Cost of borrowing shocks and fiscal adjustment

•We analyse whether capital markets impose fiscal discipline.•Our model predicts fiscal tightening in response to rising borrowing costs.•Estimates of the fiscal response in EU countries (1970-2011) confirm this prediction.•But the estimated fiscal response is insufficient to avoid higher debt ratios.•The shape of the response depends on economic structure and institutions.

Do capital markets impose fiscal discipline? To answer this question, we estimate the fiscal response to a change in the interest rate paid by 14 European governments over four decades in a panel VAR, using sign restrictions to identify structural shocks. A jump in the cost of borrowing leads to an improvement in the primary balance although insufficient to prevent a rise in the debt-to-GDP ratio. Adjustment mainly takes place via rising revenues rather than falling primary expenditures. For EMU countries, the primary balance response was stronger after 1992, when the Maastricht Treaty was signed, suggesting an important interaction between market discipline and fiscal rules.