The Euro Zone and Budget Deficit: Implications of Stabilization

Abstract

This event study focus on the response countries within the euro zone has on stabilization after a deficit crisis occurs. The data used in the analysis is collected from different sources, mainly well-known organizations such as the World Bank. The dataset contains only European economics, due to the nature of the problem in this thesis only concerning the euro zone. However, there exist some problems with the dataset. Previous research provided evidence of creative accounting in the run-up and start of the euro zone. This has made the result unreliable to some extent since it is impossible to measure the true value of the variable of interest.

The model used to capture the response of the euro zone is an extension of a previous research by Alesina et, el. (2006) on why different types of government delay adjustment of reforms. The results in this thesis includes a re-estimation of the basic empirical model (Alesina et, el. 2006) to find out whether their results holds on a sample of only European countries and results of the extended models where the political variable are changed with a variable explaining the introduction of the Euro as a hard currency. The results from the extended models were quite unexpected since they provided some evidence of countries within the euro zone that adjust more promptly in time after a deficit crisis occurs than countries with their own monetary unit. However, most of the estimates was insignificant and the results must therefore be carefully interpreted.

Three models were estimated to find out how countries within the euro zone response after the occurrence of a deficit crisis. All the models provide the same tendencies, even though most of the parameters were insignificant. To check for robustness, the crisis criteria was changed to reflect the deficit rules in the euro zone (Maastricht criteria) and a sample of PIIGS countries tested against the inner six (Germany, France…). The tendencies of the results were similar to the extended model, indicating that countries in the euro zone adjust more decisively after an occurrence of a deficit crisis. Thus, since few of the parameters of interest were significant and many problems exist with the models, no conclusion can be drawn from this event study.