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A Tale of Five PIIGS: Soft Budget Constraints and the EMU Sovereign Debt Crises

  • Thushyanthan Baskaran

    ()

    (Department of Economics, University of Göttingen, Germany)

  • Zohal Hessami

    ()

    (Department of Economics, University of Konstanz, Germany)

Why are so many EU countries currently in dire fiscal straits? A popular explanation is that monetary unification led to bailout expectations, which in turn resulted in soft budget constraints and over-borrowing. This paper investigates the validity of this explanation by studying the effects of the Maastricht treaty and the introduction of the Euro on public deficits. To identify the causal effects of these last two stages of EMU, we apply the difference- in-difference methodology to a dataset that covers 26 OECD countries (including all EU-15 countries) over the 1975-2009 period. The estimations suggest that the effect of the EMU on deficits is limited to the so-called PIIGS countries. The signing of the Maastricht treaty triggered a reduction of deficits in this group of countries. Once the Euro had been introduced, the PIIGS expanded their deficits – but only to pre Maastricht levels. In other words, the Euro led to soft budget constraints, and the PIIGS exploited these soft budget constraints to some extent (but not excessively). From a policy perspective, our findings favor reforms in the direction of administrative rather than fiscal centralization for the EU.

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Paper provided by Department of Economics, University of Konstanz in its series Working Paper Series of the Department of Economics, University of Konstanz with number 2011-45.

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Length: 30 pages
Date of creation: 13 Nov 2011
Date of revision:
Handle: RePEc:knz:dpteco:1145
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  1. Ram, Rati, 2009. "Openness, country size, and government size: Additional evidence from a large cross-country panel," Journal of Public Economics, Elsevier, vol. 93(1-2), pages 213-218, February.
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  4. János Kornai, 2014. "The soft budget constraint," Acta Oeconomica, Akadémiai Kiadó, Hungary, vol. 64(supplemen), pages 25-79, November.
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  9. Wyplosz, Charles, 1997. "EMU: Why and How It Might Happen," CEPR Discussion Papers 1685, C.E.P.R. Discussion Papers.
  10. Petroulas, Pavlos, 2007. "The effect of the euro on foreign direct investment," European Economic Review, Elsevier, vol. 51(6), pages 1468-1491, August.
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  12. Evi Pappa, 2004. "The unbearable tightness of being in a monetary union : fiscal restrictions and regional stability," LSE Research Online Documents on Economics 510, London School of Economics and Political Science, LSE Library.
  13. Baskaran, Thushyanthan, 2011. "Soft budget constraints and strategic interactions in subnational borrowing: Evidence from the German States, 1975-2005," MPRA Paper 32537, University Library of Munich, Germany.
  14. Jordi Gali & Roberto Perotti, 2003. "Fiscal Policy and Monetary Integration in Europe," NBER Working Papers 9773, National Bureau of Economic Research, Inc.
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