The Deficit–Interest Rate Connection: an empirical assessment of the EU

Abstract

The progressive deterioration of public finances in most developed countries, during the last two decades, prompted an extensive discussion on the effects of government deficits on the interest rate and, consequently, on employment and economic growth. The empirical literature, largely focused on the US, is far from conclusive. This paper examines this relationship in six core EU countries using non-causality tests, including the recently proposed LA-VAR test. The evidence suggests that, contrary to the conventional economic theory, no causal effect from the deficits to the interest rate can in general be found. On the contrary, the econometric tests highlight the preponderant negative consequences of high interest rates on the government total deficit.