Safe and Risky Sovereigns in the Euro Area Capital Market: Financial Drivers of Fiscal Policies in Germany and Italy

Abstract

This article extends the literature on the varieties of capitalism within the Economic and Monetary Union of Europe with an analysis of the financial drivers of fiscal policies in creditor and debtor countries from the euro crisis up to the coronavirus pandemic, with an application to Germany and Italy. Market perceptions of sovereign creditworthiness, as grounded in national political economies, cause a persistent segmentation of the euro area capital market between peer countries regarded as safe or risky. As a consequence, cross-border capital flows have an asymmetric effect on the public and private finances of creditor and debtor countries, adding to the asymmetric impact from their economic growth models. These financial asymmetries interact with public opinion and are in turn endogenous drivers of political choices for or against fiscal discipline and of political preferences for a stable domestic investor base of public debt. A common safe asset for the eurozone is necessary to mitigate the asymmetric systemic risks from volatile capital flows and establish a symmetric financial driver of steady output growth, fiscal soundness, and financial stability. This common mechanism for endogenous stabilisation would help to sustain euro area capital market integration and support the long-term viability of the euro.