Yield Spreads and Optimal Public Debt Management under the Single Currency
LARS TYGE NIELSEN
This chapter examines issues of optimal debt management and the determinants of default risk on government bonds issued by member countries of the future European Monetary Union.
In the context of a theoretical model of public finance, optimal default, and optimal debt management, we discuss how inflation and taxation, default probabilities, and the optimal currency composition of the public debt are affected by EMU.
In particular, we consider the argument that the loss of monetary independence by member countries of the EMU will necessarily increase their default risk. According to this argument, when nations have their own currencies, they can avoid default essentially by printing the money they need to pay back their debt. EMU member countries will not be able to do this. We evaluate and reject the argument within a model of optimal default. The fact that a country is able to avoid default by printing money does not imply that it is optimal for it to do so.
The analysis highlights some problems of public debt management under EMU. They have to do with the incentives for member countries to issue non-euro- denominated debt rather than nominal euro-denominated debt. Doing so will lower the steady-state inflation rate in the EMU, because such debt functions as a commitment device. This benefit is low for each country and is shared by all. Other benefits and costs of issuing such debt are borne by the individual issuing country, however. This implies that there is a need for a mechanism for coordinating the debt management policies of the member countries.
Different European countries pay different interest rates on their public debts denominated in domestic currencies. For example, the yields on French government bonds,