Francesco Drudi

Default risk and optimal debt management

The role of movements in real rates in explaining the relationship between long- and short-term interest rates is explored within a model of optimal government debt management. The government’s incentives to resort in the future to inflation and ex post debt taxation in order to reduce the real value of its nominal liabilities have an impact on term premia and hence on the short‐long spread. In particular, default risk and, consequently, long-term interest rates increase with the size of outstanding debt and the level of real rates; in the presence of short maturities, indexed debt and anti-inflationary governments. Optimal maturity either lengthens or shortens with inflation risk, depending on the time profile of government expenditure, while it always lengthens with default risk. However, when the stock of debt is extremely large the compensation for default risk required by the agents on long-term bonds may be so high that only shortterm debt can be issued. The implications of this model are consistent with the observed behavior of risk premia in some highly indebted countries. ” 2000 Elsevier Science B.V. All rights reserved. JEL classification: H63; H43

Signaling fiscal regime sustainability

This paper proposes a signaling model of fiscal stabilizations that offers a new perspective on why governments deviate from optimal tax smoothing. In our model, dependable -but not fully credible- governments have an incentive to tighten the fiscal regime when the signaling effect on credit ratings is larger (that is, when a sufficiently large stock debt has been accumulated). At this point, they may deviate from tax smoothing in order to avoid being mimicked by weak governments. We show that a testable prediction of our model is that primary balances and debt stocks are complementary inputs in the credit rating function and we sucessfully test it on Irish , Belgian, and Danish data from the late 1970s to the early 1990s.

Wage Indexation, Employment and Inflation

Price versus productivity-indexing is considered in a model of monetary policy with incomplete information and wage bargaining. In a perfectly price-indexed economy, the inflationary bias due to lack of credibility is eliminated. However, productivity-indexing is more appropriate to dampen macroeconomic fluctuations that are caused by real disturbances. We show that productivity-indexing alone guarantees both price and employment stability, provided the governments reputation is good enough and the unions bargaining power is not too strong. This reduces the degree of price indexation as the union becomes weaker and the governments reputation improves. Productivity-indexing is desirable with volatile productivity processes and weak unions. Copyright 2000 by The editors of the Scandinavian Journal of Economics.

The European Central Bank and Implications of the Sovereign Debt Crisis

Since the onset of financial turmoil in August 2007, the main central banks worldwide have implemented extraordinary standard and non-standard monetary measures. Accommodative fiscal measures were also implemented on a large scale. These measures have questioned the sustainability of public finances in various euro area countries, which led to the current sovereign debt crisis. The current sovereign debt crisis is even more challenging as it affects the value of banks’ assets and their collateral, and therefore increases risks to the economic outlook. Against this background, this chapter describes the actions of the European Central Bank (and their rationale) while discussing the necessary separation between the responsibilities of central banks and government. Finally, some lessons about the possible adjustment of the roles of central banks and fiscal authorities in the euro area are also addressed.