Do Sound Public Finances Require Fiscal Rules Or Is Market Pressure Enough?

This paper discusses the balance between market pressure and fiscal rules in order to keep public finances on a sustainable path. The critical factors are the financial markets’ ability to provide accurate measures of the stance of fiscal policy and the availability of enforceable rules to act as effective constraints on fiscal policy. In our empirical analysis we find that stricter fiscal rules are associated with larger primary budget surpluses, and we find no significant difference between countries in the euro area and other EU countries. The paper also provides empirical evidence on market assessments of sovereign default risk—measured by CDS spreads-to economic news, announcements of national austerity programs, EU programs designed to support government finances, and banking fragility emanating from several countries in the euro area affected by the European sovereign debt crisis. We also measure market responses to “common” policy announcements emanating from the EU/ECB and international institutions, both the direct effect of announcements on perceptions of sovereign default risk, and the indirect effect transmitted from other countries (contagion), during pre-crisis and European sovereign debt crisis periods. We find that, in general, the quality of market signals is an insufficient indicator alone to accurately guide the conduct of fiscal policy, particularly during the crisis period. Specifically, markets frequently provide mixed signals in response to policy announcements of programs designed to shore-up government finances or banking sectors, partly due to perceptions about the credibility of the programs. Therefore, we conclude that market signals should be used to complement fiscal rules rather than serving as a substitute. Sound public finances are achieved in a complicated relationship between supranational and national fiscal frameworks on the one hand, and the pressure exerted by financial markets on fiscal authorities on the other hand • An earlier version of this paper has been presented at the European Commission’s annual research conference, “Economic Growth and the Future of the Economic and Monetary Union”, November 19-20, 2012, Brussels, Belgium. We are grateful for helpful comments from Michael Thiel and other DGECFIN staff members, as well as conference participants. We thank Xin Li for excellent research assistance.