The Effect of Government Debt on Financial Stability : Analysis on Euro Area in 2000s

Abstract

Eurozone crisis aroused attention to not only emerging economies but also advanced economies that managing government debt in moderate level is crucial. Before the crisis, advanced economies regarded their government debt as a policy tool due to its credibility and stability. After the global financial crisis, however, it can be said that no debt is risk-free. It is obvious that in crisis time, severely cumulated high level of government debt will be definitely detrimental to the financial market and the whole economy. In normal days, however, the level of government debt seems no worries, especially in advanced economies, treated as very safe investment routes. Therefore, this paper raised issues that how government debt management will affect financial stability in boom times. Before conducting the empirical study, this paper touched upon literatures that dealt with definition of financial stability and how to measure it. Also, this paper reviewed literatures that figured out how debt and financial stability are related. Then empirical research has been conducted regarding the effect of the government debt level on financial stability in non-crisis time, from 2000 to 2009, with 15 sample countries in Europe. The panel data analysis has been conducted to see cross-country and cross-sectional effect among sample countries and sample periods. The regression results supported hypothesis that higher level of government debt affects financial stability in negative way even though in boom times.