Signalling Debt Sustainability

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.