Windfall of Low Interest Payments and Fiscal Sustainability in the Euro Area: Analysis through Panel Fiscal Reaction Functions

We estimate various panel fiscal reaction functions, including those of the main categories of general government revenue and expenditure for 12 Euro area member states over the 1970-2013 period. We find that in the peripheral countries where sovereign bond yields decreased sharply in the years 1996-2007, fiscal stance ceased to respond to sovereign debt accumulation. This was due to lack of sufficient adjustment in government current expenditure and direct taxes. In contrast, in the core member states, which did not benefit from yields' convergence related to the Euro area establishment, responsiveness of fiscal stance to inherited sovereign debt increased during 1996-2007. This was achieved mainly through pronounced adjustments in government current expenditure. The findings are robust to various changes in modelling approach.