Optimal Debt Management with a Stability and Growth Pact
This paper examines how the public debt should be managed to minimize the risk that the budget deficit exceeds the 3% limit of the Stability and Growth Pact. This requires to choose debt instruments which provide flexibility to fiscal policy; which create room in the budget for the automatic stabilizers or counter cyclical fiscal policy to operate. The idea is that the maturity and the indexation of public debt can be used to hedge against inflation and output shocks to the budget, so as to stabilize the deficit to GDP ratio. The optimal debt composition would depend on the correlations between output, inflation and interest rates. For instance, if interest rates and output are negatively correlated, then a long maturity debt would insulate the government budget from interest rate shocks, thus avoiding higher than expected interest payments at times of cyclical downturns. The choice of indexation of public bonds to the inflation rate or to GDP can also be examined within this framework. For instance, inflation indexed debt could be a useful hedge since deflation worsens the budget as a consequence of several nominalistic features of the tax system and spending programs.
The idea of the paper follows from the optimal taxation literature on debt man agement stemming from Lucas and Stokey (1983), extended by Bohn (1988,1990) and Barro (1995) and reviewed in Missale (1997). The main insight of this literature, that debt instruments provide insurance against macroeconomic shocks to the budget, and thus allow to smooth taxes across time and states of nature, is applied here to a situation where the constraint imposed by the Stability and Growth Pact induces a greater attention to insuring against current unfavorable events as opposed to tax smoothing over the future ahead. Specifically, the Pact introduces deficit stabilization (or deficit smoothing) as a new objective of debt management. This is formalized by a simple three period model where the government trades off the cost of exceeding the 3% deficit limit against the costs of fiscal correction. The budget is affected by cyclical conditions, namely by output and inflation, while an increase in interest rates leads to higher debt servicing costs on the part of the debt which has a short maturity. The government chooses between short and long term conventional debt and on inflation indexed debt, before any shock realizes, while it decides the fiscal correction after observing output, inflation and the interest rate. However, the effect of fiscal policy remains uncertain since the budget is hit by a random shock.
The optimal debt composition stabilizes the deficit to GDP ratio and it depends on the correlations between interest rates, output and inflation (and on the elasticities of the deficit to inflation and output). For the period preceding the EMU the relevant conditional covariances can be estimated for each member state by simple regressions. These covariances allow to derive the debt composition that would be optimal for deficit stabilization if monetary policy were carried out at the national level; i.e. before the advent of EMU. The estimated relations with the implied debt compositions provide benchmarks for implications regarding the EMU. Since empirical analysis is unfeasible for this purpose, a simple multi country model is presented where the European Central Bank (ECB) reacts to the harmonized CPI index and output gaps of member states.
The model comprises a supply equation and an aggregate demand equation for each country, but one interest rate reaction function to average EMU inflation and output gap. In this way the relevant correlations can be related to local supply and demand shocks and the responses of the ECB to such shocks. The analysis explores how the correlations of the interest rate with local output and inflation may have changed because of the loss of monetary policy autonomy by the single countries. This allows to make inferences on how the composition of the debt, which is optimal for deficit stabilization, has changed with the advent of EMU and thus derive policy implications for an efficient management of the public debt.
The move from national monetary policy to EMU does modify the debt composition which is optimal for deficit stabilization depending on the preferences of the ECB, on the correlation of supply and demand shocks across EMU member states, on differences in the size of such shocks and in the transmission mechanism of monetary policy. A longer maturity structure of conventional debt is optimal if the ECB assigns less weight on output stabilization (relative to inflation stabilization) than the national monetary authorities and if EMU member states are hit by asymmetric shocks. Short term conventional debt should instead be issued by countries which experience a relatively higher output and inflation uncertainty and present a lower sensitivity of aggregate demand to interest rate changes. The optimal share of inflation indexed debt is largest in a strict inflation targeting regime; the lower the weight on output stabilization the more attractive is inflation indexation for deficit stabilization.
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