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PKSG Working Paper Series

Working Paper PKWP1102

Default risk and fiscal sustainability in PIIGS countries

February 2011

Rosaria Rita Canale

European Monetary Union experiences the division into two major blocks according to their ability to respect fiscal criteria and replace their bonds on the market. The so-called PIIGS countries are asked to hardly reduce their deficit and debt in order to prevent speculative attacks and preserve the Currency Union. The aim of the paper is to show that speculative attacks on government debt are not directly linked to default probability, but to liquidity requirements and to the EU fiscal constraints. In times of crisis the path of deficit/GDP ratio goes up and send the signal that governments are loosening their fiscal stance. As far as there are liquidity constraints, markets increase the spreads and force governments to fiscal retrenchments, hardly increasing the cost of adjustment. The result is that in the absence of a bailout shared mechanism financial markets give policy prescriptions and exert a political pressure without having fiscal sovereignty.

Keywords: Fiscal policy, sovereign debt crisis, EMU

JEL classification: E61: Policy Objectives; Policy Designs and Consistency; Policy Coordination E65: Studies of Particular Policy Episodes F33: International Monetary Arrangements and Institutions

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