Causality and the long-term relationship between external balance and public balance in the Eurozone

Abstract

After the beginning of the financial crisis, European external imbalances —mainly in the southern countries— were explicitly or implicitly linked to the behaviour of the public finances under the so-called twin deficits hypothesis. At a theoretical level, a worsening of a government’s budgetary balance exerts upward pressure on real interest rates, which attracts capital flows –because of the relatively higher returns– resulting in an appreciation of the domestic currency and a worsening of external balances. In this article, we analyse the causality and long-term relationship between external balance and some fiscal variables for a set of ten Eurozone countries. According to our results, there is no evidence of a common causality pattern between the public balance and the external balance among different groups of Eurozone countries. In addition, when the analysis is carried out at individual level, only Spain and Finland present a long-term relationship between fiscal variables and the external balance. However, these relationships do not behave as predicted by the twin deficits hypothesis. These results call into question those symmetrical fiscal policies aimed (explicitly or implicitly) at correcting external imbalances in these countries.