Government debt deleveraging in the EMU

Abstract

We build a Two-Country Open-Economy New-Keynesian DSGE model of a Currency Union, with a debt-elastic government bond spread and incomplete international financial markets, to study the e ects of government debt deleveraging. We evaluate the stabilization properties and welfare implications of di erent deleveraging schemes and instruments, under a range of alternative shocks and under alternative scenarios for fiscal policy coordination, bringing to policy conclusions for the proper government debt management in a Currency Union. We find that: a) coordinating on the net exports gap and consolidating budget constraints across countries when deleveraging provides more stabilization, b) taxes are a better instrument for deleveraging compared to government consumption or transfers, c) by backloading the deleveraging process one can achieve greater stabilization over time, d) deleveraging government debt increases the volatility and persistence of the economy after other shocks. Our policy prescriptions for the Eurozone are to reduce government debt more gradually over time and less during recessions, to do so using distortionary taxes, while concentrating on reducing international demand imbalances and maybe creating some form of fiscal union.