Sustainability vs. credibility of fiscal consolidation. A Principal Components test for the Euro Zone

Giuliana Passamani (), Roberto Tamborini and Matteo Tomaselli ()

No 2014/09, DEM Discussion Papers from Department of Economics and Management

Abstract: Why did some countries in the Euro Zone between 2010 and 2012 - until the European Central Bank stepped in - experience a dramatic vicious circle between hard austerity plans and rising default risk premia? Were such plans too small, and hence non credible, or too large, and hence non sustainable? These questions have prompted theoretical and empirical investigations in the line of the so-called "self-fulfilling beliefs" where beliefs of unsustainability of fiscal adjustments, and hence default on debt, feed higher risk premia which indeed make fiscal adjustments less sustainable. Detecting the sustainability factor in the evolution of spreads is uneasy because it is largely non observable, and may be proxied by different variables. In this paper we present the results of a dynamic Principal Components Factor Analysis applied to a panel data set of the eleven major EZ countries from 2000 to 2013 consisting of each country's spread of long-term interest rate over Germany as dependent variable, and an array of leading fiscal and macroeconomic indicators of solvency fiscal effort and its sustainability. We have been able to identify the role of these indicators that combine themselves as significant latent variables in boosting spreads. Moreover the large joint deterioration of these variables is identifiably located between 2009 and 2012 and particularly for the group of countries under most severe default risk (with Italy and France as borderline cases).

Keywords: Euro Zone debt crisis; Models of self-fulfilling beliefs; Principal Components Analysis (search for similar items in EconPapers)
Date: 2014
New Economics Papers: this item is included in nep-eec
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