Debt and punishment: Market discipline in the Eurozone

This article challenges the conventional wisdom of weak market discipline in Economic and Monetary Union (EMU). In so doing, we empirically analyse the dynamics of market disci-pline for all 27 EU member states between 1992 and 2007. The existing literature tends to assert that markets discipline governments, without measuring whether the interest punish-ment markets impose actually have the purported effect on government policy. To better grasp the dynamics of market discipline it is essential to consider both sides. Market disci-pline is thus understood as a two-sided phenomenon. On the one hand, financial investors react to policy developments. On the other hand, policy-makers react to market signals. We find strong evidence that although the impact of fiscal policy developments on market pun-ishment slightly decreases with monetary integration, government responsiveness to market punishment increases. This runs counter to the conventional narrative of policy-makers bank-ing on bail-out from fellow EMU members.