A new framework for detecting the short term fiscal vulnerability for the European Union countries

The aim of this study is to develop a new framework (V-L-D) for detecting the short term vulnerabilities in fiscal policy for the European Union countries. The methodology relies ontwo distinct indicators: one showing the vulnerabilities signalled by the size of the cyclically adjusted budget and public debtand one indicatingthe vulnerabilities through their annual changes.V-L-D is able to categorize fiscal vulnerability into five distinct classes having scores from 0 (no fiscal vulnerability) to 4 (extreme fiscal vulnerability). From 1990-2013, we found310 episodes of fiscal vulnerability for the 28 European Union countries out of which 128 episodes of low vulnerability, 94 of moderate, 62 of strong and 26 of extreme fiscal vulnerability. We also explored the correlation between financial market sentiment and fiscal vulnerability. We used V-L-D as a predictor and Credit Default Swaps (CDS)as dependent and proxy for the market sentiment in a balanced panel model consisting in 17 European countries with random effects over the period 2008-2013. The results indicatethat CDS are higher and significant for strong and extreme vulnerability periodscompared with times having zero vulnerability. The CDS for low and moderate fiscal vulnerabilityare also higher but they are not significant, suggesting that investorsoverprice the risk randomly during low and moderate vulnerability.Employing a logit model for a panel consisting of 12 European countries over 2008-2013, we also found that governments are less likely to adjust fiscal policy when it is strong or extremely vulnerable and that the probability of fiscal consolidation increaseswhen market sentiment is negative and CDS are higher.