17.1 Introduction

In recent years public debt/GDP ratios have increased considerably in many advanced countries. This is the consequence of three concomitant causes: (i) the Great Recession following the 2007–2009 global financial crisis, (ii) anti-cyclical fiscal measures adopted in response to the crisis, (iii) government transfers to bail out troubled financial institutions. Expansionary monetary policy, operating through conventional and unconventional channels, moderated the impact of fiscal shocks on government refinancing costs. In late 2010, the emergence of unexpectedly large fiscal imbalances in a group of euro area countries shook the confidence of government bond holders. Delays in the response by European authorities aggravated the problem. Interest spreads vis à vis Germany increased considerably for many euro area countries. Greece, Portugal and Ireland had to seek international support and are currently grappling with a deep recession which also affects Spain and to a lesser extent Italy.

In view of these developments, the analysis of the linkages among fiscal shocks, public debt and refinancing rates is at the centre of the current debate among economists and policymakers. We contribute to this debate by investigating these linkages for the USA, Germany and Italy, three among the largest issuers of public debt securities in the world.

A large empirical literature is devoted to the study of the relationship between public debt/deficit and interest rates.