Fiscal Policy and Asset Price Cycles: Evidence from Four European Countries

We test for non-linear effects of asset prices on the fiscal policy of four major European economies (France, Italy, Spain and UK). We model government spending and revenue as time-varying transition probability Markovian processes (TVPMS), and find that: (i) in France and Italy, the impact of housing prices on government revenue is conditioned by the phase of the stock price cycle; (ii) a similar asymmetric pattern is found for the UK when considering the effect of stock price fluctuations on government revenue and spending vis-à-vis the troughs and peaks of aggregate wealth; and (iii) for Spain, a fall in government revenue is typically associated with a negative performance of the housing market, while government spending does not seem to adjust to the dynamics of financial market. In addition, the magnitude of the contribution of housing prices to changes in government revenue appears to have dominated that of stock prices in France and the UK. As for government spending, changes in this policy instrument are correlated with changes in asset prices, but the effect depends on the magnitude of the price variation and the influence of the output cycle. Therefore, the empirical evidence corroborates the idea that accounting for the dynamics of asset markets provides a more accurate assessment of the fiscal stance.