Fiscal Indiscipline: Why no reaction yet by the markets?

Two stylized facts emerge as we observe the evolution of public finances in the past few years. The first is a general trend towards a deterioration of fiscal positions, mainly due to cyclical factors (the persistently deceiving growth performance of the Euro zone). The second, a remarkable lack of reaction of financial markets (long term rates) to this deterioration. This is a puzzling set of findings, as the theory tells us that long term rates should react to larger deficits either because they indicate future tightening of monetary policy, or because they require a risk premium. A first explanation of this puzzle is straightforward: markets have perceived the system as well designed in spite of the latest development and hence did not react to the worsening of fiscal position, seen as temporary and harmless; such an interpretation nevertheless may be dismissed on the ground that if the system was perceived as good and well functioning, its very recent modification (March 2005) should have triggered a negative reaction that until now did not materialize. A more convincing explanation recognizes that markets do not focus on public finances alone, but look at more general conditions concerning Saving and Investment. With such a global perspective in mind, long term sustainability does not seem more at risk today than it were a few years ago; hence, the lack of reaction of markets is all but paradoxical, but may simply reflect the lack of credibility of the current formal fiscal framework for Europe.