal and current account balances, inflation and growth will be reviewed. Through the literature review the hypotheses will be discussed, and the first Subquestion will be answered. Thereafter a short empirical framework will follow. Methodology and data will be then be treated. In section 4, the empirical results will be addressed. The paper will close with a general conclusion.

Box 1. Main question and subquestions


What is the effect of current account and fiscal balances on growth and inflation in the Eurozone?

1. What are some reasons for large macroeconomic imbalances between Eurozone
countries?

2. Does the fiscal deficit lead to a current account deficit in smaller Eurozone economies?
Does this hold for larger economies?

3. Do fiscal and current account deficits predict future growth? 4. Is there a relationship between inflation and growth, and is it more significant in smaller
Eurozone economies than larger economies?

5. Is there a relationship between inflation and the budget deficit, and is it more significant
in smaller Eurozone economies than larger economies?

The Stability and Growth Pact is a framework for coordinating fiscal policy between the EU Member States. The Maastricht criteria, also mentioned in this paper, refer to the both the fiscal and monetary rules laid out in the Maastricht Treaty (European Commission).

2. Literature review
The fiscal balance, the current account and inflation
The basic background information about the current account, the fiscal balance and inflation will be covered here. Definitions and identities will be used to put the various relationships into context before addressing specific theory about these macroeconomic indicators in the Eurozone over the past decade. Keep in mind that the identities given in this section cannot be used to make economic forecasts or explain economic occurrences without additional economic theory and theory-based models. Rather, they are used here instead to flesh out the basic relationships addressed in this paper. The fiscal balance Government spending includes spending by federal, state or local governments, and includes both consumption and investment spending such as federal military spending, government support of cancer research and funds spent on highway repair and education (Krugman & Obstfeld, 2009). Government spending as a percentage of gross domestic product (GDP) gives insight into the magnitude of fiscal deficits or fiscal surpluses, and allows one to compare fiscal positions across countries. In the Eurozone, countries may not have a fiscal deficit above 3 percent of GDP except in certain circumstances (Europa). Reforms to the SGP that were adopted in 2010 have a stronger focus on medium-term deficit and debt levels, and included a provision that all countries exceeding the debt limit will be required to reduce it every year, at a rate of one twentieth of the excess debt (Manasse, 2010). Government spending makes up an important part of national income, and affects the composition of aggregate demand. In the income identity for an open economy, the sum of expenditures always equals income and is given by Y=C+I+G+(X-M). Y is national income, C is consumption, I is investment, G is government spending, and (X-M) is net exports (Krugman & Obstfeld, 2009). The government deficit is defined as (G-T), and measures to what extent the government is borrowing to finance its expenditures. (2009).

While Y does not change if G increases, the composition of aggregate demand changes, which will be discussed further below (Gartner, 2009). The current account To extend this discussion to current account balances, the current account can be represented by net exports, or CA=(X-M). Together with the financial account and the capital account, the current account is part of the international balance of payments. The current account records the net exports of goods and services, while the financial account measures the difference between sales of assets to foreigners and purchases of assets abroad (where buying international assets is recording as a - and selling domestic assets internationally a + in the financial account) (Krugman & Obstfeld, 2009). The current account and financial account mirror one another: a deficit in the current account must be financed with a surplus in the financial account. The capital account measures transfers of wealth between countries, and for the most partresult[s] from nonmarket activities orpossibly intangible assets (such as copyrights and trademarks) (2009). The financial and capital accounts will not be discussed further in this paper. The national income identity can also be rearranged so that the current account represents the difference between national income and domestic residents spending: Y-(C+I+G) = CA (2009). Since savings is Y-C-G, it can also be represented by S=I+CA. The current account, in turn, can be represented as savings minus investment, S-I. (2009) The national income identity can also be written by indentifying all the leakages (public and private savings, or S=Y-C-G, taxes, T, imports) and injections (government expenditure, investment, exports) in the economy as (S-I)+(T-G)+(M-X)=0 (Gartner, 2009), which is helpful in identifying changes in the composition of aggregate demand. According to Krugman & Obstfeld (2009), an increase in G will not affect S or I, but instead induce a rise in (MX), implying a decrease in net exports. While the term twin deficits refers to countries that run both fiscal and current account deficits, it is important to note again that no explanation for the cause of twin deficits can be gleaned from simple identities.

Inflation Inflation is simply defined as the rate at which prices increase (Gartner, 2009). Inflation can be driven by increases in demand for things like food and labor. Additional causes for inflation can include domestic developments such as wage increases out of line with productivity and employment considerations, inappropriate fiscal policies, unsustainable expansions of profit margins or untenable demand developments caused by, for instance, excessive increases in house prices or financial asset price bubble (European Central Bank(1), 2003). Typically, a countrys national central bank is charged with maintaining price stability within a country through the use of monetary policy. Many central banks achieve this via inflation targeting goals. Loose monetary policy is associated with increasing inflation (an increase in the rate at which prices rise) while restrictive policy is associated with a reduction of the rate at which prices rise (2009). In the Eurozone, countries are governed by one monetary policy carried out by the European Central Bank (European Central Bank(2)). According to its website, the ECB aims at inflation rates of below, but close to, 2% over the medium term. The Maastricht criteria for Eurozone countries stipulates that a countrys inflation rate should be no more than 1.5 percentage points above the rate for the three EU countries with the lowest inflation over the previous year (Europa).

Current account and fiscal balances in the Eurozone


In their investigation into the divergent current account imbalances in the Eurozone, Blanchard and Giavazzi (2002) describe them as a natural consequence of European integration. It is what theory suggests can and should happen when countries become more closely linked in goods and financial markets: poor countries with higher expected rates of return and better growth prospects should see an increase in investment and a decrease in savings (2002). Both a decrease in savings and an increase in investment

deteriorate the current account. See Table 1 for a comparison of real GDP per capita in the four countries under investigation in this paper.
Table 1, GDP per capita in US $, constant prices, constant PPP Germany 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Data from OECD 25,949 26,222 26,177 26,108 26,430 26,641 27,571 28,339 28,669 27,398 28,434 Netherlands 29,406 29,746 29,577 29,537 30,099 30,638 31,631 32,797 33,288 31,817 32,215 Portugal 17,749 17,980 17,976 17,684 17,856 17,910 18,108 18,498 18,472 17,994 18,228 Spain 21,320 21,850 22,119 22,429 22,789 23,228 23,794 24,202 24,025 22,961 22,857

European integration also had an effect on lending and borrowing behavior. Blanchard and Giavazzi (2002) explain that the Eurozones financial and monetary integration lowered perceived risks for investors, and the borrowing costs for both consumption and investment. Eurozone regulations also improved the quality of available information (2002). These developments encouraged investors to lend to Eurozone governments. In addition to the perceived drop in risk and lower borrowing costs, the Eurozone offered access to credit which may have not been previously available to countries which recently joined (Gruber and Kamin, 2007). Between the four countries under investigation in this paper, the theory predicts that the Netherlands and Germany would run current account surpluses, and Portugal and Spain would run current account deficits. Twin deficits According to the story above, increased borrowing opportunities stemming from European integration may have caused fiscal deficits that in turn led to current account deficits also observed in this period. There are several papers dedicated to twin deficits relationship. Khalid and Guan

(1998) investigated the connection on a sample of developing and developed countries between the 1950s and early 1990s. They argue that in a Keynesian framework, budget deficits would increase demand and expand imports, deteriorating the current account (1998). The Keynesian theory is well explained in a 1993 article by Seater: On the one hand, an increase in debt stimulated the economy in the short run by making households feel wealthier. On the other hand, public debt competed with private debt for available funds, thus driving up interest rates and changing the composition of output, in particular crowding out private investment. (1993) Similarly, Freund (2005) wrote in her paper on the costs of current account reversals that a budget deficit could worsen the international balance because of the impact of higher government spending on aggregate demand (2005). Table 2 below shows that Portugal and Spain (except for 2005-2007) have consistently had twin deficits since 2000. The Netherlands and Germany, however, have run fiscal deficits without any effect on the trade deficit. In my analysis, I expect the fiscal deficit to Granger cause trade deficits in Portugal and Spain, but to find no link between the two deficits in the Netherlands and Germany.
Table 2, Current account and fiscal balances as a percentage of GDP Germany CA 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 -1.8 0.0 2.0 1.9 4.6 5.0 6.2 7.5 6.2 5.6 5.6 Fiscal 1.3 -2.8 -3.7 -4.0 -3.8 -3.3 -1.6 0.3 0.1 -3.0 -3.3 Netherlands CA 1.9 2.4 2.5 5.5 7.6 7.4 9.3 6.7 4.4 4.9 7.6 Fiscal 2.0 -0.2 -2.1 -3.1 -1.7 -0.3 0.5 0.2 0.6 -5.5 -5.4 Portugal CA -10.4 -10.4 -8.3 -6.5 -8.3 -10.4 -10.7 -10.1 -12.6 -10.2 -9.7 Fiscal -2.9 -4.3 -2.9 -3.0 -3.4 -5.9 -4.1 -3.1 -3.5 -10.1 -9.1 CA -4.0 -4.0 -3.3 -3.5 -5.2 -7.4 -9.0 -10.0 -9.6 -5.1 -4.5 Spain Fiscal -1.0 -0.6 -0.5 -0.2 -0.3 1.0 2.0 1.9 -4.2 -11.1 -9.2

Data from OECD and Eurostat

Despite the theoretical evidence, empirical confirmation that the fiscal deficit causes the current account deficit in both developing and developed countries has been less than conclusive (Khalid and Guan, 1998). There may be, for example, a third variable that affects both the current and the fiscal balance in the same way (Vamvoukas, 1999). As Blanchard and Giavazzi (2002) imply, increased borrowing and current account deficits are consequences of catch-up growth among smaller European economies. Causal relationship between fiscal deficits and current account deficits among smaller economies in the Eurozone may be an outcome of, or lead to, economic growth. Freund (2005) also suggests that strong income growth leads to a worsening current account deficit, and as growth slows the current account imbalance shrinks. In this case, causality may run from growth to the fiscal balance (strong growth or growth prospects making investors more willing to lend) to the current account balance. It is also possible the causality runs from growth directly to the trade balance because the textbook Keynesian model predicts a worsening of the trade balance both under fixed exchange rates and under flexible exchange rates when trade balance is made a function of income (Beetsma, Giuliodori and Klaassen, 2007). In my analysis, I expect growth to predict further deterioration of the fiscal and trade balances because higher incomes would increase demand, and higher growth prospects may make investors more willing to lend to a country. Causality is expected to run both ways, with fiscal and trade deficits also leading to growth. The most popular argument against the idea that fiscal deficits cause current account deficits is Ricardian Equivalence, which states that deficit spending by governments will not affect economic activity (Seater, 1993). With Ricardian equivalence, a public budget deficit immediately stimulates private savings to pay for future taxes, which implies an improvement in the current account balance (Reisen, 1998). However, look at recent Eurozone data shows that the channel through which [the current account deficits] occurred appears to be primarily a decrease in savingstypically private savingsrather than increased

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investment

(Blanchard

and

Giavazzi,

2002).

And

Jaumotte

and

Sodsriwiboon note that current account deficits in the Euro zone during the 2000s were heavily financed with debt instead of FDI even though the creation of the EMU was marked [at first] by a substantial improvement in macroeconomic policies, including fiscal balances (2010). According to the authors, Spain, Greece and to a lesser extent Italy were large importers of bond-related inflows, while Portugaltook in large foreign loans at the beginning of the 21st century (2010). Jaumotte and Sodsriwiboon have suggested increased government savings fiscal consolidation as a means to reign in deteriorating current accounts (2010).

Inflation in the Eurozone


Even though Eurozone countries are governed by one monetary policy, they do not all have the same level of inflation due to structural difference and persistent pre-Eurozone inflation (Lane, 2006). In such a situation, real interest rates should differ: higher-inflation countries would have lower real interest rates, and the real interest rates in lower-inflation countries would be higher. According to Blanchard and Giavazzi (2002), monetary policy kept interest rates low in the early 2000s, which reduced real interest rates and increased demand in persistent-inflation countries like Spain, exacerbating the problem. At the same time, the policy kept investment demand and inflation low in Germany (2002). See Table 3 for an overview of inflation in the Eurozone countries of interest since 2001.
Table 3, Yearly inflation in select Eurozone countries 2001 Germany Netherlands Portugal Spain Data from OECD 1.94 4.16 4.35 3.59 2002 1.48 3.29 3.56 3.07 2003 1.04 2.11 3.27 3.04 2004 1.65 1.24 2.36 3.04 2005 1.52 1.67 2.29 3.37 2006 1.60 1.17 3.10 3.52 2007 2.26 1.61 2.45 2.79 2008 2.60 2.49 2.57 4.08 2009 0.38 1.19 -0.83 -0.29

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Balassa-Samuelson Effect Smaller, post-integration economies may also experience higher inflation due to the Balassa-Samuelson Effect. According to Rabanal (2006) in a la Caixa publication, the Balassa-Samuelson effect is typically used to explain inflation differentials for those countries experiencing a catching-up process. He explains the effect as follows: Suppose that the sectors of an economy that are open to international trade (the tradable sectors) experience high productivity growth. This can happen, as in the case of the EMU, when a group of countries increase economic integration, barriers to trade fall, and hence it is easier to import more productive technologies from the more advanced countries. The higher productivity in the tradable sector increases the marginal product of labor in that sector, and therefore labor demand. This puts upward pressure on wages, which increase for the whole economy. Since prices are set as a markup over production costs, inflation increases in the sectors of the economy not open to international trade (the nontradable sector), that do not benefit from productivity improvements but face higher wages. (2006) However, Rabanal notes that the economic growth Spain in particular experienced since 2000 came from the nontradable sector. Declining productivity in the nontraded sector would imply higher inflation but lower output in this sector, so the Balassa-Samuelson Effect could not be the only reason for increasing inflation (2006). The fact that output and prices in the nontradable sector increased means demand factors must have played an important role (2006). According to Zemanek, Belke and Schnabl (2009), second-round inflation effects can be induced from wage increases in the nontradable sector as trade unions in the tradable sector claim inflation compensation in the wage bargaining process. I expect growth and the fiscal balance to Granger cause inflation in Portugal and Spain. However, only growth will Granger cause inflation in Germany and the Netherlands.

The crisis
The financial crisis and subsequent recession of the late 2000s began in the last quarter of 2007 and lasted until the first quarter of 2009, according to the National Bureau Economic Research (NBER, 2010). Because of the

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large effects the crisis had for the global economy, it will be included as a dummy variable in the Granger regression equations. I expect that the financial crisis will have a negative and significant relationship with growth on all countries under investigation. I also expect the crisis to have a negative and significant effect on the fiscal balance, the trade balance and inflation. For a review of all the hypotheses mentioned, please see Box 2.
Box 2. Review of hypotheses 1. Fiscal deficits Granger cause trade deficits in Portugal and Spain. There will be no causal relationship between fiscal and trade balances for the Netherlands and Germany. 2. Fiscal and trade deficits lead to growth in Portugal and Spain, but not in Germany or the Netherlands. The causality between fiscal and trade deficits and growth for Portugal and Spain will run both ways. 3. Growth Granger causes inflation in all countries in the sample. 4. The fiscal balance Granger causes inflation in Portugal and Spain, but not in the Netherlands or Germany. 5. The financial crisis of the late 2000s will have a significant negative effect on growth, the fiscal balance, the trade balance and inflation for all countries in the sample.

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3. Empirical framework
The endogeneity of economic growth and the chosen variables lends itself to a vector autoregressive (VAR) model. According to Fregert (2004) a VAR model is a multi-equation system where all the variables are treated as endogenous [and] there is thus one equation for each variable as dependent variable. In addition to testing the given hypotheses, running the Granger causality specification for each variable in the model also allows to test if causality runs both ways between a set of variables. Granger causality tests use VAR-based models to test the predictive ability of the independent variables on the dependent variable (Studenmund, 2006). Causality is determined for each variable by the significance of an Ftest that includes the beta coefficients on all lags. Piersanti (2000) ran Granger causality tests for a number of OECD countries for data between 1970-1997 to investigate if current account deficits are linked to expected budget deficits. Vamvoukas (1999) and Khalid and Guan (1998) both use Granger causality tests to investigate the twin deficits phenomenon (Vamvoukas, 1999). However, Vamvoukas bases his analysis on trivariate causality tests in order to prevent spurious results that may occur when important variables are omitted (1999). Specifically, he runs two separate models in which either real output or inflationconsiderable determinants of government and trade deficitsare added as a third variable (1999). While Vamvoukas uses a Vector Error Correction model and cointegration analysis, the model used here is an unrestricted VAR as in Aksoy and Piskorski (2006).

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4. Data and Methodology


To study the relationship between the trade balance, the fiscal balance, inflation and growth within economies of different sizes in the Eurozone, Granger causality tests will be performed on Germany, the Netherlands, Spain and Portugal. Seasonally adjusted, quarterly data from Eurostat and the OECD during the period 1999-4 and 2010-4 is used in the analysis. The trade balance will be a proxy for the current account balance. The analysis will be comprised of two models, with three versions of each model used to test the hypotheses in Box 2, for a total of six equations. The two main models are: Equation 1.1: tb /gdpt = "0 + "1tb /gdpt #k + "2 y t #k + "3 fis /gdpt #k + "4 crisis Equation 2.1: "t = #0 + #1"t $k + #2 y t $k + #3 fis /gdpt $k + #4 crisis , ! where y is real economic growth, also referred to as growth, fis/gdp is the fiscal! balance, tb/gdp is the trade balance, " , or inf, is the inflation rate and
!
.

crisis is a dummy variable that takes a value of 1 in the fourth quarter of 2007 through the first quarter of 2009, and zero otherwise. The subscript t refers to ! the present time of each respective quarter, t, and k refers to the lag length (k=-1, -2, -n). The variable definitions and appropriate lag lengths per model are further explained in the Appendix. Equation 1.1 will test Hypothesis 1, found in Box 2, and analyzes if causality runs from the fiscal balance to the trade balance. This hypothesis is linked to Subquestion 2. Equation 1.2, listed below, tests the causality from the fiscal balance and the trade balance to growth. Equation 1.2: y t = "0 + "1 y t #k + "2 fis /gdpt #k + "3 tb /gdpt #k + "4 crisis Equation 1.3 will test if there is reverse causality: if the Granger causality runs ! from growth to the fiscal balance as well. Equations 1.2 and 1.3 are key to answering Subquestion 3 in Box 1. Equation 1.3: fis /gdpt = "0 + "1 fis /gdpt #k + "2 y t #k + "3 tb /gdpt #k + "4 crisis
. . .

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Hypothesis 3 and 4, which state that causality goes from growth or the fiscal balance to inflation, respectively, will be tested with Equation 2.1 below. These equations will help answer Subquestions 4 and 5 in Box 2. Equation 2.2 and Equation 2.3 are not used to test a specific hypothesis, but will determine if any reverse causality exists between inflation, growth and the fiscal balance. Equation 2.1: "t = #0 + #1"t $k + #2 y t $k + #3 fis /gdpt $k + #4 crisis Equation 2.2: y t = "0 + "1 y t #k + "2 fis /gdpt #k + "3$t #k + crisis ! . fis /gdpt = "0 + "1 fis /gdpt #k + "2 y t #k + "3$t #k + crisis Equation 2.3: !
. .

!The presence of the dummy variable crisis in each model will be used to test the effects on the financial crisis as stated in Hypothesis 5.

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5. Results
In this section, the results most pertinent to the original research question and subquestions will be discussed. Each subquestion2 (in bold) and hypothesis (in italics) will be considered together. See Boxes 1 and 2 for summaries of each. For descriptive statistics, a full description of sensitivity analysis, and a summary of the overall results, please see the Appendix. Tables 5 and 6 on page 24 provide an overview of the p-values of the F-tests performed on each equation, and will be referred to throughout this section. (1) Does the fiscal deficit lead to a current account deficit in smaller Eurozone economies? Does this hold for larger economies? (H1) Fiscal deficits Granger cause trade deficits in Portugal and Spain. There will be no causal relationship between fiscal and trade balances for the Netherlands and Germany. Fiscal balances d0 not predict trade balances in Portugal or Spain as tested by Equation 1.1, and reported in Table 5, Rows 9 and 12. Fiscal balances also do not predict trade balances for Germany (see Row 3). However, in the Netherlands, fiscal balances do predict trade balances, and the net effect is negative, such that an improvement in the fiscal balance would lead to a deterioration of the trade balance. Please see Table 5, Row 6 for the p-values. Trade balances do not predict fiscal balances for any country in the sample as investigated with Equation 1.3. The p-values for this specification for each country are reported in Table 5, Rows 2, 5, 8 and 11. These results suggest that growing trade and deficit balances (twin deficits) are the result of another variable affecting them both, possibly growth, which will be examined next. The results from the Netherlands may be idiosyncratic to the characteristics of the Dutch economy, and/or the time period under investigation. The fact that the twin deficits in Portugal and Spain do not predict each other suggests that simply improving the fiscal balance would not be enough to improve the current account balance.

The first Subquestion has been skipped because it was answered in Section 2. Subquestion 2 is referred to here as (1).

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(2)Do fiscal and current account deficits predict future growth? Or does growth in less developed countries cause fiscal and current account deficits? (H2) Fiscal and trade deficits lead to growth in Portugal and Spain, but not in Germany or the Netherlands. The causality between fiscal and trade deficits and growth for Portugal and Spain will run both ways. Despite strong theoretical arguments relating to catch up growth and the current account balance, the significance of the results varies between Portugal and Spain. Portugal has a lower GDP per capita than Spain (see Table 1), which implies that results related to catch-up growth would be more likely to hold for Portugal. However, when Equation 1.2 is run for Portugal, there is no evidence that fiscal or trade deficits predict growth. See Table 5, Row 7, for the respective p-values. A look at the development of the three variables over time in Portugal can be found in Figure 1.
Figure 1, Portugal: Development of key variables

Tests for reverse causality (from growth to trade and fiscal deficits due to increased demand, for example) also come up short. When testing Equation 1.1 and 1.3 for Portugal, growth is insignificant in predicting both trade deficits and fiscal deficits. See Rows 8 and 9 of Table 5. Furthermore, the net effect of growth on the fiscal balance is positive, suggesting that growth leads to an improvement in the fiscal balance. The net effect of growth on the trade balance is negative.

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In Spain, however, the fiscal balance is significant in predicting growth when Equation 1.2 is run, and the net effect is negative. This equation is run in first differences, so the evidence for fiscal deficits predicting positive growth is weaker than if the equation was run in levels. This result could reflect changes in the business cycle: that large changes in the deficit due to a recession lead to slower economic growth. The respective p-values can be found in Table 5, Row 10. Additionally, the causality between growth and the fiscal balance runs both ways as shown by Equation 1.3 (Table 5, Row 11). When growth changes, the fiscal balance changes. Growth was insignificant, however, in predicting the trade balance. See Figure 2 for the development of Spanish growth, the fiscal balance and trade balance.
Figure 2, Spain: Development of key variables

For the larger Northern economies, Germany and the Netherlands, the trade and fiscal balances are insignificant in predicting growth as tested in Equation 1.2. The p-values can be found in Table 5, Rows 1 and 4. Growth does not predict an improvement in the trade balance or fiscal balance for Germany as tested in Equations 1.1 and 1.3. However, growth does predict an improvement in fiscal balances for Germany when Equation 2.3 is estimated. In the Netherlands, growth was significant in predicting the fiscal balance and the trade balance (see Table 5, Rows 5 and 6), and the relationship is positive. It may be the case that macroeconomic balances in the Netherlands are more

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procyclical than in Germany. For the development of key variables over time in Germany, see Figure 3. While causality from fiscal deficits to trade deficits is not responsible for the twin deficits in Portugal and Spain, the third variable influencing them both is not growth. This result suggests that the trade and fiscal balances run by these countries have for the most part not been used to import or fund productive investment. If Portugal and Spain had been running trade deficits due to the import of productive assets, it should have led to higher growth. However, it could also be the case that the time span considered in this analysis was too short to capture this effect. On the other hand, the positive relationship from growth to the fiscal balance in all of the countries in the sample, except Portugal, suggests that the business cycle plays a large role in the development of government finances.
Figure 3, Germany: Development of key variables, Model 1

(3)Does growth lead to higher inflation in Eurozone countries? Is this effect stronger for less-developed, smaller economies? (H3) Growth Granger causes inflation in all countries in the sample.

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Growth Granger causes inflation in all countries3 except the Netherlands when Equation 2.1 is tested. There is little difference in the significance of these estimates, and in two out of the three cases, the relationship between growth and inflation is positive as expected. There is no clear evidence that the policy restrictions relating to inflation in the Eurozone affect smaller economies differently than larger economies. On the contrary, while growth Granger causes inflation in Portugal, the relationship is negative. This is a strange result, but could be explained by high historical inflation that persists despite slowing growth. Baldwin reports Portugal saw slower growth but higher ination between 2000-2007 (2010). (4)Is there a causal relationship between inflation and the budget deficit, and is it more significant in smaller Eurozone economies than larger economies? (H4) The fiscal balance Granger causes inflation in Portugal and Spain, but not in the Netherlands or Germany. In Portugal and Spain, the fiscal deficit was significant in predicting inflation at the 1% level when Equation 2.1 is tested. The relationship is positive; however, the equation is run in first differences, so that changes in the fiscal balance ratio lead to changes in inflation. The fiscal balance is insignificant in predicting inflation in the Netherlands and Germany. See Table 5, Rows 3, 6, 9 and 12 for the p-values for Germany, the Netherlands, Spain and Portugal, respectively. The development of the key variables of Model 1 for the Netherlands can be found in Figure 4. The development of the variables for Model 2 for all countries can be found in Figure 5 below.

For Spain and Portugal, this equation was run in first-differences, implying that as growth changes, inflation changes.

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Figure 4, Netherlands: Development of key variables, Model 1

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Figure 5, Development of key variables, Model 2

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Table 5, Granger results: p-value from F-test, Model 1 H0: A does not cause B, reject H0 if p<0.10 Dep. variable Independent variables Row Germany Real growth Fis/GDP Tb/GDP 1 Real growth -.897(-) .848(-) 2 Fis/GDP 0.12(+) -0.95 (d)(-) 3 Tb/GDP 0.63(+) 0.24(-) -Netherlands 4 Real growth -0.56(d)(+) 0.32(d)(+) 5 Fis /GDP 0.00(+)*** -0.56(+) 6 Tb /GDP 0.09(+)* 0.02(-)** -Portugal 7 Real growth -0.18(d)(+) 0.63(d)(+) 8 Fis /GDP 0.16(+) -0.36(+) 9 Tb /GDP 0.24(-) 0.68(-) -Spain 10 Real growth -0.00(d)(-)*** 0.27(d)(-) 11 Fis /GDP 0.00(d)(+)*** -- (d) 0.93(d)(+) 12 Tb/GDP 0.25(-) 0.77(-) --

Note: (d) indicates if variable was run in first differences, (+, -) indicates if the net effect was positive or negative. Asterisks denote significance levels as follows: ***1%, **5%, *10%.
Table 6, Granger results: p-value from F-test, Model 2 H0: A does not cause B, reject H0 if p<0.10 Dep. variable Independent variables Row Germany Real growth Fis/GDP Inflation 1 Real growth -0.51(-) 0.44(+) 2 Fis/GDP 0.08(+)* -0.33(-) 3 Inflation 0.04(+)** 0.17(d)(+) --Netherlands 4 Real growth -0.48(d)(+) 0.49(-) 5 Fis/GDP 0.00(+)*** -0.33(d)(-) 6 Inflation 0.23(+) 0.75(d)(-) -Portugal 7 Real growth -0.14(d)(-) 0.24(d)(-) 8 Fis/GDP 0.14(d)(+) -0.33(d)(+) 9 Inflation 0.05(d)(-)** 0.00(d)(+)*** -Spain 10 Real growth -0.03 (d)(+)** 0.18(-) 11 Fis/GDP 0.01(d)(+)*** -0.55(-) 12 Inflation 0.00(d)(+)*** 0.00(d)(+)*** --

Note: (d) indicates if variable was run in first differences, (+, -) indicates if the net effect was positive or negative. Asterisks denote significance levels as follows: ***1%, **5%, *10%.

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The crisis (H5) The financial crisis will have a significant negative effect on growth, the fiscal balance, the trade balance and inflation for all countries tested. The crisis has a significant negative effect on growth in Germany, the Netherlands and Spain when Equation 1.2 is tested. When estimating Equation 1.3, the crisis has a positive significant effect on the fiscal balance in Germany. The coefficients and significance of the crisis dummy are shown in Table 7 below. The effect of the crisis on fiscal balances and inflation was significant in the Portugal, but negative for fiscal balances and positive for inflation. In Spain, the fiscal balance is negatively affected by the crisis, but inflation was positively affected.
Table 7, Coefficients on crisis dummy Dep. variable Growth Fis/GDP Germany -.0117* .006375** Netherlands -.0074* .00099 Portugal -.0054 -.011*** Spain -.0039*** -.0078***

Tb/GDP -.006233 -.00126 -.0039 .0022

Inf .0012 .001 .003* .0128***

Coefficients marked *** are significant at the 1% level, **5%, *10%. It is surprising that the crisis has significant, positive coefficients on inflation for Portugal and Spain, although this may have been caused by events that coincided the crisis, but were not explicitly accounted for in the regression estimate. It is also surprising that the coefficient on the dummy variable is positive for Germany when the dependent variable is the fiscal balance, implying a fiscal improvement during the recession period. A summary of all the significant Granger causal relationships found is shown in Table 8 below.
Table 8, Significant results, Models 1 and 2 Country Causality Germany Real growth ! Fiscal balance Real growth ! Inflation Netherlands Real growth ! Fiscal balance Real growth ! Trade balance Fiscal balance ! Trade balance Portugal Real growth ! Inflation (d) Fiscal balance ! Inflation (d) Spain Fiscal balance ! Real growth (d) Real growth ! Fiscal balance (d) Real growth ! Inflation (d) Fiscal balance ! Inflation (d)

Sign + + + + + + + +

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6. Conclusion
This paper was written to investigate the effect of current account and fiscal balances on growth and inflation. If current account and fiscal deficits were found to predict growth, it would deepen the discussion about the dangers of macroeconomic imbalances in the Eurozone, because these dangerous imbalances would also be bearers of future economic growth. Furthermore, if fiscal deficits were found to cause trade deficits, then policy discussions about how to improve these imbalances could focus on the fiscal deficit. By comparing the results between larger and smaller European countries, the thesis aimed to analyze if the restrictions of the Maastricht criteria discriminated against countries that experienced catch-up growth. A Granger causal analysis of inflation was also included to test if the relationship between growth and inflation differed between different economies, and if excess demand caused by fiscal deficit spending caused inflation in different types of Eurozone economies. For the two smaller, Southern European economies investigated, only Spain provides any evidence of a catch-up phenomenon where fiscal deficits would affect economic growth, as seen in Table 8. However, fiscal deficits were not found to cause trade deficits. Furthermore, economic growth also leads to an improvement of the fiscal balance in Spain. For Portugal, there is no evidence that fiscal deficits have caused trade deficits over the period 19992010. The source of the twin deficits found in these countries is therefore not the fiscal deficit. The Netherlands is the only country in which there was causality from the fiscal balance to the trade balance, but the relationship is negative. The Netherlands is also the only country in which economic growth predicts an improvement in the trade balance. In every country except Portugal, growth leads to an improvement of, or causes changes in, the fiscal balance. The procyclical result is not surprising. The fiscal balance is defined as G-T, and T, tax revenue, is an automatic stabilizer that falls during periods of recession due to higher unemployment and lower corporate profits, and increases during periods of growth. Growth causes inflation in all Eurozone economies tested except the Netherlands, but the fiscal balance only causes inflation in Spain and Portugal.

26

In order to determine the best policy to narrow widening macroeconomic imbalances, a similar analysis should include more countries. The two representative problem countries used here gave conflicting results as to whether fiscal deficits predict growth. Ideally, one would include more countries over a longer period of time. Furthermore, Granger causality should be tested using different variables. The twin deficits in Spain and Portugal could be caused by consumption growth or investment. Interesting results might also be yielded if the trade balance was separated into two variables, exports and imports, as done in Beetsma, Giuliodori and Klaassen (2007). Furthermore, this thesis does not investigate the long-run relationship between budget deficits and trade deficits. The current results suggest excess inflation in certain Eurozone countries can be addressed through tighter fiscal policies. There is also evidence that improving the fiscal balance would not be enough to improve the current account balance. Moreover, the procyclical behavior of the fiscal balance serves as a reminder to EU policymakers that SGP reform of deficit and debt rules should be at least mildly countercyclical (Manassee, 2010). Economist have warned that the current proposed SGP reform exacerbates the problem of pro-cyclical adjustment: the debt rule, similarly to the deficit rule, requires tougher budget cuts the deeper the recession (2010). These deep required budget cuts during a recession might pose a larger threat to the stability of the Eurozone than the disparities they are meant to address. Reform that demands frugal fiscal policy during boom times, when unemployment is low, could make it easier to bring the Eurozone into balance.

27

7. References
Aksoy, Yunus and Piskorski, Tomasz (2006). U.S. domestic money, inflation and output. Journal of Monetary Economics, 53 (2006), 183197. Baldwin, Richard, Gros, Daniel and Laeven, Luc (2010). Completing the Eurozone Rescue: What more needs to be done? Centre for Economic Policy Research/A VoxEU.org publication. Accessed 18 June 2011 at http://www.voxeu.org/reports/EZ_Rescue.pdf Beetsma, Roel, Giuliodori, Massimo and Klaassen, Franc (2007). The Effects of Public Spending Shocks on Trade Balances in the European Union. University of Amsterdam working paper. Accessed 2 June 2011 at http://www.etsg.org/ETSG2007/papers/klaassen.pdf Blanchard, Olivier and Giavazzi, Francesco (2002). Current Account Deficits in the Euro Area: The End of the Feldstein-Horioka Puzzle? Brookings Papers on Economic Activity, 2(2002), pp. 147-186. Accessed 2 September 2010 at http://www.jstor.org/sTable/1209205 Edwards, Sebastian (2002). Does the current account matter? Preventing Currency Crises in Emerging Markets. University of Chicago Press. Accessed 20 April 2011 at https://www.nber.org/chapters/c10633 Europa. A plain language guide to Eurojargon. Accessed 14 June 2011 at http://europa.eu/abc/eurojargon/index_en.htm European Central Bank (1). Inflation differentials in the Euro Area: Potential causes and policy implications. Accessed 25 July 2010 at http://www.ecb.int/pub/pdf/other/inflationdifferentialreporten.pdf European Central Bank(2). Monetary Policy. Accessed 10 June 2011 at http://www.ecb.int/mopo/html/index.en.html European Commission. Economic and Financial Affairs, Focus on Inflation: Glossary. Accessed 25 June 2011 from http://ec.europa.eu/economy_finance/focuson/inflation/glossary_en. htm#sgp Eurostat. Fiscal balances, external (trade) balances. Accessed 25 May 2011 at http://epp.eurostat.ec.europa.eu/portal/page/portal/government_fina nce_statistics/data/main_Tables Fregert, Klas (2004). Chapter 6. Multivariate time series models. Practical Macroeconomics. Textbook draft. Department of Economics, Lund University. Accessed 10 May 2011 at http://www.nek.lu.se/NEKKFR/Practical%20macro/Practical%20mac ro.htm Freund, Caroline (2005). Current account adjustment in industrial countries. Journal of International Money and Finance, 24(2005), pp. 1278-1298.

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Gruber, Joseph W. and Steven B. Kamin (2007). Explaining the global pattern of current account imbalances. Journal of Money and Finance (26), pp. 500-522. Hewitt, Gavin (3 June 2011). Jean-Claude Trichet outlines his European dream. BBC Business News. Accessed 3 June 2011 at http://www.bbc.co.uk/news/business-13641063 Khalid and Guan (1998). Causality tests of budget and current account deficits: Cross-country comparisons. Empirical Economics (1999) 24(389) Lane, Philip R. (2006). The Real Effects of European Monetary Union. Journal of Economic Perspectives. Vol. 20 (4), pp. 4766. Maddala, G.S. and Kim, In-Moo (2000). Unit Roots, Cointegration, and Structural Change. Cambridge University Press. Manasse, Paolo (2010). Stability and Growth Pact: Counterproductive proposals. Accessed 23 June 2011 at http://www.voxeu.org/index.php?q=node/5632 NBER (2010). Business Cycle Dating Committee. Accessed 20 May 2011 at http://www.nber.org/cycles/sept2010.html OECD Stat Extract. Real GDP, inflation, nominal GDP. Piersanti, Giovanni (2000). Current account dynamics and expected future budget deficits: some international evidence. Journal of International Money and Finance, 19(2000), 255-271. Rabanal, Paul (2006). Inflation Differentials in a Currency Union: A DSGE Perspective. La Caixa Research Department publication. Reisen, Helmut (1998). Sustainable and Excessive Current Account Deficits. Empirica 25, 111131. Accessed on 22 May 2011 at Seater, John J. (1993). Ricardian Equivalence. Journal of Economic Literature 31(1993), pp. 142-190. Studenmund, A.H. (2006). Pearson/Addison-Wesley. Using Econometrics. Fifth Edition.

Vamvoukas, George A. (1999). The twin deficits phenomenon: Evidence from Greece. Applied Economics 31(9). 1093-1100. Zemanek, Holger, Ansgar Belke and Gunther Schnabl (2009). Current Account Imbalances and Structural Adjustment in the Euro Area: How to Rebalance Competitiveness. DIW Berlin: German Institute for Economic Research. Discussion paper 895. Retrieved 10 June 2010 at http://ssrn.com/abstract=1400645

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8. Appendix
Variable definitions
Table 4, Variable definitions Variable Description growth, y tb/gdp
.

Source OECD OECD Eurostat OECD NBER

Real GDP growth External trade balance as share of GDP Fiscal balance as a share of GDP Inflation, consumer prices Takes the value of one for the period 2007:42009:2, zero otherwise

!
fis/gdp inf, " Crisis

Descriptive statistics
Table 1. Germany Variable | Obs Mean Std. Dev. Min Max -------------+-------------------------------------------------------ggrowth | 45 .0028063 .0091117 -.036275 .020897 gfisgdp | 45 -.0208853 .0180847 -.0422084 .0156825 gtbgdp | 45 .0451965 .02024 -.000503 .074818 ginf | 45 .0038275 .0033916 -.0055883 .009497

Table 2. Netherlands Variable | Obs Mean Std. Dev. Min Max -------------+-------------------------------------------------------nlgrowth | 45 .0038912 .0074794 -.0240257 .0153659 nlfisgdp | 45 -.011363 .0221732 -.0621295 .0199704 nltbgdp | 45 .0714469 .0117253 .0399683 .0896801 nlinf | 45 .005028 .0052915 -.0089563 .0150485

Table 3. Portugal Variable | Obs Mean Std. Dev. Min Max -------------+-------------------------------------------------------pgrowth | 45 .0021601 .0086343 -.0200372 .0221039 pfisgdp | 45 -.0168138 .0403359 -.1153581 .0274867 ptbgdp | 45 -.0875969 .0151843 -.1235012 -.0603103 pinf | 45 .0062294 .0068904 -.0093427 .0180473

Table 4. Spain Variable | Obs Mean Std. Dev. Min Max -------------+-------------------------------------------------------spgrowth | 45 .0055013 .0065219 -.0160847 .0150719 spfisgdp | 45 -.0168138 .0403359 -.1153581 .0274867 sptbgdp | 45 -.0383878 .0184347 -.0748099 -.0128128 spinf | 45 .0071972 .0097657 -.0164946 .023791

Note: All values in decimals, not percentages.

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Sensitivity analysis
The models are estimated using Ordinary Least Squares (OLS), and a White Test is performed to check for heteroskedasticity as in Khalid and Guan (1998). The Breusch-Godfrey test is used to check for serial correlation of the error term. Augmented Dickey-Fuller tests are performed on each variable to check for stationarity. The optimal lag length of each model is determined using three commonly used tests: Akaike Information Criterion, Schwarz Bayesian Information Criterion and the Hannan-Quinn Information Criterion. A common problem in this analysis is the presence of higher-order autocorrelation and non-stationary variables. To correct these issues, first differences or additional lags (see Toma and Yamamoto,1995, as quoted in Maddala and Kim,1998) are used. When using the Toma and Yamamoto method, only the lag lengths first specified as optimal will be checked for significance. In the case of first-order autocorrelation, the Prais-Winston method is used. In terms of non-stationarity, the dummy variable, crisis, has been ignored. Where heteroskedasticity is found, robust standard errors are used.

Summary of results
Germany Model 1 For the first Granger specification with growth as the dependent variable, the regression is heteroskedastic and has no serial correlation. The optimal lag order is one. The trade balance and fiscal balance as ratios of GDP are non-stationary, and are corrected by including extra lags of the nonstationary variables into the equation as in Toma and Yamamoto (1995) as quoted in Maddala and Kim (1998). Results: In the case of Germany, there is no Granger causal relationship from the fiscal and trade balance as a percentage of GDP, to growth. P-values from the F-tests can be found in Table 5, Row 1. The only variable found significant is the crisis dummy variable (p=.068), and the sign is negative as expected. The coefficient on the lag of growth has a positive sign, while the coefficients the fiscal balance and the trade balance are negative. This is consistent with the first-difference regression. The adjusted R-squared of the equation is 0.2831. When testing the equation with the fiscal balance as the dependent variable, the appropriate lag length is given as 3 or 4 depending on the test used. I used three in my analysis per the Schwarz Bayesian Information Criterion test to preserve degrees of freedom. There is no heteroskedasticity. At the 5% level, there is first and fourth order serial correlation, and a unit root is found for the trade balance. After first-differencing the trade balance variable, all serial correlation and non-stationarity has been eliminated. Adding an extra lag to the equation worsens the serial correlation.

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Results: There is no Granger causal relationship from growth or the trade balance to the fiscal balance for Germany (See Table 5, Row 2). The lags of the fiscal balance are significant in explaining the current fiscal balance. The only other significant variable at the 5% level is crisis, which has a positive coefficient. The adjusted R-squared of the equation is 0.935. For the last equation, in which the trade balance is the dependent variable, an optimal lag length of one is used. There is no heteroskedasticity or serial correlation. The fiscal balance and the trade balance are non-stationary, and there is no serial correlation present when extra lags are used in the equation; therefore, this method is used. Results: An F-test shows there is no Granger causal relationship from the fiscal balance or growth to the trade balance. The coefficient of the first lag of the fiscal balance is negative and insignificant with a p-value of 0.235. The coefficient on the first lag of growth is positive and insignificant, with a pvalue of 0.627. The crisis dummy is insignificant and negative. The adjusted R-squared is 0.7960. Model 2 In the first specification of model 2, a lag length of one is chosen because the first test with the dummy variable gives an optimal length of zero. Without the dummy variable, the optimal length is one. There is heteroskedasticity, but no serial correlation. The fiscal balance is found to be non-stationary. After correcting with first differences and with lags, both equations are found to have no serial correlation, so the Tamo and Yamamoto (1995) method of correction is used. Results: Neither inflation or the fiscal deficit is significant in predicting growth for Germany in this period (See Table 6, Row 1). The fiscal balance has a negative, but insignificant coefficient, and the first lag of inflation has a positive, insignificant coefficient. The R-squared is 0.29. When the fiscal balance is the dependent variable, the optimal lag length is three. There is no heteroskedasticity, but there is autocorrelation up to the third order. The variable inflation has a unit root. When an extra lag length is added to address the unit root of inflation, there is no longer any autocorrelation, and this specification is used. Results: All the coefficients of the lags of growth are positive and jointly significant at the ten percent level (p=.0808). The sign of the coefficients on inflation change from negative to positive, but the net effect is negative. An Ftest on all the lags of inflation (excluding the extra lag used for stationarity purposes) is insignificant with a p-value of 0.33. The crisis dummy is positive and significant at the 5% level. The adjusted R-squared is 0.94. When inflation is the dependent variable, the optimal lag length is zero with and without the dummy variable included. One lag will be used in the analysis. There is no heteroskedasticity or serial correlation. The fiscal balance variable has a unit root, and is corrected by first differencing.

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Results: Growth is significant and positive in predicting inflation (p=0.04). The coefficient of the first lag of growth is 0.1356. The coefficient of the fiscal balance is positive and insignificant (p=0.168). The adjusted Rsquared of the equation is 0.0677. Netherlands Model 1 With growth as the dependent variable, the optimal lag length is one. There is heteroskedasticity and no first-order serial correlation. Robust standard errors are used in the final regression. The fiscal balance and the trade balance are non-stationary, and these variables are first differenced in the final model. When an extra lag of these variables is used, serial correlation of the second order is present. Results: An F-test shows both the trade balance and the fiscal balance are insignificant in predicting growth. Both coefficients are positive. The individual p-value for the fiscal balance is 0.56 and for the trade balance is 0.31. The model's R^2 is 0.4459. The crisis is significant (p-value is 0.059) and negative. When the fiscal balance is the dependent variable, an optimal lag length of three is found. There is no heteroskedasticity or serial correlation at the 5 percent level. The trade balance is non-stationary. When the model is first differenced, or an extra lag for the trade balance is used, there is no firstorder serial correlation at the 5 percent level. Results: The trade balance is insignificant in explaining the fiscal balance with a p-value of 0.56. The lags of growth are significant at the 1% level (p-value is 0.0002). The coefficients on growth and the trade balance are all positive. The crisis dummy is positive and insignificant (p=0.59). When the trade balance is the dependent variable, a lag order of two is optimal. There is no heteroskedasticity or serial correlation. Growth and the trade balance have a unit root. When an extra lag is added, there is first-order serial correlation, so the prais command is used. When the equation is firstdifferenced, higher-order serial correlation is present, so this method will not be used. Results: An F-test on the lags of growth shows significance at the 10 percent level (p=0.09) and an F-test on the two lags of the fiscal balance are significant at the 5 percent level (p=0.02). The individual coefficients on growth and the fiscal balance change sign depending on the lag length, but the net effect of growth is positive and the fiscal balance is negative. The crisis dummy is negative and insignificant. Model 2 The appropriate lag length when growth is the dependent variable is one. There is heteroskedasticity, and no first-order serial correlation. The fiscal balance is non-stationary, and the variable is estimated in first differences to correct for this.

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Results: An F-test shows that inflation and the fiscal balance are not significant in predicting growth (See Table 6, Row 4). The coefficient for inflation is negative and insignificant and the coefficient for the firstdifferenced fiscal balance is positive and insignificant. The crisis dummy, which has the expected negative coefficient, is significant at the 5% level. With the fiscal balance as the dependent variable, the optimal lag length is three. There is no heteroskedasticity or serial correlation at the 10 percent level. Inflation is non-stationary. The variable is estimated in first differences. Results: The lags of inflation are jointly insignificant (p=0.33) and the lags of growth are jointly significant at the 1 percent level (p=0.00). All coefficients are negative. The crisis dummy is insignificant and positive. When inflation is the dependent variable, the optimal lag length is four. There is no heteroskedasticity, and no serial correlation at the 5 percent level. The fiscal balance and inflation are non-stationary. When an extra lag is added to inflation and the fiscal balance, or they are first differenced, serial correlation is still present. However, when the non-stationary variables are first-differenced, there is no autocorrelation at the 5% level. Results: An F-test of all the lags of growth is insignificant with a p-value of 0.23, and an F-test of the lags of the fiscal balance has a p-value of 0.78. All the coefficients on the lags of inflation (except the fourth lag) are negative and significant at the 1% level. The signs of the coefficients for the fiscal balance are inconsistent for different lag lengths, but all insignificant. Portugal Model 1 When growth is the dependent variable, the optimal lag length is zero with or without the dummy variable. One lag will be used in the analysis. There is no heteroskedasticity or autocorrelation. The fiscal balance and the trade balance have a unit root. Adding extra lags to the fiscal balance and trade balance leads to serial correlation. The variables are re-estimated in first differences, which corrects the non-stationarity and serial correlation. Results: No variables are significant in predicting growth for Portugal, including the first lag of growth (p=0.62), which has a negative coefficient. The coefficient of first lag of the fiscal balance is positive and insignificant with a p-value of 0.18. When the fiscal balance is the dependent variable, the optimal lag length is four. There is no heteroskedasticity and no serial correlation at the 5% level. Growth, the fiscal balance and the trade balance all have a unit root. When an extra lag is used, there is no serial correlation at the five percent level, so this form will be used. Serial correlation is present at the 5% level when the model is re-estimated in first differences. Results: An F-test shows growth and the trade deficit are insignificant in predicting the fiscal balance. The lags of growth are insignificant with a p-

34

value of 0.16, and the same test on the trade balance has a p-value of 0.36. See Table 5, Row 8. When the trade balance is the dependent variable, a lag length of one is optimal. There is no heteroskedasticity, and no autocorrelation. Results: An F-test reveals the growth and the fiscal balance are insignificant in predicting the trade balance. See Table 5, Row 9. Model 2 The appropriate lag length is measured as two or zero depending on the test. My analysis will rely on the Akaike's Information Criterion and use two lags. There is no heteroskedasticity, but there is second-order serial correlation. No variables except for the dummy are non-stationary. When first differences and extra lags are used, no serial correlation is present. Results: An F-test showed that inflation and the fiscal deficit are not significant in predicting growth. See Table 6, Row 7. When the fiscal deficit is the dependent variable, a lag length of four is optimal. There is no heteroskedasticity, but there is serial correlation at the 5% level for the second, third and fourth lags. Growth, the fiscal balance and inflation have a unit root. These variables are stationary when in first differenced form. When extra lags or the first-differenced form is used, serial correlation of one degree and higher is present. Using the both differenced form and extra lags does away with any autocorrelation. Results: Neither growth nor inflation is significant in predicting the fiscal balance. See Table 6, Row 8. The crisis coefficient is significant at the 1 percent level and negative. When inflation is the dependent variable, a lag length of four is optimal. There is no heteroskedasticity, but there is serial correlation up to the fifth order. Growth, the fiscal balance and inflation all have a unit root. When the variables are first-differenced, they are stationary at the five percent level, but there is still autocorrelation. When the equation is first-differenced, and an extra lag is added, then there is only first-order serial correlation and the prais command is used. Results: An F-test confirms both growth and the fiscal balance are significant in explaining inflation. See Table 6, Row 9. The crisis is positive and significant at the 10 percent level. Spain Model 1 When growth is the dependent variable, the optimal lag length is four. There is no heteroskedasticity, but there is autocorrelation of the first and fourth order at 5 percent. The fiscal balance, trade balance and growth have a unit root. Running the model in first differences eliminates autocorrelation.

35

Results: The lags of the differenced trade balance variable are jointly insignificant with a p-value of 0.26. An F-test of the lags of the differenced fiscal balance is jointly significant at the 1% level. The net effect of the fiscal balance on growth is negative. The crisis is negative and significant at the 1% level (p-value of 0.001). When the fiscal balance is the dependent variable, four lags are optimal. There is no heteroskedasticity, but there is serial correlation up to the fourth level. Growth, the fiscal balance and the trade balance all have a unit root. When the model is run in first differences, the serial correlation is corrected. Results: An F-test of all the differenced lags of growth is significant at the 1 percent level, and the same test on the lags of the trade balance are insignificant with a p-value of 0.93. The net effect of growth is positive. The crisis dummy is negative and significant at the one percent level. When the trade balance is the dependent variable, one lag length is optimal. There is heteroskedasticity and no serial correlation. Growth, the fiscal balance and the trade balance have a unit root. When an extra lag is added to the equation, serial correlation is no longer a problem. Results: The coefficient on the first lag of growth is negative and insignificant. The coefficient on the first lag of the fiscal balance is also negative and insignificant. The crisis dummy is positive but insignificant. See Table 5, Row 12 for details. Model 2 When growth is the dependent variable, the optimal lag order is four. There is no heteroskedasticity or serial correlation. Growth and the fiscal balance have a unit root. These variables are first differenced in the final specification, because adding extra lags to the equation leads to serial correlation. Results: An F-test of only the lags of inflation is insignificant with a pvalue of 0.18. An F-test of all the lags of the fiscal balance is significant with a p-value of 0.03. The net effect of the fiscal balance is positive. The crisis dummy is significant at the one percent level and negative. When the fiscal balance is the dependent variable, the optimal lag length is four. There is no heteroskedasticity, but there is serial correlation in the first, third and fourth degree. Growth and the fiscal balance have unit roots. When first differences are used, there is no serial correlation at the five percent level. Results: An F-test of the four lagged differences of growth is significant with a p-value of 0.01. The same test on the four lagged differences of inflation is insignificant with a p-value of 0.55. The crisis dummy is negative and significant. When inflation is the dependent variable, the optimal lag length is four. There is no heteroskedasticity, and there is first and fourth order serial

36

correlation. Growth and the fiscal balance are non-stationary. When the equation is first differenced, there is first-order autocorrelation, so the prais command is used. Results: An F-test on the lagged differences of the fiscal balance alone is significant at the one percent level, and the same test on the lagged differences of growth are also significant at the 1 percent level. See Table 6, Row 12. The coefficient on the crisis dummy is positive and significant at the 1% level.

37