The last two decades have seen a dramatic shift in fiscal policies in many developed and developing economies. Balanced budgets and balanced current accounts have virtually disappeared, and government deficit financing has prevailed. This resulted in the numerous debt and financial crises that have erupted since early 2000 (Neaime, 2010, 2012, 2016; Guyot et al, 2014).

Policy-makers and researchers have been devoting considerable effort first to assessing the soundness of the external and public sectors, and then attempting to forecast whether macroeconomic policies are sustainable. In the event that they are not sustainable, various austerity and structural adjustment measures will be essential to avoid fiscal, debt, currency and perhaps banking crises.

But timing the introduction of austerity measures is a concern given the generally recessionary environment in the European Union (EU) and the Southern Mediterranean (MED) regions since the global financial crisis began in the United States in 2008.

It is widely believed that fiscal adjustment measures would keep the EU and its Mediterranean partner countries in recession, further worsening budget and current account deficits as well as the debt burden. This would hamper future efforts to grow out of the accumulated public debt through higher real GDP growth.

Moreover, the accumulated EU and MED national debts arise from both economic and political/institutional factors. Therefore, austerity measures alone may not resolve the current fiscal difficulties, but should be accompanied with other political/institutional corrective measures.

On the other hand, and in the wake of the EU debt crisis, the global financial crisis and the worldwide triple-dip recession of the past decade, the solvency of some EU countries has become a major source of concern, endangering EU efforts to achieve greater financial, economic and monetary integration (Neaime 2015a, 2015b; Michelis and Neaime, 2010).

It is well known that Greece, Ireland, Italy, Portugal and Spain have been running budget deficits for the past two decades averaging 5-10% of GDP, resulting in EU public debt averaging above 120% of total GDP in 2016. The picture is quite similar in the EU’s Mediterranean partner countries, where social, political and military tensions have aggravated an already deteriorating macroeconomic situation.

Policy-makers have introduced austerity measures to limit further deteriorations in the EU and MED fiscal and macroeconomic positions, despite fears that these measures could reduce aggregate demand, worsen high unemployment rates and further lower prices. If domestic prices decline through aggressive wage and income cuts as dictated by austerity programmes, the respective real exchange rate will depreciate, rendering national goods more competitive internationally.

While this policy may improve the current account deficits of Greece, Ireland, Italy, Portugal, Spain and the Mediterranean partner countries, it is expected to lead to painful domestic adjustment measures, as a significant number of national firms will be likely to shut down, worsening unemployment in these countries.

Our studies of the public sector’s fiscal and financial vulnerabilities (Neaime and Gaysset, 2017; Neaime, 2008) explore the issues of debt sustainability and the ‘twin deficit hypothesis’ – the idea that there is a strong link between the budget balance and the current account balance. We use the hypothesis to look at fiscal and macroeconomic sustainability in Greece, Ireland, Italy, Portugal, Spain and a subset of Mediterranean partner countries: Egypt, Jordan, Lebanon, Morocco and Tunisia.

Our empirical results validate the twin deficit hypothesis in both the EU and MED countries, but there are differences in the direction of causality. While the trade balance seems to be driving the budget deficit in the MED countries – thereby validating the current account targeting approach – the relationship runs in the opposite direction in the EU countries, where the budget balance appears to be driving the current account.

Given the well-documented dependence of MED countries on trade with the EU and the fact that most EU countries have implemented austerity policies in the aftermath of the financial crisis – thereby restricting aggregate demand and imports – we argue that the ensuing drop in export income for MED countries has contributed to increasing the budget deficit in these countries, by virtue of the causality from the current account to the budget balance.

Lower exports mean lower GDP; and lower GDP implies a lower taxable income base, lower tax revenues and, therefore, further widening of the budget deficit.

One natural response of MED policy-makers would be to implement austerity policies. But while such policies may be necessary, they are socially costly in the current context in MED countries and would not alone permit stabilisation of the budget balance given that they would leave the trade balance unaffected.

Our findings thus represent a warning against such macroeconomic policy responses and indicate that austerity policy in EU countries have unexpected consequences for fiscal stability in MED countries. We thus call for better coordination of macroeconomic policy between the EU and its Southern peripheral countries.

A major policy issue to be faced in the coming years is whether macroeconomic policies have reached a dead end (Mansoorian and Neaime, 2003; Neaime, 2000). If traditional macroeconomic policies have not helped, are there any new directions that will not only solve the current financial and debt crises but also prevent future ones?

With respect to the introduction of macroeconomic stabilisation programmes in the EU and MED countries, there is no room to use both monetary and fiscal policies in tandem to curb macroeconomic imbalances.

For the MED countries of Jordan and Lebanon, which have very limited fiscal space, fixed exchange rates and open capital accounts, monetary policy is already ineffective in terms of macroeconomic stabilisation. Egypt rendered its monetary policy more effective in dealing with external shocks after the recent move to a flexible exchange rate regime. Tunisia and Morocco seem to be moving in the same direction.

While fiscal space in the EU is also limited due to the past accumulation of huge public debts, monetary policy remains effective for preventing the EU’s unsustainable fiscal policies from developing into further debt crises like in Greece. Indeed, quantitative easing implemented by the European Central Bank since 2015 is perhaps the only macroeconomic policy tool still available to avert crisis in the EU.

In the MED region, monetary policy is largely ineffective due to fixed exchange rates and free capital movement. This boils down to no role for government policies (fiscal and monetary) to deal with macroeconomic imbalances, paving the way for future fiscal and currency crises.

Thus, the EU and MED governments will need to do three things: first, reduce the size of the public sector in favour of the private sector; second, channel liquidity to the private sector through loans and encourage investments in productive ventures; and third, reduce government spending.

Finally, given the general ineffectiveness of both monetary and fiscal policies, the private sector needs to take a leading role in addressing macroeconomic imbalances in both regions. This would increase GDP growth and render debt more sustainable. Once that is achieved, austerity and structural adjustment measures should be introduced. This will ensure sustainable growth and reduce the likelihood of future debt and currency crises.

The main source of this analysis is a FEMISE research project: ‘Twin Deficits and the Sustainability of Macroeconomic Policies in Selected European and Mediterranean Partner Countries: Post Financial and Debt Crises’ with Thomas Lagoarde-Segot and Isabelle Gaysset.

Further reading

Guyot, Alexis, Thomas Lagoarde-Segot and Simon Neaime (2014) ‘Foreign Shocks and International Cost of Equity Destabilization: Evidence from the MENA region’, Emerging Markets Review 18: 101-22.

Mansoorian, Arman, and Simon Neaime (2003) ‘Durable Goods, Habits, Time Preference, and Exchange Rates’, North American Journal of Economics and Finance 14(1): 115-30.

Michelis, Leo, and Simon Neaime (2004) ‘Income Convergence in the Asia-Pacific Region’, Journal of Economic Integration 19(3): 470-98.

Neaime, Simon (2000) The Macroeconomics of Exchange Rate Policies, Tariff Protection and the Current Account: A Dynamic Framework, AFP Press.

Neaime, Simon (2008) ‘Twin Deficits in Lebanon: A Time Series Analysis’, Lecture and Working Paper Series No. 2, Institute of Financial Economics, American University of Beirut.

Neaime, Simon (2010) ‘Sustainability of MENA Public Debt and the Macroeconomic Implications of the US Financial Crisis’, Middle East Development Journal 2: 177-201.

Neaime, Simon (2012) ‘The Global Financial Crisis, Financial Linkages and Correlations in Returns and Volatilities in Emerging MENA Stock Markets’, Emerging Markets Review 13(2): 268-82.

Neaime, Simon (2015a) ‘Sustainability of Budget Deficits and Public Debts in Selected European Union Countries’, Journal of Economic Asymmetries 12: 1-21.

Neaime, Simon (2015b) ‘Twin Deficits and the Sustainability of Public Debt and Exchange Rate Policies in Lebanon’, Research in International Business and Finance 33: 127-43.

Neaime, Simon (2016) ‘Financial Crises and Contagion Vulnerability of MENA Stock Markets’, Emerging Markets Review 27: 14-35.

Neaime, Simon, and Isabelle Gaysset (2017) ‘Sustainability of Macroeconomic Policies in Selected MENA Countries: Post Financial and Debt Crises’, Research in International Business and Finance 40: 129-40.