Fiscal Space in the Euro zone
This paper uses data from 1995 to 2008 to estimate debt limits in the European Union countries derived from the budgetary responses to debt levels before the crisis. Based on work by the IMF (Ostry, 2010), we present our suggested approach and estimate the fiscal reaction functions and the implied critical debt levels of EU governments. Since many countries did not take advantage of the boom years for consolidation, the fiscal space – availability of debt financing – in the euro zone has shrunk, especially in countries where the response to rising debt levels has historically been weak. We conclude by stressing a need for structural changes in budget policy (shifts in the reaction on debt) or risk default in cases where fiscal space was negative or has been squeezed.
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