Sustainability of Public Finances in European Economies: Fiscal Policy Reactions and Market Pricing

Abstract

This article evaluates fiscal discipline in twenty-two member countries in the European Union. We adopt a two-dimensional approach in which we evaluate the reaction of the primary balance to public debt and the response of financial markets to fiscal variables. Our results suggest that the fiscal policy in EU is sustainable. Financial markets seem to pay attention to fiscal variables. Since the beginning of the financial crisis, both markets and governments have responded more strongly to public debt. Interestingly, the reaction of the markets to GDP per capita seems to be stronger in the high-debt economies.

Keywords:

• European Union
• fiscal reaction functions
• pooled mean group
• sovereign yields

JEL Classification:

• E43
• E62
• H63

ACKNOWLEDGMENTS

The authors thank Karsten Staehr and Christos Shiamptanis for their inspiring comments and discussions as well as the participants in the ninth International Conference “Economic Challenges in Enlarged Europe,” Tallinn, Estonia, June 11–16, 2017, and the participants in the ninth RCEA Macro-Money-Finance Workshop “Monetary and Fiscal Policy in the Next Recession,” Waterloo, Canada, June 23–24, 2017, for helpful discussions and suggestions.

Notes

1. Barrios et al. (2009) note that greater market discrimination across countries may provide higher incentives for governments to attain and maintain sustainable public finances, because even small changes in bond yields have a noticeable impact on government outlays.

2. For the CDS spreads, our sample ends in 2015Q1 and starts differently for different countries. The panel is therefore unbalanced and much shorter than for the government bond yields. Moreover, the market for sovereign CDS was relatively illiquid before the global financial crisis. The results for CDS, therefore, should be treated with caution.

3. The limit set in the Maastricht criteria for euro-area member states and the Stability and Growth Pact.

4. If we change the number of lags of dependent and independent variables in the specification, the results do not change substantially. Similar results were obtained for the division of the country groups through PCA.

5. For this reason, we were not able to estimate Equation (4) using the PMG estimator for the group of countries with low debt, mainly the CEE countries.

6. Although this might not be a problem for Europe as a whole, according to the Eurostat data, interest payments as a percentage of GDP increased in some countries (Ireland, Spain, Latvia, Lithuania, Portugal, Slovenia, and the UK).

Additional information

Funding

This work was supported by the National Science Centre under grant no. DEC-2015/17/B/HS4/00297.