Fiscal Policy During the Recent Crisis

The creation of the European Monetary Union had given, at least in a statistical sense, large, additional fiscal space to the member countries, by sharply lowering the interest rates they had been paying on their public debt. This lowering of interest rates was in part more apparent than real, because it was due to the fall in nominal interest rates caused by the fall in the inflation rates. The real interest rates had fallen much less than the nominal rates. For several countries, including Belgium, Greece, and Italy, the lowering of the nominal rates on their public debt had reduced their share of GDP by several points. For example, from 1995 to 2003 the interest payment on the public debt had fallen in Belgium from 8.9 percent to 5.3 percent, in Greece from 11.3 percent to 5.0 percent, and in Italy from 11.5 percent to 5.1 percent. Because of these reductions, the countries’ governments must have felt suddenly richer. They must have believed that their fiscal policy had become far more sustainable. Unfortunately, the fiscal space so created was not used to reduce the public debt, as the countries might have been expected to do. In several countries the acquired fiscal space was instead used to increase public spending.