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

38 Pages Posted: 17 Apr 2012

Date Written: April 1, 2004

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.

Keywords: fiscal rules, risk premia, government debt

JEL Classification: E61, H63

Suggested Citation

Balassone, Fabrizio and Franco, Daniele and Giordano, Raffaela, Market-Induced Fiscal Discipline: Is There a Fall-Back Solution for Rule Failure? (April 1, 2004). Available at SSRN: https://ssrn.com/abstract=2040789 or http://dx.doi.org/10.2139/ssrn.2040789

Fabrizio Balassone (Contact Author)

Bank of Italy ( email )

Via Nazionale 91
Rome, 00184
Italy

Daniele Franco

Bank of Italy ( email )

Via Nazionale 91
Rome, 00184
Italy
+39 06 4792 2793 (Phone)
+39 06 4792 2324 (Fax)

Raffaela Giordano

Bank of Italy ( email )

Via Nazionale 91
00184 Roma
Italy

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