Government Debt Reduction in the Old EU Member States: Is This Time Different?

Abstract

The international financial and economic crisis that started in 2007 and was referred to as the Great Recession, and the subsequent sovereign debt crisis, led to a significant increase in the government debt ratio (the ratio of gross government debt to GDP) in the European Union. This was followed by a gradual and lasting consolidation in the old EU Member States (EU15), which had last been seen from the mid-1990s onwards and which ended precisely because of the economic crisis. In our study, we use a debt decomposition analysis to show the main similarities and differences between the debt reduction period in the second half of the 2010s and the one that ended with the outbreak of the previous Great Recession. In both periods, the government debt ratio declined to a nearly similar extent on an annual average in almost two-thirds of the EU15 group of countries. However, in addition to this similarity, there were significant differences in the structure of consolidation. In the period from the mid-1990s to the 2007–2009 crisis, disciplined fiscal policy, in particular, stimulated debt reduction through the primary balance, the effect of real GDP growth was offset by the impact of real interest rates and the other items did not play a significant role. By contrast, the effect of fiscal policy has been much smaller in the debt reduction experienced over the past nearly half a decade, whereas the lower level of interest rates and the other items have contributed substantially to the consolidation process. The favourable international interest rate environment has made fiscal policy complacent. If monetary policy support is terminated or weakening, the role of fiscal policy in reducing the government debt ratio will become more important again to the EU15 states.