Hands tied: Are some institutional arrangements more counter-cyclical?

Pro-cyclical fiscal policy is considered harmful. Nonetheless, pro-cyclicality is widespread and the cyclicality of fiscal policy isstrongly heterogenous in advanced economies. This paper investigates how differences in the cyclicality of fiscal policy can be understood through the lens of Varieties of Capitalism (VoC). The VoC-perspective argues for systematic differences between coordinated market economies (CMEs) and liberal market economies (LMEs). Because of consensus-based decision making and a wage bargaining system characterized by economy-wide large but non-encompassing wage setters, fiscal policy is reasoned to be less expansionary during downturns in CMEs and thus less counter-cyclical. During upswings, however, both channels may aid stronger fiscal retrenchment, making CMEs more fiscally conservative rather than less counter-cyclical overall. Thus far, the empirical literature has only investigated the overall differences in the cyclicality of fiscal policy between LMEs and CMEs, reporting contradictory results. Building and expanding on this literature, we analyze an unbalanced panel of 29 OECD countries from 1985 to 2021. We find LMEs to be consistently more counter-cyclical than CMEs, due to CMEs being less expansionary during downturns. During upswings, however, we do not identify a systematic difference between the archetypes. We furthermore find dependent market economies (DMEs) and mixed market economies (MMEs) to be more expansive during good times than the CME-group. Our results thus suggest that the capacity for counter-cyclical fiscal policy is deeply embedded in national institutional arrangements, rather than being merely a technical matter. Our findings aid in furthering our understanding of the institutional underpinnings of the export reliance in CMEs and interest rate differentials across Eurozone countries.