Working Paper: CEPR ID: DP787
Authors: Francesco Drudi; Alessandro Prati
Abstract: This paper studies the optimal debt repayment policy of a government facing a credibility problem: the public is uncertain about whether the outstanding public debt will be repaid in full or in part and requires a risk premium to roll it over. The model determines when it is optimal for the government in power to signal the sustainability (full repayment) or the non-sustainability (partial repayment) of the debt regime. The timing depends on the initial reputation of the government, the costs of taxing labour income, and the costs of defaulting on government debt, which are endogenized as a function of the redistributive preferences of the government. In the presence of a deficit net of interest payments, the uncertainty may or may not be resolved, but it will always be resolved when a lasting surplus net of interest payments is achieved. The model allows an evaluation of the deficit and the debt prerequisites for EMU set by the Maastricht Treaty: they are sufficient to exclude potentially defaulting governments, but may be excessively strict for this purpose.
Keywords: stabilization; sustainability; default; EMU; Maastricht
JEL Codes: E43; E61; E63
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| government's type (Type N or Type S) (H70) | decision to levy a surprise tax (H26) |
| public's uncertainty about government’s redistributive preferences (D72) | risk premium on government bonds (G12) |
| government’s reputation (H12) | risk premium required by investors (G19) |
| lasting surplus net of interest payments (G12) | resolving uncertainty about government’s type (D89) |
| surplus (H62) | risk premium (G19) |
| surplus (H62) | government's debt repayment strategy (H63) |
| government's redistributive goals (H10) | endogenous nature of default costs (G33) |