Debt redemption fund and fiscal incentives

Abstract

We investigate a stochastic optimal control model for the management of public debt when part of the national debt is transferred to a Redemption Fund, which is allowed to finance itself in the market at a low interest rate, in exchange of the commitment to a fiscal consolidation plan by the national government both for the national debt and the Fund. The Fund is an interesting option for countries with high debt–GDP ratio and weak fundamentals. However, we show that it is not a free lunch in a sense that a country with a higher public debt should transfer a larger amount of resources to cut down the Fund. We calibrate the model to the experience of Euro zone countries with a high debt, showing that it is possible to design the mechanism allowing to pay back the Redemption Fund and stabilizing both the national debt and the fiscal surplus with a reduction of the fiscal effort.