Fiscal consumption and private consumption in Europe: what have we learned?

ABSTRACT In this paper we contribute to the long literature on how fiscal policy affects the real economy. In particular, we focus on how government consumption affects private consumption for a pool of European economies. We estimate panel vector error correction models between the two consumption variables for the EU 28 + Norway and Switzerland, for the two periods before and after 2008. The results show that government consumption affects private consumption differently in the periods before and after 2008. This means an increase in government consumption could have a positive impact on private consumption.


I. Introduction
There has been quite a significant degree of controversy about whether fiscal policy should be deployed to tackle recessions. This was seen in the debate about the austerity measures applied by many European countries after the 2012 sovereign crisis, as their effectiveness was doubted (Cuestas, Ordóñez, and Staehr 2019).
The current academic theoretical discussion about the effect of austerity measures revolves around the Real Business Cycle (RBC) model. This model argues that production is determined only by aggregate supply, which means that fiscal expansion would be negative for output because government expenditure increases the drain on resources from the economy. However, expansionary fiscal policies do not have the same negative effect if dynamic RBC is considered instead. In this case workers increase their working hours to smooth consumption, so increasing output. Christiano, Eichenbaum, and Rebelo (2011) find from the intertemporal RBC model with nominal interest rates at the zero bound that the magnitude of the fiscal multiplier is larger than one, implying that a fiscal contraction may be quite detrimental for output. The effect of fiscal policy may also depend on the stance of the economy. This means the fiscal multiplier can have different impacts depending on whether the country's economy is increasing or decreasing (Perotti 1999), as fiscal expansions in recessions can be very painful (Bilbiie, Monacelli, and Perotti 2014) and the multiplier tends to be larger during a financial crisis (Corsetti et al. 2013) but small or even negative in countries with high debt levels (Ilzetzki, Mendoza, and Végh 2013). This is important because many European countries, as mentioned, applied fiscal contractions from 2012 at a very delicate time for their economies.
The empirical literature on fiscal multipliers is huge (Huidrom et al. 2020), but this note intends to focus on analysing how government consumption affects private consumption, with both measured as percentages of GDP. Although there is a vast empirical analysis of how fiscal policy affects GDP and unemployment, there has been less interest in its effect on consumption. In a recent contribution, Cuestas and Ordóñez (2018) analyse how fiscal policy affects unemployment for a number of European economies. They find that fiscal contractions in 2008-2014 were detrimental for unemployment. However, it seems that in the Covid-19 pandemic, private consumption did not quite keep up with its pre-Covid-19 levels in many European countries. The idea of this work is to shed some light on how expansionary fiscal policies can impact consumption so that it can return to the trends of expansion from before the Covid-19 pandemic (Abakah et al. 2021).
We have selected a large panel of European countries, taking the EU28 + Norway and Switzerland, and we analyse how government consumption shocks impacted private consumption in 1995-2021. In addition, we have divided the data at 2008 so that we can assess differences between the periods before and after the great recession. The analysis is performed using cointegration techniques based on vector error correction models (VECM) (Johansen 1988(Johansen , 1991 with impulse response analysis based on structural shocks. The analysis is performed as a panel.
Our results show that fiscal policies were countercyclical before the great recession, but the fiscal consolidation measures applied after the sovereign debt crisis make this variable behave pro-cyclically. In addition, fiscal stimulus had a positive and significant impact on the importance of consumption for GDP both before and after the beginning of the great recession.
The remainder of the paper is organized as follows. In the next section we summarize the empirical analysis and the results, and the last section concludes.

II. Empirical analysis
The data for this empirical analysis consist of quarterly observations of the seasonally adjusted series of government consumption (G) and private consumption (C), both measured as a percentage of gross domestic product, from 1995Q1 to 2021Q3 downloaded from the Eurostat database. The countries selected are the 28 member states of the European Union, plus Norway and Switzerland because of their close ties with the 28. As Figure 1 shows, the two variables seem to maintain a clear co-movement over time, which could be a sign that they share a common stochastic trend.
Since the analysis is going to be performed as a panel, we first analyse the order of integration of the series using the Pesaran (2007) panel unit root test, which accounts for cross-sectional dependence. The results of the test are displayed in Table 1.  Table 1 show, the series as a whole is a unit root process, so cointegration analysis is needed for the relationship between the variables to be assessed.

As the results in
Next we assess whether there is cointegration using the Johansen Trace and Lambda maximum tests, for a panel where we have included individual fixed effect dummy variables and no other deterministic component. The models are estimated with four lags. The results show that there is cointegration between the variables. We have complemented this analysis with the residual-based cointegration tests of Pedroni (1999) and Kao (1999). 1 The estimated VECM is shown in Table 2. As we see from the values of the loadings, both variables react to deviation from the long-run equilibrium and there is a negative relation between the variables in the long run, showing the countercyclicality of fiscal policy in this group of countries. However, the outbreak of the great recession in 2008 means these results may be unreliable because there are significant instabilities and structural breaks.
In the next step we estimate the model separately for the period before 2008Q1 and from there onwards in two different samples.
In Table 3 we report the results of the VECM estimations before and after the crisis. The second column shows that the coefficient of the long-run relationship for government consumption is only significant at the 10% level and that only private consumption corrects the disequilibria from the long-run equation. Note that since the coefficient of the loadings from D(G) is negative and G_(−1) is also negative, the variable G does not correct deviations from the cointegrating equation. We also plot in Figure 2 the impulse response functions from a Cholesky decomposition, allowing private consumption to react contemporaneously to government consumption shocks, but not the other way round.  This illustrates that government spending shocks tend to have long-lasting effects on private consumption, while the reaction of government consumption is inverse to the sign of the private consumption shock.
According to the estimations displayed in the third column of Table 3, there is a much stronger long-run relationship between the two variables, and unlike in the previous sample, government consumption is the variable that reacts to the disequilibria from the long-run relationship.
In Figure 3 we show the impulse response functions. The results show that whereas the pattern for private consumption is similar to that in the pre-crisis sample, government consumption reacts positively to positive private consumption shocks. This is not surprising as the second sample analysed coincides with a period when most countries applied fiscal consolidation measures in a period of deep drops in GDP while private consumption was important in overall income.  Note: In round brackets we report the standard errors and in square brackets the t-ratios. To save space the estimations for the individual effects and the dynamics have not been included.
This highlights the importance of using fiscal policies to alleviate drops in consumption, and justifies the deployment of extraordinary measures for the recovery in Europe from the Covid-19 pandemic.

III. Conclusion
In this paper we have analysed the effects of government consumption and private consumption on each other before and after 2008, which coincides with the great moderation and the beginning of the great recession, for a pool of European countries. We apply cointegration methods and estimate structural VECMs, and find that the response of private consumption to government consumption shocks is positive both before and after the crisis. However, during the great moderation we observe that the behaviour of government consumption is countercyclical, while the reaction of government consumption after 2008 moves in the same direction as the sign of the private consumption shock. This shows the effect of the austerity measures applied to the debt crisis because of the 2008-2010 global financial crisis.

Acknowledgments
Mercedes Monfort acknowledges the financial support from the University Jaume I research project UJI-B2020 -16. Juan Carlos Cuestas acknowledges the financial support from the Generalitat Valenciana project AICO2021/ 005.

Disclosure statement
No potential conflict of interest was reported by the author(s).