FISCAL SUSTAINABILITY AND FOREIGN DEBT IN EMU COUNTRIES: FINANCIAL MARKETS AS THE DISSUASIVE ARM OF THE STABILITY AND GROWTH PACT

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 which the financial market applies and the long-run sustainability of deficit and debt. As a consequence, some countries are asked to achieve severe retrenchment to restore financial market confidence. The aim of this paper is to show that the increase in government bond yields is not directly linked to default probability; rather it is due to liquidity needs that cannot be satisfied on domestic markets. In times of crisis the deficit/GDP ratio goes up and sends the signal that governments are loosening their fiscal stance. As long as there are liquidity constraints, foreign markets increase the interest rates applied and, due to the sharp increase in refinancing costs, force governments into fiscal retrenchments. The latter have little probability of success because of their effect upon real GDP. The high cost of exiting from the EMU makes devaluation highly unlikely and gives financial markets – lacking a common policy structure - the power to exert political pressure without having sovereignty