No. 209 - Debt Stabilization under Fiscal Regime Uncertainty

Should debt stabilization be rapid or gradual? A sudden fiscal tightening is preferable, when the benefits of lower interest payments outweigh the costs of an imperfect tax smoothing. We characterize the optimal debt stabilization plan in a theoretical framework, where the interest rates on government debt depend endogenously on the government's ability to signal the sustainability of the fiscal regime. The main finding is that a lasting surplus net of interest payments is a sufficient condition for resolving the uncertainty and eliminating the risk premia. The model also allows to discuss whether the fiscal pre-requisites of the Maastricht Treaty would exclude from the EMU countries with non-sustainable fiscal regimes.