Fincke-Wolski2016 Article AreEuropeanFiscalRulesThatBadD

Empir Econ (2016) 51:517–546
DOI 10.1007/s00181-015-1006-z
Are European fiscal rules that bad? Discretionary fiscal

policies in New Member States
Bettina Fincke1 · Marcin Wolski2
Received: 12 December 2013 / Accepted: 12 June 2015 / Published online: 8 August 2015
© Springer-Verlag Berlin Heidelberg 2015
Abstract There is no clear-cut evidence on how the adoption of the European fiscal
standards influences discretionary fiscal policies within the Member States. This study
investigates that phenomenon on the example of the 2004 enlargement. The results
show that the effects of the adoption of EU fiscal rules bring a statistically significant
change toward more counter-cyclical behavior. The results are robust for different
model specifications, including alternative time spans and correcting for the possible
influence of the financial crises and political forces. Interestingly, the year 2004 did
not have any significant impact on the change in fiscal policies in the Old Member
States, suggesting that the EU entry might motivate new members to run more prudent
budgetary policies.
Keywords Discretionary fiscal policy · New Member States · Counter-cyclical

policies · Fiscal rules
JEL Classification E62 · O52
1 Introduction
Fiscal arrangements belong to the most criticized aspects of the European Union’s
(EU) internal policy (Candelon et al. 2010). A widely cited reason for that concerns the
B Marcin Wolski
m.wolski@eib.org
Bettina Fincke
bfincke@wiwi.uni-bielefeld.de
1 Bielefeld University, Universitätsstraße 25, 33615 Bielefeld, Germany

2 European Investment Bank, 98-100 Boulevard Konrad Adenauer, 2950 Luxembourg, Luxembourg
123
518 B. Fincke, M. Wolski
inability of the EU governments to run stabilizing fiscal policies having the Maastricht
Treaty (MT) and the stability and growth pact (SGP) in the background (Wyplosz 2006;
Gali and Perotti 2003; Candelon et al. 2010). However, there has been no clear-cut
evidence on how the EU fiscal rules affect discretionary fiscal policies nor what effects
they pose on business cycles within the EU. Some studies prove a significant change
in fiscal behavior after the adoption of the MT or the SGP fiscal rules, whereas other
research shows the opposite.
This paper contributes to the topic by assessing the influence of the adoption of the
EU fiscal standards on discretionary fiscal behavior empirically, on the example of the
2004 EU enlargement. Moreover, in order to determine whether the EU entry was a
core event which influenced fiscal policies among the New Member States (NMS),
the analysis compares the tendencies in the fiscal behavior between them, the Old
Member States (OMS) and a group of control countries which did not belong to the
EU at that time.
The study is carried out on all the NMS that joined the EU on May 1, 2004; Cyprus,
Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia and
Slovenia. Following the literature, different model specifications are applied to correct
for possible biases. The first one is the simplest one and similar to the approach taken
by Gali and Perotti (2003). It estimates the influence of the output gap on discretionary
fiscal decisions using the fixed effects panel technique and assuming the existence of
a structural break in 2004. To correct for the possible bias resulting from the financial
crisis and the sovereign debt crisis in the euro zone, we carry out the robustness
check by adding a proxy variable, reflecting the situation in the loan market, and by
cutting the time span of the analysis in 2008. The fifth model combines the last two
specifications. The time span of the study has been limited by data availability and
quality and, therefore, covers years 2000–2011. Additionally, a possible policy change
around the year of accession is checked by formal structural break tests.
To further investigate this phenomenon, the study focuses on the comparison of
discretionary fiscal policies between the NMS and OMS. The OMS comprise 15
Member States which were in the EU before 2004 (Gali and Perotti 2003), i.e., Austria,
Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg,
the Netherlands, Portugal, Spain, Sweden and the UK. As another robustness check,
we conducted the same experiment on a control group consisting of the so-called
safe havens, represented by Australia and Canada, and two further central eastern
European countries (CEEC) that joined the EU later on January 1, 2007, i.e., Bulgaria
and Romania, in order to detect whether these economies experience a switch in policy
behavior around 2004 as well.
Interestingly, a remarkable and significant switch toward counter-cyclical fiscal
behavior is observed for the NMS, especially in the most recent years, with no similar
effect on the OMS or the control group. Among all the models for the OMS, the only
well-specified one suggests that the OMS were running acyclical fiscal policies for
the entire period, driven mostly by external factors rather than complying with the EU
fiscal rules.
The remainder of this paper is organized as follows. Section 2 brings forward the
recent results on the topic and discusses the influence of fiscal policies on a business
cycle. Section 3 investigates the changes in discretionary fiscal policies before and
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Are European fiscal rules that bad? 519
after the 2004 EU enlargement. Additionally, we carry out the robustness checks to
assess the validity of the results. Section 4 summarizes and discusses some concerns
regarding the results.
2 Literature review and motivation
Thinking of fiscal policy and its influence on the business cycle, one should distinguish
between the effects of automatic stabilizers and discretionary actions. The former
relates to the natural budget responses to the business cycle fluctuations (Candelon
et al. 2010). For example, the revenues from taxes should increase during upswings so
that the budget balance becomes larger. Likewise, when there is a recession, the budget
balance should decrease as a consequence of, for instance, increased unemployment
spending. In short, automatic stabilizers work as a natural mechanism to accumulate
capital during booms and spend it during downswings. This all makes the business
cycle less volatile and aims to provide solid economic growth (Wyplosz 2006).
However, fiscal authorities are able to stipulate the economy beyond the automatic
stabilizers’ level. Such actions are called discretionary fiscal policy. Following Kyd-
land and Prescott (1977), it may be driven by the time inconsistency of economic
decisions or could be a straightforward consequence of political motivation (Pendle-
ton 1938; Alesina et al. 2008). An example of a discretionary action could be a change
in the tax levels or a revision in government investment policy.
A common view supposes that once a budget is balanced, discretionary actions
should be avoided and the reaction to business cycle fluctuations should be left for
automatic stabilizers only (European Comission 2001; Beetsma 2001; Artis and Buti
2000). Looking at the EU countries, the condition of a balanced budgetary position
has not been always satisfied, mostly because when the economic and monetary union
(EMU) was introduced, fiscal policy became the only macroeconomic management
instrument. Therefore, it is unlikely that Member States would resign from it easily,
violating the balanced budget plan (Wyplosz 2006).
Excessive discretionary policy could have dramatic consequences for the economy
(Wyplosz 2006). It can not only drive the amount of public debt beyond the sustainable
level but can also exacerbate the business cycle or/and foster uncertainty in the markets.
The current situation in Europe, with many economies facing fiscal difficulties, reveals
these problems. For about five years now, EU and especially euro zone members have
been impaired by the financial and debt crises. Enormous financial rescue programs had
to be arranged in order to support seriously debt-troubled economies, such as Greece
for instance, and to restore financial stability. This assistance is tied to requirements to
implement strict austerity measures (European Commission 2013). Some euro zone
members, i.e., Ireland, Greece, Spain, Portugal and Cyprus, had to apply to receive
financial support. Recently, Ireland, Portugal and Spain left the programs.
In order to induce sound fiscal performance and to limit the excessive discretionary
actions within the EU, the MT implemented basic fiscal rules. They refer to the upper
deficit and debt ceilings which each country has to respect, i.e., 3 % deficit-to-GDP and
60 % debt-to-GDP ratio. Since their introduction in 1992, they have been steadily mod-
ified in order to make them more accurate. In 1997 they were extended by the SGP and
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in 2005 by the decision of European Council entitled ‘Improving the Operation of the
Stability and Growth Pact.’1 As a result, the performance of the EU fiscal rules has been
improved; however, they still have some drawbacks (Buti et al. 2003; Wyplosz 2006).
The biggest critique of the EU fiscal arrangements comes from the fact that they
might limit the flexibility of national fiscal authorities too much, especially during
recessions (Gali and Perotti 2003), but also during recently observed financial crises.
Consequently, governments would not be able to follow counter-cyclical policies and
impose balanced budgetary plans because they would be absorbed by fighting external
shocks instead or they would be facing internal political pressure.
Scholars have tried to explain empirically whether those threats are justified. The
results are, however, ambiguous. Two basic concepts arise from the literature. The first
one, proved by Buti et al. (1997), Gali and Perotti (2003) and Wyplosz (2006), states
that discretionary fiscal policies in the EMU countries were pro-cyclical before 1992
and acyclical afterward.2 The second concept refers to studies of Von Hagen (2005)
and Candelon et al. (2010) who also confirm that before 1992 the discretionary fiscal
policies in the EMU were pro-cyclical; however, they remained pro-cyclical after the
MT was signed. An interesting conclusion from Candelon et al. (2010) is that the
empirical results are very susceptible to the time spans of the analysis. In fact, using
similar methodology to Gali and Perotti (2003) but expanding the data set by two years
only, Candelon et al. (2010) obtained the opposite results.
Moreover, there have been some key studies on fiscal policy and business cycle
responses in NMS. For instance, Budina and Van Wijnbergen (1997) study fiscal
policies in CEEC and former Soviet Union members and their impact on economic
stabilization in the early phase of transition. They focus on sustainability of public
finances and find empirical evidence that countries which quickly implemented ambi-
tious and tight reforms have been more successful in terms of inflation stabilization
and growth performance, both, with respect to the time of recovery and the size of the
rate. Also, Lewis (2009) studies fiscal policies and their stabilizing effect in CEECs,
as well as possible inertia of budget balances and the effect of accession on public
finances. He finds some empirical evidence for counter-cyclical behavior and a less
inertial response for the Eastern economies than in the Western EU countries. More-
over, he detects a fiscal loosening prior to accession. Staehr (2007) analyzes fiscal
policy functioning as regards cyclical properties and fluctuation effects in an empir-
ical comparative study for the euro zone members and CEECs. Even though more
volatile, he finds more ‘agile’ and counter-cyclical policies for the NMS for several
specification types with pro-cyclical tendencies in the euro zone members due to the
revenue side. In a recent paper, Darvas (2009) studies the effect of the current crisis on
fiscal policies in CEECs. Among other points, the results indicate some pro-cyclicality
of fiscal policy.
Our paper differs from the contributions by Staehr (2007) and Lewis (2009) in sev-
eral aspects. Whereas Staehr (2007) focuses on a comparison of fiscal policy between
the two groups of NMS and euro zone members, we are interested in different behavior
1 For a detailed analysis of the evolution of fiscal rules in the EU, see Wyplosz (2006).
2 The term ’acyclical’ refers to Gali and Perotti (2003) and means that there was no significant impact of
discretionary policy on the business cycle fluctuations.
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before and after EU accession, i.e., over time with focus on 2004, plus, comparing
NMS and OMS. Also, the analysis done by Staehr (2007) ranges from 1995 until
2005. We extend the period to 2011, which allows us to take the early stage of the
crisis into account. Lewis (2009), for instance, employs real-time data, whereas we
rely on ‘conventional’ final data.
Several papers have studied fiscal policies and the business cycle response in the
EU. Generally, the results are rather mixed. For instance, Beetsma and Giuliodori
(2008) study fiscal policy in terms of deviations from plans due to new information
with regard to the business cycle for OECD countries. They find differences for EU
members (acyclical) and non-EU economies (counter-cyclical) ex ante, but as con-
cerns the deviations the EU countries behave pro-cyclical, whereas the other countries
reveal acyclical responses. Claeys (2008) analyzes fiscal policies, rules, business cycle
effects and sustainability in Sweden. His results suggest a more counter-cyclical pol-
icy concerning the primary balance influence in Sweden. Additionally, he identifies
regimes and shifts by incorporating structural breaks and switches and provides a
comparison with other northern European economies. Like our study, he also uses
GMM and quarterly data. Darby and Melitz (2011) study simultaneously effects of
automatic and discretionary fiscal policy for OECD countries explicitly, by separat-
ing the components of the government budget they address the revenue and spending
effects individually. Notably they do not confirm any effect of the MT and SGP for
the output gap and fiscal policy relationship in Europe. Darby and Melitz (2008) study
automatic stabilization in OECD countries and the response of the government bal-
ance and its components to the business cycle. Detailed estimations reveal a fairly
destabilizing effect of taxes, whereas expenditures function in a stabilizing manner.
Poplawski-Ribeiro (2009) analyzes the effectiveness of the fiscal framework in the
euro zone to fiscal policy disciplining and distinguishes two sub-periods to the MT
and SGP. He finds that the SGP is not an effective instrument to prompt fiscal discipline
and it does not induce counter-cyclical fiscal policies in the euro zone. Moreover, he
finds a relaxing of fiscal policy before the official accession.
For the EMU members incentives to implement structural reforms in view of the
fiscal criteria may be a crucial aspect, both, for the NMS in their entry stage and for
the OMS as many of them bear structural inefficiencies (Beetsma and Debrun 2004).
Beetsma and Giuliodori (2010) mention that the literature indicates mixed effects, even
though one of the reasoning pro EMU was perceived in enhancing structural reforms
due to competitive pressure. Beetsma and Debrun (2004) analyze with a formal model
the incentives for structural reforms in face of fiscal rules, like the SGP, and discuss the
problems of the trade-off between stability and growth. They suggest a more flexible
handling linked to progress in structural reforms and independent surveillance.
There are several commonalities of findings and proceeding in these mentioned
studies and our contribution. The two studies of Lewis (2009) and Staehr (2007)
are close to our proceeding and results, as they technically also use the instrumental
variable (IV) GMM method. Moreover, they also support the finding of less inertia
in NMS than in OMS and counter-cyclical behavior in NMS. Also, the loosening of
the fiscal behavior prior to official entry, as found in Lewis (2009) and for euro zone
members in Poplawski-Ribeiro (2009), may in part be related to our results.
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Our study contributes to the discussion by expanding the scope of the analysis to
the NMS and includes the most recent years. Additionally, our data set consists of
quarterly data having more degrees of freedom and making the analysis more robust.
3 The 2004 enlargement
Fiscal policies in the NMS have been characterized by a strong heterogeneity among
countries with some running pro-cyclical and others running counter-cyclical policies
(Schneider and Zapal 2005). However, none of the studies treated the characteristics
of fiscal policies in accordance with a structural break in 2004—a year when the NMS
officially became a part of the EU and adopted its fiscal standards. Moreover, previous
research took a very narrow view on the recent situation of fiscal policies in the NMS.
In fact, none of the studies analyzes the NMS in isolation after 2006. Eventually, we
may find an evidence in favor of the pro-cyclicality of fiscal policies in the NMS until
2006 with barely any insight on what happened afterward.
Even though the year 2004 can be considered as influential for the fiscal policies
among the NMS, as it was the official date of adopting European standards, it is very
likely that some of the countries had anticipated the accession to the EU and had
changed their fiscal behavior before. Therefore, in this study we follow a two-step
procedure. In the first step, we investigate whether there was an actual statistically sig-
nificant break in fiscal policies across the NMS. We roll the breaking point quarter by
quarter, from Q3 2000 until Q3 2007.3 We then run the Chow (1960) test on the fiscal
policies’ coefficients, determining which of them were the most statistically different
from each other between periods. We rank the breaking points by their statistical sig-
nificance, and we determine the most likely candidates for the structural break. In the
second step, we estimate the profile of fiscal policies in the NMS quantitatively, assum-
ing the structural break point we have found in the first step. We adopt the methodology
proposed by Gali and Perotti (2003) and extended by Candelon et al. (2010). The idea
is to estimate the influence of the economy output gap on discretionary policy, which
is approximated by the structural (primary) budget balance. In other words, fiscal pol-
icy is assessed from the perspective of a reference value that is not influenced by the
cyclical component. In this study, the reference value is the potential GDP.
The workhorse panel model specification may be written as:
di,t = β0 + βdBEU di,t−1 + βdAEU di,t−1

+ βgap
BEU BEU
E i,t−1 gapi,t + βgap
AEU AEU
E i,t−1 gapi,t (1)
+ βbBEU bi,t−1 + βbAEU bi,t−1 + B BEU Ωi,t
BEU
+ B AEU Ωi,t
AEU
+ u i,t ,
where di,t is a proxy for structural budget balance, E i,t−1 [gapi,t ] reflects the output
gap expected at a previous period and bi,t is the debt level. Matrix Ω consists of
control variables, described in detail later, and B is a corresponding vector of coeffi-
3 In the analysis, we focus on the period from Q1 2000 until Q2 2008 in order to avoid possible spurious
relations caused by the global financial crisis and the sovereign debt crisis.
123
cients. Subscripts i and t refer to country and time dimensions, respectively. The error
term consists of individual and time-specific effects (u i,t = vi + εi,t ) . The model
distinguishes between the influence of output gaps on the discretionary policy before
BEU ) and after (β AEU ) the structural break in 2004. Also, the control variables are
(βgap gap
split before and after EU entry as well. In fact, since we are endowed with quarterly
data, we cut the sample in the second quarter of 2004. To correct for the country size,
all of the variables are taken relative to GDP.
Taking the expectation of the output gap at a previous period makes a clear sense.
Any government decides on fiscal policy using the expected output gap variations
(Gali and Perotti 2003). This study assumes rational expectations (E t−1 [gapt ] = gapt )
which is not far from reality taking into account that the fiscal authorities should know
the response functions. In fact, perfect foresight assumption implies that our results
should not differ from the ones estimated on a real-time data set, as the ex-post data
corrections should be negligible. Due to scarcity of the real-time data in the majority
of the EU countries, similar procedures are commonly applied in the literature (Gali
and Perotti 2003; Candelon et al. 2010; Wyplosz 2006; Marinheiro 2005).
BEU or β AEU indicate counter-cyclical discretionary policy in
Positive values of βgap gap
a given period. In fact, this suggests that a fiscal authority was increasing structural
budget balance during upswings which is exactly the definition of a counter-cyclical
fiscal behavior. The βd coefficient suggests that a fiscal authority is concerned about
previous period conditions and tries to include them in the current fiscal policy. This
makes a clear sense. If a government is worried about the deficit levels from the past, it
should increase today’s balance to stabilize it. Additionally, more technically speaking
βd > 0 indicates extrapolative or a kind of trend-following while βd < 0 reveals mean
reversive behavior. The stationarity of the deficit time series is supported by |βd | < 1
(Roodman 2006).
The specification of the model may lead to an endogeneity bias which arises between
structural deficit and output gap. To correct for that, the IV technique is used with a
standard fixed effects model.4 To determine the proper instruments, we follow closely
the settings from Gali and Perotti (2003) and Candelon et al. (2010) and use up to the
second lag of the output gap in the USA. Clearly, one would expect a high correlation
between the lagged US and current EU production as a result of high trade flows and
foreign direct investments. It is, however, doubtful to find a relationship between it and
the structural budget deficits across the EU, which should make it a good instrument.
Additionally, its validity is assessed statistically.
To further confirm our findings, we run several robustness checks, which include
estimating the relationships on the annualized data and dynamic panel estimation
technique.
4 Candelon et al. (2010) applies the dynamic panel method to correct for the endogeneity bias. Originally,
the dynamic panel technique was designed for large-N and small-T samples, meaning for settings with many
individuals and limited number of periods. In our data set, however, we observe the opposite. Therefore, we
favor the panel IV technique over the dynamic panel methods. Nevertheless, we apply the dynamic panel
estimation as a robustness check, confirming our main findings.
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2
NMS
Primary balance ratio, % GDP

OMS
0
−2
−4
−6
−8
Q1:2000 Q1:2002 Q1:2004 Q1:2006 Q1:2008 Q1:2010
Fig. 1 Primary balance ratio. Source: ECB (2013), own calculations
3.1 Data
As we are interested in studying the effects of the adoption of EU fiscal rules on

discretionary fiscal behavior on the example of the 2004 enlargement, for a first step,
an illustration of the relevant variables is a good mean to get an idea of the economic
circumstances and public finances in the NMS and the OMS. Here, a special focus
may be set to second quarter in 2004, as the ten NMS officially joined on May 1, 2004.
The data for the following figures comes from the European Central Bank (2013) and
the International Monetary Fund (2013a). They show for each of our main variable
series the averages of both groups over the considered time horizon.5
The variables we take into consideration in our analysis refer to the central public
finance indicators as well as to instruments which governments may influence. As
a proxy for measuring discretionary fiscal policy design, the dependent variable in
our setting, we chose the seasonally adjusted primary balance to GDP ratio (Gali
and Perotti 2003). The primary balance is a parameter which the administration can
directly influence through its budget, tax or spending (in general: fiscal) policy. This is
also in line with similar studies such as Claeys (2008) or in some cases Staehr (2007)
for example. Moreover, the total budget balance is influenced by ‘inherited’ decisions
from the past, as it differs to the extent of including interest payments on outstanding
debt. This squeezes the available resources and limits the policy decisions. However,
we do not neglect that influence in our regressions as we include both, the debt ratio
variable and an interest rate gap regressor to capture their effects.6
The data of our seasonally adjusted primary balance ratios (averages) are depicted
in Fig. 1 for the NMS and the OMS.
What concerns the primary balance ratios for the NMS, there is a one-off effect
in Hungary in the first quarter 2011 as a distinctive feature. This irregular budgetary
surplus was due to revenues from a shift of pension assets (International Monetary
5 More detailed and disaggregated figures based on countrywise data are included in ‘Appendix 1.’
6 See also Darby and Melitz (2008) for that discussion.
123
Fund 2012).7 Besides that, the average primary balance ratio mainly increases over
time until it drops with the crisis. For the OMS, generally a slight negative tendency
of the primary surplus ratios may be observed with some improvement around 2006,
recently there is again a pronounced decline, which is in part caused by the extreme
values of Ireland in 2010, due to stabilization of the banking sector. Soon afterward,
in November 2010, Ireland applied for financial assistance with a volume of 85 billion
euros (European Financial Stability Facility (EFSF) EFSF 2013). Also for Greece there
is a severe deterioration of the primary balance ratio in the crisis years, however, for
both economies there appears to be some improvement with the recent observations.
Regarding the explanatory variables, our central regressor is the output gap ratio.
It is constructed by calculating the difference between the observed real GDP value,
denote it by Y , and the real GDP trend, Y ∗ , relative to that trend: (Y − Y ∗ )/Y ∗ . More
precisely, for the calculation of the GDP trend Y ∗ , the real GDP series had been filtered
with a Hodrick-Prescott method in R 2.9.0. As it is quarterly frequency, we applied
the commonly used smoothing parameter μ = 1600.
Obviously, positive values indicate economic booms while negative values represent
downswings. The data for the seasonally adjusted averages are depicted in Fig. 2 for
both, the NMS and the OMS. The average output gap ratio of the NMS generally shows
a slight positive trend with a small decline for the early 2000s followed by an almost
steady increase until about 2007, which, however, then collapsed with the financial and
debt crisis. Extreme negative values were conducted in Latvia and Estonia in 2009.
Latvia also achieved the highest output gap ratio in the last quarter of 2006. Recently,
some catching up tendency for most economies can be observed. For the OMS, the
general pattern is similar: The output gap ratios mainly decrease toward the early
2000s; afterward, they improve until about 2007 with especially large positive values
for Finland and Luxembourg. Certainly, the situation deteriorated with the outbreak of
the crisis. Nevertheless, the recent observations indicate a slow recovery and upward
trend in the output gap for many of the NMS and OMS.
Due to the recent developments with the financial and debt crisis afflicting Europe,
the plots of the debt-to-GDP ratios and the interest rate gap (compared to Germany’s
long-run bond yield) have been chosen to visualize the situation for the time span
2000–2011. Certainly, the public debt-to-GDP ratio is included as an explanatory
variable, since it is one of the reference indicators from the MT which recently has
become important as a result of the financial and debt crises. (For endogeneity and
likely correlation effects, it is included in lagged terms.)
Without any doubt, the evolution of the seasonally adjusted average debt-to-GDP
ratios in Fig. 3 has significantly been shaped by the crisis. Generally, the average debt
ratio level of the OMS is higher than in the NMS. Moreover, in some OMS countries,
for instance in Belgium, Greece and Italy, the initial values in 2000 were above 100 %.
Moreover, for the group of the NMS Fig. 3 shows a slight decline of the debt ratio
after the 2004 enlargement (our reference year for the behavior change due to the EU
extension). This effect is hardly observable for the OMS. Thus, while for the OMS
7 This outlier does not bring any qualitative change to the estimation results so as to the final inference.
Therefore, we decide to leave it in the data set in order to make it more methodology consistent.
123
Output gap ratio (relative to trend GDP)

NMS
4
OMS
2
0
−2
−4
Q1:2000 Q1:2002 Q1:2004 Q1:2006 Q1:2008 Q1:2010
Fig. 2 Output gap ratios. Source: ECB (2013), IMF (2013a), own calculations
80
NMS
Public debt ratio, % GDP
OMS
70
60
50
40
Q1:2000 Q1:2002 Q1:2004 Q1:2006 Q1:2008 Q1:2010
Fig. 3 Debt ratios. Source: ECB (2013), own calculations
the distinctive feature here is an increase in public debt during the crisis, many of the
NMS’s debt ratios additionally tend to be shaped by the 2004 enlargement.
Further, in order to take into account possible crisis volatility, interest rate spreads
are included in our model. They are determined by the difference between the individ-
ual long-run government bond yield compared to the reference value of the German
long-run bond yield. Figure 4 plots the seasonally adjusted averages for the NMS and
the OMS. The development of the spreads reveals a familiar pattern: Fig. 4 shows a
characteristic almost u-shaped run for the NMS, which displays the dynamics of the
proceeding of the European integration, too. On average NMS’s interest rate gaps were
remarkably decreasing until about 2004 and then stayed low until about 2008. With
the outbreak of the crisis, they began to rise again. For the OMS’s spread development
in, again, the crisis years shape the characteristic run.
Moreover, to capture potential influence of political effects, a dummy variable for
parliamentary elections is added to the model for the years when the election took place,
similar to Lewis (2009) and Poplawski-Ribeiro (2009). Such a specification corrects
123
Interest rate gap (percentage points)

NMS
4
OMS
3
2
1
0
Q1:2000 Q1:2002 Q1:2004 Q1:2006 Q1:2008 Q1:2010
Fig. 4 Interest rate gaps. Source: IMF (2013a), own calculations
for possible bias resulting from irresponsible budgetary spending in the election years
(De Haan et al. 2003).
Usually, empirical analyses are limited by data quality and availability, which holds
especially true for studies concerning NMS. Therefore, we constructed a data set
combining data from different (but few) sources. It mainly consists of data from
European Central Bank (2013) Statistical Data Warehouse for the governmental data
(public finances and GDP) and International Monetary Fund (2013a) International
Financial Statistics for the interest rates and the deflator. Concerning the demarcation
of the public sector, our data set mainly refers to general government, i.e., including
lower government tiers.8 The election variable reflects parliamentary election dates
and has been taken from IFES (2013). Table 7 in ‘Appendix 1’ summarizes the data
information and provides some descriptive statistics on the variables for the two groups
of member states. Interestingly, on average the primary balance for both, NMS and
OMS, is in deficit and for the OMS the average debt ratio is close to the MT reference
value. Plus, on average interest rate gaps are higher in NMS than in OMS, and the
average output gaps are close to balance. For both groups, the lowest debt ratio levels
were achieved in 2008, with their maxima held at the end of the series in 2011 with
the crisis. The output gap minimum values for both groups were in Q2 2009, the
highest values for the NMS were performed at the end of 2007, and for the OMS at
the beginning of 2008. The largest primary deficits for the NMS were also in Q2 2009,
however, for the OMS in Q1 2010.9 Further, both groups benefited from lowest values
in interest rate gap at the beginning of 2006, whereas the largest values are given by
the recent observations.
Regarding the frequency, we employed quarterly data in order to enhance the time
span. This is in line with Claeys (2008) or Darvas (2009). Even though fiscal and
budget decisions are made on a yearly basis, our proceeding allows for a more profound
empirical analysis and conveys more power to the results. Nevertheless, as a robustness
8 Recently, many studies use real-time data (Beetsma and Giuliodori 2008; Lewis 2009). However, we
resort to ‘conventional’ final data as availability may be a crucial issue here.
9 This number is strongly influenced by Ireland, as Fig. 7 reveals.
123
check the estimations are also run with annual data. Thus, our data cover the years from
2000 (Q1) until 2011 (Q4). This yields 48 observations per country and a total size
of N = 480 for NMS and N = 720 for OMS. Obtaining a continuous and consistent
series required a thorough data set preparation. Seldom missing observations had been
extrapolated in order to make the panel balanced.
As regards our control group of countries, we decided on two ‘safe havens,’ Aus-
tralia and Canada, and two European countries that joined EU later (in 2007), Bulgaria
and Romania. The safe havens data stems from OECD (2014a, b). For the two 2007
EU members the same data sources as for the NMS group has been used.10
Finally, and very importantly, the original data in our set were raw or crude (in
terms of not being seasonally adjusted). Thus, at last all variables had been seasonally
adjusted with X12 ARIMA methodology.
All but one variable are stationary at standard significance levels according to the
Levin–Lin–Chu unit-root test (2002). The only non-stationary variable is the debt
level. As a robustness check, we run all the regressions without the debt level, finding
no qualitative difference from our main findings. Therefore, we decide to keep the
debt variable in our regressions.
3.2 Results
In accordance with our two-step procedure, we first determine the breaking points in
fiscal policies for the OMS and NMS. We run the model from Eq. 1 with a rolling
breaking point and using the Chow test we determine which of them is the most likely
candidate for the change. We rank the all the points by their p-values, where the higher
the rank the lower the significance level of a change.11 The results for both the NMS
and OMS are presented in Fig. 5.
The results indicate that for the NMS the most likely breaking points fall within the
period Q3 2003–Q2 2004, confirming our hypothesis that the NMS anticipated the EU
accession and adjusted their fiscal standards before Q1 2004. The break in fiscal poli-
cies among the OMS was most likely to happen between Q3 2000 and Q3 2003, being
somehow more in line with the consequences of the adoption of the common currency.
In our analysis, we decide to use the last quarter from the highlighted period to
balance the number of observations between both time spans. Therefore, in the forth-
coming analysis, we use Q2 2004 as a structural break point. We confirm the results
by varying the break point from Q3 2003 until Q2 2004, finding no differences with
the main results.
The regression outcomes for the NMS, estimated on the model from Eq. 1, are
presented in Table 1.12 For clarity reasons, we present the results for all the model
specifications. First, for the full sample and standard regressors (lagged budget balance,
output gap ratio and lagged debt ratio—all before and after EU entry) see Model 1,
10 Due to data availability, the Romanian interest rate until 2005 is the treasury bill rate.
11 All the breaking points with rank 1 are considered to be the most likely candidates for the structural
change.
12 All the estimations have been implemented in STATA 12.
123
Fig. 5 The rank of the statistical significance of various breaking points in fiscal policies among the NMS
and OMS. The higher the rank, the lower the p value from the Chow test of no structural change
presented in the first column. Taking into account the current crisis, we followed a
twofold approach. On the one hand, we cut the sample and consider only the time
period before the crisis (Q12001–Q42008), model type 2, second column. On the
other hand, we include the interest rate gap, model type 3, third column. Finally, as
an additional specification, we also include an election dummy variable, capturing the
influence of politics, types 4 and 5, forth and fifth columns, respectively. The reason
for cutting the sample in the last quarter of 2008 is twofold: On the one hand, this
allows to equalize the number of the degrees of freedom, and on the other hand, it
enables to observe the behavior before the crisis began.
BEU and β AEU , which correspond
The results show that the coefficients of interest βgap gap
to the effect of the output gap ratio before and after EU enlargement in 2004 on the
primary balance ratio, are statistically significant after EU entry only. Interestingly, all
βgap
AEU coefficients are positive, indicating counter-cyclical fiscal policy in NMS after
joining the EU. This holds true for all model type specifications. The results suggest
also that the discretionary fiscal policies before the 2004 entry were acyclical, in a
sense that there was no statistically significant influence from the output gap on the
structural balance. This is somehow confirming the results from Schneider and Zapal
(2005) but on the aggregate level, with some countries running pro-cyclical and the
other having counter-cyclical budgetary positions. These results might be interpreted
in two ways proving that either the heterogeneity in fiscal behavior decreased and the
fiscal change was relatively small, or the heterogeneity persisted with the 2004 effect
being relatively larger. We investigate this phenomenon in detail in Sect. 3.5.
Concerning the other coefficients, only the lagged primary balance turns out to be
statistically significant for all of the model specifications. As expected the coefficient
is positive and lies on the unit circle, confirming the stationarity (Roodman 2006).
In line with the comments from above concerning the βd being smaller or larger
than zero, the results suggest a trend-following behavior. This reflects objections of
123
Table 1 Discretionary fiscal rule in the New Member States before (BEU) and after (AEU) accession to
the EU
Model 1 2 3 4 5
lag. deficit (BEU) 0.224** 0.216*** 0.222** 0.225** 0.223**

(0.089) (0.065) (0.088) (0.089) (0.088)
lag. deficit (AEU) 0.314*** 0.395*** 0.265*** 0.307*** 0.260***
(0.05) (0.08) (0.05) (0.05) (0.05)
H0: BEU = AEU 0.362 0.063* 0.664 0.407 0.709
output gap (BEU) −0.01 0.036 0.014 −0.014 0.009
(0.124) (0.085) (0.122) (0.125) (0.123)
output gap (AEU) 0.337*** 0.178*** 0.206*** 0.349*** 0.217***
(0.058) (0.067) (0.065) (0.059) (0.066)
H0: BEU = AEU 0.011** 0.198 0.167 0.009*** 0.137
lag. debt (BEU) −0.024 −0.053* −0.003 −0.021 −0.001
(0.026) (0.03) (0.026) (0.026) (0.026)
lag. debt (AEU) −0.001 −0.015 0.0333 0.001 0.035
(0.022) (0.029) (0.023) (0.022) (0.023)
H0: BEU = AEU 0.059* 0.000*** 0.004*** 0.06* 0.005***
int. gap (BEU) −0.075 −0.073
(0.141) (0.141)
int. gap (AEU) −0.529*** −0.524***
(0.123) (0.123)
H0: BEU = AEU 0.005*** 0.005***
election (BEU) −0.397 −0.485
(0.976) (0.957)
election (AEU) −0.808 −0.643
(0.698) (0.685)
H0: BEU = AEU 0.731 0.893
Observations 460 350 460 460 460
R2 0.236 0.252 0.267 0.238 0.268
Groups 10 10 10 10 10
Instruments GAPUS,t−1 GAPUS,t−1 GAPUS,t−1 GAPUS,t−1 GAPUS,t−1
GAPUS,t−2 GAPUS,t−2 GAPUS,t−2 GAPUS,t−2
Sargan 0.069 0.86 0.067 0.064 0.063
Model 1: the benchmark model, i.e., full sample and standard regressors. Model 2: the same as 1 but on
the truncated sample Q12001–Q42008. Model 3: the same as 1 but with the interest rate gap. Model 4:
the same as 1 but with the election dummy. Model 5: the same as 1 but with the interest rate gap and the
election dummy. Coefficients are reported as well as robust standard errors between brackets. *, ** and ***
imply significance at the 10, 5, and 1 % significance level, respectively. Equality between coefficients is
tested by a standard F test, whose p-value is indicated in the separate row H0: BEU = AEU. The adequacy
of instrument space is tested with the Sargan test
the administration about previous periods conditions. Further, the interest rate gap
variable proves to affect the primary balance significantly and negatively after 2004
entry. This may display the influence of the current crisis. The higher the gap, i.e., the
123
worse the economic condition of the economy, the higher the deficit in this period.
The negative election effect indicates lower surpluses in times of elections (potentially
‘election gifts’), also in line with theory (De Haan et al. 2003); however, our estimation
results show that those effects are not statistically significant.
Interpreting our results for the NMS from an economic policy perspective yields
very interesting insights on the actual discretionary fiscal policies in a given time span.
The outcomes reveal a statistically significant change toward the counter-cyclical fiscal
behavior after 2004. The result is robust with respect to 2 out of 5 model specifications;
however, the F-tests for all the remaining 3 specifications reject the null of no change at
0.2 significance level. When looking at the results, one should pay attention to the fact
that the change was always from acyclical to counter-cyclical. Given the limited sample
size and the data shortcomings, we consider those results as convincing, however, to
underpin our findings we investigate the robustness of the results in Sect. 3.4.
Year 2004 brought a significant change to the debt and interest rate gap in all the
model specifications. One may claim that this is a result of an increased number of
degrees of freedom for the after-2004 specification. However, even if we correct for
the sample size, the results remain similar. In fact, it seems that the EU entry did not
only change the discretionary fiscal behavior among the NMS, but it also shaped the
fiscal responses against the debt and interest rate gap factors.
One should pay attention to the possible over-identification problems, resulting from
the choice of instruments. The number of lags in the instrument space was chosen in
order to yield a maximum Sargan test p-value. Nevertheless, they might seem troubling
for some of the readers. When considering the p-values for the standard Sargan test for
over-identifying restrictions, one should keep in mind the possible heteroscedasticity
of the errors which could influence the test performance (Roodman 2006). In fact, the
magnitude of the p-values is similar to the one presented in Candelon et al. (2010)
for the comparable model specifications, being acceptable at the 5 % significance
level. Therefore, in order to draw conclusions, one should pay attention to the holistic
perspective of our estimation results. The well-specified model, i.e., model with the
truncated time span, confirms the main inference from the other models together with
satisfying the over-identification restrictions. Having pointed this out, we reproduce
models 3–5 from Table 1 on the truncated sample to limit the over-identification
problems. The main results are confirmed: In all the settings, the NMS run acyclical
fiscal policies before the accession to the EU and counter-cyclical afterward (see Table
8 in the ‘Appendix 1’). In Sect. 3.4, we apply the dynamic panel estimation technique,
yielding a better instrument space and confirming our main conclusions.
Interestingly, one may think of the reason why there are over-identification problems
with years after 2008. An explanation could lie in the increased heterogeneity in
reactions to the financial crisis among the NMS. Clearly, different NMS got different
exposure to foreign risks and were differently affected by the crisis. For instance,
countries such as Lithuania, Estonia or Latvia suffered from a huge economic losses
immediately after the US crisis. At the same time, the economic situation in Cyprus
or Slovenia was mostly affected in the aftermath of the sovereign debt crisis which
spread across Europe two years later. Countries such as Poland were pretty robust to
the foreign shocks as a result of a strong internal consumption and a relatively low
degree of internalization of the capital flows. Hungary, however, is a kind of a special
123
case, as the situation may be reckoned to be strongly politically influenced. Concerning

Slovakia and Czech Republic, the situation indicates to be relatively similar to Poland,
while the behavior of Malta resembles Cyprus.
3.3 Comparison with the OMS and other countries
The results for the OMS are presented in Table 2. The model specifications remain
the same as in the previous section.
Since the results suffer from the over-identification bias, they should be taken with
caution and should be treated as a comparison for the NMS rather than suiting to
draw actual policy conclusions from. The only model specification which is not over-
identified at the 1 % significance level, i.e., the model for the truncated time span,
suggests, however, that there was no statistically significant change in fiscal behavior
for the OMS in year 2004. Interestingly, the BEU coefficient in this model is counter-
cyclical with the AEU coefficient being acyclical. The other model specifications show
the opposite, however, the change is never statistically significant. This outcome may
suggest counter-cyclical policy after 2004 being highly influenced by crisis effects
(IMF 2013b). On the one hand, without the crisis years (the truncated sample), the
coefficient of interest looses statistical significance, and on the other hand, including
the crisis years yields significant positive effects of the output gap and negative effects
of the debt ratio (unsustainable behavior).
The goal of this comparison is to check whether there were any other factors in 2004
which could have led to a switch in the discretionary fiscal policies among the member
states. It seems that the 2004 effect could be clearly recognized for the NMS only, with
no clear-cut evidence for a change in the other member states. Interestingly, one may
get an impression that the fiscal policies in the OMS are shaped by different factors than
those in the NMS. The over-identification problems and the counter-intuitive sign for
the lagged debt variable are just symptoms of that phenomenon. One may also observe
no political influence on the fiscal behavior, together with much higher R 2 coefficients.
In fact, this might be the confirmation of previously mentioned literature, which
pointed out the problem of lack of incentives to run more counter-cyclical fiscal policies
and curb down the deficit and debt levels once in the EU (Wyplosz 2002, 2006). Our
analysis confirms that the NMS were trying to satisfy the MT and SGP regulations and
they actually changed their fiscal behavior entering the EU. It is difficult, however, to
determine the fiscal stance of the OMS. Certainly, they did not change their fiscal poli-
cies in 2004. Moreover, their fiscal behavior was mostly driven by the crisis effects with
barely any insight on other indicators. All this might be viewed as a contribution toward
the ongoing discussion on the relevance and effectiveness of the EU fiscal standards.
In order to show whether the 2004 effects were the results of the EU accession
or they could have been shaped by different factors, we run the same regressions on
the sample of countries which did not belong to the EU at that time, i.e., Canada
and Australia, together with countries which entered the EU later, i.e., Romania and
Bulgaria. The results are presented in Table 3.
Interestingly, the output gap variable is weakly statistically significant after 2004 in
all but the truncated-sample specification. The change from acyclical toward counter-
123
Table 2 Discretionary fiscal rule in the Old Member States before (BEU) and after (AEU) the 2004
enlargement
Model 1 2 3 4 5
lag. deficit (BEU) 0.607*** 0.435*** 0.614*** 0.609*** 0.616***

(0.063) (0.052) (0.063) (0.063) (0.063)
lag. deficit (AEU) 0.631*** 0.551*** 0.616*** 0.633*** 0.619***
(0.038) (0.056) (0.039) (0.038) (0.039)
H0: BEU = AEU 0.747 0.077* 0.976 0.738 0.968
output gap (BEU) 0.04 0.252*** −0.001 0.038 −0.002
(0.131) (0.095) (0.133) (0.131) (0.133)
output gap (AEU) 0.227*** 0.111 0.24*** 0.223*** 0.236***
(0.065) (0.069) (0.065) (0.065) (0.066)
H0: BEU = AEU 0.201 0.237 0.106 0.206 0.108
lag. debt (BEU) −0.035*** 0.014 −0.056*** −0.034*** −0.055***
(0.013) (0.019) (0.016) (0.012) (0.0160)
lag. debt (AEU) −0.0422*** 0.0155 −0.0620*** −0.0420*** −0.0617***
(0.0131) (0.0201) (0.0167) (0.0131) (0.017)
H0: BEU = AEU 0.049** 0.592 0.152 0.042** 0.142
int. gap (BEU) 1.133 1.145
(0.81) (0.812)
int. gap (AEU) 0.189* 0.187*
(0.104) (0.104)
H0: BEU = AEU 0.243 0.237
election (BEU) 0.032 0.074
(0.68) (0.679)
election (AEU) 0.483 0.479
(0.501) (0.499)
H0: BEU = AEU 0.592 0.629
Observations 688 522 688 688 688
R2 0.552 0.286 0.556 0.553 0.556
Groups 15 15 15 15 15
Sargan 0.000 0.018 0.000 0.000 0.000
election dummy. Coefficients are reported as well as standard deviation between brackets. *, ** and ***
imply significance at the 10, 5 and 1 % significance level, respectively. Equality between coefficients is
cyclical behavior is, however, never statistically significant. Similar to the OMS, the
other regressions suffer from the over-identification problems and unsuitable debt
behavior and should therefore be treated through a prism of illustrative purposes.
123
Table 3 Discretionary fiscal rule in Canada, Australia, Romania and Bulgaria before (BEU) and after
(AEU) the 2004 enlargement
Model 1 2 3 4 5
lag. deficit (BEU) 0.199 0.257 0.026 0.202 0.022

(0.163) (0.163) (0.199) (0.163) (0.2)
lag. deficit (AEU) 0.521*** 0.153 0.468*** 0.519*** 0.468***
(0.065) (0.111) (0.071) (0.065) (0.071)
H0: BEU = AEU 0.049** 0.581 0.03** 0.053* 0.029**
output gap (BEU) 0.063 0.075 0.096 0.062 0.088
(0.118) (0.103) (0.12) (0.12) (0.121)
output gap (AEU) 0.188** 0.052 0.148* 0.186** 0.147*
(0.083) (0.109) (0.084) (0.083) (0.084)
H0: BEU = AEU 0.397 0.882 0.73 0.409 0.699
lag. debt (BEU) −0.004 −0.019 −0.018 −0.005 −0.019
(0.017) (0.024) (0.018) (0.017) (0.018)
lag. debt (AEU) −0.035* −0.027 −0.054** −0.035* −0.054**
(0.021) (0.031) (0.022) (0.021) (0.022)
H0: BEU = AEU 0.0012*** 0.522 0.001*** 0.002*** 0.001***
int. gap (BEU) −0.088** −0.09**
(0.045) (0.045)
int. gap (AEU) −0.434** −0.427**
(0.189) (0.191)
H0: BEU = AEU 0.044** 0.051*
election (BEU) 0.083 0.422
(1.246) (1.255)
election (AEU) −0.513 −0.260
(0.871) (0.865)
H0: BEU = AEU 0.694 0.653
Observations 184 140 184 184 184
R2 0.397 0.060 0.417 0.398 0.418
Groups 4 4 4 4 4
Sargan 0.007 0.351 0.008 0.006 0.008
The only model which passes the Sargan test, i.e., model 2, suggests that there was
no change in fiscal behavior in 2004. International Monetary Fund (2013b) delivers
evidence that the advanced economies applied counter-cyclical fiscal policies as crisis-
123
management measures in the aftermath of the global financial crisis. Our sample
covers only two of the non-EU advanced economies, i.e., Australia and Canada, being
non-representative and too small to confirm this result empirically. Nevertheless, this
reflection builds an interesting scope for future research, including applications of
fiscal policies as fire-fighting tools for the advanced and emerging economies.
3.4 Robustness of the results
We carry out two robustness checks for the NMS estimations. Firstly, in order to control
for the quarterly fiscal effects, we run the regressions on the annualized data. Secondly,
we apply the dynamic panel estimator, as proposed by Candelon et al. (2010), in order
to check the results on a different instrument space. The results for the former are
presented in Table 4 and for the later in Table 5.
The results obtained from the annualized data confirm the findings from the quar-
terly data, indicating that the fiscal policies after 2004 were always counter-cyclical
and statistically significant, with their earlier counterparts being acyclical. The change
toward acyclical behavior was statistically significant in 3 out of 5 model specifica-
tions. Importantly, none of the models suffer from the over-identification problems, not
the unsustainable debt behavior. The coefficients on the interest gap are preserved from
the quarterly data estimations. Interestingly, the annualized data show the statistical
significance of the negative election effects, confirming the ‘election gifts’ hypothesis
(De Haan et al. 2003).
We run the dynamic panel estimations on the annualized data to comply with the
‘large-N and small-T’ requirement suggested by Roodman (2006). We instrument the
variables of interest with their first and second lags. We apply the standard two-step
Arellano-Bond dynamic panel estimator (Arellano and Bond 1991), with the small-
sample correction (Windmeijer 2005) and orthogonal transformation on the instrument
space in order to yield a higher number of degrees of freedom (Roodman 2006).
Choosing a different instruments space yields better Sargan test results. The only
possibly over-identified model is the truncated-sample specification. The other models
show no over-identification problems, as expected, together with no autocorrelation
in the first- and the second-lagged error terms. The results show much less statistical
significance for all variables, which could result from much smaller number of degrees
of freedom. The statistically significant coefficients in all the models preserve the
findings from previous regressions. In 2 out of 5 models, we find the statistically
significant counter-cyclical fiscal policies in the after-2004 period with acyclical or
pro-cyclical policies before. We confirm also statistically significant change toward
more counter-cyclical behavior in model 4, with also the negative election effects in
the pre-EU period.
3.5 Heterogeneity analysis
In order to investigate the heterogeneity in fiscal policies between various NMS, we run
a simple partition-clustering analysis in means as advertised by Everitt et al. (2011).
We first run the ‘kmeans’ algorithm between deficit, debt and output gap, specifying
the numbers of cluster we want to find. We vary the number of clusters from 2 to 5,
123
Table 4 Discretionary fiscal rule in the New Member States on the annualized data before (BEU) and after
(AEU) the 2004 enlargement
Model 1 2 3 4 5
lagged deficit (BEU) 0.351* 0.434*** 0.331* 0.322* 0.294*

(0.182) (0.129) (0.174) (0.172) (0.165)
lagged deficit (AEU) 0.751*** 0.475*** 0.672*** 0.713*** 0.646***
(0.099) (0.156) (0.095) (0.095) (0.091)
H0: BEU = AEU 0.041** 0.817 0.07* 0.036** 0.047**
output gap (BEU) −0.075 −0.094 −0.097 −0.148 −0.220
(0.227) (0.183) (0.220) (0.224) (0.217)
output gap (AEU) 0.317*** 0.211** 0.145* 0.366*** 0.182**
(0.07) (0.107) (0.082) (0.069) (0.082)
H0: BEU = AEU 0.1* 0.17 0.295 0.027** 0.074*
lagged debt (BEU) 0.181*** 0.141*** 0.185*** 0.186*** 0.188***
(0.037) (0.05) (0.035) (0.035) (0.033)
lagged debt (AEU) 0.213*** 0.159*** 0.227*** 0.221*** 0.232***
(0.035) (0.047) (0.033) (0.033) (0.031)
H0: BEU = AEU 0.113 0.284 0.03** 0.065* 0.017**
interest gap (BEU) −0.257 −0.313
(0.275) (0.261)
interest gap (AEU) −0.522*** −0.521***
(0.15) (0.145)
H0: BEU = AEU 0.303 0.397
election (BEU) −1.28* −1.637**
(0.71) (0.672)
election (AEU) −1.322*** −1.046**
(0.479) (0.455)
H0: BEU = AEU 0.959 0.46
Observations 100 80 100 100 100
R2 0.587 0.437 0.637 0.629 0.676
Groups 10 10 10 10 10
Sargan 0.155 0.152 0.23 0.14 0.272
123
Table 5 Discretionary fiscal rule in the New Member States on the annualized data with the dynamic panel
estimators before (BEU) and after (AEU) the 2004 enlargement
Model 1 2 3 4 5
lagged deficit (BEU) 0.648 2.515 −0.132 6.008 −16.87

(1.89) (2.354) (1.96) (3.299) (20.53)
lagged deficit (AEU) 0.908** 0.924* 4.433 −0.407 22.44
(0.379) (0.502) (4.153) (0.639) (20.57)
H0: BEU = AEU 0.907 0.585 0.398 0.130 0.362
output gap (BEU) −0.791 −2.486 13.04 −8.815* 74.68
(2.545) (3.908) (11.17) (4.775) (73.70)
output gap (AEU) 0.447*** 0.261 −3.928 0.647*** −19.37
(0.094) (0.262) (4.507) (0.173) (18.04)
H0: BEU = AEU 0.641 0.493 0.301 0.084* 0.332
lagged debt (BEU) 0.129 0.195 1.437 0.216 6.679
(0.117) (0.134) (1.462) (0.213) (5.9)
lagged debt (AEU) 0.162 0.061 1.93 −0.328 10.58
(0.135) (0.177) (1.991) (0.214) (9.875)
H0: BEU = AEU 0.856 0.548 0.398 0.135 0.354
interest gap (BEU) −0.351 −3.474
(0.652) (4.037)
interest gap (AEU) −10.38 −46.08
(10.53) (41.59)
H0: BEU = AEU 0.743 0.873
election (BEU) −12.08* 43.82
(5.518) (53.71)
election (AEU) 0.007 −11.89
(2.66) (11.95)
H0: BEU = AEU 0.123 0.352
Observations 110 80 110 110 110
Groups 10 10 10 10 10
AR(1) 0.126 . 0.162 . 0.562
AR(2) 0.257 0.167 . 0.396 .
Sargan 0.257 0.0866 0.417 0.391 0.368
Variables are instrumented with the next lags of the dependent variables in the two-step procedure with the
small-sample correction and orthogonal transformation. Model 1: the benchmark model, i.e., full sample
and standard regressors. Model 2: the same as 1 but on the truncated sample Q12001–Q42008. Model 3:
the same as 1 but with the interest rate gap. Model 4: the same as 1 but with the election dummy. Model
5: the same as 1 but with the interest rate gap and the election dummy. Coefficients are reported as well
as standard deviation between brackets. *, ** and *** imply significance at the 10, 5 and 1 % significance
level, respectively. Equality between coefficients is tested by a standard F-test, whose p-value is indicated
in the separate row H0: BEU = AEU. The adequacy of instrument space is tested with the Sargan test. The
autocorrelation of the error terms is tested with the standard AR test
123
Table 6 Cluster analysis of the fiscal policy changes among the New Member States after the accession
to the EU in 2004
Clusters Changes Countries
2 1 Cz. Rep., Lithuania, Slovenia, Estonia, Latvia

3 2 Cz. Rep., Lithuania, Slovenia, Estonia, Latvia, Slovakia
4 2 Cz. Rep., Lithuania, Slovenia, Estonia, Latvia
5 2 Cz. Rep., Slovenia, Estonia, Slovakia
Clusters determines the number of clusters which are to be found across all the NMS. Changes shows
how many of those clusters changed their fiscal behavior toward more counter-cyclical. Countries which
changed their behavior are listed in a separate column
managing at least 2 countries in each cluster. We then run the standard panel IV model
in Eq. 1 with the standard specification on each cluster. We count how many clusters
showed a statistically significant change toward counter-cyclical behavior after Q2
2004, and we list the countries which belong to that clusters. The results are presented
in Table 6.13
We can observe that the change in the NMS fiscal policies after the EU accession was
mostly driven by Czech Republic, Lithuania, Slovenia, Estonia, Latvia and Slovakia.
While some of the countries, such as Lithuania, Estonia or Latvia, were largely exposed
to the global financial crisis, Slovenia was suffering from the sovereign debt crisis
and Czech Republic and Slovakia were quite robust to those events. The common
denominator for those countries can lie in their economic size. Relatively smaller
countries tend to have more volatile public spending, suggesting that they find it
easier to adjust their fiscal behavior (Furceri and Poplawski-Ribeiro 2008).
4 Summary
In line with the economic literature and recent considerations on the European inte-
gration and adoption of the fiscal rules, this paper continues and contributes to the
discussion by addressing the aspect how fiscal rules affect discretionary policy behav-
ior of governments in the EU. In times like these, with the financial and debt crisis
affecting especially Europe, such an analysis certainly is of special relevance.
Our study includes 25 EU member economies, however, a special focus is set on
ten NMS, which joined the EU in 2004. Based on quarterly data covering the years
2000 until 2011 and different specifications regarding the explanatory variables, a
panel regression with the IV technique has been implemented. In order to study the
influence of the adoption of fiscal rules on discretionary policy, the model estimates
the relationship between the structural primary balance ratio and the central regressor:
the output gap ratio, which represents the economic performance and situation.
The results indicate a statistically significant switch toward counter-cyclical fiscal
policy behavior of the NMS after their EU entry. The findings are robust to different
data frequency and estimation methods. The specification methods confirm previous
13 The results are robust to all the other model specifications.
123
findings of possible heterogeneity in fiscal behavior in our sample (Schneider and

Zapal 2005). We find that changes in fiscal policies among the NMS were mostly
driven by relatively smaller economies. On average, however, NMS were running
stabilizing budgetary positions as of the Q2 2004.
For reasons of comparison, the same investigation has been implemented for the
OMS and a set of non-member countries, including Canada and Australia, and future-
member countries, such as Romania and Bulgaria. The results suggest that the fiscal
behavior among the OMS and other countries was driven by different factors from the
ones among the NMS. It seems that once in the EU, a member loses the incentives
for prudent fiscal behavior. This phenomenon has been recognized in previous studies
and is currently a topic of consideration of the European Commission, European
Parliament and national governments in the EU (Schaechter et al. 2012). We believe
that this study contributes to the ongoing discussion, yielding a mechanism toward
more prudent fiscal performance once in the EU.
From a policy point of view, this study suggests that the EU fiscal rules proved to be
sufficient to motivate counter-cyclical behavior within the NMS which joined the EU
in 2004. Similarly, the counter-cyclical policies of the OMS appeared to be driven by
the crisis period rather than EU fiscal framework (see also IMF 2013b). Nevertheless,
as the sovereign debt crisis evolved and the macroeconomic performance have further
deteriorated, the ongoing fiscal consolidation could have reduced the possibility to run
counter-cyclical policies, regardless of whether in the NMS or OMS. With this respect,
the EU fiscal framework seems to be ineffective to motivate counter-cyclical actions
in the Member States. Further reforms are needed to provide the EU with enough
fiscal effectiveness and flexibility to build a solid framework for sustainable growth.
Those can include fiscal responsibility laws comprising medium- and long-term fiscal
frameworks, fiscal rules, and independent fiscal councils (Darvas 2009).
The debt-overhang problem can also suggest that the fiscal behavior within the EU
can be asymmetric (for instance, counter-cyclical during the boost and acyclical or
pro-cyclical in the boom). Our policy implications depend largely on the availability
of fiscal space in particular Member States. Because the NMS benefit from relatively
lower levels of public debt (see Table 7), it is relatively easier for them to run counter-
cyclical policies during the boosts. The question of fiscal asymmetries within the EU
remains a valid point for policy agenda and deserves further investigation in order to
provide the EU with an effective fiscal environment.
Certainly, these results should not be interpreted in isolation. The budgetary policies
have been considered as an everlasting topic for discussion in the European history
and might be affected by other factors than we included in our analysis. In order to
get a comprehensive picture, one should consider country-specific research, treating
the fiscal performance of each NMS individually. Our outcomes reveal just a top of
an ice berg in the fiscal performance in the NMS after the EU entry.
Acknowledgments Authors would like to thank Cees Diks, the participants of the 11th Annual NBP-SNB
Joint Seminar in Starawieś, two anonymous referees and the editor for valuable comments. Any views
expressed are only those of authors and do not necessarily represent the views of the European Investment
Bank.
123
Appendix 1: Additional figures and data information
This appendix shows the disaggregated information from Figs. 1, 2, 3 and 4 with
countrywise data and a table on detailed information of the data (Figs. 6, 7, 8, 9, 10,
11, 12 and 13; Tables 7). Table 8 presents additional robustness results.
40
Cyprus
Czech
Estonia
30
Primary balance to GDP ratio
Hungary
Lithuania
Latvia
20
Malta
Poland
Slovenia
10
Slovakia
0
−10
Q1:2000 Q1:2002 Q1:2004 Q1:2006 Q1:2008 Q1:2010
Fig. 6 Primary balance ratio NMS. Source: ECB (2013), own calculations
10
Austria
Belgium
Germany
0
Denmark
Primary balance to GDP ratio
Spain
Finland
−10
France
UK
Greece
Ireland
−20
Italy
Luxembourg
Netherlands
−30
Portugal
Sweden
−40
Q1:2000 Q1:2002 Q1:2004 Q1:2006 Q1:2008 Q1:2010
Fig. 7 Primary balance ratio OMS. Source: ECB (2013), own calculations
123
10
Cyprus

Czech
Estonia
5 Hungary
Lithuania
Latvia
Malta
Poland
0
Slovenia
Slovakia
−5
−10
Q1:2000 Q1:2002 Q1:2004 Q1:2006 Q1:2008 Q1:2010
Fig. 8 Output gap ratio NMS. Source: ECB (2013), IMF (2013a), own calculations
6
Austria
Belgium
Germany
4
Denmark
Spain
Finland
2
France
UK
Greece
0
Ireland
Italy
−2
Luxembourg
Netherlands
Portugal
−4
Sweden
−6
Q1:2000 Q1:2002 Q1:2004 Q1:2006 Q1:2008 Q1:2010
Fig. 9 Output gap ratio OMS. Source: ECB (2013), IMF (2013a), own calculations
123
Cyprus
80
Czech
Estonia
Hungary
Lithuania
Public debt to GDP ratio
60
Latvia
Malta
Poland
Slovenia
Slovakia
40
20
Q1:2000 Q1:2002 Q1:2004 Q1:2006 Q1:2008 Q1:2010
Fig. 10 Debt ratio NMS. Source: ECB (2013), own calculations
Austria
Belgium
150
Germany
Denmark
Spain
Public debt to GDP ratio
Finland
France
100
UK
Greece
Ireland
Italy
Luxembourg
Netherlands
50
Portugal
Sweden
0
Q1:2000 Q1:2002 Q1:2004 Q1:2006 Q1:2008 Q1:2010
Fig. 11 Debt ratio OMS. Source: ECB (2013), own calculations
123
Cyprus
Czech
Interest rate gap, in percentage points
10
Estonia
Hungary
Lithuania
8
Latvia
Malta
Poland
6
Slovenia
Slovakia
4
2
0
Q1:2000 Q1:2002 Q1:2004 Q1:2006 Q1:2008 Q1:2010
Fig. 12 Interest rate gap NMS. Source: IMF (2013a), own calculations
Austria
Belgium
Interest rate gap, in percentage points
15
Germany
Denmark
Spain
Finland
France
10
UK
Greece
Ireland
Italy
Luxembourg
5
Netherlands
Portugal
Sweden
0
Q1:2000 Q1:2002 Q1:2004 Q1:2006 Q1:2008 Q1:2010
Fig. 13 Interest rate gap OMS. Source: IMF (2013a), own calculations
123
Table 7 Detailed data information (own calculations)
Variable Source No. of obs. Descriptive statistics
Mean Min Max SD
Primary balance ECB (2013) NMS: 480 −3.53 −6.74 −0.01 1.64
OMS: 720 −2.13 −8.02 1.82 2.61
Public debt ECB (2013) NMS: 480 38.66 32.55 50.17 4.81
OMS: 720 62.26 54.66 80.88 7.19
Output gap GDP: ECB (2013) NMS: 480 0.12 −4.97 4.62 2.16
Deflator: IMF (2013a) OMS: 720 0.15 −2.77 2.93 1.38
Int. rate gap IMF (2013a) NMS: 480 2.08 0.57 4.29 1.11
OMS: 720 0.51 0.04 3.27 0.73
Election dates IFES (2013) NMS: 480
OMS: 720
US data (IV IMF (2013a) 48 per variable
variable)
(GDP and Def.)
Safe havens OECD (2014a) 48 per variable
OECD (2014b) and country
For OMS and NMS (accession 2004 and 2007), each variable and source is listed separately, and for each of
the technical aspects (IV variable, control group), the information is merged, respectively. The descriptive
statistics refer to the 10 NMS and 15 OMS. Figures 1, 2, 3 and 4 support them graphically
Table 8 Discretionary fiscal rule in the New Member States before (BEU) and after (AEU) accession to
the European Union: robustness check for models 3–5 from Table 1 on the example of the truncated sample
Q12001–Q42008
Model (2) (3a) (4a) (5a)
lag. deficit (BEU) 0.216*** 0.158** 0.19*** 0.156**

(0.065) (0.065) (0.067) (0.065)
lag. deficit (AEU) 0.395*** 0.242*** 0.329*** 0.23***
(0.08) (0.076) (0.078) (0.077)
H0: BEU = AEU 0.063* 0.364 0.149 0.432
output gap (BEU) 0.036 0.075 0.0329 0.0691
(0.085) (0.085) (0.088) (0.085)
output gap (AEU) 0.178*** 0.105* 0.160** 0.110*
(0.067) (0.062) (0.063) (0.063)
H0: BEU = AEU 0.779 0.198 0.246 0.705
lag. debt (BEU) −0.053* −0.0743** −0.0792** −0.0752**
(0.03) (0.03) (0.031) (0.03)
lag. debt (AEU) −0.015 −0.0172 −0.0349 −0.0183
(0.029) (0.029) (0.029) (0.029)
H0: BEU = AEU 0.000*** 0.000*** 0.000*** 0.000***
int. gap (BEU) −0.192* −0.188*
(0.108) (0.108)
123
Table 8 continued
Model (2) (3a) (4a) (5a)
int. gap (AEU) −0.904*** −0.907***

(0.177) (0.176)
H0: BEU = AEU 0.000*** 0.000***
election (BEU) −0.628 −0.706
(0.788) (0.761)
election (AEU) −0.524 −0.527
(0.633) (0.610)
H0: BEU = AEU 0.918 0.855
Observations 350 350 350 350
R2 0.252 0.321 0.272 0.325
Groups 10 10 10 10
Instruments GAPUS,t−1 GAPUS,t−1 GAPUS,t−1 GAPUS,t−1
Sargan 0.86 0.142 0.717 0.147
Model 2: benchmark model (the same as Model 2 in Table 1). Model 3a: the same as 2 but with the
interest rate gap. Model 4a: the same as 2 but with the election dummy. Model 5a: the same as 2 but with
the interest rate gap and the election dummy. Coefficients are reported as well as robust standard errors
between brackets. *, ** and *** imply significance at the 10, 5 and 1 % significance level, respectively.
Equality between coefficients is tested by a standard F test, whose p-value is indicated in the separate row
H0: BEU = AEU. The adequacy of instrument space is tested with the Sargan test
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Empir Econ (2016) 51:517–546

Are European fiscal rules that bad? Discretionary fiscal

Bettina Fincke1 · Marcin Wolski2

Keywords Discretionary fiscal policy · New Member States · Counter-cyclical

JEL Classification E62 · O52

1 Bielefeld University, Universitätsstraße 25, 33615 Bielefeld, Germany

2 Literature review and motivation

3 The 2004 enlargement

di,t = β0 + βdBEU di,t−1 + βdAEU di,t−1

Primary balance ratio, % GDP

Q1:2000 Q1:2002 Q1:2004 Q1:2006 Q1:2008 Q1:2010

Fig. 1 Primary balance ratio. Source: ECB (2013), own calculations

As we are interested in studying the effects of the adoption of EU fiscal rules on

Output gap ratio (relative to trend GDP)

Q1:2000 Q1:2002 Q1:2004 Q1:2006 Q1:2008 Q1:2010

Q1:2000 Q1:2002 Q1:2004 Q1:2006 Q1:2008 Q1:2010

Fig. 3 Debt ratios. Source: ECB (2013), own calculations

Interest rate gap (percentage points)

Q1:2000 Q1:2002 Q1:2004 Q1:2006 Q1:2008 Q1:2010

Fig. 4 Interest rate gaps. Source: IMF (2013a), own calculations

lag. deficit (BEU) 0.224** 0.216*** 0.222** 0.225** 0.223**

case, as the situation may be reckoned to be strongly politically influenced. Concerning

3.3 Comparison with the OMS and other countries

lag. deficit (BEU) 0.607*** 0.435*** 0.614*** 0.609*** 0.616***

lag. deficit (BEU) 0.199 0.257 0.026 0.202 0.022

3.4 Robustness of the results

3.5 Heterogeneity analysis

lagged deficit (BEU) 0.351* 0.434*** 0.331* 0.322* 0.294*

lagged deficit (BEU) 0.648 2.515 −0.132 6.008 −16.87

Clusters Changes Countries

2 1 Cz. Rep., Lithuania, Slovenia, Estonia, Latvia

13 The results are robust to all the other model specifications.

findings of possible heterogeneity in fiscal behavior in our sample (Schneider and

Appendix 1: Additional figures and data information

Q1:2000 Q1:2002 Q1:2004 Q1:2006 Q1:2008 Q1:2010

Q1:2000 Q1:2002 Q1:2004 Q1:2006 Q1:2008 Q1:2010

Output gap ratio (relative to trend GDP)

Q1:2000 Q1:2002 Q1:2004 Q1:2006 Q1:2008 Q1:2010

Q1:2000 Q1:2002 Q1:2004 Q1:2006 Q1:2008 Q1:2010

Q1:2000 Q1:2002 Q1:2004 Q1:2006 Q1:2008 Q1:2010

Fig. 10 Debt ratio NMS. Source: ECB (2013), own calculations

Q1:2000 Q1:2002 Q1:2004 Q1:2006 Q1:2008 Q1:2010

Fig. 11 Debt ratio OMS. Source: ECB (2013), own calculations

Q1:2000 Q1:2002 Q1:2004 Q1:2006 Q1:2008 Q1:2010

Q1:2000 Q1:2002 Q1:2004 Q1:2006 Q1:2008 Q1:2010

Table 7 Detailed data information (own calculations)

Variable Source No. of obs. Descriptive statistics

Mean Min Max SD

Model (2) (3a) (4a) (5a)

lag. deficit (BEU) 0.216*** 0.158** 0.19*** 0.156**

Model (2) (3a) (4a) (5a)

int. gap (AEU) −0.904*** −0.907***

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lag. deficit (BEU) 0.224 0.216* 0.222 0.225 0.223**

lag. deficit (BEU) 0.607* 0.435* 0.614* 0.609* 0.616***

lag. deficit (BEU) 0.216* 0.158 0.19* 0.156

int. gap (AEU) −0.904* −0.907*