Eastern European Economics

ISSN: 0012-8775 (Print) 1557-9298 (Online) Journal homepage: https://www.tandfonline.com/loi/meee20

Sustainability of Public Finances in European

Economies: Fiscal Policy Reactions and Market
Pricing

Tomasz Łyziak & Joanna Mackiewicz-Łyziak

To cite this article: Tomasz Łyziak & Joanna Mackiewicz-Łyziak (2019) Sustainability of Public
Finances in European Economies: Fiscal Policy Reactions and Market Pricing, Eastern European
Economics, 57:1, 3-19, DOI: 10.1080/00128775.2018.1533411

To link to this article: https://doi.org/10.1080/00128775.2018.1533411

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Eastern European Economics, 57: 3–19, 2019
Copyright © Taylor & Francis Group, LLC
ISSN: 0012-8775 print / 1557-9298 online
DOI: https://doi.org/10.1080/00128775.2018.1533411

Sustainability of Public Finances in European Economies:

Fiscal Policy Reactions and Market Pricing
Tomasz Łyziak
Institute of Economics, Polish Academy of Sciences, Warsaw, Poland

Joanna Mackiewicz-Łyziak
Faculty of Economic Sciences, University of Warsaw, Warsaw, Poland

This article evaluates fiscal discipline in twenty-two member countries in the European Union. We
adopt a two-dimensional approach in which we evaluate the reaction of the primary balance to public
debt and the response of financial markets to fiscal variables. Our results suggest that the fiscal
policy in EU is sustainable. Financial markets seem to pay attention to fiscal variables. Since the
beginning of the financial crisis, both markets and governments have responded more strongly to
public debt. Interestingly, the reaction of the markets to GDP per capita seems to be stronger in the
high-debt economies.
Keywords: European Union, fiscal reaction functions, pooled mean group, sovereign yields
JEL Classification: E43, E62, H63

After the outbreak of the global financial crisis and subsequent debt crisis in Europe, the issue of
fiscal sustainability attracted renewed attention from researchers. The large debt burdens in many
advanced and emerging economies raise questions about the sustainability of public finances in
the face of aging populations, in particular in the advanced economies. Many empirical studies
have addressed this issue. A common approach taken in the assessment of fiscal sustainability is
estimation of fiscal reaction functions in the spirit of Bohn (1998) who suggested that a positive
response in the primary balance to an increase in public debt indicates that the fiscal policy is
sustainable. Studies conducted on the European countries using this concept generally suggest
that the fiscal policies are sustainable.
This condition is crucial in evaluating fiscal policy; however, it seems insufficient for a
complete response to the question of the sustainability of fiscal policy because this approach
ignores complex and mutual interactions among fiscal policy, financial markets, and the costs of
debt service. For instance, even if the primary balance responds positively to debt levels, the
magnitude of its reaction can be insufficient to convince economic actors, including financial

Color versions of one or more of the figures in the article can be found online at www.tandfonline.com/MEEE.
Correspondence should be addressed to Joanna Mackiewicz-Łyziak, Faculty of Economic Sciences, University of
Warsaw, Długa 44/50, Warsaw 00-241, Poland. E-mail: jmackiewicz@wne.uw.edu.pl
4 T. ŁYZIAK AND J. MACKIEWICZ-ŁYZIAK

market participants, that the fiscal policy is prudent and sustainable in the long term. In other
words, a positive response by the primary balance to public debt can be insufficient for
preventing public debt from rising. Therefore, in our view, to assess the degree of fiscal
discipline, the reaction of financial markets to the fiscal stance (public debt and the primary
balance) should complement the analysis of fiscal reaction functions. This view is also supported
by the observation that differences in the fiscal reaction functions among countries may be partly
enforced by the markets if they assign more risk to increases in public debt in some countries
than in others.1
In this study, we estimate fiscal reaction functions for a panel of twenty-two European
economies. We divide the sample into two subsamples of countries based on whether their
debt level is high or low and look at the differences between estimates of the fiscal reaction
functions in these two groups. The main contribution of our article is that we additionally
analyze the determinants of long-term sovereign bond yields in these countries and estimate the
response of long-term rates to fiscal variables. In this part of the article, we use spreads of bond
yields relative to German bunds and—as a robustness check—spreads of sovereign credit default
swaps (CDS).
Our results confirm that fiscal policies in the European Union (EU) are, in general, sustain-
able, in the sense that the growing public debt has been accompanied, on average, by improve-
ments in the primary balance. At the same time, however, financial markets seem to pay
attention to fiscal variables and higher levels of public debt or deficit raise long-term government
bond yields, leading to higher debt service costs. Analyzing changes in fiscal sustainability since
the beginning of the Great Recession (September 2008), we observe greater responses by both
the markets and the governments to public debt. At the same time, fiscal policy has become
more cyclical, especially in economies with high debt, which consists mostly of the original EU
member states. Interestingly, gross domestic product (GDP) per capita narrows spreads in these
economies, compensating for the upward pressure on spreads exerted by high ratios of debt to
GDP.
The remainder of the article is organized as follows. The next section offers a literature
review on the fiscal reaction functions and the link between sovereign bond yields and debt in
Europe, followed by a section with a description of our data. In the next section, we present the
results of our estimation of fiscal reaction functions and equations for long-term interest rates.
Finally, the last section summarizes our results.

BRIEF LITERATURE REVIEW

In this study, we refer to the approach of Bohn (1998) who proposed a simple fiscal reaction
function to assess fiscal sustainability. According to his approach, a fiscal policy is sustainable if
the government responds to increasing public debt by increasing the primary surplus or lowering
the primary deficit. Formally, this condition may be expressed as in Equation (1):
bt ¼ αdt þ εt (1)
where b is the primary balance in relation to GDP, d is the ratio of government debt to GDP, and
α measures the responsiveness of the primary balance to debt. According to Bohn (1998),
parameter α > 0: a positive response in the primary balance to growing government debt is a
 SUSTAINABILITY OF PUBLIC FINANCES IN EUROPEAN ECONOMIES 5

sufficient condition for the intertemporal government budget constraint to be satisfied and to
achieve fiscal sustainability. However, this interpretation of positive parameter α has been
questioned by Ghosh et al. (2013a) who call it a weak sustainability criterion. They argue that
a positive α does not rule out an ever-increasing debt-to-GDP ratio. They propose a stricter
sustainability condition, according to which public debt converges to a finite proportion of GDP.
In empirical studies, the estimated fiscal reaction function usually is expressed as in Equation (2):

X
M
bt ¼ c þ βbt1 þ αdt þ δj Xj;t þ εt (2)
j¼1

where the fiscal reaction function assumes some persistence in the fiscal stance measured by the
coefficient β , and Xj;t is a set of macroeconomic and institutional variables that may affect the
primary balance; εt is the error term.
Most empirical studies based on estimation of the fiscal reaction functions confirm fiscal
sustainability in advanced economies. In the European countries, Weichenrieder and Zimmer
(2014), using a panel of seventeen euro-area countries, find that fiscal policy in the eurozone is
sustainable, and the responsiveness of the primary balance to debt has become stronger since the
introduction of the euro. Bajo-Rubio, Díaz-Roldán, and Esteve (2009), by using cointegration
techniques for the euro-area countries, show that the fiscal policy was sustainable except in
Finland. Baldi and Staehr (2016) focus on the impact of the global financial crisis on the fiscal
reaction functions in the EU countries. They find that the global financial crisis changed the
fiscal reaction functions in Europe, making fiscal policy more prudent. Fincke and Greiner
(2012) also test fiscal sustainability in selected euro-area countries using fiscal reaction functions
and some additional tests and find that fiscal policy is sustainable. Betty and Shiamptanis (2013)
derive some additional conditions for the fiscal rule, which are necessary for preventing public
debt from becoming explosive. They find that in eleven euro-area countries these conditions are
satisfied. Theofilakou and Stournaras (2012) provide evidence for fiscal sustainability in coun-
tries in the Economic and Monetary Union (EMU) and a positive impact of financial markets on
discretionary fiscal policy. They include government bond yields spreads in the fiscal reaction
function and find a positive response of fiscal policy to the pricing of debt by financial markets.
Therefore, the general conclusion from studies based on the fiscal reaction functions regarding
fiscal sustainability in the European countries is that their fiscal policy is sustainable.
In addition to analysis of the behavior of fiscal authorities, in this study we focus on the
response of the sovereign bond yields as well as bond and CDS spreads to the public debt. A
rich body of empirical literature explores the relationship between the fiscal stance (fiscal
deficits and public debt) and long-term government bond rates. Baldacci and Kumar (2010)
use a panel of thirty-one advanced and emerging market economies and find that the impact of
fiscal variables on long-term interest rates is significant and robust but nonlinear. In seventeen
member countries in the Organisation for Economic Co-operation and Development (OECD),
Afonso and Rault (2015) show that a better fiscal stance leads to lower real long-term interest
rates in several countries, but in some cases higher government debt may lead to lower real
interest rate, which may be perceived as mispricing. Ghosh, Ostry, and Quereshi (2013b), using
their concept of fiscal space, show in a sample of twenty-three advanced economies that the
relationship between government bond yields and fiscal space is not linear, and the yields rise
more sharply when the fiscal space is exhausted. Finally, in European countries, Barrios et al.
6 T. ŁYZIAK AND J. MACKIEWICZ-ŁYZIAK

(2009) also show that higher public debt is associated with higher sovereign bond yields. They
suggest that market discipline (higher bond rates) may act against deterioration in public
finances. Similar results are obtained by Maltritz (2012). Analyzing the determinants of sover-
eign yield spreads in euro-area countries, he finds that public debt and their budget balance are
among the most likely country-specific variables influencing the yield spreads, along with
external sector variables. Empirical studies on the determinants of long-term government bond
rates in advanced economies, in particular in the European countries, suggest that sovereign
bond yields rise with increasing public debt.
The link between the level of public debt and the market’s perception of risk may be less
obvious if we look at individual countries. Most recently, Orphanides (2017) points out that
although the debt-to-GDP ratio is considerably lower in Italy than in Japan, and Italy runs
primary surpluses while Japan has primary deficits, the markets perceived Italian debt as
riskier than Japanese debt, and the spreads on five-year CDS on sovereign debt were higher
in Italy. This may suggest that the simple measure of fiscal sustainability based on fiscal
reaction functions may not provide the complete picture of risks associated with a fiscal
policy stance.

DATA

In this empirical study, we use a broad dataset of quarterly data from 2002Q1 to 2015Q4.
Estimating the fiscal reaction function, we use the following variables: the primary balance in
relation to GDP, general government debt in relation to GDP (see Figure A1) and the output gap.
The source of the variables is the Eurostat database. The public debt variable is a general
government gross debt stock as a percentage of GDP, calculated according to the ESA2010
methodology. The primary balance as a share of GDP is calculated as the sum of the budget
balance and interest payments, also calculated using ESA2010 methodology. The primary
balance series has been seasonally adjusted. The output gap is calculated as the difference
between the logarithm of real output (chained linked volumes, index 2010 = 100, seasonally and
calendar-adjusted data, using ESA2010 methodology) and its trend obtained using the Hodrick-
Prescott filter. The second estimated equation links long-term sovereign bond yield spreads or
sovereign five-year CDS spreads (see Figure A2) to variables describing different kinds of risk.
Data on nominal long-term government bond interest rates come from the European Central
Bank, while those on CDS spreads come from Bloomberg.2
The original data are monthly in the case of the government bond yields or daily in the case
of CDS spreads, so we calculated quarterly averages. Credit risk is measured by the debt and
primary balance variables described above.
The remaining determinants of long-term interest rates included in the specification (in
addition to the government debt and primary balance) are as follows: GDP per capita, measuring
the overall wealth of the economy, the measure of liquidity risk and the measure of international
risk, the VIX. The source for GDP per capita is Eurostat. As investors may assign lower default
risk to richer countries, the expected impact of this variable on long-term yields is negative.
Liquidity is given by a country’s long-term debt securities as a share of total long-term debt
securities in the EU. The source of the data is Eurostat. The data are yearly and calculated
according to the ESA2010 methodology. We make yearly data quarterly using linear
 SUSTAINABILITY OF PUBLIC FINANCES IN EUROPEAN ECONOMIES 7

interpolation. Although higher risk may be associated with less liquid markets, the expected sign
of the liquidity variable is negative.
As a measure of global risk aversion, we use the VIX. The source of the data is the Chicago
Board Options Exchange. The VIX measures the market expectation of near-term volatility
conveyed by stock index option prices. The data are quarterly. The expected impact of the
increase in the VIX (increase in global risk aversion) is an increase in long-term interest rates.

METHODS AND RESULTS

In the empirical part of the study, we construct separate models to analyze the connection
between fiscal sustainability and the role of fiscal variables in the determination of long-term
interest rates and CDS spreads. The degree of fiscal discipline is measured as the magnitude of
the reaction of primary balance to public debt. In our view, however, this method of analyzing
fiscal sustainability is imperfect, as it does not take into account the reaction of financial markets
to fiscal policy performance. The reaction of the financial markets to government debt, on the
one hand, may discipline governments, making them concerned about increases in the cost of
debt service and, on the other hand, may change the view on fiscal sustainability derived solely
from fiscal reaction functions, if long-term interest rates on sovereign bonds increase with debt
levels. For this reason, we estimate two equations involving fiscal variables (viz., the fiscal
reaction functions and the equations for sovereign risk) to obtain a broad picture of fiscal
developments and to draw conclusions on fiscal sustainability considering the reaction of
financial markets.
We conduct our estimation for a panel of twenty-two EU economies: Austria, Belgium,
Bulgaria, Czech Republic, Denmark, Finland, France, Germany, Hungary, Ireland, Italy, Latvia,
Lithuania, the Netherlands, Poland, Portugal, Romania, Slovenia, Slovakia, Spain, Sweden, and
the UK over the period 2002Q1–2015Q4 as well as separately for the periods before and after
the collapse of Lehman Brothers in 2008.
The panel of EU countries may be heterogeneous, so we allow for heterogeneity of the
analyzed countries with two estimation methods. The first one is the fixed-effects (FE) estimator,
which allows the intercepts to differ across countries, but all other coefficients are the same. In
the case of the fiscal reaction functions, we use the two-stage least squares (2SLS) method, to
account for possible endogeneity, as described in more detail below. The second method used is
the pooled mean group (PMG) estimator of Pesaran, Shin, and Smith (1999). This estimator
allows the intercepts and short-run coefficients to differ across countries in the panel, but the
long-run coefficients are assumed to be the same for all countries. Therefore, the long-run
relationship between fiscal variables or the impact of fiscal variables on spreads are assumed to
be identical for all countries, but they may differ in terms of their short-run dynamics. This
assumption seems to be reasonable in the case of European countries.

Fiscal Reaction Functions

Fiscal sustainability is analyzed with the following panel model in Equation (3):
bi;t ¼ α0 þ α1 bi;t4 þ α2 di;t4 þ α3^yi;t1 þ δi þ εi;t (3)
8 T. ŁYZIAK AND J. MACKIEWICZ-ŁYZIAK

where bi;t is the primary balance in terms of GDP in country i, d is the debt-to-GDP ratio, ^y is
the output gap used as a proxy for cyclical conditions, while δi stands for country-fixed effects.
This model illustrates the fiscal reaction function. In particular, if coefficient α2 is positive, fiscal
policy is sustainable (Bohn 1998), while if it is negative, fiscal policy is unsustainable.
As described above, we estimate Equation (3) using two estimation methods. We begin with
the 2SLS method, as suggested by Celasun and Kang (2006) and Baldi and Staehr (2016)
because the output gap may be affected by fiscal variables included in the equation. To eliminate
the effect from the fiscal stance on the output gap, we instrument it. The set of instruments used
in the estimation includes bi;t4 , di;t4 , ^yi;t4 as well as current and lagged values of the output
gap in the European Union: ^yEU t , ^yEU
t1 , and ^ yEU
t2 . Because of the presence of cross-sectional
dependence, we use panel-corrected standard errors. In the second stage, we use a PMG
estimator, with the number of lags of dependent and independent variables chosen on the
basis of the Akaike information criteria (AIC).
The results of the estimation (Tables 1 and 2) show that, in the European economies under
consideration, fiscal policy is sustainable, independent of the estimation method, sample period
under consideration, and group of countries. In all cases, the estimated coefficient on public debt
in the fiscal reaction function is positive and statistically significant. However, two estimation
methods applied give different results regarding the strength of the response of primary balance
to debt before and after the global financial crisis. According to the FE model, the responsive-
ness of primary balance increases in the crisis subperiod, while according to the PMG model, it
slightly decreases. In both cases, however, the estimates may be biased because of the relatively
short time dimension of the panel (twenty-three periods in the precrisis subperiod, and twenty-
seven in the postcrisis subperiod). Therefore, we use the Arellano-Bond difference generalized
method of moments (GMM) estimator (Arellano and Bond 1991), which is more appropriate for
shorter dynamic panels. The results, presented in Table A2, indicate that the reaction of the
primary balance to debt is stronger in the Great Recession subsample than in the precrisis
subsample, suggesting that the countries have tried to restrict their fiscal policy after a significant

TABLE 1
Fiscal Reactions Functions Estimated with the 2SLS Method

All economies Different samples Different economies

Full sample Before the crisis After the crisis High debt Low debt

Constant −3.043*** −2.131* −9.967*** −4.295*** −2.925***

(0.913) (1.205) (1.093) (1.451) (0.744)
Primary balance 0.458*** 0.416*** 0.172** 0.502*** 0.414***
(0.059) (0.068) (0.074) (0.084) (0.058)
Public debt 0.048*** 0.056** 0.140*** 0.050*** 0.072***
(0.017) (0.025) (0.018) (0.019) (0.020)
Output gap 1.518*** 0.152 1.418*** 3.048*** 1.064**
(0.487) (0.324) (0.396) (0.793) (0.420)
Number of observations 1097 503 594 500 597
Adjusted R2 0.376 0.553 0.221 0.366 0.381

Notes: Values in parentheses estimated coefficients are standard errors. ***significance at 99%; **significance level at
95%; *significance level at 90%.
 SUSTAINABILITY OF PUBLIC FINANCES IN EUROPEAN ECONOMIES 9

TABLE 2
Fiscal Reactions Functions Estimated with the PMG Method (long-run relationship)

All economies Different samples Different economies

Full sample Before crisis After crisis High debt Low debt

Primary balance 0.379*** 0.529*** 0.132*** 0.339*** 0.354***

(0.047) (0.063) (0.043) (0.060) (0.066)
Public debt 0.059*** 0.154** 0.119*** 0.040*** 0.104***
(0.010) (0.021) (0.009) (0.010) (0.016)
Output gap 0.201 0.053 0.481* 2.549*** 0.714**
(0.231) (0.163) (0.234) (0.307) (0.278)
Selected model ARDL(1,1,1,1) ARDL(1,1,1,1) ARDL(1,1,1,1) ARDL(1,1,1,1) ARDL(1,1,1,1)

Notes: Values in parentheses estimated coefficients are standard errors. ***significance at 99%; **significance level at
95%; *significance level at 90%.

increase in debt related to the outbreak of the crisis. All the models confirm that the inertia of the
primary balance has recently decreased, which means that economies have started to reduce their
deficits at faster pace than before the Great Recession. At the same time, since the beginning of
the financial crisis, fiscal policy has become more cyclical: negative output gaps lead to a larger
deterioration in the primary balance than before the crisis.
To deepen understanding of fiscal reaction functions in different European economies, we
estimate Equation (3) separately for countries with relatively high and low public debt. In the
first group of economies, we consider those in which debt-to-GDP ratios (average in the
analyzed period) are above 60% of GDP (Austria, Belgium, France, Germany, Hungary,
Ireland, Italy, Portugal, Spain, and the UK), while in the second are those in which public
debt is below 60% (Bulgaria, Czech Republic, Denmark, Finland, Latvia, Lithuania, the
Netherlands, Poland, Romania, Slovakia, Slovenia, and Sweden).3 The results of the estimation
(Tables 1 and 2) indicate two important differences in fiscal reaction functions between the two
groups of economies. First, even if they both enjoy fiscal sustainability, the response of their
primary balance to public debt is smaller in countries with high levels of debt, which suggests a
lower degree of fiscal discipline in those economies. In this respect, our findings are consistent
with those in other studies. Estimates obtained for advanced European countries, which con-
stitute most of the countries with higher debt, on average are lower (e.g., Weichenrieder and
Zimmer 2014) than estimates obtained for countries in Central and Eastern Europe (as presented
most recently in Bökemeier and Stoian 2018), which comprise most of the countries with lower
debt. Second, fiscal policy is highly cyclical in the economies with high debt—in this group of
economies, the output gap coefficient in the fiscal reaction function is three times larger than in
countries with low public debt. The inertia of the primary balance seems to be similar in both
groups of economies.

The Impact of Fiscal Variables on Long-Term Sovereign Bond Yields

The second part of our analysis concerns market forces that can influence the sustainability of public
finances. If prices in financial markets (e.g., short- or long-term interest rates and bond yields and
10 T. ŁYZIAK AND J. MACKIEWICZ-ŁYZIAK

exchange rates) are influenced by fiscal variables, on the one hand, they affect the cost of servicing the
debt, directly changing the debt burden, and, on the other hand, they affect the degree of fiscal
discipline, motivating governments to conduct more responsible policy. Therefore, we analyze the
determinants of long-term sovereign bond yield spreads, estimating Equation (4):
si;t ¼ β0 þ β1 ypc
i;t1 þ β 2 di;t1 þ β 3 bi;t1 þ β4 liqi;t þ β5 vixt þ γi þ εi;t (4)
where s is the spread on long-term government bond yields in country i vis-à-vis German bunds,
ypc is real GDP per capita, liq is liquidity, proxied by a country’s long-term debt as a share of
total long-term debt in the EU, vix is the VIX used as a measure of global risk aversion, and γi is
fixed effects in country i. Estimating Equation (4), we also add dummies used in this context in
the literature (e.g., Ghosh, Ostry, and Quereshi 2013b)—a financial crisis dummy and a dummy
for membership in the EMU. We conduct our analysis separately for economies with high and
low debt-to-GDP ratios. In addition, we estimate Equation (4) with five-year sovereign CDS
spreads, treating it as a robustness check (see results in Table A3). We estimate the model using
the PMG method and the panel least squares method, with country-fixed effects and panel-
corrected standard errors.
Estimation results (Tables 3 and 4) seem to be robust across estimation methods and samples, as
they are qualitatively similar. Generally, they suggest that both public debt and the primary balance are
important determinants of spreads on long-term sovereign bond yields in European economies. The

TABLE 3
Spread Equations Estimated with the LS Method

All economies Different samples Different economies

Full sample Before the crisis After the crisis High debt Low debt

Constant −10.946 3.132 68.011*** 29.126* −9.434

(8.040) (4.045) (22.200) (17.516) (6.965)
Public debt 0.040*** 0.025*** 0.026*** 0.043*** 0.022***
(0.005) (0.005) (0.009) (0.006) (0.007)
GDP per capita 1.082 −0.349 −6.858*** −2.959* 0.956
(0.821) (0.407) (2.242) (1.732) (0.717)
Primary balance −0.080*** −0.012 −0.085*** −0.037** −0.119***
(0.012) (0.008) (0.022) (0.017) (0.018)
Liquidity −0.233*** −0.153*** 0.059 −0.224*** 0.006
(0.045) (0.049) (0.065) (0.046) (0.170)
VIX 0.029*** 0.020*** 0.032*** 0.018 0.030***
(0.010) (0.005) (0.007) (0.012) (0.009)
Dummy crisis 0.431** 0.945***
(0.188) (0.203)
Dummy EMU −0.797*** −1.959**
(0.307) (0.766)
Dummy EMU*crisis 0.514* −1.334***
(0.285) (0.187)
Number of observations 1,083 474 609 477 624
Adjusted R2 0.59 0.864 0.6 0.62 0.609

Notes: Values in parentheses below estimated coefficients are standard errors. ***significance level at 99%; **signifi-
cance level at 95%; *significance level at 90%.
 SUSTAINABILITY OF PUBLIC FINANCES IN EUROPEAN ECONOMIES 11

TABLE 4
Spread Equations Estimated with the PMG Method (long-run relationship)

All economies Different samples Different economies

Full sample Before the crisis After the crisis High debt Low debt

Public debt 0.019*** 0.024*** 0.159*** −0.003 0.032***

(0.004) (0.007) (0.013) (0.011) (0.008)
GDP per capita −0.801* −0.54 −4.123* −7.067** −0.998*
(0.477) (0.550) (2.119) (3.435) (0.597)
Primary balance −0.196*** 0.002 −0.351*** −0.364** −0.131***
(0.033) (0.014) (0.045) (0.090) (0.034)
Liquidity −0.169 −0.579*** 0.077 −0.281 −0.660*
(0.124) (0.123) (0.100) (0.215) (0.357)
VIX 0.072*** 0.088*** 0.139*** 0.097*** 0.097***
(0.011) (0.008) (0.013) (0.033) (0.014)
Selected model ARDL ARDL ARDL ARDL ARDL
(4,4,4,4,4,4) (1,1,1,1,1,1) (4,4,4,4,4,4) (4,2,2,2,2,2) (4,4,4,4,4,4)

Notes: Values in parentheses estimated coefficients are standard errors. ***significance level at 99%; **significance level
at 95%; *significance level at 90%.

influence of the primary balance on spreads seems to be insignificant only in the precrisis subsample.
The response of long-term rates to the primary balance and debt becomes stronger in the postcrisis
period. This stronger response of long-term rates to fiscal policy after the outbreak of the global
financial crisis is consistent with the observed stronger response of primary balances to debt in the
estimated fiscal reaction functions for the same period. This may suggest that greater fiscal discipline
was enforced in part by the markets, as the cost of debt service increased. This conjecture, however,
requires further investigation. Moreover, the markets started paying much more attention to the wealth
of the economy after the beginning of the Great Recession in search of “safe havens.” The GDP per
capita is a significant determinant of long-term sovereign bond yields, with a negative sign only in the
second subsample. Finally, in the postcrisis period, the role of liquidity in determining the long-term
spreads has decreased, while the role of international risk (VIX) has increased.
In the last two columns of Tables 3 and 4, we compare the estimated coefficients of determinants of
long-term yield spreads in countries with high and low debt. As described above, the countries were
divided into two groups according to their debt-to-GDP ratios. However, this is not the only factor
differentiating the groups. Further investigation shows that the group of countries with lower debt
consists mostly of new EU member states that entered the EU no earlier than May 2004 (eight out of
twelve countries in the group and eight out of nine new member states in the full sample). The average
real GDP per capita is significantly lower in this group of economies than in the group of countries with
higher debt, including mostly the original EU member states (see Table A1). To check the robustness of
our division of the panel into two groups of countries with higher and lower public debt, we perform
principal component analysis (PCA) of the government bond yield spreads (a similar procedure was
employed in Afonso, Arghyrou, and Kontonikas 2015). The results of PCA are in Figure A3. They
suggest that over 80% of the variance in the spreads is explained by the first two principal components.
The first component may be viewed as a common factor affecting the spreads in the EU, because
almost all countries have similar weights (with the exception of Denmark, Sweden, and the UK). The
12 T. ŁYZIAK AND J. MACKIEWICZ-ŁYZIAK

second component distinguishes two groups of countries: with positive and negative signs of the
weights. The composition of the groups overlaps to a large extent with our division according to the
debt-to-GDP ratio. Only six countries were assigned to a different group than that in our division based
on the degree of indebtedness. Poland, Slovakia, Slovenia, and Sweden were classified together with
high-debt countries, which may be not surprising in the case of three countries, because the debt level
in Poland and Slovakia approaches 60% of GDP, and Slovenia exceeds this threshold. At the same
time, Austria and Hungary were classified together with low-debt countries. Therefore, the factor
differentiating the behavior of the government bond spreads among the EU countries is, rather, the
debt-to-GDP ratio, not whether a given country is an original or new EU member state.
In the high-debt countries, which on average are significantly richer than economies with low public
debt, the high levels of GDP per capita exert downward pressure on long-term yields, compensating for
the effects of weaker fiscal discipline. At the same time, GDP per capita has a statistically insignificant
(FE estimator) or much weaker (PMG estimator) impact on sovereign bond yields in countries with
low debt, which are on average poorer than the group of countries with high debt. In the case of fiscal
variables, the results are less conclusive. In the FE estimation, the fiscal variables are significant in both
groups of countries, but debt seems to have a stronger impact on spreads in the high-debt economies,
while the primary balance does so in the low-debt ones. The opposite results are obtained by the PMG
estimator; moreover, public debt is insignificant in the countries with higher debt.4 However, a
comparison of the results with an alternative measure of sovereign risk (CDS spreads) leads to the
conclusion that the increase in public debt increases spreads in countries with a higher debt-to-GDP
ratio (see Table A3). Taking into account the estimates for both sovereign risk measures, the increase in
the global risk aversion is more severe among countries with lower debt-to-GDP ratios.
The estimates for CDS spreads are presented for comparison and robustness purposes. The literature
suggests that the results for CDS spreads should be treated with caution, because of the market’s
characteristics. Paniagua, Sapena, and Tamarit (2017) point out that the sovereign CDS market is
currently relatively small and, prior to 2007, could not measure sovereign risk in developed countries
adequately. In the new member states, the CDS market is even less liquid, and the existing time-series
are very short.5 However, the results obtained for the CDS spreads are very similar to those obtained for
long-term government bond yield spreads, suggesting the important role of fiscal variables in the
determination of sovereign risk.

CONCLUSIONS

Studying fiscal discipline is a complex task that involves not only the estimation of fiscal reaction
functions but also analysis of the perceptions of fiscal policy sustainability by financial markets. Our
study attempts to examine fiscal discipline in European economies from these two perspectives.
These overall results lead to two important conclusions. First, based on the fiscal reaction functions,
we find that fiscal policies in the EU, in general, are sustainable, in the sense commonly accepted in the
literature: fiscal policy may be viewed as sustainable if the primary balance responds positively to
growing public debt. Over the long-term horizon, this should lead to a reduction of debt to preferred
levels. Second, financial markets pay attention to fiscal variables and higher debts and deficits lead,
ceteris paribus, to higher long-term government bond yields. This, in turn, means higher debt service
costs. Fiscal reaction functions ignore interest payments; moreover, it is assumed that the interest rate
paid by the government on outstanding debt in the markets is constant. If the fiscal policy is not
 SUSTAINABILITY OF PUBLIC FINANCES IN EUROPEAN ECONOMIES 13

perceived as sufficiently prudent, it provokes an increase in the interest rate paid on this debt, which
could impede improvement in the fiscal situation, even if the primary balance responded positively to
the increase in debt.6 Taking this into account may shatter the optimistic view based solely on an
estimation of the fiscal reaction functions.
Dividing the sample into period subsamples and country groups changes the conclusions a little,
although some differences are noticeable. After the global financial crisis broke out, fiscal policy became
more cyclical, but the response of both the markets and the governments to debt has become stronger.
This may be a sign of market-based fiscal discipline; however, we do not provide formal evidence of
this relationship. Division of the panel into country groups according to the debt levels, with the high-
debt group consisting mostly of the original EU member states and the low-debt group of the new
member states, reveals that the reaction of the markets to GDP per capita is much stronger in the high-
debt economies. The GDP per capita exerts strong downward pressure on the spreads, compensating for
the upward pressure on spreads exerted by high debt-to-GDP ratios. The markets allow the rich countries
to get into debt by not punishing them for it to the same extent as the poorer countries. In addition,
global risk aversion seems to affect poorer countries more. Therefore, the markets differentiate among
the EU economies and the market cost of debt also depends on factors other than the amount of debt.

Notes
1. Barrios et al. (2009) note that greater market discrimination across countries may provide higher
incentives for governments to attain and maintain sustainable public finances, because even small
changes in bond yields have a noticeable impact on government outlays.
2. For the CDS spreads, our sample ends in 2015Q1 and starts differently for different countries. The
panel is therefore unbalanced and much shorter than for the government bond yields. Moreover, the
market for sovereign CDS was relatively illiquid before the global financial crisis. The results for CDS,
therefore, should be treated with caution.
3. The limit set in the Maastricht criteria for euro-area member states and the Stability and Growth Pact.
4. If we change the number of lags of dependent and independent variables in the specification, the results do
not change substantially. Similar results were obtained for the division of the country groups through PCA.
5. For this reason, we were not able to estimate Equation (4) using the PMG estimator for the group of
countries with low debt, mainly the CEE countries.
6. Although this might not be a problem for Europe as a whole, according to the Eurostat data, interest
payments as a percentage of GDP increased in some countries (Ireland, Spain, Latvia, Lithuania,
Portugal, Slovenia, and the UK).

ACKNOWLEDGMENTS

The authors thank Karsten Staehr and Christos Shiamptanis for their inspiring comments and discus-
sions as well as the participants in the ninth International Conference “Economic Challenges in
Enlarged Europe,” Tallinn, Estonia, June 11–16, 2017, and the participants in the ninth RCEA
Macro-Money-Finance Workshop “Monetary and Fiscal Policy in the Next Recession,” Waterloo,
Canada, June 23–24, 2017, for helpful discussions and suggestions.

FUNDING

This work was supported by the National Science Centre under grant no. DEC-2015/17/B/HS4/
00297.
14 T. ŁYZIAK AND J. MACKIEWICZ-ŁYZIAK

ORCID

Tomasz Łyziak http://orcid.org/0000-0002-0488-4259

Joanna Mackiewicz-Łyziak http://orcid.org/0000-0002-4545-8221

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 SUSTAINABILITY OF PUBLIC FINANCES IN EUROPEAN ECONOMIES 15

APPENDIX

TABLE A1
Basic Characteristics of Countries under Consideration

Different economies

High debt Low debt

GDP per capita (EUR) 27 533.70 19 674.10

Debt-to-GDP ratio (%) 78 37.7
Spread (percentage points) 1.2 1.4
Number of countries 10 12
Number of new member states 1 8

TABLE A2
Fiscal Reactions Functions Estimated with the Arellano-Bond GMM Estimator

Different samples

Before the crisis After the crisis

Primary balance 0.376*** 0.125***

(0.008) (0.010)
Public debt 0.051*** 0.114***
(0.011) (0.017)
Output gap 0.190* 1.875***
(0.107) (0.080)
Number of observations 481 594
Prob.(J-stat.) 0.316 0.295

Notes: Values in parentheses estimated coefficients are standard errors. ***significance level at 99%; **significance level
at 95%; *significance level 90%.
16 T. ŁYZIAK AND J. MACKIEWICZ-ŁYZIAK

TABLE A3
CDS Spread Equations Estimated with LS and PMG Methods

FE estimator PMG estimator

All economies Different economies All economies High debt Economies

full sample high debt low debt full sample

Constant 6.475 28.68 4.605

(7.613) (20.912) (7.455)
Public debt 0.046*** 0.048*** 0.030*** 0.048*** 0.040***
(0.008) (0.008) (0.009) (0.005) (0.009)
GDP per capita −0.858 −2.985 0.36 −3.046** −4.527*
(0.768) (2.051) (0.779) (1.199) (2.643)
Primary balance −0.078*** −0.075*** −0.082*** −0.015* 0.023
(0.018) (0.027) (0.021) (0.008) (0.045)
Liquidity −0.151*** −0.194*** −0.453 −0.068 −0.093
(0.032) (0.032) (0.572) (0.043) (0.063)
VIX 0.049*** 0.033** 0.063*** 0.071*** 0.085***
(0.012) (0.016) (0.010) (0.005) (0.012)
Dummy crisis 0.549** 0.516**
(0.243) (0.230)
Dummy EMU*crisis −0.508* −1.083***
(0.300) (0.285)
Number of observations 715 477 317 612 477
Adjusted R2 0.501 0.62 0.609
Selected model ARDL(1,1,1,1,1,1) ARDL(1,1,1,1,1,1)

Notes: Values in parentheses estimated coefficients are standard errors. ***significance level at 99%; **significance level
at 95%; *significance level at 90%.
SUSTAINABILITY OF PUBLIC FINANCES IN EUROPEAN ECONOMIES 17

FIGURE A1 Government Debt-to-GDP Ratio (%).

18 T. ŁYZIAK AND J. MACKIEWICZ-ŁYZIAK

FIGURE A2 Government Bond Yields Spreads and CDS Spreads (per-

centage points).
SUSTAINABILITY OF PUBLIC FINANCES IN EUROPEAN ECONOMIES 19

FIGURE A3 Results of Principal Component Analysis.