Fiscal Adjustment in Times of Crisis: The Case of the Euro-Area

Rosaria Rita Canale

International Journal of Financial Markets, 2015, vol. 1, issue 1, 8-17

Abstract: Countries in the European Monetary Union have been divided into two major blocks according to their ability to respect fiscal criteria and ensure sound public finance. The widespread belief is that this ability influences the interest rate financial markets apply, the sustainability of deficit and debt and the long-run growth. As a consequence, some countries are asked to achieve severe retrenchment to restore confidence. The aim of this paper is to show that the financial stability is realized at expenses of a lower targeted output, rather than representing the premise of a greater growth. When a negative shock occurs the deficit/GDP ratio goes up and sends the signal that governments are loosening their fiscal stance, so that financial markets increase the interest rates applied. Due to aggregate demand effect of the sharp increase in refinancing costs, deficit grows greater and greater causing unsustainability of public finance. Hence national policy authorities, following Emu prescriptions, accept to reduce public expenditure regardless the level of output and employment to be reached. They face the choice either to target a lower output or to devalue the currency, but the uncertainty of cost of exiting from the EMU makes devaluation highly unlikely and causes a passive acceptance of fiscal retrenchments.

Keywords: EMU; Fiscal policy; growth. (search for similar items in EconPapers)
Date: 2015
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