Is there a link between the public deficit and the trade deficit in the Euro area? New evidence from panel data

The aim of this paper is to empirically explore the linkage between the public deficit and the trade deficit in the case of euro area member states for the period 1990-2015. For developed and developing countries, the empirical studies conducted until now highlight diverging results on this relationship. Most of them have used time series data rather than panel data. Because it is commonly accepted that time series models may have lower statistical power than panel data models (Campbell and Perron, 1991) - as they don’t add the cross-sectional dimension to the time series dimension to exploit additional information - I choose to work in this paper with panel models rather than time series models. To provide an empirical explanation for this relationship, I apply recent panel data techniques such as the pooled mean group estimator of Pesaran, Shin and Smith (1999), which accounts for heterogeneous effects across countries and for the non-stationarity of variables. By using these methods, I assess the validity of two opposite views: the Keynesian view and Ricardian Equivalence Hypothesis. The Keynesian view states that the budget deficit affects the current account deficit, and the Ricardian Equivalence view supports that there is no relationship between the budget deficit and the current account deficit. In other words, the first view argues that there is a unidirectional causality relationship from the budget deficit towards the current account deficit, while the second one supports the idea of no linkage between the budget deficit and the trade deficit. Preliminary empirical results show a positive and significant effect of the budget balance on the trade balance, confirming the presence of twin or triple deficits for different euro area countries. This study has relevant policy implications for the countries with twin and triple deficits phenomenon. Among them, favorable fiscal balances have a key role in reversing negative trends of trade balances.

Keywords: Current Account, Twin and Triple Deficits, Panel Causality Test, Euro Area