Fiscal Imbalances and Policy Options in a Time of Crisis: The Implications of Government Debt in the GIISP Countries

Mathias S. Ledam Rasmussen

Student thesis: Master thesis

Abstract

Motivated by the complexity and importance of the debt situation in the Euro Area (EA), this thesis seeks to analyse the country-­‐specific implications of fiscal imbalances in the case of the GIISP (Greece, Italy, Ireland, Spain and Portugal) countries. The situation in these countries demands an extensive understanding of both the long-­‐term macroeconomic effects of government debt and the distortionary effects of a sovereign debt crisis. In the thesis, a thorough analysis of prevailing economic literature clarifies the effects of government debt and fiscal imbalances. Firstly, the Diamond model reveals that rising government debt decreases the accumulated level of capital in the steady state due to a lower level of private savings. Secondly, the adverse effects of a sovereign debt crisis are contagion in nature and are partly determined by economic and fiscal fundamentals. Based on the use of econometric modelling the long-­‐term effects of government debt on capital formation are estimated. This thesis concludes that capital formation decreases as the government debt level increase in all cases but Spain. Further, it can be concluded that the magnitude of this decrease diverges between countries. More specifically, the GIISP countries with lower debt levels seem to be more severely affected by an increase in the government debt level. Through extensive analysis of the country-­‐specific fundamentals of each country and their corresponding yield spreads it is concluded that the GIISP countries are subject to adverse effects of the government debt crisis for two reasons. The GIISP countries are subject to rising borrowing costs partly because of weak economic and/or fiscal fundamentals and partly because of regional contagion effects. Based on the theoretical and empirical analysis, the thesis analyses the effects of various policy options for managing the crisis and suggests a holistic framework aimed at resolving the current debt crisis facing the GIISP and the EA. It is concluded that countries should be managed in accordance to the specific degree of insolvency. Moreover, EA sovereigns should be allowed to default if they are in a state of critical insolvency. Lastly, the role of other EA members and the IMF are crucial in stabilising markets through increased credibility.

EducationsMSc in Applied Economics and Finance, (Graduate Programme) Final Thesis
LanguageEnglish
Publication date2011
Number of pages103