In the current high-inflation regime, the use of fiscal space must: (1) be rule-based; and (2) preserve the possibility of a cooperative game between monetary and budgetary policies. This use of fiscal space should also help manage investors’ expectations, in order to minimise the risk of ‘sunspot equilibria’, where investors’ beliefs cause prices to diverge from fundamentals.
During the first two decades of the euro, investors’ mindsets regarding euro sovereign debt rested on at least three series of beliefs. The first (at least at the beginning of the period) was the convergence, over time, of the public debt and deficit situations of member countries. Second, investors also trusted that EU institutions would provide an emergency safety net in extreme situations, as was the case when Greece was on the brink of exiting the Union.
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