Revisiting the impact of financial shocks on the fiscal position of euro area countries

Abstract

This paper investigates the impact of financial distress on fiscal dynamics in the euro area. Within our analysis, special attention is given to the period during the Great Recession. This period can be characterised by significant stock market declines, increased systemic risks, and bank failures, which compelled governments to take decisive actions to stabilise the economy and prevent the collapse of the financial sector. Unlike previous crises, these actions went beyond relying on automatic stabilisers, necessitating significant discretionary and interventionist government measures. Using a sample of 20 euro area countries from 1995Q1 to 2019Q4, we employ a structural panel VAR approach to capture cross-country heterogeneity and distinct effects of common and idiosyncratic shocks. To the best of our knowledge, this is the first study to analyse the highly complex transmission of financial shocks using such a methodology. The results demonstrate diverse responses in government debt-to-GDP ratios and bond yields across countries, with significant contributions from idiosyncratic shocks. Factors such as country size, trade openness, GDP per capita, financial sector size, and debt-to-GDP levels in the pre-crisis era influence the heterogeneity of these responses. Our results indicate that structural reforms and strict fiscal discipline during economic expansions are essential for rapid recovery after financial shocks. Sustainable fiscal policy and mutual debt issuance can reduce cross-country disparities and idiosyncratic effects, stabilising fiscal dynamics in the euro area.