Sovereign Risk Premia: The Link between Fiscal Rules and Stability Culture

Abstract

Die Dis cus si on Pape rs die nen einer mög lichst schnel len Ver brei tung von neue ren For schungs arbei ten des ZEW. Die Bei trä ge lie gen in allei ni ger Ver ant wor tung der Auto ren und stel len nicht not wen di ger wei se die Mei nung des ZEW dar.Dis cus si on Papers are inten ded to make results of ZEW research prompt ly avai la ble to other eco no mists in order to encou ra ge dis cus si on and sug gesti ons for revi si ons. The aut hors are sole ly respon si ble for the con tents which do not neces sa ri ly repre sent the opi ni on of the ZEW. Non-technical summaryThe credibility crisis regarding the sustainability of public debt has transformed the markets for government bonds in the Euro area. A new sensitivity of creditors for the risk of sovereign default has pushed up financing costs of several euro member countries or has even cut them off from market access. Currently, policy makers try to enhance their fiscal reputation through the establishment of better European and national fiscal rules, particular in form of the debt brakes prescribed by the European Fiscal Compact. The hope is that, independent from the current budgetary performance, new fiscal rules send out credible signals to the markets and cut short the way towards lowering the risk spread.In our paper we study the determinants of sovereign risk premia in the EU countries between 1992 and 2008. Our contribution addresses two interrelated questions: First, do fiscal rules impact on sovereign risk premia in Europe? And second, is any such observable link really causal or rather the consequence of different national "stability cultures", which arise from differing historical institutions or fiscal preferences?In our empirical analysis, we try to shed light on this issue by employing several types of stability preference related proxies. These proxies are related to a country's past stability performance, government characteristics and survey results related to general trust. We find evidence that these indicators have an influence on risk premia. Moreover, they dampen the measurable impact of fiscal rules on risk premia. The estimated positive effect of fiscal rules on market confidence in the early years of EMU can thus mainly be explained by the fact that mainly high-stability countries introduced such constraints. Our results indicate that these stability-oriented countries would not have had a significantly lower financial market reputation if they had not established fiscal rules. Thus, for these countries strict fiscal rules may be rather interpreted as a confirmation of the underlying fiscal preferences of the voters and their political representatives. Still, even if this is true, it does not preclude the possibility that the new establishment of strict rules -such as intended by the Fiscal Compact -is relevant for fiscal reputation in countries with a lack of historical stability orientation. Our results rather point to the fact that fiscal rules have the largest potential for countries with particularly poor stability culture ...

What Drives Political Parties' Commitment to the ‘Stability Culture’? An Empirical Analysis Based on the Electoral Manifestos Issued in EU Member States

“…From this perspective, higher deficit and debt increase the call for macroeconomic prudence, as well as low growth and high unemployment rate (Fabrizio and Mody, ; Hallerberg et al ., ). Finally, inflation aversion represents the main argument in favour of the ‘stability culture’ (Heinemann et al ., ) and therefore we can hypothesize a positive correlation between inflation and the emphasis on the ‘stability culture’ in political manifestos.…”

“…There is evidence that party elites adjust the emphasis on economic‐related issues in their manifestos according to on‐going macroeconomic conditions (De Simone and Mourao, ). According to the fiscal reputation hypothesis (Heinemann et al ., ), when a national economy goes bad, parties are more likely to commit to the ‘stability culture’ by tying themselves to a binding promise, to be interpreted as a measure which improves the long‐term sustainability of public finances. In line with this perspective, Fabrizio and Mody () claim that when domestic misery increases, political alliances are more likely to adopt conservative fiscal behaviour.…”

“…The roots of this concern for fiscal discipline can be traced back to the so‐called ‘stability culture’ that, according to Howarth and Rommerskirchen (), has guided the EU economic policy since the birth of the Economic and Monetary Union in 1991. The expression ‘stability culture’ describes a policy perspective that, alongside the objective of ‘sound’ monetary policy (committed to price stability), involves ‘sound’ public finances (ensuring fiscally disciplined budgets) as well as ‘sound’ institutions (rules and procedures that favour fiscal discipline and expenditure ceilings) (Heinemann et al ., ; Howarth and Rommerskirchen, ; Underhill, ). All these elements are considered crucial for good national macroeconomic performances (Konrad‐Adenauer‐Stiftung, ).…”

“…As far as we know, this is one of the first attempts to analyze this specific topic as previous contributions analyzed political parties' commitment to the ‘stability culture’ in merely descriptive terms (Underhill, ), or they focused on such commitment as a driver of economic and institutional outcomes (Heinemann et al ., ; LeMay‐Boucher and Rommerskirchen, ).…”

Modern Financial Crises

“…On the same topic, see also Bordon et al (2014). 14 Heinemann et al (2013) study the determinants of sovereign risk premia in the EU countries between 1992 and 2008 and find that fiscal rules have the largest potential for countries with particularly poor fiscal stability culture in the past. For these countries, the effect of rules on risk premia is stronger than for high-stability countries.…”