Market-Induced Fiscal Discipline: Is There a Fall-Back Solution for Rule Failure?

Abstract:     
Fiscal discipline is a public good in federations. As with all public goods, there is a free-riding risk. Hence the need for discipline-inducing mechanisms. EU countries decided to adopt a rule-based framework, which is currently heavily criticised and which may come under further pressure with the enlargement of the EU. The paper reconsider the debate which took place before the approval of the Maastricht Treaty and asks whether market mechanisms can be relied upon as a fall-back solution in case of rule-failure. The issue is tackled in three steps. First, the conditions for an effective market solution are examined and the European institutional framework is assessed against them. Second, the relationship between fiscal performance, credit rating and interest rates is discussed, with reference to both what is expected in theory and what is found in practice. Finally, governments’ sensitivity to market signals is analysed. The findings point to a significant, though small, reaction of interest rates to fiscal imbalances, and to a not so prompt response by governments. The conclusion is thus that market mechanisms cannot be relied upon for replacing fiscal rules. However, greater transparency in fiscal accounts can allow markets to usefully complements rules.

Number of Pages in PDF File: 38

Keywords: fiscal rules, risk premia, government debt

JEL Classification: E61, H63

working papers series