Public Debt and State-Dependent Effects of Fiscal Policy in the Euro Area

by Snezana Eminidou*

Assistant Professor, University of Limassol

This study delves into how the level of public debt influences the effect of fiscal policy on economic activity and expectations in euro area countries. Particularly, we study how government spending affects the economies when they have different levels of debt. We identify high- and low-debt states depending on how much debt each country has compared to their economic output. When countries have a lot of debt, their economies react differently to government spending compared to countries with less debt. The state-dependence of fiscal policy we find in this paper is of particular importance for the euro area given the large dispersion in public debt levels across euro area economies.

The main findings of the paper suggest that the level of public debt in a country affects how effective government spending is in boosting the economy. In countries with high debt levels, increasing government spending has a greater impact on economic activity and consumption compared to countries with low debt levels. This means that implementing austerity measures to control public debt in high-debt countries could be particularly challenging and painful for their economies.

Given that the pandemic crisis, like the financial crisis before it, have seen public debt levels reach unprecedented heights in the eurozone and elsewhere, our findings based on time-serial variation suggest a tendency for expansionary fiscal policy to become less effective during this period. Nevertheless, our findings indicate that cross-sectional debt variation (variation across countries) is dominant in shaping the impact of fiscal policy on the economy in the case of the eurozone as compared to time-serial debt variation (evolution of public debt over time).

Our study highlights the critical need to consider state-dependencies associated with public debt when assessing and implementing fiscal policy. The study demonstrated that real GDP, consumption, and inflation rates respond differently to expansionary government spending shocks in high-debt states compared to previous analyses using time-series variation to identify debt states. Survey-based measures of expectations (inflation expectations and consumption intentions) also showed variation in response to the shocks, echoing the macroeconomic developments. Moreover, the study shed light on the impact of high public debt on banks’ credit extension, leading to a higher prevalence of liquidity-constrained agents in high-debt economies.

This study is essential to the public as it provides critical insights into how public debt levels can shape the effectiveness of fiscal policy and influence economic outcomes. By uncovering the state-dependent effects of fiscal policy, our study contributes to a deeper understanding of the complexities involved in managing public debt and conducting fiscal policy. It highlights the need for policymakers to consider the varying impact of fiscal measures based on public debt levels, guiding more informed and targeted policy interventions.

The full academic paper “Public Debt and state-dependent Effects of Fiscal Policy in the Euro Area” by Snezana Eminidou, Martin Geiger and Marios Zachariadis, was published in the Journal of International Money and Finance, Volume 130, 102746, February 2023.