Due to a double externality, the fact that banks in euro-zone countries hold domestic government bonds prevents the use of an expansionary fiscal policy

One of the symptoms of the absence of capital mobility between euro-zone countries is the fact that the banks of euro-zone countries mostly hold domestic government bonds and not a diversified government bond portfolio. This creates a double externality: A deterioration in a euro-zone country’s public finance situation spreads to the country's banks, whose funding costs increase; The deterioration in the situation of the banks in a euro-zone country spreads to banks in the other countries (which are linked by interbank lending, via their foreign subsidiaries). The exis tence of this double externality leads to a very negative effect of an expansionary fiscal policy in a euro-zone country, even if its impact on the real economy is positive. The present case of Italy perfectly illustrates these mechanisms.