Fiscal and external deficits nexus in GIIPS countries: evidence from parametric and nonparametric causality tests

This paper investigates relationship between fiscal and external deficits in five European Union countries: Greece, Ireland, Italy, Portugal, and Spain (GIIPS) using quarterly data for the period 1980:1-2020:1. Literature on the relationship between these series has not only used linear techniques, but generally reported inconclusive results. Nonlinearity relationship has been overlooked even though fiscal policy is likely to exhibit nonlinearity due to its sensitivity to political decisions. To capture this nonlinearity behaviour, nonlinear causality technique is applied here in addition to the usual linear techniques used in the extant literature. The results show that there is evidence of unidirectional nonlinear causality from trade balance to government deficits in Greece and Italy, a nonlinear unidirectional causality from government deficits to trade balance in Portugal. The results also indicate evidence of a nonlinear bi-directional causality between the trade and government balances in Ireland and Spain. The policy implication of these results is that governments of these countries need to address fiscal deficits to manage their trade balances. Policies that will improve the countries’ revenue base, such as tax and labour market reforms as well as capital market reforms to engender productivity and increase competitiveness would be beneficial.