Could the Stability and Growth Pact be Substituted by the Financial Markets?

In the discussions on the need for fiscal rules and their usefulness in a monetary union, researchers have not agreed if financial markets have a sufficiently disciplining effect on governments, which would mean that the fiscal rules are not necessary. This paper investigates whether the European Union’s main fiscal rule, the Stability and Growth Pact, could be substituted by financial markets, taking into account the effects of the latest financial and economic crisis. The findings presented in this paper suggest that there is certain interaction between financial markets and governments' decisions on fiscal policies and that this reaction has become stronger after the beginning of the crisis. However, the institutional setup and market conditions in the European Union are such that this interaction is biased and thus the paper concludes that the Union needs to have fiscal rules.