The Recent Dynamics of Public Debt in the European Union: A Matter of Fundamentals or the Result of a Failed Monetary Experiment?

The idea that the present euro-zone sovereign debt crisis was caused by structural weaknesses degenerating into fundamental macroeconomic imbalances in the peripheral countries prevails among economists and politicians alike. We use quarterly data from 2000 to 2011 from the 27 European Union countries to uncover the main factors explaining the debt to GDP ratio dynamics. We also examine three possible determinants of that crisis: i) weak fundamentals; ii) inappropriate fiscal policies adopted by the governments at the beginning of the crisis; iii) unfavorable debt dynamics due to a sharp GDP contraction, coupled with substantial increases in the interest rates on government bonds. Except for the current account to GDP ratio, we fail to find any significant relationship between the fundamentals prior to the financial crisis, and the ensuing dynamics on both public debt to GDP, and interest rates on government bonds. We also reject any association between the initial fiscal policy response to the crisis and the following debt crisis. We conclude that the immediate explanation for the adverse debt dynamics unraveling after 2007 was the sharp GDP contraction which, in turn, induced unfavorable expectations by creditors causing higher interest rates charged on peripheral countries’ debt and a liquidity crisis.