A Tale of Five PIIGS: Soft Budget Constraints and the EMU Sovereign Debt Crises

Thushyanthan Baskaran and Zohal Hessami

No 2011-45, Working Paper Series of the Department of Economics, University of Konstanz from Department of Economics, University of Konstanz

Abstract: Why are so many EU countries currently in dire fiscal straits? A popular explanation is that monetary unification led to bailout expectations, which in turn resulted in soft budget constraints and over-borrowing. This paper investigates the validity of this explanation by studying the effects of the Maastricht treaty and the introduction of the Euro on public deficits. To identify the causal effects of these last two stages of EMU, we apply the difference- in-difference methodology to a dataset that covers 26 OECD countries (including all EU-15 countries) over the 1975-2009 period. The estimations suggest that the effect of the EMU on deficits is limited to the so-called PIIGS countries. The signing of the Maastricht treaty triggered a reduction of deficits in this group of countries. Once the Euro had been introduced, the PIIGS expanded their deficits – but only to pre Maastricht levels. In other words, the Euro led to soft budget constraints, and the PIIGS exploited these soft budget constraints to some extent (but not excessively). From a policy perspective, our findings favor reforms in the direction of administrative rather than fiscal centralization for the EU.

Keywords: EMU; PIIGS; monetary union; budget deficits; soft budget constraints (search for similar items in EconPapers)
Pages: 30 pages
Date: 2011-11-13
New Economics Papers: this item is included in nep-cba and nep-eec
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Citations: View citations in EconPapers (5)

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