Fiscal Policy and Interest Rates in Europe

type="main" xml:lang="en"> The appetite for fiscal discipline has been steadily declining among most industrial countries. In the past, fiscal profligacy would have been punished by markets with higher interest rates and, in some cases, also exchange rate depreciation. However, in post-EMU Europe, exchange rate markets no longer discipline the fiscal behaviour of national governments. Perhaps more crucially, even the interest rate punishment to fiscal indiscipline is highly uncertain, with academic opinions being quite divided on this issue. This paper takes a close look at the link between fiscal policy and interest rates in the European context. The key finding is that an expansionary fiscal policy in one EMU member will have an effect both on its spreads and on the overall level of interest rates for the currency union as a whole, with the second effect, however, being quantitatively much more significant. This suggests that there are indeed substantial spillovers, through the interest rate channel, among fiscal policies of member countries. To limit countries’ incentive to run expansionary fiscal policies, a set of rules, like those embedded in the Stability and Growth Pact, is then needed. Some (weak) evidence is also found that after EMU, interest rate spillovers seem to be more significant for high debt countries with unsustainable fiscal policies, reflecting perhaps market concerns about a possible sovereign bail out or the impact of financial distress. There may be a case then for imposing tighter rules on high debt countries. — Riccardo Faini

[1]  V. Gaspar,et al.  On Prosperity and Posterity: The Need for Fiscal Discipline in a Monetary Union , 2004, SSRN Electronic Journal.

[2]  Peter R. Orszag,et al.  Budget Deficits, National Saving, and Interest Rates , 2004 .

[3]  L. Mello,et al.  Saving Behaviour and the Effectiveness of Fiscal Policy , 2004 .

[4]  Ludger Schuknecht,et al.  Sovereign Risk Premia in the European Government Bond Market , 2004, SSRN Electronic Journal.

[5]  Thomas Laubach.  The Effects of Budget Deficits on Interest Rates: A Review of Empirical Results , 2004 .

[6]  Fabrizio Balassone,et al.  Market-Induced Fiscal Discipline: Is There a Fall-Back Solution for Rule Failure? , 2004 .

[7]  Dariusz K. Rosati,et al.  An Agenda for a Growing Europe: The Sapir Report , 2004 .

[8]  António Afonso,et al.  Fiscal Policy Events and Interest Rate Swap Spreads: Evidence from the EU , 2004, SSRN Electronic Journal.

[9]  Martin Mühleisen,et al.  U.S. Fiscal Policies and Priorities for Long-Run Sustainability , 2004 .

[10]  Jeromin Zettelmeyer,et al.  How Private Creditors Fared in Emerging Debt Markets, 1970-2000 , 2004, SSRN Electronic Journal.

[11]  R. Hubbard,et al.  Federal Government Debt and Interest Rates , 2004, NBER Macroeconomics Annual.

[12]  R. Hubbard,et al.  FEDERAL GOVERNMENT DEBTS AND INTEREST RATES , 2004 .

[13]  Carlo A. Favero,et al.  Yield spreads on EMU government bonds , 2003 .

[14]  M. Pesaran,et al.  Testing for unit roots in heterogeneous panels , 2003 .

[15]  R. Engle,et al.  Asymmetric Dynamics in the Correlations of Global Equity and Bond Returns , 2003, SSRN Electronic Journal.

[16]  W. Gale.  The Economic Effects of Long-Term Fiscal Discipline , 2002 .

[17]  R. Cumby,et al.  Should the European Central Bank and the Federal Reserve Be Concerned About Fiscal Policy , 2002 .

[18]  Kenneth Rogoff,et al.  The Six Major Puzzles in International Macroeconomics: Is There a Common Cause? , 2000, NBER Macroeconomics Annual.

[19]  N. Gemmell,et al.  Fiscal policy and growth: evidence from OECD countries , 1999 .

[20]  F. Drudi,et al.  Signaling Fiscal Regime Sustainability , 1999, SSRN Electronic Journal.

[21]  F. Caselli,et al.  Fiscal Discipline and the Cost of Public Debt Service: Some Estimates for OECD Countries , 1998, SSRN Electronic Journal.

[22]  P. Pedroni.  Current Version : July 25 , 1999 CRITICAL VALUES FOR COINTEGRATION TESTS IN HETEROGENEOUS PANELS WITH MULTIPLE REGRESSORS * , 1999 .

[23]  K. Bagwell,et al.  An Economic Theory of GATT , 1997 .

[24]  A. Alesina,et al.  Fiscal Adjustments in OECD Countries: Composition and Macroeconomic Effects , 1996, SSRN Electronic Journal.

[25]  Alan M. Taylor,et al.  Domestic Saving and International Capital Flows Reconsidered , 1994 .

[26]  Marzio Galeotti,et al.  Stock Market Volatility and Investment: Do Only Fundamentals Matter? , 1994 .

[27]  M. Lutz.  Interest Rates and Government Debt: Are the Linkages Global Rather than National? , 1991, SSRN Electronic Journal.

[28]  V. Tanzi,et al.  Interest Rates and Government Debt , 1991 .

[29]  O. Blanchard.  Suggestions for a New Set of Fiscal Indicators , 1990 .

[30]  R. Barro.  World Real Interest Rates , 1990, NBER Macroeconomics Annual.

[31]  P. Evans.  Do budget deficits raise nominal interest rates?: Evidence from six countries , 1987 .

[32]  P. Evans.  Interest Rates and Expected Future Budget Deficits in the United States , 1987, Journal of Political Economy.

[33]  M. Feldstein.  Budget Deficits, Tax Rules, and Real Interest Rates , 1986 .

[34]  P. Evans.  Do Large Deficits Produce High Interest Rates , 1985 .

[35]  L. Summers,et al.  Perspectives on High World Real Interest Rates , 1986 .

[36]  Dale W. Jorgenson,et al.  Statistical inference for a system of simultaneous, non-linear, implicit equations in the context of instrumental variable estimation , 1979 .