Union Debt Management

Abstract

We study the role of government debt maturity in currency unions to identify whether debt

management can help governments hedge their budgets against spending shocks. We first use a

detailed dataset of debt portfolios of five Euro Area countries to run a battery of VARs, estimat-

ing the responses of holding period returns to fiscal shocks. We find that government portfolios,

which in our sample comprise mainly of nominal assets, have not been effective in absorbing

idiosyncratic fiscal risks, whereas they have been very effective in absorbing aggregate risks.

We then setup a formal model of optimal debt management with two countries, a benevolent

planner, distortionary taxes and agggregate and idiosyncratic shocks. The theoretical model

validates our empirical findings: nominal bonds are not optimal to insure against idiosyncratic

shocks. Our key finding is that governments should introduce in their portfolios also inflation

indexed long term debt since this allows them to take full advantage of fiscal hedging. Looking

at the data, we find a sharp rise in issuances of inflation index bonds in France and in Italy

since the beginning of the Euro. We show that bonds linked to French inflation were able to

absorb both aggregate and idiosyncratic fiscal risks.

Keywords: Debt Management, Fiscal policy, Government Debt, Maturity Structure, Tax Smoothing

JEL Classification: E43, E62, H63